Why Do Companies Appoint Tainted Executives as Outside Directors?

Active and retired top executives are prime candidates for outside director positions. Conventional wisdom suggests that these individuals’ experience equips them to serve effectively as monitors and advisers to management. Nevertheless, the business press has revealed that some executives remain or become outside directors even though they or the companies they lead have been involved in high-profile accounting scandals or other governance failures. The practice of appointing tainted executives to boards raises serious concerns about how effectively boards oversee management.

In a new study, we examine this practice in hopes of understanding why firms engage in it. We focus on CEOs who are named as defendants in settled securities class action lawsuits. Using a comprehensive sample of 1,282 tainted executives named in 1,178 lawsuits filed over the 2002–2017 period, we first show that these individuals tend to leave their CEO positions and have difficulty finding new jobs. However, interestingly, they remain in demand as directors. In fact, consistent with the anecdotal evidence, a significant number of these executives successfully gain new seats on the boards of other firms.

We propose two explanations for why firms would appoint individuals with questionable reputations to their boards. First, given the limited supply of highly qualified directors, firms that are less attractive or those with a greater need for competent advisers may be more inclined to settle for tainted executives as directors. We refer to this as the Board Needs explanation. Second, tainted executives, who have presumably proven to be poor monitors, may obtain board seats because CEOs of the appointing firms intend to weaken the board’s monitoring function and entrench themselves. We refer to this as the Opportunistic Selection explanation.

Our empirical tests yield five key findings. First, firms with powerful CEOs or weak monitoring are not more likely than other firms to appoint tainted executives to their boards. In contrast, tainted executives tend to join the boards of less visible firms or those with greater advising needs. Second, firms generally avoid placing tainted directors on nominating and governance committees, both of which have important monitoring responsibilities. Instead, these directors often serve on committees that play more of an advisory role. Third, the skills of tainted and non-tainted appointees are similar, and the evolution of board-level skills is comparable in firms appointing tainted and non-tainted executives to their boards. Fourth, after appointing tainted executives to their boards, firms perform better than a matched control sample. This effect is more pronounced for firms with greater advising needs. Importantly, firms with tainted appointees are not monitored less effectively. Finally shareholder satisfaction with board performance appears to remain stable or even improve following the appointment of tainted executives, suggesting that these appointments meet the needs of the board.

Taken together, our findings support the Board Needs explanation rather than the Opportunistic Selection explanation. Our study underscores that firms want directors with valuable skills, even when these individuals have a reputation for lax monitoring. Our findings shed light on the broader question of what firms look for when making director appointment decisions. Furthermore, our findings suggest that plenty of tainted executives find places to land. Despite losing their executive positions, they continue to become directors, highlighting the distinction between the executive and director labor markets.

This post comes to us from professors Leah Baer at the University of Missouri at Columbia, Yonca Ertimur at the University of Colorado at Boulder, and Jingjing Zhang at McGill University’s Desautels Faculty of Management. It is based on their recent article, “Tainted Executives as Outside Directors,” available here.

1 Comment

  1. Douglas K. Chia

    Another reason why so-called “tainted” directors may actually add value to a board is because they have been through the fire and lived to tell about it. Having been through controversy or failure, they have certain learnings that those who have only experienced smooth sailing do not. This can make some of the tainted directors better equipped to help management navigate through a crisis or even spot red flags.

    As for CEOs who are tainted because they were fired, some people make better board members than they do CEOs, similar to how some of the greatest sports coaches were mediocre players.

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