research methods assignment - the relationship among board of director characteristics, csp and cfp

[Assignment - Critical Review] 2013

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The Relationship among board of director characteristics, corporate social performance and corporate

financial performance

Amany Hamza

Student number: 21202244 Tutor: Sharif Sheriff,

Course: MBA / Research Methods, BA70020E Word Count: 2000

(Excluding Table of Contents, Acronyms, Cover Page and Appendices) Date: 08th November 2013

Figure 1 – CSP and CFP (Source: Google, Adapted for the link between CSP and CG, CFP)

[Assignment - Critical Review] 2013

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Table of Contents

1. ACRONYMS................................................................................................................................. 3

2. EXECUTIVE SUMMARY .................................................................................................................. 3

3. INTRODUCTION ........................................................................................................................... 4

4. HYPOTHESES ............................................................................................................................... 5

4.1. SHAREHOLDER ORIENTATION ................................................................................................. 5

4.2. BOARD INDEPENDENT .......................................................................................................... 5

4.3. FIRM RISK .......................................................................................................................... 5

5. METHODOLOGY .......................................................................................................................... 6

5.1. MODEL .............................................................................................................................. 6

5.2. DEPENDENT, INDEPENDENT AND CONTROL VARIABLES ............................................................... 6

5.3. SAMPLE SELECTION .............................................................................................................. 7

6. EMPIRICAL ANALYSES ................................................................................................................... 7

7. CONCLUSION .............................................................................................................................. 8

8. APPENDICES ............................................................................................................................. 10

8.1. APPENDIX I ....................................................................................................................... 10

8.2. APPENDIX II ...................................................................................................................... 11

8.3. APPENDIX III ..................................................................................................................... 12

Assignment - Critical Review 2013

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1. ACRONYMS

BoD Board of Directors

CFP Corporate Financial Performance

CG Corporate Governance

CK Corporate Knights

CSP Corporate Social Performance

CSP Score Dependent variable that is taken from the Canadian Social Investment Database as prepared by JRA which is affiliated with, among others, Kinder, Lydenberg and Domini (KLD)

CSR Corporate Social Responsibility

EPS The firm’s earnings per share

FP Financial Performance

JRA Janzi Research Associates

ROB The Report on Business is independent third party assessor of the quality of corporate governance structures of Canadian Companies, ROB rates the top 300 firms on the TSX across four areas of corporate governance: shareholder orientation, board composition, compensation, and disclosure issues

ROE The firm’s return on equity

RP Research Paper

SR firms Firms on the Domini Social Index

TSX Toronto Stock Exchange

2. EXECUTIVE SUMMARY

This report attempts to critically analyse the research paper:

Dunn, P., & Sainty, B. (2009) The relationship among board of director characteristics, corporate social performance and corporate financial performance, International Journal of Managerial, Finance, Vol. 5 No. 4, 2009 pp. 407-423.

The first section of this report covers the analysis of the RP as well as the purpose of the RP which is to investigate the relationship between qualitative measures of the BoD and its CSP. RP examines first the impact of the board on the CFP as well as its CSP. Then, it examines CSP from the perspective of agency theory. For the purpose of the RP, it developed CSP score model to test three submitted hypotheses.

The empirical study is using a longitudinal sample of 104 Canadian firms to capture CG impact on the CSP. Although the sample is small and limited to top Canadian firms listed on TSX, the results are quite robust. Moreover, a strength (and weakness) of this study is utilising qualitative methodology to identify the relationship between CSP and CG. The reason for that is that this methodology has been used within only two empirical studies with respect to the link between CG and financial statement disclosures1 and also earnings quality2. The findings illustrate a positive link between CSP-board independence but not in terms of the shareholder orientation. Another positive link between CSP with both CFP and debt is found. RP concludes with a strong recommendation for researchers to develop finer measures to capture the quality of CG structures instead of using the usual suspects.

1 Gleb and Strawser, 2001; Healy et al., 1999; Welker, 1995.

2 Niu, 2006.


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The last section outlines the overall conclusion which includes my critique and general observations.

