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Boards of Directors face uncertain futures when companies restate earnings

 

Corporate board members associated with firms that restate earnings may lose their jobs for reasons that have nothing to do with the numbers. Jo-Ellen Pozner, Assistant Professor in Organizational Behavior at the Haas School of Business at UC Berkeley, found that social mechanisms may play a larger role in penalizing board directors than is accounted for in classical economic theory.


Pozner's research, "Stigmatization, Pollution, Signaling and Symbolism: Earnings Restatements and the Market for Directors," examines the growing trend of earnings restatements to determine why directors of restating firms lose their seats on other boards. An earnings restatement occurs when a company amends a previously filed earnings report discovered to be materially incorrect, which may alter the company’s actual and perceived market value.


Pozner studied more than 300 earnings restatements filed between 1997 and 2003 by 266 S&P 1500 firms. She looked at when the restatement occurred, the reason for the restatement, the company’s performance, and how long individual directors stayed with a company after the restatement. The paper also used a sample of "clean" companies to make board comparisons. Patterns emerged, showing board members did not have to have held their positions at the time of restatement to be stigmatized, or guilty by association, to lose their seats on other boards. This may be human nature, justified or not. "We like to think that we choose directors based on a rational assessment of their skills and track record, but this does not appear to be the case.


"Instead, it's like a witch hunt. Companies get nervous about associating with other tainted companies, and their directors are essentially used as scapegoats," says Pozner. When a director's individual skills are outweighed by this negative stigma, rather than any substantive facts, Pozner says that many board members step down to disassociate themselves from the stigmatized company. Even if they leave, they face an increased probability of losing seats at other companies, although Pozner adds, "It is difficult to know for sure if they leave voluntarily or are asked to leave."


A good example of this is the comparison between Standard Commercial Corporation, which restated its earnings in June 2002 after one of its specialty fibers units, located in the Netherlands, was found to have falsified records. Even though the misstatement was because of misconduct at a relatively distant subunit, three of SCC's eight directors lost seats on other boards within three years. This is a very different outcome than what Pozner saw in companies that did not restate. For example, none of the eight directors and executives she sampled from Triarc Companies, which did not restate in 2002, had lost seats on other boards by 2005.


The passage of time also affects a member's ability to retain his or her board seat. Pozner says the so-called symbolic reaction to earnings restatements is a short-term, knee-jerk reaction. She found if directors can hold out until the end of their terms, usually three years, they are more likely to be judged by the severity and salience of the actual restatement, as the economic theories predict, as opposed to a mere symbolic measure. "In the third year after restatement, outside directors are much more likely to lose seats on other boards if the restatement reduced income, if it was the result of fraud, and if they were in office at the time of the restatement," according to Pozner's paper.


The shuffling of directors around the corporate game board may not evoke the emotional response that emerges when ordinary workers lose their jobs in a corporate merger or downsizing. Nonetheless, Pozner considers the phenomenon irrational. She says, "Nobody believed this could be the case, yet the evidence suggests that board appointments and renewals are not entirely based on rational calculation."


Pozner suggests that her findings may also be generally applied to most other forms of business misconduct. She says that the best way for boards of directors to avoid these kinds of consequences is to implement more systems and internal processes to ensure accounting mistakes come to light early on, avoiding the need for restatement entirely. Pozner also charges shareholders with increased involvement. She says, "Shareholders should look at the companies they invest in really carefully. If they're interested in corporate governance and protecting their own investments, they need to rely on more than media accounts and a companies' own press, both of which can produce biased information."


(August 27, 2008)

 

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