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Regulatory Sanctions on Independent Directors and Their Consequences to the Director Labor Market: Evidence from China

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Abstract

We investigate the regulatory sanctions imposed on independent directors for their firms’ financial frauds in China. These regulatory sanctions are prima-facie evidence of significant lapses in business ethics. During the period 2003–2010, 302-person-time independent directors were penalized by the regulator (the China Securities Regulatory Commission—the CSRC), and the two stock exchanges. We find that the independent directors with accounting experiences are more likely to be penalized by the CSRC, though they do not suffer more severe penalties than do the other sanctioned independent directors. We also find that independent directors suffer less severe penalties than do the insider directors. These results are consistent with the hypothesis that the sanctions on independent directors are tied to their assumed ethical and legal responsibilities. Following a regulatory sanction, penalized independent directors experience a significant decline in the number of other board seats held. However, they can gain board seats in better quality firms. We find that interlocked firms that share penalized independent directors with the fraud firm do not suffer from a valuation decline. Overall, our results suggest that regulatory sanctions have not triggered further sanctions on the penalized directors in the labor market but they have, instead, created a disincentive for these directors to serve on the company boards of high-risk firms.

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Notes

  1. The controlling shareholders have the capacity to do so because of their dominant control over the nomination and selection of independent directors and the establishment of special committees within their boards.

  2. For instance, Ball (2001) has shown that, when a country’s institutional environment lacks enforcement ability, firms may not be able to signal to outsiders that their financial statements are of high quality.

  3. Consistent with the relatively weak abilities of academics to serve as effective and independent directors, Fich (2005) finds that the U.S. stock market reacts negatively to the appointment of academics to a board, though the effect is not statistically significant.

  4. There is no legal requirement in China for a listed company to have an audit committee. As a consequence of this, Lo et al. (2010) find that only 18.8 % of the firms have audit committees. Therefore, we do not examine whether audit committee directors are more likely to be penalized by the regulators.

  5. Financial statement fraud refers to inflated profit or assets fabrication, which are identified in the EARD database.

  6. In examining the probability of sanctions meted out to independent directors (H1a), we use the independent director data in 328 fraud cases to conduct our tests.

  7. Financial misrepresentations, namely inflated profit or asset fabrication, major failure to disclose information, and postponement/delay in disclosure, are serious corporate misconducts in China. According to “Some Provisions of the Supreme People's Court on Trying Cases of Civil Compensation Arising from False Financial Statement in Securities Market”, which came into force in 2003, once a listed firm was sanctioned by the CSRC due to these violations, investors can sue the firm for civil compensation in a civil action. Thus, regulatory sanctions on these types of violations open the door for civil litigation in China.

  8. In financial fraud cases, the regulatory authorities will generally punish the listed firm and individuals (directors or managers) at the same time. However, in some rare cases, only individuals or firms are sanctioned.

  9. We find the EARD misses a director title for some CFOs. As a robustness check, when we drop the CFO dummy in Table 3, the results do not change substantively.

  10. Indeed, we find that nobody was sanctioned by the regulators for 475 independent directors who did not serve on the board during the fraud period.

  11. We also construct a severity score by taking into consideration the existence of multiple sanctions rather than merely using the most serious sanction. Specifically, we construct a severity score with a range from 1 (lowest) to 7 (highest). If the sanction is “public criticism”, the score is 1; if it is “public condemnation”, the score is 2; if it is “warning”, the score is 3; if it is “fine”, the score is 4; if it is “warning” +”fine”, the score is 5; if it is “banning of entry to the securities market”, the score is 6; and if it is “warning” +”fine” + “banning of entry to the securities market”, the score is 7. We re-estimate our regression and obtain consistent results by using this alternative measure of penalties severity.

  12. Missing data are due to the lack of financial variables for some fraud firms that were delisted before the regulatory sanction.

  13. An independent director may be punished twice or more in some cases, therefore, the actual number of directors receiving sanctions is less than 302. In our sample, we use the number of sanctions against independent directors.

  14. According to the regulations of the CSRC, the maximum service period of an independent director in a specified firm is 6 years. We find that in our sample, out of 81 departures, 22 independent directors serve the firm for greater than or equal to 6 years. After deducting these cases, the early departure rate is 54.1 %, (i.e., (81-22)/109).

  15. The period of investigation is 3 years before and after the sanction year (in total, 7 years). If the penalized director does not serve on the board of any other listed firms, we exclude this case. In addition, since 3 additional years are required to count the number of departures after the sanction, the sanction period used in the analysis is only from 2003 to 2007.

  16. Consistent results are obtained if we divide our sample firms into two groups on the basis of SEVERITY SCORE: low severity score (score ≤ 2) and high severity score (score > 2). We then estimate Eq. (3) for these two groups of firms, respectively. Specifically, we find a significant negative relation between POST SANC and LOG(1 + DIRECTORSHIP) for these two types of firms but the relation is stronger for firms with high severity than for the firms with low severity.

  17. In China, independent directors are not allowed to serve on a firm’s board for more than 6 years. We define a departure as mandatory if a director’s tenure is greater than or equal to 6 years, and non-mandatory if the tenure is less than 6 years.

  18. To conserve space, we do not report the detailed results but they can be obtained from the authors on request.

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Acknowledgments

We thank the reviewer for constructive feedback and suggestions. We also thank participants at the Conference on Sustainable and Ethical Entrepreneurship, Corporate Finance and Governance, and Institutional Reform in China (2013). Firth acknowledges funding support from the Government of the HKSAR (LU390113), and Xin acknowledges funding support from the National Natural Science Foundation of China (Project numbers: 71272087 and 71232004).

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Authors and Affiliations

  1. Department of Finance and Insurance, Lingnan University, Tuen Mun, New Territories, Hong Kong

    Michael Firth, Sonia Wong & Ho Yin Yick

  2. School of Economics and Business Administration, ChongQing University, Chongqing, China

    Qingquan Xin

Authors
  1. Michael Firth
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  2. Sonia Wong
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  3. Qingquan Xin
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  4. Ho Yin Yick
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Corresponding author

Correspondence to Qingquan Xin.

Appendix 1

Appendix 1

See Table 8.

Table 8 Variable definitions
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Firth, M., Wong, S., Xin, Q. et al. Regulatory Sanctions on Independent Directors and Their Consequences to the Director Labor Market: Evidence from China. J Bus Ethics 134, 693–708 (2016). https://doi.org/10.1007/s10551-014-2391-5

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