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Information Disclosure and Corporate Governance

Benjamin E. Hermalin1 Michael S. Weisbach2

1University of California, Berkeley

2Ohio State University

Talk at

Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 1 / 73

hermalin

Typewritten Text

Copyright © 2010 Benjamin E. Hermalin & Michael S. Weisbach. All rights reserved.

Introduction

Better Corporate Disclosure a Long-Sought Reform

1927: William Z. Ripley, Main Street and Wall Street

1932: Adolph A. Berle & Gardiner C. Means, The ModernCorporation and Private Property

1930s: Various reform legislation in wake of Great Depression

...

2002: Sarbanes-Oxley


Introduction

An International Phenomenon

UK: Cadbury Report, 1992.

Japan: major reforms in 2002.

Australia: CLERP 9, 2004.


Introduction

Focus of Reform: Increased TransparencyIs Increased Transparency a Good Thing?

General view is more disclosure ⇒ better governance.

Some empirical evidence suggests that firms that disclose moreperform “better.”


Introduction

Potential Problem Interpreting Empirical Evidence:

Amount Disclosed

Performance

L H

Firm 1

Firm 2


Introduction

Potential Problem Interpreting Empirical Evidence:

Amount Disclosed

Performance

L H

Firm 1

Firm 2

Regression line


Introduction

Potential Problem Interpreting Empirical Evidence:Analyzing an Equilibrium Phenomenon

Amount Disclosed

Performance

L H

Firm 1

Firm 2

Regression line


Introduction

What This Paper’s About

Why could there be a tradeoff between disclosure (transparency) andperformance?

What factors influences this tradeoff?

What are the consequences of more disclosure for corporategovernance (agency problems)?

More disclosure ⇒ Greater managerial compensation in equilibrium.More disclosure ⇒ More managerial turnover in equilibrium.More disclosure ⇒ Changes to managerial actions in equilibrium.. . . including potentially greater managerial myopia.. . . including potentially greater conservatism.


Introduction

Outline of Talk

1 Introduction

2 Model

3 General Analysis

4 Governance Models

5 General Equilibrium

6 Additional Discussion & Conclusions


Model Timing

The ModelBasic Timing

Owners(principal)set disclosureregime.


Model Timing



Ownersnegotiatewith & hireceo (agent)


Model Timing




Informationis revealed,the quality ofwhichdepends ondisclosureregime


Model Timing





Owners basean action(e.g.,dismissal) oninformation


Model Timing





Owners basean action(e.g.,dismissal) oninformation

Payoffsrealized.


Model Examples

Examples

Owners learn information about ceo’s ability. Consequent action iswhether owners keep or fire ceo. The ceo suffers a loss if fired.

Information: firm prospects. Consequent action: add or subtractresources invested. The ceo prefers to manage more resources thanless ceteris paribus.

Information: lessens ceo’s informational advantage. Consequentaction: adjustment to ceo’s compensation plan. The ceo losesinformation rents.

Information: performance more informative. Consequent action:adjustment to ceo’s compensation plan. The ceo loses quasi-rents.


Model Payoffs

Notation and Payoffs

D denotes disclosure regime.

D ≻ D′ denotes D more informative than D′.

w denotes ceo compensation.

Owners’ payoff = π(D)− w .

CEO’s payoff = U(D) + v(w); v ′(·) exists and is positive.

CEO cannot buy his job; hence, w ≥ 0.


Model Payoffs

Differing Preferences

Condition

If D and D′ are two disclosure regimes such that D ≻ D′, thenπ(D) ≥ π(D′) and U(D) < U(D′).

At the moment this is an assumption. Later will prove it holds in gamesof interest.


Model Bargaining

Setting CompensationGeneralized Nash Bargaining

Assume compensation, w , set through generalized Nash bargaining.

