The Board of Directors and Financial Interests

The Board of Directors and Financial InterestsAuthor(s): Richard SchmidtSource: The Academy of Management Journal, Vol. 20, No. 4 (Dec., 1977), pp. 677-682Published by: Academy of ManagementStable URL: http://www.jstor.org/stable/255366 .

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1977 Schmidt 677

Academy of Management Journal 1977, Vol. 20, No. 4, 677-682.

THE BOARD OF DIRECTORS AND FINANCIAL INTERESTS

RICHARD SCHMIDT University of Connecticut

The belief that financial interests influence and control industrial activity has always been stronger than the weight of evidence would seem to justify. Thus, academicians such as Gras (1953) and Sombart (1930) have spun theories attributing great power to the Financial Capitalist, while the popular belief that business is dominated by Wall Street has led to numerous Congressional investigations beginning with the Pujo Com- mittee of 1912-13. The present-day uneasiness over the activities of in- stitutional investors is a manifestation of the same belief.

But just how strong is the Wall Street influence? Can this influence somehow be made the object of an empirical investigation that centers on objective performance as opposed to subjective feelings of financial power?

Purpose and Scope

There are so many aspects to the influence and control of nonfinancial business activity by financial interests that such a broad brush approach is not feasible for empirical investigation. Accordingly, one aspect of the overall scenario will be singled out and used as a proxy of the extent of financial domination: the degree to which the representatives of financial interests are dominant on the boards of directors of nonfinancial corporations.

The extent of financial influence and control will be determined as follows. First, based on a sample of nonfinancial corporations, corporate directors who are not also officers at the corporate level of the firms they direct (outside directors) will be segregated for study. Second, the primary affiliations of these outside directors will be determined and classified. Presumably, those firms having a larger proportion of outside directors tracing their primary affiliations to financial interests than firms with a smaller proportion can be considered to be more under the influence and control of those interests. Third, to test this belief, and since influence and control must ultimately be evidenced in behavior, certain performance measures for the sample firms will be related to the degree to which their outside directors are affiliated with financial interests.

These measures are all commonly used financial ratios, subject to the standard pros and cons pertaining to their use; they are based on book values at the end of, and over, the firms' annual fiscal periods. As measures



678 Academy of Management Journal December

of liquidity, or the short-term bill paying capacity of the firm, two ratios were employed: the ratio of current assets to current liabilities, or Current Ratio, and as an alternate, to allow for varying sales volumes, the ratio of current assets less current liabilities to sales, or Net Working Capital per Sales Dollar. To measure the degree of financial leverage, or the extent to which a firm's assets are financed by long-term debt, the ratio of long-term debt to stockholders' equity, the Long-Term Debt Ratio, was used. And, to measure profitability on stockholders' investment, the ratio of net in- come after interest and taxes but before extraordinary items to stockholders' equity, or Return on Equity, was used. It is felt that a combination of liquidity, leverage, and profitability measures provides a well rounded picture of firm behavior in relation to financial influence and control.

Sample and Methodology

In order to obtain a broad spectrum of American industry, a sample cutting across size of firm and industry is desirable. It is believed that Moody's Industrial Manual (1975) provides a usefully broad listing of firms, therefore it was selected as the universe to which inferences would be made. All financial data used in the statistical tests were obtained from this source.

Since there is no theoretical justification for a stratified sample or sys- tematic inclusion of firms, a simple random sample where each firm listed had an equal probability of being included was used. Choice of sample size is based on achieving some satisfactory level of precision. Thus, minimum sample size formulas and confidence belts are predicated on achieving some predetermined level of precision; the actual level of precision set is a judgmental decision governed largely by the sampling costs involved in relation to the penalty for error. It was thought best here to take as large a sample as possible, given the constraints on this re- searcher. It was originally decided to obtain 200 firms, but after eliminating some firms for lack of data availability and confining the study to domestic corporations, 156 firms remained in the sample. It is believed that this is large enough to provide the precision necessary for the inferences made here.

