Accountability of Independent Directors-Evidence from Firms Subject to Securities Litigation
Executive Summary — Shareholders have two publicly visible means for holding directors accountable: They can sue directors and they can vote against director re-election. This paper examines accountability of independent directors when firms experience litigation for corporate financial fraud. Analyzing a sample of securities class-action lawsuits from 1996 to 2010, the authors present a fuller picture of the mechanisms that shareholders have to hold directors accountable and which directors they hold accountable. Results overall provide an empirical estimate of the extent of accountability that independent directors bear for corporate problems that lead to securities class-action litigation. These findings are useful for independent directors to assess the extent of risk they face from litigation, shareholder voting, and departure from boards of sued firms. While the percentage of named directors is small compared with the overall population of directors, individual directors can weigh their risk differently. From a policy perspective, the findings provide insight on the role that investors play in holding directors accountable for corporate performance. Key concepts include:
- About 11 percent of independent directors are named as defendants in securities lawsuits when the company they serve is sued.
- Audit committee directors-consistent with concerns about litigation exposure of these directors-and directors who sell shares during the class period are more likely to be sued.
- Shareholders in sued firms also hold independent directors accountable by voting against them, including a greater negative vote for named directors.
- Directors of sued firms, and especially those who are named, are also significantly more likely to lose their board seats in the sued firm. This effect is more pronounced after 2002 than before, possibly reflecting greater sensitivity towards the role of corporate directors in recent corporate scandals.
- Lawsuit outcomes vary when independent directors are named in lawsuits. When directors are named, cases are less likely to be dismissed, and they settle faster and for greater amounts.
- Some evidence points to the strategic naming of independent directors by the plaintiffs to gain bigger settlements.
We examine which independent directors are held accountable when investors sue firms for financial and disclosure related fraud. Investors can name independent directors as defendants in lawsuits, and they can vote against their re-election to express displeasure over the directors' ineffectiveness at monitoring managers. In a sample of securities class-action lawsuits from 1996 to 2010, about 11% of independent directors are named as defendants. The likelihood of being named is greater for audit committee members and directors who sell stock during the class period. Named directors receive more negative recommendations from Institutional Shareholder Services (ISS), a proxy advisory firm, and significantly more negative votes from shareholders than directors in a benchmark sample. They are also more likely than other independent directors to leave sued firms. Overall, shareholders use litigation along with director elections and director retention to hold some independent directors more accountable than others when firms experience financial fraud.