Quanta Corporate Citizenship The dark side of outside directors 21/05/2010
We've all had experiences with people who are somehow always around when we are on a high, but are mysteriously too busy to meet or answer our calls when we are in bad shape. Companies suffer from the same problem, accordingly to recent research from Rüdiger Fahlenbrach, René Stulz and Angie Low entitled The dark side of outside directors. Analysing statistical data from 1981 to 2006, they found that outside directors have an interesting habit of leaving boards prior to companies announcing that they had hit a bad patch.
“Following surprise director departures, affected firms have significantly worse stock and accounting performance, are significantly more likely to suffer from an extreme negative return event, are significantly more likely to restate earnings, and have a significantly higher likelihood of being named in a federal class action securities fraud lawsuit. These results are also economically significant. For example, the surprise departure of an outside director increases the probability of an earnings restatement by almost 20% and the probability of being named in a federal class action securities fraud lawsuit by 35%. These results are consistent with directors leaving in anticipation of adverse events to protect their reputation or to avoid an increased workload.”
As per their findings, the problems faced by the companies are not caused by the departure – as the root of many of the problems precedes the departure by months or even years – but the cause of their exit. But, as they put it, the directors departure might actually make things worse; “We cannot exclude the possibility that the outside director departure has a causal effect on firm operating performance post departure. Under this hypothesis, the firm loses a talented outside director. Without her monitoring and advising capabilities, firm performance deteriorates post-director turnover.”
This study is interesting to highlight two very important issues about board of directors and of trustees that are often overlooked.
Firstly, if shareholders are a primary CSR stakeholder, the departure of a director should be treated more seriously than a simple handshake followed by farewell drinks. Good governance requires a body producing independent meaningful reports on why a director is leaving and making that report available to the market on an equal basis. That is particularly important for companies with a very diluted shareholder basis, where pensioners and other small investors (or donors, in the case of trustees) aggregately hold substantial ownership, but are unlikely to be active enough in the financial market to understand what might be going on behind closed doors or to hear the noise before their investments are negatively impacted.
Second, and also to reassure good governance, it is important for the rest of the board to know why a board member is leaving. We all know boards where a director left and for some reason did not fully disclose to the board why he or she was leaving because no one actually cared to ask. “Poor health”, “personal reasons” and “spend time with my family” are catchall excuses that often hide deeper reasons. Boards need to have reliable mechanisms to share the concerns of any board member. This is particularly important in boards where asymmetric information is likely to be a substantial concern, such as boards that do not meet often, or that are constituted primarily by outside directors who do not hold enough information about the company, or are constituted by several smaller subcommittees where only the chairs meet in a main board.
On both accounts, the most straightforward solution is for an independent facilitator or legal advisors to be retained to collect the relevant information from the departing director and inform the board, and at the same time work as a reassurance mechanism that the concerns shared by the leaving director will not be used against him/her in the future in the form of bad references or criticism.
- Gus
“Following surprise director departures, affected firms have significantly worse stock and accounting performance, are significantly more likely to suffer from an extreme negative return event, are significantly more likely to restate earnings, and have a significantly higher likelihood of being named in a federal class action securities fraud lawsuit. These results are also economically significant. For example, the surprise departure of an outside director increases the probability of an earnings restatement by almost 20% and the probability of being named in a federal class action securities fraud lawsuit by 35%. These results are consistent with directors leaving in anticipation of adverse events to protect their reputation or to avoid an increased workload.”
As per their findings, the problems faced by the companies are not caused by the departure – as the root of many of the problems precedes the departure by months or even years – but the cause of their exit. But, as they put it, the directors departure might actually make things worse; “We cannot exclude the possibility that the outside director departure has a causal effect on firm operating performance post departure. Under this hypothesis, the firm loses a talented outside director. Without her monitoring and advising capabilities, firm performance deteriorates post-director turnover.”
This study is interesting to highlight two very important issues about board of directors and of trustees that are often overlooked.
Firstly, if shareholders are a primary CSR stakeholder, the departure of a director should be treated more seriously than a simple handshake followed by farewell drinks. Good governance requires a body producing independent meaningful reports on why a director is leaving and making that report available to the market on an equal basis. That is particularly important for companies with a very diluted shareholder basis, where pensioners and other small investors (or donors, in the case of trustees) aggregately hold substantial ownership, but are unlikely to be active enough in the financial market to understand what might be going on behind closed doors or to hear the noise before their investments are negatively impacted.
Second, and also to reassure good governance, it is important for the rest of the board to know why a board member is leaving. We all know boards where a director left and for some reason did not fully disclose to the board why he or she was leaving because no one actually cared to ask. “Poor health”, “personal reasons” and “spend time with my family” are catchall excuses that often hide deeper reasons. Boards need to have reliable mechanisms to share the concerns of any board member. This is particularly important in boards where asymmetric information is likely to be a substantial concern, such as boards that do not meet often, or that are constituted primarily by outside directors who do not hold enough information about the company, or are constituted by several smaller subcommittees where only the chairs meet in a main board.
On both accounts, the most straightforward solution is for an independent facilitator or legal advisors to be retained to collect the relevant information from the departing director and inform the board, and at the same time work as a reassurance mechanism that the concerns shared by the leaving director will not be used against him/her in the future in the form of bad references or criticism.
- Gus
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