Corporate board structure and foreign equity investments in weak institutional regimes

• Author: Raffaele Oriani,Enzo Peruffo,Sujata Banerjee
• DOI: http://doi.org/10.1111/corg.12298
• Published date: 01 November 2019
• Date: 01 November 2019

ORIGINAL ARTICLE

Corporate board structure and foreign equity investments in

weak institutional regimes

Sujata Banerjee

1

|Raffaele Oriani

2

|Enzo Peruffo

2

1

School of Management, Techno India

University, EM‐4, Salt Lake City, Sector V,

Kolkata, West Bengal 700091, India

2

Department of Business and Management,

LUISS Guido Carli University, Viale Romania

32, 00197 Rome, Italy

Correspondence

Sujata Banerjee, School of Management,

Techno India University, EM‐4, Salt Lake City,

Sector V, Kolkata, West Bengal 700091, India.

Email: sujataluiss2017@gmail.com

Abstract

Research Question/Issue: Concentrated ownership is more the rule than the excep-

tion in weak institutional environments, and the absence of external control mecha-

nisms, leading to ineffective legal enforcement, intensifies principal–principal agency

issues. Our study examines how the structuring of the corporate board plays a vital role

in informing foreign investors about the risk of being expropriated, which affects their

decisions to make equity investments in firms in weak institutional regimes.

Research Findings/Insights: Using a sample of large listed Indian firms in the period

2010–2014, we hypothesize that the presence of affiliate directors on the board has

a negative impact on foreign investments. Likewise, the presence of controlling

owners‐directors on the board together with chief executive officers' additional

directorial positions has an inverted U‐shaped impact on foreign investments.

Theoretical/Academic Implications: By making use of agency theory and focusing

on the importance of foreign financing, our study highlighted the factors that deter

foreign investors from providing capital to firms in weak institutional regimes. The

use of this theoretical perspective, by emphasizing the differences in agency prob-

lems prevalent in strong versus weak institutional regimes, further suggested that

the examination of the structure of corporate boards is an important way to detect and

gauge the potential for expropriation in countries suffering from weaknesses in inves-

tor protection.

Practitioner/Policy Implications: Our study has important implications for corpora-

tions operating in markets suffering from a legal environment that offers little inves-

tor protection. Investors are less prone to invest in these countries, as the risk of

expropriation by dominant shareholders means they cannot be sure of actually get-

ting the putative return. Our work shows how corporations can structure their boards

effectively to convince investors that they face less danger of expropriation and so

attract foreign capital.

KEYWORDS

corporate governance, affiliate directors, CEO “busyness”, controllingshareholders, foreign equity

investment, weak institutional regimes

Received: 15 August 2018 Revised: 17 May 2019 Accepted: 19 June 2019

DOI: 10.1111/corg.12298

458 © 2019 John Wiley & Sons Ltd Corp Govern Int Rev. 2019;27:458–476.wileyonlinelibrary.com/journal/corg

1|INTRODUCTION

Foreign capital plays a significant role in all national economies, but it is

particularly important in developing countries because it helps their

economies to become more open and integrated with the rest of the

world (Singh, 2009). In these contexts, therefore, it is important to

understand the factors that consequently deter foreign investors from

providing capital to firms. Foreign investors, in fact, being at an informa-

tional disadvantage, are more reluctant to invest in companies where

governance mechanisms are poor and weakly enforced and disclosure

is opaque (Leuz, Lins, & Warnock, 2010), as they would face principal–

principal (P‐P) agency problems. These problems are intensified in

developing countries characterized by institutional regimes that provide

weak institutional support (Young, Peng, Ahlstrom, Bruton, & Jiang,

2008) to standard corporate‐governance mechanisms (Peng, 2004).

How, then, can firms in weak institutional regimes attract foreign capi-

tal? Our work addresses this question by building on earlier research and

examining how corporate boards can serve as a means to signal the

effective risk of expropriation to potential or actual foreign investors.

The board of directors is the primary internal corporate‐governance

mechanism (Fama & Jensen, 1983), responsible for adopting control

systems to ensure that “management's behavior and actions are consis-

tent with the interests of the owners”(Filatotchev & Nakajima, 2010,

p. 594). However, boards of directors are complex structures that need

both formal and informal institutional support to function properly

(Aguilera & Jackson, 2003; Young et al., 2008). The lack of such support

makes it less likely that boards will perform a strong monitoring and con-

trol function (Young, Ahlstorm, Bruton, & Chan, 2001; Young et al.,

2008) in weak institutional regimes. This evidence can be attributed to

the lack of fiduciary duties carriedout by the boards of directors in curb-

ing opportunistic earnings manipulation in these countries (Sarkar,

Sarkar, & Sen, 2008; Young, 2000).

