Independent directors and firm value of group-affiliated firms

• Published date: 02 May 2017
• DOI: https://doi.org/10.1108/IJAIM-08-2016-0076
• Date: 02 May 2017
• Pages: 217-236
• Author: Amrinder Khosa
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Independent directors and rm

value of group-afliated rms

Amrinder Khosa

Department of Accounting, Monash University, Clayton, Australia

Abstract

Purpose –This study aims to examine the effect of board independence on rm valuation of group-afliated

rms in distinct Indian setting.

Design/methodology/approach –This study uses a sample of 317 listed rms comprising 1,350

rm-year observations for the period 2008-2012. The value-relevance model is used to examine the effect of

board independence on market value of equity.

Findings –The distinct nding of an inverse relationship between board independence and rm value of

group-afliated rms in India illustrates that effective monitoring by outside directors is largely inuenced by

the institutional setting and ownership structure. This study does not nd any evidence of different valuation

when comparing non-family CEOs and family CEOs.

Practical implications –Independent directors play an important role to stop abusive use of

related-party transactions in an environment where principal–principal conict exists. The study’s ndings

will prove useful in determining whether one should rely merely on the independent status of outside directors

or the inuence of institutional setting on effective governance.

Originality/value –This paper contributes to the existing literature in the following ways: it helps to gain

a better understanding of business groups which are characterised by unique governance structures and the

dominance of controlling families on the board, which makes the external governance mechanisms (i.e.

independent directors and non-family CEOs) ineffective and it illustrates that effective monitoring by outside

directors is largely inuenced by the institutional setting and ownership structure.

Keywords Firm value, Board independence, Controlling shareholders, Entrenchment effect

Paper type Research paper

1. Introduction

Starting with Fama and Jensen (1983) and Shleifer and Vishny (1997), several studies provide

evidence of entrenchment effects of controlling shareholders in family rms. The conict

between controlling shareholders and minority shareholders is likely to be more prominent

than the conict between a diversied spread of owners and management in the Asian

context (La Porta et al., 1999). Conict between investors, together with inadequate

regulation in emerging countries, generates an environment best suited for the extraction of

rm resources. Claessens et al. (2002),Lins (2003) and Bertrand et al. (2002) provide evidence

of expropriation of minority shareholders when controlling shareholders have less cash ow

rights and more control rights. Family members often control these group rms through

board memberships, recruiting top management, coordinating actions among member rms

and lobbying the government (Khanna and Palepu, 2000a). Family members can enforce

their controlling power to benet other rms in the group which might not be in the best

interests of public shareholders[1]. The controlling shareholders have even greater

incentives to expropriate the wealth of minority shareholders when they have fewer cash

ow rights (Bertrand et al., 2002).

The ability of minority owners to closely monitor managers is limited by the free-rider

problem, where the outside shareholder bears the full costs of monitoring but receives only a

proportion of the benets (Prevost et al., 2002). The suggested solution to the free-rider

The current issue and full text archive of this journal is available on Emerald Insight at:

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Group-

afliated rms

217

Received 7 August 2016

Revised 31 August 2016

Accepted 4 September 2016

InternationalJournal of

Accounting& Information

Management

Vol.25 No. 2, 2017

pp.217-236

©Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-08-2016-0076

problem is assigning the board of directors the monitoring function on behalf of outside

shareholders. For instance, the board of directors is assigned the function of monitoring

management and preventing wealth-reducing activities (Prevost et al., 2002). OECD (2012)

also emphasises the role of outside directors in the presence of controlling shareholders.

However, the self-control problem existing in family rms also undermines the effectiveness

of outside non-executive directors.

In spite of the obvious advantages of outside directors in the form of expertise, monitoring

skills and diversity, family rms are less likely to use them for the following reasons (Schulze

et al., 2001). First, they pose a challenge to family owners in terms of perceived loss of control.

Second, while the independent status of these directors enhances their ability to provide

advice on some matters, they have little inuence on matters involving family members

(Nelson and Frishkoff, 1991). Third, “hand-picking” independent directors for reasons other

than effective supervision of the management can undermine their value (Rubenson and

Gupta, 1996). For example, controlling families’ tendency to appoint outside members – who

happen to be friends or have a duciary relationship with them (their accountant or board

member from another rm of the family group) – to their company board compromises true

independence. Finally, outsiders rarely attain the status of blockholder in family rms,

which they sometimes do in widely held rms (Alderfer, 1988). Therefore, they are likely to

be less motivated than family members to take active part in the management of the rm.

The arguments presented above suggest that family rms are less likely to use formal

monitoring and control mechanisms than their widely held counterparts.

The focus of this study is on group-afliated rms. The business group structure has a

signicant impact not only on emerging economies but also on developed nations such as the

USA and Japan[2]. For instance, group rms account for 60 per cent of the largest 500 Indian

companies and 65 per cent of total capitalisation of the largest 500 companies (Chakrabarti

et al., 2008); 60 per cent of Chinese total industrial production is contributed by business

groups (SSB, 2000). In South Korea, 40 per cent of total output was contributed by the top 30

business groups (Chang and Hong, 2000). Despite the signicant contribution of business

groups to the Indian economy, examining these groups is limited to their evolution and

transformation (Kedia et al., 2006), group performance (Khanna and Palepu, 2000b),

tunnelling behaviour (Bertrand et al., 2002;Kali and Sarkar, 2011) and investment behaviour

(Lensink et al., 2003). The ndings of this study will generate a better understanding of the

inuence of board independence on rm value of group-afliated rms.

This study focuses on the relationship between board composition and rm value in India

which is differentiated from the extant literature in several aspects. As discussed in the next

section, India’s institutional and corporate environment is different from other developed

countries, and the primary motivation for the study is to examine if these institutional

differences inuence the role of corporate boards. First, the board’s role in effective

governance in India has only recently come under discussion. For instance, mandatory

reforms on board structure were introduced under clause 49 following the Satyam scandal of

2009. Given this relatively recent emergence of interest in the impact of outside directors on

the board and audit committee, an interesting empirical question if outside directors provide

effective monitoring has been brought to light. A nding of a signicant inverse relationship

between board independence and rm value suggests that independent directors of family

rms do not add value to the rm.

Second, the corporate structure in India is also distinct from that prevailing in other

countries. Unlike the USA, UK and other developed markets, the Indian market is dominated

by concentrated ownership. This study examines the group-afliated rms which are often

controlled by founding families through cross-holding. Thus, compared to other markets, the

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