Yonca Ertimur

By Yonca Ertimur

We examine whether there is ex-post settling up in the director labor market for tainted executives, i.e., executives who are allegedly involved in governance failures. A rich literature dating back to Fama (1980) and Fama and Jensen (1983) argues that ex-post settling up in the labor market incentivizes managers to develop reputations as experts in monitoring and advising. Prior studies focus exclusively on the managerial labor market and document reputational penalties for tainted executives. Our motivation for focusing on the director labor market is twofold. First, given the monetary and non-monetary benefits of directorships, the director labor market can play an important role in shaping executives’ incentives. Second, because firms have different monitoring and advising needs, and face different supply of potential directors, it is not clear how the director labor market will evaluate tainted executives.

Our proxy for tainted executives is top executives (CEO, CFO, and President) named as defendants in settled securities class action lawsuits. We start by examining changes in outside directorships held by tainted executives during the 2002–2014 period using a matched control sample. Consistent with ex-post settling up in the director labor market, we find that the odds of a tainted executive involved in a high severity lawsuit losing at least one directorship are 1.9 to 2.7 times that of a non-tainted executive, depending on the window over which we examine the outcomes and the proxy for severity. In contrast, executives named in low severity lawsuits are able to gain directorships—the odds of these executives gaining at least one directorship are 1.8 to 3.9 times higher than that of a non-tainted executive.

The result that executives involved in governance failures continue to be active as directors raises concerns about the effectiveness of the director labor market in disciplining managers. In the rest of the study, we focus on examining gains in greater detail. We posit two explanations for why firms appoint tainted executives as outside directors. First, tainted executives are less likely to be viewed as good monitors and as having high levels of integrity, making them desirable candidates for CEOs who aim to reduce monitoring intensity from the board. We call this the management capture explanation. Second, because of their managerial skills and experience, tainted executives may be valuable in the advising role to firms with demand for specialized knowledge and to less visible firms that find it difficult to attract directors with executive experience. Facing a talent shortage, these firms may trade integrity and monitoring ability for experience, which is critical for advising. We call this the demand for advising explanation.

We conduct several tests to distinguish these two explanations. First, we examine firms’ decisions to appoint tainted versus non-tainted executives to their boards. We find that less visible firms, firms in the same industry as the executive’s firm, and firms with higher R&D intensity are more likely to appoint tainted executives as outside directors. Further, tainted executives who gain directorships hold, on average, a greater number of outside directorships and are more likely to have held a CEO position over the previous three years compared to their non-tainted counterparts. Second, at the time of their initial appointment to the board, tainted executives are less likely to be selected to the nominating and governance committees, where the primary functions center around monitoring. In contrast, we find weak evidence that tainted executives tend to join the executive committee, where the main purpose is to provide advice to top management. Third, we examine firm-level outcomes associated with appointing a tainted executive as an outside director using a difference-in-differences design with year and firm fixed effects. Firms that appoint tainted executives display greater improvements in sales growth, are less likely to be targets of securities class action lawsuits, and do not experience an increase in CEO compensation. Collectively, these results lend support to the demand for advising explanation rather than the management capture explanation.

In our final analysis, we shift our focus to investors’ perception of the appointments of tainted executives as outside directors. We find a negative and significant market reaction to the appointment announcements of tainted executives—the difference between the market reactions to the appointment of tainted versus non-tainted executives is approximately -1.0% when the appointment is within 24 months subsequent to the lawsuit filing month. This negative market reaction is seemingly at odds with our conclusion that firms appoint tainted executives to boards in order to benefit from their advising ability. One explanation is that investors are nevertheless disappointed in the firms’ inability to attract directors who are highly qualified in both the advising and monitoring functions.

Our study contributes to the literature on the role of the labor market in aligning the incentives of managers with those of shareholders. By examining the director labor market, an important driver of managerial incentives, our study helps complete the picture of the labor market outcomes for tainted executives. While these executives are more likely to lose their outside directorships, they are also more likely to gain seats, albeit on boards of less visible firms. Our results suggest ex-post settling up in the director labor market but with a twist—the penalties may not be sufficiently high to discipline executives ex-ante. We also contribute to the literature on attributes valued in the director labor market. Our setting allows us to separate monitoring ability and integrity from advising ability (i.e. executive experience) so that we can examine how the director labor market trades off these two attributes. We find that, when facing a talent shortage, firms may place less weight on monitoring ability and integrity in exchange for executive experience.


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