Corporate governance characteristics are statutory requirements that protect outside investors from opportunistic behavior of managers, insiders or controlling shareholders. In non existence of such mechanism, difficulties of monitoring was suffered by outside investors and provided a chance to managers to misuse and expropriate organizational resources, often at the cost of minority shareholders and the long term performance of firm. Sami and Wang and Zhouc (2011) found a positive link between corporate governance and firm performance.
Shaheen and Nishat (2005) also suggested that firms with relatively poor governance are less profitable. Therefore, efficient corporate governance provides better firm performance, while poor corporate governance leads to bad financial performance. Nandelstadh and Rosenberg (2003) investigated that firms with inefficient corporate governance practices have delivered lower returns to shareholders while firms characterized by efficient corporate governance have been valued higher. Gompers and Ishii and Metrick (GIM, 2003) found that during 1990s stock returns of firms with strong shareholder rights protection outperform returns of firms with weak shareholder rights by 8.5% per year during this decade.
Corporate governance system varies with the ownership structure of the firms. A lot of research is done on the relationship between ownership structure and corporate performance but the results, however, are not uniformly in agreement. Sabur Mollah and Omar Al Farooque and Wares Karim (2012) has conducted a research to examine the association between ownership structure, board characteristics and financial performance to find out the role of corporate governance in the performance behavior of listed companies of an emerging market in Africa as Botswana. They used ordinary least square (OLS) models to data of listed companies of Botswana stock exchange over the period of 2000-2007 to investigate the role of different corporate governance measures on performance of listed companies. They suggested a positive relationship between performance and dispersed ownership, which minimize the probability of agency conflicts in corporate sector of Botswana. They also demonstrated that all concentration or major ownership blocks (e.g. sponsors, institutions, Govt, and foreign) have negative impact on performance except public shareholdings.
Guo and Kumara (2012) had conducted a study to check the link between corporate governance characteristics and performance of listed companies on Colombo stock exchange in Srilanka. They applied multiple regression analysis to the data of 174 firms for the financial year 2010 to find out the impact corporate governance on performance of Srilankan listed firms. Their findings suggested a marginal negative relationship between board size, percentage of outside directors and firm value, while a negative association between percentage of outside directors and firm performance.
Lam and Lee (2012) wrote a research paper to investigate the impact of board committees on performance and the mediating affect of family ownership for public companies of Hong Kong. They applied their tests on the data of 346 public companies of Hong Kong over the periods of 2001-2003 available on financial databases and annual reports. Their findings demonstrated a positive relationship between nomination committee and performance, while negative association between remuneration committee and firm performance and an unfavorable impact of family ownership on board committees. These relationships are dependent to independence or dependence of committees.
Sami, et al (2011) had written a research paper to find out the relationship between corporate governance and operating performance of Chinese listed companies. They used a composite measure of corporate governance ( CEO duality, Percentage of outside directors on board, Approval of CEO succession plan by board, Relationship between top ten shareholders, State ownership, Foreign ownership, Institutional ownership and insider ownership) to measure the impact of corporate governance on Chinese listed firms performance and valuation. They found a favorable relationship between composite measure of corporate governance and performance of Chinese listed firms.
Benjamin I. Ehikioya (2009) has published a paper on corporate governance structure and firm performance, to investigate the relationship between corporate governance and performance of Nigerian firms. He performed regression analysis on a sample of 107 Nigerian listed firms over the periods of 1998 to 2002. He found a negative impact of CEO duality on performance, while positive relationship between performance and ownership concentration. He was unable to find any impact of board composition on performance and suggested that more than one family member on board have a negative impact on firm performance.
Lam and Lee (2008) published a paper on CEO duality and firm performance. They suggested that combination of both agency theory and stewardship theory only can better explain duality and performance relationship. Their empirical findings proposed a positive relationship between CEO duality and performance for non family firms, while a negative impact on family firms.
