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The board of directors is a particularly powerful governance mechanism for monitoring firm performance in the U.S.  However, director monitoring incentives do not appear to be particularly strong. For example, directors appear to lack sufficient financial incentives to motivate them to effectively monitor, and the labor market for directors does not appear to effectively punish poor performance. This raises some important questions. How reliable are boards of directors in representing shareholder interests? What motivates directors to monitor? Who monitors the board monitors?

In this study, we show that institutional investor monitoring on a regular basis significantly improves director incentives to expend effort in monitoring management. But, why should institutional shareholders have a tangible impact on board behavior?  One possible answer is that in the absence of effective board monitoring, institutional investors can be exposed to severe agency problems and experience significant losses. Thus, monitoring boards of directors to ensure they perform their fiduciary duties can be a critical channel through which outside investors seek to maximize their returns on investments.

To test whether institutional investor monitoring affects board incentives, we construct measures of exogenous distraction of institutional shareholders, utilizing exogenous variations in institutional shareholder attention caused by unrelated industry shocks to their portfolio. The following example illustrates how such an exogenous shock to institutional investor monitoring of the board can occur. Suppose a mutual fund investor has two large stockholdings belonging to two unrelated industries, one a bank and the other a pharmaceutical firm. When the pharmaceutical industry is experiencing a large return shock due to technological breakthroughs, the mutual fund has incentives to allocate more time and effort to fully understand the impact of technological breakthroughs in the pharmaceutical industry. Assuming the attention and effort of a fund investor is in limited supply, we expect the bank to receive less attention.

We find an array of evidence that institutional investor monitoring of directors does improve director incentives to monitor senior management. Distracted institutions are less likely to discipline ineffective directors, while directors with poor proxy voting outcomes are less likely to depart. Consequently, independent directors face weaker monitoring incentives and exhibit poor performance. Also, boards also hold fewer meetings and they appoint or re-appoint ineffective independent directors more frequently. Such firms exhibit more earnings management, high unexplained CEO pay, and lower valuation.

Overall, we find strong evidence that distracted institutional investors cause poorer board governance, in part through less disciplinary voting in director elections. Boards generally have primary responsibility for monitoring management performance. Our study shows that the board monitors themselves benefit from being monitored. More specifically, outside shareholder monitoring provides one source of strong incentives for independent directors to exert more monitoring efforts and to more effectively perform their own monitoring duties.

 

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