The case for smaller boards

What is the optimal board size? The answer varies by firm and situation, but the governance trend has been towards smaller boards this decade.

However, academic research on this topic is mixed. Some studies have found that large boards are advantageous because they provide superior advice to management. Other studies contend larger boards are detrimental because they are associated with weaker firm monitoring and slower decision-making.

Also, large boards have been shown to be more “polite” and less critical of management compared to smaller boards, and tend towards conservative investments.

In a study titled Board size and firm value: evidence from Australia published in the Journal of Management & Governance, Australian (University of Technology Sydney) and French researchers studied the effect of board size on firm value in Australia. The authors, Pascal Nguyen, Nahid Rahman, Alex Tong and Lucy Zhao examined 1,411 unique local firms over 2001–2011, using SIRCA’s corporate governance database.

The authors found that Australian firms with a large board size are associated with lower market values. Past performance was identified with a larger board size; that is, as the firm grew it increased its board size after shareholder value was created.

“We find that investors are justified in assigning lower values to firms with large boards,” the authors wrote. “The reason is that the latter are less profitable and associated with higher operating costs. Large boards also offer higher CEO compensation that is unrelated to firm performance, but rather depends on the size of the firm’s balance sheet. This type of compensation is likely to encourage the accumulation of assets at the expense of shareholder value.”

An intriguing finding was the effect of large boards by firm size. The authors found the negative influence of large boards is most profound in smaller firms.

“A likely explanation is that small firms require less (board) advice and have greater difficulty attracting talented directors,” wrote the authors. “As a result, increasing board size tends to bring fewer advantages than in large firms.”

The authors concluded: “While Australian corporate boards are relatively small, with an average of 5.2 directors, increasing their size might not have the benign consequences that one would expect. In fact, adding one director is likely to cause a decrease in firm value of about 7 per cent (based on the study).”

The role of personal moral values in governance

The link between director ethics and corporate governance practice is well established. It is accepted that boards with strong codes of ethics and directors with high personal moral values are more likely to provide enhanced corporate governance for their organisation.

But most studies on the role of director values in corporate governance take an empirical (quantitative) approach. They examine the relationship of external factors, such as board structure to firm performance, to draw links with board values.

Auckland University of Technology researchers, Patricia Grant and Peter McGhee, have published a qualitative study titled Personal moral values of directors and corporate governance, based on interviews with 33 New Zealand directors to understand the “how” and “why” of their personal moral values in governing the organisation.

Their findings have implications for governance observers who believe the board skills matrix published in annual reports for ASX listed companies (that publish a skills matrix) should be expanded to include demonstrated director values and behaviours.

Three themes emerged in the study’s findings. First, that personal moral values are a powerful driver of ethical decisions. The authors wrote: “Directors’ personal moral values seemed to be the determining factor for deciding how to handle the challenging situations or uncomfortable circumstances in which they found themselves.” At least six directors interviewed cited preserving moral integrity as the reason for resigning from a board.

The second theme was that personal values are more influential than codes – an important finding for regulators that consider attempting to enforce board values through enforceable ethics codes. “The findings of this current study to some extent suggest that personal morals are just as, if not more, important than codes of ethics for the attainment of ethical corporate governance,” wrote the authors.

The third finding was that personal moral values are a key part of director identity. “It was found that directors understand these values to define who they are as a person and so should motivate them always, both inside and outside of work.”

The authors said the study reveals that directors’ personal ethics are extremely influential in their ethical decision-making at board level. They argue the findings provide impetus to those calling for more attention to be given to the personal ethics of directors to achieve best-practice governance.

Ethics training programs that target the development of character and reinforcement of moral values could be required, along with structural reforms, the authors suggest.

Moreover, in director performance appraisals, added importance should be given to the demonstration of ethical competency by including it as a key performance indicator. The authors say that proven moral integrity could become a bigger point of investigation prior to a director appointment.

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