Market-Based Corrective Actions

Abstract

Many economic agents take corrective actions based on information inferred from the market prices of firms' securities. Examples include directors and shareholder activists intervening in the management of firms and bank supervisors taking actions to improve the health of financial institutions. We provide an equilibrium analysis of such situations in light of a key problem: if the agent uses market prices when deciding on a corrective action, prices adjust to reflect this use and potentially become less revealing. We show that there is a strong complementarity between market information and the agent's information, so that a market-based corrective action leads to the agent's preferred outcome only when the information gap is not too large. We demonstrate that the type of security being traded matters, and discuss other measures that can increase the efficiency of learning from the market.

The role of information and financial reporting in corporate governance and debt contracting

“…For example, Hermalin and Weisbach (1998) show that the historical nature of accounting earnings makes it useful in the turnover decision because stock price reflects both the market's expectations of the CEO's continued employment and the anticipated effect of his or her replacement, with only the former being useful in motivating the CEO. More recently, Bond, Goldstein, and Prescott (2009) extend this result to a more general setting and note that learning from price is often difficult because two or more fundamentals may be associated with the same equilibrium price (or, technically, that price is not necessarily monotonic with respect to fundamentals). For example, in the case of the board's decision whether to replace the CEO, a moderate price could either indicate that (1) the market expects the board to replace the CEO and impounds the replacement CEO's actions, or (2) that the CEO is not performing poorly enough to justify replacement.…”

“…For example, in the case of the board's decision whether to replace the CEO, a moderate price could either indicate that (1) the market expects the board to replace the CEO and impounds the replacement CEO's actions, or (2) that the CEO is not performing poorly enough to justify replacement. Bond et al (2009) show that whenever a decision maker such as the board takes a "corrective action" (e.g., replacing the CEO) on the basis of information inferred from the market price of the firm's securities, there is a complementarity between market information and the decision maker's other information. 28 If the decision maker's other information is not sufficiently precise, then market price is not fully revealing, and the corrective action is thus impaired.…”

The Role of Information and Financial Reporting in Corporate Governance and Debt Contracting

“…For example, in the case of the board's decision whether to replace the CEO, a moderate price could either indicate that (1) the market expects the board to replace the CEO and impounds the replacement CEO's actions, or (2) that the CEO is not performing poorly enough to justify replacement. Bond et al (2009) show that whenever a decision maker such as the board takes a "corrective action" (e.g., replacing the CEO) on the basis of information inferred from the market price of the firm's securities, there is a complementarity between market information and the decision maker's other information.…”

Enhancing Prudential Standards in Financial Regulations

“…Bulow and Klemperer (2013) and Bond, Goldstein, and Prescott (2010) for more on the role of market-based measure (rather than accounting-based) for capital requirements.…”