joanne mba thesis 2007

7/27/2019 Joanne Mba Thesis 2007

1/121

THE DETERMINANTIONOF DIRECTORS REMUNERATION IN

MALAYSIAN PUBLIC LISTED COMPANIES

By

CHONG MENG FONG

Research report submitted in partial fulfillment of the requirements for the degree

of Master of Business Administration

MAY 2007


2/121

i

DEDICATION

. to my beloved family


3/121

ii

ACKNOWLEDGEMENT

For each new morning with its light,

For rest and shelter of the night,

For health and food,

For love and friends,

For everything Thy goodness sends.

Father in heaven,

We thank thee.

There are many individuals whom I would like to thank for their underlying support

and guidance that made it possible for me to complete this MBA project paper. First ofall, my sincere gratitude goes to my beloved family, to my parents for giving me life in

the first place and for unconditional support and encouragement to pursue my studies.

To my husband for his unremitting love and encouragements, to my two little kids for

their obedient and independent that enabled me to complete this work.

I am greatly indebted to my supervisors, Professor Dr. Hasnah Haron and Dr. Sofri

Yahya, for their stimulating suggestions, encouragement and providing much-needed

assistance in all time of research for and writing of this thesis. Truly, from the bottom

of my heart, it is really my honor to have them as my supervisors.


4/121

iii

TABLE OF CONTENTS

DEDICATION i

ACKNOWLEDGEMENT ii

TABLE OF CONTENTS iii

LIST OF TABLE ix

LIST OF FIGURE x

ABSTRAK xi

ABSTRACT xiii

Chapter 1 INTRODUCTION 14

1.1 Introduction 14

1.2 Background 14

1.3 Problem Statement 18

1.4 Research Objectives 20

1.5 Research Question 20

1.6 Definition of Key Terms 21

1.7 Significance of Study 22

1.8 Organization of the Remaining Chapters 23

Chapter 2 LITERATURE REVIEW 24

2.1 Introduction 24


5/121

iv

2.2 Executive Compensation Error! Bookmark not defined.

2.3 Agency Theory 24

2.4 Directors Remuneration 31

2.5 Board Structure 34

2.5.1 Board size 36

2.5.2 Board independence 37

2.5.3 CEO duality 39

2.6 Ownership structure 39

2.6.1 Ownership concentration 41

2.6.2 Managerial ownership 43

2.6.3 Non-executive director interest 44

2.7 Control variables Error! Bookmark not defined.

2.7.1 Firm size 46

2.7.2 Firm performance 48

2.7.3 Leverage 50

2.7.4 Growth in Earning per Share Error! Bookmark not

defined.

2.8 Theoretical Framework 51

2.9 Hypothesis Development 52

2.9.1 Board size 52

2.9.2 Board independence 53

2.9.3 CEO-duality 54

2.9.4 Ownership concentration 56


6/121

v

2.9.5 Managerial ownership 56

2.5.6 Non-executive director interest 57

2.10 Summary 60

Chapter 3 METHODOLOGY 62

3.1 Introduction 62

3.2 Research Design 62

3.2.1 Type of Study 62

3.2.2 Population 63

3.2.3 Sample Frame 64

3.2.4 Unit of Analysis 64

3.2.5 Sample Size 64

3.2.6 Sampling Method 65

3.3 Measurements of Variables 65

3.3.1 Measurement of Independent Variables 66

3.3.2 Measurement of Dependent Variables 67

3.3.3 Measurement of Control VariablesError! Bookmark not

defined.

3.4 Data Analysis 68

3.5 Summary 72

3.6 Expected Outcome Error! Bookmark not defined.

Chapter 4 RESULTS 73

4.1 Introduction 73


7/121

vi

4.2 Statistical Analysis Error! Bookmark not defined.

4.3 Descriptive Statistics of Variables 74

4.3 Correlation Analysis 84

4.5 Assumptions Testing of the Regression Analysis 86

4.5.1 Normality of the Error Term Distribution 86

4.5.2 Linearity of the Relationship 86

4.5.3 Autocorrelation 88

4.5.4 Homoscedasticity 88

4.5.5 Multicollinearity 88

4.6 Hypothesis Testing Regression Analysis 88

4.6 Summary of the Findings 96

Chapter 5 DISCUSSION AND CONCLUSIONS 98

5.1 Introduction 98

5.2 Recapitulation of the study 98

5.3 Discussion of the Findings 100

5.3.1 Board size and Directors remuneration 100

5.3.2 Board Independent and Directors remuneration 102

5.3.3 CEO-duality and Directors remuneration 103

5.3.4 Ownership concentration and Directors remuneration

104

5.3.5 Managerial Ownership and Directors remuneration 104

5.3.6 Independent Non-executive Director Interest and

Directors Remuneration 105


8/121

vii

5.4 Implications of the Study 108

5.5 Limitation of Study 111

5.6 Suggestions for Future Research 112

5.7 Conclusion 113

REFERENCES 115

APPENDIX A List of Companies Selected for the Study Error! Bookmark not

defined.

APPENDIX B Checklist Error! Bookmark not defined.

APPENDIX C Statistics Error! Bookmark not defined.

APPENDIX D Pearson Correlation Analysis Error! Bookmark not defined.

APPENDIX E Linear Regression of Directors Remuneration on Board Size

Error! Bookmark not defined.

APPENDIX F Linear Regression of Directors Remuneration on Board

Independence Error! Bookmark not defined.

APPENDIX G Linear Regression of Directors Remuneration on CEO Duality

Error! Bookmark not defined.

APPENDIX H Linear Regression of Directors Remuneration on Ownership

Concentration Error! Bookmark not defined.


9/121

viii

APPENDIX I Linear Regression of Directors Remuneration on Managerial

Ownership Error! Bookmark not defined.

APPENDIX J

Linear Regression of Directors Remuneration on Different Level

of Managerial Ownership Error! Bookmark not defined.

APPENDIX K Linear Regression of Directors Remuneration on Independent

Non-executive Directors Interest Error! Bookmark not defined.

APPENDIX L Linear Regression General Model Error! Bookmark not defined.


10/121

ix

LIST OF TABLE

Table No. Title of Table Page

Table 3.1 Number of sample selected 45

Table 4.1 Descriptive Statistics of Variables 56

Table 4.2 Frequency distribution of total directors remuneration 57

Table 4.3 Frequency distribution for board size

Table 4.4 Frequency distribution for proportion of independent

non-executive directors 58

Table 4.5 Frequency distribution for CEO duality 59

Table 4.6 Frequency distribution for ownership concentration 60

Table 4.7 Frequency distribution for managerial ownership

Table 4.8 Frequency distribution for independent non-executive 61

directors ownership

Table 4.9 Frequency distribution for firm size 62

Table 4.10 Frequency distribution for firm performance 63

Table 4.11 Frequency distribution for leverage 63

Table 4.12 Correlation Analysis for All Variables

Table 4.13 Linear Regression of Directors Remuneration

Table 4.14 Linear Regression of Directors Remuneration

With different level of Managerial ownership

Table 4.15 Summary of the Findings 89


11/121

x

LIST OF FIGURE

Figure No. Title of Figure Page

Figure 2.1 Theoretical Framework 35


12/121

xi

ABSTRAK

Sejak dekad yang lalu, isu tentang ganjaran pengarah telah menarik minat para

penganalisis tadbirurus korporat, kerajaan dan orang awam terutamanya selepas

beberapa siri krisis kewangan. Teori agensi menyarankan bahawa ganjaran pengarah

perlu dihubungkaitkan dengan prestasi untuk menghindari dari konflik agensi. Walau

bagaimanpun, kajian empirik telah mendapati perhubungan diantara ganjaran dan

prestasi masih lagi lemah.. Oleh kerana kelemahan di dalam struktur tadbirurus

korporat, pengarah telah dibayar berlebihan dengan kos dikenakan kepada pemegang

saham. Untuk terus meningkatkan keyakinan pelabur dan memastikan pertumbuhan

ekonomi yang stabil, usaha untuk membina struktur tadbirurus korporat yang baik

adalah penting. Dengan menggunakan sampel 120 buah syarikat yang telah disenarikan

di Papan Utama Bursa Malaysia pada 2005, kajian ini dijalankan untuk menentukan

ganjaran pengarah yang dibayar oleh syarikat yang disenaraikan di Bursa Saham

Malaysia, Sebagai tambahan, kajian ini juga akan melihat keberkesanan struktur

tadbirurus koporat dari sudut lembaga pengarah dan ciri pemilikan saham di dalam

menentukan ganjaran pengarah di dalam syarikat yang disenaraikan di Bursa Malaysia.

