(1) Divide and Inform: Rationing Information to Facilitate Persuasion

Solo-authored; Published at the Accounting Review, Vol. 92, Issue 5 (September 2017)
featured in “Do fair disclosure rules lead to more or less information?” by Michael Totty, UCLA Anderson Review, May 16, 2018

This paper develops a persuasion model examining a manager’s incentives to gather information when the manager can disseminate this information selectively to interested parties (“users”) and when the objectives of the manager and the users are not perfectly aligned. The model predicts that, if the manager can choose the subset of users to receive the information, then the manager may gather more precise information. The article identifies conditions under which a regime that allows managers to grant access to information selectively maximizes aggregate information. Strikingly, this happens when the objectives of managers and users are sufficiently misaligned. This finding is robust to variations of the model such as information acquisition cost, unobservable precision, sequential noisy actions taken by the users, and delayed choice of the subset of users in “the know.” The results call into doubt the common belief that unrestricted access to information to all potential users is beneficial.

(2) Investments and Risk Transfers

With Tim Baldenius;  Published at the Accounting Review, Vol. 92, Issue 6 (November 2017)

This paper demonstrates a novel link between relationship-specific investments and risk in a setting where division managers operate under moral hazard and collaborate on joint projects. Specific investments increase efficiency at the margin. This expands the scale of operations and thereby adds to the compensation risk borne by the managers. Accounting for this investment-risk link overturns key findings from prior incomplete contracting studies. We find that, if the investing manager has full bargaining power vis-a-vis the other manager, he will underinvest relative to the benchmark of contractible investments; with equal bargaining power, however, he may overinvest. The reason is that the investing manager internalizes only his own share of the investment induced risk premium (we label this a "risk transfer"), whereas the principal internalizes both managers' incremental risk premia. We show that high pay-performance sensitivity (PPS) reduces the managers' incentives to invest in relationship-specific assets. The optimal PPS thus trades off investment and effort incentives.

(3) Integrated Ownership and Managerial Incentives with Endogenous Project Risk

With Tim Baldenius; Published at the Review of Accounting Studies, Vol. 24, Issue 4 (December 2019) ​

Integrated ownership is often seen as a way to foster specific investments. However, even in integrated firms, managers invest to maximize their compensation which is chiefly driven by divisional income. Thus it is not clear that integration has any effect on investments in a world of decentralized decision-making. Building on recent findings that efficiency-enhancing investments raise not only the expected value of a project but also its variance, this paper shows that under plausible conditions integration calls for low-powered incentive contracts: the managers invest more as they are less exposed to the investment-related (endogenous) risk, and the principal of an integrated firm has more to gain from greater investment. On the other hand, integration may result in higher-powered incentives if the project is inherently very risky or if the project-specific input is personally costly to the managers (rather than a monetary investment). The qualitative takeaway remains, however, that the contract adjustments under integration mitigate any input distortions present under non-integration. We also allow for firmwide performance evaluation under integration and show that it may lead to larger input distortions, but those are outweighed by improved risk sharing.

(4) Optimal Reporting When Additional Information Might Arrive

With Henry Friedman and John Hughes; Published at the Journal of Accounting and Economics, Vol. 69, Issues2–3 (April–May 2020) ​

This paper studies how the potential for discretionary disclosure affects the way a firm designs its reporting system. In the model, the firm's primary but nonexclusive concern is to induce beliefs that exceed a threshold. Such thresholds arise in numerous contexts, including investing decisions, liquidation/continuation choices, covenants, audits, impairments, listing requirements, index inclusion, credit ratings, analyst recommendations, and stress tests. The optimal reporting system is characterized by informative good reports when the threshold is high and, potentially, uninformative reports when the threshold is low. Under an optimal impairment-type reporting system, the likelihood of reported impairments and the information content of non-impairment reports both increase in the probability of the firm observing private information. The paper provides a novel motivation for the quiet period around an IPO and empirical predictions relating the probability of discretionary disclosure to the properties of financial reports.

