Words Speak Louder Without Actions

Doron Levit is Assistant Professor of Finance at The Wharton School of the University of Pennsylvania. This post is based on a recent article by Professor Levit, forthcoming in the Journal of Finance. Related research from the Program on Corporate Governance includes Letting Shareholders Set the Rules and The Case for Increasing Shareholder Power, both by Lucian Bebchuk.

Information and control rights are central aspects of leadership, management, and corporate governance. In practice, communication of private information and intervention in the decision-making process are common remedies for information asymmetries and conflicts of interest in a wide range of situations. The interplay between communication and intervention, however, is little understood.

In my article, Words Speak Louder Without Actions, which is forthcoming in the Journal of Finance, I show that the power of a principal to intervene in an agent’s decision exacerbates the underlying agency problem and as a result limits the ability of the principal to use her private information to influence the agent’s decision. The power to intervene can therefore be detrimental to the principal. This novel result has implications for the effectiveness of visionary management, the tension between the supervisory and advisory roles of corporate boards, and the value that sophisticated investors offer their portfolio companies.

To study the interaction between communication and intervention, I consider a principal-agent model with incomplete contracts and a “top-down” information structure. In the model, the optimal scale of investment depends on the fundamentals of the firm. The principal, who is privately informed about these fundamentals, sends the agent a message that can be interpreted as a nonbinding demand (“cheap talk”). The agent has a tendency to overinvest (e.g., empire-building) and thus the challenge facing the principal is convincing the agent to choose small projects when firm fundamentals are bad. In equilibrium, information is never fully revealed by the principal, who has incentives to understate firm fundamentals to prevent overinvestment. The novel feature of the model is the possibility of intervention. Specifically, after communicating with the agent, the principal observes the agent’s decision and decides whether to intervene and adjust the size of the project. For example, the principal can overrule the agent or monitor him more closely. Since these activities require resources and attention, intervention is costly to the principal.

The main result of the article is that intervention hinders communication. In equilibrium, less information may be revealed by the principal if she has the power to intervene in the agent’s decision. The power to intervene therefore limits the ability of the principal to influence the agent. Since communication is more effective without intervention, words speak louder without actions.

How can intervention hinder communication? The underlying mechanism rests on the limited commitment of the principal. In equilibrium, the principal intervenes to alleviate the overinvestment problem. However, since intervention is costly, it is never in the principal’s best interest to completely undo the agent’s bias. In general, more overinvestment warrants more intervention, but it ultimately results in a larger final project. The agent anticipates the principal’s intervention. In response, he deliberately chooses projects that are larger than what he would have preferred in the absence of intervention. By overshooting, the agent increases the cost the principal must incur to downsize the project, thereby guaranteeing the desired amount of overinvestment. Effectively, the agent behaves as if his bias toward overinvestment is larger, and as a result, the principal has even stronger incentives to understate the true fundamentals of the firm. In other words, the principal’s attempt to prevent the agent from undoing her expected intervention further diminishes her credibility when communicating with the agent. This “vicious cycle” contributes to less informative communication in equilibrium.

The perverse effect of intervention on communication is particularly strong when the cost of intervention is low or the underlying agency problem is severe. Intuitively, the principal intervenes more aggressively when the cost is lower. Therefore, more overshooting by the agent is needed to suppress the impact of intervention on the final project. The intrinsic bias of the agent toward overinvestment has a similar effect. A larger bias implies more overinvestment, and since intervention is more beneficial to the principal when overinvestment is detrimental, a larger bias prompts the principal to intervene more aggressively. Similar to the reasoning behind the effect of the cost of intervention, the agent has even stronger incentives to overshoot, further impeding effective communication.

The perverse effect of intervention on communication is detrimental; it can offset the value of intervention as a correction device and reduce the principal’s expected welfare, especially when the cost of intervention is low or the underlying agency problem is severe. In other words, from the perspective of the principal, the power to intervene is least desirable when intervention is seemingly most effective or most needed. As explained above, under these circumstances, the negative effect of intervention is particularly strong, and as a result it dominates the other benefits of intervention. The idea that communication in and of itself can reduce the value of control rights is another novel aspect of the analysis.

Building on these insights, I discuss novel implications of the analysis for managerial leadership, corporate boards, private equity, and shareholder activism. In all of these applications, communication and intervention are the primary governance mechanisms. For example, the model predicts that visionary leadership and a “hands-off” managerial style are more likely to be successful in large and complex organizations. In addition, the advisory role of corporate boards is expected to be more significant when the number of directors is large or when directors are diverse and busy (e.g., hold other board seats). The model also suggests that private equity investors voices are more likely to be heard when their investment is cosponsored or when they have better exit options (e.g., booming IPO and M&A markets). Similarly, the ease with which activist hedge funds can launch a proxy fight could actually decrease their ability to influence the policy of their target companies.

As a whole, by studying the empirically relevant interplay between intervention and communication, my analysis highlights a novel mechanism through which the allocation of control rights affects real outcomes.

The full article is available for download here.

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