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34,3

The effects of firm performance

on corporate governance

266

School of Business, University of Houston Clear Lake, Houston, Texas, USA

M. Alix Valenti
Rebecca Luce
Williams College of Business, Xavier University, Cincinnati, Ohio, USA, and

Clifton Mayfield
School of Business, University of Houston Clear Lake, Houston, Texas, USA
Abstract
Purpose The purpose of this paper is to investigate the effects of prior firm performance on board
composition and governance structure.
Design/methodology/approach A total of 90 companies listed on National Association of
Securities Dealers Automated Quotations were used for this study. Hypotheses were tested using both
general linear regression and logit regression analyses.
Findings The results showed that prior negative change in firm performance was significantly
related to a decrease in the overall number of directors and a decrease in the number of outside
directors.
Research limitations/implications The sample size used in this study was relatively small and
the focus was on small to medium-sized firms, so the results found here may not apply to firms larger
than those used in our sample.
Practical implications Directors may want to consider the implications for governance practices
found in this study, specifically, whether smaller boards with fewer outsiders are appropriate
following periods of performance decline.
Originality/value This study is one of the first to examine the effects of trends in prior firm
performance on board composition and chief executive officer duality.
Keywords Small to medium-sized enterprises, Governance, Boards of Directors
Paper type Research paper

Management Research Review

Vol. 34 No. 3, 2011
pp. 266-283
q Emerald Group Publishing Limited
2040-8269
DOI 10.1108/01409171111116295

Corporate governance advocates and reformers claim that good governance policies are
essential for high performance. Relying on agency theory, scholars, and practitioners
reason that if a company is paying attention to safeguarding the interests of its owners, the
assets of the firm will be employed in a manner to minimize waste and maximize
profitability, resulting in above average gains to shareholders. Several studies using an
overall score of governance have found a relationship between governance and
shareholder returns (Gompers et al., 2003), leading one commentator to observe that if
companies with good governance are rewarded by better stock performance, companies
whose cost of capital [is] lower will be motivated to make [. . .] [governance] improvements
(Bradley, 2004, p. 10). When individual governance practices are examined, however,
such as insider equity ownership (Dalton et al., 2003) or executive incentive compensation
(Tosi et al., 2000), the link to performance returns becomes less evident.
Resource dependence theory has also been the basis of many studies where the research
focuses on the board of directors as the governing body. According to the resource

dependence view, directors may have the ability to reduce environmental uncertainty
by virtue of their network connections (Pfeffer and Salancik, 1978). A firm able to reduce
environmental uncertainty, especially with regard to scarce resources, is in a better
position to perform to its potential. The resource dependence perspective has also been
used as the underlying theoretical basis for studies examining changes in boards when
external circumstances or internal needs of the firm change (Hillman et al., 2000; Pfeffer,
1973). In the Hillman et al. (2000) study, the selection of directors to the boards of utility
companies became more oriented to the for-profit sector when deregulation took effect. In
Pfeffers (1973) seminal study in this area, he predicted the experiences and contacts
directors would possess based on the varying resource needs of hospitals. According to the
resource dependence view, it is the backgrounds and network ties of directors that affect
their ability to influence events in the firms favor and/or to bring additional expertise to
the boardroom. We employ the resource dependence view in our paper in a broad sense,
as developed by Hillman and Dalziel (2003), to include the prestige and status of directors
as well as their connections and expertise, as a basis for increasing their governance
effectiveness.
This paper is intended to make two contributions to the literature examining the
relationship between firm performance and governance. First, we take a fresh approach
to the governance-performance question and develop a new model that may further
explain the relationship by investigating a connection between prior performance of the
firm and specific governance practices. In this regard, we take an expansive view of
governance that includes both board structure and composition affecting directors
ability to monitor and supply resources to managers and to provide incentives to
executives as rewards for good performance. Baysinger and Butler (1985) studied the
relationship between prior firm performance and the boards of directors and found no
relationship. In their study, however, the only characteristic of the board examined was
the independence of the board from management. We take a broader approach by looking
at this relationship from a variety of angles and including moderating variables in our
analyses. Second, we test our hypotheses using moderately sized publicly traded
companies in the USA. The context of publicly held moderately sized companies presents
a different set of characteristics than large Fortune 500 or S&P 500 firms which are the
focus of most governance research, including Baysinger and Butler (1985). By examining
the prior performance-governance relationship in this type of firm, we expect to offer
insights that are valuable to a larger swath of American managers in making
governance-related decisions.
We organize the balance of this paper by first reviewing the relevant extant literature
related to the impact of governance mechanisms on a variety of firm outcomes. We next
present our hypotheses and model for the relationships we propose between prior
performance and governance characteristics of the firm. Our methods and results
section is followed by a discussion and suggestions for further research in this area.
Literature review
Board composition
From an agency perspective, outside directors are in a better position to monitor
management because of their assumed independence from the companys managers
(Fama and Jensen, 1983) and their expertise developed from prior experience (Mace, 1986).
Additionally, outsiders are preferable because:

