Insider trading, costly monitoring, and managerial incentives

In this paper we show, in an incomplete contracts framework that combines asymmetric information and moral hazard, that by permitting insiders to trade on personal account the equilibrium level of output can be increased and shareholder welfare can be improved. There are two reasons for this. First, insider trading impounds information regarding the costs and benefits of effort and perk consumption into asset prices, which allows shareholders to choose more efficient portfolio allocations. Second, allowing insider trading can induce managers to increase their stake in the firm beyond that obtained through bargaining with shareholders. This effect leads to a reduction in managerial perk consumption and/or increased managerial effort. Insider trading can also be costly for shareholders' intermediate range of monitoring costs and project difficulty because, in such cases, the efforts of managers are quite sensitive to the exact level of fractional shareownership, which managers can endogenously change if they are able to trade on personal account. Interestingly, when monitoring and effort costs are low, managers may prefer restrictions on their ability to trade as such restrictions will force shareholders to offer them a larger fraction of output.Financial markets ; Stock market

Blood and Money: Kin Altruism, Governance, and Inheritance in the Family Firm

This paper develops a theory of governance and inheritance within family firms based on kin altruism (Hamilton, 64). Family members weigh the payoffs to relatives in proportion to relatedness. The theory shows that family management entails both costs and benefits. The attenuated monitoring incentives associated with kin altruism produce a ``policing problem'' within family firms. This policing problem results in both increased managerial diversion and increased monitoring costs. Relatedness has conflicting effects on manager--owner compensation negotiations. On the one hand, owners are more willing to concede rents to family managers to increase total value. On the other hand, because family managers internalize the costs to the family from their rejection of owner demands, relatedness lowers managers' reservation compensation level. Lower compensation leads to more diversion and costly monitoring. Firm founders anticipate the costs and benefits family control when designing their bequests. For typical family trees, kin altruism ensures that founders' preferences are much more closely aligned with value maximization than those of any of their descendants'. Thus, founder bequests are designed to weaken closer relatives' bargaining power in posthumous negotiations with more competent distant relatives

If at first you don't succeed: an experimental investigation of the impact of repetition options on corporate takeovers

This paper models, and experimentally simulates, the free-rider problem in a takeover when the raider has the option to “resolicit,” that is, to make a new offer after an offer has been rejected. In theory, the option to resolicit, by lowering offer credibility, increases the dissipative losses associated with free riding. In practice, the outcomes of our experiment, while quite closely tracking theory in the effective absence of an option to resolicit, differed dramatically from theory when a significant probability of resolicitation was introduced: The option to resolicit reduced the costs of free riding fairly substantially. Both the raider offers and the shareholder tendering responses generally exceeded equilibrium predictions.Corporations - Finance ; Game theory

Who's Afraid of Selection Bias? Robust Inference in the Presence of Competitive Selection

This paper considers competitive selection dominance: what conditions on the unconditional distribution of of a random prospect will ensure that the prospect stochastically dominates a rival random prospect conditioned on competitive selection, i.e., conditioned on the prospect's realized value exceeding its rivals? Because standard distributional orders, such as stochastic dominance and the monotone likelihood ratio property (MLRP), do not provide either necessary or sufficient restrictions on the unconditional distributions to ensure selection dominance, new distribution orders are required. We provide the requisite orders, which we term supermultiplicativity on average and geometric dominance. These orderings generate conditions, satisfied by many, but not all, scale shifts of standard textbook distributions, under which the selection-conditioned distribution is stochastically dominant if and only if the unconditional distribution is stochastically dominant. When these conditions are satisfied, robust qualitative inferences concerning the unconditional population distribution can be drawn from the selection-conditioned subsample distribution and vice versa

