Corporate governance (CG) has emerged as a worldwide phenomenon after the break down of many corporate giants such as Enron and WoldCom in US, HIH and Harris Scarfe in Australia, and many others. It has acquired extensive consideration of institutions, organizations, researchers and policy makers including developed and many of the developing countries. Pakistan also came under the influence of the debate over the wave of corporate governance and has been keen to establish good governance rules. Corporate failures have been a long standing issue in Pakistan as there have been many failure scandals such as Taj Company and Sarah Textile's failures. In both of the cases many factors such as lack of transparency, violation of rules and regulations and fraud's on management part remained the obvious reasons. All this necessitated the Government of Pakistan to formulate and implement the corporate governance rules to provide an environment, conductive to business.
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In 1997, Securities and Exchange Commission of Pakistan (SECP) was established by government of Pakistan to formulate basic legal, institutional and regulatory framework to ascertain healthier management of the corporate sector. SECP has ratified and intended to enforce good governance rules to create a business sustaining environment to steer the corporate sector of Pakistan out of the critical, unconstrained and threatening environment that prevailed after a terrible wave of many incredible corporate failure scandals all around the world. Besides various regulations already in practice, in 2002, it approved the framework for Good Corporate Governance to further empowering the regulatory system. The following definition of CG, in its CG manual sections 2.12 and 2.13, acts as foundation for the new regulatory mechanism in Pakistan. According to SECP,
CG refers "to the system by which companies are directed and controlled, focusing on the responsibilities of directors and managers for setting strategic aims, establishing financial and other policies and overseeing their implementation, and accounting to shareholders for the performance and activities of the company with the objective of enhancing its business performance and conformance with the laws, rules and practices of corporate governance.
Corporate governance is also the mechanism by which the agency problems of corporation stakeholders, including the shareholders, creditors, management, employees, consumers and the public at large are framed and sought to be resolved".
SECP introduced CG framework is the key stride in restructuring the corporate sector in the country. The framework or code came into existence, at first, with the combined efforts of Institute of Chartered Accountant of Pakistan (ICAP) and SECP. The code requires the listed companies to conform to nearly all of the provisions recommended in it.
Governance code instituted further ownership and take over disclosure requirements. Besides these rules and regulation requirements, the code includes particular rules on change of ownership and transfer pricing together with the listing rules. Listed companies have obligation to report the information about annual general meetings, attendance of the directors in the meeting, changes in capital, board structure, board size, and material changes in markets or product range. In fact, the code comprises recommendations mostly consistent with international CG rules and regulations. For financial sector firms, State Bank of Pakistan has made certain changes in many aspects and has focused its implementation in financial institution such as Development Finance Institutes (DFIs) and banks. However, separate code has been issued for insurance companies and for institutions working under Islamic modes of financing such as Modarabah, Musharakah (detail on these modes can be found on the website of Mezan Bank Pakistan).
The code states the director's duties include taking care of all the stakeholder groups in general and, in particular, safeguarding the interest of shareholders. In Pakistan, most of the boards are dominated by members of a family, acting as executive directors which might include the minors (under 18 as per SECP code), and proxy directors are appointed to act on their behalf. Family dominated boards generally have been ineffective to protect minority shareholder's rights if compared with boards consisted of independent and non-executive director (Rais and Saeed, 2005). (The concepts of independent and non-executive directors have been defined in literature review of this study). Recommendations about audit committee's composition internal and external also exist in the code. Separation of Chief Executive Officer (CEO) and Board chair is the part of the code. Code requires disclosure of directors' information about qualification, experience and professional expertise, and also limits their positions in various boards and committees. However, family dominant ownership structures are not considering deranging representation of the families on the board (Rais and Saeed, 2005).
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Furthermore, Asian Development Bank and World Bank are supporting SECP by imparting training and providing technical assistance to bring in force corporate governance regulations. Institute of Chartered Accountants of Pakistan along with Pakistani stock exchanges is trying to make contribution and making concentrated efforts to ensure the enforcement the rules.