Hermailn and Weisbach (1998) demonstrated that the board effectiveness is dependent to composition of board and the board composition is partially controlled by the CEO. Ehikioya (2009) reveals that, there is not any relationship between board composition and firm performance. Ujunwa (2012) suggested a negative impact of board size on firm performance. Reddy and Locke and Scrimgeour (2010) found that board independence and board size does not have any significant impact on performance. Bhagat and Bolton (2008) suggested a negative association between board independence and operating performance of firms. Abdullah (2004) demonstrates that board independence and performance did not have any association because ratios will not consider the affect of board independence while calculating firm performance (ROA, ROE) measures.
Baysinger and Butler (1985) suggested that US firms with more executive directors underperformed on the basis of return on equity, when compared to firms with more outside directors. Ezzamel and Watson (1993) demonstrated a positive relation between outside directors and firm performance for a sample of UK firms. Kesner (1987) suggested a negative and significant association between the proportion of outside directors and return to investors. Li, et al (2008) suggested a favorable link between independent directors and financial performance. Jensen and Meckling (1976) found that independent directors perform the duty of evaluation and monitoring of management.
Eloumi and Gueyie (2001) demonstrate that firms facing financial crisis have less independent directors on their boards. Krivogorsky (2006) found a strong favorable association between the percentage of independent directors to board size and profitability ratios in European firms. Pearce and Zahra (1992) and Dwived and Jaon (2002) found a favorable relationship between board size and performance. Yermack (1996) and Hermalin and Weisbach (2003) found a negative relationship between performance and board size. Vafesa (1999) and Golden and Zajac (2001) predicted a non-linear relationship between performance and boars size. Abdullah (2004) and Daily and Dalton (1992, 1993) unable to find any link between performance and board composition.
Ehikioya (2009) found the evidence that CEO duality and firm performance have a negative relationship. Lam and Lee (2008) reveals that CEO duality and accounting performance of non-family firms have positive relationship, while CEO duality leads to performance decline of family-controlled firms.Rechner and Dalton (1991) and Daily and Dalton (1994a, b) and Chen and Cheung and Stouraitis and Wong (2005) found the positive impact of separation of CEO and chair person. Donaldson and Davis (1991) and Brickley and Coles and Jarrell (1997) and Coles and Williams and Sen (2001) reveals that combination of both roles is preferable. Ujunwa (2012) found the evidence that CEO duality is negatively related to performance of Nigerian quoted firms but using the similar characteristics of board for small companies found a positive impact of duality on performance.
Kang and Zardkoohi (2005) and Dalton and Daily and Ellstrand and Johnson (1998) and Daily and Dalton (1997a, b) demonstrates that relationship between CEO duality and performance is still mixed and indecisive. Fama and Jenson (1983) found that duality can impede board's ability to monitor management and will result in an increase of agency cost. Boyd (1995) demonstrates that separation of chair from CEO will result in an increased agency cost. Bhagat and Bolton (2008) suggested a favorable relationship between CEO-Chair separation and firm performance. Laing and Weir (1999) said that companies with combined leadership structure might have a person who has the authority and able to make decisions that are not value maximizing for shareholders. Rencher and Delton (1991) suggested that firms with joint structure performed poorly as compare to firms with separate leadership structure. Dalton, et al (1998) was unable to find any link between performance and leadership structure.
McMullen (1996) said that board committees are expected to have a favorable impact on firm performance. Reddy, et al (2010) suggested that existence of remuneration committee has a positive association with firm performance, while he was unable to find the evidence that, audit committees are negatively related to firm performance. Lam Abbott and Parker and Peters (2004) found that presence of audit committees will minimize errors, illegal acts and financial restatements, hence a positive impact of audit committee on performance. Klein (1998) found that remuneration committees can minimize the agency problems by combining the goals of senior managers and shareholders through attractive bonus schemes. Laing and Weir (1999) demonstrated remuneration and audit committees had a favorable affect on firm performance. Klein (1998) found that board monitoring committees have not any relationship with performance.
Weir and Laing (2001) suggested remuneration committees have no effect on performance. Li, et al (2008) found that auditors opinion in negatively associated with the chances of financial crisis. Altman and McGough (1974) and Menon and Schwartz (1986) demonstrates that nearly half of their samples got a going concern qualification opinion prior to distress event. Flagg and Giroux and Wiggins (1993) suggested a favorable link between distress event and going-concern qualification. Li, et al (2008) found a negative association between financial distress event and auditor's opinion.
