Corporate Fraud, Local Connections and Directors

Transcription

1 Corporate Fraud, Local Connections and Directors Chander Shekhar 1 University of Melbourne and Financial Research Network (FIRN) c.shekhar@unimelb.edu.au Jiawei Zheng University of Melbourne j.zheng12@student.unimelb.edu.au January Corresponding author. Faculty of Business and Economics at The University of Melbourne, 198 Berkeley St., Carlton, Victoria, Australia 3010, phone: , fax: We thank William Tang for research assistance.

2 Corporate Fraud, Local Connections and Directors Abstract We study the relation between geographical proximity of firms that a director belongs to and his ability to retain such directorships. Using the filing of securities class actions as an exogenous shock, we find that local directors who serve on firms geographically close to the sued firm lose more board appointments in other firms, compared to nonlocal directors. Local directors are also more likely to lose committee seats even if they retain board seats in the interlocked firms. They are also less likely to obtain new committee seats when they gain new directorships in the future. Our evidence suggests that the effects of negative information transmission among local businesses outweighs the positive effects of familiarity and mutual trust formed between local directors. Overall, local directors suffer more after lawsuits.

3 1.0 Introduction Social networks are nodes network structures where people or institutions are connected through various social relationships ranging from casual to close bond. It is considered to be an important channel to gather and diffuse information. On the one hand, such connections facilitate the information exchange and allow the transmission of knowledge, ideas and private information. On the other hand, the trust and familiarity from pre-existing social ties would interfere with effective corporate governance and undermine the individuals critical thinking ability. (El-Khatib, Fogel & Jandik, 2015) We focus on geographic proximity between firms as an important source for constructing social ties. A number of studies acknowledge that social connections between neighborhood parties can affect their behavior. 2 Dougal, Parsons and Titman (2015) show that a firm s investment is highly sensitive to the investment, cash flow and stock prices of other local firms, even though in different industry. Endogenous interaction of people living in the nearby accelerates the knowledge diffusion and transmits ideas and views through the same local social networks. Agents tend to rely on the information they have obtained via casual word-of-mouth communication and they tend to change their preferences and decisions because of the actions of others, Ellison and Fudenberg (1993, 1995). Core, Lobanova and Verdi (2016) use the geographic spillover intensity based on the distances among firms and find that in the area with high information flow, managers tend to share information and past experiences with their local neighborhood, thus leading to similar (and better) investment and accrual decisions. As people tend to connect with geographically proximate people and people with similar demographics, geographic links can act as an important source of network formation and facilitate the knowledge spillover among firms (Marmaros and Sacerdote, 2006). Previous literature has also recognized the importance of local social ties in board composition and board decision-making. Knyazeva, Knyazeva and Masulis (2013) show that the supply of prospective director in the local labor market has strong impact on board composition as small and medium-sized firms employ greater percentage of 2 Coval and Moskowitz (1999a, 2001); Hong et al. (2005); Massa and Simonov (2005); Hong, Kubik and Stein (2004)

4 locally employed independent directors. Fahlenbrach, Low, and Stulz (2010) find that CEOs are most likely to join boards of firms that are geographically close. Bouwman (2011) suggests that individuals are more likely to be appointed to boards if they previously held a seat in the same locality or at a firm with common director and shared directors create social networks among the firms and their governance practices are influenced by each other. On the other hand, it has also been shown that close relationships and affiliation formed between socially connected individuals impedes individuals in monitoring and disciplining others behaviour and undermine the critical thinking ability of the firm. The enhanced mutual trust leads them to interpret the behaviour of one another favourably and thus assume that each will take actions that are predictable and mutually acceptable (Uzzi, 1996, 1999). Furthermore, such trust may also create inefficient favouritism and raise concern of collusion (Asch, 1951; Janis, 1982). 3 Guedj and Barnea (2009) find that more connected boards undermine the effectiveness of corporate governance as poorly performing CEOs are less likely to be fired. El-Khatib, Fogel and Jandik (2015) focus on acquirer CEOs, and find among other results, that managerial labor market and external market is less efficient disciplining CEOs that the more centrally connected in the network high centrality CEOs. Finally, Khanna, Kim and Lu (2015) examine the CEO connections with top executives and directors through the appointment decisions and find both that social connections increase the likelihood of corporate fraud and reduce the likelihood of detection, and that a connected CEO may facilitate wrongdoing by providing the necessary support and coordination. Given our focus on ties formed via geographical proximity, we begin with companies that are subject to class action lawsuits. We then examine what role such ties play in future careers of directors that belong to these firms at the time the lawsuit is filed. Local networks facilitate the information flow and exchange between interlocked firms that are geographically close to the litigated firms and are likely to inflict significant damage to the reputation of associated directors, resulting in loss of directorial positions. However the mutual trust and familiarity established through local social 3 Other recent papers that document adverse effects of connected directors are Hwang and Kim (2009) who find that socially dependent directors have less monitoring and disciplining capacity, and that. CEOs tend to select directors from these social dimensions. Fracassi and Tate (2012) also find evidence for weak monitoring - firms with connected boards tend to acquire firms more frequently and these tend to destroy value.

