Corporate governance & agency


A private corporation or firm is a nexus of a set of contracting relationships between principals and agents. In this context, owners or shareholders of a firm are viewed as its principals (ie outsiders) and the managers or directors are the agents (ie insiders) in control. The separation of ownership and control that arises from this contracting arrangement can lead to an agency problem under which the directors of the firm may not always act in the best interest of the shareholders. The problem of agency can be further amplified by diverging interests amongst the firm’s shareholders and other stakeholders (eg, creditors, employees, suppliers, and customers).

Mitigating the conflicts that arise from the opposing interests of a firm’s principals and agents in order to maximise the firm’s value is the central aim of corporate governance. However, while most economists and legal scholars agree on this general aim, there remains an ongoing debate on what mechanisms should be classified as “good” (ie value-increasing) versus “bad” (ie value-decreasing) corporate governance.

Corporate governance research.

On the one hand, prior studies have found that managers may engage in activities that are harmful to shareholders, such as devoting insufficient effort to their work, pursuing empire-building activities, and executing entrenchment strategies. This evidence finds support for a shareholder-centric governance model, whereby any restrictions on shareholder democracy or power are viewed as inefficiently insulating managers from shareholder discipline. For example, some of our previous work has focused on a lack of transparency, showing that through more lax disclosure rules, compensation consultants help managers boost their pay at the detriment of shareholder value. Another related finding from our past research is that managers can use accounting manipulation to increase their compensation and entrench themselves from outside interventions like takeovers. Additionally, some of our other previous studies have examined the value of insiders to outsiders by considering stock price reactions to the sudden deaths of top executives, while other work has investigated the merits of various measures of corporate governance efficiency such as management dismissal as a proxy for effective monitoring. Under the premise that the shareholder-centric governance model is the best mechanism to maximise firm value, prior work, including ours, has also explored how to align the insiders’ interests with that of the outsiders. One approach to achieve this alignment is to design an optimal compensation package with a mixture of salary, bonus and stock/stock options. Another approach could be to introduce monitoring by external agents such as stock analysts or outside directors on insiders. Relatedly, one of our previous studies focuses on how outside directors and firms are matched.

On the other hand, prior literature has found evidence in support of a board-centric model of corporate governance. For instance, one of our recent studies analyses the impact of directors having a strengthened right to adopt a poison pill (ie a “shadow pill”) on actual pill policy and firm value, finding that it promotes the use of actual poison pills and increases shareholder value. Under this board-centric view, protective corporate governance arrangements (eg a shadow pill) that help insulate insiders from the threat of takeover can contribute to firm value in two ways. First, they can help decrease managers’ incentives to overinvest in short-term projects if investors are myopic or uninformed. Second, a protectionist arrangement could bond insiders’ commitment to the relationship-specific investments made by the firm’s stakeholders by limiting the ability of shareholders to disrupt the firm’s long-term strategy via a takeover, thus decreasing a firm’s cost of contracting with its stakeholders. Consistent with these explanations, some of our prior work finds that antitakeover laws are differentially valuable for more innovative firms or firms with stronger stakeholder relationships, and that they lead to increased investments in innovation, financial soundness, and employee job security. Another related study shows that controlling (ie more powerful) shareholders may expropriate minority shareholders through self-dealing activities like related party transactions.

Further still, corporate governance can be also be imposed via product market competition. One way this mechanism works is by providing a comparable yard stick for managers’ performance. The other is to push managers to work hard due to the heightened risk of failure and, potentially, bankruptcy, that stems from the increased competitive pressure. In addition, we have also shown in prior work that debt is another governance scheme to incentivise managers to make efficient (dis)investment decisions by limiting the amount of cash flows they can use. Moreover, the threat of takeover and leveraged buyouts can also discipline managers.

