The Impact of Financial Performance and Governance to the Board of Directors Replacement ( Empirical Study on State Own Companies in Indonesia

On of the implication of weak corporate governance may usually be measured from the low sensitivity of management to the company's performance or maintaining management with low performance. This paper is aimed to assess the influence of companies performance and governance to a normal or abnormal replacement of board of directors (turnover) at state own companies in Indonesia. This paper would investigate at the internal corporate governance mechanism which represented by the independent board of directors and external corporate governance would be represented by a political interest and leverage. The paper confirm two issues. First, that a company's performance influence the consideration in determining the board replacement. Second, there has been no proof that management entrenchment at state own companies influence the board replacement. The research shows the shareholders use return on asset/sales as a performance measurement considered prior the replacement of board member. The higher return on sales, the greater possibility the board replacement would be done on a normal turnover. Background Good corporate governance (GCG) aims to encourage the optimum allocation of resources. For the state own enterprise, GCG will give benefit to the shareholder but also useful for public and national economic. One of the implications of the implementation of the weak corporate governance is measured from the low sensitivity of the performance to the management turnover. Volpin (2002) found that there is a low sensitivity on the replacement of the management of the company's performance in Italy. However, Firth, Fung and Rui (2005) in research on state-owned company in China in the period 19982002 (a state that have low application of the regulation and corporate governance), does not find management entrenchment and high of replacement management happen to low performance companies. In state-owned in Indonesia, there are two different character, namely corporate and bureaucratic character of closely related with the political and regulations. The two characters cause potential conflict of interest in state-owned. Shareholder general meeting is held by Minister of State-Owned Enterprises, which represents the government as shareholder in state-owned and have highest authority in all powers that are not submitted to the directors or commissioners (Article 1 paragraph 5 and 13 Law No.19 of 2003: State on Enterprise Act). Many of the research explain that the political and regulatory environment significantly affects the management system of company. Regulation should be able to improve on the company's governance, because of a more strict supervision. However, Darmawati (2006) found that the implementation of GCG in the listed state-owned are weaker compared with non state-owned companies. Results of this research is supported by La Porta et al. (1999) which states that there is a weak corporate governance in countries that have weak law enforcement and less legal protection to the investors. Research on the implementation of GCG in the state-owned and various allegations of potential conflicts of interest around the state-owned, especially on the replacement of state-owned enterprise directors, have benefit to regulator of SOE. A little empirical research about the replacement of directors, especially directors SOEs also encourage the research. In the international perspective, there are many research that relate the replacement of directors to the company performance and governance. Directors have very important role to realize the company strategy and good corporate governance. This research will observed the influence of the company's performance and governance to the replacement of state-owned directors during the period of 2000-2005. Replacement of directors chategories to normal or not normal. Normally replacement happen when the directors end of the contract after 5 years, voluntary resignation or health reasons or other personal reasons and due to die. While not normally mean the replacement that conducted by General Meeting of Shareholders before the end of the contract. The reasons of replacement are caused of low performance, improving the performance by changing new directors or without a clear reason. Literature Review Implication of good corporate governance will increase the company performance, therefore, research on the replacement of many directors associated with the performance of the company. Wiesbach (1988) based on research in USA, states that low performance of company caused the forced turnover of director. The same result found in Australia (Suchard et al, 2001), Belgium (Renneboog, 2000), English (Dahya et al. 2002), Germany (Kaplan, 1994b) and Japan (Kang and Shivdasani, 1995). With data of 33, DeFond and Hung (2004) in the Firth, Fung and Rui (2005) find the degree of relationship between company performance and CEO compensation is greather in countries with strong law enforcement. The research use accounting profitability, stock returns and growth as a company performance measurement. Huson, Parrino and Starks (2001) in research on the company listed in Wall Street in the period 1971-1994 found that the forced turnover associated with lower performance of the company. But they found that the change of governance mechanism will stregthen the relationship between the replacement of a director with the company's performance. Ugur and Miller (2006) conducted research in the U.S. found that the relationship between the replacement of directors of the company's performance is higher in companies that are registered in more than one capital market. Agency theory holds that the management should be responsible for the performance of the company and they can be replaced if the company's low performance. Therefore, one of the most important task of the shareholders appoint and dismiss directors. Good corporate governance practise suggested that the performance of top management must be evaluated. Research on corporate governance has also identified the development of various monitoring mechanism that aims to ensure that the directors will act in accordance maximum interest of shareholders. According to Fama and Jensen (1983), there are two mechanisms, namely internal and external mechanisms. Internal mechanisms are the board of directors, stock ownership by management, executive compensation. External external mechanism are the market for corporate control, regulations, institutional ownership level and debt financing (Huson, Parrino and Starks (2001). The consideration of choosing the mechanism depends both on the economic and political development (Firth, Fung and Rui, 2005). Jensen (1983) in Huson, Parrino and Starks (2001) says that an external mechanism can work in harmony with the internal mechanisms for controlling agency costs between shareholders and directors. One approach frequently used in research to measure the effectiveness of corporate governance system is to test whether the director be replaced if the company has low performance. Company performance is a reliable measurement of effectiveness directors (Dahya, Mc.Connel and Travlos, 2002). If the company has low performance, the shareholder will make the replacement for the director to better realize the wishes of shareholders. Some international research likes Kaplan (1994b), Kang and Shivdasani (1995), Daily and Dalton (1995), Huson, Parrino and Starks (2001), Dahya , Mc.Connel and Travlos (2002) and Miller and Ugur (2006) give the evidence relation between the replacement of director and the low company performance. Simons (2000) in Jermias (2005) stated that performance measurement can indicate the effectiveness in achieving the company goals. There are two types of performance measurement that are typically used in evaluating the performance of the company, accounting based and market based measurement. Jermias (2005) stated that market performance, such as stock returns or the market value of equity, tend to be more objective. Accounting based performance tend to be controlled by managers so it considered as performance measurement. Firth, Fung and Rui (2005 ) also stated that market size is not relevant to use as a tool of performance measurement company. Researchers expect that the low performance of the company, the shareholders will make the replacement of directors before the end of contract or otherwise shareholders will retain a director until the end of the management contract. Fisrt hypothesis : The higher performance of the company, the replacement of directors occur normally. Given that most of the characteristics of state-owned shares are still owned by the state, so it difficult to get the market based return. The research use the accounting numbers as performance measurement. Accounting numbers that will be tested as a performance measurement is return on assets (ROA), return on sales (ROS) and sales growth. The ratio of return (profitability) based on operating profit, to avoid bias that often arise due to the action taking big bath which often appear in the vicinity of the replacement of directors . As part of the internal governance mechanisms, the board (commissioners and directors) are expected to perform the control function. The independence of the board of the company is expected to realize the GCG and to provide additional value for the company. However, research on the impact of board independence (commissioners and directors) to the performance of the company have results vary. Daily and Dalton (1995) states that the high proportion of outside board of a company associated with the positive performance of the company. Weisbach (1988) found that higher portion of outside directors make difficulties in decision making so the potential the replacement of directors will be higher. The second hypothesis: The higher the proportion of outside directors of company, the less likely the company is experiencin