The Labor Market for Directors and Externalities in Corporate Governance

• Author: NADYA MALENKO,DORON LEVIT
• Date: 01 April 2016
• Published date: 01 April 2016
• DOI: http://doi.org/10.1111/jofi.12287

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 2 •APRIL 2016

The Labor Market for Directors and Externalities

in Corporate Governance

DORON LEVIT and NADYA MALENKO∗

ABSTRACT

This paper studies how directors’ reputational concerns affect board structure, cor-

porate governance, and firm value. In our setting, directors affect their firms’ gov-

ernance, and governance in turn affects firms’ demand for new directors. Whether

the labor market rewards a shareholder-friendly or management-friendly reputation

is determined in equilibrium and depends on aggregate governance. We show that

directors’ desire to be invited to other boards creates strategic complementarity of

corporate governance across firms. Directors’ reputational concerns amplify the gov-

ernance system: strong systems become stronger and weak systems become weaker.

We derive implications for multiple directorships, board size, transparency, and board

independence.

WHY DO CORPORATE BOARDS look the way they do? Are boards structured opti-

mally to maximize shareholder value, and how do board regulations affect their

composition? To a large extent, the structure of corporate boards is governed

by the labor market for directors. On the demand side, firms decide which di-

rectors to invite based on directors’ reputation and on the preferences of those

controlling the nomination process. On the supply side, directors seek to de-

velop their reputation in order to gain more board seats and thereby obtain

prestige, power, compensation, and access to valuable networks. Thus, direc-

tors’ reputation plays an important role, affecting both directors’ actions and

the structure of corporate boards.

∗Doron Levit is from the Wharton School, University of Pennsylvania. Nadya Malenko is from

the Carroll School of Management at Boston College. We are grateful to Bruno Biais (the Editor);

the Associate Editor; three anonymous referees; Jeffrey Coles; David Dicks (discussant); Vincent

Glode; Itay Goldstein; Todd Gormley; Barney Hartman-Glaser (discussant); Oguzhan Karakas;

Andrey Malenko; Egor Matveyev (discussant); Christian Opp; Giorgia Piacentino (discussant);

Jun “QJ” Qian; Jonathan Reuter; Raluca Roman (discussant); Nikolai Roussanov; Ali Shourideh;

Jerome Taillard; Mathieu Taschereau-Dumouchel; Luke Taylor; Nicolas Serrano-Velarde (discus-

sant); Amir Yaron; Bilge Yilmaz; John Zhu; Jeffrey Zwiebel; participants at the 9th Annual Cor-

porate Finance Conference at the Washington University in St. Louis, the UNC’s Roundtable

for Junior Faculty in Finance, the 2013 EFA Meeting, the Fourth FARFE conference, the 2013

NFA Meeting, the 2014 AFA Meeting, the 2014 Financial Intermediation Research Society Con-

ference; and seminar participants at Bentley University, Boston College, University of California

Los Angeles, University of Mannheim, University of Massachusetts Amherst, and the University

of Pennsylvania for helpful comments and discussions. The authors do not have any conflicts of

interest, as identified in The Journal of Finance disclosure policy.

DOI: 10.1111/jofi.12287

775

776 The Journal of Finance R

A number of recent institutional and regulatory changes to the director se-

lection process have affected the labor market for directors and the value of

reputation. They include a shift from plurality to majority voting, proxy access

proposals, restrictions on the number of directorships, and increased board-

room transparency. However, the effect of these factors is not well understood,

and some of the recent changes are subject to much debate.1In this paper, we

shed light on these issues by developing a theory of the labor market for direc-

tors and studying how directors’ reputational concerns affect board structure,

directors’ behavior, and ultimately shareholder value.

