BM-5301C - Corporate Governance

Board Structure,
Independence, Size, Diversity

M Muzamil Naqshbandi (PhD)

UBD School of Business & Economics,
University of Brunei Darussalam
muzamil.naqshbandi@ubd.edu.bn

To provide quality education and nurture innovative and caring leaders to contribute to the community.
Objectives of the lecture:

• Board structure
• Board independence
• Board size
• Board Gender
• Board diversity

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 Board structure
The structure of a board of directors is generally described in
terms of its prominent structural attributes:
Its size

Professional and demographic information about the directors

Their independence from management

Number of committees

Director compensation

Chairman of the board

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 Board Independence
“No material relationship with the listed
company”

• Either directly or as a partner, shareholder, or

officer of an organization that has a
relationship with the company

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 Board Independence
• Has been employed as an executive officer at
the company within the past three years
• Has earned direct compensation in excess of
$120,000 from the company in the past three
years
A director is • Has been employed as an internal or external
not considered auditor of the company in the past three years
independent if
the director or • Is an executive officer at another company
a family where the listed company’s present executives
member: have served on the compensation committee
in the past three years
• Is an executive officer at a company whose
business with the listed company has been the
greater of 2 percent of gross revenues or $1
million within the past three years
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 Board independence
Conventional Wisdom:
• Large Company Boards should consist mostly of
independent directors.
• Institutional shareholders can improve corporate
governance by strengthening independence of
corporate boards.
The Question:
Will greater board independence produce
better corporate performance?
Bernard S. Black and Sanjai Bhagat, The Non-Correlation Between Board
Independence and Long-Term Firm Performance, 27 Journal of Corporation Law
231-273 (2002).
 Black and Bhagat (2002) study
First Large-Scale, Long-Time-Horizon analysis of the effect of
independent directors on corporate performance.

Stock price and accounting performance during 1985 -

1995 for 950 large U.S. firms.
Institutional Shareholder Services (ISS): Board
Composition of 957 large U.S. public corporations; Data
on inside, affiliated outside, and independent directors
from proxy statements mailed in early 1991, and 1988.
CRSP: Stock returns during 1985 -1995.

Compustat: Accounting data during 1985 -1995.

Share ownership data from 1991 and 1988 proxy statements.

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 Findings
Poorer performing firms move
towards a board that consists
of a greater proportion of
independent directors.
However, the performance of
these firms does not
necessarily improve.

Market Performance Variables and Board Structure

 If markets are efficient, then impact of board

independence on share price would occur at the time the
independent board is first elected.
 Negative correlation between board independence and
prior stock market performance. Subsequent stock
market performance is not statistically significant.
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 The Case for Inside Directors
Including insiders on the board may make it easier for other
directors to evaluate them as potential CEOs.

Insiders may be better at making strategic investment decisions.

Tradeoff between independence and other essentials to good

decisions.
• Inside directors are conflicted, but well informed.
• Independent directors are not conflicted, but are relatively ignorant about
the company.

Tradeoff between independence and incentives.

• Independent directors usually own trivial amounts of the company’s shares.

• Inside directors have their human capital (and substantial financial capital)
committed to their company. 9
A case for a modified version of the conventional wisdom
that favors highly independent boards.

Incentivize independent directors through stock and stock-option

ownership. (Bhagat-Carey-Elson (1999)

Institutional investors may need to put their own representatives

on boards. (Legal restrictions.)

Today’s “independent” directors are not independent enough.

(Board members that may be employed by a university or
foundation that receives financial support from the company.)

Require directors to disclose any (social/professional/business)

relationship (past or present) with the CEO.
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Types of Members
of
Board of Directors

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 Members of a Board of Directors
• typically officers or executives employed by
Inside directors the corporation

• may be executives of other firms but are

Outside directors not employees of the board’s corporation

• not employed by the corporation, handle

Affiliated directors legal or insurance work

• used to work for the corporation, partly

Retired executive directors responsible for past decisions affecting
current strategy
• descendants of the founder and own
Family directors significant blocks of stock

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 Board Composition
Independent non-
Balance of skills and Balanced composition Non-executive
executive directors
experiences of executive and non- directors should be of
should be expressly
executive directors sufficient calibre
identified

List of directors
Formal and transparent
updated and their Re-election at regular
procedure for Succession plan
respective role and intervals
appointment
function identified

Nomination committee formed

Proper explanation for
Specific term for non-
resignation/removal of
executive directors
directors
All directors subject to to make recommendation on
retirement by rotation appointment of directors and
succession planning for
at regular interval directors, chairman and CEO

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Remuneration of directors and senior management
Transparency of directors’ remuneration policy

Remuneration should be sufficient but not excessive

Each director not to involve in deciding his/her own remuneration

Remuneration committee to be formed, mainly from non-executive directors

Consult Chairman/CEO if needed

Access to professional advice, market comparable information

Make recommendation on policy and structure of remuneration

Determine specific remuneration packages of all executive directors and

senior management

Review and approve performance-based remuneration

Review and approve compensation arrangement in connection with loss or

termination of office, dismissal or removal of directors for misconduct
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Board size and corporate
performance

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 Board size and corporate performance
Yermack (1996)

• As board size increases, firm value falls (after controlling for factors such as firm size and
industry). The largest deterioration in value occurs between boards of 5 and 10 directors,
suggesting that inefficiencies grow the most within this range.
• Larger boards are less likely to dismiss underperforming CEOs,
• They are less likely to award compensation contracts that correlate with shareholder value, and
shareholders respond negatively to announcements that a company is increasing its board size.
• An inverse association between board size and firm value.

