Condiciones y forma de pago (55 fracción III inciso e) de la Ley)

As discussed in Section 3.1, governance theories, particularly agency theory, suggest that enhancement of corporate governance mechanisms improves firm financial performance. The empirical literature investigating the relationship between corporate governance mechanisms and firm financial performance either uses the equilibrium- variable model (e.g., Vafeas and Theodorou, 1998; Weir and Laing, 2000; Haniffa and Hudaib, 2006; Chalevas, 2011; Mangena et al., 2012) or the compliance-index model (e.g., Black, 2001; Gompers et al., 2003; Cremers and Nair, 2005; Morey et al., 2009; Bauer et

al., 2010; Renders et al., 2010; Giroud and Mueller, 2011; Black and Kim, 2012; Ammann et al., 2013; Munisi and Randoy, 2013; Tariq and Abbas, 2013; van Essen et al., 2013).

The equilibrium-variable model helps to explore the influence of individual corporate governance mechanisms on firm financial performance. In contrast, the compliance-index model involves an examination of the relationship between corporate governance and firm performance using a broad composite Saudi governance index containing 65 corporate governance provisions.

The remaining parts of this chapter are organised as follows. Subsection 3.4.1 reviews empirical studies that use the equilibrium-variable model, whereas Subsection 3.4.2 reviews the literature on the compliance-index model.

3.4.1 The Equilibrium-Variable Model and Firm Financial Performance

The board of directors is an essential part of corporate governance which can influence firm performance (Goodstein et al., 1994; Monks and Minow, 2011; Westphal and Zajac, 2013). Six characteristics of a board of directors are reviewed based on relevant prior literature. These are CEO duality, the proportion of independent directors, board size, the frequency of board meetings, board sub-committees and director ownership. These board characteristics were selected because of their important effect on board effectiveness

(Solomon, 2010; Monks and Minow, 2011; Allegrini and Greco, 2013). Moreover, the Saudi Corporate Governance Code (SCGC) considers these mechanisms to be central to good corporate governance practices.

To investigate each of the six mechanisms, four main elements are considered: (i) a review of the theoretical literature on the association between a particular corporate governance mechanism and firm performance; (ii) a review of empirical studies conducted in developed countries; (iii) a review of studies on developing countries; and (iv) a review of studies on Saudi listed firms and related corporate governance rules in Saudi Arabia. Finally, on the basis of these reviews, hypotheses are developed.

3.4.1.1 CEO Duality

i) The theoretical association between CEO duality and firm financial performance

CEO duality is considered an important corporate governance mechanism due to the sensitive nature of the relationship between agents and principals (Davis et al., 1997; Krause et al., 2014). Agency theory suggests that CEOs should run the firm in the best interest of shareholders (Jensen and Meckling, 1976; Chen et al., 2011). Jensen (1993) and Blackburn (1994) argue that combining the roles of chairperson and CEO may undermine the board’s monitoring power. As discussed in Section 3.1, weak monitoring may lead to expropriation of a firm’s resources by self-serving managers by, for example, awarding themselves compensation packages regardless of their performance (Berle and Means, 1932). Also, because they tend to have access to better information relating to the operations of the firms than non-executive directors, CEOs can exploit such information to their advantage (Jensen and Meckling, 1976; Black et al., 2006a; Chalevas, 2011). Lipton and Lorsch (1992) and Mashayekhi and Bazaz (2008) suggest that role duality can offer opportunities for self-serving CEOs to dominate board meetings, which can impact negatively on corporate financial performance.

In contrast, stewardship theory suggests that CEOs tend to work in the best interests of shareholders (Davis et al., 1997). This is because the interests of the CEO and those of shareholders are aligned. Furthermore, CEOs seek to maintain their reputation and future job opportunities (Conyon and He, 2011). Thus, they tend to make good use of firms’ resources, and thus can lead to an increase in the value of the firm (Davis et al., 1997; Nicholson and Kiel, 2007; Siebels and Knyphausen-Aufseb, 2012).

ii) The empirical association between CEO duality and firm financial performance in developed economies

Existing empirical studies show mixed evidence about the relationship between CEO duality and financial performance in developed countries. A negative relationship is observed by a number of studies. For example, Dahya et al. (1996) report a positive association between separating the roles of chairperson and CEO and financial performance. Specifically, they use a sample of 124 UK companies from 1989 to 1992 and find an improvement in firm performance in the year following separation of the roles of CEO and board chairperson.