5 connections, may mitigate any adverse effects on said directors as the neighboring firms view may be biased towards favoritism, (Uzzi, 1996, 1999). Local directors may also be able to utilize local networks to personally justify their lack of involvement in any alleged wrongdoing. As the theoretical predictions for directors career outcomes are ambiguous, we conduct empirical analyses on such directors career progression to determine which of the two effects dominates. Using firms that have director data available in Boardex and are subject to class action lawsuits (as per Stanford Law School Securities Class Action Clearinghouse) between 2005 and 2010, we first analyse the number of other directorships held by litigated directors over the three years following lawsuits. Consistent with Fich & Shivdasani (2007) we find that directors in these firms lose other directorship held over the three year after lawsuits. We then segregate these directors into mutually exclusive groups local and non-local where local directors are defined as directors who hold more than two-thirds ( 66%) of other directorships in firms that are located within 60 miles (~100 kilometres) of the sued firm. We find that the rate at which local directors lose directorship in the sued firm is much faster than that for non-local directors. Additionally the local directors also lose seats in interlocked firms much faster than directors who belong to companies that are farther away from the sued firm. Conditional on retaining their seat in interlocked firm(s) three years after the lawsuit, local directors are also less likely to keep their committee member seats in those firms. In addition, for directors who gain new directorships within three years of the lawsuits, the likelihood of them also getting a seat on any committee seat at the same time is much lower for the local directors. Taken together our results suggest that local directors face more reputational harm and bear more costs when corporate fraud is revealed. As the news of a firm facing lawsuits transmits very quickly among the local business areas, the neighbouring interlocked firms are more aware of the issues and hence directors severely lose their reputation as good monitors. The familiarity and mutual trust established through the interlocked board do not mitigate the reputational loss and relieve the directors from being blamed. Therefore, local directors suffer more and bear more negative consequence in the form of fewer other directorships held in the future.

6 The paper contributes to the literature is threefold. Firstly, a large number of researchers have analysed the effects of corporate fraud to directors reputation. (Agrawal, Jaffe, and Karpoff, 1999; Srinivasan, 2005; Helland 2006; Fich& Shivdasani, 2007).We confirm Fich and Shivdasani s findings that corporate fraud causes reputational harm to independent directors in sued firms as they have fewer directorships held afterwards. More importantly, we also contribute to this literature by using local connections to show that these connections influence the magnitude of the penalties that are brought by corporate fraud to the directors. Secondly, this paper contributes to a growing stream of research focusing on social connections and geographical spillover. The existing literature has found that social ties have both benefits and costs to the firm values. 4 Moreover, there is information spillover within geographically close firms and these firms tend to have similar investment and accrual decisions. (Dougal, Parsons and Titman, 2015; Core, Lobanova and Verdi, 2016). We contribute to this literature by focusing on the network connections formed in a local neighbourhood and show that information spillover within local area may further damage the director s reputation when their firms are involved in lawsuits. Local connections may also thus be seen as a tool to discipline directors, which adds contribution to another field that looks at monitoring and discipline effects arising from proximity of controlling parties. Kedia & Rajgopal (2011) point out that firms that are closer to SEC offices are less likely to engage in aggressive accounting practice. Here, we emphasize a different mechanism that is based on proximity among neighbouring parties, rather than proximity to controlling parties. The locally interlocked firms can act as monitors and discipline director behavior. The more the locally interlocked firms the directors have board seats on, the higher incentive for them to perform their duties well. The remainder of the paper is organised as follows: Section 2 describes the data and summary statistics. Section 3 provides the empirical tests and results and Section 4 concludes. 4 For instance see Cohen, Frazzini, and Malloy, 2007; Schonlau and Singh, 2009; Cai and Sevilir, 2012; Hwang and Kim, 2008; Fracassi and Tate, 2012; El-Khatib, Fogel & Jandik, 2015; and Khanna, Kim and Lu, 2015.

