Corporate governance in Saudi Arabia focusing on the responsibility of board of directors

Corporate governance in Saudi Arabia focusing on the responsibility of board of directors

1.0 Chapter

1.1 IntroductionThe present study seeks to examine corporate governance in Saudi Arabia focusing on the responsibility of board of directors. Effective corporate governance is key in ensuring that firms utilize their limited resources in an efficient manner, protects the interests of all shareholders, makes prudent decisions and strengthens relationship with employees, suppliers, creditors, communities and all stakeholders. As noted by Rashidah,& Yaseen, (2006) good corporate governance practices is needed for attracting the more capital required for continued long-term growth of any firm.

The proposed study shall therefore attempt ton examine the role of board of directors play in corporate governance in Saudi Arabia. By studying and examining the main duties of the board of directors, the responsibilities of the board, its formation, meetings and committees, and through careful examination of the corporate governance regulations in Saudi Arabia, the study shall explore how the board of directors function and work towards implementation of corporate governance with firms operating in Saudi Arabia.

Of late, there has been increased awareness and interest of importance of corporate governance in Saudi Arabia. In the aftermath of market correction that occurred in 2006, when the Saudi Stock Market (SSM) faced a big market crash, resulting in the Capital Market Authority (CMA) to cancel the trading of these two companies Al Sanie and Saad Group. Accordingly, these events raised serious questions regarding the role of different motoring bodies such as the board of directors in protecting the interests of investors. This forced the Saudi government and market regulators to respond by directing companies to improve their corporate governance as well as undertake legal and institutional reforms. This for example, resulted in Corporate Governance Regulation (CGR) (2006), framework on corporate governance best practices to be followed by banks, and strengthening of supervisory roles within the financial sector (The World Bank, 2009). Though these measures point to the right direction, the board of directors is needed to ensure that companies are implementing these measures as demanded by the authorities and the regulatory bodies.

This study will contribute to the knowledge of corporate governance in Saudi Arabia and help companies to develop regulators in developing suitable roles for board of directors in regard to corporate governance. Therefore, the Capital Market Authority may need to improve skills and responsibilities of boards

1.2 The importance of the topic

Presently, the importance of good corporate governance is being underline by governments and regulatory bodies to avoid corporate scandals that have witnessed in several countries. Certainly, the, corporate governance is an important tool in developing and controlling business. This is underpinned by the fact that corporate governance advocates for principles like fairness to shareholders, helping immediate communities, fighting unethical conduct and encourages companies to disclose their information. Several factors also indicate that corporate governance performance is affected by internal and external systems, one of them being the board of directors. It has been observed that there is a positive relationship between the board of directors and the firm’s performance.

Saudi Arabia like many other economies is going through increase market activities that are putting a lot of pressure for companies operating within the country to enhance their corporate governance practices. Owing to this, board of directors has a duty to ensure that corporate implement effective corporate governance practices. It is against this understood that it has become important to study the responsibility of the board of directors in corporate governance in Saudi Arabia.

1.3 Problem of study

This research study aims at analyzing the responsibility of board of directors in corporate governance in Saudi Arabia. As stated in the introduction part, Saudi Arabia in the recent past faced extraordinary stock market crash in 2006 that brought to the core the important role played by corporate governance (Al-Matari, 2012). However, there has been little research on the responsibility of the board of directors in corporate governance in Saudi Arabia. The effectiveness and efficiency of board or directors in performing the oversight role in corporate governance is expressed in different terms like composition and size. However, studies have varied on the which factors create an effective board of directors that can be used to ensure that an organization adopts corporate governance practices that will result in positive performance of the organization. This creates the need to analyze the responsibility of board of directors in corporate governance in Saudi Arabia.

1.4 Study Questions

The study questions for this research have been selected with the objective of understanding the role of the board of directors in corporate governance. This implies that each research question will be further expanded in subsequent chapters of the study. This further examination of the study questions will help in answering the present research question concerning the responsibility of Board of directors in corporate governance in Saudi Arabia. To achieve this aim the following research questions have formulated.

What are corporate governance practices in Saudi Arabia?

What are the responsibilities of board of directors in corporate governance in Saudi Arabia?

What is the improvement required on corporate governance provisions in regard to the responsibilities of the board of directors?