In fact, corporate governance, has time and again, been the subject of extensive scrutiny and controversy in response to failure scandals of business giants around the world. These flecked failures served as one of huge driving forces to such regulations as the Sarbanes-Oxley Act 2002, considered to be one of the most sweeping and comprehensive CG rules (Byrnes et al., 2003), and necessitated the policy makers around the world to concentrate on new and improved governance structures, suitable to overall business environment. The Berle and Means' (1932) seminal work happened to be one the sources of inspiration for the most of the discussions and debates in 1960s and 1970s, wherein the managerial aspects in USA and UK were focused. However, there is abundant evidence about the association of CG and performance in USA, UK, Australia, Malaysia and in a few other countries, but its functioning remained generally unattended elsewhere (Gompers et al, 2003). Rais and Saeed (2005) explain the importance of CG in relation with corporate culture and ownership structure prevailing in Pakistan as;
"CG materializes significantly in all its dimensions in developing countries especially in Pakistan, because of its underdeveloped nature of corporate culture and the fact that vast numbers of companies are held and controlled by family networks".
Overall business regulations in terms of policies implementation, directors' appointment, audit committees, role of stakeholders and lack of transparency in operations and disclosure make the country different and necessitate finding some relation about CG rules and firm performance to convince the regulators and investors about the importance of CG.
"Minorities' interests don't find a reasonable representation in corporate decision-making process. The behavioural patterns, i.e., the actual conduct of corporations in terms of performance, efficiency, growth, financial structure, and treatment of shareholders etc. are not yet well established. The laws and regulations under which firms are operating, the functioning of the board of directors in relation to ownership structures, the responsibility of executive dispensation in determining and deciding firm performance, the relationships between labour policies and firm productivity, the role of multiple shareholders, and lack of transparent and accountable corporate and financial reporting frameworks are some of the issues confronting the corporate sector in Pakistan" (Rais and Saeed, 2005).
Therefore, the current research, keeping in view the very nature of the Pakistani Corporate Sector and the SECP new CG code, will review the performance of the companies in relation to their compliance with CG code developed by SECP. In the next section (2), literature will be assessed to form the hypothesis and to review the variables intended to be used in the study. Section (3) explains the research methodology including research design. Final section (5) details the intended contribution and outcome along with the time plan for the study.
2. Literature Review; Hypothesis and Variables
Previous studies have shown mixed results concerning the relationship of corporate governance structures with firm's value and profitability. For instance, various studies (Morck et al., 1988; and Bhagat and Black, 2002) do not evidence any relationship between corporate governance variables and the firm value. Earlier, Agrawal and Knoeber (1996) present evidence that CG is not related to firm performance. However, Shleifer and Vishny (1997) state that managers possess motivation to annexing firms' assets and investments in investment schemes and ventures that are intended benefit them which, in fact, influence adversely on the wealth of shareholders. Good CG lessens the control of the managers on using creditors and investors' money; hence force the manager to invest in profitable projects which increase shareholders' wealth.
Further, governance advocates argue that poor governance, in larger part, is responsible for the failures of such ex- corporate champs as Parmalat, WorldCom, Adelphia, Enron, and Tyco. Klein (2002) and Gompers et al (2003), find positive relationship between governance variables and the profitability measures, suggesting well-governed firms worth more than the poor governed firms. Mak and Li (2001), and Goyal and Park (2002) also find positive association when they examined companies in Singapore and US respectively. Validity of these arguments suggests that relatively well-governed firms should enjoy a market premium. This formulates hypothesis for the research.
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2.1 Hypothesis: "The better-governed firms perform better than the poor-governed firms"
While the proxy for the better-governed firm is its compliance with the corporate governance rules for the variables selected in the study, and performance will be measured using traditional internal measures and a few of the market measures which will be briefly discussed in research methodology.
Further discussion of this section reviews the variables that will be used in the study.
2.2 Board Composition
SECP in its manual section 6.8 recommends that the board needs to include minimum one director who is independent, in order to safeguarding organizational equity interest. While SECP maintains that independent director "is one who is not connected on the basis of family relationship with the listed company or its promoters or directors or does not have pecuniary relationship with the company or its associated companies, directors, executives or related parties". Prior researches such as Fama and Jensen (1983) and BRC (1999) argue that independent board are more effective in improving the performance by monitoring management and ensuring the fair financial reporting. The view is further supported by Jensen (1993) who ascertains that lack of independence creates difficulties for boards to offset the failures arising from top management. Beasley's (1996) evidence, more the independent board, lower is the possibility of financial statement fraud, also provide support to the above results. Mak and Yuanto (2003) boost the findings showing association between independence of the board and the firm performance, for Malaysia and Singapore listed firms. But, Eisenberg et al. (1998) findings suggest inverse relation between size of the board and profitability.
