Why do Boards Differ? Because Owners Do: Assessing Ownership Impact on Board Composition

• Author: Michel Magnan,Sujit Sur,Elena Lvina
• Published date: 01 July 2013
• Date: 01 July 2013
• DOI: http://doi.org/10.1111/corg.12021

Why do Boards Differ? Because Owners Do:

Assessing Ownership Impact on Board

Composition

Sujit Sur*, Elena Lvina and Michel Magnan

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Does the ownership structure of a f‌irm, specif‌ically the aggregation of the different ownership

types within each f‌irm, relate with the composition of its board?

Research Findings/Insights: Using archival data from a sample comprising 1,487 U.S. f‌irms, we f‌ind that the composition

of the individual prof‌iles of directors on corporate boards (i.e., independent, aff‌iliated, or insider) match a f‌irm’s aggregated

ownership conf‌iguration (institutional, corporate parent, family-entrepreneur control) even after parsing out the impact of

CEO characteristics, f‌irm size, and performance. Further analyses elaborate on the specif‌ic relationship between each

director prof‌ile and ownership types present within the f‌irm.

Theoretical/Academic Implications: This study builds upon three conceptual perspectives: agency, resource dependency,

and behavioral. We argue that each type of ownership has differing imperativesand may prefer different types of directors

to fulf‌ill their governance needs. The paper illustrates thatthe relationship between corporate governance, specif‌icallyboard

composition, and ownership is a comprehensive phenomenon that is best understood through multiple theoretical lenses.

Practitioner/Policy Implications: This study shows thatownership and board composition are not substitutable governance

mechanisms as commonly understood, but might be complementary mechanisms. A f‌inding that governance mechanisms

are complementary implies that regulatory or institutional pressures to modify board composition with the addition of

directors with similar prof‌iles may affect the governance in unforeseen ways.

Keywords: Corporate Governance, Board Composition, Ownership, Director Independence, Structural Equation

Modeling

INTRODUCTION

Acommonly accepted precept in management theory is

that the board represents and safeguards the interests

of the dispersed shareholders (Becht, Bolton, & Roell, 2003),

mitigating the risk of managerial self-serving behavior,

thereby enhancing f‌irm value by reducing agency costs

(Shleifer & Vishny, 1997). Accordingly, the working of

boards, their composition and effectiveness (Muller-Kahle &

Lewellyn, 2011) are enduring topics in the business as

well as the popular press. For instance, while Li and

Harrison (2008) suggest that national culture and institu-

tions drive board composition differences between coun-

tries, Markarian and Parbonetti (2007) point toward

complexity and context as critical drivers. However, there

seems to be no consensus as to the eff‌icacy of boards (Dalton

& Dalton, 2011; Deutsch, 2005).

Paradoxically, practitioners and regulators support the

implementation of “one size f‌its all” board mechanisms and

composition without suff‌icient evidence as to the validity of

underlying concepts (Daily, Johnson, & Dalton, 1999; Merritt

& Lavelle, 2004). The risks underlying such a view manifest

themselves in corporate failures such as Enron, Worldcom

and Lehman Brothers, all three f‌irms having “best practice”

boards, i.e. with a high proportion of independent directors.

Reviewing the evidence on boards of directors, Adams,

Hermalin, and Weisbach (2010) highlight two fundamental

questions whose resolution may allow for a clearer under-

standing of board governance. First, what determines the

makeup of boards of directors? Second, what determines the

board of directors’ actions? Adams et al. (2010) argue that

these questions are closely related and concern the core of

*Address for correspondence: Sujit Sur, Rowe School of Business, Dalhousie Univer-

sity,6100 University Avenue, Halifax, NovaScotia, Canada. Tel: +1 (902) 494-4589; Fax:

+1 (902) 494-1107; E-mail: sujitsur@dal.ca

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Corporate Governance: An International Review, 2013, 21(4): 373–389

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12021

board governance. More explicitly, the composition of a

board affects the functionality of a board and as a result, its

composition is inf‌luenced by the entity or imperative that

determines what function the board needs to fulf‌ill.

Our study focuses on Adams et al.’s (2010) f‌irst question,

namely what determines the makeup of boards of directors.

In our view, a f‌irm’s aggregated ownership ultimately deter-

mines the board’s composition, thus driving boards to seek

and retain individuals who will be able to respond to

owners’ action desires. Anderson and Reeb (2004) also

provide some evidence of a relationship between a specif‌ic

type of owner and their choice of director and call for further

research on the determinants of board composition.

There is a consensus that the board’s role revolves around

two contrasting functions. On one hand, consistent with

agency theory, directors seek to mitigate agency costs by

monitoring management,thus ensuring that its decisions are

conducive to value creation and to the proper use of assets.