Older versions of the paper: "Bayesian Persuasion in the Presence of Discretionary Disclosure" and "The Impact of Discretionary Disclosure on Financial Reporting Systems: An Extension of Bayesian Persuasion"

(5) Responsibility Centers, Decision Rights, and Synergies

With Tim Baldenius; Published at the Accounting Review, Vol. 95, Issue 2 (March 2020) ​

This paper considers the optimal allocation of decision rights in an incomplete contracting setting where business unit managers choose inputs that enhance the efficiency of "joint projects" (projects that benefit their own and other divisions). With scalable project inputs, decision rights should be bundled in the hands of one division manager. Which of the managers to designate the investment center manager-the one facing the more volatile or the more stable environment-depends on whether the project input is a monetary investment or personally-costly effort. With discrete project specific inputs, on the other hand, it is always optimal to split decision rights symmetrically between the managers provided they face comparable levels of operating volatility. This runs counter to the conventional wisdom that bundling stimulates the provision of complementary inputs. The model also generates empirical predictions for the association of organizational structure and managers' relative incentive strength: bundling of decision rights results in PPS divergence across divisions; splitting them results in PPS convergence.

(6) A Rationale for Imperfect Reporting Standards

With Henry Friedman and John Hughes;  Published at Management Science, Vol. 68, Issue 3 (March 2022)

The aim of general purpose financial reporting is to provide information that is useful to investors, lenders, and other creditors. With this goal, regulators have tended to mandate increased disclosure. This paper shows that increased mandatory disclosure can weaken a firm's incentive to acquire and voluntarily disclose private information that is not amenable to inclusion in mandated reports. Specifically, the paper provides conditions under which a regulator, seeking to maximize the total amount of information provided to investors via both mandatory and voluntary disclosures, would mandate less informative and more conservative financial reports even in the absence of any direct costs of increasing informativeness. This result is robust to allowing the firm to make reports more informative and to imposing a nondisclosure cost or penalty on the firm. The results and comparative statics analysis contribute to the understanding of interactions between mandatory reporting and voluntary disclosure, and demonstrate a novel benefit to setting accounting standards that mandate imperfectly informative reports.

(7) Private Predecision Information and the Pay-Performance Relation

With Robert Goex; Published at the Accounting Review, Vol. 98, Issue 2 (March 2023)

This paper studies how the precision of managers' private post-contract predecision information affects the pay-performance relation. Taking into account that the information environment in decentralized firms is often endogenously determined (e.g., by investment in internal accounting systems, hiring of consultants, or learning), the paper finds that firms jointly choosing information precision and incentives may optimally tie executive pay closer to firm performance as agency problems become more pronounced. Specifically, the trade-off between information precision and incentives can render it optimal to provide agents with stronger incentives if agents are less productive, performance measures are less congruent or more susceptible to manipulation, or if agents are more risk averse. Considering that empirical studies frequently take the pay-performance sensitivity (PPS) as a measure of the efficiency of real world compensation arrangements, the results provide relevant insights for empirical research studying the determinants of the relation between executive pay and firm performance.

Older version of this paper: Optimal Information Design and Incentive Contracts with Performance Measure Manipulation

(8) In Search of a Unicorn: Dynamic Agency with Endogenous Investment Opportunities

With Felix Zhiyu Feng and Robin Yifan Luo;  Forthcoming at the Journal of Accounting and Economics (expected Vol. 78, Issue 2/3, November/December 2024)

presented at the 2023 Journal of Accounting and Economics conference; featured in “How to Properly Incentivize Your Unicorn-Finder” by Dee Gil, UCLA Anderson Review, March, 2023

This paper studies the optimal dynamic contract that provides incentives for an agent (e.g., SPAC sponsor, VC general partner, CTO) to exploit investment opportunities/targets that arrive randomly over time via a costly search process. The agent is privy to the arrival as well as to the quality of the target and can take advantage of this for rent extraction during the search process and the ensuing production. The optimal contract provides the agent with incentives for timely and truthful reporting via a time-varying threshold for investment and an internal charge for the time spent on search. In the equilibrium, as time elapses, the charge becomes progressively higher while the investment threshold is progressively lower, resulting in overinvestment at a time-varying degree. The model generates empirically testable predictions regarding investments (such as M\&As, hedge fund activism, VC investing, SPACs, and internal innovations), linking the degree of overinvestment to observable firm and industry characteristics.

