Stream Number: 7 Title: Leadership and Governance Competitive Session. Rethinking the Research on Board of Directors: A Behavioural Perspective

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1 Page 1 of 20 ANZAM 2013 Stream Number: 7 Title: Leadership and Governance Competitive Session Rethinking the Research on Board of Directors: A Behavioural Perspective ABSTRACT Board of directors has been the centre of the academic debate for corporate governance reform. The purpose of this paper is to challenge the critics of corporate governance from conventional economic perspectives. Specifically, drawing on upper echelon theory and board process literature, the study develop an integrated theoretical framework for the research on board of directors from a behavioural perspective, and reveals that the impact of directors demographic characteristics on firm performance by the board process. Thus the research provides an opportunity for extending the understanding of how diversity on board of director may impact the board design and efficiency. Keywords: board of directors, upper echelon theory, firm performance 1

2 ANZAM 2013 Page 2 of INTRODUCTION Corporate governance research concentrated on solving conflicts of interests between a company s management, its board, its shareholders and other stakeholder. Previous studies in corporate governance draws attentions to the agency theoretical perspective and have been keen to investigate how the boards can protect shareholders interest from opportunistic and self-serving managers through monitoring activities. (Hammer and Champy 1993; Hart 1995; Williamson 1996). However, a large amount of empirical tests which have yielded conflicting and ambiguous results encourage scholars to focus on the new directions in research on understanding conditions for effective board. The objective of this review paper is to serve as a step towards creating clarity on the perspective and scope of board research from a behavioural perspective,and develops a comprehensive theoretical framework of boards research to enhance the understanding of the relationship between board of directors and firm performance. Thus, a growing number of studies conduct the research on the directors demographic characteristics and board process, and adopt a behavioural perspective to theorize boards research (Hambrick, Werder et al. 2008). Specifically, building on the prediction of upper echelon theory, we first, integrate directors demographic characteristics into the previous theoretical framework of boards research to explore what determine directors makeup and what determine directors actions in the board process. Specifically, this study is consistent with the value in diversity proposition which addresses that heterogeneous groups should provide a broader range of knowledge, information and perspectives than homogeneous groups, and indicates that the main feature characterizing the behaviour of board is the directors limited ability to effectively collect and analyze information. 2

3 Page 3 of 20 ANZAM 2013 Second, this paper attempt to reveal the board process which link directors demographic characteristics to firm performance. Following the logic of the input- process-outcome sequence (Van de Ven 1992), this study introduce board processes which address how directors demographic characteristics affect firm performance, and tends to illustrate what are the mechanisms by which directors do their jobs? Thus, this paper suggest a new ontology of organizational routines that acknowledge the impact of directors demographic characteristics on board behaviour in board process and then the relationship between board of directors and firm performance (Hambrick and Mason 1984; Carpenter, Geletkanycz et al. 2004). This study contributes to research on board of directors in several ways. First, this study will explore how the boards act as groups to be responsible for the decision control and decision management in order to open the black box of board process and dynamics (Leblanc 2004). Second, this paper will explore how the directors demographic characteristics have a impact on firm performance; In sum, we will develop a theory of board behaviour in a way to optimize the conceptual framework of corporate governance from a comprehensive perspective. The rest of this paper will be organized into three sections. the section one will discuss the theoretical concepts from the Upper echelon theory which provide the basic features for a behavioural theory on boards; specifically this study will integrate the directors demographic characteristics into the conventional theory of corporate governance to touch on the question what is the impact of directors demographic characteristics in the boardroom? the second section will adopt a dynamic approach to address how the directors perform in the board process based on the directors demographic diversity. The paper ends in section three with a concluding summary of a dynamic approach to model the 3

