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Board size—Can it prevent corporate failure?
OMEGA Int. J. of Mgmt Sci., Vol. 14, No. I, pp. l--l. 1986 Printed in Great Britain. All rights reserved
0305-0483/86 $3.00+0.013 Copyright ~ 1986 Pergamon Press Ltd
EDITORIAL Board Size
Can it Prevent Corporate Failure?
THE PREVIOUS Editorial discussed whether it is possible--with our current state of knowledge--to identify the major determinants of corporate performance. In particular, the following question was posed: "Given two companies belonging to the same industrial sector and operating in the same environment, what makes one more successful than the other?" The practical implications of this question are selfevident, and it is therefore not surprising that students of business policy devote a great deal of their time to searching for relevant answers. The Editorial concluded that--however you define 'success' and whatever the lessons learnt from case-studies and current research--the problem of determining the level of corporate performance is still unresolved. My interest was, therefore, greatly aroused when I came across a recently published paper by Chaganti et al. on the effect of corporate board size on corporate failure [1]. Apart from the obvious importance of the subject matter, I was interested to learn what research methodology might be employed to explore such an issue, since the methodology could well be relevant for other research work in this area. Instead of using corporate success as a yardstick, with all the problems of definitions and measurement that such a concept entails, the authors chose to look at companies in the retailing industry in the US that managed to survive, contrasted with companies that failed over a five year period (failure being defined by the filing for bankruptcy under Chapter 11 of the Bankruptcy Act). In this context, 'success' is simply epitomised by corporate survival, without trying to differentiate between different levels of 'success', and similarly there is no attempt in the study to distinguish between different degrees of failure. The question, therefore, is whether the corporate board, in terms of its size and composition, can affect the probability of corporate survival. The reasons for the authors' investigation stem from increasing pressure in recent years to reform corporate boards and to introduce legislation "to assure desirable board governance". It has been suggested that since the consequences of corporate failure can be very harmful and distressing to customers, employees, shareholders, suppliers, and other sections of the community, corporate survival must be the prime objective of the board. Any legislation that can support the board I
2
Editorial
in this objective would then be amply justified. It is in the light of such arguments that studies (as the one undertaken by the authors) may be helpful in providing useful guidelines. The authors start by quoting the functions of corporate boards, as listed in a Conference Board Report in 1967 [2], namely: (1) To establish broad policies and objectives. (2) To appoint senior executives, determine their terms of reference, approve their actions and monitor their performance. (3) To safeguard and approve changes in corporate assets. (4) To approve important financial decisions and issue reports to the shareholders. (5) To delegate powers to executives to act on behalf of the board. (6) To maintain, enforce and revise as necessary the corporate charter. (7) To ensure the maintenance of a sound board. While the report which cites these functions was written almost 20 years ago, its description of the board's tasks would generally be endorsed by many, although nowadays perhaps greater emphasis would be put on concern for employees, on social responsibilities (which can take many forms), on business ethics, on disclosure of information, on the need to avoid conflicts of interest, and so on. (In addition, one may query, with justification, the meaning of the seventh statement in the above list, and prefer more explicit definitions of responsibility and accountability). It is generally agreed that ultimately it is the boards' function to direct operations and monitor performance, and it is not uncommon to find boards being criticised for corporate failings (for example by financial analysts, or by judges in the courts). The concern expressed' by Chaganti et al. with the possible effect on boards on corporate failure is, therefore, understandable. Their study examined three propositions: "PI:
A non-failedfirm tends to have a larger sized board than a failed firm.
P2:
A non-failedfirm tends to have a larger percentage o f outsiders compared to a failed one. Somewhat along the same line, a non-failed firm tends to have a majority o f outsiders; in contrast, a f a i l e d f i r m tends to have outsiders in the minority. P3: In a non-failed firm, the chairman does not hold another office, like that o f the C.E.O., in the company. In contrast, in a failed firm the chairman holds at least one other office."
