Words Speak Louder without Actions

• DOI: http://doi.org/10.1111/jofi.12834
• Published date: 01 February 2020
• Author: DORON LEVIT
• Date: 01 February 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 1 •FEBRUARY 2020

Words Speak Louder without Actions

DORON LEVIT∗

ABSTRACT

Information and control rights are central aspects of leadership, management, and

corporate governance. This paper studies a principal-agent model that features both

communication and intervention as alternative means to exert influence. The main

result shows that a principal’s power to intervene in an agent’s decision limits the

ability of the principal to effectively communicate her private information. The per-

verse effect of intervention on communication can harm the principal, especially when

the cost of intervention is low or the underlying agency problem is severe. These novel

results are applied to managerial leadership, corporate boards, private equity, and

shareholder activism.

Actions speak louder than words, but not nearly as often.

—Mark Twain

INFORMATION AND CONTROL RIGHTS ARE central aspects of leadership, manage-

ment, and corporate governance. In practice, communication of private infor-

mation and intervention in the decision-making process are common remedies

for information asymmetries and conflicts of interest in a wide range of sit-

uations. The interplay between communication and intervention, however, is

little understood. In this paper, I show that the power of a principal to inter-

vene in an agent’s decision exacerbates the underlying agency problem and

as a result limits the ability of the principal to use her private information to

influence the agent’s decision. The power to intervene can therefore be detri-

mental to the principal. This novel result has implications for the effectiveness

of visionary management, the tension between the supervisory and advisory

roles of corporate boards, and the value that sophisticated investors offer their

portfolio companies.

To study the interaction between communication and intervention, I con-

sider a principal-agent model with incomplete contracts and a “top-down”

∗Doron Levit is from the University of Pennsylvania, Wharton School, and ECGI. For helpful

comments, I thank the Editor (Philip Bond); two anonymous referees; anonymous Associate Edi-

tor; Archishman Chakraborty; Adrian Corum; Sivan Frenkel; Simon Gervais; Vincent Glode; Itay

Goldstein; Richard Kilstrom; Sergei Kovbasyuk; Michael Lee; Yaron Leitner; Andrey Malenko;

Christian Opp; Michael Roberts; Bilge Yilmaz; and seminar participants at the American Fi-

nance Association Meeting, Finance Theory Group, Interdisciplinary Center in Herzliya, London

Business School, London School of Economics, Tel-Aviv Finance Conference, University of North

Carolina, and University of Pennsylvania. The author has no conflict of interest to disclose.

DOI: 10.1111/jofi.12834

C2019 the American Finance Association

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92 The Journal of Finance R

information structure. In the model, the optimal scale of investment depends

on the fundamentals of the firm. The principal, who is privately informed about

these fundamentals, sends the agent a message that can be interpreted as a

nonbinding demand. Communication is modeled as cheap talk as in Crawford

and Sobel (1982). The agent has a tendency to overinvest (e.g., empire-building)

and thus the challenge facing the principal is convincing the agent to choose

small projects when firm fundamentals are bad. In equilibrium, information

is never fully revealed by the principal, who has incentives to understate firm

fundamentals to prevent overinvestment. The novel feature of the model is the

possibility of intervention. Specifically, after communicating with the agent,

the principal observes the agent’s decision and decides whether to intervene

and adjust the size of the project. For example, the principal can overrule the

agent or monitor him more closely. Since these activities require resources and

attention, intervention is costly to the principal.

The main result of the paper is that intervention hinders communication. In

equilibrium, less information may be revealed by the principal if she has the

power to intervene in the agent’s decision. The power to intervene therefore

limits the ability of the principal to influence the agent. Since communication

is more effective without intervention, words speak louder without actions.

How can intervention hinder communication? The underlying mechanism

rests on the limited commitment of the principal and has two related channels.