7 2. Data and summary statistics The fraud sample period is from 2005 to 2010 and the observations are obtained from Stanford Law School Securities Class Action Clearinghouse (SCAC). The SCAC maintains a filing database of securities class action lawsuits since passage of the Private Securities Litigation Reform Act of 1995 (PSLRA). The initial sample includes 795 litigation filings during the six-year period. We exclude the firms headquartered outside the United States, financial firms ( ), regulated utilities firms ( ) and firms without matching information in BoardEX (Knyazeva et al, 2013). The final sample contains only 476 litigation cases in total. 2.1 Main variables In terms of directors and directorships data, we extract the directors information for each sued firm in the lawsuit-filing year from BoardEX annual reports and also obtain all the directorships they hold in the lawsuit-filing year and subsequent three years. To measure the directors local connections, we firstly obtain the location (city) and zip code of headquarters of all sample firms and their interlocked firms from Compustat, and latitude and longitude data from the Census 2010 U.S.Gazetteer. For the city names and zip code that cannot be found on Gazetteer file, we check the zip code on GeoNames geographic database. 5 We measure the distance between the sued firm s headquarter and the corresponding interlocked firms headquarters for each director of the sued firms. The distance between cities is estimated using the haversine formula The haversine formula gives great-circle distances between two points on a sphere. The distance between cities 1 and 2 is calculated as = 2 arcsin 1, where R is the earth s radius (approximately 6371 kilometers), = / /2. In this expression, dlat = lat2 lat1 and dlon = lon2 lon1. Lat1 and lon1 (lat2 and lon2) are the latitudes and longitudes of City1 and City2, respectively.

8 The interlocked firms that are headquartered within a 60-miles radius of the sued firms headquarter are defined as being geographically close. We then calculate the key independent variable -- local percentage for each director based on the interlocked firms geographical proximity. For directors who only have one other directorship, they are considered as local directors and the local percentage variable is equal to one if the interlocked firm is geographically close. For directors who hold multiple board seats in addition to the sued firm s seat, their local percentage is equal to the number of closely interlocked firms divided by the total number of interlocked firms. 2.2 Control variables The existing literature has found a set of firm and director characteristics help explain directors board seats in the firms. The firm characteristics include firm size (natural logarithm of total assets), profitability measured by return on assets (ROA; earnings before interest, tax and depreciation over total assets). These data are obtained from the Compustat in lawsuit filling year. The board characteristics include board size (natural logarithm of total number of directors sitting on the board), the percentage of independent directors, CEO-chairman duality and governance index (E-Index 7 ). In terms of director level data, it includes director gender, age, tenure, education, measured number of other boards they belong to, and if they sit in the audit, compensation and nomination committee of the board. All the board and director characteristics are obtained from BoardEX and RiskMetrics in lawsuit filing years. (Fich & Shivdasani, 2006; Knyazeva et al, 2013; Bates, Becher & Wilson, 2016) 2.3 Descriptive statistics Table 1 displays summary statistics on the lawsuits in the sample. Panel A shows the distribution of the lawsuit over the six years. The sample includes a total of 476 lawsuits and the distribution is rather even, with around 16.7% occurring each year. Panel B shows the distribution of the lawsuits by industry. The lawsuits are concentrated in manufacturing and service industries that account for approximately 80% of total 7 E-Index is calculated using Bebchuk (2009) s method and the six measures are obtained from RiskMetrics.

