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Director Interlocks and Organizational Similarity: an analysis of similarities in CEO remuneration, corporate governance and sustainability reporting practices

in Singapore Yue Dong

Abstract: In this study, we are adopting a social network approach to study the effect of the interlocking directorate network on the amount a firm pays its CEO, its adoption of good corporate governance, as well as its initiatives on voluntary sustainability reporting. The explicit decision I focus on is the level of remuneration packages CEOs receive in 461local SGX-listed firms, the choice and type of firms corporate governance and sustainability reporting practices, and how social interaction between firms board of directors influence the decision. We argue that the CEO remuneration patterns, CG practices and SR initiatives of two firms will be more similar if the two firms decision-makers belong to the same social network.
Keywords: Director Interlock, CEO Remuneration, Corporate Governance, Sustainability Reporting

1. Introduction Social Network Theory & Director Interlock Social network theory dates back to the 1960s, when psychologist Stanley Milgram introduced a famous six degress of sepreation (Dunbar, 2010). He showed that any two persons in the world would be connected via six successive acquaintances. This theory has been tested and applied by researchers in many areas such as business and management. Some researchers attempted to

explain the continued existence of corporate interlocking by its practical functions (Ong, et al., 2003). A social network perspective argues that managerial actions are embedded in social structures (Granovetter, 1985). These social structures or networks, such as board appointment in other firms, allow key decision-makers to share knowledge and eventually exert certain influence on corporate decisions. (Gelekanycz and Hambrick, 1997; and Westphal et al., 2001). Sandell (2002) argues that information about different social networks can supplement more economically based explanations of organizational conducts, and social embeddedness is a factor that has to be taken seriously at explaining the rationale for a firms conduct in a group of firms belonging to the same system. Those corporate conducts that have been studied include multidivisional organizational structure, donations to nonprofit organizations, accounting decision to expense stock options, and adoption of a poison pill approach to hostile corporate takeovers, etc (Davis and Greve, 1997; Kang and Tan, 2008; Westphal et al., 2001). These researchers believe that organizational practices diffuse within a director interlock because directors, through their multiple appointments in various organizations, learn about the merits and appropriateness of different corporate practices and develop preferences for certain practice. (Westphal et al., 2001). Two firms are said to be connected by a director interlock when a person affiliated with one firm sits on the corporate board of the other firm (Mizruchi,1996). Director interlock could take several forms. For instance, Geletkanycz and Hambrick (1997) found that conformity of business strategies across firms connected by director interlocks depends on whether these interlocks depend on whether such interlocks are created by inside directors (executive directors) or outside directors (non-executives). Also Phan, et, al. (2003) studied the prevalence of intra-industry interlocks and inter-industry interlocks in Singapore, and found that intra-industry and regulatory

agency interlocks accord more benefits to the individual director. Interlocks can also be created through direct director interlocks or indirect director interlocks. Direct interlocks occur when two individuals, A and B, from two different companies simultaneously sit on each others board. Indirect interlock, on the other hand, occurs when A and B sit on the board of a third company, X. The companies of A and B are said to have an indirect interlock though a third firm, X (Phan, et al., 2003). In this proposed study, we focus on the distinction between direct and indirect director interlocks. Because direct interlocks of directors seem to suggest more communication channels and potentially strong ties between directors, as compared to indirect interlocks, we posit that firms connected by direct director interlocks are more likely to adopt similar organizational practices than those formed only by indirect director interlocks. Collectivism & Director Interlock in Singapore Collectivism versus individualism is one of Hofstedes (1984) five dimensions of cultures. For Hofstede, the collectivism individualism dimension refers to the extent to which a society is a loosely knit social framework in which people primarily operate as individuals or in their families instead of a tight network in which people primarily operate as in groups and out groups. In Hofstedes survey, Singapore ranked low in individualism, suggesting a high collectivism culture in the Asian emerging market. In fact, all Chinese-majority countries (i.e. Taiwan, Hong Kong, and Singapore) score considerably lower on individualism than the countries of the western world. To date considerable empirical research on director interlock have been conducted in the Western context, however there is a dearth of studies that have examined the extent and/or

