Corporate Governance is "a set of relationships between a company's management, its board, its shareholders, and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently." (OECD Principles of Corporate Governance, 1999).
Though issues in corporate governance have risen to prominence recently, its origins however, go back many years to the time when ownership and management of businesses first became separated. At that time, it was necessary for owners to implement mechanisms to monitor the performance of managers.
According to Heenetigala (2011 cited Chowdary 2003) it is also true that corporate governance in developed market economies has been built gradually over several centuries as a consequence of the economic development of industrial capitalism. As a result, there are different corporate governance structures evolved in different corporate forms to pursue new opportunities or resolve new economic problems.
Today corporate governance is said to be complex and mosaic, consisting of laws, regulations, politics, public institutions, professional associations and a code of ethics. Furthermore, even in the emerging markets of the developing countries many details of these structures are still missing.
2.1.1 Definitions of Corporate Governance
As per Heenetigala (2011 cited Roche 2005) corporate governance is not easy to define as a result of the continuing expanding boundaries of the subject. Therefore definitions vary according to the context and the cultural situations (Armstrong & Sweeney 2002) and the perspectives of different researchers. For example, according to Tricker (2000), corporate governance is an umbrella term that includes specific issues from interactions among senior management, shareholders, board of directors, and other corporate stakeholders. On the other hand, Blair (1995) argues that corporate governance implicates, "the whole set of legal, cultural, and institutional arrangements that determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are allocated."
According to Organization for Economic Co-operation Development (OECD) principles, corporate governance is a system by which business corporations are directed and controlled.
However, corporate governance is considered to have wider implications, which are critical to economic and social well-being and stability and equity of a society. This is captured in the broader definition stated by Adrian Cadbury. He defines corporate governance in line with the stakeholder approach:
Corporate governance is concerned with holding the balance between economic and social goals, and between individual and communal goals. The governance framework is there to encourage efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align nearly as possible the interest of individuals, corporations and society (Cadbury 2000).
2.1.2 Importance of Corporate Governance
Corporate governance promotes efficient use of resources within the firm and the larger economy. It also helps firms to attract low cost investment capital through improved investor and creditor confidence, both nationally and internationally. It also increases the firms' responsiveness to the need of the society and results in improving long-term performance (Gregory & Simms 1999).
Good governance tries to achieve firm-wide efficiency and a fair return for investors'. Furthermore, good governance can also benefit a company through better flow of funds, strong internal controls and discipline.
According to Keong (2002) good corporate governance brings better management and prudent allocation of the company's resources, and enhances corporate performance which would significantly contribute to the company's share price, increasing the value of a shareholder's holdings.
2.2 Theoretical Perspective of Corporate Governance
Corporate governance lacks any accepted theoretical base or commonly accepted paradigm as yet (Carver, 2000; Tricker, 2000; Parum, 2005; Larcker, Richardson and Tuna, 2007;Harris and Raviv, 2008).As such corporate governance research lacks coherence of any form, either empirically, methodologically or theoretically, implying that piecemeal attempts have been made to understand and explain how the complex modern organization is run. As a result, a number of different theoretical frameworks, originating from a broad range of disciplines including economics, finance, management and sociology, have been used by researchers in explaining and analyzing corporate governance. Using various terminologies, these frameworks view corporate governance from different perspectives (Bhuiyan & Biswas ca.2009). Therefore, the theoretical perspectives that are relevant to this study are based on the governance structures and reporting practices that affect the value of the firm.
2.2.1 Agency Theory
Since the early work of Berle and Means (1932), corporate governance has focused upon the separation of ownership and control which results in principal-agent problems arising from the dispersed ownership in the modern corporation. Even the most fundamental corporate governance problem deals with how is the principal (shareholder) able to prevent the agent (generally management) from maximizing his own self-interest (Jensen & Meckling,1976 ; Fama & Jensen ,1983).Therefore, a monitoring mechanism is designed to protect the shareholder interest because when the agent tries to maximize his interest; this might conflict with the objectives that are used to achieve better firm performance.
2.2.2 Stewardship Theory
In contrast to agency theory, stewardship theory presents a different model of management, where managers are considered good stewards who will act in the best interest of the owners (Donaldson & Davis 1991). The fundamentals of stewardship theory are based on social psychology, which focuses on the behavior of executives. In this model managers are more likely to serve organizational rather than personal goals where their needs are based on growth, achievement and self-actualization; they identify themselves with their organization and remain highly committed to the organizational values (Davis et al. 1997).
