A new paper by Wharton’s Doron Levit and Carroll’s Nadya Malenko fleshes out the role that reputation plays in shaping the structure and effectiveness of corporate boards.

Doron Levit and Nadya Malenko

Corporate governance matters. The formal and informal rules by which a company is governed dictate not just the specific company’s value, but also who controls the capital in the economy. Corporate governance therefore affects how capital is being put to use, and what type of capitalism we have. The question then becomes – what matters for corporate governance? The literature has paid special attention to one particular governance institution, namely, the board of directors. A new paper by Wharton’s Doron Levit and Carroll’s Nadya Malenko fleshes out the role that reputation plays in shaping the structure and effectiveness of corporate boards.

Levit and Malenko caution from assuming that directors who care about their reputation will necessarily push for stronger corporate governance (strong governance is defined in their paper as being shareholder-friendly). They note that directors tradeoff two conflicting types of reputational concerns: if you wish to maximize your chances of getting invited to other boards, you sometimes need to maximize not a reputation for being shareholder-friendly, but rather a reputation for being management-friendly. After all, if a lot of companies are run in a mode that favors incumbent managers, directors with reputation for being management-hostile may have a hard time getting invited to serve on boards.

Against this background comes the key element in Levit & Malenko’s model: the notion of governance complementarities across firms. The tradeoffs that directors make are being shaped by, and at the same time shaping, the strength of governance in other companies. In their words: “the actions a player takes to build a certain type of reputation increase the value of this reputation for other players.” If director X pushes a company toward more shareholder (manager-) friendly direction, her company will be more likely to look in the future for directors with a reputation for being shareholder (manager-) friendly. The choice of director X created governance externalities, as it increased the reputational incentives that other directors face to behave the same. In other words, when a director favors shareholders or managers, her choice affects not just her own reputation (the supply in directors labor-market), but also which type of reputation companies are looking for (the demand in directors labor-market).

Directors’ labor-market concerns therefore serve as an amplifier. In corporate governance systems that are relatively shareholder-friendly, reputational incentives push directors to favor shareholders; in corporate governance systems that are management-friendly, reputation pushes directors to side with management. Countries may fall into bad governance equilibrium or good governance equilibrium. Acknowledging this supra-cyclical nature of reputation dynamics carries important implications. Generally speaking, small regulatory changes may bring with them big changes in board behavior, because changes in legal incentives set up in motion changes in reputational incentives. More specifically, Levit and Malenko use the model to derive implications for limiting the number of board seats, reducing board size, or increasing board transparency.