Research Brief: Are Internal Watchdogs More Like Bloodhounds or Poodles?

What did the study look at?

Just under half of S&P Index firms now have internal “gatekeepers” who are charged with ensuring that their firms comply with regulations and monitoring for corporate misconduct. Often recruited from law firms, they place their professional reputations on the line by acting as intermediaries between their firms and investors. In this study, researchers ask two questions: Do executive gatekeepers actually reduce governance failures? And do equity incentives divert the attention of internal lawyers from policing corporate wrongdoing?

How was the study designed?

The researchers identified executive gatekeepers from an ExecuComp sample of more than 3,000 firms. They then looked up the full career path of their targets as well as compensation data. For indicators of corporate misconduct, they included measures such as Securities and Exchange Commission accounting fraud convictions, profitable insider sales, Accounting and Auditing Enforcement Releases (AAERs) issued by the SEC against a firm or auditor, and information from firms that disclosed government probes on misdated options.

What did the study find?

• Executive gatekeepers significantly reduce a variety of governance failures — AAERs, insider trading profitability, shareholder securities fraud as measured by class action suits, backdating, and uncaught financial misrepresentation. They decrease securities fraud and uncaught accounting fraud by 43 percent and 9 percent respectively. 
• Equity incentives given to gatekeepers are associated with higher likelihood of class action lawsuits, uncaught fraud, and option backdating. In the case of uncaught financial misrepresentation, for example, 18 percent of governance improvements are rolled back when the gatekeeper has an equity incentive.
• Gatekeepers are not diverted from frauds associated with regulatory compliance, an area in which “they are most exposed in personal liability and reputation.”

What do I need to know?

A law professor once noted acerbically that “watchdogs hired by those they are to watch typically turn into pets, not guardians.” This study’s researchers take a more nuanced view. They say executive general counsels can, indeed, improve governance by reducing the probability of fraud; gatekeepers are particularly effective in areas relating to compliance. But their effectiveness is undercut when they are given equity incentives that encourage them to play value-creating roles. 

As the researchers note, “Daily operations in a world with intangible assets and growth options mandate that expertise in intellectual property rights be a part of the value-adding executive team. The fact that executive general counsel preside over duties both as the chief lawyer and as a member of the inner executive suite surely puts a stress on time and focus.”

Ultimately, boards must take responsibility for this misalignment. They may hire gatekeepers to act merely as “totems,” the researchers say, in which case they would have little concern about lax monitoring. More likely, though, boards buy into the idea pitched by executive recruiting firms that “strategic value-creation and monitoring are other benefits of hiring an executive lawyer,” and compensate gatekeepers accordingly.

As this study suggests, members of board executive hiring committees should acknowledge that  offering general counsel an equity incentive contract comes with a potentially steep price attached.

Title: Executive gatekeepers: useful and divertible governance

Authors: Adair Morse (University of California at Berkeley), Wei Wang (Queen's School of Business), Serena Wu (Queen's School of Business)

Published: Working paper available for download 

— Alan Morantz