On the other hand, directors provide access to resources

(e.g., networks), advice or guidance to management with

respect to strategy or services (Adams et al., 2010; Zahra &

Pearce, 1989), implying a resource-providing functionality

for the board. While often presented in opposition (e.g.,

Armstrong, Guay, & Weber, 2010), these two functions may

also be viewed as the two extreme poles on a continuum,

most directors alternating between them, especially during

board meetings (Brickley & Zimmerman, 2010).

We argue that the prevalent functional role for the board,

as determined by the board composition, depends on a

f‌irm’s aggregated ownership conf‌iguration. Based upon

extant literature, we identify the three types of owners that

may coexist within each f‌irm, namely, individual/family,

corporate, and institutional. The combination of these types

along with their percentage shareholding determines the

aggregated ownership of the f‌irm. We utilize a multi-

theoretical lens to explain why the different owners have

differing views and imperatives, which type of owner

prefers what functionality from the board, and why the

aggregation of the different types of owners within the f‌irm

may be inf‌luential in determining board composition.

We assert that owners’ preferences map into individual

directors’ attributes that will collectively drive board com-

position. For instance, insiders are more likelyto be effective

advisers to family owners/entrepreneurs, independent

(outsider) directors may be in a better position to monitor

management, while aff‌iliated directors may be more effec-

tive in relaying a parent company’s strategic intent. Our

approach rests on the premise that while agency theory

works fairly well in describing board composition and deci-

sions for institutional investor-owners that seek directors

who will monitor management, we also need to retain

complementary theories to understand how other owner-

ship types such as corporations and families inf‌luence

boards. Hence, our paper offers the following unique and

novel contributions to the governance literature.

First, it develops and empirically tests a model that shows

that a f‌irm’s aggregated ownership conf‌iguration, i.e., the

aggregation of the relative stakes owned by the three types

of shareholders, is strongly correlated with a board’s com-

position in terms of insiders, aff‌iliated, and independent

directors. Such a f‌inding might contrast with prior evidence

that focuses on a f‌irm’s largest class of shareholders

(Holderness, 2009), status as widely- or closely-held

(Craighead, Magnan, & Thorne, 2004), or on CEO character-

istics as key drivers of board composition.

Second, it establishes that the two pillars of internal gov-

ernance, namely ownership and board composition (Denis &

McConnell, 2003), are complementary to each other. Such a

f‌inding sheds further light on a long-standing debate as to

whether specif‌ic governance mechanisms should be com-

bined when assessing a f‌irm’s overall quality of governance

(e.g., Poppo & Zenger, 2002). By showing that a f‌irm’s

ownership conf‌iguration relates signif‌icantly to board com-

position, we are able to explain how and why board func-

tionality may differ across ownership conf‌igurations.

Finally, it shows that there is a unique f‌it between owners

and directors, dependent upon a f‌irm’s ownership conf‌igu-

ration. Hence, it is risky to view governance as a “one size

f‌its all” toolkit with specif‌ic mechanisms (e.g., a particular

board composition) designated as “best practice”. In this

context, what constitutes “good” or “bad” governance may

not be as simple as summing up governance features. Thus,

we extend Bhagat, Bolton, and Romano’s (2008) work on

governance indices, where they argue that there is no one

best measure of corporate governance.

CONCEPTUAL UNDERPINNINGS

The Role of the Board of Directors

Adams et al. (2010) suggest that directors’ different duties

and tasks coalesce within two alternative primary gover-

nance roles. On one hand, agency theory provides a frame-

work that guides most research about governance at the

board level (Daily, Dalton, & Cannella, 2003). Consistent

with agency theory, boards act as a control mechanism that

protects shareholders’ interests from self-serving managers

(Beatty & Zajac, 1994; Fama & Jensen, 1983), i.e., the direc-

tors’ function is to monitor management as per the agency

perspective.

On the other hand, boards and directors may act also as a

critical resource that provides advice, counsel, legitimacy,

social capital (Kim & Cannella, 2008; Zahra & Pearce, 1989),

and network resources to a f‌irm’s management (Boyd, 1994;

Daily & Dalton, 1994; Salancik & Pfeffer, 1978; Westphal &

Zajac, 1995). Such resource providing may lead the board

to emphasize strategy as per the resource dependency

perspective, or emphasize ideology as per the behavioral

perspective.

By assigning different roles to a board of directors, agency,

resource dependence and behavioral theories differ in their

assessment of boards’ effectiveness. Moreover, the attain-

ment of differing goals that are dependent upon contrasting

roles suggests that the prof‌iles of boards under each perspec-

tive will differ as well, as each director has specif‌ic expertise,

experience, background, and abilities. Accordingly, most

studies assess the board attributes such as composition (e.g.,

size, insider/outsider ratio, demographics/diversity, func-

tional specialization), board leadership (unitary or duality),

and compensation incentives of board members that may

predict board effectiveness (Hillman & Dalziel, 2003).

374 CORPORATE GOVERNANCE

Volume 21 Number 4 July 2013 © 2013 John Wiley & Sons Ltd