That is, w set to maximize

λ log(

π(D)− w)

+ (1− λ) log(

U(D) + v(w)− u)

,

where

λ = owners’ bargaining power, λ ∈ [0, 1]; andu is the value of the ceo’s outside option (e.g., utility if he retires).


General Analysis Bargaining Comparative Statics

The Basic Tradeoff

Proposition

Assume wage bargaining is generalized Nash and the Condition holds.Then the ceo’s compensation, as determined by the bargaining process, isnon-decreasing in how informative is the disclosure regime.

[The talk ignores corner solutions (i.e., worlds in which ceos receive 0compensation).]



Proof of Proposition 1Non-extreme bargaining (i.e., 0 < λ < 1)

bargain powersurplus

wπ(D)v−1

(

u−U(D))

λ

π(D)−w(1−λ)v ′(w)

U(D)+v(w)−u

w e



Proof of Proposition 1Non-extreme bargaining: Better disclosure =⇒ red curve shifts up


ww e

(1−λ)v ′(w)U(D)+v(w)−u



Proof of Proposition 1Non-extreme bargaining: Better disclosure =⇒ blue curve shifts down


ww e w e

λ

π(D)−w



Proof of Proposition 1Non-extreme bargaining (i.e., 0 < λ < 1): Better disclosure


ww e w e



Proof of Proposition 1Extreme bargaining (i.e., λ = 1 or = 0)

If owners have all the bargaining power: U(D) + v(w) = u; hence,w = v−1

(

u − U(D))

.

If ceo has all the bargaining power: π(D)− w = 0; hence,w = π(D).



Why Might CEOs Resist Improved Disclosure?

Proposition

Assume wage bargaining is generalized Nash and the Condition holds.Assume, too, that neither party has all the bargaining power (i.e., assumeλ ∈ (0, 1)). Finally, assume the ceo’s utility exhibits non-increasingmarginal utility of income (i.e., assume ceo is risk neutral or risk averse inincome). If there is a reform to disclosure that results in a disclosureregime that is more informative than the one the owners would havechosen, then the ceo’s expected total utility is reduced.



Proof of Proposition 2Part I

Let D∗ be the owners’ unconstrained choice and Dr the reform level.

By assumption Dr ≻ D∗.

Let w(D) denotes equilibrium compensation given disclosure regime.

Objective is to show U(D∗) + v(

w(D∗))

> U(Dr) + v(

w(Dr))

.



Proof of Proposition 2Part II

First-order from general Nash bargaining tell us

−λ

π(D)− w(D)+

(1− λ)v ′(

w(D))

U(D) + v(

w(D))

− u= 0 . (⋆)

Dr 6= D∗ =⇒

π(Dr)− w(Dr) < π(D∗)− w(D∗) .

Proposition 1 =⇒ w(Dr) > w(D∗).

Therefore: U(Dr) + v(

w(Dr))

< U(D∗)− v(

w(D∗))

.



What if More Disclosure Just Makes Being CEO a Worse

Job?

Suppose u reflects next best ceo job.

If U(D) goes down, perhaps u should go down too.

To reflect that possibility, suppose U(D)− u(D) ≡ ∆.



Compensation Still Rises

Proposition

Assume the owners’ gross expected profit, π(·), is strictly increasing in theinformativeness of the disclosure regime (i.e., D ≻ D′ ⇒ π(D) > π(D′))and that bargaining is generalized Nash. Suppose that the ceo’s grossexpected utility from the job, U(·), decreases one-for-one with his outsideoption as disclosure is made universally more informative. Then anincrease in the level of disclosure causes an increase in the ceo’scompensation unless the owners have all the bargaining power, in whichcase his compensation is unaffected.



Proof of Proposition 3


wπ(D)v−1

(

∆)

λ

π(D)−w(1−λ)v ′(w)∆+v(w)

w e





wv−1

(

∆)

(1−λ)v ′(w)∆+v(w)

w e w e


Governance Models Learning Models

Need to Justify ConditionLearning Models

Suppose owners’ payoff is rγ(a)− c(a), where

a is owners’ action;r is a stochastic return; andγ(·) and c(·) functions.

