Publication: RAND Journal of Economics
Publication Date: 22-MAR-07
Delivery: Immediate Online Access
Author: Ferreira, Daniel ; Rezende, Marcelo

Article Excerpt
We examine voluntary disclosures of information about corporate strategies. We develop a model in which managers choose whether to reveal their strategic plans only to some partners of the firm or also to the outside world. We show that managers face a tradeoff when deciding whether to disclose their private information to outsiders. On the one hand, by disclosing their intentions, managers become reluctant to change their minds in the future. This may lead them to make inefficient project implementation decisions. On the other hand, information disclosure about corporate strategy provides strong incentives for partners of the firm to undertake strategy-specific investments.

1. Introduction

* Voluntary disclosure of information by corporations is widespread. For example, much of the information provided by firms in their annual reports is not required by laws or specific regulations (Botosan, 1997). Other than through annual reports, a firm's management may also make its private information available to outsiders through press releases, conference calls, Internet sites, and mission statements, among others. Managers who disclose information through these sources reach audiences far beyond the boundaries of their firms.

In this article, we provide a theory to explain the voluntary disclosure of information concerning the strategic decisions within a firm. As a practical concern, investors and other constituencies do appear to care about the disclosure of information regarding corporate strategy. For example, in a recent study on transparency and disclosure around the world, Standard & Poor's examined company annual reports for many different categories of information, many of them directly related to strategic decisions. Some of the questions included by S&P's researchers were: "Is there a discussion of corporate strategy? (Does the company) report the details of the kind of business it is in? Does the company disclose its plans for investment in the coming years?" (Patel and Dallas, 2002). These questions highlight the fact that information about strategy very often reflects managerial intentions, i.e., information about what a firm's management has in mind for the future of its company. This fact, however, remains relatively unaddressed by theorists.

In our model, the most important information asymmetry is between a partner of the firm (employee, supplier, strategic partner, or any other stakeholder) and managers. This general partner may choose to undertake some strategy-specific investments. For example, workers may try to come up with new ideas that can only be implemented if the firm does not change its scope. By releasing information about their future plans for the firm, managers provide firm's partners with information that is valuable in assessing the profitability of such investments.

We identify four main characteristics of information about managerial intentions that are important for our analysis:

(i) Information about managerial intentions tends to be "soft;" that is, it is information that cannot be directly verified. For example, when managers report that they are planning to enter a given line of business, this information cannot be verified before the firm actually implements this plan. Thus, the softness of the information about managerial intentions raises the question of its credibility.

(ii) Information about managerial intentions is very often forward looking. Therefore, when credible, disclosures of information about strategy may have important effects on the incentives of partners to undertake long-run, firm-specific investments.

(iii) Managers' intentions are formed based on managers' own private information. If more-talented managers have better information, the market for executives (e.g., headhunters) may use the disclosure of managerial intentions to update its beliefs about a manager's ability.

(iv) Given the informal nature of information about managerial intentions, managers may opt to announce their plans only to some partners of the firm or to the outside world as well (public announcements). For example, Cools and van Praag (2003) provide evidence that not all firms that announce corporate targets internally also disclose that information to outsiders.

With these characteristics in mind, we then ask four main questions: What motivates managers to disclose information about strategy? What makes managerial disclosures credible? Is voluntary disclosure of information about strategy value enhancing? Finally, when should we expect to see voluntary disclosures of information about corporate strategy?

We investigate these questions in a model where a manager wants to induce a partner of the firm to undertake some strategy-specific investments. Such investments are not contractible; thus, the partner's payoff may depend on the implementation of a specific strategy by the manager. If public disclosure of information somehow commits managers not to change strategic directions, a firm's partners will be more likely to undertake investments that are related to these strategies. We show that managers' announcements are credible when they are public, i.e., when everyone can see them.

The logic behind this result is as follows. In our setup, the main decision the manager has to make is whether she should release her information only to the partners (internal announcements) or to the outside world as well (public announcements). Managers would like to maximize firm value as long as they have some stake in it. However, they may differ in their abilities to forecast the future. Good managers are the ones who have more precise information. If a manager suggests a given strategic direction for the firm and later decides to change it, she signals to the market that her initial information was not very precise. Therefore, the managerial labor market provides managers with incentives to stick to their original plans, even when changing directions is the optimal thing to do from the shareholders' standpoint. This effect makes public announcements credible because managers will be reluctant to make changes that are not consistent with their original statements.

Our model thus highlights the fact that managers face a tradeoff when deciding whether to disclose their private information to outsiders. On the one hand, the commitment to the proposed strategy that is achieved when there is disclosure provides strong incentives for partners of the firm to undertake strategy-specific investments. On the other hand, by disclosing their intentions, managers will be reluctant to change their minds in the future, and this reluctance may lead them to make inefficient project implementation decisions.

There are many reasons why managers might want to publicly disclose the firm's strategy, such as reducing uncertainties or influencing investors in general. Thus, managers should weigh the costs and benefits of strategy disclosure highlighted in this article against other costs and benefits of disclosure targeted at investors. Similarly, disclosure of financial and accounting information may also reveal information about corporate strategy as a by-product. Thus, the effects we highlight here are also important for decisions to disclose information in general, as long as information disclosure reveals something about strategy.

