Diversity, outside directors and firm valuation: Korean evidence

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Abstract

This paper examines the relationship between the diversity of independent outside directors and the valuation of Korean firms after Korea's 1998 corporate-governance reforms. First, the study finds consistent positive relationships between firm valuation and the proportion of independent outside directors with government experience, but finds negative relationships between firm valuation and the proportion of independent outside directors who are accountants. Second, the study finds that the diversity of independent outside directors' academic majors or age has consistently positive effects on firm valuation. This result implies that not only the quantity but also the quality of independent outside directors affects the valuation of Korean companies.

Introduction

The monitoring role of the board of directors and its effect on firm valuation is prevalent in corporate finance literature (Berle and Means, 1933, Jensen and Meckling, 1976, Fama and Jensen, 1985). However, the evidence of independent outside directors' monitoring role and their effect on firm value is still inconclusive both in U.S. and international studies (Hermalin and Weisbach, 2003, Denis and McConnell, 2003).

Recently, Choi et al. (2007) find that in Korea, after the country's 1998 corporate-governance reforms, the effect of independent outside directors on firm valuation is strongly positive. However, they argue that the effects depend on board composition as well as the nature of the markets in which a firm operates. In addition, another study finds evidence that independent outside directors in Korea actually have a weak monitoring role (Baek et al., 2006).

With a different perspective from previous literature, this paper provides evidence of the positive effect of independent outside directors on the valuation of Korean companies after the corporate-governance reforms of 1998. The objective is to extend the knowledge of the relationship between independent outside directors and firm valuation by studying all the manufacturing firms listed on the Korea Stock Exchange. Doing so also contributes to the related literature on the effect of boards of directors on firm valuation.

Previous literature focuses on the effects of the quantity of independent outside directors, such as the number and proportion of independent outside directors, but the literature neglects the quality of these directors. Thus, this paper focuses on the effects of the quality (age, education, or industry experience) and diversity of independent outside directors on Korean companies. The Outside Director's Human Capital Database shows that many Korean companies have appointed independent outside directors with different age, education levels, and experience since the corporate-governance reforms of 1998.

The study uses Korean data because the independent outside directors of Korean firms have become a more diverse group since the corporate-governance reforms of 1998. The role of independent outside directors as monitors and their effects on firm valuation are weak in Korea (Baek et al., 2006) but strengthened after the corporate-governance reforms (Choi et al., 2007). This change is incentive to investigate the effects of other characteristics of independent outside directors on firm valuation. Finally, a significant difference exists in many Korean firms between shareholders with cash flow rights and shareholders with control rights, which leads to agency problems. Thus, the monitoring role of independent outside directors is very important, particularly when gray (or affiliated) independent outside directors have an incentive to maintain their affiliations at the potential expense of shareholder wealth (Byrd and Hickman, 1992).

The study's main empirical results are as follows. First, consistent positive relationships exist between firm valuation and the education levels of independent outside directors after controlling for financial ratios, board size, and industry. Second, independent outside directors with government experience consistently have positive effects on firm valuation, but those who are accountants have consistently negative effects on firm valuation. Finally, the diversity of independent outside directors' academic majors has consistently positive effects on firm valuation.

The nature of corporate-governance reform in 1998 comes from the aftermath of the Asian financial crisis. Korean government, through the Securities Listing Regulations in February 1998, required all Korea Stock Exchange listed companies to have at least 25% of the board composed of outside directors. The reform expects outside directors to be independent. So, people expect the improved transparency and monitoring role of the board of directors from this reform. As we can see from Appendix A, a great deal of diversity is found in Korea Stock Exchange firms since this reform is made public. As the reform focuses on independent outside directors, we also focus this study on independent outside directors. Also, we focus on Korea Stock Exchange listed companies because the reform required all Korea Stock Exchange listed companies to have certain proportion of outside directors within their board. Based on the related literature, and by using several different variables to categorize independent outside directors, two hypotheses follow.

Hypothesis 1

The education level, age or professional experience of independent outside directors on firm valuation is an empirical issue.

According to Becker (1993), human capital encompasses the knowledge, information, ideas, skills, and health of individuals; age and education reflect those characteristics. Although companies' increased emphasis on education explains the enormous rise in the market-price-to-book-value-of-assets ratio for publicly traded companies, the productivity of independent outside directors decreases after a certain age (Leibenstein, 1957, Leibenstein, 1958). Also Chun (2006) argues that the education level of independent outside directors does not have any effect on IPO firm valuation in Korea.

Experience in a specific industry enables independent outside directors to access tacit knowledge of the opportunities, threats, competitive conditions, technology, and regulations. Experience can also help independent outside directors evaluate and guide management proposals for growth wisely (Kor and Sundaramurthy, forthcoming).