9 litigations. It is followed by retail trade, transportation and utilities and mining industries. In addition, around half of the lawsuits result in settlement and the other half are dismissed. 83% of lawsuits violate Section 10-5b and 11.3% lawsuits violate Section 11. Table 2 summarizes the information of total 1322 litigated directors who have other directorships in addition to the sued firms. Panel A shows that directors are 60 years old on average, with the youngest at 32 and the oldest at 87. Director s tenure is on average 5 years and they generally have 2.83 total board seats. It can be seen that around 12% of the directors have law related degrees and 37.6% directors have MBA degree. It also shows around 44% director sitting on the sued firms audit and compensation committee whereas only 38% sitting on nomination committee. Lastly, 88% directors are male and around a quarter of the directors are considered as locally connected. Panel B compares the director data between local and non-local directors. Local directors are those whose local percentages are greater than 2/3 and non-local director are those whose local percentages are smaller than 1/3. There is not much difference between local and non-local directors in terms of age, tenure, percentage of individuals holding law degrees and percentage of board members sitting on audit committees. Local directors are more likely to be male and generally hold fewer board seats. Additionally, they are both less likely to have an MBA degrees and to sit on nomination and remuneration committees. Table 3 contains the key summary statistics on the firm control variables. We drop the firms with no financial information in Compustat and winsorize the firm size and ROA at the 1st and 99th percentiles due to existence of unreasonable outliers in both measures. In the end, 344 sued firms remain in the sample. It can be seen from Panel A that the total assets and ROA of the sued firms are $ (in million) and 5.11% on average respectively. Moreover, boards of the sued firms have 8.52 directors on average, of which 75% are independent. The CEO is the chairman in 58% of the cases. Panel B outlines the firm and board information for the interlocked 1424 firms. The total assets on average is $ (in millions), suggesting they are larger than the sued firms at 5% level of significance. However, the 4.99% ROA indicates that there is

10 no statistical difference between interlocked firms and sued firms in terms of profitability. For board characteristics, on average, it has larger board size than the sued firms, with 9.03 directors sitting on each board. Furthermore, around 77% of directors are independent, slightly higher than the sued firms and 62% CEO who also serve as the chairman of the board. 3. Empirical tests, results and analysis 3.1 Directorships held following lawsuits Table 4 reports the directorships information on independent directors of the sued firms from 2005 to It sees a drastic decrease for the retention of board seats of the sued firms over the three years following lawsuits are filed. 83% directors remain on their sued firm board one year after the lawsuit. The proportion drops to 70% in the second year and even lower to 58.48% in the third year. Fich et al (2007) find around 83% outside directors remain on the board seats in the third year following lawsuit and they conclude that there is no abnormal director turnover among outside directors, consistent with previous finding by Agrawal, Jafffe & Karpoff (1999) and Yermack (2004). However, from the sample, we find nearly half of outside directors leave the sued firms three years after lawsuits. It is significantly higher than Fich s findings and Yermack s reported 4.6% unconditional annual frequency of independent director turnover. Therefore, the results suggest that outside directors experience a negative abnormal turnover in the fraud firms. The next two measures look at directors abilities to retain the other firms board seats. The second row provides data on average number of other directorship held by outside directors of sued firms and the third row provides data on the percentage of outside directors of sued firms sitting on other boards. Data suggest that the directors do not experience a decline in interlocked firms board appointments as the numbers remain almost constant over the three years. It is in contrast to Fich s findings, where there is a declining trend reported. The possible reason is that the measures are biased because a large fraction of the sample consists of directors who do not hold other directorships or do not sit on other boards at the year 0, and thus they have no other board seats to lose

11 after lawsuits. What s more, they might increase their board seats or gain new board seats afterwards. The combined effects cause the overall loss in directorships measures to be less precise and the decreasing magnitude is much lower. The third and fourth measures focus on a subsample of directors who have at least one other board seats in addition to litigated firm seats. It provides a more precise and meaningful measure. It is shown that these directors on average have 1.8 other directorships at the lawsuit-filing period and only have 1.57 other board seats in the third year, representing a 12.8% decrease over the three years. In addition, the proportions of these directors who experience a reduction of at least one other board appointment increase from 33% in year 1 to 53% in year 3. It provides evidence that independent directors face a decline in the number of other board seats held after lawsuits. The last three rows of panel A show the frequency with which directors lose all other board seats following lawsuits. For directors with only one other board appointment prior to lawsuit, the percentage of directors losing all other seats nearly double over the three years, increasing from 14% to 28%. For directors with more than one board appointments initially, around 9% directors who have two other seats and 5.5% directors who have more than three other seats lose all other directorships in year 3. Although the overall percentages are much smaller than the results reported in Fich et al (2007), they both exhibit similar increasing trends. More and more directors lose other board seats with time going on after lawsuits. Panel B shows the directorships data for two different types of the directors: local and non-local. Among all the 1322 directors with other board appointments, we label 240 directors as local due to their local percentage being greater than 0.67 and 923 directors as non-local because their local percentage is smaller than The data indicates that 7% fewer local directors have the board appointments in sued firms in year 3, compared to non-local directors. In addition, local directors experience a more severe 14% reduction of other board seats after lawsuits (from 1.51 to 1.30) whilst other directorships held by non-local director only decrease by around 12%, from 1.81 to As of percentage of directors who lose at least one other board seat, local directors see an increase from 36% to 53.2% whilst non-local directors undergo an increase from