Coles, Daniel, and Naveen (2008)

• Board size and corporate outcomes appear linearly related, but the relationship is
more nuanced.
• A variety of other factors likely influence the relationship between board size and
firm value.
• Complexity of the organization matters.
• Complex companies (those with many business segments, those that require
external contracting relationships, leveraged firms, and those in specialized
industries) might benefit from large boards.
• Board size is negatively correlated with firm value for simple firms and positively
correlated for complex firms (with diminishing benefits beyond a certain point).

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Board Diversity

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 Board Diversity
• Many stakeholders advocate that corporate officers should increase the ethnic diversity of their
boards so that their composition more closely reflects the diversity of the broader population.
• Ethnic diversity might improve decision making by ensuring that the board has the full array of
knowledge in terms of market dynamics, customer behavior, and employee concerns to succeed
operationally and culturally.
ARGUMENTS • Diversity helps boards overcome tendencies toward groupthink.
FOR • Diversity can also encourage healthy debate by making directors more likely to challenge one
another's viewpoints without excessive concern for maintaining harmony because of social
similarity.

• Some evidence suggests that boardroom diversity might detract from the quality of decision
making.
• Social psychologists have shown that heterogeneous groups exhibit lower levels of teamwork.
ARGUMENTS • Differences among team members can lead to less information sharing, less accurate
AGAINST communication, increased conflict, lower cohesiveness, and an inability to agree upon common
goals.
• If this dynamic manifests itself in the boardroom, both advice and monitoring might suffer.
• The results are mixed.
• A significant positive relationship between diverse gender and minority board representation and
corporate performance (Erhardt, Werbel, and Shrader, 2003).
• Board diversity is correlated with higher market-to-book ratios (Carter, D'Souza, Simkins, and
Simpson, 2010)
WHAT DOES • No relationship between boardroom diversity and corporate performance (Wang and Clift, 2009)
RESEARCH SAY • A negative relationship (Zahra and Stanton, 1988) .
• Demographic similarity between the CEO and the board is correlated with higher levels of CEO
compensation (Westphal and Zajac, 1995).
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 Board Gender
• Women are significantly underrepresented on boards of directors.
• Just 17 percent of the directors of Fortune 500 companies are women,
compared with 50 percent of the general population and 47 percent of the
workforce.
• Boards might lack female directors because women are underrepresented
at the senior executive level.
• Only 18 percent of corporate officers are women.
• Several countries have made it a priority to increase female
representation on corporate boards.
• Norway was the first country to pass such a law, requiring in 2003 that all
listed company boards be composed of at least 40 percent female
directors, with full compliance required by 2008.
• Companies not compliant with the law risk being delisted from exchanges.

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 ARGUMENTS FOR BOARD GENDER DIVERSITY

Prevents groupthink and premature consensus.

Women might have different insights into customer behavior, particularly in industries
where women are the primary purchasing agents.

Women might also evaluate information and consider risk and reward differently than men,
thereby improving decision making.

Social benefits exist for increasing gender equality on the board.

Catalyst (2007) divided Fortune 500 companies into quartiles based on female board
representation.
• It found that the quartile with the highest percentage of females outperformed the lowest quartile in return on
equity (13.9 percent versus 9.1 percent), net margin (13.7 percent versus 9.7 percent), and return on invested
capital (7.7 percent versus 4.7 percent).
• It also found that companies with three or more female directors performed well above average along all three
financial metrics.
• This study did not include control variables, so it likely omits important explanatory factors, such as industry,
company size, or capital structure.

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 ARGUMENTS FOR BOARD GENDER DIVERSITY
Adams and Ferreira (2009) found that female directors
have better attendance records than men and that
male directors have fewer attendance problems when
women also serve on the board.
They also found that boards with female
representation are more likely to fire an
underperforming CEO and award more equity-based
compensation.
They did not find a positive correlation between female
board representation and either operating
performance or market valuation.
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 ARGUMENTS AGAINT BOARD GENDER DIVERSITY
 Recruitment of underqualified directors to appear gender-balanced (tokenism).
 Evidence is inconclusive about whether female board representation improves
corporate performance.
 More rigorous studies find no relationship between female board representation and
performance.
 However, modest evidence supports the idea that female representation can improve
governance quality.
 Evidence suggests that female board representation can be detrimental when
encouraged primarily to meet arbitrary quotas.
 Ahern and Dittmar (2012) examined the impact of the Norwegian law on female board
representation. They found that the law led to considerable changes in board
composition in terms of not only gender but also age, education, and experience. They
found that the somewhat arbitrary governmental constraints of the law led to a
significant decrease in firm value.
 They found that the loss in firm value was not primarily attributable to a greater
number of female directors but to the inexperience of new directors.
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Structure of the BoD of US corporations

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