New Security Offerings as an Incentive Mechanism

Abstract

Following a suggestion of Easterbrook (1984), the incentive role of new security offerings is studied in the agency model with a costly signal. We identify conditions under which the optimal contract contingent on the signal can be achieved by a mechanism that involves the monitoring of a third party investor (rather than the principal). The idea is that the terms of new security offerings, after being adjusted for the third party investor's information rent, can convey the signal. Our conditions can be compared to those under which the monitoring by the principal alone achieves optimality. The comparison indicates that, in large firms where managers' wealth constraints limit the extent to which they can be penalized, our mechanism is likely to be a more efficient arrangement than monitoring by the principal alone. Our results provide a theoretical foundation for the argument that dividend payouts force firms to issue new securities and subject them to the monitoring of the capital market. The results may also shed light on the issue of direct shareholder involvement in monitoring managers.

JEL Classification: G35, D82