EXIT AND VOICE IN CORPORATE
GOVERNANCE
4th set of transparencies for ToCF
I. INTRODUCTION
Basic idea:
Agency problem (adverse selection, moral hazard,...)
want to reduce asymmetry of information
by "hiring monitors".
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ACTIVE VS PASSIVE MONITORS
Two types of information to be collected
Prospective /
value enhancing
INTERVENTION
(ex ante)
 boards of directors
 venture capitalist
 bank led corporate governance
 takeovers
 shareholders activism
Retrospective /
value neutral /
speculative
MEASUREMENT
(ex post)
speculation (voting with one’s feet)
ST debt runs
 rating agencies
 IPOs
Retrospective info useful
only if
 enters compensation
(stock option,...)
determines refinancing
 affects pr (keeping job)
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2 INCUMBENTS VS ENTRANTS/ ENTRY INTO CORPORATE
GOVERNANCE
"Hired monitors" have their limits:
 liquidity needs
 lack of diversification (Huddart 1993, Admati et al 1994)
 "wrong choice"
 collusion.
Example of "free entry": takeovers
speculation
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voice
"exit".
CLAIMS HELD BY MONITORS
Claim = incentive scheme for monitor
Monitor
"insiders"
"uninformed investors"
claims
Firm
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Debt or equity?
Depends on what’s being monitored
no general answer.
E.g.: moral hazard:
 FOSD (“e” determines mean): equity?
 SOSD (“e” determine risk): convertible?
ST or demandable debt?
 collateral (“e” = maintenance) : secured debt.
Example of debate:
Fama 1985: junior claimants have greater incentives to monitor
First-come-first-served rule as an incentive for depositors
(Calomiris)
Collateral-taking by banks.
More likely: want different claimholders to monitor different pieces
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of information (“advocates”).
II.
INVESTORS OF PASSAGE
PERFORMANCE MEASUREMENT AND THE VALUE OF SPECULATIVE
INFORMATION
Fixed-investment model
Simplifying assumption: intermediate signal is a sufficient statistic
Effort
signal
outcome
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Notation :
pr (signal j | effort i)
pr (success | signal j)
Assumption: high signal good news about high effort:
A) FREELY AVAILABLE, CONTRACTABLE SIGNAL
• Holmström 1979 sufficient statistic theorem
reward
entrepreneur solely on basis of signal (entrepreneur not accountable
for variables (s)he does not control)
• (ICb)
when low signal
when high signal
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PLEDGEABLE INCOME
Incentives require leaving at least
to the entrepreneur
PLEDGEABLE INCOME HAS INCREASED
B) COSTLY, NONCONTRACTABLE SIGNAL
Private cost c of obtaining speculative information
DESIGNATED MONITOR:
Option: can buy s shares at ex ante par value
Call option has no value if monitor does not acquire
information.
monitors: doesn’t exercise option if low signal
exercises option if high signal.
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Collusion.
Possibility of excessive speculation
Suppose that at cost c (or
), hired monitor can learn final noise.
Then gets bigger expected reward:
Problem: pledgeable income goes back to
Notion of “good” and “bad” information acquisition.
ANONYMOUS MONITORING
Stock market: everyone has call (or put) option, integrity of
valuation process.
New issue:sale price can no longer be guaranteed to be
Grossman-Hart (1980): free rider problem:
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Someone wants to buy
price becomes
zero gross profit
speculator loses c.
Holmström-Tirole (1993): need liquidity for the equity market.
Liquidity traders:
(size s)
(simplified Kyle 1985
model)
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Outcome
moral hazard
 contract with
entrepreneur
 claims issued
 s claims held
by "liquidity
traders"
speculator
observes
signal
NET ORDER
FLOW OBSERVED
 SPECULATOR
 LIQUIDITY TRADERS
 MARKET MAKERS
Speculator can make money only if  high signal
 liquidity traders sell.
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Expected gain
Monitoring if
Remarks:
1 Expected returns on shares for liquidity traders smaller than
In fact, equal to
Empirical implications.
2 Heterogeneity among equityholders important (no liquidity trading
no speculation
stock price uninformative). Why don’t
"ST" traders sell their shares to "LT" traders?
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Beginning of an answer: general equilibrium with LT investors in short
supply
LT investors
ST investors
equity
bonds
Equity premium (here sold under par to attract ST investors).
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III. INVESTOR ACTIVISM
1 BENEFIT OF ACTIVISM: reduces MH (or AS ) and thereby
increases pledgeable income.
Modeling
Two types of bad projects:
Monitor
Entrepreneur
Monitor, by expanding c, eliminates Bad project:
thus: B
b
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Assume that monitoring capital is not scarce
Entrepreneur receives NPV if funded:
Ub=pHR – I - c lower than in the absence of intermediation:
avoids intermediated finance if (s)he can.
Pledgeable income  investors' total cost:
Intermediation facilitates financing if
No funding
Intermediated
finance
(monitoring)
Direct finance
(no monitoring)
A
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2 COSTS OF MONITORING (besides c)
i. Collusion (Dessi 2005).
ii. Scarcity of monitors (e.g., credit crunch).
iii. Lack of diversification.
iv. Lack of liquidity.
v. May facilitate soft budget constraint.
vi. Overmonitoring
– see next (Pagano-Roell 1998),
– bad for initiative (Burkart-Gromb-Panunzi 1997).
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Example of overmonitoring
c(x)
0
1
x= pr (monitor finds
Bad project)
Monitor chooses x
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Optimum:
(1):
Implementation:
(2)
Since
then
monitor should not hold all external shares.
Intuition:
2 externalities
negative on
entrepreneur
positive on other
investors (0 if
holds all external
shares)
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