“Governance by Regulation vs. Prices: Mitigating Short-Termism under Moral Hazard and Adverse Selection”
by Aycan Adrian Çorum
Cornell University
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Abstract
I study a model of short-termism where a firm’s value is affected by the actions of its blockholder (e.g., an activist, or a manager). Each blockholder either has a project with positive NPV and can further increase the NPV by exerting effort, or has a project that destroys value. The blockholders can liquidate their stake in their respective firms before the NPV of their actions is realized by the market. This ability to exit creates opportunities for the blockholders to profit from a short-term increase in the stock price even when they are actually destroying value. I find that the existence of some value-destroying blockholders (up to a certain number) increases average firm value, because it motivates the value-creating blockholders to work much harder due to a fall in the exit price. Moreover, under endogenous entry, regulations that punish short-termism (e.g., raising short-term taxes) may result in a shorter investment duration by the value-creating blockholders, thereby reducing their incentives to exert effort. Therefore, while such regulations succeed in driving out value-destroying blockholders, they also subdue the disciplinary effect of prices as a result, and hence they may reduce firms’ total value. In contrast, rewarding long-termism (e.g., reducing long-term taxes) is more likely to increase firms’ total value, even if it simultaneously results in the entry of a higher number of value-destroying blockholders.