Further, time and again, it has been believed that increase in proportion of outside directors ensures independence of the board (John and Senbet 1998). But, Hermalin and Weisbach (1991) do not evidence any relationship between the more outside directors in proportion and Tobin's Q (one of the market measures often used in the CG studies). Earlier, Fosberg (1989) also does not find any relationship between the above stated independence and firm performance measures. The same evidence comes from Bhagat and Black (2002) when they map the proportion of outside directors with return on assets, Tobin's Q and stock returns. However, Rosenstein and Wyatt (1990) show that rewards exist for the firms that appoint outside directors. The support comes from Brickley et al., (1994) when they positively relate the proportion of outside directors, a measure of independence, and response of stock market while studying adoptions of poison pills.
2.2 Board Size
Though there are no recommendations in SECP regarding board size, many of the previous studies include it as one of the important variables. Previous studies show mixed result while finding positive and negative association of the larger board size with the perm performance. Lipton & Lorsch (1992) and Jensen (1993) argue that large boards are less effective because it becomes difficult to control and coordinate the larger board size (for larger and smaller boards see Koh et al, 2007). Larger the board size, greater the difficulty to co-ordinate and to address the problems (Jensen 1993). However, the main benefit of larger board size is the combined and shared information and knowledge that the members of board enjoy on various aspects, which have possibility to influence firm's value, such as regulations, products, processes, markets, mergers and acquisitions, technology and so forth. Haleblian and Finkelstein (1993) suggest that collecting and sharing of this information can be precious for the monitoring and advisory roles of the boards. While the cost associated with the coordination and collective decision making is viewed as among the major disadvantages of large boards. The cost of the larger boards has been generalized to all the cases by Buchanan and Tullock (1974) stating that "the expected costs of organizing decisions, under any given rule, will be less in the smaller unit than in the larger". While Yermack (1996) evidences an inverse correlation between size of the board and profitability and Tobin's Q while studying US manufacturing sector sample companies.
Sakawa and Watanabel (2007) draw a sample of 522 of manufacture sector firms listed in Tokyo Stock Exchange from 1991 to 1995. The study finds that average size of board for Japanese firms is 19, which is, on average, larger in terms of board members than the US firms studied by Yermack (1996). They suggest that "Japanese boards have a difficulty of coordinating decision making.
2.3 Dual Chair
it is usually acknowledged that for a board to perform effectively, separation of CEO and Chairman positions is imperative as CEO is supposed to providing declaration in writing to the board confirming that data presented in the financial report contains fair representation of the operational results and the financial conditions, and is according to the accounting standards. Therefore, it would be unsuitable for a CEO, holding both chairs, to making a declaration to himself. Section 6.56 of SECP requires that CEO and board chair roles should be separated. It further states that "the Chairmen of listed companies shall preferably be elected from among the non-executive directors and the board should clearly define the respective roles and responsibilities of the Chairman and the CEO".
The dual chair of CEO and directors' independence has been the factor of immense importance in previous studies in terms of relating firm performance and duality. Though Brickley et al. (1997) do not find any relationship between dual chair and performance, earlier, Yermack (1996), while studying US companies, presented evidence that firm's value is increased if CEO and board chair are separated. However, earlier, Rechner & Dalton (1991), evidence that performance increases if CEO possess dual chair.