12 32% to 53.1% over the three years. Lastly, for the percentage of directors losing all other board appointments, local directors generally suffer more than non- local directors in all three years. Figure 1(a) and (b) display the panel B data in line charts. Figure 1 (a) reports the retention of sued firms board seats (left axis) and interlocked firms board seats (right axis). It can be seen that the lines are downward sloping, indicating directors lose more and more directorships with time going on. More importantly, black lines which represent local directors are below the corresponding orange lines (non-local directors), suggesting that less local directors remain in sued firms and local directors hold less directorships in interlocked firms, compared to non-local directors. In Figure (b), we note that all the black lines are situated above the corresponding orange lines, meaning that more local directors lose their board appointments than non-local directors, in terms of losing at least only one directorship (left axis) and losing all other directorships (right axis). This suggests that that local directors experience a more significant decline in the number of other board seats than non-local directors following lawsuits. Also consistent with the reputation hypothesis (Fich et al, 2007), local directors suffer a more severe reputation damage and are penalized more heavily in the form of less directorships held. 3.2 Multivariate analyses Changes in the number of other directorships In this section, we examine the impacts of a set of firm, director and lawsuit characteristics to the number of other directorships held by independent directors in litigated firms following lawsuits. The dependent variable Change is measured as the ratio of number of other board seats in the third year after lawsuits divided by the number of other board seats in the lawsuit filing year. We include the main independent variable, local percentage which measures the director s social connections within the local area, and a number of other control variables. In particular, firm-specific variables like firm size and return on assets (ROA) are included. Previous literatures find that appointments at large firms provide greater visibility and more reputation benefits to directors and thus directors may be reluctant to voluntarily forge the directorships at large firms. (Knyazeva et al, 2013; Fich et al,

13 2007) Moreover, firm s operating performance affect directors turnover as well. Directors at firms with lower ROA are more likely to leave the firms relative to directors at firms with higher ROA. (Bates et al, 2016) The model also includes different board characteristics of the sued firms board size, board independence and CEO-Chairman duality as well as Bebchuk (2009) s Entrenchment Index that consists of six provisions: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, supermajority requirements for mergers and charter amendments. Fich et al (2007) point out that a well-governed firm is more likely to replace the directors with damaged reputations. In addition, we control for the director s age, tenure, gender and other seats which is simply the number of total directorships held. Knyazeya et al (2013) find that director age has a slightly negative effect on the probability of being appointed. Whereas Bates et al (2016) conclude that the director age is positively related to the director s turnover and director reputation is negatively correlated to director s turnover. They also report that female directors are less likely to turnover. Director education variables are also included, with law degree equal to one indicating the directors have law related degrees and MBA equal to one indicating the director has MBA related degrees. Additionally we also include three indicator variables that equal to one if the director sits on the audit, nomination and remuneration committees of the sued firms respectively. Several previous papers recognize the importance of sitting on the board committees in affecting director s appointments and departures (Fich et al, 2007; Brochet et al, 2014; Bates et al, 2016). Lastly, we control for lawsuit characteristics, e.g. case status, violation of Section 10b-5 and settlement amount. The indicator variable case dismissed equals one if the case is dismissed now and otherwise zero is it is settled. Brochet (2014) finds that the named directors are more likely to leave the board if the lawsuits are settled. The indicator variable Section10b-5 equals one if it violates Section10b-5 or otherwise equals zero. The settlement amounts are scaled by the litigated firms total assets. According to Fich et al (2007), the severity of the fraud which is indicated by settlement amounts has impacts on the directors turnover as well.

