The unexpected resignation of an outside director may indicate that a company is about to experience tough times, according to a recent academic study. The research shows that a company experiencing a surprise director departure is likelier to face a number of different future adverse events.


Among other things, a company with a surprise outside director departure has a "significantly higher likelihood of being named in a federal class action securities fraud lawsuit." The study’s authors call this risk of future adverse events following a director’s departure the "dark side of outside directors."


These findings are set forth in a March 2010 paper entitled "The Dark Side of Outside Directors: Do They Quit When They Are Needed Most?" (here) by Rüdiger Fahlenbrach of the Ecole Polytechnique Fédérale de Lausanne, Angie Low of the Nanyang Technological University and René M. Stultz of Ohio State University. Hat tip to the Harvard Law School Forum on Corporate Governance and Financial Reform for the link to the paper. I note here that the author’s paper is copyrighted – a notation that the authors require from anyone quoting their paper.


The Authors’ Analysis

The authors note that among the remedial measures imposed following the era of corporate scandals last decade were requirements for increased numbers of independent directors on corporate boards. Though these measures had salutary purposes, the addition of increased numbers of independent directors also has "costs" as well as benefits.


Among these "costs" is what the authors refer to as "a dark side" of increased outside director involvement arising because of outside directors’ "incentives." That is, outside directors have "incentives to leave when they anticipate that the firm on whose board they sit will perform poorly and/or disclose adverse information."


The directors have incentives to quit "to protect their reputation or to avoid increases in the workload when the firm on which board they sit is likely to experience a tough time." As the authors put it, outside directors are "more likely to quit when they expect the firm to perform poorly or to disclose bad news, so they can at least partly and possibly totally escape the reputation loss."


Because outside directors have these incentives, an unexpected director resignation from a company’s board may indicate that the company may be poised for future adverse events.


The authors tested this hypothesis by examining "surprise director departures." The authors tracked resignations by directors whose ages were below the average director retirement age and then plotted the resignations against future events at the companies from whose boards the directors had resigned.


The authors found that following "surprise director departures" the firms involved experienced "significantly worse stock and accounting performance," and "are significantly more likely to suffer from an extreme negative return event, are significantly more likely to restate earnings, and have a significantly higher likelihood of being named in a federal class action securities lawsuit."


These results, the authors concluded, are "consistent with the directors leaving in anticipation of adverse events to protect their reputation or to avoid an increased workload."



The authors’ analysis of the "dark side" of increased outside director involvement is interesting, because it suggests that the outside directors readiness to head for the exits when the going gets tough undermines the very reasons for which increased outside director involvement was required in the first place. As the authors put it, their analysis suggests that "outside directors are more likely to resign precisely when experienced outside directors are needed the most."


The authors’ findings about the increased risk of securities litigation following a director’s resignation are particularly interesting. Back when I was part of a D&O underwriting facility, my colleagues and I were constantly involved in trying to identify factors that were positively correlated with the risk of securities litigation. The authors’ analysis suggests that a surprise outside director departure is such a factor.


Specifically, the authors found that a surprise outside director departure (that is, one that is not explained by the director having reached the average age for director retirement) is "highly statistically and economically significant" in terms of litigation risk. The authors specifically found that the surprise departure of an outside director increases the probability of a securities class action lawsuit filing by 31% to 35%, with the likelihood increasing as firm size increases; if a company’s stock and accounting performance were poor in the prior year’ and if the firm raised relatively more external financing in the prior year.


The authors’ work raises important questions about the role of outside directors. However, for D&O underwriters, the authors’ analysis about the correlation between surprise director resignations and securities litigation risk may be the most interesting finding. At a minimum, the authors’ analysis suggests a potentially important new underwriting criterion.


Questioning Rating Agencies’ First Amendment Defenses: In a recent post, I discussed the latest decision questioning the applicability of rating agencies’ first amendment defenses. Left unanalyzed in these cases is the larger question of why rating agencies’ ratings opinions are thought to be entitled to first amendment protection in the first place.


In a June 9, 2010 Am Law Litigation Daily article (here), Susan Beck questions both the rating agencies’ entitlement to rely on the First Amendment and the limitations of the judicial decisions to date where courts have found the First Amendment defense inapplicable because the ratings were given only to a small group of sophisticated investors. Beck asks, with respect to the latter point, "Why should big, sophisticated investors like CalPERS have more redress under the law than small (and large) investors who buy securities in public offerings?"


Beck also suggests that "the premise of First Amendment protection for credit ratings is shaky." After reviewing and questioning the case authority on which the rating agencies rely in asserting their First Amendment defenses, Beck concludes "I’m hoping that the next judge to address the First Amendment question reads the case law differently and concludes that a credit rating, by itself, is not a matter of public concern that deserves Constitutional protection. That’s not only fair, it’s right."