An Examination of the Effectiveness of Non-Executive Directors, Independent Directors, and New Zealand Firm Performance Before and After the Adoption of the NZX Corporate Governance Best Practice Code

Abstract

Board of director composition has become an important mechanism in the mitigation of agency costs through alignment of manager-shareholder interests. The board can be seen as a market solution to the monitoring and contracting problems prevalent in most organizations. However, the effectiveness of board composition in enhancing firm performance in practice is not clear. Using the method of three stage least squares, I estimate the endogenous relationship between firm performance measures and outside/independent board representation using a sample of New Zealand listed companies over the period 1997-2008. I find empirical evidence that board composition and firm performance impact each other. Consistent with agency theory, I find that firms with a higher proportion of outside directors have a greater Tobin’s Q. Simultaneously; Tobin’s Q is inversely related to the proportion of outside directors. Outside board representation has an insignificant effect on a firm’s return on assets.

Changes in the listing requirements imposed by the New Zealand Stock Exchange (NZX) in August 2003 has fundamentally altered corporate governance within New Zealand and impacted the outside/independent board–firm performance relationship. I find that the code improved New Zealand firm performance measured by Tobin’s Q. Firms responded to the code by increasing the proportion of outside directors. However, the code reduced the sensitivity of outside directors to firm performance which casts doubt on the effectiveness of outside board representation. Furthermore, over the sub-sample period 2004–2008, the proportion of both outside and independent directors is inversely related to Tobin’s Q, consistent with the stewardship argument. A possible interpretation is that New Zealand firms over-invested in outside/independent directors after implementation of the NZX code, leading to poor board function. This conflicting result indicates the firm performance board representation relationship is dynamic and evolves over time. The implication from a regulatory point of view is that it is preferable for governance-related regulation to have an element of flexibility that caters for changes in the economic environment, rather than a strict “one size fits all” rules-based approach that is likely to be counter-productive. I include measures of firm-level risk and directorial remuneration to test the effectiveness of outside and independent directors in enhancing firm performance. Both total fees paid to outside directors and firm-level risk does not enhance the efficacy of outside directors to firm performance. However, these measures do enhance the efficacy of independent directors to Tobin’s Q. Overall, results indicate that board composition is an important mechanism in the mitigation of agency within the firm and has implications for firm performance. However, firms that focus solely on agency reduction and adopt a high proportion of outside/independent directors must be wary that this could compromise the effectiveness of the board and may not be optimal over different time frames.