How do restatements affect outside directors and boards? A review of the literature

Journal of Accounting Literature 43 (2019) 19–46

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How do restatements affect outside directors and boards? A review of the literature

T

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Daniel A. Streeta, , Dana R. Hermansonb a b

University of Alabama, Culverhouse School of Accountancy, 361 Stadium Dr., Tuscaloosa, AL, 35487, United States Kennesaw State University, School of Accountancy, 560 Parliament Garden Way, Kennesaw, GA, 30144-5591, United States

A R T IC LE I N F O

ABS TRA CT

Keywords: Restatement Board of directors Independent director Outside director Proxy advisor Shareholders

This paper reviews academic literature related to the consequences that outside directors and boards may face in the wake of earnings restatements and suggests directions for future research. We examine loss of board seats; recruitment of new directors; proxy recommendations and shareholder support; pre-emptive director departures; director wealth effects; director reputation, litigation, and sanction risks; international evidence; and legal proposals for reform. The overall picture that emerges from the literature is that directors’ primary risk in the wake of earnings restatements is loss of board seats, in part through adverse proxy advisor recommendations and reduced shareholder support. Directors typically face little risk of legal liability or SEC sanctions, and some directors pre-emptively leave a problem company’s board and reduce their loss of interlocked board seats. Some legal scholars have called for director liability to be increased so as to promote more vigilant board oversight. Companies often focus on increasing the independence of the board in the wake of a restatement in an effort to repair organizational reputation. While researchers have revealed a host of important findings to date, much more can be learned about the effects of restatements on outside directors and boards.

1. Introduction This study reviews the impact of earnings restatements on outside directors and their boards and provides directions for future research. Financial markets rely on boards of directors composed largely of outside directors as a corporate governance mechanism to ensure accurate financial reporting (The Sarbanes-Oxley Act, 2002), but a restatement indicates that previous financial statements were misstated (Financial Accounting Standards Board, 2017). A restatement indicates that a misstatement failed to be detected and prevented in a prior period which suggests a potential failure of the board of directors to effectively monitor the financial reporting process (Richardson, 2005; Srinivasan, 2005). Restatements can provide a signal regarding the quality of outside director monitoring (Carver, 2014; Richardson, 2005). Previous authors have reviewed literature on the characteristics of outside directors associated with the likelihood and severity of restatements (Carcello, Hermanson, & Ye, 2011; Cohen, Krishnamoorthy, & Wright, 2004; Yu, 2013). In other words, prior literature reviews typically focus on variables associated with the existence or severity of restatements, the events leading up to the accounting misstatement. Using the notion of a timeline around accounting and internal control problems (Johnstone, Li, & Rupley, 2011, p. 335), previous literature reviews have not focused extensively on the consequences of restatements, but instead have focused largely on the conditions preceding the restatement. The literature on the subsequent impacts of restatements on outside directors and their

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Corresponding author. E-mail addresses: [email protected] (D.A. Street), [email protected] (D.R. Hermanson).

https://doi.org/10.1016/j.acclit.2019.07.001 Received 17 July 2018; Received in revised form 29 May 2019; Accepted 1 July 2019 Available online 13 July 2019 0737-4607/ © 2019 University of Florida, Fisher School of Accounting. Published by Elsevier Ltd. All rights reserved.

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boards has not been reviewed in detail.1 This second body of research on consequences is critical for regulators, investors, and board members, as it represents an important intersection of accounting and corporate governance. Restatements typically reflect a type of failure, and those charged with governance, including outside directors, can suffer consequences after such failures. Reviewing and synthesizing this literature highlights the nature and severity of consequences for directors and boards after restatements, including how such consequences vary across settings. Stakeholders who expect to hold outside directors accountable for accurate financial reporting should recognize factors that might limit accountability. In addition, this literature can help current and prospective directors to evaluate the various risks of public company board service, such as legal, reputational, and labor market risks. Finally, this literature complements our understanding of how corporate governance structures influence the effectiveness of financial reporting (Carcello et al., 2011; Cohen et al., 2004) by investigating how outside directors and corporate governance structures are affected by financial reporting problems. Overall, we seek to provide the first in-depth review of literature on the intersection of restatements, outside directors, and boards, focusing on consequences. We conduct a broad review of this literature by focusing on five prominent “seed” papers in the area, complemented by extensive key word searches. We focus primarily on prominent journals and U.S. findings, but also present international insights. In total, our review encompasses 51 research papers detailed in the tables. As shown in Fig. 1, we organize our review by addressing eight key areas: (1) loss of board seats; (2) recruitment of new directors; (3) proxy recommendations and shareholder support; (4) pre-emptive director departures; (5) director wealth effects; (6) director reputation, litigation, and sanction risks; (7) international evidence; and (8) legal proposals for reform. In each of these eight areas, we first assess the overall pattern of findings to identify key themes that emerge from the body of research. The key themes are: 1 Loss of board seats – Outside directors of firms experiencing restatements, fraud, or securities class action suits typically experience greater turnover, especially when the problem is more severe; the issue was identified externally (e.g., through the auditor or SEC); the director is named in a suit, has ties to the CEO, or is older; or the company is larger. Shareholder voting and proxy recommendations may be the avenue through which such director turnover often occurs. Also, outside directors generally lose interlocked board seats in the wake of accounting problems, especially for income decreasing restatements, when the director served on the audit committee, or when the director left the restating firm’s board. 2 Recruiting new directors – After an accounting problem, many companies work to increase the representation of outside or independent directors on their board, often with a focus on adding directors with military backgrounds, accounting expertise, legal expertise, or significant board experience. These changes in board composition may help to repair the organization’s reputation. 3 Proxy recommendations and shareholder support – Restatements often lead to negative proxy advisor recommendations and an increase in shareholder votes withheld from directors. There is evidence that the effects often are more negative for audit committee members than other directors, and audit committee member turnover can be the end result. 4 Pre-emptive departures – Some directors appear to anticipate the impending trouble and leave the board before any public disclosure of trouble is made. Such early departures appear to help to insulate the departing directors from the loss of interlocked board seats. 5 Personal wealth effects – Directors appear to be compensated for facing legal risk (akin to “hazard pay”), either when they have been on the board of a troubled company or when they join a board after litigation has been filed against the company. 6 Limited reputation, litigation, and sanction risk – Outside directors’ litigation risk is low, and their probability of personally paying out settlements is extremely low. Also, directors face very low risk of being named in an SEC enforcement action, and some directors seek to mitigate reputation risk by omitting from their biographies board service at companies with restatements, SEC investigations, or securities litigation. 7 International evidence – Directors face very low risk of personal liability across a range of countries, and some authors describe this low level of risk as “optimal.” These studies also provide some evidence of lost board seats in the wake of accounting problems, as well as some company-specific reforms after problems (e.g., replacing the board chair). 8 Legal proposals – There is a strong call to increase the legal liability and accountability that outside directors face, along with a call for greater disclosure about D&O insurance policies and details of apportioning liability among parties. The primary picture that emerges indicates that directors’ main risk in the wake of earnings restatements is loss of board seats, in part through adverse proxy advisor recommendations and reduced shareholder support. Other director risks (litigation, sanction, etc.) typically are quite limited, and some legal scholars have called for greater director liability and accountability. Companies often focus on increasing the independence of the board in the wake of a restatement in an effort to repair organizational reputation. Based on the eight themes and our analysis of gaps in the literature, we also provide a wide range of avenues for future research. Some of the proposed avenues would employ archival methods, while others call for experimental research to provide ex-ante evidence of potential impacts of changes to the regulatory and legal environment. We also discuss many avenues for qualitative research. The rest of the paper is organized as follows. Section 2 provides background information regarding boards and restatements,

1 In Section 2.2, we discuss several literature reviews that very briefly touch on certain consequences of restatements for directors and/or boards, but at a much more limited level than the present paper.

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Fig. 1. Organizing Framework.

describes related literature reviews, and discusses our search method. Section 3 reviews prior research and presents avenues for future research within each of eight key areas, as well as some additional avenues for research. We conclude in Section 4. 2. Institutional background, prior literature reviews, and method 2.1. Board oversight and restatements Under the corporate structure, boards of directors serve the needs of diverse shareholders by monitoring top management, largely in an effort to mitigate the agency problem (i.e., self-interested behavior by management) (Jensen & Meckling, 1976). The interests of managers and shareholders may diverge, and the board’s monitoring role is designed to protect shareholders from managerial selfinterest. Other possible functions of the board (Cohen, Krishnamoorthy, & Wright, 2008) include a resource dependence role (i.e., helping management to secure needed resources) (Boyd, 1990) and providing the firm with greater legitimacy under an institutional theory perspective (Powell, 1991). Shareholders, creditors, employees, and other stakeholders rely on corporate financial reports to provide information about a firm’s performance and to minimize agency conflicts (Armstrong, Guay, & Weber, 2010; Jensen & Meckling, 1976). However, when a prior period financial statement is found to be materially misstated, the company must amend the prior report and communicate the revision to known users of the statement (Flanagan et al., 2008). The announcement of an earnings restatement has been found to trigger a significant negative stock price reaction (Anderson & Yohn, 2002; Palmrose & Scholz, 2004; Palmrose, Richardson, & Scholz, 2004), declines in users’ reliance on future financial statements (Wilson, 2008; Wu, 2003), and an increase in restating companies’ cost of capital (Anderson & Yohn, 2002; Hribar & Jenkins, 2004). A restatement can occur either due to an intentional misstatement (termed ‘irregularity’ or ‘fraud’) or unintentional misstatement (termed ‘error’), or it may merely correct a ‘technical’ accounting issue (Financial Accounting Standards Board, 2017). Eighty percent of intentional restatements are followed by Securities Class Action lawsuits (SCA lawsuits) alleging financial statement fraud (Hennes, Leone, & Miller, 2008). Section 301 of the Sarbanes-Oxley Act of 2002 clarified and increased expectations of outside directors by requiring companies to have audit committees comprised solely of independent directors, requiring that audit committees resolve auditor-management accounting disagreements, and specifying the responsibility of the audit committee to hire and fire the external auditor. Consistent with increased expectations that outside directors will effectively monitor and govern the financial reporting process of the firm, prior research finds that audit committee effectiveness has increased post-SOX. The increase in audit committee effectiveness is demonstrated by increased audit committee support for proposed auditor adjustments (DeZoort, Hermanson, & Houston, 2008), increased audit committee activity, diligence, expertise, and power (Cohen, Krishnamoorthy, & Wright, 2010), and an increased focus on audit committee financial expertise (Beasley, Carcello, Hermanson, & Neal, 2009). 2.2. Other literature reviews In addition to the research papers that we review in Section 3, we also found several published literature reviews from 2008 to 2018 that briefly touch on some of the areas examined in our literature review. These literature reviews include the following, and in each case, we note any focus on the consequences of restatements for directors and boards: 1 Flanagan, Muse, and O’Shaughnessy (2008) – This paper provides data on restatements by U.S. companies and discusses literature examining the causes and consequences of restatements. The authors briefly mention director turnover as a possible consequence of a restatement (p. 376), and they discuss one example of directors having personal financial liability in the aftermath of an accounting issue (p. 369). 2 Kalbers (2009) – This paper provides a review of literature on fraudulent financial reporting, ethics, and governance. The author 21