structure of interlocking directorate in Asian countries. Given the high level of collectivism in the Asian countries, the importance of the role played by board interlocks should not be ignored. To build on the previous studies on interlocks in Singapore, this paper investigates the extent to which these interlocks have an influence on various corporate practices. The organizational practices this paper focuses on are CEO remuneration, sustainability reporting and voluntary corporate governance conduct. CEO remuneration The business press and the academic literature have debated the topic of increasing large chief executive officer (CEO) salaries for many years, with a majority of writings calling CEO pay unfair relative to the average worker. (Bebchuk and Fried, 2004; Fong, 2010). According to executive compensation research firm Euilar, S&P 500 chief executives last year received median pay packages of US$7.5 million. By comparison, official statistics show the average private sector employee was paid just over $40,000. To address the public anger at the increasing income disparity, a Dodd-Frank act will include a provision that requires U.S. companies to disclose regularly the ratio of the median annual pay of all their employees to that of their chief executive. In the context of Singapore, the handsome remuneration packages paid to executive officers have also been a touchy topic for the past few years. In 2009, CapitaLand's CEO Liew Mun Leong earned a record $20 million bonus, which received much local media attention and public anger. Given Singapores ever-increasing importance as a global financial hub, coupled with the fact that its corporate policies closely follow the trends in the U.S. and U.K., similar regulatory changes in Singapore is very likely.

So far most studies on CEO remuneration has been from the economic perspectives, and the best documented empirical finding in the CEO compensation literature is the consistency of the relation between CEO pay and company size. Since 1990s, corporate governance practices have received increased attention and all publicly listed firms (in Singapore) are required to set up remuneration committee (RC) to design firm-specific executive compensation strategies that align with corporate strategy. As RCs are made up of board of directors of the firms, we draw on earlier work that explored social influence among board of directors to assess how director interlocks can lead to similarity in CEO remuneration. One similar study by Sandell (2002), whose research focus was chairperson remuneration, found that firms with director interlocks showed a significant tendency to compensate chairpersons at a similar level, while the effect of regional and industrial proximity is negligible. Based on the above, together with social network theory, we form the following hypotheses: H1a: Firms with direct director interlocks are more likely to compensate their CEOs similarly than firms without director interlocks. H1b: Firms with indirect director interlocks are more likely to compensate their CEOs similarly than firms without director interlocks. H1c: Firms with direct director interlocks show stronger similarity in their CEO remunerations than firms with indirect director interlocks. Corporate Governance Being one of the leading financial hubs, Singapores corporate governance system evolves along the lines similar to those of the U.S. and U.K. (Jensen and Ruback, 1983). In the post Asian crisis era, corporate governance evolved rapidly towards the standards promulgated by the

Organization for Economic cooperation and Development (OECD) in 2000 (Phan and Yoshikawa, 2003). Both Singaporean regulatory authorities and business corporations are facing increasing pressure and challenges to practice and promote good corporate governance. Currently companies listed on Singapore Stock Exchange are governed under The Code of Corporate Governance 2005, but strict compliance with the Code is not mandatory. Companies may choose not to follow the Code requirement, with explanations have to be provided. Given the non-mandatory nature of the requirements under the Singapore Code, it seems reasonable to expect, besides the standard economic cost-benefit consideration, social influence among directors could also influence a firms decision to meet these requirements. Based on a sample of 295 listed companies in Singapore, Ong, et al. (2003) found firm size, board size, total assets, and some other economic/financial variables significantly correlate with board interlocks. Here we are interested in exploring the link between companies choice to meet these CG requirements, a non-economic variable, and director interlock, which leads to the following hypothesis: H2a: Firms that have direct director interlock with other firms that adopt corporate governance practices are likely to adopt similar practices. H2b: Firms that have indirect director interlock with other firms that adopt corporate governance practices are likely to adopt similar practices. H2c: Firms that have direct director interlock are more likely to adopt similar corporate governance practices than firms with indirect director interlocks.