4 ANZAM 2013 Page 4 of 20 behavioural framework of board of directors. 2. METHODOLOGY A systematic review is adopted to develop a reliable knowledge base of boards of directors. Our analysis process includes categorizing and classifying the existing literatures in the areas of board process and directors demographic characteristics using papers published across more than two decades. This process produced over 50 journal articles, discussion papers that are available for analysis. In this review, we focus on those papers that develop theoretical argument or report empirical findings on the relationship between directors demographic characteristics and firm performance through board process This study identifies the key areas of director s demographic characteristics that will have a significant impact on firm outcome. Meanwhile, board process is used conceptualizations of the impact of directors practices on organizational performance in empirical studies. In summary, board process indicates that director s demographic characteristics can improve the effectiveness of board of directors via increased director s capacities which can be translated into performance outcomes. Specifically, directors demographic characteristics works through increasing employees ability through cognitive conflicts; enhancing employees motivation and commitment through norm efforts; and providing employees with the opportunity to engage in knowledge-sharing and problem-solving activities via the use of knowledge and skills. Thus, this review investigates each of these three core components in turn. 4

5 Page 5 of 20 ANZAM UPPER ECHELON THEORY USED IN THE BOARD RESEARCH A behavioural theoretical framework on board of directors will foremost start from the descriptions of directors demographic characteristics in terms of Upper echelon theory. Upper echelon theory, originally developed by Hambrick and Mason in 1984, offers another explanation of how a firm s strategy emerges from directors interactions in a complex environment. Thus the theory had serve as a fruitful conceptual foundation for the behavioural research of boards, and adopt a dynamic approach to investigate the impact of directors demographic characteristics on strategic choice and thus firm performance. In the next section, this review will introduce these concepts before discussing their implications for theory development in the research of boards. Definition of Upper Echelon Theory Upper echelon theory has been emphasized in the current studies of boards. Three important tenets provide the foundation for upper echelon theory (Carpenter, Geletkanycz et al. 2004): 1. Strategic choices in the firm are reflections of the values and cognitive biases of top executives; 2. Values and cognitive biases are a function of the top managers characteristics including age, functional track and tenure; and, as a result; 3. Significant outcomes will be related to these characteristics of top managers. Specifically, the theory lie in the bounded rationality which refers to the notion that decision makers in organization are limited in their ability to process information and solve complex problems and argues that managerial strategic choices are affected by the natural limitation of organizational actors as human beings(cyert and March 1963). Thus, organizational actors cannot maximize the utility, because organizational actors. inject a great deal of their experience, personalities and value into their behaviour 5

6 ANZAM 2013 Page 6 of 20 to study the world through the lenses of their personal histories, background, knowledge, values and other personal biases, and can only take into account of an imperfect mapping of decision-making environment in terms of constraints on their decision-making capacities, their selective preference for information (Hambrick and Mason 1984). Furthermore, upper echelon theory focuses on the board s demography as part of supra-top management team with involvement in the decision making (Hambrick and Mason 1984). Thus, the directors demographic characteristics can reflect directors cognitive biases and value, and should significantly affect the information processing and strategic choice and ultimately firm performance (Carpenter, Geletkanycz et al. 2004). The Impact of Directors Demographic Characteristics Upper echelon theory offers us a new way to enrich the theoretical framework of boards research from a broad scope that encompasses the director s demographic characteristics. because, when directors often faces a large number of internal and external forces in the complex environment, directors demographic characteristics will affect directors behaviour and then the relationship between board of directors and firm performance. (Huse 2007; Marnet 2008) In empirical endeavours, Pfeffer (1972) found that board members with different constituencies can provide critical resource to improve the effectiveness of decision making in the firm. Similarly, Kosnik (1990) indicated that heterogeneity of directors background can promote the airing of different perspectives for the evaluation of managers proposals, and then produce different solutions to the problems and multiple decision criteria for strategic decisions. However, Kosnik (1990) also posited 6

7 Page 7 of 20 ANZAM 2013 that demographic heterogeneity in the board of directors will impede the group thinking process of the board and its efforts to make strategic decisions because the greater heterogeneity of the directors led to greater potential conflicts of interest based on directors different definitions of firm objectives and policies (Powell 1991). We next review the main concepts and specific studies related to directors demographic characteristics. Functional heterogeneity The directors functional background has substantial effects on boards cognitive decision making process because directors often define the problems based on the activities and goals of their own areas which are affected by their own job orientation that developed from previous experience in some function (Hambrick and Mason 1984). For example, as scholars (Eisenhardt, Kahwajy et al. 1998) explain, directors who have grown up in sales and marketing see opportunities and issues from vantage points that differ from those who have engineering experience. Some scholars suggest that functional background diversity has a positive impact on strategic decision in the decision making and then influence firm performance, specifically, heterogeneity in directors function is more valuable for diversity of knowledge and skills, and encourage directors consider their strategic decision from a company-wide perspective (Finkelstein, Hambrick et al. 2008). For instance, Wiersema and Bantel (1993) emphasized that functional heterogeneity can enhance the decision quality of directors through increasing the variety and number of decision alternative in strategic decision making. In addition, Drach and Somech (2001) posited that functional heterogeneity will also facilitate boards innovation and creativity in a complex environment. Similarly, Milliken and Martins (1996) also found that a heterogeneous functional board will be better linked into external 7