Similarly, Daily and Dalton (1994) use a sample of matching pairs of 57 bankrupt and surviving firms in the US from 1972 to 1982. They find that CEO duality was a significant factor for the firms that faced bankruptcy. Daily and Dalton’s finding supports the importance of splitting the CEO and chairperson positions in monitoring and controlling the firm’s management (Lipton and Lorsch, 1992; Blackburn, 1994). In addition, Dey et al. (2011) report that splitting the roles of CEO and chairperson is positively associated with returns for a sample of 760 firms between 2001 and 2009. Christensen et al. (2014) find that the separation of the roles of CEO and chairperson is significantly associated with higher earnings quality among 660 Australian companies from 2001 to 2004.

On the other hand, some studies show a positive relationship between CEO duality and firm financial performance. Donaldson and Davis (1991) examine a cross-sectional sample of 321 firms in the US from 1985 to 1987. They report that return on equity (ROE) is higher in companies with CEO duality. Similarly, using 192 US firms’ data between 1980 and 1984, Boyd (1995) finds evidence that return on investment (ROI) is higher in firms with CEO duality. In the same vein, Brickley et al. (1997) investigate a 1988 sample of 737 US listed firms. They find that CEO role duality impacts positively on financial performance.

Finally, a number of studies indicate that CEO duality does not affect firm financial performance. For example, using data from 375 US listed firms from 1980 to 1991, Baliga

et al. (1996) find that the US stock market return is not affected by CEO duality. Similarly,

Daily and Johnson (1997) examine 100 US firms between 1987 and 1990 and find that CEO duality had an insignificant impact on firm performance, as measured by ROE and ROI. In addition, Bozec (2005) finds no statistical impact of CEO duality on firm performance in a sample of 25 Canadian firms between 1976 and 2000. More recently,

Castaner and Kavadis (2013) examine a small sample of 59 French corporations from 2000 to 2006. They find no statistical relationship between CEO duality and firm performance.

iii) The empirical association between CEO duality and firm financial performance in developing economies

Prior empirical studies have reported mixed evidence about the impact of CEO duality on firm performance in developing countries. The findings of one stream of studies suggest a negative relationship between CEO duality and firm financial performance. For example, Haniffa and Hudaib (2006) examine 347 Malaysian listed firms from 1996 to 2000 to investigate the link between CEO duality and firm performance. They report that CEO duality had a negative association with ROA. Similarly, Jackling and Johl (2009) find that CEO duality had a detrimental effect on market value, as measured by Tobin’s Q, among a sample of 180 Indian listed firms in 2006. Hearn (2011) finds that splitting the roles of CEO and chairperson improved firm value. Hearn’s study examines a small sample of 37 listed firms across West Africa between 2000 and 2009.

Mangena and Chamisa (2008) report no association between CEO duality and suspended firms among 81 South African listed firms from 1999 to 2005. Similarly, Mashayekhi and Bazaz (2008) find no association between leadership structure and firm performance in 240 Iranian listed firms from 2005 to 2006.

iv) Studies on Saudi Arabia and Saudi Corporate Governance Regulations

Al-Abbas (2009) examines the influence of CEO duality on shareholders’ returns. Using data of 78 listed firms in 2005, 2006 and 2007 (a total of 106 firm-year observations), he finds no evidence of improvement in the performance of firms that split CEO and chairperson positions. However, Ezzine (2011) finds a negative relationship between CEO duality and stock price performance using 96 firm-year observations in Saudi Arabia between 2006 and 2008. Both Al-Abbas and Ezzine use unbalanced panel data from a small sample. As discussed in Chapter Five and Seven, endogeneity problems arising from potential unobserved firm-level heterogeneity may be exacerbated by the use of unbalanced panel data (Henry, 2008; Guest, 2009; Ntim et al., 2012b). The relatively small sample size can also limit generalisability of their findings for Saudi listed firms. Unlike their studies, this study involves both cross-sectional and time-series observations using a balanced and larger sample of 80 listed firms over seven years (i.e., giving a total of 560 firm-year observations).

The SCGC recommends splitting CEO and chairperson positions to enhance the accountability of a firm’s management. Since agency theory suggests a negative relationship between CEO duality and firm financial performance, and most empirical studies also found a negative relationship (e.g., Haniffa and Hudaib, 2006; Jackling and Johl, 2009; Dey et al., 2011; Christensen et al., 2014), the ninth hypothesis to be tested is formulated as follows: