Ninad Mhadolkar

MBA 533
Corporate Governance and Firm Value: a study of board composition in the healthcare
sector
I. Introduction
Enormous amount of research has been done in the field of corporate governance and its
importance in the development of financial markets. Numerous studies have linked
different factors to resulting firm value, Jae-Seung Baek, Jun-Koo Kang, Kyung Suh Park
(2002) have demonstrated the results of external shock on firm value depending on
corporate governance metrics, they study effects on firm value in the Korean market in
the event of an external economic shock based on controlling rights, cash flow rights and
board composition and compare various factors of owner-manager control rights versus
those in widely diversified firms. Several studies establish a link between corporate
governance and corporate valuation, Claessens et al. (2002) show that higher cash flow
rights of the controlling shareholder are associated with higher market valuation, but
higher voting rights correspond to lower market valuation. La Porta, Lopez-de-Silanes,
Shleifer, and Vishny (2000) show that firms in countries with better shareholder
protection have higher Tobins q than those where such protection is weaker. Another
important characteristic that contributes to firm valuation is ownership structure; many
large investors with no affiliations and therefore have strong financial incentives to
monitor financial behavior, while affiliated investor may have different monitoring
incentives as argued by Shleifer and Vishny (1986), Barclay et al. (1993) argue that large
shareholders can extract private benefits that are not available to diffuse stockholders.

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In this study I explore the role of different investors on the board and the effects of this
composition on firm value. A sample of 50 firms is examined in the healthcare sector and
information regarding the number of Doctors of medicine on the board is an important
characteristic whose link to firm valuation will be studied.
Before we go into more details for this specific sector lets review some trends in
corporate boards as stated by Robert Monks &Nell Minow in their book Corporate
governance (2004):
Size: According to research conducted by executive search firm Spencer Stuart, the
average size of the board has shrunk from 15 in 1998 to 10.9 in 2002 and a quarter of the
S & P 500 boards have between 8 and 9 directors as to compared 16 earlier. As boards
have shrunk, there has been a reduction in inside directors.
Inside/Outside mix: Spencer-Stuarts 2002 study found that in nearly 1/3rd of S&P 500
firms, the CEO is the only inside director. Less than 10 percent of firms had that board
configuration in 1992. The most common job of new directors is still CEO /chair /
president of another public company as found by the research.
Diversity: The study found that most corporate directors are still middle-aged white
males. However 16 percent of new outside directors were now women and 12 percent of
new directors were academics or from non-profit organizations suggesting a shift towards
looking beyond the standard candidates. There is similar steady progress in the
recruitment of directors from ethnic minorities as well.
Ownership: Spencer-Stuart concluded that the idea of paying outside directors wholly in
stock was a non-factor in its analysis. More than half of the S&P 500 firms offer outside
directors stock options and many firms have now included retainer in either stock or cash,

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reinforcing the message that if directors do their jobs well, their efforts will be
handsomely rewarded.
Governance: According to the survey conducted by Korn/Ferry governance standards in
the boardroom had transformed over time. Korn/Ferry asked directors for their views on
what were the most important development in board structure and practice in recent years
and nearly half identified the increase in independent audit, compensation and
nominating committees. It is now considered best practice to have all three committees
made up exclusively of outside directors. Meetings follow an agenda compiled by
management, though directors can ask for items to be included, the agenda and relevant
information is typically sent to directors a couple of days before the meeting. A meeting
may feature a special presentation by a non-board insider, such as a division head, etc.
Board duties:
As per Monk and Minow, the board of directors has five primary functions:
1. Select, regularly evaluate, and if necessary, replace the chief executive office.
Determine management compensation. Review succession plan.
2. Review and where appropriate, approve the financial objectives, major strategies, and
plans of the corporation.
3. Provide advice and counsel to top management.
4. Select and recommend to shareholders for election an appropriate slate of candidates
for the board of directors; evaluate board processes and performance.
5. Review the adequacy of the systems to comply with all applicable laws/regulations,
etc.

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The existence of boards, according to both the legal and definition and the description
given above is based on the premise that the board oversees management, selects
executives who will do the best job and may fire them when they dont. The fact of the
matter is that in reality this is totally opposite. Directors are obliged to management for
nomination, compensation and information. Moreover many directors are either
unwilling or unable to devote the time or energy to oversee the operations of the company
or to make a financial commitment to its success.
A large proportion of the regulatory changes have focused on boards of directors. (Beth
Young , Ivey business journal online, Sept/Oct 2003), given the critical functions
performed by the board and its key committees as we discussed earlier is quite
predictable. Many prominent witnesses testified before Congress and the national stock
exchanges, that captive boards were a major contributing factor in the corporate scandals,
and that reforms designed to increase the independence and competence of boards were
crucial to restoring investor confidence. The Sarbanes-Oxley legislation marked the first
time federal legislation imposed an independence requirement on public company boards,
requiring companies to have an audit committee composed exclusively of independent
directors and defining independence more narrowly than previous regulatory provisions.
It also prohibited new company loans to directors, proposed changes to the listing
standards of the New York Stock Exchange and Nasdaq and required a majority of
directors on listed company boards to be independent, including all directors on key
committees strengthening the independence definition. It is natural, that a director with
ties to a company or its CEO would find it more difficult to turn down an excessive pay
request, challenge the rationale behind a proposed merger or bring to bear the skepticism