14 The regression model is written as: Change =α+β local%+ firm characteristics+ board characteristics+ director characteristics+ lawsuit characteristics+ε Table 5 reports the OLS regression results. The dependent variable captures the change in a director s other directorships between year 0 and year 3. The first column includes all control variables except lawsuit characteristics. The estimated coefficient for local percentage is and it is significant at 1 % level. It means that if a director turns from completely non-local (0) to completely local (1), he/she will experience 7.84% decrease in other board seats held in the third year after lawsuits. This is consistent with Table 4 findings that local directors tend to suffer more after the revelation of securities class action lawsuits. The firm size and ROA are not significant. However, the coefficient for independent board is and it is significant at 10% level. If the sued firm board is more independent, it signals the board of high quality and directors enjoy better reputation and hence will have more other board seats. Moreover, they still remain significant after including lawsuit-specific variables. In terms of director attributes, director age is found to be negatively related to the change in other directorship held over the three years. With one year increase in age, the directors will have 1.74% fewer other board seats, which is consistent with the view of Knyazeya (2013). When the firms face lawsuits, the older directors might be blamed for lack of sufficient time, energy or competence to perform their duties, thus leads to a lower amount of board seats held. It remains negative and significant across all the regression specifications. In addition, MBA degree seems significantly and positively related to the change in the number of other board seats. As the directors hold MBA degrees, they are (presumably) considered to be more competent they will hold about 10% more board seats compared with directors without this qualification. Column 2 includes case status and violation indicators variables and both of them are not significant at 10% level. Local percentage remains negative and significant at 1%

15 level. All other variables coefficients are similar to column one except remuneration committee indicator. The coefficient become significant and shows that the director who is on the remuneration committee is likely to lose more other directorships in the third year. It implies that sitting on committees impose the directors with greater responsibility. Hence, when the firm is sued, their reputation is damaged to a much greater extent. Then we focus on a subsample of which lawsuits are settled by including settlement amounts variables in column 3. The sample size drops to 509 and the settlement amount coefficient is negative but not significant. Local percentage becomes , a slightly more negative number. It indicates the local directors undergo a more significant decline in other directorships held in settled cases. Furthermore, the coefficient for nomination committee indicator becomes significant. It suggests that a director s sitting on the litigated firm s nomination committee does not affect his directorships in the third year and overall R 2 of the model increases to The last column include additional variable E-Index. Because the governance provisions variables are not available from RiskMetrics for around half of the sample firms, the sample size drops to 640. E-Index coefficient itself is not significant and board independence and remuneration coefficients become insignificant. However, the coefficient for other seats becomes significant and it is negative. As the director holds one more directorship, their other directorships will lose by 1.84%. One possible explanation could be that as the directors have more board appointments, there are more board seats for them to lose. Overall, the table shows that local directors are likely to have less other board appointments following lawsuits and the magnitude is larger for settled cases. In addition, board independence and director age, director MBA degree and directors committee seats have influences to the directors turnover as well.

16 3.2.2 The probability and speed of losing board seats in interlocked firms Table 6 shows the results from the Cox hazard regressions model that looks at the probability and speed that the litigated directors losing the board seats in the interlocked (non-sued) firms over the three years after lawsuits. The sample consists of 1320 independent director-firm-years, which track 2401 other directorships. The event is the director losing one board seat of the interlocked firms anytime three years after the lawsuit is filed. Among 2401 directorships, 895 experience the event (lose the seats). The time variable is the time period from lawsuit filing years until the first time when the director experience a loss in other board appointments. If the directors still retain the interlocked firms board seats after three years, they are considered as right censored. The Cox proportional hazard model assumes that the hazard rate function can be represented as a parametric linear combination of a set of risk factors. In particular, it includes firm and board specific variables of the interlocked firms. For example, firm size, ROA, board size, board independence and CEO duality. It also controls for a set of director characteristics like directors age, tenure, education, committee seats. Lastly it includes settlement amounts of the lawsuits in which the directors firms are involved in. The model is written as: h t =h t exp β local %+ interlocked firm characterisrics+ interlocked firms board characteristics+ director characteristics + lawsuit characteristics+ε) The hazard function h t has two components: first, a parametric part that depends linearly on the risk factors. The risk factors are the set of factors that influence the survival duration. As the risk factors are introduced through an exponential function, their effects become proportional. Therefore, the coefficient represents the relative importance of risk factors. Secondly, the non-parametric part defined as baseline hazard h t gives the natural risk. This function gives the hazard when many risk factors are not presented.

