Mobility Restrictions and Risk-Related Agency Conflicts: Evidence from a Quasi-Natural Experiment
Manager-shareholder agency conflicts of interest manifest themselves in several forms. They include manager shirking and the consumption of private benefits, which have been the subject of extensive study. However, a frequently overlooked variant of this problem is risk-related agency conflicts. These conflicts of interest arise from the inconsistency in the risk preferences of diversified shareholders and their under-diversified managers. One important source of risk-related shareholder-manager conflicts is managerial career concerns, which include future career opportunities with rival firms.
To explore variations in career concerns driven by outside employment options, we investigate the effects of state court recognition of the Inevitable Disclosure Doctrine (IDD) as a quasi-natural experiment. Under this legal doctrine, a firm can prevent its former employee from working for a rival if this employment would “inevitably” result in the employee divulging firm trade secrets to the rival, thereby exposing the firm to irreparable harm. Thus, court recognition of IDD in a firm’s headquarter state enhances the firm’s trade secrets protection by imposing stricter enforcement of post-employment restrictions geographically on managers who have proprietary knowledge of firm trade secrets. Another attraction of using IDD as a shock is that its state court IDD recognition is staggered over our sample period, which allows us to rule out alternative hypotheses tied to calendar time such as macroeconomic events.
Unfortunately, an unintended effect of IDD recognition by individual state courts is that it reduces managers’ future employment opportunities at rival firms and thus, heightens their career concerns. Importantly, such career concerns are much less relevant for founder-managers, who are unlikely to find joining a rival firm an attractive career option. To identify CEOs who rely more heavily on outside employment, we use a unique dataset that captures the ex-ante differences in CEO entrepreneurial spirit based on whether CEOs are firm founders or professional managers.
We find that firms managed by professional/hired CEOs, for whom career concerns are aggravated by IDD, exhibit a significant decline firm risk-taking measured by both Stock Volatility and Cashflow Volatility, while no such effects are observed for founder-CEO led firms where interests in careers at rival firms are low. To provide more direct evidence on the effect of intensified agency conflicts due to IDD induced managerial career concerns, we extensively test our baseline hypotheses across major corporate policy choices, e.g., capital structure and acquisition decisions on which CEOs are known to have significant influence.
Investigating a stream of evidence on the under-utilization of debt-capacity by professional managers after state court recognition of IDD, we find that risk-related agency problems can significantly distort a firm’s leverage and capital structure decisions. We also find that after IDD adoption, professional CEO led firms make fewer investments in high-risk strategic projects such as research and development expenses (R&D) and firm-specific intangible investments such as advertising expenditures, relative to that in founder-CEO led firms.
Disentangling career concerns from CEOs’ general degree of risk-aversion is quite challenging. To gain further insights into the underlying sources of risk-related agency conflicts, we utilize corporate acquisitions as a laboratory for study. We document a notable change in the ‘acquisition style’ of professional-CEO firms following IDD adoption that adds further support for the importance of risk-related agency problems. If general managerial risk-aversion explains our results, then we should expect to observe more diversified acquisitions. However, we find that following state court recognition of IDD, professional-CEO led firms shift to acquiring targets within their own industry, since acquisitions in other industries would further restrict CEO career opportunities. Moreover, we document in the post-IDD period disproportionately more negative stock market reactions to these acquisitions, and especially to within industry acquisitions by professional-CEO led firms. This provides direct evidence of shareholder value destruction, which represents a clear example of risk-related agency conflicts.
In sum, we show that CEOs experiencing exacerbated career concerns after state court IDD recognition, will trade off the benefits of trade secrets protection against risk-related agency conflicts that distort corporate financing and investment decisions. Thus, our study highlights that unless these agency conflicts are recognized, seemingly beneficial regulatory changes may, in fact, be detrimental to shareholder interests, due to the underlying tension between diversified shareholders and under-diversified CEOs.