2.4 Safeguarding Integrity in Financial Reporting
SECP in its manual section 7.56 recommends that all listed companies need to set up Audit Committee. Further it recommends that the committee must have minimum three members counting the chairman, who will be from the directors of the company. About the composition of the Committee, SECP suggests that majority must consist of non-executive directors and chairman preferably be from among non-executive directors. Vafeas (2005) states that audit committees are instituted in order to providing a mechanism for fair financial reporting and good corporate governance. Key characteristics of a valuable committee comprise independence, commitment and financial literacy of the members (Abbott et al., 2003; and Carcello and Neal, 2003). SECP explains the purpose of non-executive directors stating that
"Non-executive directors are fundamentally appointed for purposes of bringing independence, impartiality, wide experience, special knowledge and personal qualities to the Board. Although all directors should be capable of seeing company and business issues in a broad perspective, non-executive directors are usually chosen for their experience, calibre and personal qualities and may have some expertise that would provide the Board with valuable insight".
SECP mentions the measurement criteria for independence and financial literacy as; "Audit committee characteristics in terms of independence are measured as per the board criteria for independence defined as;
"a director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, directors, executives or related parties. The test of independence emanates from the fact whether such person can be reasonably perceived as being able to exercise independent business judgment without being subservient to any apparent form of interference. Financial literacy is measured as the presence on the committee of a person with qualifications in commerce or law".
The key functions of the committee include reviewing, analysing, and authenticating fair financial reporting along with operating as liaison among mangers, board, and external auditors in order to ascertain free flow of information and discussions (Klein, 2002). BRC (1999) states that usefulness of committee in honouring its roles and responsibilities depend, among other things, upon composition and frequency of meeting.
Empirical support is generally available with an independent audit committee. Xie et al., (2003), for US firms, find relationship between independent committee and lower level of abnormal accruals. Support come from Koh et al., (2007), when they evidenced that audit committee's independence is one of the value enhancing factors, while studying the Australian companies listed in Australian Stock Exchange. However, earlier, Davidson et al., (2005) find no such evidence for Australian firms.
2.5 Disclosure of Directors' Directorships
The 6.72 of SECP manual requires to disclose particular information about directors such as qualifications, experience, responsibilities, number of meetings attended, and equity-based interests in the company. It also requires pattern of shareholding in the company, and positions held by each director to ensure that they are performing their responsibilities effectively by avoiding too many board positions. This disclosure also ensures that they are able to provide sufficient information and knowledge to the investors to help them better evaluate the knowledge, competencies, and time-commitment.
2.6 External Auditors
When establishing the standard for CG principles to ensuring financial reporting integrity, SECP proposes a structure that can independently and fairly authenticate and preserve financial reporting integrity of a company. To serve the purpose ,SECP manual sections 7.29, 7.30 and 7.31 mention selection criteria, qualification, and tenure of the external auditors and state that
"All listed companies are required to change their external auditors every five years. If for any reason this is impractical, a listed company may at a minimum, rotate the partner in charge of its audit engagement after obtaining the consent of the SECP" (SECP, section 7.31).
As for as the external mechanism (the external auditors) is concerned, it has been believed to ensure the financial reporting integrity, and the integrity of reporting process is expected to be dependent upon the quality and independence of the audit committee members (Koh et al., 2007). Existing studies have shown evidences that favour the quality auditors ( Big Five, Six, or Eight which in turn depends on period of examination, see Becker et al ., 1998, Koh et al., 2007). While independence of auditors mean that they do not have any economic bonds other that audit fee with the firm and its duration of account's examination is to maximum five years as suggested by SECP mentioned earlier. DeAngelo (1981) maintains that the external auditors' independence is influenced if there are any economic ties between the auditors and the company. Further, Levitt (2000) suggests increasing reliance of the auditors on non-audit service fees is harming the desired level of independence as it blocks auditor "both be and be seen to be free of any interest which is incompatible with objectivity" (ICAA i.e. Institute of Chartered Accountants of Australia, 2004, p. 3).
So, board composition, board size, dual chair, Safeguarding Integrity in Financial Reporting, Disclosure of Directors' Directorships and External Auditors will be used as variables in this study. To assess and analyze the hypothesis, the relevant research methodology and research design will be discussed in the following section.
3. Research Methodology
According to Creswell (2003) philosophical ideas combined with broad approaches (research strategies) and implemented with specific procedures (methods) lead to research approach and, then, to research design.