Most previous works have focused on financial disclosure rather than corporate strategy disclosure. Although we were unable to find any theoretical analysis of this topic, there are a few research articles that analyze the empirical relevance of disclosure of nonfinancial and qualitative information. Amir and Lev (1996) find that the disclosure of nonfinancial information, such as market growth and market penetration, increases value in the wireless communications industry. Narayanan et al. (2000) provide evidence that the voluntary disclosure of qualitative

information about managerial intentions in R&D project announcements affects firm policies and outcomes.

Moreover, most theoretical articles on disclosure have focused on communication between managers and investors (e.g., Diamond, 1985; Diamond and Verrecchia, 1991; Stocken, 2000; Boot and Thakor, 2001). Information disclosed to investors of publicly listed firms is a nonrival good, thus other stakeholders may also be interested in it. This gap in the literature is acknowledged by Healy and Palepu (2001, p. 406): "Corporate disclosure can also be directed to stakeholders other than investors. However, there has been relatively little research on these types of voluntary disclosures."

Our work is also related to a recent economic literature on managerial vision (Rotemberg and Saloner, 2000; Hart and Holmstrom, 2002; Van den Steen, 2005). These articles characterize a manager's vision as a bias toward particular activities. This literature gives a behavioral interpretation for managerial biases: they arise either from differences in preferences or from differences in opinions. Furthermore, these biases are assumed to be common knowledge. When managers' visions imply that they will commit themselves to always implement innovations in certain activities, workers will put more effort into developing ideas that are related to these activities. In short, vision is a partial commitment device by which managers can convince workers to exert effort. In this article, we adopt a different approach. We assume that managerial intentions are private information; thus, the manager is not committed to her announced plans. In this case, we show that public disclosure of information is a means of achieving commitment.

Many articles model the behavior of managers in settings in which there is asymmetric information. In these models, managers take different sorts of inefficient actions in order to manipulate information: managers may behave in a stubborn manner (Kanodia, Bushman, and Dickhaut, 1989; Boot, 1992), they may act too conservatively or too aggressively (Zwiebel, 1995; Prendergast and Stole, 1996), they may mimic the behavior of others (Scharfstein and Stein, 1990) or they may conform to the market expectations of their choices (Brandenburger and Polak, 1996). Similar to these previous works, our model has an element of conformism--managers will conform to their previously stated views. Unlike them, however, the manager in our model uses her own conformist behavior to provide incentives to firm's partners. Thus, managerial conformism in our analysis has both costs and benefits.

The structure of the article is as follows. We provide an informal discussion of the model in Section 2. We present our model in Section 3 and analyze its robustness to different assumptions concerning the compensation of managers in Section 4. In Section 5, we discuss some empirical implications and in Section 6 we make our final remarks.

2. Informal description of the model

* Before we describe the model, we first provide an informal discussion of its main elements. We model the behavior of a top manager who is responsible for the main decisions in a given firm (e.g., the CEO). The manager has some stake in the firm; therefore, she would like to choose actions that maximize firm value whenever these actions are not too costly. We abstain from issues related to the design of incentive contracts for the manager in order to focus only on the essentials. An extension of the model in which shareholders (or the board) choose an optimal managerial compensation scheme is straightforward, but it is omitted here for the sake of brevity.

The type of decisions we have in mind are broadly defined as the firm's "strategy" such as the choice of which product lines the firm will develop. In order to fix ideas, let us consider the case of a manager who has to decide whether or not to implement some innovation. Innovations (or ideas) are generated by workers (who play the part of the firm's partner in this case), who have to exert some effort in order to increase the probability that a profitable idea will materialize. A crucial assumption is that the workers' effort is not contractible. As in Rotemberg and Saloner (2000), we assume that workers are compensated only when they come up with new ideas and the manager decides to implement them.

An idea can yield a positive return only if it is consistent with the firm's directions. Thus, it is important for workers to have knowledge about the firm's future directions because this affects the probability that their ideas will be implemented. The manager may try to convey this information; she may tell the workers what her vision for the future of the firm is (see, for example, Rotemberg and Saloner, 2000; Van den Steen, 2005). For example, the CEO may tell the workers that she is committed to keeping the company in business A. In our model, however, the problem with this promise is that it is not credible. The CEO has an incentive to disclose her vision because, if workers believe in it, they will exert more effort. However, after workers have exerted effort, she has no incentive to keep her promises and may think it is a good idea to change the firm's business from A to B. In a world of rational agents, workers anticipate that managerial vision is not credible and therefore do not respond to it by exerting more effort.

Credible announcements are possible, however, if managers have career concerns. Managers know that there is a probability that another job opportunity might arise and that they may be inclined to accept it. They also know that any actions they take that are visible to individuals outside the firm may signal their abilities to the market. The market for executives will pay higher salaries to better managers. Therefore, when choosing to announce their plans and when choosing the final direction for the firm, managers care not only about their effects on expected profits but also about the effects of their actions on the market's perceptions of their talent. Even if managers do not leave the firm, if they develop a reputation of being talented, they can renegotiate higher salaries with their current firm (or board of directors) because their outside...



NOTE: All illustrations and photos have been removed from this article.



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