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[. . .] insider-dominated boards imply problematic self-monitoring and particularly weak

monitoring of the CEO, since the CEO is likely to be in a position to influence the insider
directors career advancement within the firm (Zajac and Westphal, 1994, p. 125).

Outside directors are also presumed to bring a level of impartiality in evaluating

managements decisions (Baysinger and Hoskisson, 1990). Unlike insiders, outside
directors careers are less likely to be affected by the outcomes of their decisions and
thus can arrive at more objective solutions (Rechner et al., 1993).
Despite the numerous studies on the appointment of outsiders to boards of directors,
the empirical evidence fails to show any significant relationship between the practice
and corporate outcomes. A meta-analytic review of 85 empirical studies involving more
than 200 samples found that no compelling evidence exists supporting a positive
connection between board composition and leadership and performance (Dalton et al.,
2003). In a similar meta-analysis, Rhoades et al. (2000) found a small positive impact on
financial performance when firms had either an insider or an outsider dominated board,
and concluded that attempts to equally balance insider and outsider representation may
negate the advantages of either an insider-dominated or outsider-dominated board.
There has been some success in studies tying firm characteristics or environmental
changes to the nature of directors using the resource dependence view as the
underlying theory. Pfeffer and Salancik (1978) developed their resource dependence
theory based on the open systems perspective which posits that the environment plays
an important part in determining organizational effectiveness. One suggestion they
offered for managing the environment is the appointment of external representatives to
positions within the organization, specifically through the naming of outside directors
to the board. Pfeffer (1973) argued that changes in the membership of a corporate board
are a direct response to changes in the environment. Baysinger and Butler (1985)
characterized the board as consisting of an instrumental component of independent
directors who provide a source of managerial wisdom and external linkages which in
turn enable the firm to achieve measurable performance dividends.
Hillman et al. (2000) found that utility companies made changes in the directors
serving on their boards to make them more responsive to competitive conditions when
the industry underwent deregulation. Hillman et al. (2007) found that organizational
characteristics predicted board composition, in this case, the likelihood of the presence
of female directors on firm boards. While Baysinger and Butler (1985) and Hillman
(2005) found a relationship between the nature of directors and firm performance,
(outsider status in the former study and political connections in the latter), most of the
studies utilizing resource dependence theory have not found or have not examined a
relationship between board and director attributes and subsequent firm performance.
CEO duality
Agency theorists advocate separation of the chief executive officer (CEO) and board
chair positions as necessary to avoid managerial entrenchment and to curb the CEOs
power (Mallette and Fowler, 1992). When the CEO is also the chair, it becomes more
difficult to replace the CEO for poor performance (Goyal and Park, 2002). According to
agency theory, duality signals the absence of separation of decision management
and decision control (Fama and Jensen, 1983, p. 314). Unitary leadership can lead to
opportunistic behaviors at the expense of shareholders (Fosberg, 1999).