First, in equilibrium, the principal intervenes to alleviate the overinvestment

problem. However, since intervention is costly, it is never in the principal’s

best interest to completely undo the agent’s bias. In general, more overin-

vestment warrants more intervention, but it ultimately results in a larger

final project. The agent anticipates the principal’s intervention. In response,

he deliberately chooses projects that are larger than what he would have pre-

ferred in the absence of intervention. By overshooting, the agent increases the

cost the principal must incur to downsize the project, thereby guaranteeing

the desired amount of overinvestment. Effectively, the agent behaves as if his

bias toward overinvestment is larger, and as a result, the principal has even

stronger incentives to understate the true fundamentals of the firm. In other

words, the principal’s attempt to prevent the agent from undoing her expected

intervention further diminishes her credibility when communicating with the

agent. This “vicious cycle” contributes to less informative communication in

equilibrium.

Second, intervention hinders communication to the extent that it is also an

alternative channel through which the agent can “elicit” private information

from the principal. To understand this channel, note that because of the intrin-

sic conflict of interest, the principal never fully communicates her information

in equilibrium. Therefore, the agent always faces uncertainty about the fun-

damentals of the firm. In general, the risk of making a large investment when

fundamentals are bad reduces the agent’s incentives to overinvest. Interven-

tion weakens this mitigating force by providing the agent with an alternative

source of information. Indeed, the agent can condition his decision on the in-

formation embedded in the principal’s decision to intervene, information that

Words Speak Louder without Actions 93

was not previously communicated. Knowing that the principal will intervene

only when fundamentals are very bad emboldens the agent to take more “risk”

by choosing larger projects than he would take otherwise. Put differently, to

elicit additional information from the principal, the agent must provoke in-

tervention, which he does by intentionally overshooting. Since the principal

expects the agent to be less responsive to her messages, she has stronger in-

centives to understate the true fundamentals and hence communication is less

informative in equilibrium.

The perverse effect of intervention on communication is particularly strong

when the cost of intervention is low or the underlying agency problem is se-

vere. Intuitively, the principal intervenes more aggressively when the cost is

lower. Therefore, more overshooting by the agent is needed to suppress the

impact of intervention on the final project. In addition, since more aggressive

intervention more fully reveals the principal’s private information, the risk of

overinvesting when fundamentals are bad is lower, which induces the agent

to choose even larger projects in equilibrium. The intrinsic bias of the agent

toward overinvestment has a similar effect. A larger bias implies more over-

investment, and since intervention is more beneficial to the principal when

overinvestment is detrimental, a larger bias prompts the principal to inter-

vene more aggressively. Similar to the reasoning behind the effect of the cost

of intervention, the agent has even stronger incentives to overshoot, further

impeding effective communication.

The perverse effect of intervention on communication is detrimental—it can

offset the value of intervention as a correction device and reduce the princi-

pal’s expected welfare, especially when the cost of intervention is low or the

underlying agency problem is severe. In other words, from the perspective of

the principal, the power to intervene is least desirable when intervention is

seemingly most effective or most needed. As explained above, under these cir-

cumstances, the negative effect of intervention is particularly strong, and as a

result it dominates the other benefits of intervention. The idea that communi-

cation in and of itself can reduce the value of control rights is another novel

aspect of the analysis.1Interestingly, when intervention harms the principal,

it benefits the agent. Similar to the principal, the agent suffers from the neg-

ative effect of intervention on communication. However, as intervention also

provides an informational benefit to the agent, it can substitute for the lack of

informative communication and offset its negative effect on the agent.

I consider several extensions to the baseline model. First, I demonstrate

that intervention hinders communication and decreases the principal’s welfare

even if the principal can choose the sensitivity of the agent’s payoff to perfor-

mance. Second, intervention has a weaker adverse effect on communication if

1This result does not imply that the principal is worse-off with communication. As in Crawford

and Sobel (1982), the sender (i.e., the principal) is ex ante better-off when more information is

communicated in equilibrium. This is true whether or not the sender can intervene. See Melamud

and Shibano (1991) for an alternative cheap-talk game in which the sender can be ex ante better-off

in equilibrium without communication.