Executive Gatekeepers: Useful and Divertible Governance?

In our paper, Executive Gatekeepers: Useful and Divertible Governance?, which was recently made publicly available on SSRN, we study the role of executive gatekeepers in preventing governance failures, and the counter-incentive effects created by equity compensation. Specifically, we examine the following two questions. First, do executive gatekeepers actually improve governance in the average firm? Second, does the effectiveness of gatekeepers in ensuring compliance and/or reducing corporate misconduct depend on their incentive contracts?

The phrase “corporate gatekeeper” typically triggers thoughts of external agents—auditors, analysts, credit rating agencies, and the like. Coffee (2006) lays out three criteria that define a gatekeeper as an independent professional who: (1) acts as reputational intermediary between the corporation and investors, (2) is positioned to prevent wrongdoing, and (3) is susceptible to significant reputational capital to depreciation or depletion if he or she were found to have condoned wrongdoing. Coffee then continues to criticize the conflicts created by gatekeeping and compensation. By the definition above, it is not even clear that internal gatekeeping is at all possible. Internal gatekeepers are not independent, and they are certainly paid by those who they should be gatekeeping. In fact, internal gatekeeping has crept further and further into everyday corporate decision-making as a reaction to a series of pressures—the hostile takeovers of the 1980s, the scandals and subsequent Sarbanes-Oxley legislation of the 2000s, Dodd-Frank, and now shareholder activism.

Regarding the first question of how gatekeepers in the executive suite impact governance, we find that their presence significantly reduces a variety of types of fraud. Regulatory compliance failures (AAER frauds and insider trading profitability) drop to negligible levels. Frauds scores, which are the least evidence-driven measure of fraud monitoring of our measures, drop by a smaller 9 percent. And securities class action suits, which are in-between combination of compliance and verbal misrepresentation or omission of information, fall by 43 percent. Following the literature starting with Bertrand and Schoar (2003), we find that general counsel fixed effects explain an additional 3 percent to 12 percent of the variation in the governance failures, especially with regard to compliance.

Regarding our second question, we again consider the hiring of gatekeepers, but we assert that executive gatekeepers hired from law firms, as opposed to being hired from other companies, are initially less likely to alter their lawyering behavior (gatekeeping) as a reaction to equity incentives. The logic is as follows: law firm lawyers (i) have their entire reputational capital built on their successful careers as effective lawyers, (ii) have the habit of being a lawyer, and (iii) are not yet skilled in value-creation. Most law firm lawyers arriving in the executive suite have never before been exposed to equity incentives with payoffs tied to outcomes unrelated (or not closely related) to legal milestones.

Using this identification strategy, we find equity incentives increase the likelihood of class action lawsuits, uncaught fraud, and option backdating. In particular, a one standard deviation increase in the sensitivity of general counsel’s wealth to a one percent change in stock price (the compensation “delta”) unwinds 82 percent of the governance improvements in terms of avoiding securities fraud associated with hiring an executive gatekeeper. In terms of uncaught financial misrepresentation, we find that the gatekeeper unwinds 18 percent of governance improvements. We also find evidence that equity incentives hinder backdating prevention. Conversely, we find no effect of equity incentives on AAER fraud and insider trading profits. Executive gatekeepers do not get distracted from frauds associated with regulatory compliance where they are most exposed in personal liability and reputation. Rather, equity incentives divert attention from monitoring for corporate malfeasance in arenas where fraud is harder to prove (e.g., misleading communication and accruals). For validation of our results, we look for evidence consistent with the idea that general counsels exert effort elsewhere as a reflection of equity incentives. Using the same identification assumption, we find that equity incentives are associated with increases in investments in organic growth and R&D by 5 percent and 7 percent, respectively.

We do not take the strong stance that it is the intent of compensation packages to change the rigor of gatekeeping as suggested by Coffee (2006). Rather, in our view, the board views the general counsel’s job as one of balancing time in adding expertise to strategic issues with their lawyer-like need to monitor, all of which is a secondary priority to compliance. Our inference leaves one alternative interpretation as a possibility. It may be that some firms hiring executive lawyers from other corporations hire them partially as gatekeepers and partially as strategy officers in the world of increasing need for intellectual property strategy and planning. Our specification tests suggest that this is not the case. Nevertheless, even if so, the gatekeepers may only be totems of governance, while firms divert their duties to other value-creating activities.

The full paper is available for download here.