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Summary of the winning paper of the III
“Jaime Fernández de Araoz on Corporate Finance”Award

THE INTERNAL GOVERNANCE OF FIRMS” by Viral Acharya, Stewart Myers and Raghuram Rajan

While corporate governance is by and large interpreted as the effectiveness of mechanisms such as Boards, takeover activity and shareholder activism, the recent financial crisis has illustrated that the internal governance of firms can be equally important. In particular, checks and balances employed and imposed by a firm’s own employees on its decision-makers can play an important governance role.

We develop a model of such internal governance of a firm where the self-serving actions top management are limited by the potential reaction of subordinates. Put simply, if top management is myopic or short-termist and does not invest in firm’s long-run future, then subordinates and junior management – who are better aligned with the firm’s long run – can hold their effort back. Such reaction can hurt the top management as it also affects the firm’s short-run prospects. Thus internal governance can lengthen the horizon of top management’s decision-making, working best when both top management and subordinates are important to value creation. We also allow for governance provided by external financiers and show that external governance can complement internal governance in enhancing firm value. Interestingly, this provides a theory of investment and dividend policy over the firm’s life-cycle, where dividends are paid by the top management when growth prospects diminish so as to maintain a balance between internal and external control. Finally, the internal organization of firms – for example, the succession plan – may be structured to enhance the role of internal governance. Our theory explains why firms with limited external oversight, and firms in countries with poor external governance, can have substantial value; conversely, it explains why even firms with external oversight can go astray when their internal governance mechanisms break down.

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