Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies
1. Introduction
Corporate Governance and Corporate Performance are interrelated because corporate governance has huge impact on the performance in an organization. On the other hand, corporate performances should be associated with the rules and regulation of the corporate governance which is needed to be strictly followed. This study will cover the Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies.
2.Literature Review (Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies)
Many researchers have addressed the topic of corporate governance and how it impacts performance in an organization. For every company, there are different forms and levels of performance including financial, internal efficiency in various organizational processes. There are several cases of corporate failure that have seen big organizations fall. Given that leaders in an organization are responsible for making decisions about all the processes in the organization, their role is ultimately important in increasing and sustaining performance in the organization.
2.1 Corporate Governance Introduction
Due the separation of ownership and management functions and the existence of information asymmetries lead to the possibility of a principal-agent conflict because the manager’s own interests may lead to the misuse of company assets, for example by pursuing risky or unrealistic projects, which may cause losses to the shareholders’ interests (Jensen and Meckling, 1976). To solve agency conflicts and limit agency costs, various internal and external mechanisms have been suggested through what is known as corporate governance. The governance mechanisms include, among others, board composition, board size, board diversity, chief executive status, managerial ownership and audit committee, Gregory and Simms (1999) states that effective corporate governance is important as it promotes the efficient use of resources both within the firm and the larger economy, as well as assisting firms and economies in attracting lower‐cost investment capital via the improved confidence of investors and creditors, both domestically and internationally. They also suggest that it helps in increasing the responsiveness of firms to societal needs and expectations and in improving the long‐term performance of firms.
2.2 Corporate governance theories
Corporate governance theory is an important part of corporate governance. Many specific measures are based on corresponding theories. For this part, some crucial theories will be introduced to help understand corporate governance mechanisms.
2.2.1 Agency theory
Fooladi and Chaleshtori (2011) proposed that the importance of corporate governance to reduce the conflicts between principal and agents, corporate governance as one mechanism needs to make sure the consistency of shareholders and managers, and the definition is based on agency Theory. Jensen and Meckling (1976) explained that an agency relationship can be understood as “a contract under which the principal(s) engage the agent to perform some service on their behalf”. The root of this problem may lie in the different interests of the principal and the agent, which violates the expectation that the agent represents the interests of the shareholders rather than the agents themselves. The agency cost is the cost associated with the difference between the agent’s and the client’s intention. For example, shareholders may want to increase earnings per share by focusing on cutting costs, while managers are more inclined to spend money to increase their benefits. These differences in opinion may result in a large amount of additional costs or loss of value. Jensen and Meckling (1976) believe that agency costs are unavoidable because the agency costs are entirely borne by the owner. They also believe that owners are motivated to minimize these costs. The agency theory mainly focuses on how to construct the rational contractual relationship between the principal and the agent, and provides the agent with appropriate incentives to make the selection in order to maximize the interests of the shareholders and minimize the agency cost. in the meantime, they claimed that the decentralization of decision-making authority and the divided ownership in the modern corporation can reduce the firms’ efficiency and terms increased costs.
The most representative agency problem is Principle-Agent problem which was defined by Ross(1973), this problem is due to inconsistent of profit between shareholders and managements and lack of appropriate supervision. Furthermore, if the company not running by owners, managers may misuse the corporate property (Berle and Means,1932). A particularly famous example is Enron, many analysts believe that Enron’s board of directors did not perform its supervisory duties well in the company, directly leading the company to venture into illegal activities. The lack of consistency between shareholders and directors may be the ultimate reason for the end of Enron. To solve this problem, Jensen and Meckling (1976) tend to focus on the ownership of managers, which means that companies increase the relationship between shareholders and managers by providing company stocks. For example, giving managers shares can increase the number of the consistency of interests between agents can reduce the conflicts between agents and shareholders. In addition, agency theory also has an important influence on the composition of the board of directors. Rosenstein and Yuet (1990) claim that boards with a reasonable structure help shareholder supervise managers’ decisions by providing useful advice. The correct supervision of the board of directors also shows the positive impact on the resolution of principal-agent problem.
2.2.2 Resource dependency theory
In the study of the relationship between organizations and the environment, organizational theorists proposed many different theoretical explanations, and the most popular one is the resource dependency theory. The assumption of resource dependency theory is that no organization can survive from the external environment. the environment provides the organization with critical resources to help it operate, as well as the company may look for more resources from the environment to protect its own interest. The reason why independent organizations rely on each other is that resources are the foundation of the company’s power, and various resources are likely to make the company more unique. There is a direct relationship between power and resource dependence. For example, the power of company K to company J is equal to company J’s dependence on company K resources. Pfeffer and Salancik(1978) proposed that The ecology of the organization is the premise and background for understanding organizational behavior. Resource dependence theory now is widely used in the company’s strategy formulation. The main purpose of this theory is to state how companies can reduce environmental uncertainty and interdependence.