Conversely, separation of the CEO and chair positions facilitates objective evaluation
of organizational and managerial performance (Weidenbaum, 1986).
Some studies have found support for benefits to the firm from the separation of the two
positions. Research in the banking industry revealed that cost efficiency and return on
assets (ROA) were lower for chairman-CEO banks and were positively related to
nonchairman-CEO ownership (Pi and Timme, 1993). In an integration of previous studies,
Boyd (1995) found a weak negative relationship between firm performance and duality.
When controlling for environmental differences, CEO duality was found to be positively
related to performance in environments with low munificence and high complexity. Other
board scholars also suggest that the relationship between CEO duality and firm
performance is contingent on the fit between firm and/or CEO characteristics and duality
(Faleye, 2007; Kang and Zardkoohi, 2005). In another study, however, when the CEO
occupied both the chair and the president position, stock market performance suffered
(Worrell et al., 1997).
The mixed results of these studies support Finkelstein and DAvenis (1994)
characterization of the issue as a double edged sword. They note that the agency
problems with CEO duality are often mitigated by the resource dependence advantages
associated with the CEOs ability, as chair, to provide important information to the outside
directors about firm operations and finances, as suggested by resource dependence theory.
In the next section, we utilize theory and prior research to develop hypotheses that
illustrate our proposed relationships between prior firm performance and governance
mechanisms.
Theory and hypotheses
Firm performance and board composition
Hermalin and Weisbach (1988) suggested that shareholders will seek to replace inside
directors with outsiders in order to provide better monitoring of management.
Consistent with their suggestion, Shivdasani (2004) proposed that board composition is
affected by declines in financial performance because companies react to performance
downturns by adding outside directors to the board who are willing to take corrective
action, such as replacement of the CEO. Firms may also choose to add outsiders
following periods of performance decline in order to provide new ideas, to add to the
pool of knowledge or to signal to stakeholders that operations are now under control
(Pearce and Zahra, 1992). Davis and Thompson (1994) pointed out that the threat of
lawsuits may also prompt the appointment of outside directors to exercise more control
over management. In addition, while there is some dispute regarding the effect of board
size on performance in general (Alexander et al., 1993; Yermack, 1996), evidence
suggests that larger boards are preferable for smaller firms (Dalton et al., 1999).
An alternative view suggests that in years in which firm performance declines
relative to previous years performance, board membership will decrease. The number of
outside directors is likely to decrease because outsiders are more costly for the firm
(Yermack, 1996). Pearce and Zahras (1992) data showed that past poor performance is
positively associated with smaller boards and fewer insiders, and Gilson (1990) reported
that only 46 percent of outside directors remained on the board of firms following a
bankruptcy or debt restructuring. These results are similar to those of DAveni (1990)
who found that prestigious managers will leave a firm shortly before bankruptcy in
order to avoid damaging their careers.

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We suggest that when faced with potential loss of power due to the addition of outside
monitors or with the threat of being fired due to poor firm performance, powerful CEOs
will attempt to maintain the status quo and, therefore, new appointments to the board of
directors will be minimized. Zajac and Westphal (1996) proposed that the source of power
(with the CEO or with the board) would predict the selection of individual board members
based on their prior experience and thus shape the composition and effectiveness of the
board. They hypothesized that powerful CEOs will seek to maintain their control by
selecting and retaining board members with experience on passive boards and excluding
individuals with experience on more active boards. On the other hand, powerful boards
will seek to maintain their control by favoring directors with a reputation for more active
management and avoiding directors with experience on passive boards. Their research
confirmed that powerful actors in CEO-board relationships can manage the composition
of board membership. Thus, we suggest the following:
H1a. Following periods of declining firm performance, both the number of directors
and the number of outside board members will decrease or remain the same;
the power of the CEO will strengthen this relationship.
Firms that have experienced a period of unusually strong performance may be in a better
position to recruit outside directors. An outside directors prestige is derived from a
number of sources including the directors title and job position (DAveni, 1990). Outside
directors with higher qualifications are those with backgrounds suggesting increased
abilities to monitor management and/or contribute to strategic decision making within
the firm (Hillman and Dalziel, 2003). They may also have the potential to exert influence
on outside resource providers, such as financial institutions, or send signals to investors of
the value of the firm. Research suggests that outside directors will seek to protect their
reputations (Fama and Jensen, 1983); one way they can accomplish this is to identify
themselves with successful firms and avoid associations with firms that could damage
their reputations. Companies may use the prestigious reputation of directors to the firms
advantage. For instance, Certo et al. (2001) found that high status directors can send a
signal of firm legitimacy and future success in initial public offering firms. The addition of
a prominent director on the board of a new firm serves as a seal of approval to address the
concerns of dubious investors (Davis and Robbins, 1998, p. 294). Conversely, individuals
will avoid serving as directors for poorly performing firms because of the potential stigma
that could be transferred to the directors, thus causing their own reputations to suffer
(Lester, 2008). Thus, consistent with our previous hypothesis, we posit that:
H1b. Following periods of improving firm performance, the size of the board will
increase, with highly qualified and sought after outside directors added to the
board.
Firm performance and duality
Finkelstein and DAveni (1994) posit that vigilant boards will prefer the CEO and chair
position be separated in periods of good performance for several reasons. First, good
performance increases CEO power and creates organizational slack, both of which lead
to undesirable governance consequences such as entrenchment and opportunistic
behaviors; second, in periods of good performance there is no need to create managerial
efficiency through duality; finally, the board is less likely to remove a CEO after periods
of good performance, with the increased potential for CEO entrenchment. In contrast,

