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E-MailUgur Lel is Associate Professor and Nalley Distinguished Chair in Finance at Darius Miller is Caruth Chair of Financial Management at the Southern Methodist University Cox School of Business. This post is based on their recent article, forthcoming in the Journal of Accounting and Economics.
In our recent article titled The Labor Market for Directors and Externalities in Corporate Governance: Evidence from the International Labor Market, forthcoming in the Journal of Accounting and Economics, we examine how the potentially opposing forces created by country level aggregate governance impacts the ability of the labor market for outside directors to align the interest of managers and shareholders.
The board of directors is one of the pillars of modern corporations. Corporate boards are delegated by shareholders to protect their interests worldwide by monitoring and advising managers. While theory recognizes that the incentives and ability of directors to safeguard shareholders’ interests can vary significantly across countries (see Levit and Malenko (2016)), there is no cross-country evidence on the directorial labor market’s ability to align the interests of shareholders and managers.
An investigation of the labor markets for directors faces several challenges such as defining director reputation which is a multi-faceted concept and controlling for various potential sources of endogenous variation in the directorial labor market. This article addresses these challenges by examining a wide range of corporate events that provide the labor market with positive and negative as well as domestic and cross-country signals of directors’ shareholder friendliness. These proxies of shareholder friendliness are supported by recent research, and they capture both the monitoring and advising functions of outside directors. These events represent relatively discrete signals to the labor market, both positive and negative and scattered through time and vary both at the firm and director level. This facilitates an identification strategy that allows us to mitigate several potential sources of endogenous variation in the total number of outside directorships held, and rule out other alternative explanations and confounding effects.
Using a sample of 294,000 director-firm-year observations from 38 non-U.S countries, we find strong support for the hypothesis that the directorial labor market’s ability to align the incentives of managers and shareholders depends on the aggregate level of investor protection in a country. First, outside directors are more likely to be turned over at the firm where they are revealed as shareholder unfriendly but only in strong investor protection countries. For example, the likelihood of director turnover following a shareholder unfriendly signal is a statistically significant 4.3% in common law countries compared to an insignificant 0.4% in civil law countries where the unconditional average director turnover is 7.5% in the entire sample.
Second, in strong investor protection countries, directors gain (lose) outside board seats following shareholder friendly (unfriendly) actions. For example, directors gain on average 0.42 seats following shareholder friendly events in common law countries, which translates into a 20% increase for an average director. While these results provide, to the best of our knowledge, the first evidence outside the U.S. on the existence of Fama’s (1980) and Fama and Jensen’s (1983) “ex-post settling up hypothesis” governance mechanism, they are for firms located in countries with strong aggregate governance like the U.S. On the other hand, in countries with weak aggregate governance environments, changes in the number of outside directorships following shareholder friendliness actions are substantially attenuated.
Further, firms are more likely to hire shareholder friendly directors and dismiss shareholder unfriendly directors when firms have better internal governance, reside in strong investor protection countries, have more growth opportunities, are more complex and rely on external financing. Finally, we find that investors view the appointment of directors revealed as shareholder friendly or unfriendly as value relevant only in strong investor protection countries. Taken together, our findings suggest that the labor market offers fewer incentives for directors to monitor managers in weak investor protection countries.
The complete article is available for download here.