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briefly mentions (p. 194) one study on director turnover after a restatement. 3 Dechow, Ge, and Schrand (2010) – This paper reviews literature on earnings quality. The authors very briefly mention (p. 375) one study that examined outside director turnover after restatements. 4 Greve, Palmer, and Pozner (2010) – This paper reviews literature on organizational misconduct, and the authors note that research on consequences is much more limited than research on causes of misconduct. The authors briefly mention (pp. 90–91) director labor market penalties after organizational misconduct, including restatements. 5 Brown, Beekes, and Verhoeven (2011) – This paper examines corporate governance research in accounting and finance. The authors very briefly mention consequences of restatements and fraud for managers and directors (pp. 152–153). 6 Carcello et al. (2011) – This paper focuses primarily on the “big picture” revealed by corporate governance research in accounting: that “good” governance on paper is associated with “good” accounting, auditing, and internal control outcomes. The authors briefly summarize (p. 16) four studies that examine consequences for directors in the wake of accounting problems. 7 Ghafran and O’Sullivan (2013) – This paper reviews literature on the audit committee’s role in corporate governance. The authors briefly mention (p. 390–392) one study indicating that restatements can create reputational and turnover issues for audit committee members. 8 Habib and Hossain (2013) – This paper examines financial reporting quality and CEO/CFO characteristics. A key focus is on management turnover after accounting problems, rather than outside director turnover. 9 Johnson, Schnatterly, and Hill (2013) – This paper reviews literature on board composition. The authors briefly mention (p. 245) two studies on director turnover after restatements or fraud. 10 Malik (2014) – This paper examines the composition and effectiveness of audit committees in the post-SOX period. The author cites one study (pp. 98, 102) on the consequences of restatements for audit committee members. 11 Alperovych, Calcagno, and Geiler (2018) – Much of this review focuses on factors associated with fraud, including macroenvironmental factors, governance characteristics, and management traits. One section examines the consequences of fraud, but with very limited focus on outside director issues (pp. 525–526). 12 Amiram et al. (2018) – This paper reviews literature on financial reporting misconduct published in accounting, finance, and law journals. One section briefly examines the consequences for directors (pp. 764–765), concluding (p. 765), “The personal consequences to directors who serve on the boards of firms that experience financial misconduct, in contrast, are less clear [than those for managers].” The authors also note that companies often seek to rebuild their reputations by improving their boards after an accounting issue (p. 762). Overall, these prior literature reviews have a much broader focus than the present paper, and they tend to provide limited insights into the consequences of restatements for outside directors and boards, primarily that outside directors may experience turnover after a restatement. These limited insights tend to be based on review of a very small number of papers. By contrast, our literature is focused squarely on restatements and their consequences for outside directors and boards. As noted below, we review over 50 published studies and provide deep insights related to eight major themes that emerge from our analysis, as well as numerous avenues for future research. We seek to provide extensive insight into the intersection of accounting problems and the consequences for outside directors and boards, an important area that has been the subject of a great deal of research in recent years. 2.3. Search method We utilized a three-pronged search strategy to comprehensively identify the literature related to the consequences of restatements for outside directors and boards published between 1997 and 2018.2 First, we performed a Boolean search within Ebsco Host’s Business Source Ultimate database.3 Second, we identified four highly cited ‘seed papers’ on the consequences of restatements for directors and one highly cited seed paper on the consequences of restatements for management. Our five seed papers are Farber (2005); Srinivasan (2005); Fich and Shivdasani (2007); Arthaud-Day, Certo, Dalton, and Dalton (2006); and Burks (2010).4 These seed papers were selected to ensure that we identified all relevant literature from disciplines including accounting, finance, economics, and management. We gathered all of the references cited within the five seed papers and used Endnote to conduct a backward Boolean search through all of the articles referenced by these seed papers. Then, we used Google Scholar to conduct a forward Boolean search for all papers that cited these seed papers. Finally, we manually reviewed forthcoming articles made available through the American Accounting Association website. Our search process initially identified over 3,500 papers. Our Boolean search reduced the result set to 795 papers. To ensure that 2 Our start date of 1997 was selected because an early article empirically examining the consequences of restatements either for executives or directors was around this time (Beneish, 1999). In addition to published work, we searched for forthcoming articles made available in advance of publication through the American Accounting Association website as of January 2019. 3 The Boolean search we used within Ebsco Host, Google Scholar, and Endnote was: “board of directors” AND “restatement” AND (“turnover” OR “departure” OR “termination” OR “penalty” OR “consequence” OR “compensation” OR “loss” OR “lose” OR “lawsuit” OR “legal” OR “fines” OR “enforcement” OR “labor market”). 4 Burks (2010) studies the effect of restatements on CEOs and CFOs. Despite not examining the consequences of restatements for outside directors and therefore not appearing as one of our final 51 unique papers, this paper was selected as one of our seeds to ensure broad coverage of the literature. Several of the papers ultimately appearing in this review provide results pertaining to outside directors as part of a broader article focused on consequences of restatements for management.

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this review referenced only high-quality, peer reviewed research, we only retained empirical articles in journals ranked “3″ or higher according to the Chartered Association of Business Schools (2018) (available at https://charteredabs.org/academic-journal-guide2018-view/).5 The 795 papers were manually filtered by one of the authors to produce the final resulting set of 51 unique papers in the scope of our current review. Some of the 51 papers relate to multiple facets of our review and appear in more than one summary table. 3. Findings from the literature and avenues for research In each of the sections below, we synthesize the key themes from the literature, discuss highlights of selected papers, and provide promising avenues for future research. The themes reflect the “general sense” of the research to date, but we acknowledge that there are some inconsistent findings across various studies. Please refer to the table that accompanies each section for details on each cited paper’s method, sample, dependent variable, and key results. 3.1. Directors lose board seats at restating and interlocked firms (Table 1) Table 1 provides details of 19 papers examining outside directors’ loss of board seats at restating and interlocked firms. One main theme is that outside directors of firms experiencing restatements, fraud, or SCA suits typically experience greater turnover, especially when the problem is more severe; the issue was identified externally (e.g., through the auditor or SEC); the director is named in a suit, has ties to the CEO, or is older; or the company is larger. Shareholder voting and proxy recommendations may be the avenue through which such director turnover often occurs. Second, outside directors generally lose interlocked board seats in the wake of accounting problems, especially for income decreasing restatements, when the director served on the audit committee, or when the director left the restating firm’s board. Overall, outside directors of companies with accounting problems appear to risk their seat on the problem company’s board and on interlocked boards.6 Given the large number of papers in Table 1, we briefly focus on judgmentally-selected highlights, rather than discussing every paper. Srinivasan (2005) is one of our seed papers, and the author provides a comprehensive analysis of director turnover after restatements and how turnover risk varies with the type and severity of the restatement, as well as with the director’s tenure. Arthaud-Day et al. (2006), another seed paper, and Helland (2006) build on this understanding by documenting the particularly negative effects on directors when the SEC or an external auditor prompts the restatement / investigation. Fich and Shivdasani (2007) is a seed paper that provides evidence on directors, especially audit committee members, losing seats on other boards. Further, the authors quantify the net present value of board seat losses. Carver (2014) adds to our understanding of director turnover by highlighting that CEO power and involvement in director nominations serve to shield directors from turnover, while director ties to the CEO can increase the risk of losing the board seat. Marcel and Cowen (2014) indicate that directors with high social and human capital seem to fare better after financial statement frauds than those with low social and human capital. Finally, Baum, Bohn, and Chakraborty (2016) and Kachelmeier, Rasmussen, and Schmidt (2016) provide more fine-grained insights into factors associated with increased risk of losing a board seat, such as greater director age, firm size, and settlement amount, as well as risks to directors stemming from other accounting-related problems including internal control weaknesses or stock option backdating. While this area appears to be the most mature of the eight areas in our review, there still is room for additional research. One promising avenue relates to director networks and the consequences of restatements. Specifically, Marcel and Cowen's (2014) findings suggest that the strength of a director’s social capital / external network can mitigate board seat losses after a restatement. Questions for future research include the following: Precisely how do directors’ social ties play into the risk of losing restatement firm board seats or interlocked board seats? Are there specific types of connections that may serve to insulate directors from loss of seats?7 5 Legal articles in our review were exempt from the ranking restriction because law journals are not included in the Academic Journal Guide. Nevertheless, we present these legal articles in this review to provide readers with a deeper understanding of the legal liability that outside directors face. Journals and outlets which were excluded based on the ranking criteria include: Journal of Forensic & Investigative Accounting, Asian Review of Accounting, Journal of Applied Finance and Banking, Accounting and Finance, Advances in Financial Economics, Review of Accounting and Finance, African Journal of Business Management, Advances in Accounting (incorporating Advances in International Accounting), Applied Economics, International Journal of Commerce and Management, Research in Accounting Regulation, Academy of Management Annual Meeting Proceedings, Asia-Pacific Journal of Accounting & Economics, Journal of Management Control, TDRI Quarterly Review, The Journal of Applied Business Research, Applied Financial Economics, International Journal of Financial Management, and Journal of Management and Governance. 6 One issue to consider when interpreting the research on corporate governance and restatements is that non-restatement firms may include some firms with weak governance that have accounting issues that should warrant a restatement, but no restatement has occurred. This is a limitation of archival studies that compare restatement versus non-restatement firms on dimensions including director turnover. 7 Much of the research reviewed in this paper utilized difficult hand-collection from proxy statements to identify board of director service and committee membership, making many research questions very time consuming to address. However, BoardEx now provides data on the membership of the board of directors and its committees, director compensation, as well as each director’s individual academic and professional experience. This database facilitates the extension of archival governance research, and it covers a range of international firms and can make multi-country research more feasible. Further, some (Cohen et al., 2004; Carcello et al., 2011; DeFond & Zhang, 2014) have discussed the extent to which archival measures of governance quality truly reflect “good” governance, and there is potential for noisy data when individual researchers independently hand collect data. It is possible that the emergence of BoardEx will serve to reduce noise in governance data, and it may offer additional governance

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Archival

Fich and Shivdasani (2007)

Archival

Arthaud-Day et al. (2006)

Legal Arguments with Case Evidence

Archival

Srinivasan (2005)

Sale (2006)

Archival

Agrawal, Jaffe, and Karpoff (1999)

Archival

Archival

Gerety and Lehn (1997)

Helland (2006)

Method

Author(s)

216 securities class action lawsuits, each affecting different firms, from 1998 to 2002.