they argue that duality is preferable after periods of poor performance to convey a sense
of unity of command and strong leadership. In times of financial distress, combining the
roles may be preferable to enable the CEO to make critical decisions affecting the future
of the organization (Harris and Helfat, 1998).
The relationship between performance and an independent chairperson is supported
by Rechner and Daltons (1991) findings which showed a strong difference in three
accounting measures of performance between firms with independent structures and
those with CEO duality. These results confirmed the hypotheses that firms with separate
CEO and chair positions will consistently outperform firms with dual structures.
Meanwhile, Harjoto and Jo (2008) found the opposite result, i.e. that combining the chair
and CEO positions had a positive relationship with firm performance. Boyd (1995)
explains the discrepancy by arguing that the effect of duality depends on previous firm
performance. His research supports the conjecture that in times of uncertainty,
characterized by low munificence or high complexity environments, the combined
structure will be more effective. Boyd (1995) suggested that a resource-scarce environment,
such as is likely to exist following a decline in performance by the firm, may lead to
duality so that the power in the firm can be consolidated for a faster, more unified response
to the poor conditions. The findings of Elsayed (2007) support Boyds (1995) view. In his
research on a sample of Egyptian firms, Elsayed discovered that CEO duality had a
positive impact on firm performance when examined in the context of firms with low
corporate performance. Conversely, when a corporation experiences an improvement in
performance, the arguments for combining the CEO and chair positions become moot:
H2a. Following periods of improving performance, the CEO and chair positions
will be separate.
When performance of the firm has been unusually poor, the board has several options
available to it in regard to the CEOs status. The board may choose to do nothing; it may
choose to demote the CEO in some fashion as a penalty for the firms poor performance;
or the board may choose to fire the current CEO and appoint someone new to the position.
Evidence exists that the stronger the board, the more likely that it will take serious action
such as CEO dismissal if they are not satisfied with firm performance (Bhagat et al., 1999;
Weisbach, 1988). In the case of stronger boards, directors are more likely to prefer
separate CEO and chair positions because duality represents less separation between
management and control (Fama and Jensen, 1983) and can lead to CEO entrenchment
(Mallette and Fowler, 1992). Thus, we propose the following alternative hypothesis:
H2b. The CEO and chair positions will be separate following periods of declining
performance; this relationship will be stronger when there is a high
percentage of outsiders on the board.
A model showing our proposed relationships between prior firm performance and
governance is shown in Figure 1.
Methods and results
Sample
A random sample of 120 companies listed on the National Association of Securities
Dealers Automated Quotations (NASDAQ) was selected for this analysis. The random
sample was selected by assigning a number to each firm and selecting 120 numbers

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CEO
power
(+)

272

H1a (+)

- No. of directors increase or same

- No. of outside directors increase or
stay the same

Declining
firm
performance

- Duality
H2b ()
(+)
Number of
outsiders

H1b (+)

Figure 1.
Relationships between
prior firm performance
and governance

Increasing
firm
performance

- No. of directors increase

- No. outside directors increase

- Duality
H2a ()

using a random number generator (Ocasio, 1994). While there are some fairly large
companies listed on this exchange, for the most part companies traded on the NASDAQ
represent firms much smaller, based on sales, than those of the Fortune 1000. We found
that the average sales for our sample population were approximately $1.4 billion.
According to CNN.money.com, 2007 revenue for the smallest firm in the Fortune
1000 was $1.6 billion. Thus, it appeared that our sample represented a reasonable sample
of small to mid-sized firms. After eliminating several firms for missing or incomplete
data, our study covered 90 companies.
While most of the extant literature on governance focuses on large US companies, we
chose our sample because governance in mid-sized corporations has been largely
understudied, although it is garnering increased attention (Gabrielsson and Huse, 2002;
Gabrielsson and Winlund, 2000). Lynall et al. (2003) contend that boards formed early in
the firms life cycle are apt to set the tone for future boards of directors. If this is the case,
choices of directors at this time are decisions that are of substantial importance for the
future of the firm. Medium-sized companies face some disadvantages compared to their
larger corporate counterparts in that they are often not considered as competitive or
resourceful and may not, therefore, receive fair treatment when it comes to access to
capital, for instance (Castaldi and Wortman, 1984). Borch and Huse (1993, p. 23) agree;
they must consider how to best make strategic decisions in competitive environments
such as exist today and such firms seldom have the economic or political power to
control their environment. In this sense, we offer a conservative test of our hypotheses,