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necessary for effective monitoring. Despite the consensus that has developed around
director independence, however, there is limited evidence that the so-called resume
independence-defined as the absence of familial, employment and financial relationships
between directors and the company promoted through both the reforms to date and codes
of governance best practice actually improves corporate performance. With one
exception, empirical studies have not found a statistically significant positive relationship
between the degree of board independence and better financial performance. In a recent
study, Sanjai Bhagat of the University of Colorado at Boulder and Stanfords Bernard
Black found no correlation between the degree of board independence and four measures
of firm performance, controlling for a variety of other governance variables, including
ownership characteristics, firm and board size, and industry.
(Journal of Corporate Law, Winter 2002). Bhagat and Black did find that poorly
performing firms were more likely to increase the independence of their board. Earlier
meta-analyses similarly failed to find a correlation between board independence and
various measures of corporate performance. One study, by Paul MacAvoy and Ira
Millstein, did find a positive relationship between a novel measure of independence and a
measure of firm performance related to economic value added (EVA). However,
monitoring is only one of a board's roles. Directors also contribute to a firm's success by
advising senior management, channeling outside resources to the firm and relating to
stakeholders such as communities and employees. Researcher Jill Fisch has theorized that
while independence may improve directors' performance as monitors; it may be
counterproductive with respect to managerial tasks. Similarly, Lynne Dallas has argued
that the board's multiple roles and the differing significance of independence with respect

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thereto, support the use of a dual board structure. The lack of a relationship between
board independence and performance across a large number of companies does not,
however, mean that increased independence is not the right prescription for any
individual company's board. When a board is falling short of fulfilling its monitoring
duties-for example, where executive compensation is excessive in relation to
performance or where the integrity of financial controls has been compromised in the
past-increasing the number of independent directors on the board could reduce the
likelihood of the problem recurring. But increased board formal independence should not
be viewed as a panacea for poor corporate performance or board failure.
The focus of this paper is on board composition and the contribution of directors to board
and governance effectiveness. Firms have in recent years been increasingly pressured by
institutional investors and shareholder activists to appoint directors with different
backgrounds and bases of expertise, under the assumption that greater diversity should
lead to less insular decision making processes and greater openness to change (Westphal
and Milton, 2000). Companies must structure their boards to serve their needs and boards
need to think about whether they have the right composition to provide the diverse
perspectives that today's businesses require (Biggins, 1999; Grady, 1999). Board
composition will vary according to the differing governance, performance and social
requirements of organizations pertaining to the type of ownership structures (Van der
Walt et al., 2002), and the strategic nature of the environment within which they operate.
Board composition involves more, however, than director selection and achieving the
right skill mix, important as these elements are in building better balanced boards. It is
also important to consider group process, especially when diverse perspectives are

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introduced into the boardroom, and to question what happens to the dynamics of the
board when such appointments are made.
Important also in relation to group process is the ability of directors to influence
boardroom debate and decision making when, because of their background, they are
prone to recommend and channel the firm to a particular direction in which they have
technical superiority as compared to others on the board. Thus, how board dynamics and
group process are managed is a key aspect of board effectiveness.
Two criteria of board effectiveness highlighted by Forbes and Milliken (1999) are board
task performance and board cohesiveness. Task performance relates to the board's ability
to perform its control (hiring, compensation and replacement of senior managers, and
approval of major initiatives proposed by management) and service tasks (providing
expert and detailed insight during major strategic events such as acquisition or
restructuring, informal and ongoing activities such as generating and analyzing strategic
alternatives during board meetings). Forbes and Milliken (1999) identify these two
measures as classic "task" and "maintenance" criteria common to many models of group
effectiveness. The converse applies when a group of people, assembled for their
knowledge and competence, is unable to utilize that expertise because of process issues
that disable individuals and sub-groups and prevent them from making a full contribution
to the work of the group. This can be experienced as a destructive process that requires a
strong maintenance culture just to keep the group operating at a level that is typically
sub-optimal. Recent attention has been directed in the corporate governance literature to
board dynamics with particular regard to diversity in the boardroom. Factors associated
with individual directors and their contribution to the board include professional

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reputation, qualifications, experience, knowledge, expertise, remuneration, motivation,
attendance, participation, committee involvement. Those factors associated with the role
of the board include CEO selection, risk management, shareholder value, and firm
survival, while factors relating to board composition include skill mix, the proportion of
non-executive and executive directors, and level of experience.
Elements affecting board effectiveness that are relatively uncontrollable by the board
include external factors such as legislation, economic conditions, industry complexity,
and industry ethos (Van der Walt and lngley, 2001).
With corporate governance the concept of diversity relates to board composition and the
varied combination of attributes, characteristics and expertise contributed by individual
board members in relation to board process and decision-making. In the widest sense, the
various types of diversity that may be represented among directors in the boardroom
include age, gender, ethnicity, culture, religion, constituency representation,
independence, professional background, knowledge, technical skills and expertise,
commercial and industry experience, career and life experience (Milliken and Martins,
1996). Boardroom diversity, thus, refers to the mix of human (intellectual and social)
capital - where human capital is defined as the skills, general or specific, acquired by an
individual in the course of training and experience (Dictionary of Business, 1996) - that a
board of directors comprises collectively and draws upon in undertaking its governance
function.
This paper considers the selection and appointment of directors with regard to their
contribution to the board as a strategic resource of the organization. Companies cannot
take the risk of having directors who cannot contribute and directors, themselves, must be

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comfortable that they have the experience and knowledge to serve, not only considering
educational expertise but also business acumen. Of particular consideration in this paper
are issues relating to efforts to examine the technical make up of the board, wanting to
benefit from a wider range of perspectives in decision making and gauge the impact of
Doctors of medicine on the board of healthcare firms.

2. Hypothesis:
The hypothesis I want to test is that a corporate governance characteristic board
composition plays an important role in changes in firm valuation as a result of the
concentration of doctors of medicine on firm boards in the health care sector.

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