N/A

4,330 directors of firms targeted by an SCA suit alleging fraud plus 691 directors of firms targeted by an SEC suit alleging fraud out of a total of 50,476 directors between 1994 and 2002, drawn from Compact Disclosure.

116 restatements between 1998 and 1999 from the GAO restatements database matched with 116 control firms.

Number of directorships held at interlocked firms, two day (-1, 0) CAR for interlocked firms, two day CAR

N/A

Net outside directorships held.

Executive, outside director, and audit committee member turnover.

(continued on next page)

Three-year average director turnover from a restating company’s board is 48% after an income-decreasing restatement, compared to 28% for an incomeincreasing restatement and 19% after a technical restatement. Turnover is greater for audit committee members when they have longer service during the misstatement period and when the restatement is of greater duration and magnitude. Outside directors of a restating firm lose an average of 0.3 board seats from interlocking firms after an income-decreasing restatement versus no loss of other board seats for an income-increasing or technical restatement. Outside directors and audit committee members are more likely to leave a restating firm than a nonrestating firm, and outside directors are even more likely to leave the board if the restatement was prompted by the external auditor or the SEC, and if the firm is held by large outside blockholders. Conditional on an allegation of fraud, privately filed allegations of fraud are followed by a gain in net outside directorships after the allegation, in general. Only following an SEC allegation of fraud do net outside directorships decline. The author interprets this finding to mean that the average allegation of fraud does not actually identify fraud and therefore does not damage a director’s reputation. Historically, independent directors have not faced many penalties after a firm’s financial misconduct. For example, the board of Stirling Homex only met seven times between the company’s IPO and its bankruptcy, and did not detect or remedy financial misstatements. Despite these facts, the independent directors did not resign. Independent directors from WorldCom, Adelphia, Enron, Global Crossing, Waste Management and Tyco “continue to serve on public company boards, indicating that at least for some, having to pay out of pocket did not deter them from continuing service as board members.” However, the article indicates, “the SEC has stated that it intends to broaden its focus to include independent directors in its investigations.” Outside directors are no more likely to lose their board seat at the firm accused of fraud, but the average

Outside director turnover at the restating firm, number of interlocking directorships held by directors of the restating firm.

Outside director turnover at the fraud firm.

Over the three years following the SEC allegation, directors of affected firms lost approximately 6% more board seats than directors of control firms. No statistically significant increase in turnover among outside directors.

Percentage change in number of directorships.

62 firms charged with financial disclosure violations by the SEC between 1981 and 1987 matched with 62 control firms. 103 firms with a fraud news article in the Wall Street Journal Index between 1981 and 1992 matched with 103 control firms. 409 earnings restatements between 1997 and 2001 from the GAO database.

Key Results

Dep. Variable

Sample

Table 1 Directors Lose Board Seats at Restating and Interlocked Firms.

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Archival

Archival

Archival

Archival

Brochet and Srinivasan (2014)

Carver (2014)

Marcel and Cowen (2014)

Archival

Cowen and Marcel (2011)

Boivie, Graffin, and Pollock (2012)

Method

Author(s)

Table 1 (continued)

805 SCA lawsuits from 1996 to 2010 with 5,461 independent directors, matched by industry, size and ROA to 805 control firms with 4,739 independent directors. 562 audit committee members serving on 159 boards of firms with income decreasing restatements from 2002 to 2005 drawn from the GAO database.

2,266 directors of S&P 500 firms between 1996 and 2003, randomly selected.

432 board-director observations for non-restating firms which have director interlocks to 63 restating firms on the NYSE or NASDAQ exchanges between 2001 and 2004.

Sample

Director departure within three years.

Audit committee member retention.

Independent director turnover.

Director departure.

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CEO influence in the firm and CEO involvement in the director nomination process are negatively related to an outside director’s loss of board seat at the restating firm, but directors’ social and professional ties with the CEO as well as stock ownership in the firm are positively associated with the loss of a board seat.

number of other directorships held declines from 0.95 before the fraud lawsuit to 0.47 three years after the fraud lawsuit. The likelihood of losing a board seat at an interlocked firm is greater if the director was on the audit committee of the sued firm or is on the audit committee of the interlocked firm, but is negatively related to the interlocked firm’s governance index (Gompers). 49% of directors who hold three or more other board seats lose all other board seats besides their board seat at the alleged fraud firm by the third year after the allegation. The estimated net present value of the loss of these board seats is $990,155. Firms with an interlocking board member suffer an approximately 1% cumulative abnormal decrease in stock price in the (-1,0) window around the fraud allegation and are more likely themselves to be sued for fraud as well, but experience a positive abnormal return again of approximately 1% when departure of the tainted director is announced. Director departure from interlocked firms after a restatement is more likely when the director departed from the restating firm, was the CEO of the restating firm, or when the restating firm had a previous restatement. Turnover is less likely when the interlocked firm is a Fortune 500 company and when the interlocked firm is owned by a public pension fund (an external governance mechanism). This article finds no main effect between a restatement and the probability of a director’s loss of board seat at the restating firm, but does find that the presence of a restatement changes the relationship between a firm’s performance (ROA) and the likelihood of a director’s exit. In the presence of a restatement, a director is less likely to depart the firm when ROA is poor, but more likely to depart the firm when ROA is high. The authors interpret this finding as support for their hypothesis that restatements affect a director’s intrinsic motivations to serve on a firm’s board. Directors named in an SCA lawsuit are more likely to depart from the board of the restating firm than directors who are not named in the lawsuit.

around director departure, probability of fraud, probability of retaining directorship at affected firm.

Likelihood of director departure from interlocked firm.

Key Results

Dep. Variable

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Archival

Archival

Gal-Or, Hoitash, and Hoitash (2016)

Bar-Hava, Huang, Segal, and Segal (2018)

Archival

Baum et al. (2016)

Archival

Archival

Crutchley et al. (2015)

Kachelmeier et al. (2016)

Method

Author(s)

Table 1 (continued)

5,647 independent director resignations from 2,916 firms between 2004 and 2012 per Audit Analytics.

2,249 audit committee members up for election in 597 non-staggered S&P 1500 boards during 2007; 137 of these firms allowed a misstatement that led to a restatement.

673 SCA lawsuits from the Stanford Law School SCA Clearinghouse database between 1997 and 2009, 30% of which correspond to restatements, deceit, or earnings issues. 333 corporate SCA defendants between 1996 and 2003, identified from S&P 1500 firms or firms with assets exceeding $500 million, representing 2,364 outside and 800 inside directors; 24% of the sample contains allegations related to a restatement. Voting records and proxy advisor recommendations for 18,296 audit committee member-firm-year observations between 2004 and 2010.

407 directors across 63 fraud firms on the NYSE and NASDAQ exchanges between 2001 and 2004.

Sample

Probability of director departure, (-4,1) CAR and (2,360) CAR.

Audit committee member turnover.

Departure of audit committee financial expert, nonfinancial expert, and replacement of audit committee financial expert.

Director turnover probability.

Number of directorships held at interlocked firms.

Dep. Variable

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Outside directors are more likely to lose their board seat at the firm facing the SCA if they are older than 66, if the firm is large, if the suit is settled, or if the settlement amount is in the highest quartile. Turnover is less likely as the director’s voting rights increase. This study fails to reject the null hypothesis that accounting financial experts leave the audit committee after a restatement, whether the board is staggered or not. Similarly, the study fails to reject the null hypothesis that other audit committee members leave the board after a restatement. It is probable that these findings arise either because the study does not differentiate between the severity of restatements (intentional or not, non-reliance or merely technical, etc.) or because the study includes adverse shareholder voting for audit committee members as a control variable, potentially blocking a main effect of restatements. Audit committee members are more likely to leave a firm’s board if the firm restates its earnings, allows a material weakness in internal control to occur, allows backdating of stock options to occur, does not file its financial statements timely, allows aggressive or questionable accounting policies, or is involved in a financial reporting settlement with the SEC, whether the director was on the board at the time or merely serves with another board member in place at the time. Audit committee member turnover is also positively associated with the proportion of shareholder votes withheld from the director election. Five of the 5,647 director resignations were attributed to regulatory (SEC) investigations, but the article does

The authors argue that, after financial statement fraud, directors with high levels of human and social capital are likely to “jump ship” and leave a board voluntarily in an effort to protect their reputations, while directors with low human and social capital are more likely to be removed from a board involuntarily in an effort by the firm to “clean house”. The authors find significant negative relationships between human- and socialcapital variables and the probability of turnover, suggesting involuntary turnover (“cleaning house”) of low human- and social-capital directors after financial statement fraud. Directors of firms faced with an SCA lawsuit increase the number of interlocked board seats they hold by 0.05-0.07 seats in the three years after the lawsuit.

Key Results

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Journal of Accounting Literature 43 (2019) 19–46

Archival

Archival

Ertimur et al. (2018)

Harrison, Boivie, Sharp, and Gentry (2018)

52,552 outside director-year observations of 1,031 different S&P 1500 firms between 2003 and 2014.

Voting records for 23,844 director-year elections at S& P 500 firms between 2003 and 2010.

Sample

Director turnover probability.

Withheld votes, director turnover (in general and on specific committees), firm responsiveness to proxy advisor ‘withhold’ recommendations.

Dep. Variable

not note whether the investigations were triggered by restatements. Conditional on controlling for shareholder voting and ISS recommendations, income-decreasing restatements are unrelated to director turnover at the restating firm. This suggests that restatements may have their effect on director turnover only through shareholder voting and proxy advisor recommendations. Restatements and securities litigation are positively associated with departure from a board, even after controlling for media sentiment, star analyst recommendation downgrades, and CEO turnover.

Key Results

Note: Throughout the tables, we sometimes use/adapt phrases from the underlying articles (without quotes) when summarizing the sample, dependent variable, or key results.