To answer the questions above, the main broad objective of the research study is to investigate corporate governance in Saudi Arabia and its relationship with board of directors. Alongside this broad objective the following specific objectives are also significant to the study:

to investigate the relationship between board size and firm performance in Saudi Arabia

To investigate the relationship between the independence of the audit committee and firm performance

To investigate how frequency of meetings affects firm performance

1.5 The reasons for choosing the topic

The current topic has been selected because Saudi Arabia as an emerging economy is facing increased interest to improve its corporate governance. This is because good and effective corporate governance will reduce the vulnerability of the Saudi stock market; enhance the property rights and lower transactions costs. In addition, strong corporate governance increases the investor confidence within the markets. However, the board of directors has a big responsibility in success of corporate governance. This research is interested in understanding the responsibilities of board of directors in relation to corporate governance. Understanding these responsibilities will assist in formulating strategies to improve oversight work of the board of directors regarding corporate governance.

1.6 The Structure of the Study

The dissertation is arranged in 5 chapters as underlined below

Chapter 1: Introduction: this chapter opens the with research paper by providing the background information of the dissertation, outlining the importance of the topic, pproblem of study, study questions and T reasons for choosing the topic.

Chapter 2: the literature review: this reviews the past literature on corporate governance and role of the board of directors in Saudi Arabia.

Chapter 3: methodology: this chapter describes the research methodology, instruments and techniques adopted by this dissertation to gather and analyze the data.

Chapter 4: data analysis: Describes both qualitative and quantitative techniques to be used in presenting and interpretation of the data in graphical forms and explains the findings.

Chapter 5: Conclusions, Recommendations: This is the final chapter, it summarizes the findings in each of the chapters as a conclusion, and offers recommendation based on the findings of the present research.

Literature review

Background of Corporate governance in Saudi Arabia

Corporate governance in Saudi Arabia was entrenched in 1985, when the ministry of commerce and industry enacted the disclosure and transparency standard. Al-Mulhem (1997) explains that corporate governance was strengthened in Saudi Arabia through this standard, owing to the fact that disclosure and transparency is viewed as one of core factor of corporate governance best practice. Al-Mulhem (1997) restates that the enactment f this standard in Saudi Arabia was an important decision that enhanced accounting and reporting in the country. Before, 1985, disclosure requirements in Saudi Arabia were awfully low. Advancement in corporate governance was made in 2006, when developed code of corporate governance. This code was developed to harmonize the standards of Saudi Arabia with international standards of corporate governance for example, the OECD code. The Saudi Arabia code of corporate governance comprises of three sections, Al-Janadi, et al (2013, 26) names them as “the rights of shareholders, the general assembly, disclosure and transparency and board of directors”.

Board independence

Past empirical studies have found a positive relationship between board independence and corporate voluntary disclosure. One such study was carried out by Forker (1992), which found a positive relationship between the number of external directors on the boards and comprehensiveness of the financial disclosure given. Similar findings have been reported by Laksamana (2008); Boesso and Kumar (2007) and Arcay & Vazquez (2005). Some studies have attempted to explain this positive relationship. For instance, Klein (2002); Beasley (1996) both established that the possibility of corporate managers to manage earning and engage in fraud is reduced when the number of non-executive directors on board is high. More so, Gul and Leng (2004) assert that a larger number of independent directors enhance the role board monitoring and increases the degree of corporate transparency.

On the contra, some empirical studies have found a negative relationship between external directors on boards and the degree of voluntary disclosure. For example,

Eng and Mak (2003) and Hoitash, et al (2009) found this negative relationship. similarly some studies such as Ho and Wong, (2001); Haniffa and Cooke, (2002)have found insignificant difference between independence of boards and voluntary disclosure.

According to Rashidah, and Yaseen, (2006) the board independence indicates the level of the independence of the board from the management of the company. The independence depends on the number of external board directors. Al-Matari et al (2012) note that including independent external directors is a critical tool to help the board of directors in overseeing the activities of the management of the company. Abbott et al (2004) explain that the OECD code of corporate governance (2004) outlines that independent board members have the ability to contribute considerably to the decisions taken by the board. Independent board directors are thought to be more objective in examining the performance of the management. More so, these independent directors play a crucial function in areas where the varying interests of the management, the shareholders and the company may differ, for example on succession, corporate control, audit function and executive remuneration.

Understanding that significance of having a high number of independent directors on the board of directors is important for a company. Indeed, as stated before, a numbers of researchers have found a positive link between board independence and shareholder interest. In addition, the proportion of independent or external directors on the board is usually used to assess the board independence. According to Al-Matari et al (2012) past findings have consistently reported that the number of independent directly has a positive relationship with the monitoring and financial reports. Instance, Beekes et al., (2004) in their study found that companies with a comparatively high percentage of external directors on the board, increased the conservativeness of these boards. Similar findings have been reported by Kiel and Nicholson (2003) who investigated the link between board demographics and corporate performance in selected Australian big public traded companies. Their study also revealed that there exists a positive link between the number of external directors and the performance of the company.