According to Smallman (2004) where shareholders wealth is maximized, the steward's utilities are maximized too, because organisational success will serve most requirements (including better performance) and the stewards will have a clear mission. He also states that, stewards balance tensions between different beneficiaries and other interest groups. Therefore stewardship theory is an argument put forward for firm performance that satisfies the requirements of the interested parties resulting in dynamic performance equilibrium for balanced governance.
2.2.3 Stakeholder Theory
With a view to discuss the firm's responsibility in relation to the wider community the Stakeholder theory is used. A stakeholder is any group of individuals who can affect or is affected by the activities of the firm, while trying to achieve its objectives (Freeman 1984). According to Ansoff (1965), a firm's objective could be achieved through balancing the conflicting interests of these various stakeholders. The stakeholder theory is in fact an extension of the agency perspective, where responsibility of the board of directors is increased from shareholders to other stakeholders' interests (Smallman 2004).
In fact the stakeholder theory provides a vehicle for connecting ethics and strategy (i.e., Phillips, 2003), and that firms that diligently seek to serve the interests of a broad group of stakeholders will create more value over time (i.e., Campbell, 1997; Freeman, 1984; Freeman, Harrison & Wicks, 2009) and perform better. This is also because a firm's decisions, and hence its performance, can be affected by the stakeholder activities.
2.3 Corporate Governance and Firm Performance
Many Corporate governance reforms, were made with a view to increase investor confidence in their capital markets which in turn increases firm performance. Among these were reports produced on corporate governance like the Cadbury, Hampel , Greenbury and Higgs reports in the UK, the Bosch report in Australia, the Business Roundtable report in the US and OECD Principles of Corporate Governance (Haniffa & Hudaib 2006).
Moreover, Khurram Khan et al. (2011) investigated the effect of corporate governance on firm's performance of the Tobacco Industry of Pakistan by making use of data as from the year 2004 to 2008. The results showed that there is a strong and positive impact of corporate governance on firm's performance.
Muhammad Azam et al. (2011) examined the impact of corporate governance on the performance of firms from the oil and gas sector of Pakistan. A sample of 14 oil and gas related firms was taken for the period of 2005 to 2010.The findings show that corporate governance has significant and positive impact on firm's performance and it is concluded that the performance of a firm can be increased by improving the corporate governance structure.
Brown and Caylor (2004) conducted a study entitled: "Corporate Governance and Firm Performance". The study examined whether firms with weaker corporate governance perform more poorly than firms with stronger corporate governance. It was found that firms with weaker corporate governance performed more poorly.
There are also documentary evidence suggests that the relationship between corporate governance structure and firm performance can either be positive (Morck et al., 1989), negative (Lehman and Weigand, 2000), or none (Burkart et al., 1997; Bolton and Von Thadden, 1998).
2.3.1 Board Structure and Firm Performance
Heenetigala (2011 cited Berle & Means 1932; Mace 1971) found that there are different ways in which boards can be structured to meet the needs of the organization. The variation in governance structures reflects the following competing view ; where it is believed that boards are formed to maximize the managerial control of the firm's board, resulting in superior performance due to the inside information and better understanding of the needs of the firm than is possible with outside independent directors. As such external investors consider corporate governance as a significant factor which affects their investment decisions, because appropriate governance structures reduce risks and promote performance (Davis 2002). The governance structures that are considered in this study are: board leadership, board independence (composition), board committees and board size.
A review of the existing research which addressed board structure in relation to the director composition and leadership structure, argued that board structure can influence a variety of organizational outcomes (Donaldson & Davis 1991; Daily & Dalton 1994, 1995; Dalton et al. 1998; Laing & Weir 1999).
The results of a study conducted in the UK by Weir and Lang (2001) on companies that complied with the governance structures, recommended by the Cadbury Committee did not find a relationship between the recommended structures and performance based on accounting-based measure of ROA. They found that the best performing firms have the lowest incidence of Cadbury preferred governance structures comprising of the separation of the CEO and the chairman, and boards comprising of majority of non-executive director representation and board committees. However the poorest performing firms tend to adopt the preferred governance structures. They state that a structure appropriate for one firm may not be suitable to another one.