Er = θ.

θ is an unknown parameter.

From information owners receive, they form an unbiased estimate θ.

How good an estimate depends on disclosure regime.



Learning ModelsExamples

Parameter θ is ceo’s ability (or monotonic transformation thereof).Action is fire ceo (a = 1) or keep (a = 0). (Alternatively, a = 1 ⇒sell to acquirer; a = 0 ⇒ reject acquirer.)

c(1) > c(0) (i.e., firing costs) and γ(a) = 1− a .

Or parameter θ reflects firm’s future prospects. Action is to adjustcapital in firm (a > 0 is adding, a < 0 is subtracting).

c(a) =a2

2(i.e., quadratic adjustment costs) and γ(a) = K + a ,

where K is baseline capital in firm.



Learning ModelsOwners’ Actions and Payoffs

Given θ, owners choose a to maximize θγ(a)− c(a).

Let a∗(θ) be solution.

Owners’ expected payoff conditional on θ is, thus,Π(θ) = θγ

(

a∗(θ))

− c(

a∗(θ))

.

Lemma

The owners’ payoff function Π(·) is convex.



Owners’ Choice of ActionProof of Lemma

θ

$

θ

Π(θ)

θγ(

a∗(θ))

− c(

a∗(θ))

θL θR



Owners’ Choice of ActionProof of Lemma (continued)

θ

$

θ

Π(θ)

θγ(

a∗(θ))

− c(

a∗(θ))

θL θR



Owners’ Choice of ActionProof of Lemma (continued)

θ

$

θ

Π(θ)

θL θR

Π(θ)



Information and Risk

Ex ante the estimator θ is a random variable.

Result from statistics: If D ≻ D′ in the sense of Blackwellinformativeness, then the distribution of θ(D) is a mean-preservingspread of the distribution of θ(D′).

That is, θ(D) is riskier than θ(D′) in the sense of second-orderstochastic dominance.



Owners Like More Informative Disclosure Regimes

From Lemma, owners’ payoff is convex in θ; that is, they are riskloving.

From previous slide, more informative ⇒ riskier.

Hence, owners must prefer more informative disclosure regimes to lessinformative ceteris paribus.

In other words, owners’ “part” of the Condition is met.



The Dismissal Model

Consider the dismissal model outlined earlier.

CEO’s utility is

u(θ) =

−ℓ , if θ < −c(1)

0 , if θ ≥ −c(1).



The Dispersive OrderRed distribution dominates blue distribution in the dispersive order

1ξ

ξ′

F −1(ξ ′

|D)

F−1(ξ′|D′)F −

1(ξ|D

)

F−1(ξ|D′)



The Dismissal ModelOpposing preferences

All distributions of θ have the same mean.

Hence, F (·|D′) ≥disp

F (·|D) implies F (·|D′) ≥ssdF (·|D).

Previous analysis implies F (·|D′) ≥disp

F (·|D) means owners prefer D toD′.

CEO has opposite preferences:

Proposition

Suppose the median of the estimate θ equals the mean and the meanexceeds firing cost. Then F (·|D′) ≥

dispF (·|D) implies the ceo prefers D′ to

D. In other words, the Condition holds for the dismissal model.




Result follows if F (·|D′) ≥disp

F (·|D) ⇒ F(

−c(1)∣

∣D)

> F(

−c(1)∣

∣D′)

.

F (·|D′) ≥disp

F (·|D) implies

F−1(

1/2∣

∣D′)

− F−1(

ξ∣

∣D′)

< F−1(

1/2∣

∣D)

− F−1(

ξ∣

∣D)

(†)

for all ξ < 1/2.

Mean and median coincide ⇒ F−1(

1/2∣

∣D′)

= F−1(

1/2∣

∣D)

.