17 Table 6 reports hazard ratios, i.e. exponentiated coefficients. The hazard ratios allow me to quantify the economic magnitude of the explanatory variables. For example, the first column only includes the main explanatory variable local percentage of the directors. The hazard ratio of is statistically significant at 1% level, implying that when a director turns from completely non-local (local% =0) to completely local (local%=1), the annual hazard of losing other directorships increase by 33.5% (from 1 to 1.335). After including the interlocked firms and boards attributes in the regression, the local percentage hazard ratio of in column 2 remain greater than one and significant at 10% level. It indicates that it is more likely and sooner for a local director to lose the board appointments in the interlocked firms within three years after lawsuits, holding other covariates constant. In addition, the ROA hazard rate of 0.52 is statistically significant at 1% level and it shows that if the interlocked firms have better operating performance, the directors are 48% less likely to lose the directorships in these firms and the lost time will occur later. It is consistent with previous findings that directors of poorly performing firms are more likely to face disciplinary pressure to leave the board (Yermack, 2004; Fahlenbrach, Low & Stulz, 2015). It is also noticed that board size has a negative and significant relationship to the probability of losing other directorships. As the interlocked firm s board size increase by one unit, the directors are 44% less likely to lose the seats and the lost time will occur later. Moreover, a more independent board will reduce the hazard of losing other board seats by 35%, holding other covariates constant. Column 3 includes the director attributes. The hazard ratio for local percentage becomes smaller but still remain greater than one and significant at 10% level. Firms and board attributes hazard rate do not change considerably. For director characteristics, we find that director s tenure plays a role in affecting the probability of losing directorships in interlocked firms. The hazard ratio suggests that if the director sits on the interlocked firm s board for one more year, they are 1.9% more likely to lose the seats and will lose it earlier when facing lawsuits. Furthermore, directors who have Law degree will be 20% less likely to lose the board seats in interlocked firms. Because they have legal expertise which is of great value to the company. For the directors sitting on sued firms audit committee, they are more likely to lose the board seats in their interlocked firms and lose them sooner. It is likely that they are considered not to have

18 performed their duties well (being on the audit committee), hence harming their reputations more. Srinivasan (2005) finds similar results that directors on the audit committee are more likely to lose board seats following a downwards restatement. However, for the directors sitting on audit committee of the interlocked firms, they are 26% less likely to lose other board seats, which is not consistent with the results in Fich et al (2007). Finally, as the number of total board appointments increase, the directors are 5.7% more likely to lose the board seats in interlocked firms and lose them earlier. This is in line with the findings in Table 5. In column 4, we include settlement amounts of the lawsuits. The hazard ratio of director s local percentage increase to and it is significant at 5% level. Moreover, the director age become significant and for the directors are one year older, it increases the hazard to lose other board seats by 1.2%, consistent with Bate s findings. All the regression reported control for year fixed effects and standard errors are clustered. The data fits the model very well, with the p values for chi-square are almost 0. Overall, it shows that local directors are more likely to lose the seats in interlocked firms and lose them earlier three years after lawsuits. It is consistent with results reported in Table 4 and 5. Moreover, ROA, board size, independence and some director attributes also affect the directors abilities to retain the board seats in interlocked firms following lawsuits. In the unreported table, we estimate a logit regression model using the same data, and it provides similar results that local directors are less likely to retain the board seats in interlocked firms Retention and gains in committee seats in interlocked and new firms In this section, we focus on subsamples of directors and analyses their committee seats in the firms in the third year after lawsuits are filed. In the first subsample, we retain the directors who remain on the boards of the interlocked firms in the third year and then check whether they retain their committee seats in the third year as well. The dependent variable in column 1 Audit equals to one if the director holds the audit committee seats in the third year and zero otherwise. The explanatory variables include local percentage, the interlocked firm, board characteristics and director characteristics in lawsuit-filing years.

