Structuring Corporate Boards for Wealth Protection and/or Wealth Creation: The Effects of National Institutional Characteristics

• Published date: 01 May 2014
• Date: 01 May 2014
• Author: Young Un Kim,Salih Zeki Ozdemir
• DOI: http://doi.org/10.1111/corg.12062

Structuring Corporate Boards for Wealth

Protection and/or Wealth Creation: The Effects

of National Institutional Characteristics

Young Un Kim* and Salih Zeki Ozdemir

Manuscript Type: Empirical

Research Questions/Issue: This study examines variation among f‌irms in different countries in terms of how corporate

boards are structured for effective governance. We discuss the f‌iduciary role of boards along two dimensions: (1) boards as

wealth protectors and (2) boards as wealth creators. We explore how external governance mechanisms affect the emphasis

placed on these two board role dimensions.

Research Findings/Insights: Using data from 23 countries and 19 industries, we show that board structure choices depend

upon nationalinstitutional characteristics. Specif‌ically,Investor Protection, Rule of Law, and Open Markets institution act as

complements or substitutes to how a board is structured to emphasize two different aspects of corporate governance. The

results hold while controlling for f‌irm, industry, and other country level effects.

Theoretical/Academic Implications: We offer a more nuanced understanding of the linkages between internal/f‌irm and

external/institution level governance mechanisms by studying them in tandem. Our results imply that external governance

mechanisms within a nation alter the costs and benef‌its of designing boards for a certain f‌iduciary role. This f‌inding

contributes to the governance bundles literature by articulating how governance mechanisms from both f‌irm and nation

levels conf‌igure together to form national governance bundles.

Practitioner/Policy Implication: As opportunities and constraints differ by country due to distinct institutional character-

istics, f‌irms varyingly structure their boards in accordance with the environment. They emphasize stronger wealth protec-

tion and/or wealth creation, or neither. This paper contributes to public policy by presenting how corporate laws and

de/regulating markets may affect board structure choices.

Keywords: Corporate Governance, Board Roles, Board Composition, Governance Environments, Governance Bundles

INTRODUCTION

There has been an increasing recognition that there is no

one universal way to achieve effective corporate gover-

nance (Bhagat, Bolton, & Romano, 2008; Guillen, 2000;

Yoshikawa & Rasheed, 2009). As a result, there is growing

academic interest on how f‌irms make conscious choices

among alternative governance mechanisms based on the

context the f‌irm resides in (Aguilera, Filatotchev, Gospel, &

Jackson, 2008). These choices are affected by other various

governance mechanisms in play within the f‌irm (Rediker &

Seth, 1995; Ward, Brown, & Rodriguez, 2009). Moreover,

they also depend on the external environment the f‌irm

faces (Filatotchev & Nakajima, 2010; Judge, Filatotchev, &

Aguilera, 2010; Li & Harrison, 2008).

A growing body of evidence has conf‌irmed this position

and uncovered that governance practices varysystematically

across f‌irms and nations (Aguilera & Jackson, 2003; Doidge,

Karolyi, & Stulz, 2007).An explanation of this variance is the

differences in institutions that nations develop and possess.

Institutions shape how f‌irms organize themselves to

compete in the market and portray themselves to investors

(North, 1990; Scott, 2001). The institutional context in which

the f‌irm operates further works as an external governance

mechanism through establishing various cultural norms,

regulations, and policies (Judge, Douglas, & Kutan, 2008).

Although external and internal governance mechanisms

operate together and inf‌luence each other, there has been

little research integrating the two governance mechanisms.

Thus, how the institutional context as an external gover-

nance mechanism shapes the potential benef‌its or costs of

incorporating f‌irm level governance practices needs further

investigation.

*Address for correspondence: YoungUn Kim, Australian School of Business, Univer-

sity of New South Wales,Sydney, NSW 2052, Australia. Tel: +61 02 9385 9727; E-mail:

young.kim@unsw.edu.au

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Corporate Governance: An International Review, 2014, 22(3): 266–289

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12062

Furthermore, arguments on effective internal governance

practices have centered around agency theoretical perspec-

tives, where a corporate board is predominantly structured

to monitor and protect shareholders from self-interested

managers (Daily, Dalton, & Cannella, 2003; Fama & Jensen,

1983; Petrovic, 2008). However, as part of their f‌iduciary

role, corporate boards should also be concerned with advis-

ing and coaching managers to assist with prof‌it maximizing

decisions (Filatotchev, Toms, & Wright, 2006; Pugliese,

Bezemer, Zattoni, Huse, Van den Bosch, & Volberda, 2009;

Zahra & Pearce, 1992). Following Filatotchev et al. (2006),

we refer to effective corporate governancethrough minimiz-

ing downside shareholder risk from managerial opportun-

ism as “wealth protection” and through maximizing share-

holder value from the upside potential of f‌irms as “wealth

creation” aspects of corporate governance. Both functions

help the board satisfy their f‌iduciary role to yield share-

holder benef‌its but in very different ways. Moreover, the

two governance functions are not mutually exclusive.