Framework for Research Design (Creswell, 2003)
by the researcher
Approaches to research
Design process of research
Hence, it is imperative to understand the philosophies of research in order to better comprehend the approach, research design and theoretical backing for the research (Hussey & Hussey 1997). Inability to identify the philosophical assumptions indicates that research methodology determines the structure and nature of research (Morgan & Smircich, 1980). All of research approaches involve distinctive assumptions on the nature of reality (ontology), how that reality is reached and realized (epistemology), and how that reality is systematically accessed (methodology) (Guba & Lincoln, 1994).
While the process can be studied in numerous ways, this essay explains briefly positivism and Social Constructionism as the quantitative-qualitative divide in management research centers on them, and earlier studies (Burrell & Morgan, 1979) suggest that ultimate goal of the analysis is the essential difference between positivism and social constructionism.
3.1 Social Constructionism
It is based on ontological assumption subjectivity that states that reality is not objective and external, rather it is socially constructive and given meaning by the people (Easterby-Smith et al, 2008). As it assumes that every person will come up with a unique interpretation of the results (Labianca et al., 2000), it is useful for theory development. "It is based on the belief that a deeper understanding of a phenomenon is only possible through understanding the interpretations of that phenomenon from those experiencing it" (Shah & Corley, 2006), and Bryman and Bell (2004) the goal is generally accomplished through qualitative research approaches.
It is based on ontological assumption of objectivity (world exists externally, and external methods should be applied to measure its properties instead of using subjectivity through sensation, reflection, or intuition to infer them) (Easterby-Smith et al, 2008). Replication in the service of theory testing and refinement is the ultimate goal, and that collection and analysis of data should be performed in such a way that, under similar conditions, similar results can be drawn by another researcher if similar data is collected and analyzed. Prior studies (Shah & Corley, 2006) state that the goal is generally accomplished through the methodological traditions of quantitative data collection and statistical analysis. Theory development is seldom phenomenon in the Positivism (Eaterby-Smith, 2008). Its extreme opposite epistemological position is Social Constructionism.
The above discussion leads to the research design for the author's research interest, and it has been discussed in the next section.
3.3 Research Design
The current research, using all the variables and performance measures from the prior literature, will relate the performance and corporate governance code's compliance in Pakistan. Various variables such as board composition, board size, dual chair, safeguarding integrity in financial reporting, disclosure of directors' directorships and external auditors will be used as variables in this study.
The study consists of all 100 companies, of almost 17 sectors, listed in the Karachi Stock Exchange (KSE) and are part of KSE 100-index. The financial data will be collected from the financial statements and websites of the companies, and from Karachi stock exchange. The market data about the market returns will be collected from Karachi Stock Exchange.
The financial performance will be measured by using the traditional internal measures of return such as return on equity (ROE), return on assets (ROA). The market performance will be measured by calculating Economic Value Added (EVA), Market Value Added (MVA) and Tobin's Q (used by various researchers in Corporate governance studies, and ownership studies. e.g. Jenson, 1993, Koh et al, 2007), and Average Market Returns for the year 2007/2008. Factor analysis will be performed separately on governance variables to remove the interaction among various governance structures in order to avoiding multi-colinearity into subsequent regression analysis (Dechow et al.1996).
It is evident from these variables and performance measures that data will be collected using secondary data sources, and is quantitative in nature. Therefore, the conceptualization of positivism and nature of the research reveal that the research area with its purpose of generalization, use of secondary numerical data and aim to represent the results in numbers falls in positivism position, and hence, qualifies as quantitative approach. So above stated research area lies in the top left corner of the following fig as it has positivism as epistemological orientation, and it is detached as well because of not involving and considering human factor during the entire research activity. This quantitative approach has been described by Bryman and Bell (2004) to be deductive with epistemological orientation, in particular, positivism and to have objectivism as ontological orientation.
Quantitative approach provides wide range of situations in an economical and efficient way, and provides help in business decision making when statistics are based on large samples (Easterby-Smith et al, 2008). Further, Most of the researchers such as Lipton and Lorsch (1992), Fama and Jensen, (1983a), and Yermack (1996) have used approach in their studies of governance structure. Therefore, this quantitative approach has preferred to be applied in this part of the research.
