A response to recent corporate governance scandals, such as Enron and Worldcom, has been the imposition of tougher disclosure requirements. For example, Sarbanes-Oxley (SOX) requires more and better information: more, for instance, by requiring reporting of off-balance sheet financing and special purpose entities, and better by its increasing the penalties for misreporting. In the public's (and regulators') view, improved disclosure is good.
This view is an old one, dating at least to Ripley (1927) and Berle and Means (1932). Indeed, there are good reasons why disclosure can increase the value of a firm. For instance, reducing the asymmetry of information between those inside the firm and those outside can facilitate a firm's ability to issue securities and consequently lower its cost of capital.1 Fear of trading against those with privileged information could reduce willingness to trade the firm's securities, thereby reducing liquidity and raising the firm's cost of capital. Better disclosure presumably also reduces the incidence of outright fraud and theft by insiders.
But if disclosure is unambiguously value-increasing, why have calls for more disclosure—whether reforms advocated long ago by Ripley or Berle and Means or those embodied in more recent legislation like SOX—been resisted by corporations? What is the downside to more disclosure?2 The direct accounting costs of disclosure could lie behind some of this resistance. Some commentators have also noted the possibility that disclosure could be harmful insofar as it could advantage product–market rivals by providing them valuable information.3 Although these factors likely play some role in explaining corporate resistance to disclosure, it seems unlikely that they are the complete story. In addition to direct costs and costs from providing information to rivals, we argue here that there are important ways in which disclosure affects firms through the governance channel.
This paper argues that disclosure, as well as other governance reforms, should be viewed as a two-edged sword. From a contracting perspective, increased information about the firm improves the ability of shareholders and boards to monitor their managers. However, the benefits of improved monitoring do not flow wholly to shareholders: If management has any bargaining power, then it will capture some of the increased benefit via greater compensation. Even absent any bargaining power, managerial compensation will rise as a compensating differential because better monitoring tends to affect managers adversely. In addition, increased monitoring can give management incentives to engage in value-reducing activities intended to make them appear more able. At some level of disclosure, these costs could outweigh the benefits at the margin, so increasing disclosure beyond that level would reduce firm value.
We formalize this argument as follows. In Section I, we start with a very general model of monitoring, governance, and bargaining. We show that, if owners and management have opposing preferences with respect to disclosure, then increasing disclosure leads to greater equilibrium managerial compensation (although possibly lower managerial utility). We then present a series of monitoring models, both learning-based and agency-based, in which we prove that owners and managers have opposing preferences regarding disclosure. Consequently, managerial compensation rising with increased disclosure is a characteristic of many models of governance.
An implication of this logic is that CEO compensation should increase following an exogenously imposed increase in the quantity or quality of information that needs to be disclosed about a firm and its managers. This increase would occur regardless of whether the reason for the increase is government regulation or intense public pressure created by, for instance, increased media attention to governance in light of scandals or economic conditions. A potential countervailing incentive is that greater regulation or public scrutiny could reduce CEO bargaining power, which one might expect would lower the CEO's compensation. We consider this possibility in a setting in which a CEO's threat-point in bargaining declines one-for-one with the decline in his utility due to greater disclosure. We show that, nonetheless, CEO compensation still rises (unless the CEO initially had no bargaining power). Of course, such exogenous changes are often not wholly limited to disclosure. For instance, public outrage in light of scandal or financial crisis could lead to greater disclosure as well as make it politically infeasible to raise executive compensation immediately. Consequently, in situations such as the recent financial crisis in which much attention has been given to the actions and compensation of investment banks' top managers, our predicted effect of greater mandated disclosure on the compensation of those managers is likely to operate with some lag (or possibly be offset completely depending on the nature and duration of these other effects).
Anticipating how owners may make use of what they learn, the CEO is likely to have incentives to distort the owners' information. A particular example is where the CEO engages in myopic behavior to boost his short-term numbers at the expense of more valuable longer term investments (e.g., in a model along the lines of Stein (1989)).4 We show that this is a downside to improving the disclosure regime; that is, better disclosure can perversely lead to greater agency problems.
In Section II, we extend our analysis in three ways. First, we show how our results are affected by firm characteristics, particularly size. We show that larger firms will tend, ceteris paribus, to have better disclosure regimes, but also greater executive compensation. We then extend our analysis to encompass a general equilibrium analysis of the entire market for CEOs. We show, among other results, that there is a positive correlation between a firm's disclosure regime and its CEO's ability in equilibrium. We further show that our partial equilibrium analysis carries over to a more general equilibrium model insofar as a reform that increases disclosure for some firms will result in greater compensation for all CEOs.
The third extension addresses the following. In our one-point-in-time model, there is no reason to predict that either owners or management would favor a government-imposed tightening of disclosure regimes. Who, then, is pushing governments to tighten disclosure? We show that, in a more sequential model in which there are lags in compensation increases (for, perhaps, the political reasons discussed above), the owners will in fact wish to lobby the government to tighten the disclosure regime. In the short run, this increases the owners' payoffs. Because there is no free lunch, ex ante the owners would, however, prefer to commit not to so lobby the government.
In Section III, we discuss some of the empirical implications of our analysis. One specific prediction is that an exogenously imposed increase in disclosure requirements should lead to an increase in executive compensation and turnover, which is consistent with the upward trend in CEO salaries and CEO turnover rates that have accompanied the increased attention given to corporate governance in recent years (see Kaplan and Minton (2008)).
Section IV contains a summary and conclusion. Proofs not given in the text can be found in the Appendix.
Our paper is related to recent work concerning the CEO's ability to distort information and disclosure policy. Song and Thakor (2006) deal with the incentives of a CEO to provide less precise signals about the projects he proposes to the board. Here, in contrast, we assume that it is the owners (principal) who determine the signal's precision. Hermalin and Katz (2000), Singh (2004), Goldman and Slezak (2006), and Axelson and Baliga (2009) assume there is no uncertainty about the CEO's ability, their focus being the CEO's incentives to distort information. Hermalin and Katz consider a situation in which the CEO chooses the information regime and investigate his incentives to choose a less informative regime than would be desired by the owners. In Singh's model, the issue is the board's ability to obtain accurate signals about the CEO's actions. The primary concern of Goldman and Slezak is how the use of stock-based compensation can induce the CEO to divert effort to manipulate the stock. In contrast, in our model the CEO can have incentives to manipulate information about his ability. In addition, while Goldman and Slezak treat disclosure rules as exogenous, one of our objectives is to understand how owners choose the value-maximizing rules. Axelson and Baliga, like Goldman and Slezak, are interested in how compensation schemes can induce information manipulation by the CEO. In particular, they present a model in which long-term contracts are optimal because short-term measures can be manipulated. But it turns out to be optimal to allow some manipulation of information or lack of transparency because, otherwise, the long-term contracting equilibrium would break down due to ex post renegotiation.
Although our focus is on disclosure, we note that many of our results would carry over to consideration of other governance reforms. In particular, if owners and CEOs have opposing preferences with respect to the direct effect of these reforms (i.e., Condition 1 below or its appropriate analog holds), then the insights of Sections I.B and II would continue to apply.