Kajian mendapati bahawa apabila komsentrasi pemilikan saham meningkat,

ganjaran pengarah akan berkurangan oleh kerana keberkesanan pemantauan oleh

pemegang saham luar yang memiliki saham yang banyak. Saiz lembaga pengarah

didapati berhubungan positif dengan ganjaran pengarah kerana saiz pengarah yang

besar membuatkan mereka kurang berkesan untuk memantau pihak pengurusan. Walau

bagaimanapun, kebebasan lembaga pengarah, penduaan ketua pegawai eksekutif,


13/121

xii

pemilikan saham oleh pengarah dan pemegang saham oleh ketua pegawai eksekutif

tidak didapati mempunyai perhubungan dengan ganjaran pengarah


14/121

xiii

ABSTRACT

Over the past decade, the issue of directors remuneration has attracted the

attention from corporate governance analysts, goovernment and the general public

especially after the serial of financial crisis. Agency theory suggests that directors

should be rewarded based on their performance so as to avoid agency conflict.

Nevertheless, empirical studies found that the linkage betweenpay and performance is

still very weak. Due to the weaknesses in corporate governance structure, directors had

been paid excessively at the expense of shareholders. To continually boost the

investors confidence and to ensure a steady economic growth, the move to build up

stronger corporate governance structure is essential. Thus, using a sample of 120

companies listed in the Main Board of Bursa Malaysia in 2005, this study is conducted

to determine the amount of directors remuneration that is paid out by the Malaysian

public listed companies. In addition, this study will examine the effectiveness of the

corporate governance structure in terms of board and ownership characteristics in

determining the directors remuneration among Malaysian public listed companies

This study found that as ownership concentration increases, the amount of

directors remuneration will decrease due to the effective monitoring by the external

block-holders. Board size was found to be positively associated with directors

remuneration because increase board size makes them less effective at monitoring

management. However, boards independence, CEO-duality, managerial ownership

and independent non-executive directors shareholding are not found to be related to

directors remuneration.


15/121

Chapter 1 INTRODUCTION

1.1 IntroductionThis chapter introduces the research outline of the study. It begins with highlighting the

background of the study and the problem statement followed by research objectives and

research question. Definition of key terms of major variables will also be included to

assist in understanding. This chapter ends with the significance of the study and will give

a brief overview of the remaining chapters in the thesis.

1.2 BackgroundOver the past decade, executive compensation has been regarded as an internal

mechanism to reconcile the agency problem between executives and shareholders.

Nevertheless, it has been a subject of debate among corporate governance specialists,

compensation experts and institutional investors in the western countries on how to pay

their top executives. Much of this debate has been fuelled by concerns that executive

compensation is excessive, it is unrelated to firms performance and there is a low level

of compensation disclosure.

Numerous studies on executive compensation have been conducted in the United

States and United Kingdom, where public disclosure of top management compensation

has long been the norm. The limited evidence in other countries may be due to the fact

that corporate governance reformation is relatively new and that data is unavailable.

Academic research into how executives are rewarded has captured the attention of the

Malaysian public, particularly after the Asian financial crisis. The massive distortion in


16/121

15

economic system during the Asian financial crisis has alerted Malaysians on the

importance of effectiveness of corporate governance mechanisms, and compliance to

accounting and auditing standards. There is also an increasing request from the

shareholders and investors of companies, especially the public listed companies for an

increase in transparency, including even with respect to the directors remuneration.

According to MCCG, the amount of directors remuneration should be sufficient

to attract and retain the directors needed to run a company successfully and should also

be structured so as to link rewards to corporate and individual performance. Generally,

the criteria used to set directors remuneration are the size of the company, its profit, sale

growth and turnover but the absence of clear guidelines has created a room of

manipulation by the directors.

Price Waterhouse Coopers (2003) investigation into what top Malaysian directors

earn revealed a surprising finding on to the fact that there are evidences to show that

some companies listed in Bursa Malaysia, despite making losses, are paying their director

excessively. This finding had been supported by subsequent research in year 2006 by

KPMG Malaysia who found out that out of 46 companies that increased its total

directors remuneration in 2005, 10 had reported losses in that year and also that the

increase in total directors remuneration in 2005 is more than doubled that of the previous

year.

According to the survey on directors remuneration published by Malaysian

Business magazine for the period from year 2002 to 2005, Berjaya Group, paid RM33.5

million to its directors in the entire group, even though the group suffered losses as high

as RM651.6 million for the financial year 2002. Besides the Berjaya Group, Malayan


17/121

16

United Industries Bhd, which incurred a net loss of RM996 million, paid out RM6.1

million in total remuneration while Pan Pacific Asia Bhd, with net loss of RM487.3

million, paid RM2.5 million (Nurani & Sakran, 2003).

More peculiar was the instance of directors being paid excessively although the

company was suffering negative shareholder fund and fell into Practice Note 4 (PN4,

thereafter) category. In the case of Mycom, despite the company being in the red for the

last couple of years and was still in PN4 status, it increased its directors compensation

from RM1.41 million in year 2002 to RM4.03 million in year 2003. Other companies

also showing these features in their director remuneration were Faber Group, Aokam

Perdana, Pica Corporation, Anson Perdana, Kemayan Corporation and Sriwani Holdings

(Kaur, 2004). This situation has not improved over time, Prathaban, Rahim and KPMG

(2006) found that 26 companies that reported losses in the year 2005, still paid their

directors well.

To deter excessive executive compensation, there is an increasing call for the design of

incentive compensation scheme that ties executive pay to shareholders wealth. By

linking pay to performance, the executive will be accountable to the consequences of his

actions and thus acting rationally to maximize firms performance. However, there is no

perfect compensation scheme that is able to transfer the profits and risks of the firm to the

executives, as shareholders are unlikely to let the executives take huge profit of their firm

home. Directors on the other had are unwilling to compensate the shareholders, if their

actions had caused the companies to perform badly. It can also be considered fair that the

directors not be penalized for poor performance of the companies as there are other

external factors beyond the control of the executives that can also effect the firm


18/121

17

performance for instance the movement of oil price, exchange rate variation and sector-

wide fluctuations.

In light of the uncertainties and difficulties to design a perfect compensation scheme and

is impossible to regulate the structure of executive compensation, the issue of who gets to

decide the compensation scheme take the forefront of the scene. The decision-making

power of the person who gets to set up the executive compensation package will enjoy an

unfettered discretion. Under the corporate system, the power to set the executive

compensation is vested in the board of directors.

The boards power to determine the executive compensation package is also

supported by the Malaysia Code of Corporate Governance which recommends that

public listed companies to set up a remuneration committee. Remuneration committees

primary function should be to assist the board in evaluating and recommending to

remuneration policy and should be consistent with the strategic direction of the company.

The committee should also consist of non-executive directors to ensure that directors

remuneration is paid fairly..

In conclusion, the above phenomenon have highlighted a troubling issue about

directors remuneration in Malaysia i.e. there is an indication that directors remuneration

is not based on company performance. According to Hariri, Haron, Aktharuddin and

Ismail (2006), the level of directors remuneration disclosure in Malaysia is as low as 28

percent for the year of 2003. As such, in situation where the level of disclosure is among

the lowest, there is high possibility of some forms of compensation will go unnoticed and

give the impression of lower remuneration among Malaysian companies. This may lead

the executive directors to use non-cash forms of compensation to avoid public scrutiny. If


19/121

18

the above situation was left unresolved, shareholders confident will be affected and

ultimately Malaysian economic growth will also be affected.