As a consequence, it can be easily stated that in developing coun-

tries suffering from weak institutional regimes, a number of expropri-

ation decisions (e.g., earnings management and asset allocation, in the

interests of the controlling groups) are likely to originate in the board-

room. This situation makes examination of the structure of corporate

boards an important way of detecting and gauging the potential for

expropriation (Su, Xu, & Phan, 2008). Miletkov, Poulsen, and Wintoki

(2014) have investigated the role of corporate boards, focusing their

attention on board independence in attracting foreign equity invest-

ment, but they have not elaborated the specific problems associated

with weak institutional regimes.

In this paper, we highlight three features of the board's composi-

tion: the proportion of affiliate directors on the board, the proportion

of controlling shareholders on the board, and chief executive officer

(CEO) “busyness.”These characteristics are chosen for their crucial

role in, and manifest connection with, the issue of expropriation in

weak institutional regimes.

In strong regimes, affiliate directors serve on boards for valuable

advice and counsel (Anderson & Reeb, 2004). In countries with weak

institutional regimes, instead, the power of controlling shareholders

in appointing the other board members makes these affiliates

reluctant to advise CEOs or even to question their judgment (Young

et al., 2001), thereby making P‐P agency problems worse. This situa-

tion is further aggravated when controlling owners also hold manage-

rial positions, making it still easier for them to serve their own

interests at the expense of outside investors (Lin & Chuang, 2011).

Whereas in countries with strong institutional regimes the presence

of controlling owners on boards has the main effect of reducing

principal–agent (P‐A) problems, in weak institutional settings, above

a certain threshold, such a presence runs the risk of exacerbating

P‐P problems. Finally, CEO busyness (or external directorships held

by CEOs) is a further matter of serious concern: According to agency

theory, these outside directorships produce managerial entrenchment

(Geletkanycz & Boyd, 2011) to the detriment of firm performance. The

inefficient management typical of weak institutional regimes means it

cannot control the busyness of executives in the same way as in

strong institutional regimes.

By means of choosing these board attributes, we make various

contributions to the existing literature. By positing corporate board

structure as a device for informing potential foreign investors of the

probability of being expropriated, this study makes a key contribution

in trying to clarify controlling shareholders' direct role (by their being

on the board and/or holding managerial positions) and their indirect

role (appointing chosen representatives in the form of affiliate direc-

tors or in key managerial positions) in influencing boardroom activities

that, in turn, severely impact foreign equity investments in weak insti-

tutional regimes.

Board independence is perceived differently in different institu-

tional regimes. The pervasive influence of controlling shareholders in

corporate boards in weak regimes impairs independent directors from

exercising their judgment (Balasubramanian & George, 2012). Thus,

building upon Miletkov et al. (2014), who focused on the role that board

independence plays in attracting foreign capital, we explore relevant

dimensions of board structure that are significant in distinguishing the

direct and indirect influences of controlling shareholders and, at the

same time, are relevant to the threat of expropriation in weak regimes,

by further considering a richly detailed within‐country sample. The find-

ings of our study, when combined with those of other countries, can

help to identify how governance practices vary depending on firm and

country characteristics, indicating that governance is not one‐size‐fits‐

all (Balasubramanian, Black, & Khanna, 2010).

Our empirical setting uses a database from India, an ideal repre-

sentative of a country suffering from weak institutional regimes and

one that, to our knowledge, has not yet been analyzed in this con-

text. Analyzing the impact of corporate board structure in Indian set-

tings is important because this type of economy has a number of

unique governance issues not prevalent in more widely researched

developed economies (Jackling & Johl, 2009). Furthermore, despite

the increasing importance of Indian equities in global portfolios

(Jameson, Prevost, & Puthenpurackal, 2014) and the weak protection

of minority shareholders, we still have considerably less large‐sample

evidence on the board structure of Indian firms. Hence, we consider

that the focus on India as our “empirical setting”adds further value

to our work.

BANERJEE ET AL.459