Researchers have been using case study research designs in corporate governance and performance studies. But problems due to their uncontrollable nature associated with this approach, (Hoque 2006), are sometimes difficult to handle, and lack of generalizability and criteria deter me to go along. For example, Ferreira and Merchant (1992) state that approaching the organization for case studies is problematic and success rate is 50%. Bedard and Gendron (2004) report even lower to 17%. Keeping in view all these problems, above discussed selected research design has been preferred.
Nevertheless, there are certain limitations of quantitative approach and lots of controversy over the use the approach in social sciences is going on (Hoque, 2006). Proxies used to measure various aspects of the event or trend in large quantitative studies can be believed to be simple and generalizable, but accuracy can be debatable (Hoque, 2006). Similarly, in corporate governance studies using quantitative techniques of data collection without involvement and considering people ignores many important factors such professionalism, leadership, business relations and social relationships, and skills of the board members and the executives which might have contributed to success and failures, and better and poor performance of the firms. Problems of accuracy, generalizability, and reliability are, somehow, attached with any approach or research design that is used on its own.
The solution to these issues is the relativism (involving both positivism and constructionism together) epistemological position that leads to triangulation approach, and has been suggested by many researchers. Combining different approaches and methods offers more potent ways than using any single approach or method (Bennett and Braumoeller 2004). Even in governance studies triangulation of approaches and methods are in use. MacAvoy and Millstein (2003) wrote a book based on the results of the study of board independence and the firm performance of nine major collapses including Global Crossing, K-Mart, Lucent, and Qwest. (The book was awarded as the best book of 2003 used, first, quantitative approach, and then surveys and interviews with qualitative data analysis techniques to reach the consensus).
However, I believe as suggested by King et al (1994) that using only one approach but with great precision and accuracy can better serve the purpose.
4. Intended outcomes and contribution
The research intends to relate various governance variables to the firm performance in Pakistan. As discussed earlier the nature of Pakistani corporate sector in terms of ownership structures and the under developed nature of the stock markets, study will be important for academics, investors, regulators, policy makers and others who advocate and relate governance with firm performance such as Koh et al., 2007. Further, previous studies as discussed in literature review evidenced different results for different countries and for different variables, therefore, this study will provide an opportunity to further improve generalizations which still lack because of different nature of economies of various countries. So, results if positive association found, will add credence to the concept that better governed firms perm better.
However, in case of negative relationship for certain variables, the study can suggest the policy makers and the regulators that good governance can reflect unwanted results for certain economy.
4.1 Time Plan for Study
The project time plan for this research proposal explains specific time line on which the time is allocated for each phase of the research. It indicates the specific activities this research plans to undertake which will lead to its completion. The time period of this research is 12 months and the time line of the project is mentioned in months. This research proposal produces a 5 phase timeline which includes Research Collection, Literature Review, Data Collection, Data Analysis and Report Writing. Further, these main activities will include various sub-activities within them. One of the main activities of the research proposal which will be continued thought the period of this research is meeting with the supervisor. This activity is very important from the research and researcher point of view as the guidance for this project will help to get us a high quality outcome.
In the first phase after the finding the supervisor, research proposal will be discussed in detail. Governance variables may be included further, and performance measures can also be added. The planning for all further phases will be finalized after detailed discussion with the supervisor. However this necessitates further readings and discussion. This phase also includes the finalizing the data collection resources. Initial time plan for this stage is 2 months.
In the second phase first extensive reading will be done on each variable and each performance measure. However, as the reading reaches the satisfactory level for one specific variable, its review will be written. This process will continue till the last variable and measure. Supervisor's guidance is of immense importance to clear ambiguities if any. This process can take approximately 3 months.
As secondary data is needed in this study, and as data is available on website Karachi stock Exchange and on websites of the companies, these websites will be accessed and data will be collected and organized to be analyzed in further stages. It can take 2 and half months.
In this phase data will be analyzed using SPSS. However, data will be further streamlined and organized for all the companies. Various measures and tests as discussed earlier will be applied. For, this phase, approximate time is 2 and half months
Final phase will be writing the report. After discussion with the supervisor, structure of the report will be finalized. This task may take 2 months. Early competition (as 15 days are remaining) of the report will ensure the availability of the time to remove flaws and weaknesses present in writing.