2.3.1.1 Board Leadership Structure
An important mechanism of board structure is its leadership, which is reflected in the positions of the chairman and CEO (Heenetigala, 2011). Normally, combined leadership structure occurs when the CEO is both the CEO and the chairman and Cadbury (2002) refers to this as combined leadership. Alternatively, separate leadership is when two different people occupy the positions of the chairman and CEO (Rechner & Dalton 1991). Separation of the role of CEO and chairman is largely grounded in the agency theory (Dalton et al. 1998), because the role of the board of directors is to monitor management and to protect the interests of the shareholders (Fama & Jensen 1983). However, combining the roles of the CEO and the chairperson, will result in a dominant CEO which will lead to ineffective monitoring of the management by the board (Lam & Lee 2008). Conversely, advocates of stewardship theory argue that managers are inherently trustworthy and are good stewards of firm resources and work to attain a higher level of corporate profits (Donaldson & Davis 1991, 1994). An advantage of combining the two roles is that it strengthens the leadership (Suryanarayana 2005).
Baliga et al. (1996) found weak evidence that duality of board chairman and CEO affect long term performance of US companies. Moreover, by analyzing 347 Kuala Lumpur Stock Exchange (KLSE) listed companies, Haniffa and Hudaib (2006) provides evidence that companies with role duality seem not to perform as well as their counterparts with separate board leadership. Yermack (1996) and Brown and Caylor (2004) also support the notion that firms are more valuable when the CEO and board chair positions are separate.
In addition, agency theorists argue that the same person holding the CEO and chairman roles simultaneously will reduce effectiveness of board monitoring, whereas the argument put forward by stewardship theorists is that one person holding both roles may improve performance. A study conducted by Daily and Dalton (1992) reported no relationship between combined leadership structure and performance indicators, and Rechner and Dalton (1991) also reported that a firm which had a separate leadership structure indicated higher performance than firms with combined leadership structures.
Cyril H. Ponnu, (2008) examined the effect of corporate governance on company's performance of the Malaysian Public Listed Companies using data for the years 1999 and 2005. Performance of the companies was compared with duality and board's independence with those without duality and board's independence. The results show that there is no significant relationship between corporate governance structures and company's performance.
2.3.1.2 Board composition
Another important mechanism of board structure is the composition of the board, which refers to executive and non-executive director representation on the board. Both agency theory and stewardship theory apply to board composition. Boards dominated by non-executive directors are largely grounded in agency theory. According to agency theory, an effective board should be comprised of a majority of non-executive directors (their key responsibility being monitoring), who are believed to provide superior performance due to their independence from firm management (Dalton et al. 1998). In contrast to this the stewardship theory stipulates that the board of directors should comprise of a majority of executive directors (whose responsibility is the day-to-day operation of the business such as finance and marketing), this theory argues that managers are good stewards of the organization and work to attain higher profits and shareholder returns (Donaldson & Davis 1994).
If the representation on the board of non-executive directors increased the effectiveness of monitoring, then the performance of the company should improve. Studies by Fama (1980) and Fama and Jensen (1983) indicate that non-executive directors have more incentive to protect the interest of the shareholders, because of the importance of maintaining their reputation in the market for outside directorships. Therefore, independent directors are considered valuable by the regulators due to their importance of better monitoring. Beasely (1996) reports that boards with a majority of outside directors fulfill their monitoring role in respect to financial reporting. Also, the International Corporate Governance Network (ICGN) 2009 states that "corporate boards should be independent."
Empirical evidence reports mixed results in relation to the proportion of non-executive directors and firm performance. However appointment of non-executive directors is widely accepted. Studies conducted by Rosentein and Wyatt (1990), concluded that appointment of outside directors results in significant and positive share price reactions. Companies which are dominated by non-executive directors are more likely to remove the CEO if their entity's performance is poor (Boeker 1992), and they are also likely to initiate restructuring if the performance declines (Perry & Shivadasani 2001). Studies by Hillman and Dalziel (2003), Pfeffer and Salancik (1978) and Yoshikawa & McGuire (2008) report that the expertise and knowledge non-executive directors bring to the firm help it to perform better. Peng (2004) also found that institutional outside directorship impact positively on firm performance.