Pfeffer (1987) proposed five basic points for resource dependency perspectives, one, the basic unit to understand the relations between enterprises and society is the organization; Two, these organizations are not self-governing, but are subject to the constraints of networks that are interdependent with other organizations; Three, the organizations are interdependent, furthermore, the mutual organizations The uncertainty resulting from the reliance on actions leads to uncertainty about the need for sustained success in fierce commercial competition; Four, organizations take actions to manage external dependencies, although such actions will inevitably not be fully successful and generate new patterns of dependence and interdependence; Five, these dependence forms generate power among and within organizations, and this power has a certain influence on organizational behavior. This view and the need for organizations to respond to the external environment occupy a very important position in organizational theory and strategic management.
RDT has important influence for corporate governance mechanism, the most significant one is the composition of the board of directors, Kaplan and Harrison (1993) claimed that the theory emphasis on the function of the board of directors in allocating the resources. The board of directors provide resources to help management make decision. The capital of the board of directors can be understood in a narrow sense as the resources that can be provided to the company. In the one, the resources of the board of directors can be understood as human capital. This includes the resources of the board members, such as their own professional knowledge and work experience. Another one is relationship capital, which means that when other external board members they have a good relationship with each other, they are likely to provide resources to reduce the conflict between shareholders and the board of directors. The board has its own advantages that can help the company understand the company’s external environment and provide it with more information, thereby helping the company to reduce uncertainty and dependence. Therefore, when the company’s external environment changes drastically, changes in the composition of the board of directors can change according to the external environment. This involves recruiting board members and recruiting professionals in different fields according to the needs of the company, so that board diversity can be achieved. Providing organizations with sufficient resources can help companies survive and grow (Richard, 2000). In the later part of the subject, it will show numbers of theoretical and empirical evidence that the diversity of the board of directors could have a positive impact on corporate performance.
2.3 Relationship between corporate governance mechanisms and corporate performance
(Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies)
As for the variable design, this paper will focus on four corporate governance mechanisms (board composition, board size, board diversity and managerial ownership) and three firm performance measures, which include ROA, ROE and EPS, and use Tobin-Q to reflect changes and growth in company value during this period. Besides, the total assets of listed companies will be used to represent the size of the firm.
2.3.1Board composition:
To address agency problems, internal, as well as external, corporate governance mechanisms have been put into place, like the board of directors, proxy fights, large shareholders, hostile takeovers and financial structure (Hart, 1995). The most important internal corporate governance mechanism is the board of directors (Subramanian and Swaminathan, 2008). The role of the board is not simply to fulfill its legal requirements. The board of directors of a company provides strategic guidance and leadership; objective judgment, independent of management, to the company; and exercises control over the company, while at all times remaining accountable to the shareholders. An effective corporate governance system is one which allows the board to perform these dual functions efficiently. However, shareholders do not escape agency problems by leaving them to the board of directors, since the directors are themselves agents, whose interests are not necessarily aligned with the shareholders (Hermalin and Weishbach, 1991). There are many widely studied board characteristics like board composition, which includes board size and the proportion of independent directors, as well as board diversity.
2.3.2Board size:
There exist two important functions of the board of directors are providing advice and supervision. Firstly, the function of advisory can be understood as providing expert advice to the CEO and obtaining key information and resources for the company (Fama and Jensen 1983). They also noticed the importance of outside directors who brought valuable expertise and potential resources. The advantage of larger board size is the greater collective information that the board subsequently possesses and hence larger boards will lead to higher performance (Dalton and co-workers 1999, 2005). The two, the board of directors are responsible for supervising the management to ensure that managers pursue the interests of shareholders. A lot of previous research on group decision-making shows that a larger group needs more effort to reach a consensus, so the final decision of the larger group reflects more compromises and is not as extreme as a small group. (Kogan and Wallach, 1966). As a result, both functions predict an initial improvement in board performance as board size increases, furthermore, it will increase the firm performance.
