It is common for those who prefer markets to regulation to argue that reputational sanctions are an effective constraint on behavior. (I've made this argument more than once myself.) This is generally referred to as "shaming" in the literature. In response to a paper Hillary Sale recently presented at my seminar, however, one of my students made an interesting observation:
Sale argues that the SEC’s remedial powers, such as a bar order, can act as an incentive by shaming or dishonoring the director. She presumes that the corporate director community is small enough for a shaming sanction to work. A little research tends to undermine this argument. Sale tells of the rare private suit that led independent director Bert Roberts to owe $4.5 million as part of the Worldcom settlement. While this is in the context of a private suit, we should still expect to see the same shaming or dishonoring incentive at work. Given this result is rare, while we may not see it promote good behavior among other directors, we should at least see an impact on the corporate community’s treatment of Roberts personally. So what happened to Roberts? A Google search reveals that currently he sits on the boards of Valence Technology (traded on Nasdaq), John Hopkins University, and CaPCURE. The Valence website brags that, “he served as chairman and chief executive officer of MCI, having previously held the positions of president and chief operating officer” (hmmm, doesn’t sound like full disclosure). After Worldcom, we would not expect to see him serving on the board of another publicly traded company, though there he is. Perhaps this illustrates the lack of SEC action. Perhaps the SEC should have barred Roberts from serving as an officer and director anywhere. Perhaps Roberts has learned his lesson and is now the model independent director (I doubt it). As far as shame and dishonor, this shows that the director world maybe looks out for their own. Perhaps, the director community comprises a heard that sticks together rather than a close-knit community quick to shame those who fail in their director duties. My point is not that Sale is wrong in lobbying for more SEC action, but that relying on peer pressure will probably be insufficient. Certainly, a more comprehensive study showing the impacts of SEC and private action on directors and the corporate world’s response and later treatment of those directors could further prove me right or wrong.
Indeed, it would be instructive to collect the 10Ks for Enron, WorldCom, Adelphia, and some of the other prominent scandal firms to see what happened to their outside directors. Did their outside directors lose seats on other boards? Lose their day jobs? And so on. Of course, since post-SOX, the average number of boards on which a director sits has gone down, so you'd need to compare the scandal firm results to a control group. But this still would make an interesting law review article or student note for somebody with more patience for wading through a stack of 10Ks than I have.
Update: The Unknown Professor emails:
I had actually started on this project, but found out it's been done - Suraj Srinivasan has a Journal of Accounting Piece titled "Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members" (May, 2005).
He finds that "directors experience significant labor market penalties. In the three years after the restatement, director turnover is 48% for firms that restate earnings downward, 33% for a performance-matched sample, 28% for firms that restate upward, and only 18% for technical restatement firms. For firms that overstate earnings, the likelihood of director departure increases in restatement severity, particularly for audit committee directors. In addition, directors of these firms are no longer present in 25% of their positions on other boards. This loss is greater for audit committee members and for more severe restatements."
So it appears that these directors at least get disciplined by the labor market for directors' seats.
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