Shareholder Interests versus Board of Director Members’ Interests and the Profitability of Firms

Abstract

Closer alignment of board members interests with shareholder interests has been viewed as a key to unleashing the firm’s performance potential. However, empirical validation of the actual link between board alignment with shareholder interests and performance remains a matter of considerable debate. This study empirically tests the hypothesis that the closer alignment of board of director members’ interests with shareholder interests improves the economic profitability of firms. The hypothesis is tested by examining the relationship between operating earnings in excess of the cost of capital (ER) and a new “shareholder confidence” index that captures board of director alignment with shareholder interests for a sample of large publicly traded Canadian firms from 2002–2006. High shareholder confidence index values are generally associated with higher ER, although the relationship is not monotonic for higher-graded boards. This suggests that while highly-graded boards are generally beneficial, there may be diminishing returns to efforts to design “optimal” boards in the sense of their alignment with shareholder interests. The performance gap between firms with high vs. low expected agency costs as reflected in terms of higher differentials between board members’ interests alignments with those of shareholders amounts to almost 30%.