However, based on the agency theory, the connection between board size and the variability of corporate performance potentially arises because larger boards have the communication problems and the agency problems. At first, coordination and communication problems arise because it is difficult for the board of directors to reach consensus, resulting in slower and less effective decisions (Jensen 1993). Secondly, the cohesion of the board of directors is weakened because board members are unlikely to share common goals, communicate clearly and reach a consensus based on the different opinions of directors (Lipton and Lorsch 1992). Thirdly, the free-riding rate of directors has risen. Because the cost of any non-diligent director is proportional to the size of the board of directors, the CEO is more likely to influence and control the board. Therefore, CEO’s decision-making power increases as the size of the board increases (Lipton and Lorsch 1992). Jensen (1993) believes that if the board of directors has more than eight directors, then the directors cannot operate effectively and the CEO is easier to control. When the board becomes bigger, it is more difficult for the company to arrange board meetings and the board to reach a consensus. As a result, larger board decisions are less effective. According to Jensen (1993), with the increase in the size of the board of directors, the cost and communication problems of agency problems will lead to more directors to attract potential advantages, leading to a decline in company performance.
Through review literature, many US empirical studies have documented a negative relationship between board size and firm performance, Hermalin and Weisbach (2003) to conclude that this relation is one of the prominent empirical regularities in the literature. Using data from 452 large US industrial corporations between 1984 and 1991, Yermack (1996) documents a negative relationship between board size and firm performance, as measured by Tobin’s Q and profitability. Eisenberg et al. (1998) confirmed Yermack’s conclusions, their research shows that there is a similar relationship between small-scale and medium-sized Finnish companies. That is, the scale of the board is negatively related to the company’s value. Another empirical test of the data of 1,252 companies covered by the company’s directors’ data set during the period of 1996-2004 of the Investor Responsibility Research Center (IRRC). The results show that, between the larger board and the lower company, the monthly stock returns over time, the ROA of the assets and the Tobin Q value are related. When the size of the board increases by one standard deviation, the standard deviation of monthly stock returns falls by 7% and 8%, respectively, from the average and the median. For the same increase in the size of the board of directors, the standard deviations of annual average ROA and Tobin Q decreased by 9% (14%) and 17% (36%) from the average.
2.3.3 Board diversity
Based on the resource dependency theory, the key role of the board of directors is to control and monitor the managers and providing resources. The research dependency theory suggest that firms are dependent on their environment (Pfeffer, 1972). Firms have to secure resources from the environment, this reduces uncertainty and enhances firm performance (Pfeffer, 1972). Board diversity, created by diverse board capital, supports the ability to secure resources from the environment, which reduces uncertainty and increases firm performance (Hillman & Dalziel, 2003).
The European Commission seeks more women as board members because they can diversify the board, which has a positive effect on the performance of the board. Their idea is to establish a binding gender quota to encourage women on the board. In this study, the board of directors examined the relationship between board diversity based on board age, race and education level of women, and company performance (such as return on assets). In addition, the possible role of gender quotas in the relationship between board diversity and corporate performance was studied. The sample consists of 468 companies from 12 European companies that operate in the trade and service industry and have at least one female on the board of directors. The results show that there is a positive relationship between women in the board and company performance. When studying the specific characteristics of these women, the results show that there is no positive correlation between board diversity and the age, race and education level of the women on the board of directors, and company performance. The results also show that gender quotas have no modest impact on the expected relationship between women in the board of directors, board diversity, and company performance.
But there is still a series of studies that show a negative association between board diversity. Some researchers claim that board diversity determines conflicts that negatively affect firm performance (Arena et al., 2015). These conflicts are the results of more diverse opinions and more critical questions, which increases the time that is needed to decide. Firms operating in a competitive industry have to react quickly to market shocks, therefore diverse boards could negatively affect firm performance (Smith et al., 2006).
2.3.4 Managerial ownership
To alleviate the agency problem, Demsetz and Lehn (1985) pointed out that giving managers shares might align interests between owners and managers. Many scholars believe that turning directors into shareholders is one of the long-term incentives to motivate managers to improve their performance and guide the company’s performance, because shareholders benefit from good corporate performance.
Many literature investigated and studied agency costs and the relationship between executive ownership and corporate performance. Jensen and Meckling(1976) proposed that managerial ownership can reduce this kind of agency costs and this kind of costs will decrease when the proportion of management’s shareholding is increasing. Based on Jensen and Meckling’s research, Ang et. al(2000) made further study and found the agency costs for companies with external shareholdings are much higher than the agency costs for companies which have internal management shareholdings, what is more, the agency costs increased when the proportion of external ownership is higher. Biswas and Bhuiyan(2008) illustrated managerial ownership is essential because it may encourage directors working responsibly to their own benefits.