Method

Author(s)

Table 1 (continued)

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Another area for future research consists of exploring which portion of their social and professional networks directors utilize to obtain subsequent board positions after a restatement. Do directors find social, educational, executive, or concurrent directorial ties to be most helpful in obtaining subsequent directorships? Future research could investigate whether particular portions of directors’ networks tend to be robust to restatements by comparing how directors associated with restatements secure future directorships compared to their non-restatement peers.8 In addition, we encourage research on how restatements affect the social ties of directors. Bruynseels and Cardinaels (2014) examine social ties as an input to the financial reporting quality, and we believe that this line of inquiry can be extended by exploring how restatements subsequently alter the social ties of directors – are restatements a shock to social networks of directors and audit committee members? If so, how? Finally, we encourage additional research on the extent to which director consequences from restatements are linear. In other words, are there factors that can drive break-points, or even U-shaped patterns, in terms of the impact of a restatement on directors, or certain types of directors? Overall, the effects of restatements on directors (and boards) may not be linear.

3.2. Restating firms recruit new independent directors (Table 2) Table 2 presents details of 12 papers that examine restating firms’ recruitment of new independent directors. The main theme of these papers is that, after an accounting problem, many companies work to increase the representation of outside or independent directors on their board, often with a focus on adding directors with military backgrounds, accounting expertise, legal expertise, or significant board experience. These changes in board composition may help to repair the organization’s reputation.9 Given the large number of papers in Table 2, we briefly focus selected highlights. Farber (2005) is one of our seed papers and focuses on companies’ responses to SEC sanctions for fraud. The author finds that such firms tend to increase the proportion of outside directors, the number of times the audit committee meets, and the size of the audit committee, as well as separating the CEO and board chair roles. Further, Almer, Gramling, and Kaplan (2008) provide experimental evidence that adding new independent directors after a fraud enhances management’s credibility, and Marciukaityte, Szewczyk, and Varma (2009) document positive stock returns from replacing a director after a restatement. Simpson and Sariol (2018) and Ghannam, Bugeja, Matolcsy, and Spiropoulos (2019) find evidence that outside directors added to boards after accounting-related problems often have military experience, accounting expertise, or legal expertise. The overall tenor of these papers is that companies with accounting problems are working to enhance their reputation by improving the apparent quality of the board. A key issue for further research is any relation between the replacement of directors and the likelihood of future accountingrelated problems. Replacement directors may be more independent and possess stronger accounting or legal expertise than outgoing directors, which would suggest an increase in monitoring effectiveness with a new board. However, replacement directors likely lack the firm-specific knowledge possessed by outgoing directors, and this lack of expertise may hinder monitoring effectiveness. Therefore, it is an empirical question whether the replacement of outside directors after a restatement increases or decreases the probability of repeat restatement. Notably, research on the effect of replacing executives after a restatement contains conflicting findings and is consistent with both scenarios noted above. Dao, Huang, Chen, and Huang (2014) find that firms which replace their CEOs and CFOs face an increased likelihood of repeat restatement in the following three years, while Chi and Sun (2014) find that replacing the CEO or CFO after a restatement decreases the likelihood of a repeat restatement in the following three years. Engel, Gao, and Wang (2015) find that CFO successions following restatements, internal control weaknesses, SEC comment letters, and late regulatory filings decrease the likelihood of repeat restatements, but that similar improvements are not found after CEO successions. Based on the mixed results of this executive-focused research, and because responsibilities for financial reporting differ between executives and outside directors, it is difficult to form a prediction regarding whether replacing outside directors will effectively reduce the likelihood of repeat restatement. A related avenue for future research is the relation between replacement director characteristics and the risk of a future restatement. Habib and Bhuiyan (2016) show that audit committees composed of members who have been previously associated with a restatement, bankruptcy, or other accounting scandal at other firms are associated with an increased likelihood of restatement and fraud. Schmidt and Wilkins (2012) demonstrate that increased accounting expertise on the audit committee is associated with a shorter time between when a company discovers it needs to restate earnings and the date of the disclosure of the restatement’s effect on earnings. However, this research does not examine which qualifications, experience, and social capital attributes of outside directors following a restatement have the effect of reducing the likelihood of a repeat restatement. In summary, it is important for boards and shareholders to be provided with evidence regarding the effectiveness of replacement directors when these parties are deciding whether to advocate for the replacement of incumbent directors. For instance, if research indicates that replacing directors results in an increased risk of repeat restatement, then shareholders may wish to seek alternative

(footnote continued) characteristics to examine more feasibly. 8 Such examinations would complement research on the longer-term effects of accounting problems on managers (e.g., Groysberg, Lin, & Serafeim, 2017; Condie, Convery, & Johnstone, 2018). 9 Despite the evidence of firms seeking to enhance the independence of their boards after a restatement, we note that Kim and Klein (2017) find no evidence that improvements in audit committee independence due to the 1999 changes in stock exchange listing requirements enhanced firm value or financial reporting quality. 28

Method

Archival

Archival

Archival

Experimental

Archival

Archival

Author(s)

Agrawal et al. (1999)

Farber (2005)

Desai, Hogan, and Wilkins (2006)

Almer et al. (2008)

Marciukaityte et al. (2009)

Chakravarthy, deHaan, and Rajgopal (2014)

Percentage of independent directors added (removed) from the board.

103 firms with a fraud news article in the Wall Street Journal Index between 1981 and 1992 matched with 103 control firms. 87 firms receiving AAERs from the SEC from 1982-2000 with 87 control firms matched by industry and net sales.

Percentage of independent directors on the board.

Financial statement credibility level.

Number and percentage of outside directors on the board and audit committee for voluntary and forced restatements.

Two day CAR (0, +1) surrounding a reputation repair announcement.

146 restatements from 1997-1998 from the GAO database with 146 control firms matched by industry, age, and size.

50 MBA students taking a financial accounting course at a large state university.

187 restating firms from the GAO database from January 1997 to June 2002 with 187 control firms matched by industry and market value of equity.

94 firms with irregularity restatements from the GAO database from January 1997 to July 2006 with 94 propensity score matched control firms.

Number and percentage of outside directors.

Dep. Variable

Sample

Table 2 Restating Firms Recruit New Independent Directors.

29

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Fraud firms tend to increase their outside director percentage, the number of audit committee (AC) meetings, and the number of AC members from the year before to the fourth year after the fraud. They are also likely to separate the CEO from the Chairman of the Board position. Fraud firms that increase their outside director percentage have less negative buy-and-hold returns than fraud firms that do not. Firms increase the percentage of outsiders on their boards after a restatement, although this increase is not significantly different from the increase in outside board membership for non-restatement firms. On an 11 point scale, recruiting new independent directors after a fraud improves experimental participants’ judgment of management’s credibility (mean increase from 5.0 to 5.9), but other actions were more effective at improving credibility (changing external auditors: from 5.0 to 6.0; outsourcing the internal audit function: from 4.6 to 6.3). After three years, companies that were forced to restate their earnings by the SEC, auditor, or other external parties increased their proportion of independent board members from 60% to 71%. The proportion of independent board members for firms with an internally prompted restatement increased from 65% to 71% by the third year after the restatement. Director replacements are identified as one of six ‘reputation repair strategies’ targeted to capital providers. From 0.5 to 2 more capital provider reputation repair strategies are announced by firms after an earnings restatement relative to those same firms before a restatement and relative to matched control firms. Announcement of a director replacement after a restatement is met by a cumulative abnormal return of 2.8% in the two day (0, 1) trading window surrounding the firm’s announcement. This return is significantly higher than the returns for director replacement prior to a restatement and than the returns surrounding director replacement for control firms.

No statistically significant increase in the proportion of outside directors on the board after a fraud.

Key Results

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30

Archival

Archival

Ghannam et al. (2019)

Archival

Baum et al. (2016)

Simpson and Sariol (2018)

Archival

Diestre, Rajagopalan, and Dutta (2015)

Archival

Archival

Crutchley et al. (2015)

Gal-Or et al. (2016)

Method

Author(s)

Table 2 (continued)

144 lawsuits from the Stanford Law School SCA Clearinghouse database from 2002-2012 which alleged misconduct, financial misconduct, other fraud, or product problems. 330 legal actions (alleging fraud, option backdating, accounting malpractice, etc.) drawn from Audit Analytics from 2005-2015.

Voting records and proxy advisor recommendations for 18,296 audit committee member-firm-year observations between 2004 and 2010.

Likelihood of appointing a director who has experience in accounting, law, or previous boards.

Likelihood of director appointment.

Replace audit committee financial expert indicator variable.

Affected firms are more likely to appoint accounting and legal experts to the board and appoint directors with greater previous board experience.

Appointment of a new independent director.

125 pharmaceutical firms with 1,810 directors from 20002006, resulting in 4,446 possible new non-executive director appointments. Number of directors, percentage of outside directors, and percentage of new directors.

Firms faced with an SCA lawsuit increase the independence of their boards by 5 to 6 percentage points on average in the three years after the lawsuit. Directors named in the SCA lawsuit and institutions as the lead plaintiff are associated with decreases in the number of total directors on the board. SCA lawsuits led by an institution and naming directors are associated with an increase in the independence of the board and an increase in the number of financial experts. Outside directors with experience in a new specific market that a firm seeks to enter are less likely to join the board of a firm that has experienced a restatement in the past three years. SCA defendant firms increase the percentage of outside directors on their boards approximately 5.5 percentage points in the four years after the lawsuit is filed, whether the case is settled or dismissed. Boards of firms that settle their lawsuits have 49% new directors four years after the filing of the case, on average, while boards of firms whose lawsuits are dismissed have 40% new directors in this same period. Firms in the top quartile of settlement amounts tend not to change their overall board size, but increase the proportion of outside directors in the four years after the lawsuit is filed. Boards of firms with lower settlement amounts tend to decrease their board size and increase the proportion of outside directors on their board. This study fails to reject the null hypothesis that the accounting financial experts of an audit committee are replaced after a restatement, whether the board is staggered or not. It is probable that this finding arises because the study does not differentiate between the severity of restatements (intentional or not, non-reliance or merely technical, etc.) or because the study includes adverse shareholder voting for audit committee members as a control variable, potentially blocking a main effect of restatements. Firms with misconduct (including restatements and allegations of financial statement fraud) are more likely to appoint new directors with military experience. Number of directors on the board, independent director percentage, and number of financial experts on board.

673 SCA lawsuits from the Stanford Law School SCA Clearinghouse database between 1997 and 2009, 30% of which correspond to restatements, deceit, or earnings issues.

333 corporate SCA defendants between 1996 and 2003, identified from S&P 1500 firms or firms with assets exceeding $500 million, representing 2,364 outside and 800 inside directors; 24% of the sample contains allegations related to a restatement.