3. INTRODUCTION

The notion of CPS encompasses the dimensions of community relations, workplace, the environment and the society at large. This RP ties up the integration of the societal concerns into business practices to the characteristics of the CG. Prior work3 documents that board independence is strongly correlated with the CSP. In the same vein, positive association is noted4 between investor ownership and CSP. However, counter arguments have prevailed unclear impact of the BoD shareholder orientation has on CSP, while the managerial ownership –CSP link is less clear (see Appendix I).

With regards to the impact of the CG structures on the CFP, agency theory claims that there should be a direct link between the strength of CG and the CFP; it has parallels to strong independent Boards. Moreover, compensating directors with equity should further enhance the Board and the common shareholder relationship5 (see Appendix I). Thus, independent board with a shareholder orientation view should be closely interrelated to CFP.

In examining the CSP-CFP link, empirical research has generated mixed results. In Roman et al (1999) review of 51 exploratory studies, 32 studies posit a positive CSP-CFP correlation, about 5 with a negative correlation and 14 resulted in hybrid correlation or no correlation was found. Thus, this CSP-CFP model resulted in a fragmented literature in this area, and this could be because of flawed investigations.

The holistic view of CSP captures the principles of CSR and the processes of CS responsiveness towards different societal actors over the long term. Hence, the integration of CSP into governance systems incorporates a long term perspective. In this sense, CG is driven by long term commitment to serve corporate purposes by providing a structure which creates sustainable business. Similarly, short term executive compensation contracts do not imply a strong CSP (McGuire et al, 2003).

Agency theory’s contention addresses interest conflicts between managers and investors. This potential conflict derived from keeping management divorced from ownership. Thereof, shareholder value capitalism is based on the duty of the BoD to align the interests of management with those of shareholders through the use of stock-based compensation. Hence, well governed corporations will contribute to sustainable improved performance.

Nonetheless, another issue6 within the agency theory is the adverse selection problem of the right business investment for the bondholders. In seeking to lessen this issue, some researchers7 find that firms can alleviate the debt risk by spurring corporate citizenship view. Contradictory to that, McGuire et al (1988) note adverse link between the risk and CSP. Either way, CPS may act as a signal to external parties about the quality of management.

3 Studies by: Ibrahim and Angelidis, 1995; Johnson and Greening, 1999; Wang and Dewhirst, 1992.

4 Consensus by: Cox et al., 2004; Johnson and Greening, 1999; Graves andWaddock, 1994; Neubaum and

Zahra, 2006 5 Consensus by: Hillman and Dalziel, 2003.

6 Issue noted by: Defond and Jiambalvo, 1994

7 Consensus: Cahan and Malone, 1995; Graves and Waddock, 1994; Husted, 2005; Orlotizky and Benjamin, 2001


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Firms with more independent boards of directors wil have better corporate social performance than firms with less independent Boards of Directors.

H2

4. HYPOTHESES

This RP so far provides in depth picture of the impact of CG on CSP. This impact is gauged with qualitative measures of shareholder orientation and board independence.

4.1. SHAREHOLDER ORIENTATION

The study highlights the assumption of agency theory that a more close association incurs between investors and managerial ownership. Abreast with this speculation, director ownership is positively related to CFP. This is in compliance with the findings that top-performing firms have boards with a large ownership interest. However, it is not clear if the shareholder orientation and CSP should be positively correlated as well. In contrast, researchers confirm a positive relationship between CSP8and institutional investors. This is quite unlike the link between CSP and managerial ownership, which only incurs in some aspects of CPS. Moreover, Frye et al (2006) deem compensating management with stock may induce them to squander corporate resources to benefit themselves.

The findings of a matched sample of 400 SR firms with another 400 of non-SR firms indicate that there is no impact of stock options on CEOs at SR firms to take on more risks though they have an impact on the latter in order for CEOs to increase their personal wealth.

4.2. BOARD INDEPENDENT

External independent directors can be appointed to the Board to better monitor management in order to tackle management opportunistic behaviour. They, in turn, promote a broader stakeholder orientation and their interests, thus, are more closely aligned with the interests of the other investors9.

