By Po-Hsuan Hsu, Yiqing Lü, Hong Wu, and Yuhai Xuan
Under the escalating global technology competition, corporate innovation activities play a critical role in determining firms’ future growth and survival. While the board of directors serves as perhaps the most important governance mechanism in modern corporations, its role in corporate innovation remains underexplored in both the academic literature and extant policy discussions. In this paper, we focus on how the job security of directors influences corporate innovation. There are two competing views by scholars about the effect of directors’ job security. On the one hand, job security insulates directors against the reputational consequences of random realizations of bad operating performance and thus motivates them to be supportive to risky innovation activities. On the other hand, as directors may prefer a “quiet life”, enhanced job security may discourage them from exerting efforts in advising and monitoring corporate innovation. In other words, a lack of job security may encourage self-interested directors to embrace safe yet myopic investments due to excessive shareholder monitoring and capital market pressure.
In this article, we empirically examine whether and how governance mechanisms that subject directors to greater job insecurity impact corporate innovation. We exploit a novel, quasi-natural experiment utilizing the staggered enactment of legislative changes at the state level known as majority voting (MV) legislation. In nearly all U.S. states, a plurality voting standard was the default rule in director reelections before 2006. This standard, however, has attracted increasing criticism for its disregard for withheld votes, as a single vote could be sufficient to ensure that a candidate is elected. Hence, shareholders who advocate “shareholder democracy” have requested a shift to a more stringent voting standard, that is, MV, under which a candidate must receive a majority of the shares voting or present at the meeting in order to be elected. In other words, if a candidate’s “for” votes do not exceed “withheld” votes and “against” votes, the candidate will not be elected. The main motivation for such advocacy is that the MV standard is perceived to hold directors accountable and hence can improve governance. Starting in 2006, Delaware as well as several states enacted the MV legislation, which enables shareholders to adopt the more stringent MV standard.
While many believe that the adoption of the MV standard can discipline directors more and hence creates value, it also weakens the job security of directors. Indeed, our analysis shows that after MV enactment, the sensitivity of directors’ turnover to firm performance increases significantly, suggesting that directors face higher job insecurity after the legislation. More importantly, we find that the passage of MV legislation in a firm’s incorporation state is associated with a reduction of approximately 7% in the number of patents and 8% in the number of forward citations. These results indicate that job insecurity created by the passage of MV legislation may discourage firms’ innovation activities. In particular, the reduction in patents is concentrated in exploratory patents: the number of exploratory patents drops by 5% after MV legislation, while the number of exploitative patents does not change substantially. We also find that, consistent with director myopia, firms significantly reduce their R&D investment and become less likely to miss earnings benchmarks after MV legislation. In addition, the originality and quality of patents, as well as firm-level patent values, all experience significant decreases after MV legislation.
Our empirical findings suggest that firms become more conservative in project choices after the adoption of the MV rule, resulting in worse innovation performance that subsequently reduces their opportunity to create new competitive advantages. These findings are consistent with the interpretation that heightened job insecurity may re-orient directors’ governance mission toward promoting safer investments rather than riskier ones, and their weakened incentives to support highly risky and effort-costly innovation may lead firms to reduce innovation activities and/or change project choices.
This research has rich implications for shareholders as well as policy makers. First, we offer new insights on the important role of directors in advising and monitoring corporate innovation. Since firms’ intellectual property is the core of market valuation and competitive advantages, both investors and governments may consider the function of boards of directors beyond corporate governance. Second, this study highlights the effect of directors as a new dimension in the driving forces of corporate innovation and substantially differs from prior studies that focus on the effects of investors, managers, and inventors. Last but not least, our findings provide new insight into the investigation on the effect of the majority voting standard on firm value. While the MV legislation aims to empower shareholders, it may come with unintended consequences. Our analysis shows that in terms of corporate innovation, MV legislation has clear negative implications. Therefore, a thorough evaluation of the effect of the MV standard on firm value and performance must take into consideration not only the resulting enhanced shareholder protection but also any negative (and perhaps unintended) consequences in the long run, such as the potential costs of weakened innovation prospects.