The size of the Board of Directors

The board of directors is responsible for overseeing the operations of the organization on behalf of the shareholders. The size of the board of directors therefore its effectiveness has drawn a lot of argument among various scholars. When talking of the board of directors of a given company, reference is made to the total number of directors who constitute the board. In this perspective and basing on the number of directors who sit in the board, there could be a small or large board of a company. A lot of contrast has existed among various researches who have studied the effectiveness of both small and large boards of directors in minimizing the agency costs of their companies as well as the suitability of their management practices.

Board size

Researchers on one side have argued that larger boards are effective when it comes to safeguarding the interests of the shareholders because the large boards varied expertise in addition to a wide range of experience which constitutes the some of the greatest assets in the synergistic governance by the board. Additionally, a large board is powerful and this is vital when it comes to advising and counseling on strategic options of the firm. Some writers such as Abdul Rahman and Ali (2006) as well as Zahra and Pearce (1989) have argued that having a large board is crucial because it helps create corporate identity as well as strengthening the link between the environment and the firm. To further support this stand, Forbes and Milliken (1999) have argued that the size of the board has a bearing on its effectiveness. For instance, they say that for a large board a wide range of skills and knowledge is at their disposal. Additionally, cognitive conflict is enhanced by the huge perspective assembled by a large board. According to Pfeffer (1972) the resource dependency theory points to the fact that the variety of knowledge present in large boards is crucial for resource management.

On the contrary some scholars have strongly advocated for a smaller board of directors citing various reasons. First of all, such researchers have criticized the credibility of large boards by saying that a larger number of directors frustrate decision making, coordination and communication as these processes become increasingly complex in the large boards. Again, in large boards it is argued that coordination of the various contributions of group members is very difficult. Proponents of this idea point to the fact that when the board is large, effective utilization of skills and knowledge is also difficult. Large boards are criticized on the basis that building trust, having strong cohesion, maintaining norms, building and maintaining trust and personal relationships is a daunting task. According to Lipton and Lorsch (1992) a large board is dysfunctional because it is easier for top managers to control the large board that does not realistically criticize the management decisions.

After analyzing various views on the size of the board, Abdellatif (2009) came to a conclusion that the performance of a corporation was negatively related to the size of the board but the size of the board was positively related to the value of the firm. The scholar also said that large boards did not necessarily add value or influence the value of accounting information. Supporters of a small board say that contradiction in objectives of the firm does not exist. Various reports and committees best practices in corporate governance supports small sizes of the boards of directors. For instance the Hampel Report (1998), Saudi Code of Corporate Governance (2006) and the Malaysian Code on Corporate Governance (2000, Revised 2007) support a smaller size of the board. Studies by Byard, Lin and Weintrop (2006), Yermack (1996) and Vafeas (2000) have found an association between disclosure and board size. The small size of the board therefore aids in quality management and better disclosure.

Board Member Perspective

There may be a difficulty in pinning a responsibility or accountability to the board of governors without understanding the role this board plays in terms of each board member or based on the role generally assigned to each board member. While members of the board may be appointed based on the individual’s expertise, the members have to understand that the authority they have is not exercisable collectively (Al-Matari et al 2012). According to the Saudi Arabia regulations on corporate governance (2011), there are rules and standards that control the management of joint stock companies that are listed on the Saudi Stock Exchange to guarantee that there is compliance with the best practices in governance to ensure that the rights of stakeholders are protected. According to the regulations, the board of directors is responsible for approving the corporate body’s strategic plans and key objectives. Besides this, the board of directors is also responsible for supervision of their implementation. As is evident, this mandate implies that the board of directors is answerable if and when the company’s strategic plans and objectives are not steering the company in the right direction. By and large, the board is thus culpable when a corporate body fails because it has an approval and a supervisory role in the formulation and implementation of the strategic plans as well as the objectives. Among the roles and functions of the board mandated by the Saudi Arabia corporate governance regulations, the board must lay down a comprehensive plan for the corporate body or company, detailing the main work plan and the strategy regarding management of any risk, review and revision of such policy. Determination of capital structure is also part of what the board is mandated to take care of and this includes establishing the accompanying financial objectives and then approval of annual budgets. This aspect of the role of board of governors shows that even financial failure of the corporate body shall ultimately cast culpability on the board. Coupled with the fact that another regulation (Corporate Governance Regulation 1(2) 2011) mandates the board of governors to supervise the main capital expenses and the acquisition or disposal of assets implies that almost everything that happens in the corporate body is in the limelight of the board and it is culpable when almost anything goes bad.

