Abstract

We develop and test the hypothesis that private information incorporated into stock prices affects the structure of corporate boards. Stock price informativeness may be a complement to board monitoring, because the information revealed by prices can be used by directors to monitor management. But price informativeness may also be a substitute for board monitoring, because more informative prices can trigger external monitoring mechanisms, such as takeovers. We develop a simple model in which these two effects interact and show under which conditions one effect dominates the other. We examine these issues empirically using a large panel of U.S. firms. We find robust evidence for the substitution effect: Stock price informativeness, as measured by the probability of informed trading (PIN), is negatively related to board independence. Consistent with the model’s predictions, this relationship is particularly strong for firms exposed to external governance mechanisms (firms with few takeover defenses) and internal governance mechanisms (firms with a high concentration of institutional ownership), and firms for which firm-specific knowledge is relatively unimportant (firms with low R&D expenses). We address endogeneity concerns in a number of different ways and conclude that our results are unlikely to be driven by omitted variables or reverse causality. The results are also robust to using different measures of price informativeness (such as firm-specific return variation and price impact) and different proxies for board monitoring (such as director attendance and the number of board meetings). JEL classification: G32, G34