Hence (†) implies, for all ξ < 1/2,

F−1(

ξ∣

∣D)

< F−1(

ξ∣

∣D′)

⇒ F−1(

F(

−c(1)∣

∣D′)

∣

∣

∣D)

< −c(1)

⇒ F(

−c(1)∣

∣D′)

< F(

−c(1)∣

∣D)

,

(recall F(

−c(1)∣

∣D′)

< F(

Eθ∣

∣D′)

= 1/2 and distributions areincreasing functions).



An Example Satisfying the Dispersive OrderA normal-learning-model version of the dismissal model

CEO ability, θ, is distributed normally with mean 0 and precision τ(i.e., variance 1/τ).

Information: owners observe a signal s, which is distributed normallywith a mean equal to ceo’s ability and a precision δ.

Hence, δ > δ′ means signal given δ more informative than signalgiven δ′; that is, δ > δ′ corresponds to D ≻ D′.

Corollary

Consider the ceo-dismissal model. Suppose the estimate θ is formedaccording to the normal-learning model. Then mean and median of θcoincide. If D is a more informative disclosure regime than D′, thenF (·|D′) ≥

dispF (·|D). Hence, the owners prefer D to D′ and the ceo prefers

D′ to D. In other words, the Condition follows.



More on Learning Models of Governance

Note that if the ceo’s utility were concave in θ, then the Conditionwould hold.

Such would be the case, for instance, if ceo’s future wage were amultiple of θ and the ceo were risk averse in income.



A Signal-Jamming Model

Recall example in which owners’ action was to add (a > 0) orsubtract (a < 0) resources/capital from firm.

Suppose ceos like to run bigger empires ceteris paribus.

Specifically, ceo’s utility (gross of compensation) is K + a, the size ofhis empire.

Suppose, too, that the ceo can jam the owners’ information.

Specifically, ceo can take action x ∈ R+ such that owners see x θwhenever θ > 0 (when θ < 0, they see θ).



Signal-Jamming: A Heuristic DiscussionGraphical Interpretation

0signal

True distribution



Signal-Jamming: A Heuristic DiscussionGraphical Interpretation

x

signal

True distribution

Apparent distribution



Signal-Jamming: A Heuristic DiscussionGraphical Interpretation: In equilibrium no one fooled

−x

x

signal

Equilibrium distribution

Apparent distribution



Signal-Jamming: A Heuristic DiscussionGraphical Interpretation: Red queen problem

−x

signal



The Signal-Jamming Model: Continued

As noted, no one fooled in equilibrium.

That is, when statistic positive (i.e., x θ > 0), owners will divide it byxe , the value they anticipate ceo chooses in equilibrium.

Owners’ choice of a maximizes Eθ(K + a)− a2/2.

So choice of a when statistic positive is x θ/xe .

Condition for equilibrium is x = xe ; that is,

xe = argmaxe

∫

∞

0

x

xeθdF (θ|D)− g(x) , (‡)

where g(·) is ceo’s cost-of-effort function, which is increasing andconvex.



The Signal-Jamming Model: Continued

Employing integration by parts on (‡) and using the FOC, xe isdefined by

∫

∞

0

(

1− F (θ|D))

d θ = xeg′(xe) .

An increase in the left-hand side implies an increase in xe .If D ≻ D′ in the Blackwell sense, then F (·|D′) ≥

ssdF (·|D), hence

∫

∞

0

(

1− F (θ|D))

d θ >

∫

∞

0

(

1− F (θ|D′))

d θ .

Hence, xe increases as disclosure becomes more informative.ceo’s equilibrium utility is −g(xe), so ceo prefers a less informativeregime to a more informative regime ceteris paribus. We have shown:

Proposition

If D is a more informative disclosure regime than D′, then the ownersprefer D to D′ and the ceo prefers D′ to D. In other words, theCondition holds.



Signal-Jamming and the Dark Side of Disclosure

Suppose the action x directly or indirectly harmful to owners.

