August 09, 2007
Reputation Sanctions for Outside Directors
Posted by Lisa Fairfax

            My post on Tuesday suggested that outside directors are not likely to be subject to criminal or civil liability for their actions on the board.  This means that such liability is not likely to play a significant role in influencing director conduct.  Whether that is good or bad is for another debate.  However, it indicates that we must rely on other factors to regulate director conduct.  One of the biggest factors is reputation sanctions.  So, how influential are reputation sanctions?  I came across a study that appears to confirm the notion that reputation sanctions can have a tremendous impact on outside directors. 

            A study by two business professors at Drexel and North Carolina found that following a financial fraud lawsuit, outside directors do not experience abnormal turnover from the board of the sued firm, but experience significant decline in other board seats held.  Thus, on average the number of board seats held by outside directors of sued firms declines by fifty percent, while ninety-six percent of directors lose at least one board seat at another corporation within the three year period following a fraud lawsuit.  This suggests that outside directors face significant indirect penalties as a result of corporate fraud.  In turn, the study suggests that reputation sanctions can provide incentives to monitor.  Then too, the study suggests that reputation penalties do have at least some correlation to culpability.  Hence, the decline in other board seats is greater when a director is perceived to have had greater responsibility for monitoring corporate officers, such as when the director sits on an audit committee. 

            Nevertheless, the authors of the study caution that reputation penalties are insufficient on their own to insure that directors effectively monitor or deter fraud.  Indeed, the study found that the decline in board seats is driven by the corporation itself, as opposed to voluntary actions by directors.  This undermines the hypothesis that directors cut back on board seats in order to minimize their legal exposure.  The study also found that reputation sanctions are highly dependent on the governance structure at corporations.  Thus, corporations with strong corporate governance apparatus are more likely to oust directors than those with weak governance systems.  As a result, directors who serve on boards with weak governance systems face a low likelihood of losing their positions, and hence suffering reputation damages.  In the authors’ view, this means that while reputation damages clearly have an impact on directors, we cannot rely solely on them to ensure director compliance with their responsibilities.

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