1.3 Problem StatementThe principle-agent problem arises due to the interest of individual agents (director)

conflict with the organization (shareholder). The boards of directors are expected to

monitor the firms manager to mitigate agency conflict, however if there are problem

with the implementation of the monitoring mechanisms, it can lead to the breakdown of

the corporate governance mechanism, no matter how well the structure is. Prior research

about the relationship between corporate governance structure and directors

compensation had been widely conducted in United States and Europe, and it had been

confirmed that the strength of the governance of the firm and ownership structure of the

firm have significant influence on the directors remuneration (e.g., Core, Holthausen &

Larcker, 1999; Lambert, Lacker & Weigelt, 1993; Yermack, 1996).

In Malaysia, concentration of ownership for which the domination of control is by

family members or government institution is a very common structure. According to

Claessens, Djankov and Lang (1999), one forth of the corporate sectors of Malaysia is

controlled by ten families. These companies are being run and dominated by large

shareholders who could lead to the insiders maximizing their private benefits at the

expense of the general investor for which can be done through attractive remuneration

packages.

Researches in the area of directors remuneration are important as remuneration is

often a major factor in rewarding and motivating the directors to perform their duties


20/121

19

efficiently. Furthermore, previous research was more concentrated on the level of CEO

remuneration rather than the board of directors as a whole. As the agency cost covers not

only the CEO but all the board members, total directors remuneration will be a more

appropriate measure in finding the determinant factors of director remuneration.

Research that uses Malaysian data is important as institutional, regulation and

environmental factors and the uniques characteristics of ownership and corporate

structures are quite different from those overseas. Most empirical studies are conducted

in the United States and United Kingdom. The research in the area of corporate

governance in Asian countries was initiated only after the Asian financial crisis when

there was a reformation of the corporate governance structure. Thus, this study which

was based on the data collected from the annual reports of the Malaysian public lisred

companies in 2005, that is a few years after the code of cororate governance was

implemented, will assist in understanding the influence of corporate governance on the

directors remuneration. Previous studies have also shown that firms attributes such as

size, performance and leverage of the company have an infleunce on the directors

remuneration. Pprior researches in the United States and United Kingdom have revealed

inconsistent findings on the topic of directors remuneration. This this study warrants to

be undertaken.

Thus, this study is conducted to examine whether the characteristics of board of

directors, ownership and firm attributes do in fact have an influence on the amount of

directors remuneration.


21/121

20

1.4 Research ObjectivesTherefore, this study attempts to accomplish four main objectives as follows:

(1) To determine the level of directors remuneration paid by public listed companiesin Malaysia;

(2) To examine whether there is a relationship between board of directorscharacteristics (board size, proportion of independent non-executive directors and

CEO-duality) and the level of directors remuneration;

(3) To examine whether there is a relationship between ownership characteristics(managerial ownership, ownership concentration and the independent non-

executive directors ownership) and the level of directors remuneration.

(4) To examine whether firm attributes (firm size, firm performance and leverage)will affect the level of directors remuneration.

1.5 Research QuestionTo achieve the above objectives, the study tries to answer the following research

question:

a) What is the overall level of directors remuneration among the Malaysian publiclisted company?

b) What is the relationship between the directors remuneration and the board size?c) What is the relationship between the directors remuneration and proportion of

independent non-executive directors on the board?

d) How does CEO duality affect the level of directors remuneration?


22/121

21

e) Do managerial ownership and the ownership of independent non-executivedirectors affect the level of directors remuneration?

f) How does ownership concentration affect the level of directors remuneration?g) How does firm size affect the level of directors remuneration?h) Is the directors remuneration associated with firms performance?i) How does a firms leverage affect the level of directors remuneration?

1.6 Definition of Key TermsIn order to share common understanding of the concepts and for better understanding of

further discussion, the following key terms definition were referred specifically.

1) Level of Directors remuneration

The level of directors remuneration refers to the total amount of cash

compensation including wages, salaries, allowances, fees, paid annual leave and

paid sick leave, profit sharing, bonuses and value of benefits-in-kind such as

company car and insurance coverage that is received by both executive and non-

executive directors of the company. (FRS 119, 2003)

2) Board of directors

The board of directors is a formal body that is formed in accordance to the

Memorandum and Articles of Association to govern the corporation. The board of

directors may not actually participate in the daily operations of the corporation,

but the board has authority to set business goals and strategic plans. (Bursa

Malaysia Listing Requirement, 2001)

3) Independent non-executive director


23/121

22

An independent non-executive director is a director who is independent of

management and free from any business or other relationship which could

interfere with the exercise of independent judgment or the ability to act in the best

interests of the corporation. (Bursa Malaysia Listing Requirement, 2001)

4) CEO dualityCEO duality is a situation that a person who is the chairman of the board at the

same time is the CEO of the company. (Malaysian Code of Corporate

Governance, 2001)

5)

Ownership concentration

It is a situation when a major shareholder (family, government or institutional

shareholder) that hold substantial amount of a companys equity share and as such

have majority voting power over other shareholder (Dogan & Smyth, 2002).

1.7 Significance of the StudyTheoretically, this study contributes to the agency theory . Agency theory is used to

explain the effort to align the interests of the agent with those of the principal for which

remuneration packages had been used as tool to counteract the agency conflict. However,

this principal-agent problem has remained unresolved due to the conditions of incomplete

and asymmetric information which had lead to moral hazard in term of excessive

directors remuneration in the expenses of shareholders. This study uses agency theory to

explore the determinants of directors remuneration and investigate how director uses the

information asymmetry to draw up their remuneration packages.


24/121

23

This study will make contributions to the regulators, accountants and investors by

providing useful information on directors remuneration and its determinants factors. To

the regulator, the study will provide reference to Bursa Malaysia on the board structure

that is currently practiced by the public listed companies. The information regarding the

level of directors remuneration that is disclosed in the annual reports is important for the

Malaysian Accounting Standard Board to monitor the companies compliance with the

accounting standards. Malaysian Institute of Corporate Governance can also benefit from

this study as this study would be able to shed some light on the level of compliance of the

companies with the Malaysian Code of Corporate Governance principles and best

practices.

1.8 Organization of the Remaining ChaptersThis study is structured in five chapters. The first chapter provides an introduction as well

as an overview of this study. The second chapter presents the review of literature that

outlines previous studies undertaken in relation to directors remuneration, theoretical

framework and the hypotheses development. Chapter three will illustrate the data and

variable in term of research design, sample collection, measurement of variables, the

method of data analysis and expected outcome. Chapter four analyzes the results of

finding, focusing on statistical analysis, descriptive statistic, correlation analysis and

regression analysis. Lastly, chapter five will present the overall findings and implications

of the research will be discussed, limitation of the study as well as suggestion for future

research and conclusions.


25/121

24

Chapter 2 LITERATURE REVIEW

2.1 IntroductionThis chapter will present the previous literature that has been undertaken. As such, this

chapter will give an overview of literature on directors remuneration, board

characteristic, ownership characteristic and the underlying theory. The theoretical

framework and the hypothesis development will be presented towards the end of the

chapter.

2.2 Agency TheoryIn most companies, investors do not manage the companys affairs but entrust the

managers to carry out the task. This separation of ownership and control has resulted in a

potential conflict of interest (Berle and Means, 1932 as cited in Abdullah, 2004).

Although this problem is acute in public listed companies without a controlling

shareholder, it permeates all types of business organizations for which a strong block-

holder may effectively monitor the management but act in league with executive in the

expense of other shareholders.

To limit the agency conflict, the shareholders have to monitor the agents and try

to ensure that the latter effectively act in their best interest. Although effective corporate

governance and high level of compliance system may minimize agency and transaction

costs arise as a result of conflicts of interest between principal (shareholder) and agents

(director), it entail costs and these efforts drain resources away from productive uses.