Sustainability Reporting During the last decade, Sustainability Reporting (SR) has been increasingly adopted by corporations worldwide. (Lozano & Huisingh, 2010). Sometimes also labeled Corporate Social Responsibility (CSR) reporting, sustainability reporting fulfills a role in showing how companies account for their CSR, a concept that is seen to embody companies economic, legal, ethical and philanthropic responsibilities towards society in general and their range of stakeholders in particular (Carroll, 1999; Whetten et al., 2002). A companys sustainability initiatives are usually reported as part of the companys annual reports. In its simplest form, the sustainability report or SR spells out a companys non-financial initiatives and activities. Growing concerns and interests in environmental protection and social responsibility worldwide are driving investors and other stakeholders to look beyond companies standard financial reporting to how they are managing their environmental and social impact in the conduct of their business (Sadashiv, 2010). In the past, companies mostly followed their own reporting styles. Although sustainability reporting is not yet made mandatory in Singapore, the Singapore Exchange (SGX) has always been encouraging companies to consider the adoption of SR. It has recently proposed through a policy statement that listed companies adopt sustainability reporting as part of their corporate disclosures (Sadashiv, 2010). Leaders and staff are increasingly recognizing their role and responsibilities and consequently, are engaging in voluntary actions to contribute to sustainability. Since board members are known to be eligible to sit on more than one board, it is reasonable to expect that board interlocks between firms provide valuable information about the

costs and benefits of sustainability reporting, thus influencing firms SR choices. Based on the above, we hypothesize that H3a: Firms that have direct director interlock with other firms that adopt sustainability reporting are likely to adopt similar practices. H3b: Firms that have indirect director interlock with other firms that adopt sustainability reporting practices are likely to adopt similar practices. H3c: Firms that have direct director interlock are more likely to adopt similar sustainability reporting practices than firms with indirect director interlocks. Figure 1 summarizes the above hypotheses into a conceptual diagram. Contribution This study seeks to contribute to existing literature about by highlighting the network effects on organizational decisions among publicly traded firms in Singapore. The three aspects on which we examine the social network effects are not chosen coincidentally. CEO remuneration, corporate governance and sustainability reporting have raised much controversy and sparked considerable academic interest in both local and global financial regime. To date, numerous empirical work on interlocking directorates has been conducted in the United States and to a lesser extent in Canada, Europe, and Australia. (Ong, et al. 2003). Only a handful of such studies are carried out in local context, despite the fact that collectivism is more prevalent in Asian countries, with the influence of interlocking directorate is expected to be stronger than that in Western countries. This study will fill the literature gap here.

Following the collapse of Lehman Brothers and global financial crisis, changes to the corporate governance landscape are looming on the horizon (Chan, 2010). Sustainability reporting, which has also drawn growing investor attention in Singapore, is being reviewed extensively by relevant local authorities. While many countries are setting up guidelines on the mandated reporting of sustainability disclosures, Singapore may eventually make many corporate governance requirements and SR mandatory for local listed companies as well. This study is important because currently local regulatory bodies are still facing much resistance and reluctance from firms with regard to certain corporate governance requirement changes. Knowing the importance of social embeddedness in corporate conducts, regulators could focus their efforts on increasing awareness in those directors who have appointments in multiple firms.

Figure 1. Conceptual Diagram

Direct Director Interlock H3a H1a H1b CEO Remuneration H2a Voluntary Corporate Governance Initiatives H2c: H2a > H2b H2b

Indirect Director Interlock


Voluntary Sustainability Reporting

H1c: H1a > H1b

H3c: H3a > H3b

3 Types of SR:

 Fixed Component  Variable Component  Total Remuneration

 Internal Audit Function  Existence of Independent Financial Expert  Full and Detailed 10 Disclosure of Executive Remuneration

 Separate Sustainability Report  Financial Reports with Integrated Sustainability Info  Website Disclosure of Sustainability Initiatives

