Boards of Directors and Capital Structure: Alternative Forms of Corporate Restructuring
Journal ofCorporate Finance, (1996).
Posted: 11 Nov 1996
Author's description of his paper:This paper analyzes the role of corporate boards and compares them with other governance mechanisms of the firm. The analysis is based on the assumption that managers may resist profitable restructuring decisions in order to protect their investments in firm specific human capital. Outside directors and investors can monitor managers' decisions at a cost and motivate them through adjusting their compensation schemes. If information is not too costly for outsiders, directors are the optimal institution to constrain managerial decisions, and managers become less entrenched if independent directors' compensation is more closely aligned to the value of the firm. In firms where the scope for profitable divestments is small, external control through debtholders or the market for corporate control is optimal. If information is costly to transfer, it is best to leave managerial decision making unconstrained. This paper discusses a model that combines internal and external control mechanisms in a firm in which assets can have alternative uses that are in some states more profitable than the current one. However, restructuring a firm in order to realize the gains from alternative uses affects managers adversely since they invest in firm-specific human capital. Managers can be motivated to restructure the firm through their compensation scheme. Alternatively, investors can acquire costly information on the firm and interfere with managers' decisions. The main focus is on independent directors, who review and monitor contracts and managers' compensation. If information is not too costly, directors are the optimal institution to check managerial discretion and the degree of managerial entrenchment depends on the compensation of independent directors. However, if directors fail to exercise control over management properly, takeovers or creditor control become second best solutions. If information is costly to transfer, unchecked managerial control may be optimal.
JEL Classification: G31, G32, G34
Suggested Citation: Suggested Citation