Reputation Concerns Of Independent Directors: Evidence From Individual Director Voting
Columbia Business School – Finance and Economics
Shanghai Lixin University of Commerce
Shan Zhao
Grenoble Ecole de Management
July 1, 2012
Review of Financial Studies, Forthcoming
Abstract:
Using a unique dataset of board proposal voting by individual independent directors of public companies in China from 2004 to 2009, we analyze the effects of career concerns and current reputation stock on independent directors’ propensity to confront management. Younger directors and directors in their second (and last) terms, who have stronger outside career concerns, are more likely to be aligned with investors rather than the managers. Directors with higher reputation stocks (measured by mentions in news articles and the number of board seats) are also more likely to dissent. Their dissenting behavior is eventually rewarded in the market place in the form of more outside career opportunities and the avoidance of regulatory sanctions. Finally, we find that career concerns are significantly stronger among directors who already enjoy higher reputation.
Reputation Concerns Of Independent Directors: Evidence From Individual Director Voting – Introduction
Boards of directors are key players in corporate governance. Within a board, the responsibility to monitor management and mitigate agency issues mostly falls on independent directors. By definition, however, independent directors are not significant shareholders and do not receive the same type of generous and/or performance-sensitive compensation as the managers they monitor (Bryan and Klein 2004; Yermack 2004; Fich and Shivdasani 2006; Adams and Ferreira 2008). Additionally, management—the individuals the independent directors are meant to monitor— has significant influence on the appointment of independent directors (Shivdasani and Yerack 1999; Dahya, Dimitrov, and McConnell 2008). Thus, a natural question arises as to what motivates these outsiders to align themselves with shareholders rather than with management. Moreover, do independent directors have a positive impact on corporate governance when they stand up to management?
Fama and Jensen (1983) conjecture that “outside directors have incentives to develop reputations as experts in decision control. . . . They use their directorships to signal to internal and external markets for decision agents that they are decision experts. . . . The signals are credible when the direct payments to outside directors are small.” A number of studies have supported this hypothesis by showing that career opportunities for directors are indeed related to their performance. Positive performance includes rescission of takeover defenses (Coles and Hoi 2003), termination of underperforming CEOs (Farrell and Whidbee 2000), receipt of high takeover premium (Harford 2003), retention during a bankruptcy process (Gilson 1990), and/or general firm performance (Yermack 2004). Mirror-image examples include shareholder lawsuits (Fich and Shivdasani 2007), option backdating (Ertimur, Ferri, and Maber 2012), and proxy contest nominations (Fos and Tsoutsoura 2014).
The aforementioned studies confirm that independent directors are rewarded with more career opportunities for “good” performance. However, these studies do not study how independent directors should have responded to such career concern incentives, and they do not explain the variation in directors’ behavior given the ex post benefits of taking the right action. More importantly, most studies on boards of directors are conducted at the firm-board level. To the extent that the composition of boards is endogenously chosen, any relation between board governance characteristics and firm performance could reflect the optimization of individual firms under different parameters rather than a causal relation resulting from the actions of directors (Hermalin and Weisbach 1998; Boone et al. 2007; Denis, Denis, and Walker 2012). A related issue, highlighted by Adams, Hermalin, and Weisbach (2010), is that it is difficult to observe the actual behavior of individual directors and harder to quantify these behaviors for formal analyses.1 Hence, even the studies that carefully address endogeneity provide only indirect evidence of the heterogeneity in board effectiveness.
Our study explores a unique director-level voting dataset from China’s stock market to overcome the aforementioned empirical challenges. In 2004, the Chinese Securities Regulatory Commission (CSRC), the regulatory authority of China’s stock market, mandated that the voting behavior of independent directors be publicly disclosed. We are thus able to compile a comprehensive sample of voting records on 859 board proposals involving dissension from 2004–2012 by handcollecting information from corporate filings. Given that almost all board proposals that result in a vote are sponsored by management or controlling shareholders, dissension reflects a director’s willingness to confront the management on behalf of the outside shareholders.
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