Governance Through Trading and Intervention

The following post comes to us from Alex Edmans of the Finance Department at the University of Pennsylvania, and Gustavo Manso of the Finance Department at the Massachusetts Institute of Technology.

In our paper, Governance Through Trading and Intervention: A Theory of Multiple Blockholders, which is forthcoming in the Review of Financial Studies, we analyze the optimal shareholder structure that maximizes the efficiency of corporate governance. Traditional theories argue that shareholders exert governance through directly intervening in a firm’s operations, for example by firing a shirking manager or blocking a wasteful investment. (This is sometimes referred to as “voice”). Under this view, the optimal governance structure features a single concentrated blockholder, as her large stake overcomes free-rider problems and maximizes her incentives to intervene. However, in reality, most firms have multiple small blockholders. This appears to be inefficient as no blockholder has a large enough stake to induce her to bear the cost of intervention. Therefore, some commentators argue that policymakers should encourage more concentrated stakes.

Our paper reaches a different conclusion. We show that a multiple blockholder structure can in fact be efficient. While splitting a block hinders the traditional governance mechanism of intervention, it increases the power of a second governance mechanism that has previously been under-analyzed—trading (otherwise known as “exit”). Blockholders (such as mutual funds or insurance companies) have superior information on a firm’s fundamental value than household investors or investors that currently do not have a stake in the firm. This is because their large stake gives them access to management and greater incentives to gather information. By trading on this information, they increase the informativeness of prices. Prices more closely reflect the firm’s fundamental value, and thus the effort exerted by the manager to enhance firm value. If the manager shirks or extracts private benefits, such actions typically do not affect stock prices immediately, as they are unobservable to the market. However, a blockholder who monitors the firm closely can observe such behavior. When the manager destroys value, she follows the “Wall Street Rule” of “voting with her feet” and selling their shares. This drives down the stock price, reducing the manager’s equity compensation and thus punishing him for his actions.

However, the threat of selling one’s shares to punish the manager for misbehavior is only credible if it is dynamically consistent. Once the manager has taken his action, blockholders cannot change it and are only concerned with maximizing their trading profits. A single blockholder will strategically limit her order to reduce the revelation of her private information. If she tries to sell too many shares, other investors will figure out that she has negative information and will only buy from her at a very low price. Thus, she will choose to sell only a few shares to reduce her price impact, but this is bad for governance as it means the manager is not punished much for his misbehavior. By contrast, multiple blockholders trade aggressively. This is because they compete for profits with each other (as in a Cournot oligopoly). A given blockholder knows that other blockholders have also observed the misbehavior and will be selling, driving down the stock price. Thus, the motive of trading only a little to avoid driving down the stock price too much does not exist, because other blockholders will already be driving down the stock price. Thus, an individual blockholder thinks that she might as well sell a large number of shares. Since all blockholders think this way, all will sell aggressively as they race for the exit – similar to what we saw in the hedge fund crisis of 2008. Thus, the stock price falls significantly, which hurts the manager. Knowing that multiple blockholders will sell aggressively to drive down the stock price if he destroys value, the manager refrains from destroying value in the first place.

The optimal number of blockholders that maximizes firm value is therefore the result of a trade-off. On the one hand, fewer, more concentrated blocks maximize the effectiveness of governance through intervention. On the other hand, a greater number of blocks maximizes the effectiveness of governance through exit. Therefore, the optimal number of blockholders depends on which governance mechanism is more important. If blockholders can add significant value by direct intervention (such as activists and venture capitalists), concentrated ownership is efficient. By contrast, if blockholders are passive, such as mutual funds, they are more effective at governing through trading and a large number of blocks is optimal. Similarly, if the manager has a large effect on firm value, this increases the importance of disciplining the manager through trading and also increases the optimal number of blocks.

The model has a number of empirical implications, which fall under two broad themes. First, the model suggests a different way of thinking about the interaction between multiple blockholders, which can give rise to new avenues for empirical research. Prior models perceive blockholders as competing for private benefits, and so existing empirical studies of multiple blockholders typically focus on rent extraction. Our paper suggests that future research may be motivated by conceptualizing them as informed traders, competing for trading profits. This link between blockholders and the microstructure literature generates a new set of predictions relating to informed trading and financial markets. The model predicts that blockholder structure impacts price efficiency and consequently firm value, and their power in exerting governance depends on microstructure factors such as liquidity and the blockholders’ information advantage.

Second, the theory implies that the number of blockholders is important as both a dependent and independent variable in empirical studies. Existing research often focuses on explaining total institutional ownership or the size of the largest blockholder. This paper suggests that the number of blockholders is another important feature of governance structures. As a dependent variable, the model generates testable predictions for the factors that should cause blockholder structure to vary across firms, potentially explaining the heterogeneity observed empirically. As an independent variable, the number of blockholders is a driver of both market efficiency and the strength of corporate governance. Empirical papers frequently use total institutional ownership as a gauge of price efficiency, since institutions are typically more informed than retail investors. However, market efficiency requires not only that investors be informed, but that they impound their information into prices and so the number of informed shareholders is a relevant additional factor. Similarly, governance is typically proxied for using total institutional ownership, or the holding of the largest shareholder, but the number of blockholders is also important.

The full paper is available for download here.

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