Board independence and the quality of board monitoring: evidence from China

Abstract

Purpose – In 2001, the China Securities Regulatory Commission required that at least one-third of the members of corporate boards of directors come from outside the organization. The purpose of this paper is to investigate the impact of this change of regulation on corporate governance in China. In particular, the authors examine whether the increase in the proportion of outsider directors can increase the monitoring quality of the board. Design/methodology/approach – The basic empirical methodology is a logit regression in which the dependent variable is a binary variable that represents one of the three “negative events” identified as the indicators of poor monitoring quality. The independent variables are firm-level control variables. Findings – Using Chinese stock data from 1999 to 2005, the authors find that the resulting increase in board independence has reduced the occurrence of connected transactions and violations such as financial statement fraud, illegal insider trading, and asset misappropriation. However, this positive effect of board independence is not uniform across firms. The authors show that a higher degree of fundamental uncertainty in a firm impedes the effectiveness of board independence. The authors also document that the level of board independence is positively associated with firm performance, as measured either in stock market return or accounting return. Originality/value – In this paper, the authors aim to investigate the effectiveness of outsider directors in a more direct way than has previous research. The authors measure the improvement in the quality of board monitoring by the reduction of the likelihood of those corporate events that could reduce firms’ value. In particular, the authors examine the relationship between the board independence and the occurrence of “negative” corporate events in China. To the best of the knowledge, this is the first study that explores the link between board independence and the probabilities of these events.