Independent outside directors with certain types of experience tend to take on certain roles. For example, Agrawal and Knoeber (2001) show that independent outside directors with backgrounds in politics, government, or law tend to play political roles in regulated firms. In addition, in countries with weak as well as strong legal systems, a positive correlation between the political connections of firm's board and the firm's valuation exists (Faccio, 2006, Goldman et al., forthcoming). However, in Korea, independent outside directors with government experience who manage affiliated firms that may have government-related projects tend to become very entrenched directors. Also, according to the ‘Economic Reform Report’ from Solidarity for Economic Reform in Korea, independent outside directors who have indirect relationships with its management is 37.5%, 35.44% or 32.09% in 2006, 2007 or 2008, respectively. The examples of the indirect relationship are high school alumni, former government officials related to firm's projects, former employees of subsidiary, former clients if independent outside directors are accountants or lawyers, and former executive students if they are professors.

Expertise in business or law enhances the efficiency of the advising role of independent outside directors for each firm. Similar empirical evidence exists regarding the management of firms conducting seasoned equity offerings (Chemmanur et al., forthcoming). Clearly, expertise in business, economics, or law can be a useful asset to the firm. Thus, the education level, age or professional experience of independent outside directors on firm valuation is an empirical issue.

Hypothesis 2

The diversity of age, academic majors or professional experience among independent outside directors is positively correlated with firm valuation.

Diversity in the board structure embeds itself in the American enterprise system. For example, Vance (1978) argues that no two companies in his study had identical board structures and no single board follows the same boardroom blueprint today as it did a generation ago. In the field of economics, Becker (1993) argues that an individual's skill set and knowledge embed themselves in his or her age, education and experience. From the discussion in Hypothesis 1, the relationship between age and firm valuation is an empirical issue because age has two different perspectives: productivity and experience. Young independent outside directors are productive, while old ones have experiences. If independent outside directors are diverse in terms of age within a board, productivity and experience can create a synergy. A more diverse board does help in a board's decision-making process through different perspectives and cognitive conflict, and in asserting board influence on management (Kosnik, 1990, Westphal and Milton, 2000). It also helps acquiring of critical resources for the organization (Pfeffer, 1972, Pfeffer and Salancik, 1978). Empirical evidence shows a positive relationship between board diversity and firm's activities or expected future cash flows (Keys et al., 2003). Further, Kor and Sundaramurthy (forthcoming) argue that independent outside directors' collective knowledge or experience positively affects the sales growth of the firm. In short, the more diverse the outside director's knowledge or experience is, the more the firm grows.

Some studies argue that board diversity may constrain prompt initiative to implement strategic changes in times of environmental turbulence (Clegg, 1990, Powell, 1991, Goodstein et al., 1994), facilitate inefficiencies and complexities in board work (Jensen and Meckling, 1976, Adams and Ferreira, 2002). Their argument stands on the basis of the fact that a conflict of interest arises from the trade-off between firm performance or valuation and board goals. Diverse group of people in the board hamper board goals even though that diversity can lead to an increased, or no effect on, firm performance or valuation. However, no empirical evidence, documenting the negative relationship between board diversity and firm performance or valuation, exists while evidences of positive relationship exist in the literature (Carter et al., 2003, Krishnan and Daewoo, 2005, Auh and Menguc, 2006). Related literature finds insignificant relationship between diversity within the boardroom (Molz, 1988, Shrader et al., 1997, Kochan et al., 2003) or outside the boardroom (Moncrief et al., 2000) and firm performance.

Thus, this study hypothesizes that the diversity of independent outside directors' academic majors, job experiences or age has relationships with firm valuation.

The rest of the paper proceeds as follows. Section 2 describes the data and variable construction. Section 3 discusses the empirical results. Finally, section 4 concludes the paper by discussing the main findings.

Section snippets

Data

The data source for the characteristics of independent outside directors is from the Korea Companies Information TS2000 database in the Korea Listed Companies Association, or from the Repository of Korea's Corporate Filings on the Financial Supervisory Service website. When no relevant data from those two sources exists, the study refers to the KISline database of the Korea Information Service. The database provides the names, ages, education levels, and current or previous positions for

Summary statistics

Table 1 shows the summary statistics for 593 firms with data from 1999 to 2006. The average Q is 0.89 (median, 0.79). The average age is 56.44 (median, 56.96). The average edu is 0.76 (median, 1). As we can see from the number of outside directors with bachelor's degree (edu2), roughly half of outside directors receive bachelor's degree. The average manufacturing and financial is 0.28 (median, 0) and 0.13 (median, 0), respectively, suggesting that Korean firms tend to have more outside

Conclusion

The major contribution of this paper is to investigate the quality (age, education or industry experience) and diversity (academic majors and job experience) of independent outside directors and its effect on firm valuation in Korea. This study is the first one to look at the relationship between them for Korean firms.

Consistent with previous literature, the study finds that the proportion of outside directors on a board has a positive effect on firm valuation. Also, outside directors with

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    For helpful comments and discussions, we would like to thank Kam C. Chan, Maria Boutchkova, Dharmendra Dhakal and seminar participants at 2008 Financial Management Association Meeting. Special thanks to anonymous referees and to the associate editor — finance and accounting, David M. Smith, for the helpful suggestions. We remain solely responsible for any remaining errors.

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    Lim acknowledges the support from the Catholic University of Korea, Research Fund, 2008. Tel.: +82 2 2164 4287.

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