Working Paper: NBER ID: w12050
Authors: Benjamin E. Hermalin; Michael S. Weisbach
Abstract: In light of recent corporate scandals, numerous proposals have been introduced for reforming corporate governance. This paper provides a theoretical framework through which to evaluate these reforms. Unlike various ad hoc arguments, this framework recognizes that governance structures arise endogenously in response to the constrained optimization problems faced by the relevant parties. Contract theory provides a set of necessary conditions under which governance reform can be welfare-improving: 1) There is asymmetric information at the time of contracting; or 2) Governance failures impose externalities on third parties; or 3) The state has access to remedies or punishments that are not available to third parties. We provide a series of models that illustrate the importance of these conditions and what can go wrong if they are not met.
Keywords: Corporate Governance; Reform; Welfare Economics; Contract Theory
JEL Codes: G30; G38; L51
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Governance reforms increase transparency (G38) | Higher CEO compensation (M12) |
| Higher CEO compensation (M12) | Increased incentives for information distortion (D82) |
| Increased incentives for information distortion (D82) | Decreased expected profits for firms (D21) |
| Reforms raising the cost of concealing information (H29) | Improvement in welfare (D60) |
| Penalties for concealing information (H26) | Altered CEO behavior (G34) |
| Altered CEO behavior (G34) | Improved overall governance outcomes (G38) |