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Anup Agrawal and Charles R. Knoeber*
Abstract
This paper examines the use of seven mechanisms to control agency problems between managers and shareholders. These mechanisms are: shareholdings of insiders, institutions, and large blockholders; use of outside directors; debt policy; the managerial labor market; and the market for corporate control. We present direct empirical evidence of interdependence among these mechanisms in a large sample of firms. This finding suggests that crosssectional OLS regressions of firm performance on single mechanisms may be misleading.
Indeed, we find relationships between firm performance and four of the mechanisms when each is included in a separate OLS regression. These are insider shareholdings, outside directors, debt, and corporate control activity. Importantly, the effect of insider shareholdings disappears when all of the mechanisms are included in a single OLS regression, and the effects of debt and corporate control activity also disappear when estimations are made in a simultaneous systems framework. Together, these findings are consistent with optimal use of each control mechanism except outside directors.
l. Introduction
Agency problems arise within a firm whenever managers have incentives to pursue their own interests at shareholder expense. Several mechanisms can reduce these agency problems. An obvious one is managerial shareholdings. In addition, concentrated shareholdings by institutions or by blockholders can increase managerial monitoring and so improve firm performance, as can outsider representation on corporate boards. The use of debt financing can improve performance by inducing monitoring by lenders. The labor market for managers can motivate managers to attend to their reputations among prospective employers and so improve performance. Finally, the threat of displacement imposed by the market for corporate control can create a powerful discipline on poorly performing managers.
The effect that these several mechanisms to control manager-shareholder agency problems have on firm performance has been the subject of a number of empirical studies. One strain of empirical work looks at a particular event that alters the extent to which a mechanism is employed, such as the addition of an outside director to the firm's board (Rosenstein and Wyatt (1990)). If the event triggers an unexpected increase in the firm's stock price, this suggests that the mechanism works to improve performance. Other studies in this vein look at the adoption of antitakeover...