Key Results

Dep. Variable

Sample

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Method

Archival

Archival

Archival

Archival

Archival

Archival

Author(s)

Cai et al. (2009)

Ye et al. (2013)

Brochet and Srinivasan (2014)

Kachelmeier et al. (2016)

Ertimur et al. (2018)

31

Gal-Or et al. (2018)

Withheld shareholder votes for directors, responsiveness of firm to withhold recommendations.

Raw and adjusted shareholder support (“for” votes) for independent directors, audit committee members, and independent non-audit committee members.

Voting records for 40,120 director-year (8,740 firm-year) elections from 2004 to 2010.

Audit committee member turnover from the board.

2,249 audit committee members from 597 S&P 1500 firms in 2007, of whom 330 are ‘tainted’ by unfavorable proxy recommendations and of whom 405 serve alongside one of these ‘tainted’ directors.

Voting records for 23,844 director-year elections at S&P 500 firms between 2003 and 2010.

ISS “withhold” recommendation and “withheld” shareholder votes.

Withheld votes for directors who served on the audit committee.

370 firms disclosing initial material weaknesses in internal control between 2004 and 2011 and 370 control firms.

845 SCA lawsuits (5,461 directors) from 1996 to 2010 per the ISS Securities Class Action database with 805 matched control firms (4,739 directors).

Excess shareholder votes for a given director versus average shareholder votes for all directors standing for election at that firm.

Dep. Variable

13,384 director elections in 2,488 shareholder meetings from 2003 to 2005.

Sample

Table 3 Directors of Restating Firms Receive Negative Proxy Recommendations and Lower Shareholder Support.

Audit committee chairs of firms with an accounting restatement in the prior year receive no fewer shareholder votes than other directors of the firm, on average, once ISS’s proxy recommendation is controlled for. Rather than indicating that restatements do not affect shareholder voting decisions, this evidence simply suggests that the ISS recommendation either dominates shareholder voting decisions or subsumes multiple decision criteria. Audit committee members receive more “withheld” (negative) shareholder votes when firms restate their earnings. Directors named in SCA lawsuits face negative voting recommendations from Institutional Shareholder Services (ISS) and, perhaps as a result, receive more withheld (negative) votes from shareholders. These withheld recommendations and votes are more likely if the firms’ share turnover is high, if the firm is large, or if the firm is in a high litigation risk industry. Audit committee members named in SCA lawsuits are more likely to face withheld recommendations and votes than other outside board members. This paper’s analysis (effects of shareholder voting on director turnover) is in part conditioned upon negative proxy recommendations by Glass, Lewis & Co. and does not analyze the extent to which financial reporting failures give rise to these negative proxy recommendations. However, this research indicates that negative proxy recommendations and withheld shareholder votes are positively associated with audit committee member turnover. Restatements are associated with a 2.25% increase in withheld shareholder votes in uncontested director elections. This association declines to 1.38% once the ISS recommendation is controlled for, suggesting that the ISS recommendation incorporates some of the main effect of a restatement (i.e., ISS’s recommendation for a director is decreased in the presence of a restatement). Audit committee members receive more “withheld” (negative) shareholder votes when firms restate their earnings, but independent directors who are not members of the audit committee do not receive more “withheld” votes after a restatement. The effect of a restatement on shareholder votes for an audit committee member does not appear to be affected by the member’s financial expert or audit committee chair status. New audit committee members receive fewer “withheld” votes, consistent with shareholders only holding audit committee members responsible if they served at the time of the restatement.

Key Results

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consequences, such as reduced compensation, rather than director replacement after a restatement. 3.3. Directors of restating firms receive negative proxy recommendations and lower shareholder support (Table 3) Table 3 presents details of six papers that examine proxy recommendations and shareholder voting for directors in the wake of restatements. The main theme of these studies is that restatements often lead to negative proxy advisor recommendations and an increase in shareholder votes withheld from directors. There is evidence that the effects often are more negative for audit committee members than other directors, and audit committee member turnover can be the end result. Specifically, Cai, Garner, and Walkling (2009) find that audit committee chairs of restatement firms do not receive fewer shareholder votes than other directors, once ISS voting recommendations are controlled, while Ye, Hermanson, and Krishnan (2013) find that audit committee members receive fewer votes after restatements. Similarly, Brochet and Srinivasan (2014) find that directors who are named in SCA suits face negative ISS recommendations and more shareholder votes withheld, and these effects are more severe for audit committee members. Kachelmeier et al. (2016) further link negative proxy recommendations and withheld shareholder votes to audit committee turnover, and Ertimur, Ferri, and Oesch (2018) conclude that ISS recommendations capture a portion of the effect of restatements on shareholder voting. Finally, Gal-Or, Hoitash, and Hoitash (2018) highlight the negative effects of restatements for audit committee members, but not other directors, as well as the reduced effects for audit committee members who are new to the committee. Overall, research to date reveals interplay among restatements, proxy recommendations, withheld shareholder votes, and director turnover, with audit committee members facing the greatest risk. Future research in this area can further examine how the effect of restatements on proxy recommendations and shareholder voting varies with other governance characteristics, company characteristics (e.g., recent financial performance, history of violations, blockholder ownership, etc.), the nature of the restatement (e.g., severity, financial statement area affected, nature of sanctions against management), auditor type and culpability/sanctions, and prior history of the directors involved. This area appears to be quite fertile ground for research, as the linkages among restatements, proxy recommendations, and shareholder voting may vary significantly across different settings, including internationally (see Section 3.7). 3.4. Directors leave the boards of restating firms pre-emptively (Table 4) Table 4 presents details of two papers that examine directors’ pre-emptive departures from boards, before accounting problems are revealed. The primary theme of these papers is that some directors appear to anticipate the impending trouble and leave the board before any public disclosure of trouble is made. Such early departures appear to help to insulate the departing directors from the loss of interlocked board seats. More specifically, both Fahlenbrach, Low, and Stulz (2017) and Gao, Kim, Tsang, and Wu (2017) highlight apparently preemptive departures by some directors (i.e., the directors leave before the accounting problem is disclosed). Gao et al. (2017) provide evidence that early departure is more likely with smaller boards, female directors, blockholder directors, and directors with more interlocked board seats, and it is less likely for longer-tenured directors. Early departure is more likely as severity of the issue increases, and such departures appear to shield directors from loss of interlocked board seats. With only two studies reviewed in this area, we encourage additional research on pre-emptive director departures, including research on the nature of disclosures or business press stories about such departures. For example, are there textual indicators in disclosures or business press stories that are associated with an increased likelihood of accounting problems after director departures? Other issues worthy of research include: Are there other characteristics of the directors, the companies, or the audit firm that are associated with director departures being more likely to signal an impending accounting problem? Do previous internal control problems or corporate ethical violations enhance the likelihood that a director departure signals future accounting trouble? How do professional and social ties among directors and managers relate to the probability that a director departure enhances the chance of a future accounting problem? Can an unexpected director departure at a company be informative about the potential for accounting problems at other companies in the same industry, or other clients of the same audit firm? Overall, pre-emptive director departures are relatively unexamined, and there are many fundamental questions to be answered. 3.5. Directors’ personal wealth is affected by restatements (Table 5) Table 5 presents details of three papers that examine director compensation or holdings. The key theme is that directors appear to be compensated for facing legal risk (akin to “hazard pay”), both when they have been on the board of a troubled company or when they join a board after litigation has been filed against the company. A secondary theme is that directors who depart a board before a fraud is disclosed sell much more of their holdings than directors who remain on the board until fraud disclosure. Specifically, Crutchley, Minnick, and Schorno (2015) find that director compensation increases after a lawsuit that names directors, but decreases after a suit that does not name directors. Similarly, Ghannam et al. (2019) find that new directors have higher pay when joining a board after a financial misconduct lawsuit has been filed. Both studies suggest that directors are compensated for the risks associated with litigation. Gao et al. (2017) document that directors departing before the disclosure of a fraud sell much more of their holdings than directors who remain on the board. Given the limited literature in this area, we encourage additional research on director compensation issues around restatements. Prior research demonstrates a negative relationship between audit committee short-term stock option ownership and accounting 32

Method

Archival

Archival

Author(s)

Fahlenbrach et al. (2017)

Gao et al. (2017)

Dep. Variable Cox proportional hazard of director turnover, stock return alpha, ROA, bad event (restatement, bad acquisition, lawsuit, or extreme negative stock return) indicator.

Probability of abnormal director turnover.

Sample

95,690 independent director-firm-years (14,428 firmyears) between 1999 and 2010 from RiskMetrics (now ISS).

195 firms (1,805 outside directors) with settled SCA lawsuits alleging fraud between 1997 and 2007, together with 195 control firms (1,778 outside directors) matched by industry, size, and year.

Table 4 Directors Leave the Boards of Restating Firms Pre-emptively.

Directors appear to anticipate future restatements and other negative events and depart from the affected firm’s board before disclosure of these negative events, even after controlling for other known determinants of voluntary departure, including firm performance, director busyness, and director retirement age. Directors are more likely to leave fraud firms during the fraud period (before disclosure of the fraud) than control firms. A director’s departure in advance of fraud disclosure is more likely if the board has few members, if the director is female, if the director is a blockholder in the firm, or if the director holds many interlocking board seats. A director’s departure in advance of fraud disclosure is less likely if the director has significant tenure at the firm. Directors are more likely to depart in advance of the disclosure of fictitious fraud (e.g., fictitious revenues), improper disclosure, and managerial selfdealing than they are for frequent fraud (e.g., premature revenue recognition or understated expenses) or accounting misstatements. The likelihood of a director departing in advance of fraud disclosure is positively associated with the severity of the fraud as measured by settlement amount and fraud length. Directors who depart in advance of the disclosure of fraud do not experience a significant decline in interlocking board seats in the three years after the disclosure of fraud, while directors who stay on the board through the disclosure of fraud do lose interlocking board seats.

Key Results

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33

Archival

Gao et al. (2017)

34

Director compensation increases by $4.3 K on average after a lawsuit that names directors, while director compensation decreases by $4.5 K after a lawsuit that does not name directors. Directors departing a firm before disclosure of a fraud sell approximately 29% of their holdings in the firm, compared to a sale of 7% by directors who stay on the board until fraud disclosure. Directors joining boards after a lawsuit alleging financial misconduct receive greater average compensation per day ($3,194) than those directors who joined the board before the lawsuit ($744). Similarly, directors joining boards after a lawsuit alleging financial misconduct receive greater compensation than they do for their other newly-obtained interlocking board seats ($991) and the directors for the total merged Compustat/BoardEx universe ($480). Results hold for median pay per day as well.