4.3. FIRM RISK

Risk is associated with issuing debt instruments because of the asymmetric information in this regards. Hence, the engagement in socially responsible activities to signal to bondholders its business credence will reduce the inherent risk (See Appendix I).

8 Consensus: Cox et al., 2004; Graves and Waddock, 1994; Johnson and Greening, 1999; Neubaum and Zahra, 2006

9 Consensus: Jensen and Meckling, 1976; Zahra and Pearce, 1989

The degree of shareholder orientation of the BoD will have no effect on the CSP of the firm.

H1

Fig. 3: Hypothesis 2

Fig. 2: Hypothesis 1


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Firms with high debt ratios will have better corporate social performance than firms with low leverage ratios.

H3a

The findings from Fortune 500 corporate reputation scores10 show a positive relationship between performance and social responsibility scores, while revealing that there is a negative relationship between leverage and social performance. The findings propose that firms with high performance and low debt are more economically viable to afford participating in social activities.

5. METHODOLOGY

5.1. MODEL

The CSP score model that is used to test these hypotheses is:

5.2. DEPENDENT, INDEPENDENT AND CONTROL VARIABLES

CSP score is the dependent variable, where JRA rates the largest 300 firms listed on TSX by using KLD’s11 multidimensional construct, fig.7. Aggregated CSP score is weighted based on its relative importance to the five stakeholders’ domain, fig. 8. The top 50 firms’ names and scores are published annually since 2002 in CK, though for 2003 only the rankings were disclosed.

10 By: McGuire et al. , 1988. 11

Kinder, Lydenberg and Domini is a financial advisory firm specializing in the assessment of corporate social performance.

CSP score f (shareholder orientation, board independence,

leverage, controls).

Fig. 6: CSP model

Fig. 4: Hypothesis 3a

Firms with high leverage ratios will have poorer corporate social performance scores than firms with low leverage ratios.

H3b

Fig. 5: Hypothesis 3b


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Corporate governance

Community relations

International relationships

Environment

Workplace diversity

Product safety and business

practices

Employees’ relations

Share performance

Fig. 8: Stakeholder groups

nature Employees

Shareholders

On the other hand, the annual ratings for the independent variables, shareholder orientation and board independency, are compiled by the ROB12. The orientation variable is scored out of a possible 24 points with regard to stock option criteria, while the independence’s score is out of a possible 40 points in terms of board composition (See Appendix II). The Debt ratio, another independent variable, is measured as the ratio of long-term debt to total assets. Compustat is used to obtain financial statement data.

In line with prior studies, the RP controls for firm Frequency, firm size (which measures by the log of total assets), and for the financial performance (EPS, ROE).

5.3. SAMPLE SELECTION

The supporting evidences are derived from a sample composed of the 50 best Canadian companies over multiple industries (See Appendix III, Table III). Data are collected from the period of 2002 to 2006. While JRA ranking excluded 2003 because actual score was unavailable, also out of the total sample of 200 observations only 174 firms (See Appendix III, Table I, is the final sample because 19 do not have ROB scores and 7 firms have incomplete financial data. 104 unique firms (See Appendix III, Table II) reflect the number of times that each firm was rated in the top 50 firms over the 5 years.

6. EMPIRICAL ANALYSES

First, the correlation matrix and statistics (See Appendix III, Table IV) provide support for H1, H2, and H3a. The results show the CSP score highly correlated with Independence and Leverage but not with Orientation.

Fig. 7: multidimensional nature of CSP


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Second, multiple regressions results for Model 1 (See Appendix III, Table V) reveal a positive association between CSP and CFP. This is consistent with prior studies13. However, the CSP-Frequency link is not statistically related. Moreover, the coefficients of control variables in Model2 are in line with the results of Model1. Also the coefficients and statistics results of the three independent variables are in accord with those of Model1. The empirical analyses, thus, support hypotheses H1, H2, H3a.

The results show that strong positive CSP is embedded within a highly independent board, whereas board shareholder orientation is not related to CSP. This is consistent with stakeholder theory, hence supporting the holistic view of CSP. With regards to the link between firm risk and FP to CSP, this study finds similar results of other studies.

