Mechanisms of Board Turnover: Evidence From Backdating

• Published date: 01 June 2014
• Date: 01 June 2014
• DOI: http://doi.org/10.1111/jacf.12068
• Author: Clifford W. Smith,Frederick L. Bereskin

In This Issue: Regulation and Capital Markets

Pick Your Poison—Fragmentation or Market Power? An Analysis of RegNMS,

High Frequency Trading, and Securities Market Structure

8Craig Pirrong, University of Houston

Systematic Policy and Forward Guidance at the Fed 15 Charles I. Plosser, Federal Reserve Bank of Philadelphia

Another Look at Bookbuilding, Auctions, and the Future of the IPO Process 19 Zhaohui Chen, University of Virginia. Alan D. Morrison,

University of Oxford, William J. Wilhelm, Jr., University of

Virginia and Lingnan College, Sun-Yat-Sen University

Economic Growth and Inequality: Why It Matters and What’s Coming Next 30 Chris Pinney, High Meadows Institute

Is There a Better Way to Examine Income Inequality? 40 Ron Schmidt, University of Rochester

A South African Success Story:

Excellence in the Corporate Use of Capital and Its Social Benets

50 Brian Kantor, Investec Wealth & Investment and

David Holland, David Holland Consulting

Attracting Long-Term Investors Through Integrated Thinking and

Reporting: A Clinical Study of a Biopharmaceutical Company

57 Andrew Knauer and George Serafeim,

Harvard Business School

Mechanisms of Board Turnover: Evidence From Backdating 65 Frederick L. Bereskin, University of Delaware, and

Clifford W. Smith, Jr., University of Rochester

Do Bond Covenants Affect Borrowing Costs? 79 Martin Fridson, Lehmann, Livian, Fridson Advisors LLC;

Xiaoyi Xu, FridsonVision LLC; Ruili Liu, FridsonVision LLC;

Yinqiao Yin, Bond Street Group

The Decision to Repurchase Debt 85 Timothy Kruse, Xavier University; Tom Nohel and

Steven K.Todd, Loyola University Chicago

More Evidence That Corporate R&D Investment (and Effective Boards)

Can Increase Firm Value

94 Jamie Y. Tong, University of Western Australia and

Feida (Frank) Zhang, Murdoch University

2013 Nobel Prize Revisited: Do Shiller’s Models Really Have Predictive Power? 101 Brian Kantor and Christopher Holdsworth, Investec

Securities and University of Cape Town

VOLUME 26 | NUMBER 2 | SPRING 2014

APPLIED CORPORATE FINANCE

Journal of

Journal of Applied Corporate Finance • Volume 26 Number 2 Spring 2014 65

Mechanisms of Board Turnover: Evidence From Backdating*

* We thank participants at Emory University, University of Delaware, the 2012 CFA-

FAJ-Schulich Conference on Fraud, Ethics and Regulation, the 2012 FMA conference, as

well as Jim Brickley, Douglas Cumming, Charles Elson, Paul Laux, Sanjog Misra, and

Nancy Ursel for helpful comments and suggestions.

1. See Downs (1957), Hammond and Thomas (1989), and Barclay and Holderness

(1989).

2. See Bebchuk and Fried (2005).

B

by Frederick L. Bereskin, University of Delaware, and

Clifford W. Smith, Jr., University of Rochester

S

hareholders are the owners of the corporat ion

and, as such, they have ulti mate control in that

they have the authority to elect the rm’s board

of directors. In theory, if the board or its board-

appointed managers fai l to maximiz e shareholder value,

shareholders can replace them t hrough the voting process.

But at least since Berle and Means’ 1932 classic Private

Property and the Public Corporation, many observers have

viewed this theory more as a legal ction than an economic

reality. ey note that small shareholders have incentives to

“free ride” and thus are “rationally” passive, and that manag-

ers control the agenda and use this control to entrench

themselves.1

One observation often cited as empirical support for

the view that shareholder power is largely a myth is that

nominated directors are virtually always elected. For example,

in evaluating improvements to board accountability, Bebchuk

and Fried (2005) concluded that “even in the wake of poor

performance and shareholder dissatisfaction, directors now

face very little risk of being ousted. Shareholders’ ability to

replace directors is extremely limited.”2

This low frequency with which nominated directors

lose elections has been oered as compelling evidence of an

ineective corporate governance process. Indeed, securities

regulators recently proposed revisions to proxy-access rules

with the explicit aim of increasing the number of contested

board elections and, in so doing, improving the general eec-

tiveness of boards.

Despite its intuitive appeal, there are some fundamental

problems with the logic that assumes that high rates of direc-

tor reelection imply that elections are ineective governance

mechanisms and hence that boards are inadequate as share-

holder representatives. For one thing, if directors were indeed

reasonably eective as a group in representing shareholders’

interests, one should expect most of them to be reelected. But

more to the point, shareholder voting is only one step within

a multi-step process in which directors could be subjected to

shareholder control and discipline.

Director Reelection Process

For a director to be reelected to the board, standard gover-

nance practice requires the following: (1) the director must

not resign during his or her term; (2) the director must oer

to stand for election; (3) the corporate governance committee

must recommend the director for nomination; (4) the board

must approve this nomination; and (5) shareholders must

elect the director. Examining only the nal step in this process

understates—perhaps seriously—the responsiveness of boards

to shareholder interests; it ignores potentially important disci-

plining that takes place during steps (1) through (4). What’s

more, it’s important to keep in mind that the decisions in each

of these earlier steps are likely to have been inuenced by the

expected outcome of a potential shareholder vote.

For example, if we begin by assu ming that board elections

are reasonably eective governa nce mechanisms, we might

also infer that a d irector that engaged in m isdeeds might

withdraw rather than face a signific ant chance of being

rejected when standing for reelection— a kind of public

humiliation that could be d amaging to one’s reputation

and future prospects a s a director. Moreover, members of

the corporate governance committee as well as other board

members might be reluctant to nominate someone they

believe to be unelectable. Separate ex amination of the various

steps in the process adds to our unders tanding of the mecha-

nism underlying d irectors’ departures.

On the regulatory front, this approach is also likely to

provide better guidance as to whether the proposed election

reforms are likely to shore up weaknesses in the board election

process. Our results suggest that examining only the outcome

of a shareholder vote provides a woefully incomplete analysis.

Director Misconduct and the Backdating of Options

In their 1983 analysis of corporate decision-making, Eugene

Fama and Michael Jensen decomposed the decision-making

process into four basic stages—(1) initiation, (2) ratication,

(3) implementation, and (4) monitoring—and attempted to

identify where the decision “rights” for each stage were typi-