There is a striking paradox that confronts the reader of that part of the modern literature on Marxian crisis theory written in English. On the one hand, it is evident that monetary and financial problems have been and continue to be at the very center of the recurring economic crises that have afflicted most capitalist economies in the past fifteen to twenty years. These economies have experienced roller-coaster inflation, secular stagnation, domestic credit crunches and recurring waves of bankruptcy.
Simultaneously, the international financial system that guided the general prosperity of the 1950s and 1960s has broken down, giving way to a decade of unpredictable, disruptive gyrating exchange rates. International debt crises of suffocating magnitude ensnare most of the Third World and a good deal of the Second as well. The business press asks with regularity if an international financial collapse of depression-producing magnitude is very likely, or only moderately likely: the answer changes from time to time.
Corporate governance reform has become a global issue over the last decade. The Asian crisis in 1997 and corporate scandals such as Barings, WorldCom and Enron have highlighted the need for corporate governance reform at a global level (Demirag and Solomon, 2003). The passage of the Sarbanes Oxley Act of 2002 (SOX) was to respond to the accounting scandals mentioned above and several other large corporations. This regulation imposes a number of corporate governance guidelines on all publicly traded companies in the U.S. Specifically, it requires that the board be composed of the majority of independent directors and in addition, the audit committee consists entirely of independent directors in which at least one financial expert is included in the audit committee.
Additionally, the new regulations also impose restrictions on the types of services that outside auditors can provide to their audit clients to assure the independence of the auditors opinion, thereby enhancing the audit quality. By requiring more oversight and imposing more restrictions on the composition of board structure, the SOX Act aims to prevent deceptive accounting and management misbehavior. Despite the claimed benefits of this Act, the passage of SOX gives rise to a broader concern that SOX could signal a shift to a more rigid federal and state regulation of corporations, thereby causing that the direct and indirect costs of SOX can outweigh its benefits. For instance, a 2004 Price water house Cooper’s survey of CEOs finds that 59% of the respondents view the risk of over regulation as one of the biggest threats to the growth of firms (Norris, 2004). As a result, whether the enactment of the SOX Act can improve firm performance becomes an empirical question.
Different firms rely on different types of financial instruments to conduct their business, which differ in terms of how they are repaid to the investors, how secure the repayment is, who retains the control rights in the event of failure to repay, etc. The Modigliani Miller theorem (1958) notwithstanding, some firms choose to finance their investment project by issuing debts to the financial market, whereas others have to give investors equity stakes and some control rights. This paper attempts to address this observation by studying a situation where nonverifiability of cash flow and contractual incompleteness result in different optimal financial arrangements depending on the characteristics of an investment project to be undertaken.
Suppose that an investment project lasts for two periods, yielding a strictly positive expected net cash flow in each period, but that the cash flows accrue to entrepreneur and are not verifiable. Since a potential investor for the project is at the risk of expropriation by the entrepreneur, the investor will be reluctant to provide financing unless an appropriate financial arrangement is made. There can be two mechanisms to deal with this expropriation risk: one is the threat of liquidation after first-period default, and the other is the governance control which converts a part of cash flow into verifiable income and thus reduces the need for liquidation threat. These mechanisms, however, are not costless. A better governance mechanism costs more to design and maintain, and an actual liquidation results in the loss of positive surplus of the second period. Therefore, the optimal financial arrangement will maximize the (expected) net surplus while ensuring that the investor be repaid.