Fama and Jenson (1983) found that duality can impede board's ability to monitor management and will result in an increase of agency cost. Boyd (1995) demonstrates that separation of chair from CEO will result in an increased agency cost. Jensen and Meckling's (1976) found that with the separation of ownership and control agency cost will increase. Li, et al (2008) suggested a positive link between agency cost and chances of financial crisis.
There are number of studies that have investigated the relationship of different Corporate Governance measures (e.g. ownership structure, leadership structure, board composition and board committees) and performance measures (e.g. return on assets, return on equity, market to book value and Tobin's Q) but the results, however, are not uniformly in agreement. Hence, this issue is still an unresolved. In order to find the solution of this issue, in this paper, we just focus on the relationship between corporate governance and performance within in the sample of Pakistani listed companies of textile sector, hoping to find useful results.
Methodology:
A methodology is not a formula but a series of choices from which, we choose specific methods to solve specific problems. To investigate the impact of corporate governance characteristics on firm performance in Pakistan, this study is conducted by using the methodologies adopted in earlier research work on this issue.
As other studies have discussed these relationships, conceptual frame work of our study is based on deduction method and for analysis of data collected from secondary sources quantitative techniques were employed. Descriptive statistics, regression and correlation models are generally used for analysis of data.
Data and data sources:
In general sense processed form of information is called data but in statistics, it is a numerical statement about facts. Data were collected from secondary sources including annual reports, Karachi stock exchange publications and websites over the period of five years 2007, 2008, 2009, 2010 and 2011.
Karachi Stock Exchange is the biggest and most liquid exchange in Pakistan. Karachi Stock Exchange was declared as the "best performing stock market of the word in 2002" by "Business Week". As at March 15, 2007 754 companies were listed on Karachi Stock Exchange with market capitalization of Rs. 3,200.182 billion having listed capital of Rs. 495.968 billion. Our study will check the impact of corporate governance practices on firm performance of listed firms at Karachi Stock Exchange in textile sector.
As at March 15, 2007 754 companies were listed on Karachi Stock Exchange out of which 183 firms are related to textile sector. Textile sector contributes a major portion to GDP of country and most important sector for economy after agriculture sector. On the basis of these facts I choose textile sector for conducting this research.
Data were collected from secondary sources including annual reports, Karachi stock exchange publications and websites over the period of five years 2007, 2008, 2009, 2010 and 2011. The sample of companies and firm performance data were selected from 15 highly ranked listed companies in textile sector at Karachi stock exchange over the period of five years 2007, 2008, 2009, 2010 and for comparative analysis. Data regarding Board structure, Leadership structure, Shareholding pattern and Board committees were collected from annual reports of selected firms. Then collected data were rechecked with the Karachi stock exchange for verification of collected data.
Dependent variables:
1-Tian and Twite (2001) and Sami, et al (2011) and Hermalin and Weisbach (1991) and Lam and Lee (2008) and Yarmack (1996) and Bhagat and Bolton (2008) and Guo and Kumara (2012) and Reddy, et al (2010) and Mollah, et al (2012) has used Tobin's Q as market based performance measure and it is calculated as for this research.
Tobin's Q = MVCS+BVPS+BVLTD+BVCL+BVINV-BVCA
BVTA
Where MVCS = market value of common stock, BVPS = book value of preferred shares, BVLTD = book value of long term debt, BNINV = book value of inventory, BVCL = book value of current liabilities, BVCA = book value of current assets, BVTA = book value of total assets.
2-Bhagat and Bolton (2008) and Guo and Kumara (2012) and Reddy, et al (2010) has used Market to Book value as a market based performance measure and it is estimated as for the purpose of study.
Market-to-book value of equity = Market value of ordinary shares
Book value of ordinary Shares
3-Tian and Twite (2001) and Sami, et al (2011) and Hermalin and Weisbach (1991) and Lam and Lee (2008) and Yarmack (1996) and Bhagat and Bolton (2008) and Guo and Kumara (2012) and Reddy, et al (2010) and Mollah, et al (2012) has used Return on Assets as accounting based performance measure and it is calculated by following formula.