in that medium-sized corporations are likely to face more challenges in finding the types
of directors we predict.
Variables
Predictors. In each of our models, improvements or declines in performance are the main
predictor variables. When selecting the appropriate performance variables, we note that
many measurements of performance have been used in the governance literature and it is
generally recognized that not one measure is universally ideal (Cameron, 1986;
Venkatraman and Ramanujam, 1986). We follow a traditional approach in using both
accounting measures (ROA and return on equity (ROE)) (Harrison et al., 1988; Allen and
Panian, 1982) and market measures (returns to shareholders and P/E ratios) (Hoskisson et al.,
1993). Specifically, we examine whether the change in these measures from one three-year
period (2000-2002) average to the following (2003-2005) three-year period average,
determined using a difference score, will have the predicted effect on board composition and
structure.
Criteria. The change in the number of directors was calculated by subtracting the
total number of directors that existed for each firm at the end of period 1 from the number
that existed at the end of period 2. The change in the number of outside directors was
similarly calculated, but excluded any directors that also held management positions
within the firm.
To measure board prestige, we relied on prior studies to characterize highly qualified
or sought after directors. Baysinger and Butler (1985) describe the instrumental
component of the board as consisting of directors who provide more than monitoring of
and advice to management. They are the lawyers, financiers, and consultants who are a
source of managerial wisdom and can, therefore, assist in decision making as well as
provide links to resources outside the firm (Baysinger and Butler, 1985, p. 110). Similarly,
in Hillman et al.s (2000) typology of board functions, the role of support specialists
would include lawyers and bankers who are able to provide specialized expertise. We
also theorized that while the law does not require a certified public accountant (CPA) or
other accounting expert to sit on a companys audit committee, it does require the
committee to include a financial expert. To satisfy this requirement, companies will want
to attract an accountant or chief financial officer (CFO) to the board due to the likely
favorable market reaction of such an appointment (DeFond et al., 2005). In addition,
nominating an accounting expert to the board (and most likely to the audit committee),
signals that the firm is concerned with avoiding fraud and places high importance on
self-auditing. However, the pool of available accountants is limited (McGee, 2005), and
many qualified candidates may be reluctant to serve on boards due to the risk of being
sued (Beresford, 2005). As a result, the ability to attract directors with accounting
expertise will depend, in part, on the financial soundness of the company. Conversely,
shareholders of firms with past performance losses are less likely to demand a high level
of scrutiny of the firms finances due to other, more overriding priorities, and thus will be
less concerned with the caliber of the audit committee membership (Klein, 2002). Thus,
we include CPAs and CFOs in the measure of highly qualified, desirable directors.
Moderators. Moderating variables include CEO power and the percentage of
outsiders on the board. CEO power was measured by a composite variable taking into
account both CEO tenure and the percentage of the board appointed by the CEO. CEO
tenure is predictive of power because the CEOs influence over firm operations increases

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as his years of tenure increase and the CEO becomes better able to control governance
decisions due to his leadership position (Hambrick and Fukutomi, 1991; Wright et al.,
2002). As noted by Ocasio (1994), longer tenure leads to increased legitimacy of
the CEOs authority and ability to maintain power. While CEO tenure is correlated with
the number of board members appointed by the CEO, directors who are appointed by the
CEO are likely to feel an obligation to the CEO (Boeker, 1992; Wade et al., 1990), thereby
enhancing the CEOs power even if tenure is not relatively long. The percentage of
outsiders was measured by the number of non-employee or former employee directors
divided by the total number of directors.
Controls. Control variables were included to account for institutional ownership, firm
size, and average performance for the period between 2003 and 2005. The percentage of
shares owned by institutional or large blocks of shareholders was added as a control
variable since external owners apply pressure on CEOs to appoint independent board
members (Huse, 2000). Firm size, operationalized as the log of sales in thousands of
dollars, was also added as a control variable as board structure is often related to firm
size (Gabrielsson and Huse, 2002).
Results of hypothesis testing
Prior to testing our hypotheses, data were evaluated for normality, linearity,
and independence of residuals. Several of the variables had significantly skewed and
leptokurtic distributions and for certain regression models, multicollinearity was detected
between predictors and interaction terms. As a result, the variables were converted to
z-scores and standardized solutions are presented in all tables (Friedrich, 1982).
Several hierarchical and logistic regression models, depending on the nature of the
dependent variables, were estimated for each of the hypotheses. Descriptive statistics
and correlations for the variables are presented in Table I.
H1a predicted that declines in performance would result in a decrease in the number of
directors and a decrease in the number of outside directors. To test this hypothesis, two
sets of models were estimated using hierarchical regression, one with the change in total
number of directors as the criterion and the other with the change in outside directors.
The results are shown in Table II. Prior to evaluating the models, we found the variance
inflation factors (VIFs) for several interaction terms and predictors exceeded the
recommended cutoff of 10, indicating the presence of multicollinearity, particularly for
the market return variables. Although variables were standardized, this did not fully
resolve the issue and therefore the market return variables were dropped from further
analysis. The VIFs for models 1 and 2 were within acceptable range (,10); however, the
results of model 3 should be interpreted with caution. In model 1, the control variables did
not explain significant variance for either criterion (number of directors: p , 0.08; number
of outside directors: p , 0.10). After adding the firm performance variables in model 2,
ROA, PE ratio, and ROE predicted both a significant decrease in the overall number of
directors (R 2 0.26, p , 0.01) and a decrease in the number of outsiders (R 2 0.24,
p , 0.01). The change in R 2 was 0.14 ( p , 0.01) for the number of directors and 0.13
( p , 0.05) for the number of outside directors. The addition of CEO power as a moderator
did not contribute any incremental variance to a change in the number of directors
(DR 2 0.01, p , 0.61) or the number of outside directors (DR 2 0.02, p , 0.70). This
suggests that CEO power has little effect on the decrease in number of directors following
a decline in performance. Therefore, we found strong support for the main effect