Audit Committee Variables

Independence of Audit Committee and Firm Performance

There are a number of factors that are related to the audit committee and which have a direct impact on the firm performance. Past studies have delved into investigating the impact of various audit committee variables on firm performance. For instance, the study by Chan and Li (2008) brought out the empirical result of the relationship that exists between audit committee independence and firm performance though the results generally showed that it is ambiguous. In the same study, Chan and Li (2008) established that autonomy of the audit committee such that there are at least 50% of expert-independent directors perform on audit committee has a positive impact on the performance of the firm based on the measurement of Tobin’s Q. in a similar light, the study by Ilona, (2008) established that there is a positive correlation between audit committee independence and performance of the firm performance when analyzed from the Return on Assets (ROA) basis.

Additionally, Erickson et al (2005) contended that independent directors can lessen agency problems. Founded on the contention provided by Erickson et al (2005) that the independence of a firm’s directors can help in reducing the agency problem, it can equally be argued that independence of audit committee can also help in reducing the agency problems. What this means is that a positive relationship between the independence of audit committee and firm performance is not only expected but also justified. Following from the above contention with reference to the agency theory, it is possible to empirically test the hypothesis that there is a positive correlation between the autonomy of the audit committee members and firm performance.

Audit committee meeting and Firm Performance

The frequency which members of the audit committee hold meetings should be considered to be an imperative attribute for the monitoring effectiveness of the audit committee (Lin et al 2006). In another study, Anderson et al (2004) argued that audit committee supervises the internal control and supplies steadfast information to the shareholders. For that reason, according to Hsu (2007) audit committee reinforces the internal auditing function and watches over management’s evaluation of business risk.

Xie et al (2003) add that the frequency of audit committee meetings is deemed as a surrogate for audit committee function.

The point by Xie et al (2003) as noted above therefore implies that the audit committee that meets more regularly with the internal auditors has better information about issues that relate to auditing and accounting. When a significant auditing or accounting concern comes up, the audit committee can direct the appropriate level of internal audit function to deal with the problem without delay. As a consequence, an audit committee that conducts meetings frequently can mitigate the likelihood of financial fraud in the firm (Abbott et al 2004). Audit committees that essentially inactive and which conduct with smaller number of meetings are not likely to effectively take charge of management. In a study conducted by Beasley et al (2000), the authors found that fraudulent companies with corrupted earnings and financial reports have smaller number of audit committee conventions than firms that do not experience such fraudulent cases such as misstatement of earnings. An audit committee that regularly conducts meetings has sufficient time to supervise the financial reporting practice, detect and ascertain management risk and monitor internal controls. Accordingly, firm performance strengthens with audit committee activity. More outstandingly, there have not been many studies that have focused on examining the impact of audit committee meeting on performance of the firm performance. As a point of illustration, Hsu (2007) established that audit committee meeting has appositive relationship with firm performance. This implies that on the basis of investig7ation into the subject of audit committee meetings, it is justifiable to empirically test the hypothesis that the frequency of audit committee meeting has a positive correlation with firm performance.

Audit Committee Size and Firm Performance

Another variable that relates to audit committee is its size and this is a relevant characteristic regarded as being relevant to the successful discharge of its duties (Al-Matari et al 2012). According to assessment done by Al-Matari et al (2012) it is generally proposed that an audit committee should have a minimum of three audit committee directors; and among the corporate governance reports that recommend this include the Capital Markets Authority and the New York Stocks Exchange. These recommendations not only provide evidence of the significant role the size of the audit committee plays but also points to the significance of the main argument behind audit committee size, which holds that a bigger committee size has superior organizational standing and authority (Al-Matari et al 2012) and an extensive knowledge base (Karamanou & Vafeas, 2005). Nevertheless, an audit committee can experience process losses and dilution or dispersal of responsibility if it becomes extremely. Similarly, just as the previous hypotheses that have been fronted for investigation and testing, the aspect of audit committee size can also be empirically investigated by testing the hypothesis that the size of the audit committee has a positive correlation with firm performance.

Research Method and the Study Models

This research undertaking only focuses on the listed companies in Saudi Arabia, without including financial companies at the end of the year 2010. The total number of companies in Saudi Stock Market (TADWAUL) is 176 companies at the end of the year 2010.

Quantitative Research Design

This study applies quantitative research approach. This is what can also be referred to as the research design in the study. Creswell (2003) offers an explanation of research design by observing that research design is a framework that guides the researcher in carrying out the study. They go on to state that research design links the research questions to the data collected. There are several research designs that a study can employ, these designs are grouped based on their logic, results, process and objective of the study. It is also possible to describe a single project using different ways.

