In the paper, CEO Ownership and External Governance, which was recently made publicly available on SSRN, my co-author, Yao Lu, and I demonstrate that studying only one part of the governance system, in isolation from other governance mechanisms in place, may lead to inaccurate conclusions. Because there are multiple governance mechanisms at work, both internally and externally, understanding of corporate governance requires analysis on how various governance mechanisms interact in affecting agency problems and firm performance, and the channels through which the interactive effects take place. In this paper, we make that attempt by examining how CEO share ownership and the strength of external governance (EG) interactively affect firm value and R&D investments.
Our results on firm valuation show how the relation between Tobin’s Q and managerial share ownership, a long-running controversy in the literature, depends on the strength of external pressure for good governance. When EG is weak, we find a hump shaped relation between Q and CEO ownership. Weak EG allows for greater managerial slack, providing more room for CEO ownership to either mitigate agency problems through the alignment effect or exacerbate insufficient risk taking problems by increasing CEO wealth sensitivity to performance. When EG is strong, the relation is insignificant. Strong EG holds CEOs accountable for their performance, leaving little slack for agency problems that can be mitigated or exacerbated by CEO ownership.
Our study also helps identify channels through which EG and CEO ownership affect Tobin’s Q. We find a significant hump shaped relation between R&D investments and CEO ownership when EG is weak, but find no relation when EG is strong. Because R&D investments tend to be discretionary and risky, these results support the hypothesis that CEO ownership has identifiable effects on agent efforts and project risk choices when EG is weak. The results also help articulate the nature of entrenchment effects causing the negative slope in the Q relation.
The full paper is available for download here .