Equity Prices and the Dynamics of Optimal Corporate Governance
Abstract: Measures of firm performance and corporate governance are well known to be positively correlated, and performance-sensitivity of compensation increases in firm performance. We describe how governance affects stock prices, and in turn, how stock prices affect governance, and how compensation is affected by both of these. We present a model of firm financing structure that permits a unified analysis of corporate governance, pay sensitivity of the agent's compensation, and how these relate to stock prices and other securities issued by the firm. Our main results show why corporate governance and stock prices are positively correlated, and how governance and pay sensitivity are substitutes, which rationalises these empirical observations. Our setting allows us to analyse the impact of policy interventions like the Sarbanes-Oxley Act. We also propose a measure of governance in terms of observables of the securities the firm issues.
