Managerial Compensation, Voluntary Disclosure, and Large Shareholder Monitoring

Abstract

We analyze a manager's investment decision when choosing between projects with differential resolution of information in an asymmetric information setting. The manager maximizes an objective function that has weights on the market value of the firm and the true long-term value of the firm reflecting the concerns of shareholders with short-term and long-term investment horizons. We show that the manager's concern for the current market value of the firm can lead to investment distortions - both overinvestment in short-term projects consistent with the literature and an over-investment in long-term projects. We also show that a manager's concern for current market value can induce the manager to voluntarily disclose his private information. Voluntary disclosure serves to reduce the cost of large shareholder monitoring, transfers a part of the monitoring costs to other shareholders, and alleviates investment distortion. In the context of compensation contracting, our results imply that equity based incentives can play a disclosure role in inducing managers to voluntarily disclose private information in addition to their traditional role in aligning managerial and shareholder interests. Our model generates several testable empirical implications. In firms with high levels of information asymmetry incentive compensation along with monitoring-with-disclosure constitutes and optimal governance structure. In these firms, the incentive compensation and large shareholder monitoring are complementary. In firms with low levels of asymmetric information and in firms where voluntary disclosure does not significantly reduce the large shareholder's monitoring costs, incentive compensation and monitoring are substitutes. Our model thus predicts that the use of stock options in executive compensation will be associated with the presence of institutional shareholders and will induce voluntary disclosure consistent with the findings in the empirical literature.