Corporate Governance and Firms Performance in Nigeria

BY Muhammad Tanko Department of Accounting, Kaduna State University, Kaduna-Nigeria And Oladele O. Kolawole Department of Economics and Management Sciences, Nigerian Defence Academy, Kaduna-Nigeria

Abstract The aim of this paper is to measure the relationship between corporate governance and the performance of firms in Nigeria. To achieve this objective, we use Return on equity, Net profit margin, Sales growth, Dividend yield, and Stock prices/values as the key variables that defined the performance of the firm. On the other hand, for the measure of corporate governance, we use Board Independence, Board size, audit independence, ownership, and the progressive practices of the company. The paper found that there is a high relationship between the boards size of the companies use in the study and their performances. On board composition, the study found that averages of 30 percent of all board members are outsiders which suggest that these boards are relatively not independent. They therefore show weak relationship in that direction. The study concludes that the more outsiders there are on a companys board, the better the performance in terms of return on equity. On CEO to serve as the chairman of the company, the study found that when a CEO also serves as the board chairman performance worsens. It is the recommendation of the paper that there should be on the average about 10 to 15 board members for a firm that is averagely large. The composition of the directors should be more outsiders, as there is evidence as to the relationship between the compositions of the directors to the performance of the firm. Furthermore, since performance worsens when the chief executive serves as the board chair, it is the recommendation of the paper that the two positions should be separated. Keywords: Corporate Governance, Firm Performance

Introduction Corporate Governance has become a central issue of policy debate for more than 3 decades now. The mechanism of corporate governance and the type of information about corporate decisions on the one hand and on the other hand, the performances of the firm and the information that the corporation should make public, constitutes major issues of discussion in the corporate governance debate. Specifically, the issue of making corporate financial reporting more transparent to the stakeholders, and the extent to which, the oversight bodies set to oversee the firms becomes functional. The practice good corporate governance is seen as the ultimate objective of studies in this area, which the neoclassical theory of market economy defines as the maximization of shareholders value. The theoretical foundation of this understanding is the fact that, in a develop or market economy, existence of well-functioning markets in capital, labor and products ensure the allocation of scarce economic resources to their best alternative uses to achieve the most efficient performance of the economy that is possible. In contrast to this theory, Alexander and Matts, (2003) observe that, corporate managers, rather than markets, exercise allocative control. Furthermore, Oliver (1985; 1996) observe that Asset Specificity made it necessary for managerial control over the allocation of resources, thus creating agency problem for those principals who have made investments in the firm. Desai and Yetman (2004), Identified two areas of agency problems that made human ability to make allocative decision imperfect; the cognitive and behavioral limitations. The cognitive limitation is hidden information, also known as bounded rationality. This prevents investors from knowing a prior whether the managers, whom they have employed as their agents, allocate resources in the most efficient manner. The behavioral limitation, also known as opportunism, is hidden action that reflects the productivity, inherent in an individualistic society of managers as agents to use their positions for resources allocation to pursue their own selfish interest and not necessarily the interest of the firms principals. This makes it very crucial and important to study the existence of the influence of corporate governance on the performance of firms. What it means is that, how a good governed firm does performed differently from a bad governed one. Or in other words, is there any difference between a good manager and a bad manager? And can the difference be seen in the performance of the firm they governed. This are some of the issues that this paper intends to look at. The aim of the paper therefore, is to measure the relationship between corporate governance and the performance of firms in Nigeria. The rest of the paper is structured into four sections. Section two

discusses the literature, and section three the methodology, while section four cover the discussion and analysis. Concluding remarks were made in section five. Literature Review Corporate governance issues have received wide attention of researchers for more than three decades now. The definition of the term goes along the line of who is defining the term. For instance, the way the investor will define the term may be different with the definition of a manager in the firm. Metrick and Ishii (2002) for example, define corporate governance from the perspective of the investor as both the promise to repay a fair return on capital invested and the commitment to operate a firm efficiently with a given investment. Now this definition clearly states the need to raise funds and give adequate return as the yardstick or guiding drive of the definition. That is why Metrick and Ishii (2002) argue that firm level governance may be more important in developing markets with weaker institutions as it helps to distinguish among firms. According to Mayer (1997), corporate governance is concerned with ways of bringing the interests of investors and managers into line and ensuring that firms are run for the benefit of investors. Corporate governance is concerned with the relationship between the internal governance mechanisms of corporations and societys conception of the scope of corporate accountability (Deakin and Hughes, 1997). Corporate governance as defined by Alexander and Matts, (2003) refers to corporate decision making and control, particularly the structure of the board and its working procedures. Ahmed (2004) sees the term as the arrangement between the managers of the firm and the owners of the firm, particularly, addressing the issue of how managers report the financial health of the firm to the owners. Cadbury Committee (1992) defines corporate governance as the system by which companies are directed and controlled. Corporate governance has also been defined by Keasey et al (1997) to include the structures, processes, cultures and systems that engender the successful operation of organizations. The definition could therefore be centered on how the organization relates with other stake holders within an environment. Therefore, corporate governance describes how companies ought to be run, directed and controlled (Cadbury Committee, 1992). It is about supervising and holding to account those who direct and control the management. The problems faced by researchers is not only on defining the term, but also what level of corporate governance results to good or bad corporate governance. This paper therefore identified factors that best define good corporate governance. Furthermore, the paper addresses the issue of firm performance, which over the years has also receive wide range of interpretations. Some look at the