Stochastic orders and the anatomy of competitive selection

This paper determines the conditions under which stochastic orderings of random variables, e.g., stochastic dominance and the monotone likelihood ordering, are preserved or reversed by conditioning on competitive selection. A new stochastic order over unconditional distributions is introduced—geometric dominance—which is sufficient for a random variable, conditioned on competitive selection, to be stochastically dominant and both necessary and sufficient for it to be dominant under the monotone likelihood ratio ordering. Using geometric dominance, we provide an “anatomy of selection bias” by identifying the conditions under which competitive selection conditioning preserves and reverses unconditional stochastic order relations. We show that, for all standard error distributions (e.g., Normal, Logistic, Laplace), competitive selection preserves stochastic order relations. One implication of this result is that, even in the presence of self-selection bias, the sign of treatment affects can be identified by standard uncorrected OLS and Logit/Probit models. Another is that, for almost all “textbook” distribution families, MLRP ordering is preserved by competitive selection

Naked Aggression: Personality and portfolio manager performance

We provide evidence that a personality trait, aggression, has a first-order effect on group financial decision making. In a laboratory experiment on group portfolio choice, highly aggressive subjects (measured by a standard psychology test) were much more likely to recommend risky investment strategies consistent with their own personal information, regardless of the information received by other group members. Outside of this group context, aggression had no effect on subject behavior. Thus, our aggression measure appears to capture an aggressive disposition, which seeks to dominate group decisions, rather than simply reflect risk attitudes or cognitive biases

Naked Aggression: Personality and portfolio manager performance

Why do portfolio managers actively manage their stock portfolios? The finance literature suggests the importance of financial incentives, effort, information and career concerns. We suggest that personality can also be a factor. We perform an experiment with industry experts. The experiment documents that, in a group decision setting, subjects with high aggression, measured by a standard psychology test, were much more likely to deviate from market tracking. In an individual decision setting, these same subject’s behavior was not significantly affected by aggressiveness. This result suggests that, in group settings, personality, rather than cognitive biases, might be the most important source of behavioral deviations from the rational choice paradigm

Board structures around the world: An experimental investigation

We model and experimentally examine the board structure-performance relationship. We examine single-tiered boards, two-tiered boards, insider-controlled boards, and outsider-controlled boards. We find that even insider-controlled boards frequently adopt institutionally preferred rather than self-interested policies. Two-tiered boards adopt institutionally preferred policies more frequently, but tend to destroy value by being too conservative, frequently rejecting good projects. Outsidercontrolled single-tiered boards, both when they have multiple insiders and only a single insider, adopt institutionally preferred policies most frequently. In those board designs where the efficient Nash equilibrium produces strictly higher payoffs to all agents than the coalition-proof equilibria, agents tend to select the efficient Nash equilibria.

Corporate board composition, protocols, and voting behavior: experimental evidence

We model experimentally the governance of an institution. The optimal management of this institution depends on the information possessed by insiders. However, insiders, whose interests are not aligned with the interests of the institution, may choose to use their information to further personal rather than institutional ends. Researchers (e.g., Palfrey 1990) and the business press have both argued that multiagent mechanisms, which inject trustworthy but uninformed “watchdog” agents into the governance process and impose penalties for conflicting recommendations, can implement institutionally preferred outcomes. Our laboratory experiments strongly support this conclusion. In the experimental treatments in which watchdog agents were included, the intuitionally preferred allocation was implemented in the vast majority of cases. Surprisingly, implementation occurred even in the absence of penalties for conflicting recommendations.Corporations - Finance ; Game theory

Lending without creditor rights, collateral, or reputation - the “trusted-assistant” loan in 19th century China

This paper considers lending to finance projects in a setting where repayment enforcement appears impossible. The loan was illegal and thus legally unenforceable. Creditors were incapable of applying private coercion to force repayment. Borrowers lacked both collateral and reputation capital. Project cash flows were unobservable. The projects were the acquisition of Imperial administrative posts by scholars in nineteenth century Qing China. The lending mechanism was the “trusted-assistant loan.” Our model of trusted assistant lending shows that it is a renegotiation-proof implementation of efficient state dependent financing. Empirical analysis of officials’ diaries and bank records shows that the employment of trusted-assistant lending and the performance of trusted-assistant loans conforms roughly with the model’s predictions