Information concerning the primary affiliations of the outside directors of the above 156 firms was obtained from the following sources: Dun and Bradstreet's Reference Book of Corporate Managements (1975), Standard and Poor's Register of Corporations, Directors and Executives (1975, 1976), Dun and Bradstreet's Million Dollar Directory (1975) and Middle Market Directory (1975), and selected annual reports and phone calls in those cases not listed.

The statistical methodology consisted of two separate phases. In the first phase, the profiles of director affiliations were analyzed in relation to firm size. Firms were first plotted on a linear scale of total asset size and, since no clustering of firms by size was observed, the sample was divided



1977 Schmidt 679

into three size categories with an equal number of firms in each category. Then, for descriptive purposes, directors were divided into 10 arbitrary categories based on their primary affiliations. Finally, these affiliations were condensed into three categories designed to measure financial control versus size of firm and a chi square test was performed to determine if the differ- ences in affiliations were greater than that attributable to chance.

In the second phase, financial data pertaining to the latest accounting period were first obtained for each of the four ratios previously described. These ratios were then correlated, individually, with a proxy variable designed to measure the degree of financial influence and control, the ratio of outside directors deemed as having financial affiliations to all outside directors (financial control proxy), in order to determine if financial interests are a significant determinant of the behavior of nonfinancial firms.

Findings: First Phase

Table 1 shows the number of outside directors, by size of firm, for each primary affiliation category. These categories are designed to show some detail in the affiliations pertaining to financial interests, although the detail is far from complete. Other classification schemes are possible and have been used, for example, Bacon (1973, p. 29) and Business Week (March 29, 1976, p. 100).

Most studies concerning board composition, however, stop at this point, that is, remain in the area of descriptive as opposed to inferential statistics. Two important inferences can be made, however. It can be determined, first, whether board composition, here confined to the degree of financial representation, is related to firm size and, second, to the performance of the firm itself.

TABLE 1

Affiliations of Outside Directors in Relation to Asset Size Category

Size Affiliation Large Medium Small Total Percent

Commercial banks and trust companies, bank holding companies, savings banks 46 30 22 98 8.9

Insurance companies 11 7 5 23 2.1 Pension and investment funds, foundations 10 6 1 17 1.5 Investment banks, securities dealers and

underwriters 36 25 25 86 7.8 Retired financial executives 19 9 2 30 2.7 Consultants (includes accountants, college

professors and administrators, representatives of nonprofit institutions) 45 37 24 106 9.6

Lawyers 24 37 26 87 7.9 Nonaffiliated (private investors and

"professional directors") 19 7 7 33 3.0 Active nonfinancial executives 212 185 103 500 45.4 Retired nonfinancial executives 54 49 20 123 11.1 Totals 476 392 235 1103 100.0




TABLE 2

Control Type in Relation to Asset Size: Percent Composition

Size of Fir_ Control Category Large Medium Small

Financial 25.6 19.6 23.4 Intermediate 18.5 20.7 24.3 Nonfinancial 55.9 59.7 52.3 Totals 100.0 100.0 100.0

(476) (392) (235)

Table 2 groups the first five categories of Table 1 as being indicative of financial control, the last two as nonfinancial, while the remaining three are believed to be intermediate in nature. Note that firm size and the number of outside directors are positively related (the relationship was found to be statistically significant at the alpha .01 level). It can be seen, however, that the proportion of directors wtihin each control category seems to be independent of firm size. This is not to be expected: Directors with financial affiliations are supposed to be concentrated on the boards of large firms, the giants of industry.

To test the significance of this relationship statistically, the number of directors was determined by size of firm and control category (Table 3) and a chi square test was performed. The computed chi square statistic of 7.44 is not statistically significant at any commonly used alpha level, a result intuitively expected from the rather close agreement between the observed number of directors and the number that might be expected (shown in parentheses) if indeed there were no relationship between firm size and control type.