2. Methods 2.1 Selection of Sample A list of listed companies on the Singapore Stock Exchage (SGX) mainboard is to be obtained. Companies listed on the mainboard have at least a five-year history of stable operations. Therefore their corporate governances are more stable, which means that board interlocks would have been formed. (Phan, et. al 2003). By January 2010, there were 774 listed companies. We exclude 313foreign listings. Each of the remaining 461 companies is treated as a separate entity. Annual reports of all firms listed under SGX are downloadable from SGX websites. From each companys 2009 annual report, the following information will be extracted: (1) (2) (3) Names of directors Industry classification Company accounting data, namely Return on Equity (ROE), Market Capitalization, Value of Total Assets (4) (5) (6) (7) (8) (9) (10) (11) (12) CEOs remuneration classification, level and mix of remuneration CEOs age and number of years with the same company Percentage of stock holdings of each of the top 20 shareholders Whether or not an Internal Audit Function is established within the firm Whether or not there is an Independent Financial Expert in the board Whether or not there is full and detailed disclosure of CEO remuneration Whether or not the firm issues a separate sustainability report Whether or not the firm issues financial reports with integrated SR info Whether or not there is website disclosure of sustainability initiatives

2.2 Design and Procedure Matched Pair Design Interlocking Pairs - Pairs of firms with interlocking directorate are to be identified and extracted. For the purpose of this study, listed subsidiaries of other listed parent companies are to be excluded from interlocking pairs. However, they could be used as control firms (see below). We define Direct interlocks as the number of individuals who sat simultaneously on the boards of firms i and j. Indirect interlocks was the number of times in which board members from firms i and j sat together on the boards of firms k, i.e. indirect interlocks exist between firm i and j. Control Pairs - For each of firms identified in the interlocking pairs, it will be matched by another firm (not in the interlocking samples) by size and industry. Inter-rater Reliability Given the complexity of this study, two raters will analyze the financial statements and use an excel spreadsheet to store their codings. Both of them will conduct analyses and prepare codings on the 50 same sets of financial statements in the beginning. Following which an inter-rater reliability test (Cohen's kappa) will be carried out. If satisfactory agreement between the two raters is achieved (say, Cohens kappa greater than 0.75), each of them will be working on different sets of statements for the remaining samples. Measures - CEO Remuneration 1)Dependent Variables Following the same methods by Sandell (2002) and Mizruchi (2002), we operationalize similarity between two firms CEO remunerations as:

Sij = -1*|( i- j | Where Sij equals similarity in CEO remunerations between firms i and j; and and
j equal


amount of remuneration received by the CEO from firm i and j, respectively. The absolute difference in CEO remuneration is multiplied by negative one to transform it into a similarity score. In this way, a high level of similarity could correspond to high values of Sij. In a typical annual report of a SGX-listed firm, directors remuneration is usually broken down into the components: Salary and Directors fees, Bonuses, Stock Options and Others. The Others include remuneration components, for instance retirement benefits, which cannot be grouped under other categories. CEOFIX represents the fixed component (Salary, Directors Fees, etc) of the remuneration package. CEOVAR represents the variable component (Stock Options, Bonuses, etc.) of the remuneration package. CEOTOT represents the total amount of the remuneration a firms CEO receives. In this study we do not study the others component for two reasons. First, companies usually do not disclose the exact amount and/or type of payment to executives allocated under this category. The second reason is the weights of others component are usually negligible (<5%). 2) Independent Variables (Firm-specific Characteristics) I measure firm size using the value of the firms total assets (TotAss) (in million Singapore Dollars). A firms performance is measured in terms of its profitability, which I define as Return on Equity. (ROE). Market values of the firms are measured in terms of market capitalization (MarCap), which is computed as the product of share price at the closing date of annual report and total number of shares outstanding on the same day. To control for the agency problem, I also measure ownership concentration (OwnCon) by Herfindahl Index = si, where si is the