As a research methodology, the authors selected 42 boards of retailing firms, half of which had failed between 1970 and 1976 (retailing constituted the largest segment of commercial and business failures in the US at that time). Each failed firm in the sample was paired with a non-failed one of a similar type and comparable size, and the differences
Omega, Vol. 14..Vo. I
in board size and structure in each pair were noted for a period of five years prior to the failure of each failed firm. In this way, the investigators tried to ensure that the firms in each pair were subjected to similar economic and social conditions. Now, although the set of firms used in this investigation had been used in other published studies, and although "comparability of the firms in each pair has been tested and goodness of the set for use in paired design has generally been acknowledged [1, pp. 409-410], I confess to feeling somewhat uncomfortable with this methodology. Since a large number of firms in the industry have not failed, it is presumably possible in most cases to pair a failed firm with any one from a set of many non-failed firms of similar type and size, and since the non-failed firms are likely to differ widely in the size and structure of their boards, the selection process in this paired design may well be crucial and significantly affect the results. Suppose, for example, that the selected non-failed firm has the average board size of the non-failed firms in its set, or that it is selected at random, and suppose that this average is higher than that of the failed firm in the pair. This result would tend to support proposition P1, but if a significant proportion of the firms in the set have a smaller board size than the failed firm, can this fact be ignored in making a judgement about PI? And to what extent are conclusions derived from studies, which are based on paired comparisons, sensitive to the sample size of available data? Leaving aside the problems of research methodology, let us turn to the authors' findings. First, with reference to proposition P2, the results showed that over the five year period considered in the study, the percentage of outside directors on the boards of failed firms ranged from 17 to 86, compared with 20 to 80 in the non-failed firms. Clearly, both ranges are very wide, with a marked degree of overlap. Also, the average of outsiders for the failed group was 51%, compared with 49.6% for the non-failed. These results and other considerations rightly led the authors to reject proposition P2. Similarily, the results showed that the chairman held at least another office in 7 to 10 failed firms, compared with 9 to 11 non-failed firms, and furthermore the differences across the pairs were not significant, so that proposition P3 was also rejected. But the authors assert that their results confirm their first proposition, which "suggests that the non-failed firms, as compared to the failed firms, tend to have larger boards", and "that this observation was further confirmed by the pair-wise t-test at 95% confidence level" [1, p. 411]. Reference to the table of data [1, p. 410] reveals a very wide overlap between the ranges of board size of failed and non-failed firms, so that yet again one needs to ask whether the results of the statistical tests are not sensitive to the sample size and to the paired design. Let us assume, however, that the statistical result is correct and that proposition P1 may then be endorsed, namely that in practice non-failed firms are found, on the average, to have larger boards than failed firms.
4
Editorial
What practical conclusions can we draw from such a result? We note that the proposition merely points to an association of two characteristics (one being an average of a widely distributed variable and the other representing the binary state of failure or non-failure), but provides no causal relationship between them. There is nothing in the study that suggests that firms failed because they had small boards, and that, had they taken action in good time to increase the size of their boards, all their problems would have been resolved. Apart from the fact that such a causal relationship would be quite impossible to establish in a research exercise of this kind, there is always the distinct possibility that the size of the board is merely a manifestation of other factors which influence the operations of the company and the level of its performance, rather than their primary cause. It is quite likely that a chairman who is worried about the possibility of corporate failure and who then decides to increase the size of the board, instead of addressing himself to the root causes of poor performance, would eventually find that such an act of faith has done little to improve the position. I am, therefore, somewhat sceptical about the value of such research, though the motives that led Chaganti et al. to undertake it are laudable enough. If boards are supposed to have an effect on the welfare of their firms, it is natural to probe into the circumstances under which they succeed or fail. My feeling is that board size is hardly relevant in this context. As the authors observe, a small board can be more easily 'managed' by the C.E.O., but then its members may not have adequate opportunities to influence policy and operations, whereas a large board can offer a wider range of expertise, but may be more difficult to control. It is not at all obvious which of these attributes are more conducive to the achievement of corporate goals, as much depends on the style of management of the C.E.O. and on the mix of personalities on the board. It is, therefore, not the size of the board that matters, but how it operates, the quality o f the information at its disposal, the way in which it gets involved in setting objectives and budgets, the kind o f decisions it takes, and the way it exercises control over the executive directors o f the company. These issues are less amenable to a simple statistical analysis of the kind reported by the authors. SAMUEL EILON Chief Editor REFERENCES 1. Chaganti RS, Mahajan V and Sharma S (1985) Corporate board size, composition and corporate failures it. retailing industry. J. Mgmt Stud. 22 (4) 400--417. 2. Conference Board (1967) Corporate directorship practices, studies in business policy. Conference Board, New York.
