Accountability of Independent Directors: Evidence from Firms Subject to Securities Litigation (Digest Summary)

The authors examine the extent to which independent directors are held accountable when investors sue firms for financial and disclosure-based fraud. Using a sample of 805 firms sued for US Securities Act violations under Rule 10b-5 or Section 11, the authors find that 11% of independent directors of sued firms are named as defendants in class-action lawsuits. When named directors serve on an audit committee or sell shares during the class period, they are more likely to be sued. Also, shareholders of sued firms appear to hold independent directors accountable by voting against them. Consequently, directors of sued firms, particularly those named in lawsuits, are more likely to lose their board seats. The authors interpret these findings as evidence that shareholders are holding some independent directors accountable for these management failures.

Professionals focused on strengthening corporate governance, such as investors, audit committee members, and independent directors, would find this research useful. Ultimately, the authors conclude that shareholders hold directors accountable for corporate performance. Furthermore, their findings reinforce the idea that independent directors are expected to add value through management oversight and that they will be held accountable by shareholders for significant management failures. The consequences include litigation, reputational harm, and lack of future support as a board member.

The authors obtain data on sued firms from the Institutional Shareholder Services (ISS) Securities Class Action Litigation and the Investor Responsibility Research Center Institute Directors databases. The final sample consists of 805 US firms in the S&P 1500 Index with 5,461 independent directors who were sued for violations of Rule 10b-5 or Section 11 of the Securities Acts of 1934 and 1933, respectively, over the 1996–2010 time period. A matched sample of 805 non-sued firms (and 5,461 independent directors) with similar litigation risk as the sample of sued firms is also created to facilitate comparison of independent directors between sued and non-sued firms.

The authors examine the role of independent director accountability using both univariate and multivariate analysis. In their univariate analysis, the authors analyze the following: determinants for directors being named as defendants, ISS recommendations, shareholder votes, and non-named director turnover in sued firms. In their multivariate analysis, the authors use logistic regressions, ordinary least squares, and the Rogers and Stocken (Accounting Review 2005) litigation risk-based model to analyze the following: determinants of directors being named as defendants; shareholder voting in sued and matched firms; director turnover in sued and matched firms; shareholder voting and director turnover in other board positions; lawsuit dismissal, settlement, speed, and amount; and the estimated litigation risk. The authors find that the following independent variables increased the litigation settlement amount: more directors named in the lawsuit, greater alleged US generally accepted accounting principles (GAAP) violations, more US SEC enforcement actions, longer length of class period, and larger firm size. They were not able to measure the director and officer (D&O) insurance in this regression analysis because it was not available in the data. The D&O insurance would likely have an effect on the settlement terms.

The authors also find that, in the period after the Enron and WorldCom scandals in 2002, there appears to have been a greater awareness of the role of corporate directors; they are more likely to have shareholders vote against them when their associated companies’ stock prices decline as a result of management failures.

The authors use the findings and evidence from at least 30 other industry publications to address their objectives and strengthen their conclusions. Furthermore, each regression analysis specifically tests the key variables mentioned in the industry publications referenced. Although there were many detailed univariate and multivariate analyses tabulated, each table includes footnotes to clearly describe the assumptions, sources, significance levels, and calculations. The paper was organized and well-written so that it could be easily understood.

Historically, many board members have been close friends with management and have had no idea about the firm’s business and what would constitute prudent actions. It is refreshing to validate that shareholders are finally demanding that independent directors add value and provide meaningful oversight, rather than past practices of rubber-stamping whatever ill-conceived actions management wanted to take.