Director Liability Protection and the Quality of Independent Directors

Abstract

We study whether legal liability protection helps companies to recruit and retain high-quality independent directors. We conduct difference-in-differences analyses exploiting the 1999 Ninth Circuit Court of Appeals Ruling on the Silicon Graphics case, which substantially raised the bar for filing securities class action (SCA) lawsuits as a shock. We document supporting evidence for the talent attraction hypothesis by showing improvements in newly recruited independent director quality following the ruling, but only for candidates who are previously not exposed to SCA litigation risk. The effects are stronger for firms facing greater litigation risk ex ante or smaller local supplies of director candidates. Results are more evident for experience-based quality dimensions. We also analyze a sample of voluntary independent director departures and find little support for the talent retention hypothesis, suggesting that more complex factors enter into a director’s continuation decision once a director is already exposed to SCA litigation risk. A policy implication is that liability protection can be useful in attracting more unexposed high-quality candidates to the pool of public boards but do little to attract high-quality candidates who are already in the pool of public firms.

Keywords: Legal liability, board of directors, board quality, litigation, securities class actions

JEL Classification: G30, G34