firm performance to mean the development of share prices, while others view it as the firm is said to perform when it has made a lot of profit or it has increase its present value. This is also defined in the paper under the methodology. Corporate Governance and Firm Performance The empirical literature shows that a lot of studies try to measure the corporate governance influence on firm performance. The first group of researches in this area reported inconclusive results as their findings, for instance the works of Heracleous (2001), Yermack (1996), Claessens et al., (1999); Klapper and Love, (2002); Gompers et al., (2003); and Black et al., (2003). Heracleous (2001) in his study concludes that, studies have failed to find any convincing connection between the best practices in corporate governance and organizational performance. Furthermore, Barkema and Gomez-Mejia (1998) argue that firms governance structure play no significant role in the study of CEO and performance of firm. Coles, et al (2001) argue that firms have the ability to choose among different governance mechanisms that results to the optional performance of the firm. The second group of the researches in this area has shown that well governed firms have higher firm performance, for example the works of Bebchuk & Cohen (2004), Bebchuk, and Cohen & Ferrell (2004). In a study by Me Kinsey (2003), he surveyed over 200 Institutional Investors and found that 80% of the respondents would pay a premium for well governed companies. The research has been able to capture a perceived interest of investors that are willing to pay premium for good corporate governance. The findings of Antunorich et al (2000) and that of Business week (2000) have further echoed the finding of Kinseys that Investors favored companies that are perceived to be wellgoverned. Cubin & Leech (1983) studied the relationship between governance and performance and find that a positive relation exists between ownership concentration and profitability. Other studies that examine the CEOs remuneration and performance relationship include the studies of Jensen and Murphy (1990), Barkema & Gomez-Mejia (1998) and Dalton et al (1998). These studies have identified factors such as, board composition, financial expertise of the board members, and whether the CEO is also the board chairman, as the main characteristic of corporate governance. Furthermore, kessey et al (1997), Identified key mechanism of an effective corporate governance framework to include ownership, directors and the board, CEO, auditing and information, directors remuneration, and the market for corporate control. Similarly, sheleifer and Vishnu (1997) supports the contribution of keasey et al (1997).

There is a view that larger boards are better for corporate performance because they have a range of expertise to help make better decisions, and are harder for a powerful CEO to dominate. However, recent thinking has leaned towards smaller boards. Jensen (1993) and Lipton & Lorsch (1992) argue that large boards are less effective and are easier for a CEO to control. When a board gets too big, it becomes difficult to coordinate and becomes problematic especially in terms of the process involve in decision making. Smaller boards also reduce the possibility of free riding by individual directors, and increase their decision taking processes. Empirical research supports this, for example, the study of Yermack (1996); Eisenberg et al. (1998); Kyereboah-Coleman and Biekpe (2005) and that of Mak and Yuanto (2003). Kyereboah-Coleman and Biekpe, (2005), for example found that small board sizes enhance the performance of firms quoted on the stock exchange. Mak and Yuanto (2003), also found that firm valuation is highest when board has five directors, a number considered relatively small in their study for the markets they considered in their sample. Though the issue of whether directors should be employees of or affiliated with the firm (inside directors) or outsiders has been well researched, yet no clear conclusion is reached. On the one hand, inside directors are more familiar with the firms activities and they can act as monitors to top management if they perceive the opportunity to advance into positions held by incompetent executives. On the other hand, outside directors may act as professional referees to ensure that competition among insiders stimulates actions consistent with shareholder value maximization (Fama, 1980). John and Senbet (1998), argue that boards of directors are more independent as the proportion of their outside directors increases. Though its been argued (Fama & Jensen 1983, Baysinger and Butler 1985, Baysinger & Hoskinsson, 1990, Baums 1994) that the effectiveness of a board depends on the optimal mix of inside and outside directions, there is very little theory on the determinants of an optimal board composition, or the factors that determines the size of the board that remains optimal. (Hermalin & Weisbach 2002). Another aspect of the corporate governance and firm performance issue is the position of the chair and the chief executive of the firm. Researchers find mixed evidence, on which is better, between separating the position of the chair of the firm with that of the CEO. Yermack (1996) argue that, firms are more valuable when the CEO and board chair positions are separate. Furthermore, Daily & Dalton (1992) find no relationship between CEO duality and performance in entrepreneurial firms. Klapper and Love (2002) examine corporate governance and performance in a sample of firms in 14 countries, most of which are developing economies. They find that better corporate governance is associated

