The Consequences of Restatements for Outside Directors

Serving on a public company’s board of directors carries responsibilities and risks as well as benefits for directors.  If directors do not carry out their duties effectively, they risk damaging their reputation, losing their board seats, and facing shareholder lawsuits.  In a recent paper, “Consequences of Restatements for Outside Directors,” I review the academic literature to identify the consequences directors face if the company on whose board they serve must restate its financial reports.

A restatement is required when a firm, its auditor, or the SEC finds that a prior period financial statement is materially inaccurate, forcing the company to amend the prior report and communicate the revision to known users of the statement.  A restatement can occur due to either an unintentional misstatement or the introduction of a new requirement (a “technical restatement” or an “error”) or an intentional misstatement (an “irregularity” or a “fraud”).  In addition to affecting  directors, restatements can trigger a significant drop in the company’s stock price, a decline of faith in the company’s future financial statements, and an increase in the company’s cost of capital. [1]

Financial markets rely on outside members of the board of directors to ensure accurate financial reporting. Unlike bankruptcy, which represents a corporate failure, a restatement indicates that a financial reporting misstatement was not detected and prevented in a prior period and therefore may represent a failure of the board of directors to effectively monitor and govern the financial reporting process. [2]

Factors Affecting the Consequences of Restatements

The academic literature consistently indicates that directors are more likely to lose their seats on the restating company’s board as well as on other boards on which they serve at the time of the restatement.  The likelihood of losing board seats is greater when the restatement results in decreased reported income, when the restatement is large and the director served on the audit committee, and when the misstatement is thought to have been intentional (i.e. fraudulent financial reporting). [3] Similarly, if a director has previous social and professional ties to the CEO of the restating firm or is named in a securities class action lawsuit, the director is  more likely to lose board seats.  On the other hand, if the director has a strong professional network or is female, or if the CEO is particularly powerful in the firm, then the director is less likely to lose board seats. [4]

Why Do Directors Lose Board Seats?

The literature also attempts to identify whether directors lose board seats involuntarily or whether they simply decide that the costs of public board service exceed the benefits.  Unfortunately, the literature in this topic is less clear and only infers the nature of turnover using publicly available data rather than by directly surveying or interviewing board members.  Thus, it is unsurprising that the literature is conflicted regarding whether directors are involuntarily separated from boards or leave by their own choice. [5]  In either event, it is clear that directors tend to lose their board seats both at the firm affected by a restatement and on the boards of other firms that they serve as directors.

Do Directors Face Lawsuits After a Restatement?

Because directors have a fiduciary responsibility to monitor the firm on behalf of shareholders, they are frequently named in shareholder lawsuits after the disclosure of a restatement.  However, the academic literature indicates only reputational costs rather than direct financial penalties resulting from litigation.  Specifically, directors named in a securities lawsuit are more likely to receive negative voting recommendations from proxy advisors and therefore more negative votes from shareholders, but there is no evidence that outside directors have paid any lawsuit settlements or judgments, because the cost of these settlements is likely born by the firm or its director and officer insurer. [6]  Therefore, while outside directors do not appear to be responsible for paying any portion of a litigation settlement, being named in a lawsuit is associated with reputation damage for directors.

What Remains Unknown?

Despite the considerable academic literature in this area, a fundamental question remains: whether the consequences that directors face after a restatement actually improve the firm’s future financial reporting.  Thus, investors, boards, and regulators should continue to seek information on this topic to enable the monitoring of financial reporting underpinning the effectiveness of financial markets.

ENDNOTES

[1] Anderson, Kirsten L., and Teri Lombardi Yohn. 2002. “The Effect of 10K Restatements on Firm Value, Information Asymmetries, and Investors’ Reliance on Earnings.” SSRN Scholarly Paper ID 332380. Rochester, NY: Social Science Research Network. Hribar, Paul, and Nicole Thorne Jenkins. 2004. “The Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost of Capital.” Review of Accounting Studies; New York 9 (2–3): 337–256. Palmrose, Zoe-Vonna, Vernon J. Richardson, and Susan Scholz. 2004. “Determinants of Market Reactions to Restatement Announcements.” Journal of Accounting and Economics 37 (1): 59–89. Wilson, Wendy M. 2008. “An Empirical Analysis of the Decline in the Information Content of Earnings Following Restatements.” The Accounting Review; Sarasota 83 (2): 519–48. Wu, Min. 2003. “Earnings Restatements: A Capital Market Perspective.” Ph.D., United States — New York: New York University, Graduate School of Business Administration.

[2] Srinivasan, Suraj. 2005. “Conseque nces of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members.” Journal of Accounting Research 43 (2): 291–334. Richardson, Scott A. 2005. “Discussion of Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members.” Journal of Accounting Research 43 (2): 335–42.

[3] (Srinivasan, 2005). Chang, Jui-Chin, and Huey-Lian Sun. 2016. “Reputation and Regulation Effects on Director Turnover and Change of Directorships.” Review of Accounting & Finance; Patrington 15 (3): 274–93.

[4] Carver, Brian T. 2014. “The Retention of Directors on the Audit Committee Following an Accounting Restatement.” Journal of Accounting and Public Policy 33 (1): 51–68. Marcel, Jeremy J., and Amanda P. Cowen. 2014. “Cleaning House or Jumping Ship? Understanding Board Upheaval Following Financial Fraud: Research Notes and Commentaries.” Strategic Management Journal 35 (6): 926–37. Pozner, Jo-Ellen. 2012. “Departure Status: The Effect of Leaving a Misconduct Firm on Director Labor Market Outcomes.” In Academy of Management Proceedings, 2012:1–1. Academy of Management.

[5] Boivie, S., S. D. Graffin, and T. G. Pollock. 2012. “Time for Me to Fly: Predicting Director Exit at Large Firms.” Academy of Management Journal 55 (6): 1334–59. Marcel, Jeremy J., and Amanda P. Cowen. 2014. “Cleaning House or Jumping Ship? Understanding Board Upheaval Following Financial Fraud: Research Notes and Commentaries.” Strategic Management Journal 35 (6): 926–37. Pozner, Jo-Ellen. 2012. “Departure Status: The Effect of Leaving a Misconduct Firm on Director Labor Market Outcomes.” In Academy of Management Proceedings, 2012:1–1. Academy of Management. Withers, Michael C. 2011. “Director Mobility: The Role of Human and Social Capital in Board Appointments.” Ph.D., United States — Arizona: Arizona State University.

[6] (Srinivasan, 2005). Brochet, Francois, and Suraj Srinivasan. 2014. “Accountability of Independent Directors: Evidence from Firms Subject to Securities Litigation.” Journal of Financial Economics 111 (2): 430–49.

This post comes to us from Daniel Street, a PhD student at the University of Alabama. It is based on his recent paper, “Consequences of Restatements for Outside Directors,” available here.

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