In the wake of recent corporate governance scandals around the world, policymakers have called for increasing the independence of directors as well as their accountability to shareholders. One potential lever that has received considerable attention by regulators is personal liability. In theory, imposing personal liability for corporate malfeasance should improve directors’ incentive to monitor management and reduce agency problems. On the other hand, the fear of personal liability could deter individuals from serving as directors or make them risk-averse and thereby reduce board effectiveness. Despite a rich literature on corporate directors, direct evidence of whether personal liability deters individuals from serving on corporate boards is scant.

In a recent study forthcoming in the Journal of Financial Economics, we exploit a quasi-natural experiment from India in the form of a recent corporate governance reform, which introduced personal liability for independent directors. In spirit, the reform imposes unlimited personal liability for fraud, supplemented with civil and criminal penalties. Following the reform, decisions in landmark cases reveal that the judicial system in India upholds a stringent definition of personal liability. Independent directors are held personally liable for the oversight of operations, resulting in the freezing of personal assets of independent directors. Moreover, appeals arguing that independent directors have no role in day-to-day operations have been rejected.

We study the effect of the reform on the desirability to serve as an independent director. We show that introduction of personal liability results in an increased turnover of independent directors. We also find stronger deterrence to serve as an independent director on boards of firms that are subject to litigation and regulatory risk, high monitoring costs, and weak pecuniary incentives to serve as an independent director. 

A priori, it is unclear whether the reform, which increases the cost of serving as independent directors, will have a differential impact for high and low-quality directors. On the one hand, the reform might induce high-quality directors to quit due to reputational concerns. On the other hand, the reform might imply that directors now incur the cost of their poor oversight, leading low-quality directors to quit. We find support for both arguments. Specifically, we find that the reform leads to higher turnover among expert directors, as well as higher turnover among directors with attendance problems. Shareholders react negatively to the enactment of the law, and stock price reactions to director replacements suggest a 1.16% lower firm value after the reform. These results are consistent with the view that the introduction of personal liability is costly. 

Our findings have important policy implications for the ongoing discussion on how to improve the effectiveness of corporate boards. From shareholders’ perspective, personal liability is a trade-off between reducing agency problems through increased board monitoring, and on the other hand, ensuring that the most capable individuals are employed on the board and that those directors take the optimal amount of risk. Our study primarily documents the existence of costs for directors associated with the introduction of personal liability, leading to director replacements and lower firm value. At the same time, our results also show that personal liability improves meeting attendance among incumbent directors. Collectively, these results highlight that the potential benefit from introducing personal liability to strengthen directors’ incentives is counteracted by an increased cost of serving as a director. Our study is the first step towards understanding whether personal liability of independent directors can improve the effectiveness of corporate boards.

S Lakshmi Naaraayanan is a PhD Candidate in Finance at the Hong Kong University of Science and Technology.

Kasper Meisner Nielsen is Professor of Finance at Copenhagen Business School and Research Fellow at the Danish Finance Institute.