Return on Assets = Net profit attributable to shareholders
Total Assets
4-Tian and Twite (2001) and Sami, et al (2011) and Hermalin and Weisbach (1991) and Lam and Lee (2008) and Yarmack (1996) and Mollah, et al (2012) had used Market to Book value as accounting base performance measure and it is calculated by following formula.
Return on equity = Net profit attributable to shareholders
Equity
Independent variables:
The independent and control variables used in this research are factors demonstrated in earlier research work as they influence performance, either positively or negatively. The variables and the way in which they are determined in this study are:
5-The board size (BDS) is the number of members on the board of a particular firm. Board size (BDS) is the natural log of the total number of directors.
6-Non executive directors (NED) are the proportion of the outside directors on the board.
7-To investigate the impact of board committees on firm performance, three dummy variables are created. The Audit Committee (ACOM) is the dummy variable set equal to 0 if companies have not audit committee; otherwise it is set equal to 1. A Remuneration Committee (RCOM) is the dummy variable set equal to 0 if companies have not audit committee; otherwise it is set equal to 1. A Nomination Committee (NCOM) is the dummy variable set equal to 0 if companies have not audit committee; otherwise it is set equal to 1.
8-CEO duality is a corporate leadership structure that combines the position of chairman and chief executive officer. To investigate the impact of duality (DUAL) on performance a dummy variable is created. CEO Duality (DUAL) is the dummy set equal to 1 for companies that have merged the both positions; otherwise it is set equal to 0.
Controlling Variables:
9-Firm age is the time period in term of number years from which a firm is operatin, starting from the day of incorporation. Berger and Udell (1998) demonstrated that financial growth of firms depends upon age of firm and also capital structure varies with age factor. At start firms are expected to have more expenses, have less experience of market and trying to build a market position, that's why new firms have higher cost structure as compare to old firms. Older firms may be approaching towards last stage of their life cycle. Therefore, complexities increase with age of firms. Log of years since incorporation of firm is used as firm age.
10-In this study firm size is used as controlling variable. Firm size is taken as the natural log of annual average assets. If the dependent variable is return on assets, the firm size will be taken as natural log of sales. A large amount of literature has discussed the relationship between firm size and firm performance.
Hypothesis development
Board size and firm performance:
There is not any hard and fast rule for board size. It is suggested by many researchers that large board will increase the cost, while it is also possible that small board might fail to monitor issues effectively. Guo and Kumara (2012) had conducted a study to check the link corporate governance and firm performance of listed companies in Srilanka. Their findings suggested a marginal negative relationship between board size, percentage of outside directors and firm value.
Colse and Daniel and Naveen (2008) found that board size will increase with the age and size of firm. Jenson (1983) demonstrates that for effective functioning board should consist of maximum seven or 8 directors. Psaros (2009) found that boards of 250 big companies consist of average 6.89 directors. Firstenberg and Malkiel (1994) said that according to agency theory larger boards are less effective than smaller boards.
Pearce and Zahra (1992) and Dwived and Jaon (2002) suggested a positive relationship between board size and firm performance. Psaros (2009) and Goodstein and Gautam and Boeker (1994) proposed that large board can provide a big group of experts, effective management oversight and access to multiple resources and contracts. To test the above arguments in relation to Pakistan following hypothesis are suggested.
HOa: Board size is not associated with firm performance.
H1a: Board size is positively associated with firm performance.
Board composition and firm performance:
In this research paper board composition refers to the proportion of executive or inside directors and non-executive or outside directors serving on the board. Code of corporate governance for Pakistani listed firms was released by Securities and Exchange Commission of Pakistan in March 2002. This suggested that all listed companies should have at least one independent director on board. According to agency theory boards composed of majority of non-executive directors are considered better to protect the rights of shareholders and effective monitoring of management.
Li, et al (2008) suggested a favorable link between independent directors and financial performance. Eloumi and Gueyie (2001) demonstrate that firms facing financial crisis have less independent directors on their boards. Krivogorsky (2006) found a strong favorable association between the percentage of independent directors to board size and profitability ratios in European firms. Pearce and Zahra (1992) and Dwived and Jaon (2002) found a favorable relationship between board size and performance.