26/121

25

Instead of focusing on agency cost and finding efficient way of monitoring,

compensation could be used to counteract the agency conflict.

According to Berle and Means (1932) Principal-Agent model, the primary means

for the shareholders is to ensure that managers take optimal actions to tie managers pay

to performance of their firm; in effect to provide incentives for managers to maximize

return to shareholders (as cited in Kakabadse, Kakabadse & Kouzmin, 2003). Recent

research in executive compensation has re-confirmed the above relationship. In Elayan et

al., 2001, it was found that compensation policy tying directors pay to corporate

performance or shareholders wealth provides incentives to exert appropriate efforts on

behalf of shareholder.

To effectively monitor the agents behavior, agency theory suggests that

directors compensation needs to be correlated with the total return to shareholders,

typically through ownership of firms stock or options on the firms stock (Kakabadse et

al. 2003). By increasing directors stock ownership, individual directors wealth will be

tied up with the performance of company. In the context of the agency theory, directors

behaviour are less likely to exhibit behaviors that are inconsistent with those of the other

owners. As a result, greater directors stock ownership should produce more stable and

potentially predictable returns.

Agency theory predicts that large shareholding in a firm improves monitoring of

managerial behavior and therefore reduces abusive compensation (Shliefer & Vishny,

1986).Baker, Jensen and Murphy (1998) noted that the level of compensation determines

where the directors work and the compensation structure determine how hard they work.


27/121

26

As such, direct share ownership by executive directors is the most powerful link between

directors rewards and corporate performance (Jensen & Meckling, 1976).

Overall, agency theory predicts that the separation of owners and managers

potentially will lead to managers of firms taking actions, which do not maximize

shareholders wealth (Jensen et al., 1976). As such, internal monitoring system such as

effective corporate governance and compensation system must be in place to ensure that

directors implement policies consistent with the maximization of shareholders wealth.

2.3

Corporate Governance

Corporate governance is the process and structure used to direct and manage business and

affairs of the company towards enhancing business prosperity and corporate

accountability with the ultimate objective of realizing long term shareholders value,

whilst taking into account the interest of others stakeholders (Malaysian Code of

Corporate Governance, 1999). The principles of corporate governance cover the issue of

the directors, directors remuneration, shareholders, accountability and audit.

Malaysian Code of Corporate Governance (MCCG, thereafter) laid down the

principles to form an effective and balance board. According to MCCG, the effect of

board size should be examined on the board effectiveness. Too big the size of the board

will constrained active participation and have little sense of accountability. Too small the

size of the board, there may be not enough directors to discharge the board

responsibilities to lead and control the company. However, there is no specified number

of boards recommended.


28/121

27

MCCG stressed on the issue of board balance to avoid the domination of power

by a single individual. As such, it was suggested that company must have at least one

third or minimum two independent non-executive directors on the board of directors. The

term independent refers to the independence from management and from a significant

shareholder. It was intended that independent non-executive directors be appointed to the

board of directors so as to bring an independent judgment on the issue of strategy,

performance and resources.

MCCG suggested a clear division of responsibilities between chairman and chief

executive director (CEO, thereafter) to ensure the balance of power and authority so that

no one individual has unfettered power of decision. The chairman is primary responsible

for the working of the board, the balance of membership in the board and to ensure all

directors execute their duties in professional manner. In the other hand, the task of

running the business and implementation of strategies adopted by the board shall be

executed by the CEO. In the event that there is a combination of these two roles, an

explanation must be made public in the companys annual report.

In term of directors remuneration, MCCG recommended that the levels of

directors remuneration should be sufficient to attract and retain the directors needed to

run the company successfully. In this context, the components parts of executive

directors remuneration should be structured so as to link rewards to corporate and

individual performance. As such, companies are expected to set standard which provide a

rational and objective remuneration policy for developing and fixing the remuneration

packages of individual directors. In term of directors remuneration disclosure, MCCG

recommends that companys annual report should contain the procedure on the make-up


29/121

28

of remuneration and details of the remuneration of each director so that to promote the

principles of fairness and accountability.

MCCG suggests public listed company to form a remuneration committee which

consisting wholly or mainly of non-executive directors, to recommend to the board of

directors on the remuneration of the executive directors in all its forms. The task of the

remuneration committee is to develop proposals on remuneration which have to be

approved by the full board. The existence of remuneration committee is consistent with

agency theory, which stresses on the separation of management from control.

Bursa Malaysia requirement on corporate governance was enforced on January

2001 through the issuance of Revamped Listing Requirements. The Revamped Listing

Requirements has set out greater obligation for public listed company in financial

reporting, disclosure on corporate governance matters under its continuing listing

obligations. Under the Revamped Listing Requirement, public listed companies are

required comply with the principle stated in the MCCG and to include in their annual

report in relation to its level compliance. In term of directors remuneration, Bursa

Malaysia listing requirements differ from the Best Practice suggested by MCCG by just

requires companies to disclose in bands of RM50,000 their directors remuneration

without disclosing the identity of recipients.

2.4 Accounting Standards on Employee Benefits

Employee benefits also refer to the Directors compensation.The awareness of

good corporate governance demands high-quality and transparent financial reporting so

that the real financial position can be seen and confident established (Devi, 2003). To


30/121

29

have confidence, investor must believe that a company will apply recognized accounting

standard consistently. This led to the establishment of Financial Reporting Act 1997,

which established an independent accounting standards body, the Malaysian Accounting

Standards Board (MASB). Prior to the establishment of MASB, Malaysia followed the

International Accounting Standard. After the formation of MASB in year the 2003,

Malaysia has introduced its own accounting standard, known as the MASB. However,

globalization had forced Malaysia to standardize its accounting standard to conform to

international practice, thus the MASB had been further enhanced by the issuance of the

Financial Reporting Standard (FRS, thereafter) in the year 2005.

The accounting treatment for employee benefits had gone through a series of

revolution before the introduction FRS 119 in the year 2005. Back to the year 1980, the

exposure draft on Accounting for Retirement Benefits in Financial Statements of

Employers had been issued for public comment and was approved as an accounting

standard in the year 1985, which was known as IAS 19. Through the years 1990s, the

issue of employment benefits has only been concentrated on the issue of retirement

benefits. However, when years go by, the corporate world become more supplicated so as

the compensation packages. The introduction of share based payment, share option and

warrants had made the existing accounting standard of little relevant. As such, IAS 19

Employee Benefits was enforced in the year 1999 and was superseded by IFRS 2

Share-based Payment in the year 2004. With the formation of MASB, Malaysia had

adopted MASB 29 Employee Beneftst in the year 2003 which was superseded by

FRS 119 Employee Benefits in the year 2005.


31/121

30

The principle underlying the accounting standard on employee benefits is that

the cost of providing employee benefits should be recognized in the period in which the

benefit is earned by the employee, rather than it is paid or payable. As to deter creative

accounting for employment benefits, both MASB 29 and FRS 119 covered all categories

of short and long term benefits and request a high level of disclosure not only on

provision and obligation but also actuarial assumption of each benefit plan. Both MASB

29 and FRS 119 specified five categories of compensation and benefit as follow:

a) Short-term employee benefits, such as wages, salaries and social security

contributions, paid annual leave and paid sick leave, profit sharing and bonuses (if

payable within twelve months of the end of the period) and non-monetary benefits

(such as medical care, housing, cars and free or subsidized goods or services) for

current employees;

b) Post-employment benefits such as pensions, other retirement benefits, post-

employment life insurance and post-employment medical care;

c) Other long-term employee benefits, including long-service leave or sabbatical

leave, jubilee or other long-service benefits, long-term disability benefits and, if

they are payable twelve months or more after the end of the period, profit sharing,

bonuses and deferred compensation;

d) Termination benefits; and

e) Equity compensation benefits.