However, although managerial ownership may have positive impact on reducing agency costs, the influence of it on corporate performance might not be always positive. Different scholars have come to different conclusions in this area. Although after investigating 2000-2004 Athens listed companies, Drakos and Bekiris(2010) found executive ownership can influence firm value positively. Most of the literature demonstrated that there is a non-linear relationship between management holding and effect of enterprise performing. In the US, when directors have less than 40% equity, Tobin’s Q value increases with the raising in the proportion of holdings. When the equity is between 40% and 50%, the Q value begins to decline with the raising in the proportion of holdings(McConnell and Servaes, 1990). Coles et. al(2012) supported this discovery and found that the impact of managerial ownership on firm performance was positive before a particular figure and became negative after that number. While Bos et. al (2011) did a research of UK organisations, and concluded that when companies’ executive ownership is lower than 5 percent or higher than 15 percent, companies perform best, when the proportion is between 5-15 percent, the performance of organisation may deteriorate. What’s more, some literature found there is no remarkable correlation between management shareholdings and firm performance. For example, Demsetz and Villalonga (2001) drew a conclusion that there was no conspicuous relation between these two, although increasing the dispersion of stocks might lead to agency problems, making management salary depends on the rate of return can offset those drawbacks. It is also supported by Jahmani and Ansari(2006), they brought forward giving shares to managers is just a form of salaries, there was no incentive effect on promoting company performance.
Given the literature review, there exists a number of gaps in the existing research. Certain researchers strongly believe that stronger enforcement of corporate governance has the potential of increasing the performance of the company. On the other hand, some researchers have reasons to believe that corporate governance does not always result in better performance. The contradicting arguments only imply that the topic of the relationship between corporate governance and performance of listed companies has not been thoroughly explored. Clearly, corporate governance influences the performance of an organization because without it even the greatest corporations do not stand a chance in the market (Renneboog & Szilagyi, 2015). In order to utilize corporate governance effectively, it is important to understand how and to what extent it influence performance. Identifying specific processes that are directly impacted by corporate governance will shed more light on the relationship that exists between governance and performance. In addition, previous studies do not states the level of investments into corporate governance results in or inhibits performance in an organization. The purpose of the study is to assess the relationship while measuring the strength of the relationship and best practices for ensuring that corporate governance helps optimize the performance in various aspects of the organization.
3.Methodology (Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies):
The methodology of the paper is deductive. The research paradigm is functionalist, starting point are theories including agency theory, resources dependence theory and stakeholder theory. Based on these theories, this paper will present four hypotheses, and then use data to validate these theories.
Corporate governance mechanisms have different degrees of impact on company performance.
3.1 Hypothesis
Boards are considered as the institutions to mitigate the effects of agency problem existent in the organizations. According to agency theory, there may be a connection between board size and corporate performance. Many researchers have suggested that large-scale board usually has difficulties in communication, which may have negative impact on company performance.
H1: Board size positively influences the firm performance at smaller sizes followed by a negative influence at larger sizes.
When managers own the company’s stock, their stock income depends on the price of the company’s stock, and better company performance can attract investment from other investors, thereby increasing stock prices. Therefore, the higher the proportion of shares owned by managers, the higher the company’s performance.
H2: There is a positive correlation between managerial ownership ratios and company performance in list companies in UK.
According to the stakeholder theory and the resource dependency theory, all members of the board of directors are associated with groups of different types and levels. gender diversity leads to the diversification of interest groups. The diversity of the board of directors can consider the interests of different groups.
H3: The participation of female directors has a positive impact on company performance.
In addition, according to agency theory, a higher proportion of external staff on the board can better monitor and control the opportunistic behavior of current management, thereby minimizing agency problems and maximizing shareholder wealth (Fama and Jensen, 1983). Therefore, the board should have a majority of outside directors because a higher percentage of outsiders can enhance board independence, provide broader knowledge and experience, and improve the effective functioning of the board (Bacon and Brown, 1973) Fama and Jensen (1983) further support this by providing a view that independent boards are more objective in monitoring companies than non-independent boards.
H4: There is a significant relation between proportion of Independent Non-Executive Director and the corporate performance for UK Listed Companies.
4.Research Methods (Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies)
4.1 Research strategy
This article will use quantitative method, Quantitative research designs are either descriptive or experimental. A descriptive study establishes only associations between variables; an experimental study establishes causality. Quantitative research deals in numbers, logic, and an objective stance. Quantitative research focuses on numeric and unchanging data and detailed, convergent reasoning rather than divergent reasoning. The researcher will use specific indexes to measure company performance to verify the its relationship with corporate governance mechanisms, the main way is by collecting second-hand data and the annual report of the selected company. The data source for this article is the database. Datastream database and Fame database will be used.
Cavana, Delahaye & Sekaran (2001) assert that, the data, after collection, has to be processed and analyzed in accordance with the outline laid down for the purpose at the time of developing the research plan. This is essential for a scientific study and for ensuring that all relevant data is available to help make comparisons and analysis. The term analysis refers to the computation of certain measures along with searching for patterns of relationship that exist among data-groups. The mass of data collected will be coded, summarized into frequency tables, and analyzed using quantitative techniques. To perform the analysis, the researcher will make use of various software including MS Excel, SPSS and any other as will prove necessary.
4.2 Sample design
This article is going to select about 500 UK listed companies and use the data disclosed by these companies in the 2000-2015 annual report as the research object. Excluding financial institutions and companies with ROEs higher than 200% or companies that undisclosed information of senior management shareholding, companies with incomplete data are not selected. The main reason for the selection of UK listed companies is that the UK has a good economic environment, for example, the UK stock market is the largest stock market in Europe. The level of management is also mature. Compared with some developing countries, data is preserved better, more convenient to search and has higher reference value.
4.3 Variable design
4.3.1 Dependent variable
corporate performance as the dependent variable is measured by two accounting proxies: Return on Assets (ROA) and Return on Equities (ROE). As an accounting measure of performance, these two proxies are commonly employed and generally accepted by the corporate governance researchers, though some researcher prefers to use the market measures. The two measures, which represent different perspectives of how to evaluate a firm’s financial performance, have different theoretical implications (Hillman and Keim, 2001). These measures are consistent with other studies on organisational performance and are frequently used by market and financial analysts in assessing a company’s performance (Shrader et al., 1997). Tobin’s Q is also a widely applied measure within the corporate governance literature serving as a proxy for a firm’s ability to generate shareholder wealth and it reflect changes and growth in company value during certain period. Firms with a Tobin’s Q ratio greater than 1.0 are expected by investors to be able to create more value by using available resources effectively, while those with a Tobin’s Q ratio of less than 1.0 are associated with poor utilisation of available re- sources. In addition, Tobin’s Q accounts for risk and, unlike accounting measures such as return on assets, is not liable to reporting distortions due to tax laws and accounting conventions (Lindenberg and Ross, 1981). In particular, reported financial performance may vary significantly from year to year as firms write off items such as goodwill from an acquisition. Accounting results are based on events that have already occurred, and thus offer a view of past performance, while Tobin’s Q focuses on expectations of future performance (Demsetz and Villalonga, 2001). Besides, the total assets of listed companies will be used to represent the size of the firm.
4.3.2 Independent variable
As for the independent variable, this paper will focus on four corporate governance mechanisms which include board independence, board size, board diversity and managerial ownership. Firstly, the independency of the board was measured through two proxies – the proportion and motivation of Independent non-executive directors. Proportion of independent non-executive directors was measured as the overall percentage of independent non-executive directors on the board to the board size, while the motivation was measured as the average compensation or monetary fees, including salaries and bonuses paid to independent non-executive directors in a year. Secondly, for managerial ownership part, this paper will use chairman’s shareholding ratio, proportion of general managers’ shareholdings and shareholding proportion of senior executives to represent managerial ownership.
Thirdly, as an agent of the board’s gender diversity, we first use the dummy variable DWOM-AN, which has a value of 1 when at least one woman appears on the board, otherwise zero. The second variable is the percentage of women on the board, PWOMEN, divided by the number of female directors divided by the total number of directors. lastly, board size is the number of directors on the board at the end of each sample year.
4.3.3 Control variable
Among the general control variables, firm size is measured by taking the natural logarithm of total revenues for each year, as the size alone is not normally distributed. Firm age is measured by the logarithm of the number of years between the observation year and the firm’s founding year. Board meeting frequency also should be considered into the control variable.
5.a Limitation and ethics (Relationship Between Corporate Governance and Corporate Performance in UK Listed Companies)
Due to the lack of sufficient research time, data collection may not be comprehensive. In the selection of explanatory variables and control variables, although this paper considers some of the major factors, control variables with certain explanatory capabilities such as industry categories, are not included in the analysis. As we all know, the effect of equity governance has certain differences in form and strength in different industries. Therefore, the results of the study may not discuss separately from the specific industry, this point has a certain impact on the research results.
Since the approval of ergo2 has been approved, researchers will use the database to collect second-hand data reasonably and legally.
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