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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
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
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 2 / 73
Introduction
An International Phenomenon
UK: Cadbury Report, 1992.
Japan: major reforms in 2002.
Australia: CLERP 9, 2004.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 3 / 73
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.”
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 4 / 73
Introduction
Potential Problem Interpreting Empirical Evidence:
Amount Disclosed
Performance
L H
Firm 1
Firm 2
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 5 / 73
Introduction
Potential Problem Interpreting Empirical Evidence:
Amount Disclosed
Performance
L H
Firm 1
Firm 2
Regression line
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 6 / 73
Introduction
Potential Problem Interpreting Empirical Evidence:Analyzing an Equilibrium Phenomenon
Amount Disclosed
Performance
L H
Firm 1
Firm 2
Regression line
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 7 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 8 / 73
Introduction
Outline of Talk
1 Introduction
2 Model
3 General Analysis
4 Governance Models
5 General Equilibrium
6 Additional Discussion & Conclusions
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 9 / 73
Model Timing
The ModelBasic Timing
Owners(principal)set disclosureregime.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 10 / 73
Model Timing
The ModelBasic Timing
Owners(principal)set disclosureregime.
Ownersnegotiatewith & hireceo (agent)
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 11 / 73
Model Timing
The ModelBasic Timing
Owners(principal)set disclosureregime.
Ownersnegotiatewith & hireceo (agent)
Informationis revealed,the quality ofwhichdepends ondisclosureregime
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 12 / 73
Model Timing
The ModelBasic Timing
Owners(principal)set disclosureregime.
Ownersnegotiatewith & hireceo (agent)
Informationis revealed,the quality ofwhichdepends ondisclosureregime
Owners basean action(e.g.,dismissal) oninformation
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 13 / 73
Model Timing
The ModelBasic Timing
Owners(principal)set disclosureregime.
Ownersnegotiatewith & hireceo (agent)
Informationis revealed,the quality ofwhichdepends ondisclosureregime
Owners basean action(e.g.,dismissal) oninformation
Payoffsrealized.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 14 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 15 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 16 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 17 / 73
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).
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 18 / 73
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).]
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 19 / 73
General Analysis Bargaining Comparative Statics
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
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 20 / 73
General Analysis Bargaining Comparative Statics
Proof of Proposition 1Non-extreme bargaining: Better disclosure =⇒ red curve shifts up
bargain powersurplus
ww e
(1−λ)v ′(w)U(D)+v(w)−u
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 21 / 73
General Analysis Bargaining Comparative Statics
Proof of Proposition 1Non-extreme bargaining: Better disclosure =⇒ blue curve shifts down
bargain powersurplus
ww e w e
λ
π(D)−w
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 22 / 73
General Analysis Bargaining Comparative Statics
Proof of Proposition 1Non-extreme bargaining (i.e., 0 < λ < 1): Better disclosure
bargain powersurplus
ww e w e
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 23 / 73
General Analysis Bargaining Comparative Statics
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).
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 24 / 73
General Analysis Bargaining Comparative Statics
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 25 / 73
General Analysis Bargaining Comparative Statics
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))
.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 26 / 73
General Analysis Bargaining Comparative Statics
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∗))
.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 27 / 73
General Analysis Bargaining Comparative Statics
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) ≡ ∆.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 28 / 73
General Analysis Bargaining Comparative Statics
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 29 / 73
General Analysis Bargaining Comparative Statics
Proof of Proposition 3
bargain powersurplus
wπ(D)v−1
(
∆)
λ
π(D)−w(1−λ)v ′(w)∆+v(w)
w e
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 30 / 73
General Analysis Bargaining Comparative Statics
Proof of Proposition 3
bargain powersurplus
wv−1
(
∆)
(1−λ)v ′(w)∆+v(w)
w e w e
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 31 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 32 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 33 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 34 / 73
Governance Models Learning Models
Owners’ Choice of ActionProof of Lemma
θ
$
θ
Π(θ)
θγ(
a∗(θ))
− c(
a∗(θ))
θL θR
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 35 / 73
Governance Models Learning Models
Owners’ Choice of ActionProof of Lemma (continued)
θ
$
θ
Π(θ)
θγ(
a∗(θ))
− c(
a∗(θ))
θL θR
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 36 / 73
Governance Models Learning Models
Owners’ Choice of ActionProof of Lemma (continued)
θ
$
θ
Π(θ)
θL θR
Π(θ)
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 37 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 38 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 39 / 73
Governance Models Learning Models
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).
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 40 / 73
Governance Models Learning Models
The Dispersive Order
Let F (·|D) be the distribution function for θ conditional on thedisclosure regime.
Distribution F (·|D′) dominates F (·|D) in the sense of the dispersiveorder (denoted F (·|D′) ≥
dispF (·|D)) if
F−1(ξ|D′)− F−1(ξ′|D′) < F−1(ξ|D)− F−1(ξ′|D)
whenever 1 > ξ > ξ′ > 0.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 41 / 73
Governance Models Learning Models
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′)
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 42 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 43 / 73
Governance Models Learning Models
Proof of Proposition 6
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).
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 44 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 45 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 46 / 73
Governance Models Learning Models
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).
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 47 / 73
Governance Models Learning Models
Signal-Jamming: A Heuristic DiscussionGraphical Interpretation
0signal
True distribution
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 48 / 73
Governance Models Learning Models
Signal-Jamming: A Heuristic DiscussionGraphical Interpretation
x
signal
True distribution
Apparent distribution
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 49 / 73
Governance Models Learning Models
Signal-Jamming: A Heuristic DiscussionGraphical Interpretation: In equilibrium no one fooled
−x
x
signal
Equilibrium distribution
Apparent distribution
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 50 / 73
Governance Models Learning Models
Signal-Jamming: A Heuristic DiscussionGraphical Interpretation: Red queen problem
−x
signal
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 51 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 52 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 53 / 73
Governance Models Learning Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 54 / 73
Governance Models Agency Models
Agency ModelsTiming and Assumption
Owners(principal)set disclosureregime.
Owners hireceo and hisbase salary,w , is set.
Owners getinformationrelevant todesign ofceo bonusplan.
Owners setthe bonusplan.
ceo choosesx andreceivesbonus, b,according toplan.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 55 / 73
Governance Models Agency Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 56 / 73
Governance Models Agency Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 57 / 73
Governance Models Agency Models
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?
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 58 / 73
Governance Models Agency Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 59 / 73
Governance Models Agency Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 60 / 73
Governance Models Agency Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 61 / 73
Governance Models Agency Models
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 62 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 63 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 64 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 65 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 66 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 67 / 73
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 68 / 73
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.
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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.
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Additional Discussion & Conclusions
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.
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Additional Discussion & Conclusions
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.
Hermalin & Weisbach (Berkeley & OSU) Disclosure & Governance May 27, 2013 72 / 73
Additional Discussion & Conclusions
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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