with better performance in the form of Tobins q and ROA and that good governance seems to matter more when the legal environment of a country provides investors with weaker protections. Finally, Delton et al (1998:282) in their study using subgroup moderating analysis based on variables like the firm size, nature of the performance indicators and operationalization of board composition conclude that there is no evidence of a substantive relationship. Furthermore, another study, using Meta analysis methodology found no meaningful relationship between board composition and the financial performance of firms. Michael et al (2002:6) using simultaneous equation method also concludes no significant relationship between the governance control mechanism and firm performance. The indecisive nature of the literature as it relates to whether there is any relationship existing between the firm performance and the nature of how the firm is been operated calls for this paper. The papers methodology is therefore explained below. Methodology The aim of this paper is to measure the relationship between corporate governance and the performance of firms in Nigeria. The study uses secondary data based on the financial statements of the companies chosen in the sample, which are randomly selected from the companies registered in the stock exchange list. To achieve this objective, we use Return on equity, Net profit margin, Sales growth, Dividend yield, and Stock prices as the key variables that defined the performance of the firm. On the other hand, for the measure of corporate governance, we use the following variables: 1. Board Independence: The proportion of outside directors in a company is used as a proxy for board independence which is a measure of good corporate governance. This was also used by studies such as the work of Hermalin and Bach (1991), and that of Bhagat and Black (2002). 2. Board Size: Limiting board size is believed to improve firm performance. Although there is no scientific limit as to the size of the board, or any level identified as optimal for the size of the board, empirical research has established that the size of the board has a significant influence on the performance of firms. This is documented in the work of Anderson et al (2004) which shows that cost of debt is lower for larger boards. There are other benefits established for larger boards especially in the works of Upton and Lorsch (1992); Jensen (1993); and Yermack (1996). 3. Audit Independence: Frankel et al (2002) established that the separation of chief executive officer of an organization with the organizations chairman improves the quality of the

organizations corporate governance. We therefore, use the audit independence as a measure of good corporate governance. 4. Ownership of the company: Empirical studies have established a strong relationship between the companies that have its directors owning shares and that the company that has not. Therefore those companies whose directors have sort of ownership to the company are believe to perform better. Therefore, we use the number of shares owned by the directors of the company for the definition of the ownership. 5. Progressive practices: This involves the retirement practices of directors of the company. The measures of the corporate governance and their proxies: S/No 1. 2. 3. 4. 5. Discussion of Results The descriptive statistics presented the output of the mean, median, maximum, minimum, standard deviation, kurtosis, Jarque-Bera, and probability for the data, the result is presented in table 1 below. Table 1: Descriptive Statistical Reports ROE Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability Period CCEO 0.164067 0.138150 0.404100 DT DY NDB 0.004483 0.004850 0.008400 0.000300 0.002743 NPM 4.916667 5.000000 7.000000 OD 0.026042 0.033250 0.224900 SG 3.000000 3.000000 6.000000 Variable Board of Directors Board size Audit independence Ownership Proxy BOD outside Directors The number of directors on the board Counseling fees/Audit fees Structure of share ownership

Progressive practices Directors/retirement.

0.083333 0.166667 0.000000 0.000000 1.000000 1.000000

-0.090500 0.000000 0.000000 0.145437 0.106873 2.275682 0.285162 0.867117 12 0.288675 0.389249

4.000000 -0.295000 0.000000 0.996205 0.143561 1.809068

3.015113 1.788854 -0.037548 0.742982 -0.814150 0.000000 10.09091 4.200000 43.32231 7.120000 0.000000 0.028439 12 12 1.922271 0.583570 0.746929 12 2.529748 1.214613 0.544816 12 3.363008 1.391569 0.498683 12 2.111111 0.395062 0.820755 12

