The Separation of Corporate Ownership Finance Essay

Agency theory suggests that the separation of corporate ownership and control potentially leads to self-interested actions by managers (Jensen and Meckling, 1976). To combat agency problems, outside directors, due to their presumed independence relative to insiders, may be able to do a better job in monitoring and controlling management, thus helping improve firm performance (Walsh and Seward, 1990). In the conceptual, practitioner, and policy literature, there is a near consensus in favor of a higher proportion of outside directors. Still dwelling on whether independent directors produce superior performance for firms, and value for shareholders, Choi et al. (2007) report that the effects of independent outside directors on firm performance are strongly positive. Reporting under a study titled "Do outside Directors Enhance Firm Performance: Evidence from an Emerging Market", the authors comment that the results of their study "support a notion that board independence is critical in post-crisis emerging market environments that lack sufficient liquidity and infrastructure, and which are subject to economic instability and external shocks." So, for South Korea, an emerging market country, this study provides evidence that there is a positive relationship between board independence and higher firm performance, especially in the aftermath of the Asian crisis of 1997 which was seen to have occurred as a result of the poor governance system of that region. The authors thus report that the basic empirical result of their study is that board independence, measured by the proportion of outside directors on the board, has significant and positive effects on firm performance in the post economic- crisis Korea. They note that this positive relationship with firm performance is stronger in firms with true independent directors than with those whose non-executive directors have professional ties with their firm (grey directors). Comparing their findings with earlier findings in the US, the authors contrast their results from those obtained in the US that affirm no positive relationship between board composition and firm performance. An Analysis of the association between firms' investment opportunities, board composition and firm performance is the subject of a study by Hutchinson (2002) in which 229 Australian firms were surveyed. Results of the study showed that the investment opportunities of the firms surveyed are strongly associated with a higher proportion of executive directors on the board. That is to say that firms that have a higher proportion of executive directors on their board tend to have more investment opportunities than firms with a greater proportion of non-executive directors. The result of the study also suggests that a higher proportion of non-executive directors on the board of growth firms monitor managers' actions to ensure that such actions are value adding. Again, the author reports that the interaction of investment opportunities and the proportion of non-executive directors on the board shows that firms perform better with increased number of non-executive directors on the board. This suggests that the negative relationship between firm performance and investment opportunities is weakened when the proportion of non-executive directors on the board is higher. Thus, it does appear that the monitoring role of non-executive directors overcomes the agency problem of high investment opportunities such that these firms become more profitable. Kumar and Sivaramakrishnan (2007) used an agency model of the firm to analyze how the board-CEO relationship affects shareholder value. They measured board dependence on the CEO by the extent to which the board's interests are intrinsically aligned with the CEO's interests, and came to the finding that, other things held constant, a more dependent board exhibits a greater alignment with the CEO. They were thus able to examine the effects of bringing to the board more independent directors or less of them on the firm's investment, managerial compensation, board equity compensation and shareholder value. The main finding in this study is that shareholder value can increase as board dependence (not independence) increases. Indian Evidence: In developed economies corporate governance issues mostly focus on disciplining the management, whereas in case of emerging economies such as India, the problem lies in limiting expropriation of minority shareholders. Indian corporate sector is characterized by the presence of largely three types of companies: a) public sector units, where government is the major shareholder, b) multi-national companies, where the foreign parent is the major shareholder, and c) the Indian business groups where either the promoters are major shareholders or they have a minority stake with government owned financial institutions owning a sizeable stake and rest owned by the general public. The problem of dominant shareholders, with or without a higher stake, gives rise to serious corporate governance issues (Varma, 1997) in case of India such dominate shareholders are a particular group or family. The quality of corporate governance in such a family based organization is always been an issue. India presents a unique scenario for corporate governance research because of the important role played by the promoters of Indian companies. The promoters maintain control over the group companies by virtue of a pyramid ownership structure. Unlike in the Western countries, the major corporate governance problem in India is one of exploitation of the minority shareholders by the promoters who are often the majority shareholders. ( Mishra, Mohanty 2006). Corporate governance in emerging economies such as India poses a challenge due to the typical characteristics associated with such economies such as imperfect product market, illiquid capital market, rigid labor market and regulatory environment, and lack of adequate contract enforcing mechanisms (Khanna and Palepu, 1997). Companies with good governance practices raise money at a lower cost of debt (Agarwal et al., 1996). The linkage between corporate governance and firm performance in the presence of information asymmetry and institutional void makes an interesting area of research, particularly in countries such as India. Independent directors on the board have significant impact on the performance of the firm. The efficacy of outside directors on the corporate boards of non-financial Indian companies for influences firm performance. Research finding reveals that while the proportion of grey directors on board has marginally deteriorated effect, the independent director's proportion has an insignificant positive effect on firm value. (Kumar and Singh 2008) Several other empirical studies, however find either no significant effect or negative effect of outside directors on firm performance. Many researchers (Baysinger and Butler, 1985; Dalton et al., 1998; Dalton and Daily, 1999; Fernandes, 2005) do not find any relationship between board composition with representation of outside independent directors and firm performance. Hermalin and Weishbach (1991), Meharan (1995), report an insignificant relation between corporate board independence and various measures of firm performance. Many researchers also have reported a negative relationship between the proportion of outside directors and firm value. Bhagat and Black (2002), finds a negative relationship between the proportion of outside directors on board and firm performance. Efficacy of outside directors as governance mechanism is therefore questionable in the developed counties because of presence external governance mechanism like mergers and acquisition, market for corporate control and product market competition.

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