The Dark Side of Outside Directors

In the paper, The Dark Side of Outside Directors: Do They Quit When They are Most Needed? which was recently made publicly available on SSRN, my co-authors (Rüdiger Fahlenbrach from the Ecole Polytechnique Fédérale de Lausanne and the Swiss Finance Institute and Angie Low from the Nanyang Technological University) and I focus on a cost of board independence that has not received attention so far and demonstrate that it is economically significant. Corporate governance reforms following the corporate scandals of the turn of the century focused heavily on increasing the representation of outside directors on boards. Listing standards on U.S. exchanges were changed to require boards to have a majority of outside directors. Many countries have introduced requirements on the percentage of outside directors on boards as well as on the fraction of outside directors on the nominating committee, compensation committee, and audit committee (see IOSCO (2007)).

Although governance activists have been strong proponents of having more outside directors on boards, the theoretical and empirical academic literature has been more ambiguous. The theoretical literature points to costs and benefits of having more outside directors on the board. In particular, outside directors may have weaker incentives to expend effort, may have higher information acquisition costs, and may be more dependent on the CEO for their information. Recent empirical papers on the structure and role of the board of directors have found evidence that firms structure their boards according to their monitoring and advising needs and take the costs and benefits of outside directors into account.

Outside directors have incentives to quit to protect their reputation or to avoid increases in their workload when the firm on whose board they sit is likely to experience a tough time either because of poor performance or because of disclosure of adverse actions. We call these incentives the dark side of outside directors. Our evidence shows that following surprise outside director departures, affected firms have worse stock performance, worse accounting performance, a greater likelihood of an extreme negative return, a greater likelihood of a restatement, and a greater likelihood of being sued by their shareholders. These results provide further evidence that increasing board independence has costs as well as benefits.

The full paper is available for download here.