The Link Between Board Composition and Corporate Diversification in Australian Corporations

• DOI: http://doi.org/10.1111/j.1467-8683.2009.00734.x
• Author: Sue Wright,Rongrong Chen,Maria Cadiz Dyball
• Published date: 01 March 2009
• Date: 01 March 2009

The Link Between Board Composition and

Corporate Diversif‌ication in Australian

Corporations

Rongrong Chen, Maria Cadiz Dyball, and Sue Wright*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study investigates the association between the composition of the board of directors and

corporate diversif‌ication, to explore the role of the board in corporate strategic choice.

Research Findings/Results: Based on a sample of 101 Australian publicly listed f‌irms in 2005, this study f‌inds that there is

no link between corporate decisions on product and/or geographic diversif‌ication and two aspects of board composition –

board independence and institutional representation. However, there is a positive link between total diversif‌ication and a

third aspect of board composition – the proportion of directors who have ties to boards of corporations in other industries.

Theoretical Implications: The results provide support for the managerial hegemony and the resource dependency theories.

Corporate strategic decisions regarding diversif‌ication are more likely to be made by management than boards of directors,

and to be encouraged by interlocking directors with extra-industry ties.

Practical Implications: Contrary to the requirement or recommendation in many jurisdictions that boards be more inde-

pendent, these results indicate that shareholders’ interests, represented by lower levels of diversif‌ication, are not promoted

under such circumstances. Interlocking directors appear to effectively link the corporation to the external business envi-

ronment and to encourage diversif‌ication. Existing recommendations and regulations to align management with share-

holders’ interests through independent boards should be revised. Board composition should also consider directors’

knowledge, relevant expertise, availability, and length of tenure.

Keywords: Corporate Governance, Board Composition, Managerial Hegemony Theory, Resource Dependency Theory,

Australia, Corporate Diversif‌ication

INTRODUCTION AND AIMS

This study explores the role of the board of directors in

corporate strategic choice. It focuses on the impact that

the composition of the board has on its decisions regarding

the corporation’s product and geographic diversif‌ication, a

topic hitherto not empirically investigatedin the literature. It

links the corporate governance literature to both the f‌inance

and the strategic management literatures, by investigating a

key strategic decision that is discussed in both areas, that is

diversif‌ication.

Do more independent boards, boards with more institu-

tional directors or more interlocking directors make differ-

ent decisions on corporate diversif‌ication? Because of its

exploratory nature, the study tests hypotheses that predict

different decisions by boards with different compositions,

based on alternative theories – managerial hegemony, stew-

ardship, agency, and resource dependency.

Corporate diversif‌ication is def‌ined as participation by the

corporation in other markets (Montgomery, 1994), evidenced

by the reporting of operations in multiple business segments

(Graham, Lemmon and Wolf, 2002). It has been shown to have

a signif‌icant role in economic activity in the US (Lichtenberg,

1992), Japan (Goto, 1981), and the UK (Goudie and Meeks,

1982).1In Australia,more than 70 per cent of the top 300 listed

corporations are diversif‌ied by product and/or geographi-

cally (See Table 1).

For investors, portfolio diversif‌ication generally improves

their individual wealth because it reduces risk and/or

increases return to the portfolio. However, the impact of

corporate diversif‌ication on aggregate shareholder wealth is

debated in the literature. The eff‌iciency theory approach

is that unrelated2corporate diversif‌ication is detrimental

*Address for correspondence: Department of Accounting and Finance, Macquarie

University, NSW 2109,Australia. Email: swright@efs.mq.edu.au

208

Corporate Governance: An International Review, 2009, 17(2): 208–223

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00734.x

to shareholders’ interests and is ineff‌icient (Amihud and

Lev, 1981; Matsusaka, 2001; Graham et al., 2002). Sharehold-

ers can and should diversify their own portfolios as broadly

as possible and will not pay a premium for shares in a

corporation that does this on their behalf. An alternative is

the resources approach, under which f‌irms with more spe-

cif‌ic and more valuable resources diversify around a core

organizational capability (Rumelt, 1982; Varadarajan and

Ramanujam, 1987). This is known as related3diversif‌ication,

and results in increases to aggregate shareholder wealth.

Unrelated diversif‌ication, on the other hand, is not expected

to result in increased shareholder wealth. In this paper, we

focus on unrelated diversif‌ication.

