Information Disclosure and Corporate Governance

The following post comes to us from Benjamin Hermalin, Professor of Finance and Economics at the University of California, Berkeley; and Michael Weisbach, Professor of Finance at Ohio State University.

Corporate disclosure is widely seen as an unambiguous good. In our paper, Information Disclosure and Corporate Governance, forthcoming in the Journal of Finance, we show that this view is, at best, incomplete. Greater disclosure tends to raise executive compensation and can create additional or exacerbate existing agency problems. Hence, even ignoring the direct costs of disclosure (e.g., meeting stricter accounting rules, maintaining better records, etc.), there could well be a limit on the optimal level of disclosure.

The model used to study disclosure reflects fairly general organizational issues. A principal desires information that will improve her decision making (e.g., whether or not to fire the agent, tender her shares, move capital from the firm, adjust the agent’s compensation scheme, etc.). In many situations, the agent prefers the status quo to change imposed by the principal (e.g., he prefers employment to possibly being dismissed). Hence, better information is view asymmetrically by the parties: It benefits the principal, but harms the agent. If the principal did not need to compensate the agent for this harm and if she could prevent the agent from capturing, through the bargaining process, any of the surplus this better information creates, the principal would desire maximal disclosure. In reality, however, she will need to compensate the agent and she will lose some of the surplus to him. These effects can be strong enough to cause the principal to optimally choose less than maximal disclosure.

The notion that the principal directly benefits from better information is fairly general. Whether or not the agent is harmed is more dependent on the specifics of the model. Nevertheless, we show, for a number of alternative learning and agency models, that having a better informed principal is not in the agent’s interest. We extend the analysis to consider the consequences of firm size, showing through a number of analyses that larger firms will tend, all else equal, to adopt more stringent disclosure regimes than smaller firms. We also extend the analysis to consider general equilibrium effects. We show that, in a model of assortative matching, there is a positive correlation between the stringency of a firm’s disclosure regime and the ability of the manager it employs. A potentially interesting finding of that model is that an increase in the disclosure requirements that bind on only a subset of firms could, nevertheless, result in all executives earning more. Finally, we addressed the political economy of disclosure reform. Our analysis suggests that shareholders could have an incentive to lobby for disclosure regime ex post, although they would wish they commit not to do so ex ante. Although our analysis has focused on disclosure, many of our insights apply more broadly to any governance reforms.

This paper also extends the bargaining approach to the study of governance (see, e.g., Hermalin and Weisbach, 1998). Once it is recognized that governance does not descend deus ex machina or is something that shareholders can impose any way they wish, it is clear that important tensions exist: Shareholders must, in essence, buy better governance from management at the price of higher managerial compensation. This creates tradeoffs that are not immediately apparent from a deus ex machina view or a view that ignores the existence of a labor market for managerial talent. Our analysis also contributes to a growing literature that demonstrates that better information is not always welfare improving.

Many issues, however, remain. We have abstracted away from any of the concerns about revealing information to rivals or to regulators that other work has raised. Because we have focused on settings in which principal and agent have opposing preferences concerning improved information, we have largely ignored those settings in which they have coincident preferences. We have also ignored the mechanics of how the information structure is actually improved; what accounting rules should be used, what organizational structures lead to more or less informative information, etc.? While future attention to such details will, we believe, shed additional light on the subject, we remain confident that our general results will continue to hold.

The full paper is available for download here.

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