8 ANZAM 2013 Page 8 of 20 networks to strengthen efficient exchange of strategic information in decision making. However, other scholars argued that directors functional heterogeneity which is associated with differences of opinion and perspectives will negatively influence the effect of board interaction process and ultimately influence the effectiveness of their communication and decreased group integration (Hambrick and Mason 1984). For example, Pelled, Eisenhardt and Xin (1999) found that heterogeneous functional background often increases the task conflict which leads to incongruent task perceptions, because heterogeneous functional directors held a multiple belief structure about a variety of information and then defined the problem in terms of their own activities and goals. In addition, some scholars (Hambrick, Cho et al. 1996) also found that function heterogeneity is negatively related to the firm s response generation speed and executive speed, because the design, negotiation and elaboration of high-magnitude responses from heterogeneous team took much more time than from homogeneous team. Tenure heterogeneity In addition to functional background, tenure heterogeneity also has been indentified as one of the most important demographic characteristics affecting the decision making process in management scholarship. Some scholars demonstrated that heterogeneous tenure has a positive impact on interaction quality in the boardroom. For example, Katz (1982) indicated that boards with heterogeneous tenure can create more different information collection, understanding and interpretation to generate different solution generation which can promote organization and strategy change (Dutton and Duncan 1987). Similarly,Wiersema and Bantel (1992) also found that the boards with heterogeneous tenure are more open to change to enhance the effectiveness of decision making 8

9 Page 9 of 20 ANZAM 2013 because they will rely on a broader set of information and perspectives while making strategy. Conversely, other scholars (Allen and Cohen 1969; Zenger and Lawrence 1989) found that heterogeneous tenure negatively impact the interaction effect on the board, because heterogeneous tenure will generate different interpretation of events to causes the conflict of communication in the boardroom. Therefore, they demonstrated that boards with homogenous tenure will facilitates the communication among the members of boards, because they have a single frame of reference, which seals them off from portions of the environment and have similar outlooks (Wagner, Pfeffer et al. 1984; Campion, Medsker et al. 1993). 4. MAJOR RESEARCH STREAMS IN STUDIES OF THE IMPACT OF BOARD PROCESS A number of studies have focus on the impacts of directors demographic characteristics on the monitoring and controlling role of board, however, what has not been well established is what directors do in the interaction process and how does the interaction among the directors influence decision control and decision management? In particular, we should know what are the optimal board conditions and practices for task fulfilment, and how should board be constituted to meet the optimal conditions? (Finkelstein and Mooney 2003; Pye and Pettigrew 2005) Thus, some scholars have further explored how boards act as groups to be responsible for the decision control in order to open the black box of board process and dynamics (Leblanc 2004),and demonstrated three critical processes, which include cognitive conflict, efforts norms and use of knowledge and skill, to recognizing board task performance (Forbes and Milliken 1999; Finkelstein and Mooney 2003; Leblanc and Schwartz 2007). Furthermore, this review will draw attention to the 9