Total director compensation, director compensation payfor-performance sensitivity, and cash as a percentage of total director compensation. Number and percentage of shares sold in fraud (nonfraud) firms before director departure.

673 SCA lawsuits from the Stanford Law School SCA Clearinghouse database between 1997 and 2009, 30% of which correspond to restatements, deceit, or earnings issues.

195 firms (1,805 outside directors) with settled SCA lawsuits alleging fraud between 1997 and 2007, together with 195 control firms (1,778 outside directors) matched by industry, size, and year. 330 legal actions (alleging fraud, option backdating, accounting malpractice, etc.) drawn from Audit Analytics from 2005-2015. Director compensation per day served.

Key Results

Dep. Variable

Sample

Note: This table summarizes papers addressing specific wealth impacts (compensation and stock sales) to directors after restatements. This does not include the very broad literature examining stock price impacts of restatements, but not focusing on director wealth specifically.

Archival

Archival

Crutchley et al. (2015)

Ghannam et al. (2019)

Method

Author(s)

Table 5 Directors’ Personal Wealth is Affected by Restatements.

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quality (Archambeault, DeZoort, & Hermanson, 2008; Cullinan, Du, & Wright, 2008; Magilke, Mayhew, & Pike, 2009). However, no research has examined whether firms adjust the structure of director compensation to reduce the level of short-term stock options after a restatement. In other words, how does the mix of director compensation change after a restatement? If the mix of compensation changes, how is this change associated with the likelihood of future restatements or other accounting problems? Do changes in the mix of director compensation after a restatement appear to affect the company’s ability to recruit new talent to the board? Understanding of these issues could be very helpful to investors, attorneys, and compensation committees. Another avenue for future research consists of examining the joint effects of manager and director compensation changes after a restatement (Brick, Palmon, & Wald, 2006). Executives are charged with setting the strategy of the firm, conducting operations to earn a profit, and preparing financial reporting which accurately reflects the performance of the firm, while directors are charged with monitoring the firm and the financial reporting process (Cohen et al., 2004; Fama & Jensen, 1983). If the structure of compensation is similar for executives and outside directors, there may be little financial incentive for outside directors to constrain selfserving executive behavior. Two prior studies (Brick et al., 2006; Oxelheim & Clarkson, 2015) assess CEO versus director compensation and chairman compensation, respectively, and conclude that positive relationships between the two are consistent with cronyism. This provokes the following question: Do firms which have a similar compensation structure for both management and outside directors before a restatement (suggesting cronyism) modify their compensation structures differently than those firms which had divergent incentive structures between their managers and directors? The joint effects of a restatement upon executive and outside director compensation remain unexplored despite the critical relationship between the duties of these two groups. 3.6. Directors face limited reputation, litigation, and sanction risks after a restatement (Table 6) Table 6 presents details of 14 papers that examine directors’ reputation, litigation, and sanction risks in the wake of restatements.10 The main theme of these papers is that outside directors’ litigation risk is low, and their probability of personally paying out settlements is extremely low. There is evidence that the chances of a director being named in a suit are greater when the director is directly involved in the misstatement, serves on the audit committee, is male, or sold stock. Such naming also is more likely with institutional lead plaintiffs and when CEO compensation is higher and less linked to performance. Second, directors face very low risk of being named in an SEC enforcement action, and some directors seek to mitigate reputation risk by omitting from their biographies board service at companies with restatements, SEC investigations, or securities litigation. Gow, Wahid, and Yu (2018) directly examine director reputation issues by providing evidence on directors’ efforts to omit board service to companies with accounting problems. Such omissions appear to insulate directors from the loss of board seats. Several studies address litigation against directors. Some highlights of these papers include the following. Thompson and Sale (2003) find that directors are much less likely than managers to be named in litigation, and only directors who were directly involved in a misstatement are at risk. Srinivasan (2005), a seed paper, notes that directors are rarely named in suits, and they do not appear to pay any portion of the settlements. Klausner, Black, and Cheffins (2005) find that directors vastly overestimate their personal litigation risk. Finally, more recent studies (Brochet & Srinivasan, 2014; Crutchley et al., 2015) provide evidence that a director being named in a suit is more likely when the director served on the audit committee, was male, or sold stock. Director risk also is higher when CEO compensation is more generous and when an institution is a lead plaintiff. Finally, two studies (Sale, 2006; Srinivasan, 2005) provide evidence of very limited director risk of SEC sanctions. The evidence to date is consistent in reflecting limited reputation, litigation, and sanction risk for directors, apart from the loss of board seats described in Section 3.1 and the negative proxy recommendations and withheld shareholder votes discussed in Section 3.3. Changes in the legal or regulatory landscape could alter directors’ litigation and sanction risk over time, and we encourage continued monitoring of the landscape in this regard. Also, see Section 3.8 below for discussion of several proposals to enhance directors’ legal risk and accountability, along with discussion of several avenues for ex-ante research on the potential impacts of such proposals. Directors’ reputation risk for being associated with accounting problems also may vary over time as notions of best practices or director expectations fluctuate. We encourage research on variations in director reputation risk that may be associated with troubled versus strong industries, boom or recessionary times, or periods of minimal or more significant business press focus on accounting misstatements. Such research may uncover certain contexts in which director association with restatements is more or less damaging. 3.7. International evidence (Table 7) Table 7 presents details of six papers that examine the international landscape related to restatements, outside directors, and boards. The primary theme of these papers is that directors face very low risk of personal liability across a range of countries, and some authors describe this low level of risk as “optimal.” These studies also provide some evidence of lost board seats in the wake of accounting problems, as well as some company-specific reforms after problems (e.g., replacing the board chair). In Canada (Kryzanowski & Zhang, 2013), there is little evidence of director turnover risk, but there is evidence of companies increasing audit committee independence after a restatement. One Chinese study (Firth, Wong, Xin, & Yick, 2016) finds evidence of independent director turnover after sanctions, with greater turnover as sanction severity increases. Directors who turned over appear 10 The loss of restating firm and interlocked boards seats and the incidence of negative proxy recommendations and withheld shareholder votes (Sections 3.1 and 3.3) provide additional evidence of the reputation risks faced by outside directors.

35

36

Archival

Archival

Legal Argument

Fairfax (2005)

Srinivasan (2005)

Archival

Palmrose and Scholz (2004)

Legal History and Survey

Archival

Thompson and Sale (2003)

Klausner et al. (2005)

Method

Author(s)

N/A

146 of the study’s 409 sample firms between 1997 and 2001 faced lawsuits after restatements according to the Stanford Law School SCA Clearinghouse.

N/A

N/A

Director wealth impacts of legal outcomes.

Survey results from an unknown number of outside directors prior to the WorldCom and Enron settlements in January 2005.

N/A

Probability of litigation.

N/A

86 securities class action lawsuits filed in 1999 alleging fiduciary duty complaints under state law in the Second, Third, and Ninth Circuits, 88% of which allege accounting misrepresentations.

492 restating companies between 1995 and 1999 identified from Lexis-Nexis.

Dep. Variable

Sample

Table 6 Directors Face Limited Reputation, Litigation, and Sanction Risks After a Restatement.

(continued on next page)

21 of the 86 cases reviewed named an outside director as a defendant, versus 81 cases naming the CEO as a defendant. Of the cases naming outside directors, only outside directors directly associated with the misstatement were named (such as those accused of insider trading during the misstatement period), rather than the full board. Delaware cases now focus on the duty of loyalty (i.e., profiting by illicit insider trading) rather than the duty of care (i.e., adequate oversight). First study to explicitly note that litigation after restatements names directors (including audit committee members). Does not note what proportion of the litigation includes outside directors, though. All payments by defendants were made in pre-trial settlements. The author claims that the trend is “toward virtual elimination of director liability” (p. 405), but then notes that as the article went to press, Enron and WorldCom settlements were announced in which directors paid $15 million and $13 million personally out of pocket, respectively. The author argues for the addition of specified legal penalties for director failures within SOX, but notes that previous lawsuits brought by directors can be dismissed by the board at large (pp. 408-409). In sum, this article argues previous legal mechanisms for director accountability have been ineffective (pp. 408410), so additional legal liability is necessary for directors within SOX. According to surveys conducted by the authors, outside directors believe that personal liability occurs in about 5% of suits, but it actually only occurred in ˜0.25% of cases between 1980 and 2005. Outside directors overestimate their risk of personal liability by 20 times. This overestimation of their liability risk affects outside directors’ willingness to serve. A portion of the sample of restating companies were subject to AAERs, but the SEC focused the enforcement actions on the managers and auditors of the companies. No outside directors were cited in any of the sample AAERs. Securities lawsuits named 5.5% of the outside directors and audit committee members, but for those lawsuits where settlement information was available, no portion of the settlement was paid by the outside directors or audit committee members. The author concludes that outside directors and audit committee members bear only ‘nuisance costs’ on their time resulting from involvement with the litigation.

Key Results

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37

Legal History

Legal History

Sale (2006)

Gordon (2007)

N/A

N/A

N/A

Legal History

Black, Cheffins, and Klausner (2006b)

Sample

13 cases identified by an extensive search for lawsuits against public companies and their directors that proceeded to trial. The search covered approximately 5,200 lawsuits from 1980 to 2005.