0305-0483/86 $3.00+0.013 Copyright ~ 1986 Pergamon Press Ltd
EDITORIAL Board Size
Can it Prevent Corporate Failure?
THE PREVIOUS Editorial discussed whether it is possible--with our current state of knowledge--to identify the major determinants of corporate performance. In particular, the following question was posed: "Given two companies belonging to the same industrial sector and operating in the same environment, what makes one more successful than the other?" The practical implications of this question are selfevident, and it is therefore not surprising that students of business policy devote a great deal of their time to searching for relevant answers. The Editorial concluded that--however you define 'success' and whatever the lessons learnt from case-studies and current research--the problem of determining the level of corporate performance is still unresolved. My interest was, therefore, greatly aroused when I came across a recently published paper by Chaganti et al. on the effect of corporate board size on corporate failure [1]. Apart from the obvious importance of the subject matter, I was interested to learn what research methodology might be employed to explore such an issue, since the methodology could well be relevant for other research work in this area. Instead of using corporate success as a yardstick, with all the problems of definitions and measurement that such a concept entails, the authors chose to look at companies in the retailing industry in the US that managed to survive, contrasted with companies that failed over a five year period (failure being defined by the filing for bankruptcy under Chapter 11 of the Bankruptcy Act). In this context, 'success' is simply epitomised by corporate survival, without trying to differentiate between different levels of 'success', and similarly there is no attempt in the study to distinguish between different degrees of failure. The question, therefore, is whether the corporate board, in terms of its size and composition, can affect the probability of corporate survival. The reasons for the authors' investigation stem from increasing pressure in recent years to reform corporate boards and to introduce legislation "to assure desirable board governance". It has been suggested that since the consequences of corporate failure can be very harmful and distressing to customers, employees, shareholders, suppliers, and other sections of the community, corporate survival must be the prime objective of the board. Any legislation that can support the board I
2
Editorial
in this objective would then be amply justified. It is in the light of such arguments that studies (as the one undertaken by the authors) may be helpful in providing useful guidelines. The authors start by quoting the functions of corporate boards, as listed in a Conference Board Report in 1967 [2], namely: (1) To establish broad policies and objectives. (2) To appoint senior executives, determine their terms of reference, approve their actions and monitor their performance. (3) To safeguard and approve changes in corporate assets. (4) To approve important financial decisions and issue reports to the shareholders. (5) To delegate powers to executives to act on behalf of the board. (6) To maintain, enforce and revise as necessary the corporate charter. (7) To ensure the maintenance of a sound board. While the report which cites these functions was written almost 20 years ago, its description of the board's tasks would generally be endorsed by many, although nowadays perhaps greater emphasis would be put on concern for employees, on social responsibilities (which can take many forms), on business ethics, on disclosure of information, on the need to avoid conflicts of interest, and so on. (In addition, one may query, with justification, the meaning of the seventh statement in the above list, and prefer more explicit definitions of responsibility and accountability). It is generally agreed that ultimately it is the boards' function to direct operations and monitor performance, and it is not uncommon to find boards being criticised for corporate failings (for example by financial analysts, or by judges in the courts). The concern expressed' by Chaganti et al. with the possible effect on boards on corporate failure is, therefore, understandable. Their study examined three propositions: "PI:
A non-failedfirm tends to have a larger sized board than a failed firm.
P2:
A non-failedfirm tends to have a larger percentage o f outsiders compared to a failed one. Somewhat along the same line, a non-failed firm tends to have a majority o f outsiders; in contrast, a f a i l e d f i r m tends to have outsiders in the minority. P3: In a non-failed firm, the chairman does not hold another office, like that o f the C.E.O., in the company. In contrast, in a failed firm the chairman holds at least one other office."
