The Labor Market for Directors, Reputational Concerns, and Externalities

In the paper, The Labor Market for Directors, Reputational Concerns, and Externalities in Corporate Governance, which was recently made publicly available on SSRN, we examine how the labor market for directors and directors’ reputational concerns affect corporate governance.

Being a director on the board of a public company is a privilege that often brings generous monetary compensation, prestige, publicity, power, and access to valuable networks. In order to retain old board seats and gain new ones, directors need to develop a reputation and prove they are a good match for other companies. However, it is not clear what reputation is “relevant” in this context. If corporate governance is strong and boards of other companies protect the interests of their shareholders, then building a reputation for being shareholder-friendly can help in obtaining more directorships. On the other hand, if corporate governance is weak and boards of other companies are captured by their managers who want to maintain power, then having a reputation for being management-friendly might be more useful. The goal of this paper is to understand how the labor market for directors and these conflicting reputational concerns affect directors’ behavior and the quality of corporate governance.

To study this question, we develop a model with three key ingredients. First, being a board member gives a director the ability to affect corporate governance in his firm and thereby change the allocation of control between management and shareholders. Second, directors’ preferences over the allocation of control, i.e., whether they are shareholder-friendly or management-friendly, are the private information of directors. Third, the allocation of control in a given firm determines, among other things, which type of directors it is looking for. In particular, companies that are controlled by shareholders (management) have a demand for shareholder-friendly (management-friendly) directors. In this setting, both the aggregate level of corporate governance and the “relevant” reputation that directors need to develop in order to gain more directorships, are endogenously determined in equilibrium.

Our main result shows that the labor market for directors and directors’ reputational concerns lead to strategic complementarity of corporate governance decisions across firms. Stronger corporate governance in one firm leads to stronger corporate governance in other firms, and vice versa. Intuitively, when corporate governance in most other firms is weak, the decision of whom to invite to the boards of these firms is controlled by managers. Thus, to increase their chances of being invited to these boards, directors have incentives to create a reputation for being management-friendly. This type of reputation can be established by transferring more control to the management of their own firms and not “rocking the boat.” Similarly, when corporate governance in most other firms is strong, directors will strengthen corporate governance of their firms and monitor the management closely in order to create a reputation for being shareholder-friendly. Overall, the labor market for directors creates externalities of corporate governance across firms.

Similar to other models with strategic complementarity, our model exhibits multiple equilibria. Thus, industries or countries with similar characteristics can have very different corporate governance systems as an equilibrium outcome. However, different from other studies with strategic complementarity, the channel through which externalities are transmitted in our model is the concern of directors for their reputation. Thus, multiple equilibria are more likely to exist when the reputation motive is stronger. We show that when reputational concerns are sufficiently strong, an equilibrium in which the labor market rewards directors for being shareholder-friendly co-exists with an equilibrium in which a management-friendly reputation is rewarded. In this respect, the aggregate quality of corporate governance is self-fulfilling.

Directors’ reputational concerns, which are the key driving force in our model, can be affected by regulations that limit the number of board seats a single director can hold or that change the value of a single directorship. We show that a policy that increases directors’ reputational concerns is a double-edged sword, whose effect crucially depends on the aggregate quality of corporate governance. Specifically, when directors become more concerned about their reputation in the labor market, corporate governance becomes even stronger in systems where shareholders have control over the nomination process and a shareholder-friendly reputation is rewarded. However, in systems where managers are in control and directors are rewarded for being management-friendly, stronger reputational concerns weaken corporate governance even further. In other words, directors’ reputational concerns amplify the aggregate level of corporate governance.

We also show that exogenous shocks to the corporate governance system are magnified due to strategic complementarity between firms. This implies that a small regulatory change, such as, for example, marginal easing of proxy access for shareholders, can have a very significant effect on the aggregate level of corporate governance. Intuitively, if shareholders can replace directors more easily, directors are more likely to promote strong corporate governance in their firms. The anticipation that other corporate boards will similarly increase their accountability to shareholders increases the relative value of building a shareholder-friendly reputation. This reinforces directors’ incentives to promote strong corporate governance in their firms and magnifies the initial effect.

Our paper has implications with respect to other dimensions of corporate governance. We show that increased transparency of board decision-making can weaken corporate governance. For example, the 2004 SEC disclosure law, requiring companies to disclose if one of the directors left the board due to a disagreement, could have had adverse unintended consequences. Intuitively, if a management-friendly reputation is rewarded in the labor market, directors may be more reluctant to oppose the management and strengthen corporate governance of their firms when they know that their actions will be disclosed to other market participants. We also show that board size matters not only because of a potential free-riding problem among directors within a firm, but also due to externalities between firms that are imposed by the labor market for directors.

Our model has several new testable implications. First, all else equal, a director of one firm is more likely to be appointed to the board of another firm if the corporate governance systems of the two firms are similar, i.e., are either both strong or both weak. Second, a positive exogenous shock to the corporate governance of one firm should positively affect corporate governance of other firms in the industry, and this spillover effect should be stronger for firms whose directors have stronger reputational concerns. Third, directors with stronger reputational concerns are more (less) likely to promote corporate governance improvements in their firms if corporate governance of other firms in the industry is sufficiently strong (weak). Finally, our analysis has implications for firms’ choice between “incumbent” directors, i.e., directors who are currently serving on the board of another firm, and “non-incumbent” directors, who are currently not serving on any board.

The full paper is available for download here.