Directors’ Incentives from Potential Penalties: Evidence from Their Voting

What makes independent directors perform their duty? One possible reason is that they are concerned about being punished if they do not fulfill their duties diligently. Using unique features of the Chinese capital market, we estimate the extent to which independent directors’ subjective perceptions of penalty risk affect their voting on proposals. Our results suggest that they are more likely to vote against management after observing how another director in their board network received a regulatory penalty related to negligence. This effect is long-lasting and stronger if the observing and penalized directors share personal characteristics and if the observing director is at a firm that is more likely to be penalized. These results provide novel evidence suggesting that the salience of penalty risk is an important factor motivating directors, which provides regulators with a powerful and cost-effective tool to improve firms’ governance.