The major provision that differentiate the FRS 119 from MASB 29 is regarding

the equity compensation benefits. MASB 29 required company to disclose the equity

compensation benefits in term of its nature, term, amount, exercise date, exercise price,


32/121

31

conversion rights, voting rights and fair value of the share option scheme by way of notes

to account. In this context, company will take up the accounting transactions only when

the employee exercises the share option because the companys share capital will

increase. However, no transaction has been made to take up the gain made by the

employee on the exercise of the share option. As such, FRS 119 go a step further by

required company to recognized the equity compensation scheme in the face of the

Income Statement as an employment benefit once the share option scheme was granted.

By having the benefits accrued from the equity compensation plan charge to the

Income Statement, creative accounting of deferring executive compensation paid and

payable by disclosing it as an asset of the company rather than expenses, to be deducted

from the future profit figure will be taken care of.

2.5 Directors RemunerationAfair remuneration package of the directors remuneration should be in line with the the

responsibility and commitment of the board members. In this study, the empirical

analysis of directors remuneration is mainly based on three different measures, i.e.

salary, cash remuneration and total remuneration. Salary measures the fixed monthly

compensation, while cash remuneration includes annual bonus, fees, allowances, defined

contribution plan and benefits-in-kind such as insurance coverage and company car. Total

remuneration is the sum of cash remuneration plus stock options and long term

remuneration such as retirement plan.

Conyon and Gregg (1994) argue that total remuneration is the most

comprehensive measure of directors pay, which had been adopted by Elloumi and


33/121

32

Guiyie(2001), Craighead, Magnan and Thorne (2004) and Ghosh et al. (2003).

Nevertheless, cash compensation had been more popular measures in previous research

which was adopted by Main, Bruce and Buck (1996), Crespi and Grispert (1998), Laing

and Weir (1998), Andjelkovic, Boyle and McNoe (2000) and Hassan, Christopher and

Evans (2003). According to Core et al. (1999), the amount of compensation that will

ultimately be received from long-term compensation plans is uncertain at the time the

compensation was awarded. Conyon (1997) and Core et al. (1999) further conclude that

inclusion of stock options does not induce the results that based on cash compensation

only.

In the context of Malaysia, employee share option scheme was disclosed in total

without a clear distinction between the portions of share option allocated to the board of

directors and the companys employee. Due to the limitation of data and the reliability of

cash compensation as a valid remuneration measurement, this study will adopted cash

compensation approach to measure directors remuneration which is consistent with the

measurement used by Abdullah (2006).

Previous research in Western countries shows that there are existence of excessive

director remuneration packages among the companies though the corporate governance

and disclosure requirements had been long established. According to Kochan (2002), the

directors average remuneration in USA was 325 times the average pay of shop floor

worker in the year 1997 which increased to 523 times in year 2000 and as high as 600

times in year 2002. The gap between directors remuneration and average pay is

continuously increasing, for instances, the CEO of AT&T earns 400 times what the

lowest paid employee earns (Wagner & Minard, 1999). This phenomenon was due to the


34/121

33

increase in the use of stock option as incentive for top management and board of

directors. The granting of stock options has given great opportunity for directors to utilize

their insider information to raise share price for their individual benefits.

While the Greenbury Committee Report (1995) had recommended for the shift of

stock options to more performance based criteria, Malaysia companies still embraced in

stock options. Towers Perrin (2003) shown that among Malaysian companies granting

options in 2002, average dilution levels were approximately 3.4% of share outstanding,

50% higher than comparable 2001 levels and more than 3 times the level of Hong Kong

and Singapore. As such, there is a need for Malaysian companies to adopt vehicles such

as performance shares and restricted stock in the globalization challenges.

Empirical evidence indicates that CEO compensation is inversely related to the

level of control exercised by the remuneration committee. Conyon and Peck (1998) show

that the proportion of outsiders on remuneration committee will enhance the strength of

link between top management pay and firm performance. However, in the case of Enron

Corporation, the remuneration committee was composed entirely by independent director

and yet their presence in the committee did not result in critical reduction in CEO

compensation (Petra, 2005). A possible rational is that favorable CEO compensation

could be hidden in ways that are difficult to captured as some boards has become more

creative in designing compensation contracts that do not attract undue attention.

In the context of Malaysia, the Standard & Poor Corporate Governance Studies

(2004) shows that 82% of Malaysia public listed companies have their remuneration

committee but out of this only 7% are wholly independence. Thus, Mak (2006) stated that


35/121

34

the adoption of corporate governance in Asia is only in form rather than substance, as

such the lacking of regulatory and market enforcement has led to false disclosure.

Overall, the investors initiative to curb senior directors pay is gaining

momentum (Kakabadse et al. 2003). Corporate governance specialist and human

resources practitioner has increasingly capitalize on investor irritation concerning

excessive remuneration particularly in poor performing companies. Beside more stringent

corporate governance structure and disclosure was introduced, companies must be

educated to treat corporate governance not merely for compliance but as strategic vehicle

to enhance long term performance and shareholder values.

2.6 Board CharacteristicsPrevious corporate governance literature identifies four sets of board attribute; namely,

composition, characteristics, structure and process. Board composition refers to the size

of the board and the mix of different directors demographics in term of education

background and working experiences. Board characteristics encompass the director stock

ownership, independence and other variables that may influence directors interest and

performance. Board structure covers board organization, board committees, board

leadership and the information flow in decision making. Lastly, board process refers to

decision making activities; the frequency of board meeting, formality of board

proceedings, style and culture. To facilitate a good board process, the commitment of

each individual director is a key success factor. An efficient board is a board that is able

to perform the duty of hiring, compensation, approval of major management initiatives


36/121

35

and strategic decision making. Ability among group member of the board to work and to

lead is crucial in setting up a powerful board.

With the introduction of MCCG, the corporate governance framework has set up

a list of good practice for the firm to comply. However, if the initiative for the firm is just

for compliance, it wont generate any internal advantage. As such, firms must use the

framework as a guideline to improve operational and strategic efficiency so that the rules

will no longer be a burden but serve as a tool to improve the competitive advantages.

Previous research in Western counties found that corporate governance mechanism has

no positive impact on financial performance (Elayan et al., 2000 & Wright, 1996). The

main investment criterion is the financial performance and growth potential, corporate

governance was less emphasized of except the aspect of information regarding

management remuneration. As such, the compliance of FRS 119 should have important

impact of increase investor confident.

However, the extent of disclosure heavily depends on the board quality and the

compensation package that is in place. Muslu (2005) found that board dominated by

insiders will be reluctant to disclose non-optimal directors compensation and insider

ratio and incentive pay are the predominant explanatory variables for the transparency of

compensation disclosure. The research done by Lo (2002) found that the extensiveness of

compensation disclosure lead to value-increasing governance improvement; and firm that

comply with the disclosure regulation have higher stock return and their performance

improved subsequent to the regulation. Thus, we can conclude that the compliance to the

disclosure of employee benefit is beneficial to the firm if the firm does not have any

practice that contradict to the corporate governance, or exercise excessive pay.


37/121

36

2.6.1 Board size

With the reformation in corporate governance, firms have been increasingly

pressured to appoint directors with different backgrounds and expertise under the

assumption that greater diversity should lead to more efficient decision making process.

However, the determination of an efficient board size varies according to the differing

governance, performance and operation requirements of an organization structure. As

such, for a board to be effective, it should not be too big or too small so as to allow for

active participation with minimum communication barriers and able to make effective

decisions.

The empirical evidence to date is mixed and gives little evidence on optimal

governance structure. Jensen (1993) found that increase in board size make them less

effective at monitoring management because of free-riding problems among directors and

increase decision making time. In studying the effect of board size to firm performance,

Adams and Mehran (2002) have found a positive relationship between board size and

Tobins Q. On the contrast, Baysinger and Butler (1985) and Hermalin and Weisbach

(1991) found no meaningful relationship between various characteristics of board and

firm performance. In terms of directors remuneration, Yermack (1996) observes that the

linkage between directors remuneration and performance sensitivity decreases when the

board size increases. This can be explained by Jensen (1993) who found that too big a

board is likely to be less effective in supervision of management. It was understood that

when a board consists of more members, the total amount of directors remuneration will

increase correspondingly. However, in studying the CEO compensation alone, Core et al


38/121

37

(1999) found that CEO compensation increase when the board is larger which suggests

that when board size is bigger, the likeliness of excessive directors remuneration will

occurred.

