The Dark Side of Outside Directors Performance

The Dark Side of Outside Directors: Do They Quit When They Are Most Needed? a working paper by Rüdiger Fahlenbrach, Swiss Finance Institute, Ecole Polytechnique Fédéralede Lausanne, Angie Low, Nanyang Business School, Nanyang Technological University,René M. Stulz, Department of Finance, The Ohio State University (link below) suggests that outside directors are actually rats, ready to leave a sinking ship when bad news is on the way instead of  a good earning's performance.  Reaching retirement age is the most common reason for director departure and Dark Side takes this into account along with a model of director turnover based on characteristics other than age, to define certain outside director departures as surprise or unexpected departures.  Dark Side ignores the departing directors stated rationale and  assesses surprise departures in relation to corporate performance, establishing a correlation between “surprise” departures by outside directors and ensuing disasters like earnings restatements, securities fraud claims, and  horrible earning's results. 

As Dark Side notes, association with a troubled company will damage the director's reputation, rendering him or her less attractive as a candidate for other boards.  The director's workload also expands with problems while the director's compensation does not, in fact the value of non-cash comp may be falling along with the stock price.

Dark Side recognizes that correlation is not causation and expends some effort ruling out the possibility that the companies are tanking because the outside directors left, rather than the outside directors leaving because they see bad news on the horizon.  In most cases, the events creating the bad news occur before the resignation, even if the results do not become public knowledge until later, thus  the departures are an unlikely cause.  I fully agree with Dark Side's interpretation on this point, but using retirement age departures as a control might produce some additional,  convincing data.

Some of Dark Side's analyses based on relative stock prices suggests an investment strategy that might produce a winning performance. Follow EDGAR reports on director departures, plus compare proxy statements year to year to pick up directors who simply fail to stand for reelection.  Each time you find a departure that is not clearly explained by age or some other extremely compelling rationale, short that company's stock.  You can take an equal long position on a broad index if you want to hedge against general market movement.

Massive kudos to  Profs. Fahlenbrach, Low and Stulz for questioning the sacred cow of the independent director.  Second, I think Dark Side is correct in positing that these outside director departures generate transitional costs and problems for the companies they formerly served, just at the point when the companies are having problems and needs experienced directors.  The closing query  on raising directors compensation to reduce desertions is relevant, but there may be a deeper question. 

How much is independence worth?.  The theory that checks are needed to rein in the potentially dictatorial power of the CEO makes sense to me, but are there actually  studies showing that increasing the percentage  of  outside directors improves corporate performance – on earnings, ESG or any other metric, even after the percentage is already high – will a board of ten do better with nine outside directors than eight?  Footnotes in Dark Side suggest there are inconsistent results on this, and certainly no clearly established “tipping point” beyond which extra independent directors do not matter.   Maybe, for example,  it's important to get a simple majority of outside directors on the full board, audit and comp committees, and any more than that is a needless expense in good times  and counterproductive in a crisis.

Photo Credit: Wolfiewolf