Source: Authors computation using E-views

The table shows the relationship in the data used for the analysis. The report shows clearly that the items used for the dependent and independent variables can be related as they are independent. The data in appendix 1 on the corporate governance variables shows that the mean board size of the companies studied has the maximum board size of about 14 while the minimum is about 4. This suggests that, on the average, the companies considered have moderate board sizes. This is good in respect of the performance of these companies because it supports recent thinking about board sizes. On board composition, the study shows that averages of 30 percent of all board members are outsiders which suggest that these boards are relatively not independent. This is because, studies have shown that the more outsiders present on a board, the more independent the board is, for example, the work of John and Senbet, (1998) and that of Anthony et al 2000. The firms used for the study on the average have been performing with an annual average return on of 16.4%. The maximum on this performance variable is 40% with a minimum of -09%. The net profit margin indicates that on average the companies not done so good with 3 percent, 18 percent as the maximum while the minimum is about -29 percent. Further look at the sales growth, the result indicates that there is a 123 percent increase on average. With 339 been the maximum and 8.1 minimum. The stock price on average increase by about 3.5 percent over the period covered in the study. On the output of the regression equation with the variables measuring the corporate governance as the dependent variables and the measure of the firm performance as the independent variable, as presented by the SPSS OUTPUT presented in table 2 and the appendixes presented using the E-views output, we found out that the result favoured firms with larger boards. this confirms studies that support the view that larger boards are better for corporate performance because members have a range of expertise to help make better decisions, and are harder for a powerful chief executive officer of the firm to dominate and that the larger the size of the board, the better the performance. On board composition, the study shows that the more outsiders there are on a companys board, the better the performance in terms of return on equity. The implication is that when a board is deemed independent, performance of companies becomes better. This result is not consistent with the findings of Agrawal & Knoeber (1996). In their study they found that boards expanded for other reasons often result in too many outsiders on the board, which does not help performance. While on the other hand, the result is consistent with the findings of other studies such as Weisbach 1988, and Brickley et al. 1994. In their study they are of the opinion that where there are more outside directors they will

support the beneficial monitoring and advisory functions thereby strengthening the monitoring of the shareholders fund. On CEO to serve as the chairman of the company, the study suggests that when a CEO also serves as the board chairman performance worsens. This is consistent with studies of Bickley & Coles 1997, which found out that the one-tier board structure type leads to leadership facing conflict of interest and agency problems, thus giving preference for the two tier system. Again, it has been argued that problems tend to be higher when the same person holds both positions (Brickley et al. 1994). There is no clear relationship between the rate of retirement of firms directors and the performance of the firms. This may be due to the fact that the data we analyzed has only 2 companies that have their directors changed during the period covered in the research. Therefore, we suggest further analysis for a good conclusion to be made. The - statistics further confirms the significance of the entire variable put together in the model. The standard error of regression of 1.3661 is relatively low to confer high predictive power on the variables used. Furthermore, the greater than the upper value of tests for auto correlation. With a calculated DW of 2.03 which is from the table at 1% level of significance. It means that there is

no reason to suggest the presence of auto correlation in the variable used. SPSS Output 2 Unstandardized Coefficients B .020 -.268 -300.8 -.012 3.84 Std. Error .435 .703 253.7 .011 4.90 Standardized Coefficients Beta .241 .079 .706 .771 .220 t .045 -.382 -1.185 -1.160 .783 Sig. .966 .722 .301 .311 .491 f 1.361 .406 2.390 .604 2.22 df 5 5 5 5 5 Mean Square .097 .015 11601.3 .000 12.94 R .794 .580 .866 .656 .887

Authors Computations

Conclusion The mean board size of the companies studied shows that the maximum board size is about 14 while the minimum is about 4. This suggests that, on the average, the companies considered have moderate board sizes. This is good in respect of the performance of these companies. On board composition, the study shows that averages of 30 percent of all board members are outsiders which

suggest that these boards are relatively not independent. This is because, studies have shown that the more outsiders there are on a board, the more independent the board is, for example, the work of John and Senbet, (1998) and that of Anthony et al 2000. The firms with these characteristics as used in the study on the average have been performing with an annual average return on of 16.4%. The maximum on this performance variable is 40% with a minimum of -09%. On board composition, the study shows that there are fewer outsiders on the companys board; this has worsened the performances of these companies in terms of return on equity. The implication is that when a board is deemed independent, performance of such companies becomes better. On CEO to serve as the chairman of the company the study suggests that when a CEO also serves as the board chairman performance worsens. The paper found two variables to be incomplete, the issue of audit independence and the retirement of the directors. There is no clear relationship between the rate of retirement of firms directors and the performance of the firms. This may be due to the fact that the data we analyzed has only 2 companies that have their directors changed during the period covered in the research, likewise the issue of the audit independence. Therefore, we suggest further research in that direction, for a good conclusion to be made. Therefore, it is the recommendation of the paper that there should be on the average about 10 to 15 board members for a firm that is averagely large. The composition of the directors should be more outsiders, as there is evidence as to the relationship between the compositions of the directors to the performance of the firm. Furthermore, since performance worsens when the chief executive serves as the board chair, it is the recommendation of the paper that the two positions should be separated.

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