For instance, problem similar to Stein (1989) managerial myopiastory: x represents actions that boost earnings in short term in anegative-NPV way relative to the long term.

Then see that one downside to greater disclosure is it could lead tomore harmful signal-jamming activities.


Governance Models Agency Models

Agency ModelsTiming and Assumption


Owners hireceo and hisbase salary,w , is set.

Owners getinformationrelevant todesign ofceo bonusplan.

Owners setthe bonusplan.

ceo choosesx andreceivesbonus, b,according toplan.



Hidden-Information Agency

At last stage, before choosing action x , ceo only learns θ, apayoff-relevant parameter.

θ ∈ B ,G.

Before setting bonus plan, owners learn ψ = Prθ = B. Withprobability 1/2, ψ = δ+1/2; and with probability 1/2, ψ = −δ+1/2.

δ ∈ (0, 1/2) is the information structure (disclosure regime).

In what follows assume negative bonuses are not feasible.



Mechanism Design and Information Rent

Bonus plan will be a mechanism: θ 7→ 〈x(θ), b(θ)〉.

What is critical is the good type’s information rent: I(

x(B))

, whereI (·) increasing and I (0) = 0. (Note I (·) is derived endogenously fromrest of model.)

Define X (ψ) = x(B) under owners’ optimal plan givenPrθ = B = ψ.



Hidden-Information AgencyOpposing preferences over disclosure

Proposition

If D is a more informative disclosure regime than D′ (i.e., δ > δ′), thenthe owners prefer D to D′. If the function mapping [0, 1]2 → R defined by

(ψ,ψ′) 7→ ψI(

X (ψ′))

+ ψ′I(

X (ψ))

,

is Schur concave, then the ceo prefers D′ to D; that is, owners and ceo

have opposing preferences over disclosure regimes (i.e., the Conditionholds)

What is Schur Concavity?



Hidden-Information AgencyAn Example

Suppose owners’ payoff is x − y , where y is ceo’s total compensation.

Suppose ceo’s payoff is y − x2/kθ, where kG > kB > 0.

Then conditions of previous proposition can be shown to hold.



Disclosure and Outrage

Lots of bad press about big payouts to ceos.

More disclosure could contribute to bigger payouts:

Proposition

Consider the hidden-information agency model. The maximum bonus thatcan occur in equilibrium is greater the more informative is the disclosureregime.



Hidden-Action Agency

CEO utility is b − xC , where x ∈ 0, 1 is hidden action taken in laststage and C > 0.

Owners’ payoff is R(x)− b, R(1) > R(0).

The realization R(x) is not verifiable.

If CEO “goofs off,” then owners detect this in a verifiable way withprobability δ.

No negative bonuses.



Hidden-Action Agency

Readily shown that to induce ceo to choose x = 1, owners shouldpromise a bonus equal to C/δ provided they don’t detect that he hasgoofed off.

Detection of goofing off yields no bonus.

Owners’ equilibrium payoff is R(1)− C/δ.

CEO’s equilibrium payoff is C/δ − C .

Hence,

Proposition

If D is a more informative disclosure regime than D′ (i.e., δ > δ′), thenthe owners prefer D to D′ and the ceo prefers D′ to D. That is, theCondition holds.


General Equilibrium

A General Equilibrium Model

Might worry that considering one firm in isolation.

Now consider a market model.

A continuum of firms, with each firm being indexed by β.

Equal measure of ceos, indexed by α.

Let α[i ] and β[i ] be, respectively, the i × 100 percentile of ceo typeand firm type.

Assume α[0] > 0.

Assume the distributions of α and β are twice continuouslydifferentiable so that α[·] and β[·] are as well. Both functions arestrictly increasing.


General Equilibrium

Meaning of Type

CEO’s index, α, is his type. Assume it is observable.

Profit, gross of ceo compensation, is αΩ(δ, β).

Ω : R2 → R+ is twice continuously differentiable in each argument.

