Independent directors have strong incentives to quit a company’s board when they are most needed, creating an economically significant “dark side” affecting future performance, according to an academic study.

“Affected firms have worse stock performance, worse accounting performance, a greater likelihood of an extreme negative return, a greater likelihood of a restatement, and a greater likelihood of being sued by their shareholders” following surprise outside director departures in difficult business circumstances, the study found.

Board RoomGovernance advocates and regulators have long argued that independent directors improve corporate decision-making and business performance.  Listing standards of U.S. stock exchanges require that boards have a majority of non-executive or so-called “outside” directors.  The requirements were amended following high-profile scandals at companies such as Enron and WorldCom and enactment of the Sarbanes-Oxley Act of 2002.  Guidelines for non-executive board members vary in other countries but most also recommend active roles for independent directors.

The study – The Dark Side of Outside Directors: Do They Quit When They Are Most Needed? – was based on analysis of 332,327 “outside director-firm-years” involving 10,513 distinct firms and 64,105 distinct directors from 1989 through 2004.  It was conducted by finance and business professors Rüdiger Fahlenbrach, of the Ecole Polytechnique Fédérale de Lausanne; Angie Low of Nanyang Technological University; and René M. Stulz of Ohio State University.

The study’s authors assert that an inside director who resigns from a board most likely also has to resign from his or her job, creating an incentive for them to stay on the board and work to improve the firm’s performance.

“In contrast, an outside director in the same situation who does not resign faces the risk of experiencing a loss of reputation as an outside director when the bad news breaks,” the authors write. “Such a loss of reputation may make it harder for the director to obtain other board seats and perhaps even to keep the seats she already has.”   Additionally, the director would likely face an increase in his or her workload as the firm undergoes change and restructuring.