10 ANZAM 2013 Page 10 of 20 differences in cognitive conflicts, effort norms and use of knowledge and skills in board process in an attempt to capture the decision-making behaviour and the nature of the relationships between board of directors and firm performance (Finkelstein and Hambrick 1996; Stiles and Taylor 2001). Cognitive conflict Cognitive conflict refers to differences in judgments about a task or disagreement about content of a task among the directors of companies, and will affect the managerial role of directors in the strategic decision control and the quality of strategic decisions (Eisenhardt, Kahwajy et al. 1997; Forbes and Milliken 1999). Directors demographic diversity will lead to different levels of cognitive conflict in the boardroom and have important effects on the quality of decision control, because directors with heterogeneous demographic characteristics always express varying opinions about solutions to problems when they face complex issues and decisions. (Nemeth and Staw 1989; Reality 2006). Effort norms Effort norms refer to a group s shared beliefs regarding the level of effort which each individual is expected to put toward a task (Wageman, 1995). Specifically, the effort is the intensity of an individual s task performance behaviour; the norm may have a strong impact on the member s behaviour. therefore, a strong effort norm can promote the directors to devote a large amount of time and energy to evaluate the strategic decision alternatives and monitor top managers (Forbes and Milliken 1999). Use of knowledge and skills Use of knowledge and skills refers to the board s ability to apply the knowledge and skills to its tasks 10

11 Page 11 of 20 ANZAM 2013 (Amason 1996; Amason and Sapienza 1997). Therefore, directors with different backgrounds can bring different knowledge and skills to influence quality of decision making, which will affect the effectiveness of decision control in the firms and ultimately firm performance. For example, some scholars (e.g., Cohen & Frazzini, 2008) suggest that a firm should increase the number of independent directors on the boards because the independent directors can bring the important information about management practices and business policies in order to improve capability of problem-solving and facilitate the group discussion. In addition, other scholars also emphasized that directors demographic diversity provide a large amount of expertise and knowledge in terms of their different backgrounds which contribute to the quality of the strategic discussion on the board (Harris & Raviv, 2008). To summarize above discussion, heterogeneous board will trigger divergence in the cognition, efforts norms and the use of skills and knowledge in board processes and ultimately will influence the relationship between board of directors and firm performance (Baysinger and Hoskisson 1990; Carpenter and Westphal 2001). because, when individuals are grouped and arranged in a particular way and in a specific framework, they behave differently from a group structured in a different way (Becker and Baloff 1969). As a result, this study extends both the upper echelon theory and the board process literature to establish an integrated paradigm for contributing to the knowledge of board of directors. 5. DISCUSSION AND FUTURE DIRECTIONS There are been challenge to investigate the actual behaviour of boards to extends the understanding of boards of directors and corporate governance. The purpose of this study were to open up the black box of board to serve as a measure towards crafting clarity on the scope of board of directors from behavioural perspective. Specifically, we emphasize in our systematic review not only the impact of 11

12 ANZAM 2013 Page 12 of 20 directors demographic characteristics on the research of corporate governance, but also the mechanisms of board process which explain how boards can perform their functions to strengthen the effectiveness of decision making? What are the mechanics by which the boards do their jobs (Adams, Hermalin et al. 2010)? To sum up, the review highlights the relationship between directors demographic characteristics and firm performance through the board process. This study has implications for the current debate about the board research. This review suggests that scholars and policy makers should indentify behavioural issues that are integral to improve the effectiveness of boards. Specifically, this study suggest that the board research should involve not only board composition, structure, but also duties and power that support decision that are informed by high-quality collective insight and personal accountability (McNulty, Florackis et al. 2013). Another concern is that this study also has practical implications for managers. Specifically, scholars and policy maker should look beyond the board structure towards board behaviour to further explore whether the interaction of directors can generate insights for the board practice based on an integrating theoretical framework shown in Figure 1,. Briefly, this study can create a measure to detect the behaviour of the board of directors and provide us with a new perspective for enhancing the knowledge and practice of corporate governance. 12

13 Page 13 of 20 ANZAM 2013 Input process outcome Directors Demographic Characteristics -Age -Tenure -Function Board Process -cognitive conflicts -effort norms -use of skills and knowledge Outcomes & Impacts of Performance Figure.1 Research Framework 13

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20 ANZAM 2013 Page 20 of 20 Stream Number: 7 Title: Leadership and Governance Competitive Session Rethinking the Research on Board of Directors: A Behavioural Perspective Dr. Liang Guo School of Economics and Management Zhejiang University of Science and Technology Hangzhou China Liang @126.com Dr. Weiyan Lu School of Economics and Trade Guangxi University of Economics and Finance Frankguo2004@126.com