Academic journal article Academy of Accounting and Financial Studies Journal

Is Board Quality an Indicator of a Firm's Future Performance?

Academic journal article Academy of Accounting and Financial Studies Journal

Is Board Quality an Indicator of a Firm's Future Performance?

Article excerpt


The world stock markets have shown extreme volatility in the first nine months of 1998. On August 31 the Dow Jones Industrial Average (DJIA) dropped 512.61 points (6.73%), the largest one-day point drop since October 1997. This came after a week which was the DJIA worst one-week loss in the history of the index. That day the Nasdaq Composite Index dropped to 1499.15, more than 25% off its all time high. The very next day, September 1, the DJIA was up 288.36 points, followed in one week (September 8, 1998) by another 380.53 increase. Stock Exchanges outside the US are also volatile. The stock exchanges in Russia (where the Russian Trading System index plunged 17% in a single day), and Eastern Asia have caused worldwide concern, increasing fears of assets being liquidated in Brazil and Argentina. The European stock markets were down by 17% from their 1998 peaks. In the same week in August when the DJIA had its worst drop, Japan's Nikkei 225 index dropped 9% to below 13915.63, a 12-year low.

What type of companies can maintain their stock prices and increase cumulative stockholder returns in times like these? In this paper, the results show that it is those companies with the highest quality board of directors that perform best.

High quality boards of directors follow the interest of shareholders by monitoring the excesses of management. Fama and Jensen (1983) describe the board of directors as the highest level control system of corporations. Fama (1980) views the role of board of directors as an internal monitoring mechanism. If board of directors effectively monitors the management decisions, the performance of such companies will exceed those of other companies with less effective boards of directors. Shivdasani (1983) argues that the ineffectiveness of the board is a cause of hostile takeovers and other agency problems.

This paper examines the future performance and other characteristics of companies with boards of directors considered to be the best and worst in the U.S. The 25 best and 25 worst corporate boards that were identified by a survey of professional stock portfolio and pension managers and corporate governance experts performed by the Business Week organization and published in December of 1997. The companies were evaluated on the criteria of board independence, stockholder accountability, board quality and corporate performance. Companies were evaluated numerically on these criteria from two points of view: professional judgment and governance standards. Professional judgment was used by the professional portfolio managers. Governance standards were based mostly on the standards of the National Association of Corporate Directors with professional judgment playing some part.

We examined if the firms rated highly or poorly performed better or worse than the market in a future period. We compared cumulative stock return, stock return subtracting the effects of the industry and market return on equity for these corporations over the period January 1, 1998 to September 8, 1998. The results show that for the best ten and worst ten and the best twenty and worse twenty, excess stock return over the market is significantly higher for companies with high quality boards of directors than for companies with low quality boards of directors. Cumulative stock return and excess stock return over the market for the 10 best boards were significantly better than the ten worst (at a p-value two-tailed of 0.009). The results indicate that independence, accountability and overall quality are important indicators of the future performance of a firm.

The rest of this paper is organized as follows: Section 2 reviews previous research on the role of corporate boards of directors. Hypothesis is developed in section 3. Section 4 explains the method Business Week used to identify the best and worst boards in America. Section 5 discusses empirical test design, and test results are presented in section 6. …

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