Do Independent Directors Face Incentives to Monitor Executives?

Corporate directors who suspect malfeasance by managers may face conflicting incentives. On the one hand, encouraging transparency and demonstrating diligence by pressing for the investigation and disclosure of problems might be rewarded with re-election, appointment to seats on other boards, and greater shareholder support. On the other hand, revealing misconduct could draw negative attention to the company and result in worse career outcomes for directors. In Do Independent Directors Face Incentives to Monitor Executives? we empirically examine whether directors who publicly demonstrate diligent monitoring are rewarded. Our findings cast doubt on whether directors face strong incentives to monitor. Instead, our results suggest that directors sometimes benefit from looking the other way when they suspect problems.

We examine the stock options backdating scandal of 2005 to explore the effects on directors of public displays of diligent monitoring. We measure director outcomes (turnover, votes withheld, and ISS withhold recommendations) in the aftermath of the options backdating scandal and exploit two aspects of the options backdating context. First, there was a substantial lag between when the practice of backdating options largely ended (2002) and when the scandal came to public attention (2005). In the interim, a number of board seats turned over, meaning that we can identify a substantial sample of “new” directors who joined the board after backdating ceased, but before the scandal came to light. These new directors were not in a position to prevent backdating, since they weren’t on the board when it happened, but they could help manage the company’s response to the unfolding scandal. Second, it is possible to identify companies with a high likelihood of having backdated based on statistical properties of option grants. This allows us to identify firms that probably backdated but did not disclose (“probable backdaters”).

In our main tests, we compare outcomes for new directors at probable backdaters with new directors at firms that publicly announced an investigation and issued a backdating restatement. We find that new directors at restating firms bear a cost for backdating restatements, even if the backdating predates their tenure on the board, and even relative to directors at firms that do not act despite the appearance of material backdating. Comparing outcomes in the last director election before the backdating scandal (November 2005) to the first election after (June 2006), we find that new directors at restating firms were 6% more likely to lose their board seats (an increase of 50% over the unconditional rate), received 7% more votes withheld (an increase of 140%), and were 10% more likely to receive a recommendation to withhold votes from ISS (an increase of 100%), relative to directors at probable backdaters that made no disclosure.

The penalties for new directors at restating firms are greater than penalties for directors who held their seat when backdating probably occurred but whose firms do not issue a restatement. In fact, we find that some outcomes for new restating directors worse than for directors who were not only present on the board during backdating (“early” directors), but also served on the compensation committee at firms that issued a non-material “charge” related to backdating (thus confirming the presence of backdating at the firm) or even received a suspicious option grant themselves. Further, we find no differences in outcomes between early and new directors at restating firms. This suggests that the penalties new directors face at restating firms are not attributable to more egregious behavior along some unobservable dimension or simply because a restatement confirms with certainty what would otherwise be a probabilistic estimate of backdating.

Although directors at firms that investigate and restate are penalized, there is no reward for directors at firms that announce an investigation and do not restate. In fact, we find that outcomes for directors at firms that announce a backdating investigation but do not restate are not statistically different from outcomes for directors at probable backdaters. We also find that new directors at restating or investigating firms are not more likely to be rewarded with board seats at other firms. Finally, we present suggestive evidence that a similar dynamic applies to restatements outside the backdating context.

One might expect that a new director would be well-positioned to press for transparency with respect to problems that pre-dated her tenure. If she was not on the board, then she does not bear responsibility for any failures of monitoring that resulted in misstatements or other problems. But, our results suggest that, at least with respect to career incentives, new directors and early directors do not face appreciably different decision problems. A new director who anticipated the dynamics we describe above may have decided that pressing for transparency was not in her interest, as it would create a no-win situation in which any material problems brought to light would require costly disclosure, while even a publicly-announced investigation that does not result in a restatement would not improve career outcomes.

The incentives we document are consistent with at least two explanations. From a shareholders’ point of view, a desire to “clean house” after a problem may well be rational. The new directors, after all, would typically have been chosen by the early directors. Another possibility is that shareholders rely on a simple heuristic along the lines of “replace all board members after a scandal” that does not distinguish between early and new board members. But in either case, the ex post desire to have a clean slate creates ex ante incentives for new directors to avoid transparency.

The complete paper is available here.