An independent board is widely considered to be an

important element of good corporate governance and is

used as a goal in both legislative and advisory pronounce-

ments regarding corporate governance in many jurisdic-

tions. In the US, the listing requirements of the New York

Stock Exchange and the NASDAQ include requirements

for a majority of independent directors on the board, and

independence requirements for the board’s auditing, nomi-

nating, and compensation functions. The UK’s Financial

Reporting Council recommends that for larger corpora-

tions, at least 50 per cent of the board members should

be independent non-executive directors. In Australia, one

of the Principles of Good Corporate Governance and

Best Practice Recommendations of the Australian Stock

Exchange (ASX)4regarding corporate governance is that

the board should be structured to add value, which is

operationalized in a recommendation that “a majority of

the board should be independent directors” (ASX Corpo-

rate Governance Council, 2003: 19).5

Corporate governance as an integrated set of internal

and external controls seeks to prevent goal incongruence

between management and shareholders (Baysinger and

Hoskisson, 1989). These recommendations and require-

ments ref‌lect a view that boards are a key element of

corporate governance,acting as a formal link between share-

holders and management (Cieri, Sullivan and Lennox, 1994;

Loewenstein, 1994; Bonn et al., 2004) and protecting share-

holders’ interests (Hermalin and Weisbach, 1988; Hill and

Snell, 1988; Heracleous, 2001).

However, the ability of independent directors to protect

shareholders’ interests in practice is limited to the extent

that information asymmetry between management and

independent directors impedes their independence – the

independence paradox (Hooghiemstra and van Manen,

2004). Information asymmetry is a product of the limited

amount of time that independent directors devote to

the corporation (McNulty and Pettigrew, 1999; Maassen

and Van den Bosch, 1999) and their reliance on the

CEO, whom they are monitoring, for information with

which to monitor (Delfos-Roy, 1997 as cited by Hooghiem-

stra and van Manen, 2004; Stiles and Taylor, 2001).

The results in the empirical literature do not support the

view that an independent boardadds value by being directly

associated with higher returns for shareholders (Hermalin

and Weisbach, 2001; Bonn et al., 2004; Hayes, Mehran and

Schaefer, 2004; Nicholson and Kiel, 2007), and this study

does not seek further evidence of it. Our focus is on the role

of the board of directors in one key aspect of its decision-

making, that of corporate strategic choice. This focus is con-

sistent with another of the best practice recommendations of

ASX, which is that boards of directors “make input into and

f‌inal approval of management’s development of corporate

strategy and performance objectives” (ASX Corporate Gov-

ernance Council, 2003: 16).

Some writers have taken the view that the board

may have an indirect inf‌luence on performance, through

its participation in strategic choice and implementation

(Hill and Snell, 1988; Heracleous, 2001). Others propose

that boards only play a review and approval role, control-

ling and inf‌luencing the corporations’ directions through

the management control system (Hoskisson, Johnson and

Moesel, 1994; Hendry and Kiel, 2004). This study’s con-

tribution is to examine the association between the

composition of the board of directors and its corporate

strategic decisions about diversif‌ication, to determine if dif-

ferently composed boards play a more or less active role

in setting strategy, and whose interests they represent in

doing so.

Indeed there is limited research on the relation between

the board and corporate strategic choice. Based on a survey

of CEOs, Tashakori and Boulton (1983) found that board

involvement has signif‌icantlyincreased in all phases of strat-

egy formulation. There is also some evidence of this role in

research investigating the diffusion of innovations in inter-

locking directorates (Mizruchi, 1989; Davis, 1991; Haun-

schild, 1993; Palmer, Jennings and Zhou, 1993). Examining

executives on boards, Geletkanycz and Hambrick (1997)

suggest that executives who maintain extra-industry ties are

associated with the adoption of innovative strategies. This

study contributes to this avenue of researchby exploring the

association between different aspects of board composition

and corporate strategies. Australian corporations have been

chosen for this exploratory research on the basis of the

recency and non-legislative nature of the applicable corpo-

rate governance changes.

The rest of the paper is organized as follows. Section 2

provides a review of relevant literature on the role of board

of directors in corporate strategic choice, and develops the

hypotheses. Section 3 discusses the method, and Section 4

presents the results and their implications. Section 5 con-

cludes the paper, identifying the study’s limitations, areas of

further research, and contributions.

TABLE 1

Top 300 Australian Listed Companies’ Diversif‌ication

Status in Financial Year 2004/2005

Diversif‌ication Status No. of Companies (%)

Non-Diversif‌ied 67 (22.30)

Only Product Diversif‌ied 66 (22)

Only Geographic Diversif‌ied 44 (14.70)

Diversif‌ied in both Directions 106 (35.30)

Non-found Companies 17 (5.70)

Total 300 (100)

THE LINK BETWEEN BOARD COMPOSITION AND CORPORATE DIVERSIFICATION IN AUSTRALIAN CORPORATIONS 209

Volume 17 Number 2 March 2009© 2009 Blackwell Publishing Ltd