x

SD

0.11

2 0.06

0.01

2 0.15
0.16
20.08
0.03

2 0.28 * *

0.15
2 0.10
2 0.10
2 0.05

0.02

2 0.06

20.10
0.00

0.08
0.00
0.03
20.11

20.02

0.04

2 0.16

2 0.17
0.07

2 0.16

0.20

0.12

0.00

0.19

0.26 * *

20.11 2 0.13
0.07
0.04

2 0.05
0.42 * * 2 0.08
0.48 * *
0.05
0.03
0.06
0.06
0.81 * *
0.01 20.05
*
*
0.27
0.01
0.11
0.04

0.30 * *
0.12
20.02
0.69 * *
0.02

2 0.03
0.20 *
0.19
0.02

20.11
0.20
2 0.32 * *

2 0.17

Note: Significance at: *p , 0.05 and * *p , 0.01

1. Log sales
5.22
1.02
2. Institutional
ownership
0.25
0.18
0.11
3. ROA
24.32 24.52
0.57 * *
4. Market
return
44.40 70.43 2 0.09
5. PE ratio
13.05 62.50
0.12
6. ROE
216.05 66.46
0.38 * *
7. D Market
return
21.16 85.03 2 0.15
8. D ROA
7.65 53.56 2 0.11
9. D PE ratio 23.53 68.49 20.03
10. D ROE
16.55 144.15 2 0.08
11. CEO and
chair
separation
0.54
0.50 20.08
12. CEO power
9.64
9.42 2 0.01
13. D Number
of director
0.44
1.86
0.00
14. D Number
of outside
director
0.81
1.92
0.14
15. Percentage
of
prestigious
director
0.78
0.62 2 0.13
2 0.04

0.19

0.23 *

0.08
2 0.05

0.03
0.37 * *

10

11

0.05

0.05

2 0.05

0.06

0.00

0.03 2 0.01

0.06

0.07

2 0.05
0.02
0.09 2 0.10 2 0.24 *

0.02

13

0.04 0.07

2 0.11 0.74 * *

2 0.12

12

2 0.10

14

Effects of firm
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275

Table I.
Descriptive statistics
and correlations

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Variables

276

Table II.
Results of firm
performance on
board composition

Control variables
Log sales
Institutional ownership
ROA
PE ratio
ROE
Firm performance
D ROA
D PE ratio
D ROE
CEO power
Interactions
CEO power D ROA
CEO power D PE ratio
CEO power D ROE
F
R2
Adjusted R 2
DR2