One of the research designs is quantitative research which is used to measure individuals, cases or units and evaluate limited aspects using numbers. On the other hand, qualitative research normally entails qualitative data and assesses a lot of aspects of a small population of cases over a short or long time and explains those aspects. Similarly, a researcher can use a mixed approach where he combines both quantitative and qualitative research methods.

Accordingly, this can be observed in the present research in that element of qualitative; however small or minute, mixed with the quantitative aspects boil up to applied a mixed research design. In addition, Creswell (2009) provides support for this notion by noting that that approach helps the researcher to get better results since the each design complement another. As observed Creswell and Plano-Clark (2011), the mixed approach provides better insights in the aspect being researched. However, while the research basically focuses on quantitative approach as the most preferred strategy, it would not go without realizing the advantages of the approach by comparing it with the aspects of the sister approach: the qualitative approach. Creswell (2009) provides a good starting point on the basis of giving the merit of the qualitative study by opining that qualitative method provides verbal data instead of numerical values which means that qualitative method does not use statistical analysis, but rather uses content analysis to describe and understand the research findings. Following this reasoning and understanding, it implies that to use the qualitative method, a research employs inductive reasoning and not deductive. Creswell (2009) turns to the quantitative methodology and explains that the key aspect projected through quantitative methods is the validity of the measurement and its reliability. Using these two aspects, the researcher can generalize the findings and have a clear predication of the cause and effect. This explanation shows how generalization is an important strength that is keenly put into account in the case where quantitative approach is used.

Philosophical Basis for Research DesignRationale for choice of quantitative bias in approach mixed method design as the best research design for the study was arrived at based on several aspects of the research study that call for a mixed methodology approach in order to be effective. First off, the study encompasses multilevel perspectives that that are intended to solve research questions that require real-life contextual understandings. For this to be achieved effectively, Creswell (2003) admonitions that a quantitative method approach is essential to ensure that the advantages of employing quantitative research are of benefit to the study. The first advantage comes from the fact that quantitative rese4arch approach employs prescribed procedures that make it more standard and can be replicated easily under similar circumstances. When analyzed on the perspective, this point basically implies that quantitative research commands better grounds on the basis of generalizability. The quantitative approach allows for a broader study approach to be carried thereby enhancing the generalization of results and it also brings the researcher to the platform of using and building upon good data collection methods such as standardized methods such as in-depth interviews and survey questionnaires. Creswell (2003) further points out that taking the quantitative method approach enables the research study to draw from the strengths of the quantitative that relate to avoiding bias in the study. Using quantitative approach helps in avoiding personal bias that can jeopardize reliability (Creswell 2009). Quantitative research also allows for greater objectivity and accuracy of results and these are important when considering the validity and reliability.

In addition to the philosophical bases provided above for choice of research design, there is yet another basis for the choice of quantitative methodology approach as identified by Greene (2007). Greene points out that generally researchers and investigators collect diverse types of data and these will ultimately need to be quantitatively analyzed in order to make sense in terms of decision making (Greene 2007).

Quantitative Data Analysis

According to Creswell and Plano Clark (2011) there are about four issues in quantitative research method and they mainly concern the quantitative data analysis. The first is the aspect dealing with hypotheses, and then there is causality, generalizability and reliability. The authors point out that since quantitative research is often concerned with establishing evidence to either concur with or contradict a formulated hypothesis or a held idea; hypothesis testing is a very essential part of the entire quantitative research. Formulating hypotheses for testing starts with formulation of two hypotheses where the null hypothesis forms the backbone of what is being tested since it is the one that indicates no change and it is the one to be rejected or accepted (Gupta 2011). Hewitt and Cramer (2007) add that the formulation of null hypothesis provides good basis for selecting a sample from which evidence is sought to support the null hypothesis or if it does not support the null hypothesis then it supports the alternative hypothesis. The alternative hypothesis is basically the experimental hypothesis that allows the researcher to have an alternative option for decision making when the null hypothesis is rejected. The other issue that quantitative research has to take care of is the causality and this is essentially concerned with cause and effect hence it ensures that the researcher clearly identifies the independent and dependent variables correctly. Gupta (2011) explains that independent factor in research study is the variable that is deliberately manipulated to determine what effect it has on another variable while the dependent variable is the one that the researcher measures to find out the effect of the independent factor. In this study, the dependent variable is “firm performance” and it shall be evaluated on the basis the company’s To