In the context of Malaysia, based on the Corporate Governance Survey Report

(2006), the smallest board in Malaysia had three directors and the biggest had fifteen with

an average of nine directors a board which is consistent with the finding of Standard &

Poor Corporate Governance Studies (2004). However, there was lack of research on the

impact of board size in Malaysia context, thus this study is conducted to provide an

insight of board size in determine directors remuneration.

2.6.2 Board independence

Board characteristics, particularly on the issue of independence has been studies

over the years. The board of director will usually be blamed for failing to protect the

interest of shareholders especially after a series of financial scandals. One of the reasons

for inability to perform expected role to control the management is the lack of

independence of the board of director, and ineffective board monitoring. Jensen (1993)

stated that top executives serving on companys boards exploit boards authority and

inflict real costs on their companies. A board composed of relatively high ratio of

outsiders is more likely to exercise independent judgment on matters pertaining to

shareholders interest.

The extent of independence is an important issue, a director may be independent

only on the surface which creates a grey area director, who are not insider but are

relatives of officer of the firms, former employee or employee of a firm with interlocking


39/121

38

directorate. The independence of a board member may also eroded over time, the longer

is the length of time in the office and the relationship with the CEO becomes closer, the

independent director is no longer a watchdog but a supporter for CEO. This weakness is

particularly relevant to directors remuneration since remuneration committee, whose

function is to approve the remuneration scheme, are usually composed of non-executive

directors who are supposed to be independent (Elayan et al., 2001). Consistently, Muslu

(2005) found that ineffective board monitoring may result real cost for companies by

paying their CEO more for performance beyond CEOs control and record greater

abnormal accruals.

Empirical studies on the effect of board independence show either mixed or

contradictory findings to what has been expected if the agency theory is applied. The

research by Adams and Mehran (2002) suggested that the increase in the proportion of

independent directors will increase firm performance due to more effective monitoring of

managers. However, Firth, Tam and Tang (1999) found that the extent of board

independence has little association with compensation level.

In Malaysia, the result of Standard & Poor Corporate Governance Studies (2004)

has shown that only fourteen percent (14%) of Malaysia companies has between one-half

and two-thirds of the board made up of independent directors, while just four percent

(4%) of companies has more than two-thirds independent director. Abdullah (2002)

found that board independence is negatively associated with directors remuneration. In

study the level of accounting standard compliance, Ismail (2006) found that board

independence will improve the compliance level of MASB financial disclosure.


40/121

39

2.6.3 CEO duality

Board structure is an important factor in building a better balanced board. Boards

have weak structure if it is dominated by older or busier directors, and where CEO has a

strong influence over the board of directors. Board dominated by the CEO is not expected

to play the role as effective monitors and supervision of management. Nevertheless,

CEO-duality has been a common structure in todays corporation as confirmed by survey

done in Europe and US which shows that a quarter of the director on the boards also

serve as company executives and majority of board chairs serve as a company CEO

(Muslu, 2005). The occurrence of CEO-duality is treated as an unhealthy board because

the greater the power of CEO, the less efficient is the role of independent director.

According to Williamson (1985), shareholder interests will be safe-guarded only

where the chair of the board is not held by the CEO or where CEO has the same interest

as the shareholders through appropriately designed incentive compensation plan (as cited

in Donaldson & Davis, 1991). The study done by Rechner and Dalton (1991) confirmed

that corporation which had independent chair-CEO structures has higher return on equity,

return on investment and profit margins. In contrast, Donaldson et al. (1991) found that

ROE returns to shareholders are improved by combining the role of the chair and CEO

position.

2.7 Ownership CharacteristicsCorporate governance problem does not arise merely from separation of managerial

control from ownership but only arise if there are multiple ownerships in a single

company (Akmova & Schwodiauer, 2004). As such, corporate governance problem will


41/121

40

not exist in the case of non-managing sole-proprietorship because the agency problem

can be solved by monitoring mechanism and incentive schemes to make the management

pursue the owners interest with condition benefits of monitoring does not over-weight

the costs. According to Jensen et al. (1976), this type of ownership separation is more

likely to result in performance of the firm closer to value maximization than owner-

managed enterprise, since owner-managers drive satisfaction from non-pecuniary aspects

of their engagement which they trade-off against profits.

In corporation which ownership is shared by more than one individual with

different preferences, conflict may arise due to the transferability of ownership rights and

imperfection of stock market. The conflict of interest will lead to sub-optimal policies in

the shareholders wealth maximization process. Nevertheless, separation of ownership

has become the most common structure in todays business world due to the vast

financing requirement in line with the corporations growth. Therefore, modern

corporations are potentially affected by two type of corporate governance problem.

Firstly, it is the problem of securing the control of shareholders over managerial

discretion. It arises from the dispersion of shareholder ownership in the form of dispersed

outside ownership in publicly held companies. Since the individual shareholders

marginal cost of monitoring is bigger than the benefits, dependent on the effort of large

shareholders is a dominant approach. As such, to overcome the dilemma, a well

functioning stock market with proper corporate control must exist.

According to Paul Krugman (1998), the Asian financial crisis was due to the

structural weakness in the domestic financial institution supported by unsound

macroeconomic policy and moral hazard. Even though various factors had been


42/121

41

highlighted, the consensus was the existence of poor corporate governance structure

among Asian developing countries. As such, after the financial crisis Malaysia has

actively promoted corporate governance to improve the aspect of fairness, transparency,

accountability and responsibility in running the organization.

Secondly there is the problem of resolving the conflict of interest arising from the

various shareholders especially when there is a majority ownership. The conflict of

multiple ownership and heterogeneous preferences is due to capital market imperfection,

for which substantial shareholders may pursue long-run value maximizing but minority

shareholders may prefer short term income, such as currently paid out dividend. By

possessing majority voting right, a substantial shareholder may try to use their influence

in order to impose policies at their interest but not value-maximizing to other

shareholders. High level ownership concentration may deter the forming of efficient

market for corporate control. Without such a market, neither the disciplining of managers

will be successful nor will the improvement in corporate sector performance.

2.7.1 Ownership concentrationThe issue of ownership concentration has been a topic of reasearch since Berle

and Means (1932). Further to Berle et al. (1932), La Porta, Lopez-De-Silanes and

Shleifer (1999) found that ownership in countries other than United State is more

concentrated. When ownership was concentrated, the intensity of supervision will

increase because shareholders have better information to monitor manager effort and thus

compensation can be tied more closely to actual and observable effort (Dogan & Smith,

2002). Core at al. (1999) found that United State CEO compensation decreases when


43/121

42

there is ownership concentration. Consistently, Ramaswamy, Veliyath and Gomes (2000)

found that the proportion of ownership is negatively correlated with CEO compensation

in India. Similar results were found by Firth et al. (1999) in the context of Hong Kong

family controlled firms.

Concentration of shareholding is very common ownership patterns in Malaysia.

According to Samad (2002), Malaysia corporate sector had been highly concentrate in

term of ownership where about half of public listed companies had five shareholders

owning approximately 60.4 per cent of the total equity in the corporate sector. Claessens

et al. (1999) using the percentage of shares owned by the largest ten shareholders as a

benchmark, reported that the state controls 17.8% and families controlled 67.2% of

public listed companies in Malaysia. The main reasons of ownership concentration are

the significant amount of government ownership and the prevalent of family control in

public listed company.

Government ownership constitutes a significant part of Malaysias economic

structure. The government linked company account for approximately RM260 billion

market capitalization of Bursa Malaysia. The survey done by CIMB founds that although

government linked company boards complied with the legal form of corporate

governance but lack in the performance of the corporate governance in its operation

which might be due to the adoption of corporate governance only in form rather than

substance.