Change in the number of

directors
Model 1
Model 2
Model 3
0.17
20.05
20.42 *
20.14
0.36 *

2.02
0.11
0.06

0.28 *
20.17
20.43 *
20.46 *
0.33 *

0.28 *
20.19
20.35
20.48 *
0.21

0.35 * *
0.40 *
20.12
20.11

0.14
0.39
0.07
20.11

2.89 * *
0.26
0.17
0.14 * *

20.43
20.11
0.32
2.29 *
0.27
0.15
0.01

Change in the number of outside

directors
Model 1
Model 2
Model 3
0.25
2 0.02
2 0.36 *
2 0.03
0.36 *

1.93
0.11
0.05

0.36 * *
2 0.13
2 0.37 *
2 0.39 *
0.34 *

0.38 * *
2 0.12
2 0.53 *
2 0.25
0.51 *

0.30 * *
0.44 *
2 0.11
2 0.12

0.69
0.35
2 0.41
2 0.06

2.68 * *
0.24
0.15
0.13 *

0.80
0.02
2 0.50
2.09 * *
0.26
0.13
0.02

Notes: n 87; significance at: *p , 0.05 and * *p , 0.01; table contains standardized regression
coefficients

of changes in all three performance variables (i.e. ROA, PE ratio, and ROE) on board
composition in H1a, but no support for the moderating effects of CEO power.
H1b stated that following periods of improving firm performance, highly qualified
and sought after directors would be added to the board, increasing their relative
percentage of overall board composition. The results of the hierarchical regression
models to test H1b are reported in Table III. None of the models predicted board
prestige (model 1: p , 0.18; model 2: p , 0.47; model 3: p , 0.23); therefore, there was
no support found for H1b.
H2a and H2b were competing hypotheses stating, respectively, that following
periods of improving or declining performance, the position of CEO and chair would be
separated. Table IV reports the results of the logistic regression used to test these
hypotheses. Comparison of the log-likelihood ratios for the models showed no significant
improvement with the addition of firm performance ( p , 0.42) or the percentage of
outsiders ( p , 0.65) as predictors. None of the performance change variables were
significantly related to CEO duality. Therefore, no support was found for H2a or H2b.
Discussion
Hermalin and Weisbach (2003) point out that studies of boards of directors examining
the relationship between boards of directors and subsequent firm performance treat
boards as if they were an exogenous variable. Many fewer studies examine predictors of
board characteristics than the outcomes of board characteristics. Hermalin and
Weisbach (2003) suggest that the study of factors that affect the characteristics
of the board are also important to our understanding of firm governance and may more

Variables
Control variables
Log sales
Institutional ownership
ROA
PE ratio
ROE
Firm performance
D ROA
D PE ratio
D ROE
CEO power
Interactions
CEO power D ROA
CEO power D PE ratio
CEO power D ROE
F
R2
Adjusted R 2
DR2

Model 1

Model 2

Model 3

0.08
20.04
20.39 *
0.03
0.05

0.10
20.02
20.41 *
20.08
0.07

0.03
20.05
20.34
20.20
0.12

1.55
0.09
0.03

20.04
0.12
0.01
0.09

0.62
0.32
0.08
0.07

0.97
0.10
0.00
0.02

20.73
20.22
20.08
1.31
0.18
0.04
0.07

Notes: n 87; significant at: *p , 0.05; table contains standardized regression coefficients

Variables
Constant
Control variables
Log sales
Institutional ownership
ROA
Market return
PE ratio
ROE
Firm performance
D Market return
D ROA
D PE ratio
D ROE
Interactions
Percentage of outsiders D market return
Percentage of outsiders D ROA
Percentage of outsiders D PE ratio
Percentage of outsiders D ROE
Model x 2
D x2
Cox & Snell R 2
Nagelkerke R 2

Model 1

Model 2

Model 3

0.21

0.36

0.37

0.00
0.25
20.39
0.29
20.46
0.05

20.02
0.25
20.45
1.23
20.92
0.22

0.11
0.33
2 0.11
1.32
2 0.99
2 0.42

21.44
0.04
0.50
20.44

2 1.52
2 1.34
0.61
1.00

9.41
3.33
0.10
0.14

2 0.77
0.51
2 0.12
2 1.21
14.36
4.96
0.15
0.21

6.07
0.07
0.09

Notes: n 87; table contains standardized regression coefficients

Effects of firm
performance

277

Table III.
Results of firm
performance on
board prestige

Table IV.
Results of the logistic
regression analysis of
CEO and chair separation

