SSRN-Agency Costs of Overvalued Equity by Michael Jensen
I know we talked about this one in class, but it is just so so good. Jensen talks about what led to the governance crisis we saw at Tyco, Enron, etc. A big part of teh answer may be overpriced equity. Why? A stock price that is overvalued is caused when investors have overly optimistic expectations. Thus, if the investors were to learn the truth, the stock price would fall. This creates an incentive to hide information from investors. Moreover, to keep the stock price high, management may be willing to take more chances and further hide the bad results.
Typical control mechanisms fail to work on this problem. For instance, stock based pay makes the problem worse and the takeover market fails miserably since no one would want to take over an overpriced stock. Jensen suggests one solution: the board providing more information (including to short sellers).