Status as a mechanism to co-opt the board : evidence from Hong Kong natural experiments

Abstract

In the early 2000’s, corporate governance reforms were adopted by dozens of countries worldwide to promote financial reporting quality by increasing board independence. However, the effectiveness of these provisions depends on which directors are appointed. This study uses two regulatory changes in independent director (ID) requirements in Hong Kong, a representative stock market characterized by high investor protection and concentrated control, to examine how ID status relates to board co-optation and financial reporting quality. Status measures are derived from director–firm networks and are validated in the Hong Kong setting. A measure of relative ID status (ID status relative to executive director status) is then constructed to enable tests of changes of within-board relative power. I find that in response to ID-enhancing regulations, initially noncompliant firms exhibit decreased relative ID status. I further find some evidence that this type of power shift is associated with lower financial reporting quality. I address alternative explanations and perform several robustness tests to validate these findings.

Regulators around the world use rules regarding corporate board composition, and specifically ID quotas and/or proportions, to promote corporate governance. While many studies draw conclusions on the effectiveness of ID regulations in the United States, markets with high ownership concentration may have particular issues with the effectiveness of IDs, as owners of tightly-held firms have both the motivation and ability to appoint IDs who are tractable. This study provides evidence that status may be a mechanism used to control a board, and calls into question the effectiveness of ID regulations meant to bolster corporate governance in the presence of concentrated control.