The Adverse Effect of Internal Control on Governance and Leverage

We study the effect that improved management information has upon a firm's leverage and corporate governance choices. Corporate headquarters can create internal control systems that identify managerial opportunities to shirk, and can make governance interventions to prevent shirking. Governance interventions are unobservable, and only happen if the firm's leverage is not too high. An internal control system lowers governance costs by facilitating more targeted interventions. But it is also a source of information asymmetry between the headquarters and outside investors. Headquarters may attempt to use its capital structure to signal its inside information. In some circumstances, this results in high levels of leverage and a corresponding attenuation of incentives to intervene that reduces the quality of governance. Investors anticipate this effect and, when it obtains, it is inefficient ex ante to establish internal control systems. We consider an extension in which managerial project search is costly and the headquarters cannot commit to compensate the manager for project discovery. We show that in this case it may be optimal not to have an internal control system, so as to leave the manager with higher ex ante rents, and, hence, a stronger incentive to search.