Cremers, K.J.M., Guernsey, S.B., Litov, L.P. and Sepe, S.M. (2019) “Shadow pills, actual pill policy, and firm value.” European Corporate Governance Institute (ECGI) Finance Working Papers, No 595/2019. Brussels: ECGI. (available online via the SSRN)

Cremers, K.J.M., Guernsey, S.B. and Sepe, S.M. (2019) “Stakeholder orientation and firm value.” Social Science Research Network Working Paper (available online via the SSRN)

Helmers, C., Patnam, M. and Rau, P.R. (2017) “Do board interlocks increase innovation? Evidence from a corporate governance reform in India.” Journal of Banking and Finance (DOI: 10.1016/j.jbankfin.2017.04.001)

Chu, J., Faasse J. and Rau P.R (2015) “Do compensation consultants enable higher CEO pay? New evidence from recent disclosure rule changes.” (available online via the SSRN)

Do, Q-A., Nguyen B.D. and Rau P.R. (2015) “Sugar and spice and everything nice: what are independent directors made of?” (available online via the SSRN)

Nguyen B.D. and Nielsen, K.M. (2014) “What death can tell: are executives paid for their contributions to firm value?” Management Science, 60(12): 2994-3010 (DOI: 10.1287/mnsc.2014.2011)

Cheung, Y.-L., Rau, P.R. and Stouraitis, A. (2012) “How much do firms pay as bribes and what benefits do they get? Evidence from corruption cases worldwide.” NBER Working Papers, No 17981. Cambridge, MA: National Bureau of Economic Research.

Nguyen, B.D. (2012) “Does the Rolodex matter? Corporate elite’s small world and the effectiveness of boards of directors.” Management Science, 58(2): 236-252 (DOI: 10.1287/mnsc.1110.1457)

Bigelli, M., Mehrotra, V. and Rau, P.R. (2011) “Why are shareholders not paid to give up their voting privileges? Unique evidence from Italy.” Journal of Corporate Finance, 17(5): 1619-1635 (DOI: 10.1016/j.jcorpfin.2011.09.005) (available online via the SSRN)

Nguyen, B.D. and Nielsen K.M. (2010) “The value of independent directors: evidence from sudden death.” Journal of Financial Economics, 98(3): 550-567 (DOI: 10.1016/j.jfineco.2010.07.004)

Cheung, Y.-L., Jing, L., Lu, T., Rau, P.R. and Stouraitis, A. (2009) “Tunneling and propping up: an analysis of related party transactions by Chinese listed companies.” Pacific-Basin Finance Journal, 17(3): 372-393 (DOI: 10.1016/j.pacfin.2008.10.001) (available online via the SSRN)

Cheung, S., Qi, Y.-L., Rau, P.R., and Stouraitis, A. (2009) “Buy high, sell low: how listed firms price asset transfers in related party transactions.” Journal of Banking and Finance, 33(5): 914-924 (DOI: 10.1016/j.jbankfin.2008.10.002) (available online via the SSRN)

Botsari, A. and Meeks, G. (2008) “Do acquirers manage earnings prior to a share for share bid?” Journal of Business Finance and Accounting, 35(5/6): 633-670 (DOI: 10.1111/j.1468-5957.2008.02091.x) (available online via the SSRN)

Lambrecht, B.M. and Myers, S.C. (2008) “Debt and managerial rents in a real-options model of the firm.” Journal of Financial Economics, 89(2): 209-231 (DOI: 10.1016/j.jfineco.2007.07.007) (available online via the SSRN)

Cheung, Y.-L., Rau, P.R. and Stouraitis, A. (2004) “Tunneling, propping, and expropriation: evidence from connected party transactions in Hong Kong.” Hong Kong Institute for Monetary Research Working Papers, No.2004/9. Hong Kong: HKIMR. (available online via the SSRN)

Dissanaike, G. and Papazian, A. (2004) “Management turnover in stock market winners and losers: a clinical investigation.” European Corporate Governance Institute Working Paper Series in Finance, No.2004/61. Brussels: ECGI. (available online via the SSRN)