TABLE 3

Control Type in Relation to Asset Size: Number of Directorsa

Size of Firm Control Category Large Medium Small Totals

(109.6) (90.3) (54.1) Financial 122 77 55 254

(97.5) (80.3) (48.2) Intermediate 88 81 57 226

(268.9) (221.4) (132.7) Nonfinancial 266 234 123 623 Totals 476 392 235 1103

a Numbers in parentheses are the number of directors that might be expected if there were no relationship between firm size and control type.



1977 Schmidt 681

TABLE 4

Statistics Concerning the Relationship Between Selected Measures of Firm Performance and the

Financial Control Proxy (n - 156)

Correlation Coefficient

with Financial

Standard Control Z Expected Variable Mean Deviation Proxy Statistic Direction

Current ratio 2.240 1.040 0.046 0.574 Net working capital

per sales dollar 0.205 0.122 -0.005 -0.062 Long term debt ratio 0.857 1.994 -0.168 -2.094 + Return on equity 0.077 0.461 0.157 1.954

Findings: Second Phase

The results of the correlation analysis between the selected performance variables and the financial control proxy are shown in Table 4. It is possible to specify direction on the basis of popular belief so that one-tailed tests of significance are called for: Firms dominated by financial interests are supposed to rate low on indicators of liquidity, be heavily committed to and be burdened by long-term debt, and be rather poor performers in the marketplace. Yet none of the four relationships were observed to be statistically significant; indeed, in two cases the observed relationship was strongly in the wrong direction.

All relationships were plotted against the financial control proxy. In all cases, the scatter was quite random and did not support the contention that a more sophisticated relationship might provide a better statistical fit. Several outliers were observed in each case; they were removed and the correlations rerun. The conclusions were the same as with the full sample.

Implications

It has been shown elsewhere (Schmidt, 1975) that the inside-outside aspect of board composition, long debated at the theoretical level in the management literature but seldom tested empirically, was statistically insignificant as an explanatory variable in relation to corporate economic performance and financial policy. Here it can be concluded that the significance of the affiliations of outside directors should be questioned in relation to the behavior of the industrial corporation. The belief that financial interests exert strong influence on industrial activity is open to further questioning.

REFERENCES

1. Bacon, J. Corporate Directorship Practices: Membership and Committees of the Board, Study No. 588 (New York: The Conference Board, 1973).




2. Dun and Bradstreet Middle Market Directory 1976 (New York: Dun and Bradstreet, 1975).

3. Dun and Bradstreet Milliotn Dollar Directory 1976 (New York: Dun and Bradstreet, Inc., 1975).

4. Dun and Bradstreet Referetnce Book of Corporate Managements 1975-1976, 9th ed. (New York: Dun and Bradstreet, 1975).

5. Gras, N.S.B. "Capitalism-Concepts and History," in F. C. Lane and J. C. Riemersma (Eds.), Enterprise and Secular Change (Homewood, Ill.: Irwin, 1953), pp. 66-79.

6. Moody's Industrial Maniual 1975 (New York: Moody's Investors Service, 1975). 7. Schmidt, R., "Does Board Composition Really Make a Difference?" Conference Board

Record, Vol. 12, No. 10 (1975), 38-41. 8. Sombart, W. "Capitalism," Encyclopaedia of the Social Sciences, Vol. 3 (New York:

Macmillan, 1930). 9. Standard and Poor's Register of Corporations, Directors and Executives 1975 (New

York: Standard and Poor's 1975). 10. Standard and Poor's Register of Corporations, Directors and Executives 1976 (New

York: Standard and Poor's 1976). 11. "Why Lawyers and Bankers Desert the Board," Businiess Week, March 29, 1976,

pp. 100ff.

Note to Researchers:

The JDI (Job Descriptive Index) and the SWV (Survey of Work

Values) are copyrighted by Bowling Green State University. For price

lists and other information concerning the JDI or the (original or

revised) SWV, please write or call:

Dr. Patricia C. Smith

Department of Psychology

Bowling Green State University

Bowling Green, Ohio 43403

[4191 372-2301



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