19 Pr Audit=1 =α+β local %+ firm characterisrics+ board characteristics+ director characteristics +ε The second and third column follows the same logic and analyses nomination and remuneration committee seats respectively. The results in Table 7 suggest that local directors are more likely to lose the audit committee seats in the third year. From Tables 4 and 5, we surmise that local directors reputation is damaged more severely as they tend to lose more seats in the interlocked firms. Here the results indicate that even if directors they keep the board seats after lawsuits, the local directors still suffer in the form of losing audit committee seats. Audit committee members with greater oversight of accounting and disclosure issues face higher litigation risks post SOX and are more likely to be named as defendants in securities class actions (Brochet & Srinivasan, 2014; Hogan, Schmidt & Thompson, 2015) They are potentially culpable for accounting irregularities, therefore they lose the reputation as good monitors if the interlocked firms are aware that they have been involved in the lawsuits. Nevertheless, it is interesting to note that serving on audit committee of the litigated firms will increase the chance of sitting on the audit committees in interlocked firms but lower the chance of sitting in nomination and remuneration committees, holding other covariates constant. In addition, as the interlocked firms become larger and the boards become larger, the directors are more likely to lose their audit committee seats. Moreover, directors who are older or have MBA degree are have greater chance sitting on the audit committee as they are more experienced and have more expertise and knowledge in the firms operations. However the directors tenures are negatively correlated to the probability of sitting on audit committees. For nomination and remuneration committee seats in next two columns, the coefficients for local percentages are negative and statistically significant at 5% level and 1 % level respectively. It implies that local director not only lose the audit committee seats, but also have high chance losing other committee seats. In a word, even if local directors

20 remain in the interlocked firms board, they are still negatively affected by the revelation of lawsuits as they hold less committee seats in hand afterwards. In addition, directors sitting on higher profitable firms are less likely to lose the nomination committee seats. Moreover, directors who are on larger board are less likely to retain their nomination and remuneration committee seats. In contrast to audit committee results, directors with longer tenure are more likely to remain in the nomination committee. Furthermore, holding a law degree helps the directors retain the nomination committee seats. Overall, local directors bear more costs after lawsuits as they are more likely to leave the board committees of the interlocked firms. We now turn our attention to analyzing another subsample of directors who gain board seats in new firms in the third year. In each column in Table 8, the dependent variable equals to one if they get the corresponding committee seats at the same time they obtain the new board seats. Column 4 models if the director obtains any committee seat in the new firms boards. The independent variables include the primary variable of interest -- local percentage of the directors. Firm and board characteristics of sued firms as well as director characteristics are also included. The local percentages are negative and statistically significant at 10% level for nomination and remuneration committee seats. It suggests that even though they gain new board seats in the interlocked firms, local directors are still less likely to obtain the nomination and remuneration committee seats in the third year. Furthermore, results in column 4 indicate that local directors are less likely to become any committee members when they obtain new board seats in the third year. It is consistent with previous findings that local directors tend to suffer more reputational harm after lawsuits. However, the result does not apply to audit committee seats. Apart from that, directors with law degrees are more likely to gain nomination committee seats. Older directors are more likely to gain all three kinds of committee seats whilst longer tenure might decrease the chance that directors sit on the audit committees. Finally, directors who sit on audit committees of sued firms before are less likely to sit on remuneration committees whilst they have higher chance to gain audit committee seats in the interlocked firms. To conclude, among directors obtaining new

21 board seats after lawsuits, local ones are less likely to gain the committee seats at the same time. This can again be considered as penalties or punishments for local directors. 4.0 Conclusion In this paper, we investigate reputational effects of financial fraud for independent directors of firms accused of fraud. In particular, we take into account the director s social network effects and construct a measure of director s local connectedness. Using a sample of 467 firms facing securities class actions lawsuits between 2005 and 2010, we find that litigated directors who have more other directorships in neighbouring firms experience a more significant decline in the number of other board seats held. It is consistent with the notion that independent directors bear reputational penalty following lawsuits. More importantly, it indicates that costs associated with having local connections are greater than the benefits for the litigated directors. Furthermore, we show that for directors who keep the directorships in interlocked firms following lawsuits, they still face the reputational damage in the form of losing committee seats. For the directors who gain new board appointments, they are less likely to be appointed in the committees of the new firms at the same time. Overall, local directors face more reputational harm as they hold less board appointment and committee seats in other firms after lawsuits are revealed. Therefore local independent directors should exercise more care and due diligence in performing their duties to avoid the more severe negative consequences to their careers.

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