Internal and External Corporate Governance

7 December 2009 at 11:34 am Leave a comment

| Peter Klein |

Most of the corporate governance literature focuses on external mechanisms for limiting managerial discretion: competition in product and factor markets; discipline from banks, institutional investors, and other large capital suppliers; and, of course, the market for corporate control. Firms have access to internal control mechanisms as well — performance-based pay, internal audits, a strong Board, competition among the top-management team, adoption of the M-form structure, and so on — but these are usually considered weaker, less effective instruments.

Viral Acharya, Stewart Myers, and Raghu Rajan have a new theory paper, “The Internal Governance of Firms,” on internal control mechanisms, focusing on dividend policy as a means of satisfying both internal and external constituents. NBER version here, ungated version here, older SSRN version here. Abstract:

We develop a model of internal governance where the self-serving actions of top management are limited by the potential reaction of subordinates. Internal governance can mitigate agency problems and ensure that firms have substantial value, even with little or no external governance by investors. Internal governance works best when both top management and subordinates are important in generating cash flow. External governance, even if crude and uninformed, can complement internal governance and improve efficiency. This leads to a theory of investment and dividend policy, where dividends are paid by self-interested CEOs to maintain a balance between internal and external control. Our paper can explain why firms with limited external oversight, and firms in countries with poor external governance, can have substantial value.

Entry filed under: - Klein -, Corporate Governance, Strategic Management, Theory of the Firm.

The WSJ on Vertical Integration Becker and Posner on Williamson and Organizational Economics

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