Our key observation is that directors care about two conflicting types of rep-

utation, and which type of reputation is rewarded more in the labor market

depends on the aggregate quality of corporate governance. If governance is

strong and boards of other firms protect the interests of their shareholders,

then building a reputation for being shareholder-friendly can help one ob-

tain more directorships. Conversely, if governance is weak and boards of other

firms are captured by managers who want to maintain power, then building

a management-friendly reputation can be more useful in getting additional

board seats. The empirical evidence is consistent with the importance of both

types of reputation. On the one hand, papers such as Coles and Hoi (2003)and

Fich and Shivdasani (2007) find that directors who demonstrate shareholder-

friendly behavior and monitor management are more likely to gain additional

directorships. On the other hand, papers such as Helland (2006)andMar-

shall (2011) find that shareholder-friendly actions hurt directors’ chances of

being invited to other boards. Zajac and Westphal (1996), Eminet and Guedri

(2010), and Bouwman (2011) find evidence consistent with the existence of con-

flicting reputational concerns: firms controlled by shareholders (managers) are

more likely to invite directors who have demonstrated shareholder-friendliness

(management-friendliness) in their previous board positions.2

To study how these conflicting reputational concerns affect directors’

behavior and firm value, we develop a model with three key components.

First, being a board member allows a director to affect corporate governance

in the firm and thereby change the allocation of control between management

and shareholders. Second, whether a director is shareholder-friendly or

management-friendly is the director’s private information, and, by allocating

control to either managers or shareholders, directors can affect the market’s

perception of their shareholder-friendliness. Third, the allocation of control in a

given firm determines, among other things, which type of directors it is looking

for. In particular, firms that are controlled by shareholders (management) have

greater demand for shareholder-friendly (management-friendly) directors.

Therefore, the aggregate quality of corporate governance, the structure of

boards, and the type of reputation that is more valuable in the labor market

are all determined in equilibrium.

1See, for example, “The Proxy Access Debate,” The New YorkTimes, October 9, 2009.

2Section III provides a review of these and other relevant papers in the empirical literature.

See also Adams, Hermalin, and Weisbach (2010) for a discussion of this reputational trade-off.

Labor Market for Directors and Externalities in Governance 777

We show that directors’ reputational concerns lead to strategic complemen-

tarity of corporate governance across firms. In particular, stronger governance

in one firm leads to stronger governance in its peer firms, and vice versa.3In-

tuitively, when most other firms have weak corporate governance, the decision

of whom to invite to the boards of these firms is controlled by managers. Thus,

to increase their chances of obtaining additional directorships, directors have

incentives to build a reputation for being management-friendly. This type of

reputation can be established by giving more control to the managers of their

firms and not interfering with their decisions, leading to weaker governance.

Conversely,when most other firms have strong corporate governance, directors

will strengthen corporate governance of their firms to build a reputation for

being shareholder-friendly.

Our paper thus identifies a novel channel of strategic complementarities

between firms, which work through directors’ reputational concerns in the labor

market. Strategic complementarities arise due to the dual role that directors’

actions have on supply and demand in the market for directors: in addition

to affecting directors’ own reputation (supply), they also affect which type of

reputation is more valuable in the market (demand).4

Strategic complementarity of governance has two implications. First, due

to strategic complementarity, a small regulatory change, such as a marginal

increase in the required percentage of independent directors, can have a signif-

icant effect on the aggregate quality of governance. Second, strategic comple-

mentarity implies that there can be multiple equilibria, characterized by the

aggregate quality of corporate governance. In particular, we show that, when

directors’ reputational concerns are sufficiently important, an equilibrium in

which aggregate governance is strong and the labor market rewards directors

for being shareholder-friendly coexists with a weak governance equilibrium,

in which a management-friendly reputation is more valuable. In this respect,

the strength of corporate governance is self-fulfilling, and hence countries and

industries with similar characteristics can have very different governance sys-

tems.

Our analysis demonstrates that the effect of various corporate governance

polices crucially depends on the existing aggregate quality of corporate gov-

ernance. Consider a policy that strengthens directors’ reputational concerns,

such as increasing the maximum allowed number of directorships a single indi-

vidual can hold.5We show that, when directors become more concerned about

3In what follows, we use the term “strong corporate governance” to describe firms in which

shareholders have control, and “weak corporate governance” to describe firms in which manage-

ment has control.

4The existing literature on labor markets highlights other channels of strategic complemen-

tarities between firms. In particular, prior work shows that strategic complementarities can arise

when both workers and firms make investment or entry decisions in the presence of search frictions

(e.g., Laing, Palivos, and Wang (1995), Acemoglu (1996)), or when there are increasing returns to

scale in either the matching technology (e.g., Diamond (1982)) or the production function (e.g.,

Benhabib and Farmer (1994)).

5Directors’ reputational concerns can also be affected by regulations that change the value of

a given directorship or that include term or age limits on directors. Note that restrictions on the