“Bad Reputation as Tradable Asset and Responsibility Bearing as Cost of Corporate Control” by Yuk-fai Fong
Pak Hung Au
To ensure a firm's incentives to produce high quality products, the firm's profit ought to suffer following failure to maintain high quality. This punishment imposes a negative externality because all shareholders, including those with no control rights and not responsible for the bad outcome, are punished. In a dynamic model of an experience goods firm whose control right is tradeable, we identify equilibria in which buyers forgive the firm's bad outcomes as soon as its control right changes hands. Through turnover of the control right, the firm's profit and values of non-controlling shares can be preserved without undermining the incentives of the controlling shareholder. Buyers' asymmetric treatments of the existing and new owners following bad outcomes gives rise to equilibrium turnover of ownership of firms with damaged reputations. Our analysis provides a rationale for separation of ownership and control and we derive the founder's optimal ownership structure of the firm. We also identify an endogenous cost of corporate control which helps explain the empirical observation that some companies' shares with superior voting rights are traded at a discount compared to non-controlling shares.