In family controlled firms, corporate management tends to consist of controlling

owners, who might try to maximize their own interests, often at the expense of minority

shareholders. However, Fama and Jensen (1983) argue that family relationships among


44/121

43

owner-managers should reduce agency costs because when ownership and control rests

with the same person the need for outside monitoring is reduced. The argument is that a

high concentration of family ownership creates a direct control which functions as a

built-in check against excessive compensation. Moreover, since any money saved will

revert to the family, such companys directors do not emphasizes on compensation but

will focus on primary rewards accrued through increasing the value of firm over time. On

the other hand, there are also evidences suggested that family obligation can interfere

with the efficient operation of family controlled firm.

No matter whether the ownership concentration is in the hand of government or

family, it should result in greater vigilance and therefore increase pressure on directors to

discipline directors compensation. Abdullah (2004) found that high monitoring

incentives of outside block-holders increases the value of the firm. Although ownership

concentration might mitigate the conflict of interest between manager and owner, a

fundamental problem is how to protect minority shareholders from expropriation by

controlling shareholders as they might act at their own interest at the expense of minority

shareholders.

2.7.2 Managerial ownershipThe key aspect of corporate ownership structure is its composition as it will

determine who the controlling shareholders are. As such, it is an important element in

forming better corporate governance. For the initiative of minimizing the temptation of

manipulating accounting based performance measures and the doubt of board ability to

monitor firm operations; alternative compensation schemes had been introduced. The


45/121

44

most common scheme is the ownership of company stock by senior managers by granting

company stock options. The managerial ownership program was granted on the premise

that the potential agency problem can be mitigated. This is consistent with the findings of

Jensen et al. (1976), who found that ownership could align the interest of management to

the interest of owners. However, Fama et al. (1983) demonstrated various possibilities

that managers who own enough stock to dominate the board of directors could

expropriate corporate wealth.

The study on the impact of managerial ownership on compensation has been

widely conducted. Allen (1981) found that CEO compensation is a decreasing function of

CEO ownership of company stock which is consistent with the finding of Holderness and

Sheehan (1998) who found that managers who are majority shareholders receive a higher

salary. However, Morck et al. (1999) found firm value rises with managerial ownership

but the value eroded at higher level of ownership due to the entrenchment effect.

In Malaysia, the research by Cleassens et al. (1998) found a positive relationship

between managerial ownership and corporate performance. Vethanayagam, Yahya and

Haron (2006) found that increase in managerial ownership from 25 percent to 45 percent

cause the management to become more entrenched.

2.7.3 Independent Non-executive director ownershipWhile the executive directors were expected to execute daily functional

responsibility to ensure the successful management of the business, the independent non-

executive directors are perceived as experienced and influential part-timers who are

trusted to ensure that standards are maintained. The part-time nature of the role means


46/121

45

that when incompetence or malpractice occurs the non-executive will then present.

However, we live in a very fast changing society where a reluctance to accept

responsibility has become a hallmark of public and business life. As a result, the

existence of independent non-executive directors is just compliance to the corporate

governance system without bringing substantial benefits to the organization. This was

confirmed by the study done in the United States by Yermark (1996) who found a

negative relationship between the proportion of outside directors and corporate

performance.

As such, by increasing the percentage of shares held by independent non-

executive director, this will ensure they do actually carry out their duties as a watchdog of

the organization because their personal wealth was being tied to the shareholders.

Hambrick and Jackson (2000) found that the extent of independent non-executive

directors interest will make them feel more affiliated to the company, resulting in them

being more involved in their oversight and more generous in their time and attention.

This was consistent with the empirical finding by Jensen (1993) that outside board

members that hold substantial equity interests would have better incentive in monitoring

the management.

In Malaysia, Abdullah (2006) stated that non-executive directors shareholdings

could influence directors remuneration because ownership leads to greater vigilance by

the outside directors because their wealth is tied to firms performance.


47/121

46

2.8 Firm AttributesThe internal and external environment that the firm operates plays an important role in

determining the level of remuneration. In macro-economic context, market growth,

demand structure, industry structure, globalization and regulation might affect the level

of top management remuneration. These factor though important, it remain a as a poorly

understood issue surrounding the directors remuneration. In micro-economic context, the

firms characteristics in term of firm size, firm performance and firm debt position play an

important role in determine the level of top management remuneration.

2.8.1 Firm sizeThe common industry norm suggested that the level of remuneration is positively

correlated to company size. Larger firms are expected to have a more complicated

operation structure, greater growth opportunities and have more extensive hierarchical

management structure. The top managers of large size company have more scope to

exercise their skills. As such, larger firm do need a higher remuneration package to attract

and retain highly qualified man power to manage its operation. Besides, large companies

will usually show higher profits, thus an even relatively high compensation may appear

as an insignificant expense in the annual report.

The growth in firm size can be achieved through the issuance of share to finance

acquisition, investments, internal expansion and to finance the employees compensation.

Jensen (1986) found that expanding firm size will benefit the manager by enabling them

to obtain higher directors remuneration. Due to the wide dispersion of shareholders in


48/121

47

large companies, no initiative will be taken by the shareholders in questioning the

directors remuneration as the transaction costs might be high.

Empirical studies have evidenced the positive relationships between company size

and directors remuneration. Conyon et al. (1998) evidenced a positive significant

correlation between firms size and the firms highest paid directors remuneration. This

was further confirmed by Firth et al. (1999) who found that the larger the company, the

higher the compensation and Andjelkovic et al. (2000) who found that the sole

determinant of variations in CEO pay is the firm size. Consistently, Elayan et al. (2001),

CEO compensation is positively related to company size. In contrast, Murphy (1985)

documents an inverse relationship between company size and pay-performance

sensitivities which reflects the agency cost over-weighted by the benefits derived from

economies of scale. This was due to the fact that when a firm is too large, the amount of

directors pay will look immaterial if compared to the firm revenue, as such, the board

might approve a more favorable remuneration package regardless of the firm

performance.

In local context, Dogan et al. (2002) found strong evidence on the positive

relationship between board remuneration and firm size. Firm size had also been widely

used in other areas of corporate governance studies, for instances, Tan (2006) in examine

the relationship between corporate social responsibilities and corporate governance found

insignificant relation between firm size and corporate social responsibilities and Ismail

(2006) in examining the level of mandatory compliance with MASB found that firm size

will not affect the level of compliance.


49/121

48

2.8.2 Firm performanceThe agency theory suggests that the level of pay is an increasing function of firm

performance in terms of stock return or accounting profitability. In practice, the

commonly used firm performance measures are stock return and accounting profitability.

Stock return is a good measure of firm performance as it represents shareholders wealth.

However, in determinant of pay-for-performance, stock returns reflect only the overall

business operation but not the efforts of individual director and there are reasons for stock

price movement that other than corporate financial performance which directors have

little control over the factors. Accounting profit measures though can zoom down to sub-

division and product line but can be subject to falsification by management to reflect

short term performance.

Numerous studies have been conducted in the United States and United Kingdom,

it was found that there is a positive association between chief executive officer

compensation and recent stock return (e.g. Hallock, 1998; Boshen & Smith, 1995, Jensen

et al., 1990). The research by Firth et al. (1999) found that managerial pay is positively

related to accounting profitability although the relationship with stock return was

insignificant and previous year accounting profitability is associated positively with CEO

and executive directors compensation. Main et al. (1996) found a positive link between

pay and performance. However, although significant, the relationship was found to be

weak mean that there is little incentive for top management to try to improve

performance (Liang et al., 1998).

To tie the directors pay directly to the shareholders wealth, there is an increasing

call for the design of incentive compensation scheme called pay-for-performance, i.e.


50/121

49

directors will be paid based on firm and personal performance. However, past research

on pay-performance link also failed to identify a robust relationship between top

management compensation and firm performance. Elayan, Lau and Meyer (2001) found

no significant association between CEO compensation with performance measures which

is consistent with finding of Jensen and Murphy (1990) who found weak relationships

between pay and performance.