percentage of equity held by each individual shareholder. To account for the effects of human capital factors, I use the age of the CEO (CEOAge) and number of years spent on the board of the current firm (CEOYr) as a measure for CEO experience. Similar to the case of independent measure, I transform all of these independent measures of two firms specific characteristics into a joint measure of similarity by using the procedure above. 3)Independent Variablie (Relational Measures) Two relational measures, director interlock and competitive relationship, are used in the study. As mentioned above, Direct interlocks (DirInt) as the number of individuals who sat simultaneously on the boards of firms i and j. Indirect interlocks (IndInt) was the number of times in which board members from firms i and j sat together on the boards of firms k, i.e. indirect interlocks exist between firm i and j. A dummy variable is created to measure the competitive relationship between two firms. The dummy variable is coded as 1 (one) if two organizations operate in the same industry, and 0 (zero) otherwise. Measures - Corporate Governance (CG) Measures of CG practices are: internal audit function, independent financial expert, and full and detailed disclosure of executive remunerations. These are the commonly used and easily measurable indicators for CG. Also, for the purpose of this study, these are some of the important practices recommended under Singapore Corporate Governance Code (2005). IntAud is coded as one if a firm has such function in practice, coded as zero otherwise. Similarly coding


applies to IndFin and FulDisc, which represent the existence of an independence financial expert on the firms board and full disclosure of executive remunerations, respectively. Measures - Sustainability Reporting (SR) We measure SR initiatives in terms of the three types of disclosure. SepSR is coded as one if a firm prepared a separate sustainability report for the financial year2009/2010, coded as zero otherwise. FIntSR represent financial reports with integrated sustainability information and WebSR refers to the website disclosure of sustainability initiatives. Codings for FIntSR and WebSR are the same as coding for SepSR. 3. Analyses Descriptive Statistics The mean, standard deviation and correlations among the similarity variables will be presented. Comparisons of the CG and SR practices among direct interlocking pairs, indirect interlocking pairs and control pairs will be shown in tables, with relevant histograms. Industry classifications for the interlocking firms and control firms will be tabulated as well. CEO Remuneration The random effect model regression below is used: Sij = +
ij+ ij+



Where Sij is the similarity in the CEO remuneration as defined above, describing the relationships between firms i and j, specific characteristics,
and ij is

ij is

the k variables

the k measures of simililarities in firm

are regression coefficients, i is the unit-specific residual. It


differs between is, but for any particular i, its value is constant. the usual properties.


is the ordinary residual with

The model is to be run on both interlocking and control pairs. Coefficients

and on the

regression of pairs are to be compared, with p values to be analyzed. From these coefficients we could examine the similarities in various firm-specific characteristics among interlocking firms. The Sij in CEO remuneration will be compared between interlocking and control pairs to the testing of hypotheses 1a and 1b. Results for direct interlocking firms and indirect interlocking firms will be compared for the testing of hypothesis 1c. Corporate Governance (CG) & Sustainability Reporting (SR) The number of times the same practices are observed between pairs is to be compared between 1) direct interlocking firms and control firms; 2) indirect interlocking firms and control firms; and 3) direct interlocking firms and indirect interlocking firms. Chi-square test is appropriate for the testing of any statistical significance. 4. Discussion In this study, we seek to identify if director interlocks among Singaporean firms play a part in firms decisions. Using a matched-pair design, we create pairs of firms which are interlocked by common board of directors and select another pair of firms that match the interlocking pair by size and industry as control pair. To test the effect of interlocking directorate on CEO remuneration, we adopt a random effect regression model. To test the effect of interlock on CG and SR practices, chi-square test is used. With several similar research done previously (Mizruchi & Sterns, 2002; Sandel 2002), Results are expected to be significant for CEO


remuneration (H1a, b & c) in our study. Tests for direct director interlocks are expected to show stronger significance as compared to indirect interlocks. The limitations of the proposed study are as follows: 1. Sample size is a key issue in this study. With four companies are needed in each set of pairs, a total number of 461 companies could only render a maximum of 115 valid sets of samples. 2. Double interlocks may exist for firms, i.e. both direct and indirect interlocks may exist for some pairs of firms. For the purpose of the study we do not account for the double interlocks. In the case of double interlocks only direct interlock is recorded, since direct interlock is expected to be more significant than indirect interlocks. Therefore bias may exists. With the results from this study, we wish to bring local regulators attention to the significance of interlocking phenomenon in Singapore. The regulators, such as Singapore Stock Exchange (SGX) and Securities Investors Association Singapore (SIAS), could consider focusing their educational campaign on not only individual managers, but also directors who hold appointments in multiple firms.


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