Boards can be structured to accommodate neither, only one,

or both. However, we know little about how f‌irms choose

and emphasize a specif‌ic governance function.

To address these gaps, we seek to build on the corporate

governance bundles literature by extending complementary

and substitutive effects of internal governance mechanisms

to include external governance mechanisms. For external

governance mechanisms, we specif‌ically focus on three

important institutional environments, which directly or

indirectly govern business activity: (1) strength of investor

protection, (2) strength of rule of law, and (3) openness of

markets. These institutional contexts have been shown to

impact legitimacy of governance practices (Judge et al.,

2008), emphasis placed on all stakeholders vs. only share-

holders (Aoki, 2001), executive remuneration (Filatotchev &

Allcock, 2010), and earnings management (Leuz, Nanda, &

Wysocki, 2003). In this study, we particularly focus on how

these institutions affect the potential benef‌its and costs of

incorporating a f‌irm level governance practice to ultimately

shape which board function, whether wealth protection

and/or wealth creation, is emphasized.

Overall, this paper contributes to the corporate gover-

nance literature in two primary ways. First, we assert that

effective governance includes aspects of both upside and

downside potential, an important but sparsely researched

area where empirical evidence is much needed. Second, we

bridge literatures on f‌irm corporate governance practices

and nationalgovernance systems to uncover how f‌irms align

internal governancepractices with the external environment

they face to achieve effective governance. In recognizing

these points, this study especially provides insights into how

governance mechanisms operate concurrently at the f‌irm

and national levels to form national governance bundles

(Aguilera & Jackson, 2003; Judge, 2012).

GOVERNANCE ROLES OF BOARDS

How f‌irms compose their boards of directors is an important

research area within the corporate governance literature

(Finkelstein, Hambrick, & Cannella, 2009). Hendry and Kiel

(2003) assert that boardstructure gives clues about the politi-

cal and psychological aspects of board behavior. How a

board is conf‌igured in terms of its structure is a key deter-

minant of what board members can do and what roles the

board of directors can play for the f‌irm (Deutsch, 2005;

Minichilli, Zattoni, & Zona, 2009; Petrovic, 2008). As a result,

board composition and the functioning of boards are funda-

mentally intertwined (Adams,Hermalin, & Weisbach, 2010).

The overarching purpose of the board is one of a f‌iduciary

role: to represent shareholders and maximize shareholder

return (Adams et al., 2010; Bhagat et al., 2008; Stiles &

Taylor, 2001). This can be achieved in two ways: (1) resolving

agency problems and ensuring the minimization of down-

side shareholder risk and (2) helping managers to realize the

upside potential of the f‌irm through involvement in strategic

decision making (Filatotchev, 2007; Filatotchev et al., 2006;

Lorsch & MacIver, 1989). In other words, while monitoring

the top management team is a critical function of the board,

it is not its sole function; functions of the board also include

the review, development, and monitoring of strategy.

However, the focus on increasing this upside potential by

coaching managers to increase competitiveness of the f‌irm

has been underemphasized in both the corporate boards

literature and the literature examining bundles of gover-

nance mechanisms (Aguilera et al., 2008; Kim, Burns, &

Prescott, 2009).

The literature has perceived these two focuses of corpo-

rate governance using various terms.1Although the terms

are quite similar, in this study we follow the terms laid out

by Filatotchev et al. (2006) and use wealth protecting vs.

wealth creating as two aspects of corporate governance to

describe how boards are structured to emphasize a particu-

lar function. These two functions of the board should be

considered in tandem as the two are quite distinct with

respect to approach, process, and their demands on board

composition (Ees, Gabrielsson, & Huse, 2009; Hermalin &

Weisbach, 2003). Furthermore, while corporate boards can

be structured for either wealth protection or wealthcreation,

they can also be structured to provide both functions at the

same time (Pugliese et al., 2009) or they can be structured for

neither function (Adams et al., 2010; Hermalin & Weisbach,

1988).

Wealth Protection Function of Boards

A core role of corporate boards is to prevent managers from

appropriating shareholder wealth for private benef‌it (Jensen

& Meckling, 1976). The ability to control and effectively alle-

viate any agency problems arising from misalignment of

managers’ and shareholders’ interests depends largely on

the use of a board’s monitoring power (Fama & Jensen, 1983;

Westphal & Zajac, 1995). Much of the literature on corporate

governance has voiced well-functioning boards that are

able to vigilantly monitor and protect shareholder wealth in

the same breath with good f‌irm performance (Ferris,

Jagannathan, & Pritchard, 2003; Johnson, Daily, & Ellstrand,

1996). This role has been highly emphasized especially given

the high prof‌ile corporate debacles and many instances of

corrupt accounting practices. The emphasis of this role is to

minimize agency problems and devise ways to reduce man-

agers’ private gain or theft while focusing less on developing

strategy. The wealth protection role used other names such

STRUCTURING CORPORATE BOARDS 267

Volume 22 Number 3 May 2014© 2014 John Wiley & Sons Ltd