Do Outside Directors Face Labor Market Consequences?

Steven M. Davidoff is an Associate Professor of Law and Finance at Ohio State University College of Law, Andrew Lund is an Associate Professor of Law at Pace University School of Law and Robert J. Schonlau is an Assistant Professor of Finance at Brigham Young University.

Do directors face consequences for their poor performance?  We examine this question in Do Outside Directors Face Labor Market Consequences? A Natural Experiment from the Financial Crisis, a draft of which we recently posted to the SSRN.

We theorize that the exogenous shock of the financial crisis made shareholders and regulators particularly attuned to financial firm performance. We thus use the financial crisis as a natural experiment to study labor market consequences for outside directors at banks and other financial companies. In particular, we explore the question of whether shareholders and regulators acted to penalize directors for poor firm performance during the financial crisis.

We examine 6,507 director years at bank and financial companies over the period from 2006 to 2010.  We find that outside director turnover at financial firms is negatively correlated to lagged variables for stock returns. However, the increased chance of being replaced for poor performance is only 0.99% for a one standard deviation change in performance compared to 0.59% at non-financial firms, in either case an arguably trivial amount. Instead, the biggest indicator of director turnover is wholly unrelated to firm performance: it is a director being over the age of 70, an age when many boards have mandatory retirement age. We also find that outside director pay is not correlated with firm performance. It is instead largely a function of firm size.

In addition, while we theorize that shareholders and regulators may be more proactive with respect to unseating outside directors in the wake of the financial crisis, we find little evidence of increased discipline. The average annual level of outside director turnover in the financial industry following the crisis was 6.28 percent, less than one percent higher than during the period immediately prior to the crisis. We further examine TARP recipients in particular, finding that entry into the program or delays in repayment did not negatively affect outside directors.

We draw on these empirical findings to assess current board-centered responses to the financial crisis. In the wake of the financial crisis, financial firm boards have come under heavy criticism for generally failing to spot the events leading up to the crisis. Nonetheless, the Dodd-Frank Act and other financial reform has further empowered boards in an attempt to prevent future crises from occurring. We conclude that, to the extent that financial reform is board-centered, it may be on shaky ground given the lack of negative consequences in a salient environment. In the absence of an active labor market for outside directors we find no reason to expect them to act any more effectively than they did pre-crisis.

Ultimately, our findings are grist not just for regulators but for corporate law theorists who examine the validity and effectiveness of board governance.

The full paper is available for download here.

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