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Discussion paper

The complementary roles of board incentives and market monitoring: theory and evidence

Governance Investments Business ethics Business enterprises Shareholders Corporate social responsibility

In this paper I rectify and extend the market governance model of Holmstrom and Tirole (1993) to develop and test a number of hypotheses concerning board structure and incentives. The forced departure of "non-independent" directors from the boards of companies due to regulatory-induced pressure enables the testing of this new theory of corporate governance based on external market monitoring by informed traders. These traders utilize information about the actions of the CEO and blockholders on the board to reinforce market-based incentives. I find that as directors deemed "non-independent" due to significant shareholdings depart the board, various market and accounting measures of performance, investment decision-making with respect to acquisitions, and negotiation and monitoring of CEO and non-executive director pay substantially worsen in the presence of this external market monitoring.

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