Yermack (1996) and Hermalin and Weisbach (2003) found a negative relationship between performance and board size. Vafesa (1999) and Golden and Zajac (2001) predicted a non-linear relationship between performance and boars size. Abdullah (2004) and Daily and Dalton (1992, 1993) unable to find any link between performance and board composition. Consequently, we propose the following hypothesis.
HOb: Majority of non-executive directors on the board is not associated with firm performance.
H1b: Majority of non-executive directors on the board is positively associated with firm performance.
Board Duality:
It is a corporate leadership structure that combines the position of chairman and chief executive officer. Agency theory applies to leadership structure and its relationship to firm performance. Fama and Jenson (1983) found that duality can impede board's ability to monitor management and will result in an increase of agency cost. Laing and Weir (1999) said that companies with combined leadership structure might have a person who has the authority and able to make decisions that are not value maximizing for shareholders. Boyd (1995) demonstrates that separation of chair from CEO will result in an increased agency cost.
Ehikioya (2009) found the evidence that CEO duality and firm performance have a negative relationship. Rechner and Dalton (1991) and Daily and Dalton (1994a, b) and Chen and Cheung and Stouraitis and Wong (2005) found the positive impact of separation of CEO and chair person. Bhagat and Bolton (2008) suggested a favorable relationship between CEO-Chair separation and firm performance. Rencher and Delton (1991) suggested that firms with joint structure performed poorly as compare to firms with separate leadership structure.
Lam and Lee (2008) reveals that CEO duality and accounting performance of non-family firms have positive relationship, while CEO duality leads to performance decline of family-controlled firms. Donaldson and Davis (1991) and Brickley and Coles and Jarrell (1997) and Coles and Williams and Sen (2001) reveals that combination of both roles is preferable. To test the above arguments in context of Pakistan following hypothesis are suggested.
HOc: Separate leadership structure is not associated with firm performance.
H1c: Separate leadership structure is positively associated with firm performance.
Board committees and firm performance:
Board committees are an integral part of board structure and have a great affect on performance of firms. The Cadbury committee (1992) suggested to make sub-committees for problematic areas of firms. The important areas were quality of financial reporting, appointment of directors and remuneration of directors. Therefore, Cadbury committee suggested establishing audit committee to improve the quality of financial reporting, remuneration committee to settle the compensation issues and nomination committee for appointment of directors and key officials.
Code of corporate governance for Pakistani listed firms was released by Securities and Exchange Commission of Pakistan in March 2002 also has recommended the same practices for conduct of listed firms. McMullen (1996) said that board committees are expected to have a favorable impact on firm performance. Reddy, et al (2010) suggested that existence of remuneration committee has a positive association with firm performance, while he was unable to find the evidence that, audit committees are negatively related to firm performance.
Lam Abbott and Parker and Peters (2004) found that presence of audit committees will minimize errors, illegal acts and financial restatements, hence a positive impact of audit committee on performance. Klein (1998) found that remuneration committees can minimize the agency problems by combining the goals of senior managers and shareholders through attractive bonus schemes. Laing and Weir (1999) demonstrated remuneration and audit committees had a favorable affect on firm performance. To test the above arguments following hypothesis are recommended.
HOd: Board committees composed of audit, remuneration and nomination committees are not associated with firm performance.
H1d: Board committees composed of audit, remuneration and nomination committees are positively associated with firm performance.
Model Specification:
Multiple regression models are used to find out the association between corporate governance characteristics and firm performance in the context of Pakistan. Four multivariate regression models are formulated to check the relationship between corporate governance and performance. Our base model takes the following form:
Firm performance = f (corporate governance characteristics)
Return on Assets / Return on Equity / Market to book value / Tobin's Q = f (board size, number of outside directors, board duality, audit committee, remuneration committee, nomination committee, firm age, firm size)
Where firm performance is measured by Return on Assets (ROA), Return on Equity (ROE), Market to book value (MTBV) and Tobin's Q (TQ). Corporate governance characteristics and control variables are board size (BDS), number of outside directors (NED), board duality (DUAL), audit committee (ACOM), remuneration committee (RCOM), nomination committee (NCOM), firm age (NL-IY) and firm size (NL-NSAL).