As a definition of firm type:

∂2Ω(δ, β)

∂δ∂β> 0 . (comp)

Assume better disclosure raises gross profit; that is, ∂Ω/∂δ > 0.

Assume higher type firms have greater profit ceteris paribus:∂Ω/∂β > 0.


General Equilibrium

CEO Utility and Total Welfare

CEO utility is w + h(δ).

Assume h(·) is a twice continuously differentiable function.

Consistent with the models above, assume h′(δ) < 0.

Welfare is αΩ(δ, β) + h(δ).

For all α and β, assume the function defined by

δ 7→ αΩ(δ, β) + h(δ)

is globally concave in δ and has an interior maximum.

Global concavity implies this maximum is unique.


General Equilibrium

Rest of Assumptions

In addition to working for one of the firms, a ceo can retire or pursuesome vocation other than being ceo.

His utility if he does so is u.

Firms make compensation offers and do so simultaneously.

Looking for an assortative-matching equilibrium.


General Equilibrium

Equilibrium

Lemma

An assortative-matching equilibrium of the market described above existsin which a firm of type β[i ] chooses disclosure regime δ[i ], where δ[i ] solves

maxδ

α[i ]Ω(

δ, β[i ])

+ h(δ) .

In this equilibrium, the ith ceo is paid

w[i ] = u − h(δ[i ]) +

∫ i

0Ω(

δ[j ], β[j ])

α[j ]dj , (wage)

where α[j ] = dα[j ]/dj.


General Equilibrium

Comparative Statics

Proposition

In equilibrium, a higher-type firm (e.g., a larger firm) has a greater level ofdisclosure than a lower-type firm. Furthermore, a more able ceo earnsgreater compensation, has greater utility, and works for a firm with morestringent disclosure than a less able ceo.


General Equilibrium

The Potential and Likely Unintended Consequences of

Reform

Proposition

Let δ[·] be the equilibrium disclosure schedule absent reform. If a reform isimposed such that disclosure must be at least δ[ı], where ı ∈ (0, 1), andthis reform causes no firms to go out of business, then all ceos will seetheir compensation increase in equilibrium and all but the least able ceo

will see his utility increase.


Additional Discussion & Conclusions

Who Wants Reform?

In model above, neither owners nor ceo benefit from a binding“reform” of disclosure.

But if we change timing to permit owners to lobby government afteragreeing to compensation but before subsequent compensationnegotiations, then owners have an incentive to do this.

The paper analyzes how this plays out and shows that if ownerscannot commit not to lobby, they will lobby.



Some Empirical Implications

A consequence of imposing a binding disclosure reform on a firmshould lead to (i) increases in managerial pay; (ii) increase in theturnover rate of top management; and (iii) a decrease in firm value.

Larger firms should have greater disclosure than smaller firms.

An increase in disclosure/information could lead to greater efforts atsignal boosting and more myopia.

An increase in disclosure could lead to greater managerialconservatism.

Cross-sectionally, industries in which more information is releasedabout managerial performance (e.g., mutual funds) could see higherpay and greater turnover rates than in industries in which lessinformation is released.



Conclusions

Disclosure/transparency is not unambiguously desirable from theperspective of good governance.

In a model of optimizing behavior, external reforms aimed atincreasing disclosure/transparency can be welfare reducing.

Importance of an equilibrium approach to governance: Just becausesome policy is beneficial to owners ignoring equilibrium adjustmentsdoesn’t mean it is truly beneficial (i.e., once equilibrium adjustmentsare taken into account).

Model has applications to other principal-agent relations.



Schur Concavity

A symmetric function f : Rn → R, n ≥ 2, is Schur concave if

x majorizes x′ =⇒ f (x) < f (x′) .

What does “majorize” mean?

It essentially means the elements of the vector x are amean-preserving spread of the elements of the vector x′.

For example (1, 3, 7, 9) majorizes (2, 4, 6, 8).

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