Reputation Turnaround Through Voluntary Ownership and Management Turnover

Pak Hung Au, Yuk fai Fong, Jin Li

Research output: Working paper

Abstract

In order to be incentivized to produce high quality products, the firm’s key decision maker must suffer following failure to maintain high quality. When the firm is run by a dominant controlling shareholder, the punishment on him imposes a negative externality on shareholders without control rights, as the firm’s reputation is damaged and its profit drops. We employ a dynamic model of experience-goods firm to show how ownership turnover can mitigate this negative externality. We identify equilibria in which consumers forgive the firm’s bad outcomes as soon as its control rights change hands. Buyers’ differential treatment of the existing and new controlling shareholders following poor outcomes gives rise to an equilibrium trade of ownership of firms with damaged reputations. Voluntary turnover of control rights enhances firm profit and shareholder value even though it does not make punishment on the existing controlling shareholder harsher and the new controlling shareholder is not better at running the company. Our analysis identifies an endogenous cost of corporate control and provides a novel explanation to the negative control premium puzzle. In a different governance structure with a fully delegated management, the possibility of collusion with managers gives rise to a negative externality of punishment on the firm owner. We solve for the optimal stationary relational contract and show that manager turnover improves the firm’s profit by making collusion difficult to sustain.
Original languageEnglish (US)
Number of pages43
StatePublished - Nov 2011

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