Testing the Bargaining Model of Corporate Governance: Evidence from the Korean Market

The agency conflict between the managers of a company and the shareholders of a company is a crucial issue in corporate governance. Many finance researchers have searched for ways to ensure that managers will act in the best interests of shareholders, which are referred to as monitoring mechanisms. There are many well-known monitoring mechanisms identified in the corporate finance literature, such as concentrated ownership by shareholders (block holders), board of director oversight, oversight by the market for corporate control, proxy contests and shareholder activism. Recently, discussions of the failures of corporate boards in company oversight have become popular both in academic and practitioner-focused finance literature. In academia, early models of corporate governance have been challenged by bargaining models. Early models of corporate governance focus on board characteristics and their impact on firm performance or firm-level decision-making (Fama, 1980; Fama and Jensen, 1983; Brickley et al., 1994; Kini et al., 1995; Yermack, 1996; Cotter et al., 1997; Dennis and McConnell, 2003). In contrast, bargaining models are based on the assumptions that there are divergent forces in corporate governance that facilitate or block effective monitoring mechanisms and corporate decision-making (Hermalin and Weisbach, 1998, 2003; Raheja, 2005). Especially Hermalin and Weisbach relate existing empirical findings to their theoretical work on bargaining models, including prior firm performance, the relationship between outside directors and CEO tenure, corporate decision-making of a firm, and the measures of firm performance (Coughlan and Schmidt, 1985; Warner et al., 1988; Jensen and Murphy, 1990; Weisbach, 1988; Goyal and Park, 2002; Dahya et al., 2002; Murphy and Zimmerman, 1993). This paper tests the empirical predictions of the bargaining model of corporate governance of Hermalin and Weisbach (1998) using Korean Stock Exchange companies. The objective of this paper is to empirically test the predictions of bargaining models including data from the Korean Corporate Governance Index (KCGI) as a proxy for the quality of board monitoring so that this paper can investigate the relationship between firm valuation and CEO tenure. Specifically, following the empirical predictions of Hermalin and Weisbach (1998), three hypotheses are examined: H1. The effect of the board quality index on firm performance is positive after controlling for board size and board characteristics. H2. The board quality index of a firm declines over the course of a CEO’s tenure after controlling for the independent director ratio and the persistence of board independence. H3. Accounting measures of performance are better predictors of management turnover than stock price performance. This paper uses a sample of Korean firms for empirical analysis in this paper for several reasons. First, empirical evidence is not enough related to the bargaining model for Korean firms. Second, Korean firms are different from U.S. firms in terms of their board compositions and board characteristics. In Korea, the monitoring role of outside directors is weak (Baek et al., 2006) and the independence of outside directors is also questionable (Kim and Kim, 2008). Moreover, there is a regulation imposing mandatory outside director ratios of 50 percent on large firms with assets greater than two trillion won (Black et al., 2006). The effect of outside director ratios on firm performance or corporate decision-making is questionable and is thus an empirical issue in Korea. Finally, the Korean Corporate Governance Index (KCGI) appears to be a good predictor of the quality of corporate governance for publicly listed companies in Korea (Black et al., 2006; Black et al., 2008; Black and Kim, 2012). Using the fixed effects estimation of panel data, this study finds a positive relationship between the ranking of a firm by the board quality and the valuation of a firm by the stock market (H1). Additionally, this paper finds that accounting measures of firm performance are a better predictor of CEO turnover than financial measures of firm performance (H3). These findings are particularly strong for Korean firms in non-business sample group. Finally, this paper finds a negative relationship between a firm’s board quality rank and a CEO’s tenure after controlling for board structure and the persistence of board independence (H2). However, similar results are not found for business group related Korean firms. Additionally, accounting measures of firm performance are a better predictor of CEO turnover than financial measures of firm performance when there is no financial subsidiary within the business group. The contribution of this paper is as follows. First, this is the first paper to investigate the empirical predictions of the bargaining model of corporate governance in Korea. In Korea, there are institutional difference from developed market, e.g. weak monitoring role and true independence of outside directors, and regulation imposing mandatory outside director ratios depending on the size of assets. Despite the difference, this paper adds an empirical evidence that supports prediction by Hermalin and Weisbach (1998). Additionally, this paper could also apply to U.S. firms under similar restrictions as in Korea.