The Elusive Monitoring Function of Independent Directors

Abstract

Federal law mandates that audit and compensation committees of public companies be comprised entirely of independent directors. The assumption underlying these legal requirements is that independent directors are more likely to act as monitors of the company’s top management. In this paper, we test this assumption. We conduct our tests by examining the level, direction, and profitability of independent directors’ insider trades and compare these to the trades of other members of top management in firms defending class-action lawsuits. Our evidence indicates that there are no differences between the trading activity of independent directors and other insiders during the class period. Our findings cast doubt on the effectiveness of independent directors’ monitoring role.

Keywords: Independent Directors, Corporate Governance, Corporate Fraud, Gatekeepers

JEL Classification: G34, G38, K22, K41, K42