David Hirshleifer and Anjan V. Thakor
This paper examines some policy issues related to the interaction between internal and external corporate control mechanisms—board dismissals and takeovers—by focusing on the information aggregation and other effects related to this interaction. We model the functioning of corporate control mechanisms as an example of a multilayered principal-agent relationship in which shareholders delegate the task of monitoring management quality to the board and rely on the external takeover market to provide additional disciplining of the manager as well as of the board. This gives rise to two effects: (1) a substitution effect, whereby the takeover market partially substitutes for board dismissal of the manager, leading to greater lenience toward the manager by a board acting in the shareholders’ best interest, and (2) a kick-in-the-pants effect, whereby the board is stricter with the manager because it may be dismissed by a successful acquirer who views it as lax. The interaction of these two effects leads to various implications about the behavior of boards and potential acquirers. In particular, a well-functioning internal control mechanism (the board) does not obviate the need for external control (takeovers). Moreover, somewhat counterintuitively, there may be a greater incidence of takeovers when the internal control mechanism is working well than when it is not.