In Malaysia, Dogan et al. (2002) found that there is a positive relationship

between board remuneration and stock market performance but negative for accounting

measures. This may be due to the manipulation of accounting profits by Malaysian

companies. The research by Hassan et al. (2003) using the data of Malaysian firms during

the Asian financial crisis showed that the level of directors remuneration grow at a

steady percentage against the deteriorating ROE. This finding suggested that the directors

experienced an increase in remuneration at the expense of shareholders return. Abdullah

(2006) found that firms growth and size are more important factor in determine top

management compensation than performance.

Apart from that, Towers Perrins research of pay-for-performance link among

Asias largest companies in year 2003 revealed that among Asian countries, Hong Kong

directors are the best paid across Asia with average pay of USD310,000 which was

double of Malaysian director with average pay of USD115,000. However, Malaysian

directors experienced the highest pay increase of 11.5% as compared to 7% in Singapore

and 1.95% in Hong Kong. The research indicates a weak link between directors

remuneration and company performance. The result of this study has further confirm the


51/121

50

research undertaken by Malaysian Business magazine that significant pay increases occur

despites declining profits or even suffering losses.

2.8.3 LeverageA companys financial leverage determines the company finance structure. A firm

financial leverage will determine available free cash flow. Thus, when the leverage level

increases this will add pressure to the management to efficiently manage the cash flow. A

company is said to be highly leveraged if the extent of debt financing is more significant

than equity financing. Although the leverage level determines the available free cash flow

after financing all profitable projects, it is constrained by the obligation to utilize for high

return investment or employ in operating expenses and debt repayment. As such, to

ensure the managers utilize the cash efficiently, a firm may increase their leverage. By

reducing the available free cash flow, the possibility of allocating these cash flows to

low-return diversification, sumptuary expenses, raising managers salary and others

suboptimal investments decision will be reduced. This was confirmed by Jensen (1993)

who found that the board obligation to fulfill an enforceable contract decrease the

possibility of opportunistic behavior and reduce the amount of cash flow that they can

freely allocated.

When the shareholders control is supplemented with higher level of creditors

ability to monitor the debt contract, the leverage level will become higher. In return, the

discretionary power of the board members will be reduced. However, the research by

Crespi and Gisprt (1998) using the data of Spanish companies, was not able to derive a


52/121

51

clear tendency about the impact of leverage in the board remuneration-performance

relationship.

In Malaysia, in the study of level of compliance with MASB, Ismail (2006) found

that leverage does not affect the level of compliance with MASB. Apart from that,

leverage had seldom been studied especially in Malaysia context. Due to lack of

empirical evidence, this study will explore further the effect of leverage on directors

remuneration.

2.9

Theoretical Framework

The design of top management compensation contract has been an important topic of

investigation in the principal agent literature. The objective of excessive research in this

area is to formulate an optimal compensation scheme that motivates the agents to

maximize firm performance, taking into account corporate governance structure. The

corporate governance conditions depend on the rule and regulation in the country of

origin. Furthermore, the external environment in which the firms operate such as industry

performance, firm size and business risk may also influence the director-shareholder

relationship.

Previous studies on the determinants of top management remuneration have

produced mixed evidence and little research had been done in Malaysia context. As such,

this study will try to examine the determination factors of directors remuneration in

Malaysia. The theoretical framework of the study described in schematic diagram is

shown in Figure 2.1.


53/121

52

Figure 2.1: Theoretical Framework

2.10 Hypothesis DevelopmentThe hypothesis development in this study is based on the agency theory framework.

Based on the theoretical framework shown above, nine hypotheses and will be tested in

this study.

2.10.1 Board size

There is no any regulation that spelled out specifically the number of director

required to form an effective board. As such, the size of companies board will normally

depend on the firm size and operational efficiency. Jensen (1993) and Yermack (1996)

find that boards are less effective if they grow in size. This may be due to communication

Directors Remuneration

Board Characteristic

- Board size- Board independence

- CEO duality

Firm Attribute

- Firm size

- Firm performance- Leverage

Ownership Characteristic- Ownership concentration

- Managerial ownership

- Independent non-executivedirectors ownership


54/121

53

barrier when there are too many people involved in the decision making process. Smaller

board is expected to be able to better control over its operation. Ghosh et al. (2003) found

that larger boards are associated with higher CEO compensation. Consistently, Core et al.

(1999) found that CEOs compensation increases as board size increase. As such, smaller

boards seem more likely to constrain directors pay.

The size of the board of directors is expected to be associated with less effective

board monitoring, based on the argument that when boards become larger, the decision

making power become diluted while the CEO will dominate the board, and are less able

to control employee compensation effectively. Therefore, based on the discussion above,

the hypothesis of this study will be:

Hypothesis 1:Board size is positively related to the level directors remuneration.

2.10.2 Board independence

The composition of the board of director is an important element to protect the

interest of the shareholders. The link between board independence and directors

remuneration is predicted to exist as the independent non-executive director may exercise

their power to monitor and discipline the manager.

Ryan and Wiggins (2004) found that an independence board is generally

associated with good corporate governance and thus the compensation packages will be

more closely align with shareholders wealth maximization. However, Crystal (1991)

argued that in a system where outside directors serve essentially at the pleasure of the

CEO, it is difficult for them to oppose the decision of the CEO particularly in his

compensation (as cited in Ghosh & Sirmans, 2003). However, Conyon et al. (1998) and


55/121

54

Firth et al. (1999) did not found the link between board independence and directors

compensation to be existed. Consistently, Petra (2005) found no clear benefit to firm

performance given by independent director; and the present of independent director on

remuneration committee did not result in critical evaluation of CEO performance and

reduced CEO remuneration. Due to the different of regulation and corporate governance

structure, in the context of Malaysia, Abdullah (2006) found that board independent is

negatively associated with directors remuneration.

Traditionally, independent non-executive directors were appointed for the

strategic insights based on their political background or experiences or even just for

compliance purpose. However, now they are expected to be the watchdog of the boards

activities by focusing on the realization and promotion of corporate governance

especially in areas where the interests of management and the shareholders diverge, such

as directors remuneration, corporate control, accountability and audit. Due to the change

on the perception of independent non-executive directors function, therefore, this study

hypothesized that:

Hypothesis 2:The proportion of independent non-executive directors negatively related

to the level of directors remuneration.

2.10.3 CEO-duality

The board is perceived as independent if the chairman and the Chief executive

Officer (CEO) post are held by different persons. CEO-duality enables the CEO to gain

full control in dominating the decision making of the company. By holding two main

positions in an organization, the CEO may have the conflicts of personal interest to


56/121

55

shareholders interest and have strong influence over the board of directors in shape his

own compensation. This result in ineffective monitoring and therefore are likely to

exercise his discretionary power at the expense of the shareholders. Daily and Dalton

(1993) state that duality is often a sign of strong CEO power, which combined with a lack

monitoring of board decision, may have negative consequences for corporate

performance.

Core e al. (1999) found that CEO compensation increase when the CEO also is

board chair. Consistently, Kakabadse et al. (2004) found that shareholders bear the cost

of excessive pay when a director has notable power. Similarly, Elloumi et al. (2001)

found that the greater the power of CEO, the higher is the level of total compensation.

More recent study by Muslu (2005) also found that incentive compensation is greater in

companies with board chairs serving as CEOs. However, due to different regulation and

corporate structure, Abdullah (2004) found that CEO-duality do not have significant

impact on directors remuneration.

To enhance board independence, a firm not only need to ensure substantial

number of independent non-executive directors was appointed but also having the board

chairperson is someone other than the CEO. This is to ensure that the role of supervisor

and manager should not be combined. If the situation of CEO-duality occurred, it will be

difficult for the chairman to represents the interest of the shareholders due to his own

economic benefits. Therefore, it is hypothesized that:

Hypothesis 3:Firm with CEO-duality is more likely to have higher directors

remuneration.

joanne mba thesis 2007

Documents