As a research methodology, the authors selected 42 boards of retailing firms, half of which had failed between 1970 and 1976 (retailing constituted the largest segment of commercial and business failures in the US at that time). Each failed firm in the sample was paired with a non-failed one of a similar type and comparable size, and the differences
Omega, Vol. 14..Vo. I
in board size and structure in each pair were noted for a period of five years prior to the failure of each failed firm. In this way, the investigators tried to ensure that the firms in each pair were subjected to similar economic and social conditions. Now, although the set of firms used in this investigation had been used in other published studies, and although "comparability of the firms in each pair has been tested and goodness of the set for use in paired design has generally been acknowledged [1, pp. 409-410], I confess to feeling somewhat uncomfortable with this methodology. Since a large number of firms in the industry have not failed, it is presumably possible in most cases to pair a failed firm with any one from a set of many non-failed firms of similar type and size, and since the non-failed firms are likely to differ widely in the size and structure of their boards, the selection process in this paired design may well be crucial and significantly affect the results. Suppose, for example, that the selected non-failed firm has the average board size of the non-failed firms in its set, or that it is selected at random, and suppose that this average is higher than that of the failed firm in the pair. This result would tend to support proposition P1, but if a significant proportion of the firms in the set have a smaller board size than the failed firm, can this fact be ignored in making a judgement about PI? And to what extent are conclusions derived from studies, which are based on paired comparisons, sensitive to the sample size of available data? Leaving aside the problems of research methodology, let us turn to the authors' findings. First, with reference to proposition P2, the results showed that over the five year period considered in the study, the percentage of outside directors on the boards of failed firms ranged from 17 to 86, compared with 20 to 80 in the non-failed firms. Clearly, both ranges are very wide, with a marked degree of overlap. Also, the average of outsiders for the failed group was 51%, compared with 49.6% for the non-failed. These results and other considerations rightly led the authors to reject proposition P2. Similarily, the results showed that the chairman held at least another office in 7 to 10 failed firms, compared with 9 to 11 non-failed firms, and furthermore the differences across the pairs were not significant, so that proposition P3 was also rejected. But the authors assert that their results confirm their first proposition, which "suggests that the non-failed firms, as compared to the failed firms, tend to have larger boards", and "that this observation was further confirmed by the pair-wise t-test at 95% confidence level" [1, p. 411]. Reference to the table of data [1, p. 410] reveals a very wide overlap between the ranges of board size of failed and non-failed firms, so that yet again one needs to ask whether the results of the statistical tests are not sensitive to the sample size and to the paired design. Let us assume, however, that the statistical result is correct and that proposition P1 may then be endorsed, namely that in practice non-failed firms are found, on the average, to have larger boards than failed firms.
4
Editorial
What practical conclusions can we draw from such a result? We note that the proposition merely points to an association of two characteristics (one being an average of a widely distributed variable and the other representing the binary state of failure or non-failure), but provides no causal relationship between them. There is nothing in the study that suggests that firms failed because they had small boards, and that, had they taken action in good time to increase the size of their boards, all their problems would have been resolved. Apart from the fact that such a causal relationship would be quite impossible to establish in a research exercise of this kind, there is always the distinct possibility that the size of the board is merely a manifestation of other factors which influence the operations of the company and the level of its performance, rather than their primary cause. It is quite likely that a chairman who is worried about the possibility of corporate failure and who then decides to increase the size of the board, instead of addressing himself to the root causes of poor performance, would eventually find that such an act of faith has done little to improve the position. I am, therefore, somewhat sceptical about the value of such research, though the motives that led Chaganti et al. to undertake it are laudable enough. If boards are supposed to have an effect on the welfare of their firms, it is natural to probe into the circumstances under which they succeed or fail. My feeling is that board size is hardly relevant in this context. As the authors observe, a small board can be more easily 'managed' by the C.E.O., but then its members may not have adequate opportunities to influence policy and operations, whereas a large board can offer a wider range of expertise, but may be more difficult to control. It is not at all obvious which of these attributes are more conducive to the achievement of corporate goals, as much depends on the style of management of the C.E.O. and on the mix of personalities on the board. It is, therefore, not the size of the board that matters, but how it operates, the quality o f the information at its disposal, the way in which it gets involved in setting objectives and budgets, the kind o f decisions it takes, and the way it exercises control over the executive directors o f the company. These issues are less amenable to a simple statistical analysis of the kind reported by the authors. SAMUEL EILON Chief Editor REFERENCES 1. Chaganti RS, Mahajan V and Sharma S (1985) Corporate board size, composition and corporate failures it. retailing industry. J. Mgmt Stud. 22 (4) 400--417. 2. Conference Board (1967) Corporate directorship practices, studies in business policy. Conference Board, New York.