Inelastic Labor Markets and Directors’ Reputational Incentives

Christopher Armstrong is EY Associate Professor of Accounting at The Wharton School of the University of Pennsylvania. This post is based on a recent paper authored by Professor Armstrong; David Tsui, Assistant Professor of Accounting at the University of Southern California Marshall School of Business; and John D. Kepler, The Wharton School of the University of Pennsylvania.

In our recent paper, Inelastic Labor Markets and Directors’ Reputational Incentives, we examine the extent to which independent directors on corporate boards face consequences for their individual performance and how these consequences, in turn, shape directors’ incentives. Prior studies of directors’ incentives largely focus on collective performance measures that are necessarily common to all directors at a given firm (e.g., a firm’s stock price and accounting performance during a particular period of time does not differ across its directors). However, relying on collective measures of performance can create free-rider problems among directors and can dampen any resulting incentives. Thus, to understand the factors that motivate directors to act in shareholders’ interests, it is important to assess whether directors face appreciable consequences from their individual performance.

We consider three director-specific performance measures. First, we compute cumulative abnormal stock return over the director’s tenure to date, which provides a comprehensive summary measure of performance that could be plausibly attributed to the director. Second, we estimate “excess” CEO compensation and examine whether the directors on the compensation committee—who are primarily responsible for executive pay decisions—experience different consequences from directors who do not sit on the compensation committee. Third, we consider internal control weaknesses and examine whether members of the audit committee, who are primarily responsible for overseeing the firm’s financial accounting function, experience different consequences from directors who do not sit on the audit committee.

We then examine whether directors experience different labor market outcomes based on their performance on these individual measures. We also examine whether directors receive different levels of shareholder voting support based on their individual performance as an alternative, highly visible assessment of directors’ performance. In addition to providing a broader assessment of the consequences directors face, considering each of these outcomes allows us to evaluate whether the labor market and shareholders rely on similar measures of individual performance.

We find that directors with poor stock returns over their tenure are more likely to lose not only board seat, but also any seats they might have on other boards, suggesting that directors face labor market consequences for their individual contribution to shareholder value creation or destruction. However, we find no evidence of differential labor market consequences for compensation committee members when the CEO receives “excess” compensation or audit committee members when the firm has an internal control weakness. In contrast, when we examine shareholder voting, we find that directors receive lower shareholder support when they have lower stock returns over their tenure as well as when they serve on the compensation committee of a firm whose CEO receives more “excess” compensation or the audit committee of a firm that receives an internal control weakness.

These findings suggest that shareholders individually evaluate (and reward or punish) directors based on a broader set of individual performance measures than does the labor market. One potential explanation for this difference is that directors view their role on the board as primarily strategic while shareholders’ voting decisions reflect a more balanced assessment of both strategic and non-strategic performance. Consequently, the director labor market—which is shaped, in part, by nominating committees comprised of directors themselves—might place less weight on non-strategic measures of performance, such as setting CEO compensation or ensuring the integrity of financial reporting, than shareholders do.

Interestingly—and perhaps counterintuitively—we find that although directors with lower stock returns over their tenure are more likely to lose their board seat, they are also more likely to gain a seat on another board. That is, directors who leave one board may often simply move to another board rather than exit the labor market entirely. As a result, labor market consequences may be insufficient to provide directors with meaningful incentives. In particular, if departing directors are readily able to move to new boards regardless of their previous performance, the primary factor preventing directors from joining additional boards may be constraints on their available time rather than their inability to demonstrate appropriate qualifications or talent (i.e., a supply constraint rather than a demand constraint).

To directly test how changes in the available supply of directors influence the director labor market, we examine whether directors who leave one board tend join another board using Institutional Shareholder Services (ISS) voting recommendations as an instrument for director turnover. Consistent with a relatively inelastic supply of directors, we find that turnover induced by ISS recommendations leads to directors subsequently gaining seats on other boards. In contrast, we find that ISS-induced turnover does not lead to directors losing any other board seats they might have, suggesting that these recommendations provide little information to outside boards about directors’ performance or ability. In related analyses, we also find that directors who leave one board are more likely to join another board when their skills are in relatively short supply or the departure freed up more of their time, providing additional evidence that supply constraints play an important role in the director labor market and, ultimately, in shaping directors’ incentives.

Finally, we examine the characteristics of the firms that directors who move from one board to another join. If these new firms tend to be smaller or otherwise less prestigious than their previous firms, directors may have reputational incentives to avoid losing existing directorships, even if they can quickly (and easily) gain new directorships. However, we find no evidence that directors “downgrade” when they leave one board and join another. If anything, our evidence is to the contrary: when poorly performing directors leave one board and join another, they tend to “upgrade” to firms that are larger and more profitable than their previous firm. Moreover, the largest “downgrades” tend to occur for the best-performing directors, who tend to join smaller and less profitable firms when they move from one board to another.

Our study provides several insights into the source and nature of directors’ incentives. First, we provide evidence that although the labor market appears capable of distinguishing between individual directors’ performance, the inelastic supply of qualified directors limits the labor market consequences of poor individual performance. This lack of meaningful labor market consequences, which are typically assumed to be one of the primary forces that motivates directors to act in shareholders’ interests, dampens directors’ incentives stemming from individual performance evaluation.

Second, our findings indicate that one of the primary determinants of directors’ ability to obtain additional directorships is their ability or willingness to supply labor. Specifically, directors appear to evaluate their capacity to devote sufficient time and effort to serve on an additional board when considering prospective new directorships, rather than simply aiming to acquire as many seats as possible. Consequently, the prevalent notion of director “busyness” in the governance literature and among proxy advisory firms may largely capture relatively innocuous variation in the severity of directors’ supply constraints rather than their inability to adequately fulfill their responsibilities.

Third, our findings help explain the relatively modest financial incentives of directors that have been consistently documented in prior literature. Agents with greater bargaining power, such as those whose supply is constrained or otherwise inelastic, should be able to negotiate more favorable (e.g., less risky) labor contracts. Thus, one explanation for directors’ relatively low pay-for-performance sensitivity is that their compensation contracts are designed primarily to attract, rather than motivate qualified directors.

Finally, our results suggest that shareholders and directors have different beliefs about the board’s primary responsibilities. Shareholders appear to hold individual directors accountable for a broad range of strategic and non-strategic activities, while directors themselves appear to focus on a narrower set of responsibilities and view their primary function as strategic.

The complete paper is available for download here.

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