Are All Outside Directors Independent? An Investigation of the Compliant Director Market

Abstract

Most research in accounting and finance suggests that outside directors who obtain multiple board memberships do so by cultivating a reputation as vigilant directors who are both able and committed to ratifying and monitoring management decisions. We investigate an alternative perspective that there exists a market for compliant directors who obtain multiple directorships by associating with managers who desire directors who are less committed to external monitoring. We divide outside directors, who are members of the audit committee, into vigilant and compliant directors on the basis of relatively high (low) audit fees paid to the external auditor. We find that, for compliant (versus vigilant) outside directors, each additional audit committee membership is associated with higher levels of income-increasing earnings management. We also find that the level of earnings management associated with each additional audit committee membership for compliant directors is positively related to managers’ incentives to manage earnings. These findings highlight the need for future corporate governance research to explicitly consider the fact that outside directors and managers associate by mutual choice, and it is not always in outside directors’ interest to act as vigilant monitors of managers.