Method

Black, Cheffins, and Klausner (2006a)

Author(s)

Table 6 (continued)

N/A

N/A

N/A

Dep. Variable

(continued on next page)

Of the 37 cases naming directors that proceeded to trial, only 13 (including Enron and WorldCom) involved payments by outside directors. Of these 13, 10 alleged oversight failures, two alleged self-dealing and failure to exercise the duty of loyalty, and one involved directors acting beyond their authority (“ultra vires”). In all but one of these cases, the company was already insolvent before the outside directors paid. The authors conclude that most of these cases “should not recur today for a company with a state-of-the-art [Directors and Officers] insurance policy”. Outside directors face very low personal liability risk in the U.S. and internationally. International legal proceedings against outside directors in “loser pays” regimes are typically taken by public officials rather than private parties because the lawsuit proceeds from a private suit rarely justify the financial risks of lawsuit failure. Protection for outside directors under U.S. law is attributable to 1) standards of care where violation is difficult to prove, 2) corporate indemnification of directors, and 3) ample D&O insurance. Outside directors are only likely to face personal liability in the U.S. in a “perfect storm” situation where the company is insolvent, D&O insurance coverage is less than the plaintiff’s expected lawsuit benefit, the claim relates to disclosures pertaining to a public offering, and one or more directors are sufficiently wealthy to personally fund substantial damages. Historically, federal and state governments in the U.S., Canada, Japan, U.K., and Germany have responded to legal situations which have threatened to increase outside director responsibility by enacting laws protecting independent directors. This paper argues that independent directors are securities monitors. It also reports on statements made by SEC staff members recommending that the SEC bring actions against independent directors, and recounts that the SEC has issued Wells notices (advance notice of charges by the SEC) to independent directors recently. This paper also reports about the situation surrounding the 2005 WorldCom independent director settlement payment. It reviews the various legal statutes that enable independent directors to be targeted with lawsuits or director and officer bans, as well as historical cases affecting independent directors. Finally, the paper analyzes the types of cases the SEC might pursue against independent directors. In general, post-Enron, it seemed that independent director liability might be on the rise, but the 2005 victory by Disney’s directors against a gross negligence

Key Results

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38

Archival

Crutchley et al. (2015)

Archival

Karpoff, Lee, and Martin (2008)

Archival

Legal History and Archival

Davis (2008)

Brochet and Srinivasan (2014)

Method

Author(s)

Table 6 (continued)

673 SCA lawsuits from the Stanford Law School SCA Clearinghouse database between 1997 and 2009, 30% of which correspond to restatements, deceit, or earnings issues.

Probability of naming an independent director in the lawsuit, lawsuit announcement and settlement returns (-30, +30), lawsuit duration, settlement likelihood, settlement amount, and legal fees as a percentage of settlement amount.

Probability of an independent board member being named as a defendant.

Lawsuit settlement amounts and non-lawsuit caused “readjustment” losses.

585 firms targeted by the SEC between 1978 and 2002.

805 firms (5461 independent directors) targeted by SCA lawsuits from 1996 to 2010 per the ISS Securities Class Action database with 805 control firms (4739 independent directors) matched by industry, year, size, performance, and litigation risk.

N/A

Dep. Variable

152 derivative claims alleging corporate impropriety against the directors of Delaware corporations from 2000 to Q1 2007, 64 of which claimed that defendants provided false or misleading information or withheld negative information.

Sample

(continued on next page)

allegation indicated that “bad faith” requires intentional dereliction of duty. However, demonstrating intention can enable D&O insurers to avoid liability, thereby reducing settlement amounts to what the affected company can pay. However, in the specific case of a public offering, directors are obliged to perform due diligence on disclosures, not just rely on an auditor’s assessment. This explains the $20 million settlement paid by the WorldCom independent directors. The vast majority of these claims were dismissed (86 cases) or simply involved procedural matters (40 cases), leaving 26 surviving cases. However, in at least four cases that survived a motion to dismiss, the defendants settled with “significant attorneys’ fees or monetary awards”. It is unclear from this article the extent to which D&O insurance covered any eventual settlements or financial judgments from trial. 231 class action or derivative lawsuits were brought by shareholders against officers and directors of the firm, resulting in total assessments of ˜$8.7 billion. Monetary penalties are five times more likely to result from SCA suits than from regulatory actions. However, the paper does not note whether these assessments were levied against inside or outside directors. Additionally, even though “directors of Delaware corporations can be held personally liable if their firms do not comply with the law,” these assessments are often reduced by D&O insurance, corporate indemnification, bankruptcy, and subsequent legal proceedings. Outside directors are more likely to be named in an SCA lawsuit after a restatement if they are audit committee members, male, or if they sold stock during the ‘class period’ of the lawsuit. They are also more likely to be named in the lawsuit if the firm has issued new equity, backdated stock options, suffered poor performance (ROA), or the lead plaintiff of the lawsuit is an institutional investor. Directors are more likely to be named in SCA lawsuits when CEO compensation is higher and less sensitive to performance or when an institutional investor leads the suit. Directors are less likely to be named in SCA lawsuits when they sit on a higher number of other interlocked boards, when the restating firm is large, when the restating firm’s board has a higher proportion of independent directors, or when the restating firm’s anti-takeover rights are higher. The announcement of a lawsuit naming outside directors triggers a larger stock price decline than a lawsuit not naming directors, but the settlement or dismissal of a lawsuit that names

Key Results

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Journal of Accounting Literature 43 (2019) 19–46

Archival

Gow et al. (2018)

Dep. Variable

Probability of not disclosing a previous board seat at an adverse-event firm, probability of adding or dropping disclosure of a previous board seat at an adverse-event firm, (-1, 0) and (-1, 1) CAR surrounding director appointments, number of interlocking directorships held/added, ISS recommendation, and shareholder votes.

Sample

218,795 biographies of directors as filed in proxy statements between 2002 and 2013.

outside directors results in a stronger rebound in stock price. Director-aimed lawsuits are resolved more quickly and with a higher settlement amount than non-directoraimed lawsuits. Director biographies when filed for interlocking firms are less likely to note director service at a firm which has restated its earnings and has had an SEC investigation or which has experienced securities litigation. Omission from the biography is even more likely when the restatement related to revenue. Biography omission is less likely after a 2010 SEC rule mandating disclosure of any board service in the past five years. The appointment of a director who discloses board service at a restating firm triggers a less positive stock recommendation than the appointment of a director who omits the disclosure. Directors who omit disclosing their board membership at a restating firm are less likely to lose their current board seat and are more likely to gain additional board seats at other firms. ISS recommendations appear to be unaffected by the disclosure of board service at a restating firm within the director’s biography.

Key Results

Note: This table does not include papers that examine director turnover, but do so conditional on a director/firm having been litigated against or sanctioned.

Method

Author(s)

Table 6 (continued)

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39

Legal History

Black et al. (2006b)

Archival

Legal History and Empirical

Cheffins and Black (2006)

Wang (2010)

Method

Author(s)

Table 7 International Evidence.

147 fraud firms and 140 control firms in China between 1998 and 2004.

Statutory law and case outcomes from U.S., Canada, Japan, U.K., and Germany.

Statutory law and case outcomes from Britain, Germany, Australia, Canada, France, and Japan.

Sample

Three-day CAR (-1,1) surrounding the restructuring announcement.

N/A

N/A

Dep. Variable

40

(continued on next page)

Personal liability for outside directors across Britain, Germany, Australia, Canada, France, and Japan is not zero, but very low. This reality results from the combined effects of “substantive law, procedural rules, and market forces.” Liability is most likely for suits brought by government agencies rather than private parties, because the returns to litigation do not provide an expected net benefit after the cost of litigation by private parties, while governments have non-financial objectives. The authors conclude that the current level of personal liability is optimal (i.e., directors are motivated to perform their duties effectively, and the labor market still provides willing outside directors). Outside directors face very low personal liability risk in the U.S. and internationally. International legal proceedings against outside directors in “loser pays” regimes are typically taken by public officials rather than private parties because the lawsuit proceeds from a private suit rarely justify the financial risks of lawsuit failure. Protection for outside directors under U.S. law is attributable to 1) standards of care where violation is difficult to prove, 2) corporate indemnification of directors, and 3) ample D&O insurance. Outside directors are only likely to face personal liability in the U.S. in a “perfect storm” situation where the company is insolvent, D&O insurance coverage is less than the plaintiff’s expected lawsuit benefit, the claim relates to disclosures pertaining to a public offering, and one or more directors are sufficiently wealthy to personally fund substantial damages. Historically, federal and state governments in the U.S., Canada, Japan, U.K., and Germany have responded to legal situations which have threatened to increase outside director responsibility by enacting laws protecting independent directors. Replacement of the board Chairperson after financial reporting fraud is associated with a .08% cumulative abnormal return. However, other restructuring activities generate stronger market responses after a fraud: CEO dismissal (+0.09%), stock buybacks (+0.10%), and subsidiary divestment (+0.11%).

Key Results

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Archival

Kryzanowski and Zhang (2013)

Archival

Legal History and Empirical

Black et al. (2011)

Firth et al. (2016)

Method

Author(s)

Table 7 (continued)

Unrelated director and audit committee member turnover pre- and post-SOX, number and percentage of unrelated directors, number and percentage of unrelated audit committee members.

177 restating firms listed on the Toronto Stock Exchange between 1997 and 2006 identified by searching Lexis-Nexis News Wires together with 177 control firms matched by industry and market capitalization.

Probability and severity of sanction, number of directorships held by penalized independent directors, market reaction to sanction.

Few Korean firms had independent directors until 1997, and before 1997 there were no lawsuits filed against inside directors alleging failure to perform their duties. Korea increased outside director responsibilities and risks after the East Asian financial crisis and adopted requirements which facilitated securities suits. However, despite these reforms, there have only been two suits which resulted in outside director liability. In one of these suits the outside director did not pay damages, while the payment of damages is unknown for the second suit. The authors conclude that a low-but-not-no liability risk level for outside directors is optimal. Audit committee member turnover in the two years following the restatement is no higher for restatement firms than control firms. On the other hand, outside director turnover in the two years following a restatement is higher, but only in the pre-SOX period. Post-SOX, outside director turnover is not significantly different between restating and control firms. Restating firms increase their proportion of outside directors on the board after a restatement, but this increase in outside directors is not significantly different from the increase in outside directors for control firms. Restating firms do increase the independence of their audit committee after a restatement to a greater extent than control firms. In the three years after the sanction, independent directors lose 0.2 board seats on average. Board seat loss is greater if a more severe sanction (i.e., warning or fine) is levied upon the independent director. Independent directors who have experienced sanctions tend to join better quality firms (larger, more profitable, and less leveraged) after the sanction than directors who have not experienced sanctions. This suggests that sanctioned directors are personally disincented from serving on the boards of troubled firms rather than facing external restrictions by the labor market.

N/A

Two cases resulting in outside director liability identified through an extensive search in Korea from 1997 to 2011.

106 sanctions of Chinese independent directors between 2003 and 2010.

