The Performance-Activism Relation: Financial Reporting, Governance Transparency, and Activists' Strategic Target Selection

Abstract

Early empirical studies find a negative association between firm performance and shareholder activism, whereas more recent studies document a positive association. We argue and theoretically show that this change in behavior results from mandating executive compensation disclosure. We develop a two-period model in which a potentially dependent board contracts with a CEO and a shareholder decides on the costly replacement of the board. Our key feature is information asymmetry between insiders and the shareholder about whether the firm faces a board dependence issue, i.e., information asymmetry about governance quality. We show that when only earnings are disclosed, shareholders intervene in firms with intermediate performance and dependent boards distort CEO contracts to manage earnings in order to avert replacement. However, if CEO pay levels are jointly disclosed with earnings, shareholders target intermediately and well-performing firms with a high pay-performance ratio and dependent boards' incentives to manage earnings are mitigated. Further results are consistent with the argument that executive compensation disclosure not only facilitates shareholder monitoring ex post but also alleviates the detrimental ex ante incentive effects of shareholder monitoring. The paper provides a number of novel empirical predictions.