7. CONCLUSION

By using a set of qualitative characteristics, this investigation can make a salient contribution to further develop the understanding of the relationship between CG and CSP. The data is analysed by an inductive research strategy which uses interpretivist approach to explore the degree of board independency and its level of shareholder orientation in relation to the CSP. Nonetheless, despite using qualitative research instead of the dominant quantitative method in this strand, the results demonstrate consistency with other two qualitative empirical studies with respect to the link between CG and financial statement disclosures14 and also earnings quality15.

The negative correlation between a board with shareholder orientation and CSP supports the broad notion of CSP. Hence CSP is geared towards the Stakeholder theory, which is the emerging view of socialised capitalism16. This offers ground for speculation on the validity of the claim of H1.

Using a strong independent board view does not only lead to strong CSP, but it can steer CEOs towards good management practices to tackle managerial capitalism. Hence it relates to serving many actors and this leads to holistic view of CSP. This represents a coherent construct of the RP.

Furthermore, it is important to take into account that the independent variable, Leverage, is compiled for the five-year period 2002 to 2006. Thus, the ratios of debt took place in the context of economies of pre-recession; therefore there is a possibility for the ratios of 2007 onwards to be volatized. Further work is recommended to examine H3 in the light of these changes.

The use of multidimensional measurements by JRA, KLD and ROB reflect the internal reliability of the sample. However, by limiting the sample to Canadian companies, the results might not be valid for companies outside the Canadian governance tradition because of the differences in the legal and cultural environments. Hence, further studies should consider an international sample to reflect transferability criteria.

The small size of the sample could be convenient to limit errors in the early stage of using qualitative approach in such strand. But it is recommended to consider a large sample for further insights into firms with medium and low CSP scores.

Further studies with detailed CSP score instead of the aggregated used one may highlight the unique CS dimension of each firm to develop better understanding and promote the scope of CSR.

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Cox et al., 2004; Johnson and Greening, 1999; McGuire et al., 1988 14

Gleb and Strawser, 2001; Healy et al., 1999; Welker, 1995. 15

Niu, 2006. 16

Kakabadse et al. (2010) suggests a fundamental shift in the investment time horizon from shorter to longer term

and build around stakeholders.


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This study sheds a light on the role of the board in the CSP-CFP which has been ignored in prior studies. The model used results in a positive link between both. Hence it paves a strong way for further research in this link.

RP proposes that CSP is similar to CFP in terms of not having long-term view. This emanates from the frequency findings of the sample. Although good performance in one year does not mean same results in following year, still long term performance is necessary to leverage stability which is the main perspective for CFP strategies. Though short term view can be defined as tactics, stable business cannot merely rely on it. Hence this creates avenues for future studies to parse CSP from permanent, transitory and price irrelevant persistence.


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8. APPENDICES

8.1. APPENDIX I

Domains Influential

authors/Period CSP

Influential authors/Period

CFP

CG Structures

1.Independent BoD

Ibrahim and Angelidis, 1995; Johnson and Greening, 1999; Wang and Dewhirst, 1992

a strong link between board independence and CSP

Beasley, 1996; Bujaki and McConomy, 2002; Core et al., 1999; Kosnik, 1987

Strong association between strong independent board-CFP

Hillman and Dalziel, 2003

Board with shareholder orientation should further enhance the Board and common shareholder link

2.Managers

Johnson and Greening, 1999

Managerial ownership is only related to some aspects of CSP

McGuire et al, 2003

Short term executive compensation contracts is not related to strong CSP.

Institutional Investors

Cox et al., 2004; Johnson and Greening, 1999; Graves and Waddock, 1994; Neubaum and Zahra, 2006

Positive Investor ownership-CSP association

Debt instruments/ Firm risk

Cahan and Malone, 1995

Strong link between socially responsible behaviour and the level of voluntary disclosures

McGuire et al, 1988- using Fortune 500 corporate reputation scores

A positive link between performance-social responsibilities scores.

McGuire et al, 1988-using Fortune 500 corporate reputation scores

A negative link between firm risk and social responsibility scores


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8.2. APPENDIX II


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8.3. APPENDIX III