Key Results

Dep. Variable

Sample

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Table 8 Legal Proposals. Author(s)

Method

Key Arguments

Fairfax (2005)

Legal Argument and Proposal

Coffee (2006)

Legal Argument and Proposal

Griffith (2006)

Legal Argument and Proposal

Hamdani and Kraakman (2007)

Legal Argument and Proposal

Kesten (2013)

Legal Argument and Proposal

This article provides a legal analysis of liability mechanisms for directors and concludes that directors are rarely held personally accountable. It provides a strong normative call to increase directors’ legal liability through the addition of specified penalties for independent directors like those specified in SOX for officers. This paper contends that SCA lawsuit settlements should be funded by the errant officers and directors, but instead are funded by corporations or insurers, so they simply transfer funds from some shareholders to others. The paper cites other work that shows: 1) directors are rarely named in SCA lawsuits alleging fraud because it is hard to show that an occasionally involved and modestly paid director is likely to have committed fraud; 2) D&O insurers and the defendant firm pay an average of 99.6% of SCA settlements; and 3) federal courts will not supervise how liability is distributed among defendants, so typically firms indemnify their independent directors. The paper provides five recommendations to alter the present situation: 1) The SEC should require independent directors to publicly explain the apportionment of liability among defendants in an 8-K; 2) The same insurer should not be permitted to cover both the individual directors and officers and the corporation, resulting in these different insurers apportioning liability among the parties; 3) Independent counsel should be required to study the responsibility and fairness of the division of liability among the corporation and its directors and officers; 4) Higher contingent legal fees should be offered for settlements by directors and officers versus by the corporation (see footnote 175 for examples where this has been implemented); and 5) Corporations should be exempted from liability under SCA lawsuits, leaving only individual directors and officers liable. This paper contends that the SEC should mandate U.S. firms disclose their D&O insurance policies’ premiums, limits, and retentions so that users can benefit from an external party’s assessment of the firm’s governance. This disclosure is already required in Canada. The existing legal regime provides a nearly complete ‘cocoon’ against any independent director liability. Instead, this paper proposes a “reverse negligence regime” wherein directors can bring legal suits after a triggering event (like a restatement, SEC investigation, or SCA lawsuit settlement) alleging that their behavior met or exceed a standard of reasonable vigilance. Successful suits would result in substantial rewards to those directors. This proposal would build the reputation of successful plaintiffs rather than harming those who took no action or those directors whose evidence was insufficient. This proposal would also provide the market with better information of directorial skill. This paper contends that claims of strong social and reputational damage for directors are questionable. It cites two pieces of evidence relevant to restatements: 1) Many directors of fraud firms (and bankrupt firms) do not lose their interlocking directorships, and any ‘tainting’ is extremely short-lived (executives and directors at Enron, Lehman Brothers, Bear Sterns, and AIG who gained new directorships shortly after their departure from these firms), and 2) 2/3 of executive and director respondents to a survey (Larcker & Miles, 2011) say that “a board member at a company with ‘substantial accounting and ethical problems’ could be a good board member at another company.”

to seek lower risk firms for future board positions. The other Chinese study (Wang, 2010) indicates that there is a positive stock price response to replacing the board chair after a financial reporting fraud. Finally, a Korean study (Black, Cheffins, & Klausner, 2011) and two multi-country studies (Black, Cheffins, & Klausner, 2006a; Cheffins & Black, 2006) all conclude that directors’ legal liability for accounting problems is quite low overall. The studies reviewed cover a range of countries, and they deal with director turnover, company boards’ response to accounting problems, and directors’ legal liability. We encourage research in additional country settings beyond those examined to date, provided that there are institutional, legal, or cultural differences in the unexamined countries that would be expected to yield different results. Further, we see little evidence of international research examining several of the key areas in our literature review, namely proxy recommendations, shareholder voting, pre-emptive director departures, director compensation, or director reputation risks. Each of these may be a fruitful avenue for future research. 3.8. Legal proposals (Table 8) Table 8 presents details of five papers that make proposals about the legal environment for directors. The overall theme of these papers is a strong call to increase the legal liability and accountability that outside directors face, along with a call for greater disclosure about D&O insurance policies and details of apportioning liability among parties. More specifically, Fairfax (2005) notes the very low liability that directors face and calls for director penalties to parallel those for officers that were included in The Sarbanes-Oxley Act (2002). Similarly, Kesten (2013) asserts that director penalties and limited and short-lived. Coffee (2006) discusses research indicating the very limited legal liability faced by directors and then proposes several remedies related to liability apportionment among defendants and D&O insurance. Likewise, Griffith (2006) calls for much greater disclosure about D&O coverage. Finally, Hamdani and Kraakman (2007) propose a “reverse negligence regime” to allow directors to attempt to demonstrate their vigilance, despite the existence of an accounting problem. These various proposals suggest to us several avenues for experimental research to, on an ex-ante basis, assess the potential effects 42

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of these proposals. Among the questions that could be examined with rigorous experimental research are the following: How does director oversight of financial reporting vary with the level of external legal penalties? How does the level of legal penalties affect directors’ compensation demands, insurance coverage demands, and willingness to serve on a board? Precisely how is a “tainted” director candidate’s nomination to a board viewed by nominating committee members? How does the view of the candidate vary with the type of prior misstatement, presence of self-dealing, and/or level of business press attention? How do directors apportion liability among insurers, the firm, the officers, and independent directors when the apportionment will be disclosed publicly (not disclosed)? What if the directors have to justify their decision to another party? How do investors respond to different apportionments of liability? Do D&O disclosures affect non-professional investors’ valuation/stock purchase decisions? Which disclosures (premiums, limits, or retentions) are most influential? How do experimental participants making a director nomination recommendation view (a) a director who successfully won a reverse-negligence suit, (b) a director who did not win such a suit, and (c) a director who did not bring such a suit? What makes a director willing to engage in a reverse-negligence suit? Overall, the authors of these legal proposals offer a host of ideas about changes in the legal landscape for directors. We believe that ex-ante experimental research can provide important insights into the possible effects of these proposals.

3.9. Additional calls for research In addition to the calls for research in Sections 3.1 to 3.8 above, we highlight three additional avenues for research. First, we encourage researchers to examine a range of director turnover and replacement issues using qualitative research methods and employing theories beyond agency theory and resource dependence theory. Specifically, a key role of the board under an institutional theory view is to provide the company with legitimacy, perhaps by having prominent directors or by following best practices or mimicking other firms. Researchers could examine, using qualitative methods such as interviews of key players, how and to what extent director turnover and replacement is motivated by a quest for restoring the legitimacy of the board and firm. Further, we believe that interviews of directors, including board chairs and nominating committee chairs, could provide key insights that will not be directly revealed by archival research, including: (a) precisely how and why directors lose or retain their board seats after restatements, including the extent to which director departures are voluntary or involuntary; (b) the nature of boardroom or informal discussions and group interactions that take place around these “replace or retain” decisions (including discussions with nominating committees, compensation committees, audit committees, internal and external auditors, and legal counsel);11 (c) the factors cited by directors, executives, shareholders, or other stakeholders to justify terminating or retaining individual directors; (d) directors’, shareholders’, and others’ perceptions of how certain characteristics of new directors may serve to enhance firm legitimacy; (e) factors considered by new directors who join a board after a company has had a restatement; (f) how directors who have suffered from their association with a restatement change their board search process going forward; (g) how proxy advisors view the substance of various boardroom efforts to restore board and firm legitimacy after a restatement; (h) factors that directors consider when leaving a board before an accounting problem is disclosed; and (i) how and to what extent directors are concerned about the legal and other risks of board service. Overall, we believe that qualitative research into a range of issues discussed across our eight themes could provide important new insights into issues that are difficult to directly address with archival methods. Second, research has not yet examined how audit committee processes change in the wake of a restatement. Studies have examined various audit committee processes (e.g., Beasley et al., 2009; Gendron, Bédard, & Gosselin, 2004), but this research can be extended to examine how audit committee or other board processes change in the wake of restatements or other accounting-related problems. Do audit committee and board processes become more formalized, or more closely aligned with best practices? Does the substance of audit committee or board processes increase, such that governance is enhanced? These and other related questions offer fruitful avenues for research. Finally, prior research has examined spillover effects of restatements to other firms, such as industry peers (Guo, Kubick, & Masli, 2018). This type of research and related theories could be extended to the board or director level. For example, do restatements affect the board seats or future prospects of directors at industry peer firms? Do industry peers enhance the independence of their boards when a peer has a restatement? Overall, to what degree do spillover effects extend to boards and directors of peer firms?

11 In a related vein, Van Peteghem, Bruynseels, and Gaeremynck, (2018) employ faultline theory to examine the relation of boardroom group dynamics (i.e., extent of apparent boardroom faultlines based on director characteristics) with a variety of performance measures. This approach may be adapted to examine restatement versus non-restatement firms.

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4. Concluding observations The published literature on the effect of restatements on directors and boards provides an overall picture of some of the consequences of accounting problems for those charged with governance. From a practice perspective, the literature highlights that directors’ primary risk in this setting is loss of board seats, which appears to be in part caused by adverse proxy advisor recommendations and reduced shareholder support. Directors’ litigation and sanction risks typically are quite limited, and some have called for greater director legal liability and accountability. Company boards typically respond to restatements by increasing board independence in an effort to repair organizational reputation. Despite the knowledge gained to date, we believe that this is a very fruitful area for future research. We identify specific avenues within each of the eight themes, some of which are archival examinations and others experimental. Beyond the eight themes, we call for a host of research questions to be examined through qualitative studies involving interviews of directors, executives, shareholders, proxy advisors, and others. In addition, we believe that there is much more to learn regarding changes to board processes in the wake of restatements, as well as regarding spillover effects of restatements to directors and board of industry peers. We hope that our synthesis will spur additional research in this area. Acknowledgements We thank Brian Mayhew and two anonymous reviewers for their constructive comments on this paper. References Agrawal, A., Jaffe, J. F., & Karpoff, J. M. (1999). Management turnover and governance changes following the revelation of fraud penalties: Public and private. The Journal of Law & Economics, 42, 309–342. Almer, E. D., Gramling, A. A., & Kaplan, S. E. (2008). Impact of post-restatement actions taken by a firm on non-professional investors’ credibility perceptions. Journal of Business Ethics, 80, 61–76. Alperovych, Y., Calcagno, R., & Geiler, P. (2018). Corporate governance and fraud: Causes and consequences. In S. Boubaker, D. Cumming, & D. Nguyen (Eds.). Research handbook of finance and sustainability (pp. 513–531). United Kingdom: Edward Elgar Publishing. Amiram, D., Bozanic, Z., Cox, J. D., Dupont, Q., Karpoff, J. M., & Sloan, R. (2018). Financial reporting fraud and other forms of misconduct: A multidisciplinary review of the literature. Review of Accounting Studies, 23, 732–783. Anderson, K. L., & Yohn, T. L. (2002). The effect of 10-k restatements on firm value, information asymmetries, and investors' reliance on earnings. Working paper. Washington, DC: Georgetown University. Archambeault, D. S., DeZoort, F. T., & Hermanson, D. R. (2008). Audit committee incentive compensation and accounting restatements. Contemporary Accounting Research, 25, 965–992. Armstrong, C. S., Guay, W. R., & Weber, J. P. (2010). 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