2.3.1.3 Board Committees
Board committees are also an important mechanism of the board structure providing independent professional oversight of corporate activities to protect shareholders interests (Harrison 1987). The agency theory principle of separating the monitoring and execution function is established to monitor the execution functions of audit, remuneration and nomination (Roche 2005). Corporate failures in the past focused criticism on the inadequacy of governance structures to take corrective actions by the boards of failed firms. Importance of these committees was espoused by the business world (Petra 2007). As a result the Cadbury Committee report in 1992, recommended that boards should nominate sub-committees.
audit committee
Its use is beneficial as it monitors the integrity of the financial statements of the company, review of the company's internal control and risk management systems and others. This committee consists entirely of independent non-executive directors and the CEO may not be its member.
In particular, Brown and Caylor (2004) provide evidence in this respect by showing that solely independent audit committees are positively related to dividend yield, but not to operating performance or firm valuation ( Bhuiyan & Biswas ca.2009).
remuneration committee
This committee must comprise only of non-executive directors, and it must also set the remuneration of executive directors. Hence the purpose of a remuneration committee is to determine the remuneration policy regarding executive directors and also to appraise their performance. In this one the CEO may be a member.
nominating committee
The use of a nomination committee enables the board to independently assess the value of a potential new board member. It does not usually include the chair or the CEO. The use of the nomination committee is to allow for a true assessment of a potential board member based on their experience, merit and industry or other skills that they can offer to the board.
According to the Code of Corporate Governance in Mauritius all companies should have, at a minimum, an audit committee and a corporate governance committee. The Corporate Governance Committee should include in its terms of reference the key areas normally covered by a nomination Committee and a remuneration Committee (unless these have been separately constituted); (Governance, 2004).
Research on the relationship between board committees and corporate performance is scarce (Dalton et al. 1998). However, an investigation of board sub-committees and firm performance by Klein (1998) revealed evidence that the presence of remuneration committees was positively related to firm performance, but the relationship was not strong. On the other hand, Petra's (2007) study on board structures composed of audit, remuneration and nomination committees was not associated with earnings informativeness to the stock market performance, and Weir and Laing et al. (2002) found audit committee structure had no effect on firm performance.
2.3.1.4 Board Size
Board size is mostly used as an indication of both monitoring and advisory role (Klein, 1998). Empirical results on optimal board size are inconclusive. Large board size has been criticized for increasing cost and quarrel about trivial matters during board meetings, while it is also argued that small board size might not effectively monitor powerful managers.
Limiting board size is believed to improve firm performance because the benefits of larger boards (increased monitoring) are outweighed by the poorer communication and decision making of larger groups (Lipton and Lorsch, 1992; Jensen, 1993). Consistent with this notion, Yermack (1996) documents an inverse relation between board size and profitability, asset utilization, and Tobin's Q ( Bhuiyan & Biswas ca.2009).
Even Brown and Caylor (2004) showed that firms with board sizes of between 6 and 15 have higher returns on equity and higher net profit margins than do firms
with other board sizes. Conyon and Peck (1998b) also conclude that the effect of board size on corporate performance (return on equity) is generally negative.
2.4 Firm Performance
Firms may not be able to operate or exist if they are unable to access primary capital, in which case corporate governance would not be relevant as there would be no suppliers of capital (Banks ;2004).
Firm performance considered is based on the value of the firm. Studies show that corporate governance affects firm value as a result of reduced expropriation by insiders and improvement in the expected cash flows that can be distributed to investors (Black et al. 2006; Claessens & Fan 2002; Gomper et al. 2003; Klapper & Love 2004).
To evaluate performance, it is necessary to determine the constituents of good performance using performance indicators. To be useful, a performance indicator must be measurable, relevant and important to the performance of the organization, it must be meaningful and the cost of obtaining the information must not outweigh its value (Oakland 1989).
There are many measures of firm performance. Financial measures of firm performance used in empirical research on corporate governance fit into both accounting-based measures and market-based measures (Kiel & Nicholson 2003). Most commonly used accounting based-measures are return on assets (ROA) (Kiel & Nicholson 2003), return on equity (ROE) (Baysinger & Butler 1985), net profit margin (NPM) and earnings per share (EPS). The most commonly used market-based measures are debt-to-equity and Tobin's Q (Barnhart et al. 1994).However even the free cash flow (FCF) can be used as a measure of financial performance.