(9) Board Bias, Information, and Investment Efficiency

With Martin Gregor; Conditionally accepted at the Review of Accounting Studies

featured in “Why Activist Hedge Funds Deserve Representation on Corporate Boards” on the Columbia Law School Blue Sky Blog, August 22, 2022; featured in “A Skeptical Board Can Protect Shareholders From an Empire-Building CEO" by Michael Totty, UCLA Anderson Review, January 12, 2022

This paper studies how interest alignment between CEOs and corporate boards influences investment efficiency and identify a novel force behind the benefit of misaligned preferences. The model entails a CEO who encounters a project, gathers investment-relevant information, and decides whether or not to present the project implementation for approval by a sequentially rational board of directors. The CEO may be able to choose the properties of the collected information strategically—this happens, for instance, if the project is “novel” in the sense that it explores new technology, business concept, or market and directors are less knowledgeable about it. The paper finds that only sufficiently conservative and expansion-cautious directors can discipline the CEO's empire-building tendency and opportunistic information collection. Such directors, however, underinvest in projects that are not novel. From the shareholders' perspective, the board that maximizes firm value is either conservative or neutral (has interests aligned with those of the shareholders) and always overinvests in innovations. Boards with greater expertise are more likely to be conservative, but their bias is less severe. The analysis shows that board's commitment power and bias are substitutes.

Older version of this paper: How CEO-Friendly Should Boards With Limitted Attention Be?

(10) With a Grain of Salt: Uncertain Veracity of External News and Firm Disclosures

With Jonathan Libgober and Elyashiv Wiedman;  Working paper

featured in “What Investors Infer From External News And Management Silence” by Dee Gil, UCLA Anderson Review, June 2023; featured in “How Markets Keep Getting Social Posts and Silence Wrong” on How The World Works with Warren Olney podcast

The paper examines how uncertain veracity of external news influences investor beliefs, market prices and corporate disclosures. Despite assuming independence between the news’ veracity and the firm’s endowment with private information, the analysis finds that favorable news is taken “with a grain of salt” in equilibrium—more precisely, perceived as less likely veracious—which reinforces investor beliefs that nondisclosing managers are hiding disadvantageous information. Hence more favorable external news could paradoxically lead to lower market valuation. That is, amid management silence, stock prices may be non-monotonic in the positivity of external news. In line with mounting empirical evidence, the analysis implies asymmetric price reactions to news and price declines following firm disclosures. The model further predicts that external news that is more veracious may increase or decrease the probability of disclosure and link these effects to empirically observable characteristics.

(11) Board Compensation and Investment Efficiency

With Martin Gregor; Working paper

featured in “How Directors’ Liability Protection Can Affect the Quality of Company Projects” on the Columbia Law School Blue Sky Blog, March 22, 2024

As initiators of new business projects, CEOs have an advantage over access to and control over project-related information. This exacerbates pre-existing agency frictions and may lead to investment inefficiencies. To counteract this challenge, incentive compensation for corporate boards (responsible for approving major projects) emerges as a critical governance tool. This study demonstrates that the optimal compensation design requires strategically allocating a liability burden between CEOs and boards. When this burden is shifted onto the boards, shareholders pay lower management rents, albeit at the expense of residual inefficiency. Our findings thus highlight that shareholders' tolerance for investment inefficiencies may be rooted in optimal compensation. The analysis predicts that contracts tolerating excessive investments are optimal under conditions of low labor market value for CEOs, severe CEO empire-building, and attractive outside options for directors. Because of structural changes associated with the reallocation of incentives, the non-financial characteristics of CEOs and boards may impact investment efficiency, information quality, project profits, and management rents in a non-monotonic manner.

Older version of this paper: Boards and Executive Compensation: Another Look

(12) Synergies, Collusion and Incentive Compression

With Tim Baldenius; Working paper

Divisional managers often face incentive contracts with differential pay-performance sensitivity (PPS), e.g., because one operates in a riskier environment than the other.  Such PPS differentials incentivize the managers to collude against the principal when trading intermediate goods: they agree on a transfer price that shifts profits to the high-PPS division and transfer quantities that exceed the efficient level. One way to alleviate the collusion threat is to move the managers’ PPS closer together (PPS convergence), at the expense of eliciting suboptimal efforts. However, we also identify circumstances in which the threat of collusion calls for increasing the wedge in PPS across divisions (PPS divergence), to take advantage of how the managers share risk. While such “risk sharing through collusion” may suggest little benefit to firm-wide performance evaluation, we show that relative or joint performance evaluation can be optimal as it may mitigate the trade distortions.