MRR
34,3

278

accurately reflect the positioning of board variables in our research models. In this
paper, we study the effect of prior firm performance on changes in board characteristics
and other governance structures.
The results suggest that performance effects on board composition are more dramatic
when there has been a downward change in the firms performance. Measuring the
change in performance over a three-year period from the previous three-year period, the
result was fewer board members and fewer outsiders. One might argue that the overall
size of boards has, on average, declined largely in response to governance experts call
for smaller, more dedicated boards. With respect to smaller firms, however, relatively
larger boards are preferable (Dalton et al., 1999). Thus, the effect of poor performance on
board size may be more damaging for smaller companies. In addition, our prediction that
the number of outsiders would also be affected by performance declines was supported.
Conversely, companies whose performance had improved were able to add outsiders to
their boards. This is an important finding for small companies as the ability to attract
qualified outsider directors is critical for companies to establish the needed linkages with
the external environment (Pfeffer, 1973). If smaller companies intentionally reduce the
number of outside directors in an effort to cut costs (Gilson, 1990), future performance
improvements may be hampered due to both a deceased availability of resources and a
decreased perception of status.
The predictions of our remaining hypotheses were not supported. Neither the
presence of a prestigious director nor an accounting expert on the board seems to be
influenced by previous performance. In the former case, it may be that our measures of
prestige do not take into account all of the facets of member reputation. Previous studies
have included the number of other board seats held by the director and the members
equity ownership as indicia of status (Udueni, 1999). Further, it may be that performance
as well as size and corporate reputation is independent of board composition; the mere
presence of distinguished directors on a board is sufficient to attract additional prestige
appointments (Davis and Robbins, 1998). In the latter case, while accounting experts
may prefer to hold membership on boards of financially sound firms (Udueni, 1999),
companies experiencing declines in performance may seek out financial experts to assist
in turning the company around. Thus, the two competing reasons for seeking out
accounting experts may have led to our lack of findings. Similarly, the poor financial
position of the company may necessitate the presence of an outsider director from a bank
on the board. Once those problems are resolved, the bank director often resigns and is
replaced by another outsider ( Johannisson and Huse, 2000).
Lack of support for either H2a or H2b warrants further consideration. Researchers
have raised the issue whether the relationship between CEO duality and performance is
contextual (Boyd, 1995), with Rhoades et al. (2001) finding a contingency effect based on
previous firm performance. If context matters, our model may be underspecified as it did
not account for variations in industry or other governance mechanisms such as equity
ownership or incentive compensation arrangements. Alternatively, our findings suggest
that phenomena underlying the explanation for both propositions may be present. In some
cases, improving performance negates the need for CEO duality while in other cases, the
CEO might be rewarded for performance gains by promotion to board chair or may
be fired following poor performance and replaced by a successor who is not also named as
chair (Hatfield et al., 1999). The strong relationship between tenure and CEO duality
suggests that CEO power may be a more compelling determinant of board structure.

Overall, our findings continue to follow the pattern established by prior studies: the
relationship between performance and individual governance practices is weak, at best,
regardless of the causality. With respect to board composition, social capital and
network influences may be a much more important determinant of board membership
than monitoring concerns. While agency theory offers a primarily economic explanation
of board appointments and suggests that performance should be the ultimate dynamic
in board composition, lack of empirical support suggests directors are selected based on
social ties to the management team (Westphal, 1999) or have common associations
within the same social group (Galaskiewicz and Wasserman, 1981; Useem, 1980).
The relatively small size of the sample and focus on small- to medium-sized
enterprises may also explain the absence of support for our hypotheses. Future studies
are needed expanding both the scope of the research as well as tailoring both the
performance and governance variables to match the characteristics of smaller companies.
Our study contributes to the extant literature in that it suggests that the results of
large-corporation studies may apply in the same way to small and mid-size firms.

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About the authors
M. Alix Valenti is an Assistant Professor of Management and Legal Studies in the School of
Business at the University of Houston Clear Lake. Dr Valenti holds a PhD in Management from
the University of Texas at Dallas, a J.D. from St Johns University School of Law and a Masters
in Law from New York University School of Law. Dr Valentis primary areas of teaching are:
organizational behavior, employment and business law, and compensation and employee
benefits. Prior to becoming an Assistant Professor at the University, Dr Valenti was a Senior
Consultant with a global human resource consulting firm, specializing in employee benefits and
executive compensation. M. Alix Valenti is the corresponding author and can be contacted at:
valenti@uhcl.edu
Rebecca Luce is an Assistant Professor of Management and Entrepreneurship at Xavier
University. She obtained her PhD in Strategic Management at Michigan State University. Prior
to her career in academia, she was a business executive in various organizations in the fields of
human resources and strategic planning. Her research interests are in the areas of corporate
governance, social performance and bottom of the pyramid issues. She has previously published
articles in Strategic Management Journal and Business and Society.
Clifton Mayfield is an Assistant Professor of Management in the School of Business at the
University of Houston Clear Lake. Dr Mayfield obtained his PhD in Management from the State
University of New York at Albany. His primary areas of teaching include organizational theory,
organizational behavior, and management.

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