2.4.1 Return On Assets
Return On Assets (ROA) is also a measure of performance widely used in the governance literature for accounting-based measures (Finkelstein & D'Aveni 1994; Kiel & Nicholson 2003; Weir & Laing 2001). It is a measure which assesses the efficiency of assets employed (Bonn, Yoshikawa & Phan 2004) and shows investors the earnings the firm has generated from its investment in capital assets (Epps & Cereola 2008). Efficient use of a firm's assets is best reflected by its rate of return on its assets. Since managers are responsible for the operation of the business and utilization of the firm's assets, ROA is a measure that allows users to assess how well a firm's corporate governance system is working in securing and motivating efficiency of the firm's management (Epps & Cereola 2008); (Heenetigala, 2011).
A study conducted by Wassem" mohammad yahya" Al-Haddad et al. (2011) found that there is a direct and positive relationship between performance measured by ROA and corporate governance.
2.4.2 Return On Equity
Heenetigala (2011) found that another important measure of firm performance used in corporate governance research is Return On Equity (ROE), which is also an accounting-based measure (Baysinger & Butler 1985; Dehaene, De Vuyst & Ooghe 2001). The primary aim of an organization's operation is to generate profits for the benefit of the investors. Therefore, return on equity is a measure that shows investors the profit generated from the money invested by the shareholders (Epps & Cereola 2008).
The study considered by Heenetigala.K (2011) further provides evidence in support of a positive relationship for separate leadership, board composition, board committees and firm performance based on ROE.
2.4.3 Earnings Per Share
Even the earnings per share (EPS) can be used as a measure of firm performance. Being an accounting-based measure it tries to indicate whether or not the firm's earnings power on per share basis has changed over a certain period of time.
Aggarwal et al. (2008) examined the relationship between firm performance and governance scores. They found that the relationship generally was not significant between the scores and accounting- based measure of performance EPS which was one among.
2.5.4 Net Profit Margin
The net profit margin (NPM) is used as a performance indicator as it indicates a firm's capacity to withstand adverse economic conditions and how effective it is at cost control. Normally, shareholders look at net profit margin closely because it also shows how good a firm is at converting revenue into profits available for shareholders.
This number is an indication of how effective a company is at cost control. The higher the net profit margin is, the more effective the company is at converting revenue into actual profit.
As mentioned earlier, the study conducted by Muhammad Azam et al whereby NPM was used as a dependent variable for measuring firm performance led to the conclusion that a firm's performance can be increased by improving corporate governance structure.
2.5.5 Leverage
Leverage (LR) is used as a measure of firm performance since it tries to judge the long-term financial position of a firm. It identifies the extent to which a firm uses debt in financing its assets and the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
Furthermore, according to the trade-off theory of capital structure, having a higher leverage (using more debt), will increase the firm value because of the tax deductibility of interest.
The debt-to-equity ratio being used as a measure of financial leverage here indicates what proportion of equity and debt the company is using to finance its assets.
2.5.6 Free Cash Flow
The free cash flow (FCF) is a measure of firm performance being the annual cash flow available after all good investment decisions and all non-discretionary expenditures of cash have been undertaken. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value (the FCF can be returned to shareholders or invested in assets).Without cash, it is tough to develop new products, make acquisitions, pay dividends and reduce debt.
2.5.7 Tobin's Q
Tobin's Q is a market-based measure of profitability widely used in corporate governance studies as a proxy for firm performance (Agrawal & Knoeber 1996; Gomper, Ishii & Metrick 2003; Hermalin & Weisbach 1991). It is defined as the ratio of the market value of assets to the replacement value of assets (Bhagat & Jefferis 2002), which shows the financial strength of a company.
It is considered that the higher the value of Q, the more effective are the governance mechanisms and the better is the market's perception of the company's performance.
Agrawal and Knoeber (1996) found a significant negative relationship between boards dominated by outsiders and firm performance based on Tobin's Q. Studies conducted by Hermalin and Weisbach (1991) in the US and Weir et al. (2002) in the UK using Q-ratio, found no significant relationship between the proportion of non-executive directors and performance (Heenetigala, 2011).
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