Attracting Attention: Cheap Managerial Talk and Costly Market Monitoring

Abstract

This paper provides a theory of informal communication (cheap talk) between firms and the capital market. The theory emphasizes the central role that agency conflicts play in firms' disclosure policies. Since managers' information is a consequence of their actions, incentive compensation and information disclosure become two intrinsically linked aspects of corporate governance. In the model, the information disclosed by managers attracts market attention and guides investors in their investigation efforts. Optimal incentive compensation, however, discourages managers from attracting market attention unless the firm is severely undervalued. The analysis relates the credibility of managerial announcements to the use of stock based compensation, the presence of informed trading, and the level of liquidity in the market. The study can also explain why apparently innocuous corporate events (e.g., a stock dividend or a name change) can affect a firm's stock price, and suggests that an adequate use of incentive compensation can foster the communication of managerial information to the market.