Heterogeneity in Corporate Governance: Theory and Evidence

Abstract:     
Optimal contracts under information asymmetry require an amount of ownership that management needs to have for incentive compatibility, that is often not practical for large firms. I argue that corporate governance mechanisms help achieve second best control for the investor under such conditions. I propose that the amount of management autonomy in a firm is chosen as a best response to exogenous firm characteristics, such as output variance. Shareholders face a trade-off regarding autonomy as higher autonomy increases firm productivity but also leads to increased private benefits. Shareholders in firms with higher exogenous variance attempt to reduce the information disadvantage they face by reducing autonomy of management. Thus, in practice, I observe a range of governance control that is negatively correlated to the variance of firm output. In addition, I find that over time, this information gap has decreased in US capital markets, and since Sarbanes-Oxley the information asymmetry does not play a role in the choice of corporate governance mechanisms.

Keywords: Corporate Governance, Shareholder Response, Sarbanes-Oxley

JEL Classifications: G34, M52

Working Paper Series