The Effect of Liquidity on Governance

This post comes from Alex Edmans of the Department of Finance at the University of Pennsylvania and NBER, Vivian Fang of the Department of Accounting at Rutgers University, and Emanuel Zur of the Department of Accounting at Baruch College.

In our paper, The Effect of Liquidity on Governance, which was recently made publicly available on SSRN, we study how stock liquidity affects whether and how blockholders choose to exert governance on a firm. We find that liquidity encourages shareholders to acquire blocks (stakes of at least 5%). Conditional upon a block being formed, liquidity discourages blockholders from governing through “voice” (intervention) as it increases the likelihood of them filing Schedule 13G (which conveys a passivist intent) rather than 13D (which conveys an activist intent). This switch has two interpretations: the blockholder is abandoning governance altogether, or instead is switching to the alternative governance mechanism of “exit” (informed trading of a firm’s shares, otherwise known as the “Wall Street Rule” or “Wall Street Walk”).

Our evidence supports the latter: the effect of liquidity on both block acquisition and the switch from 13D to 13G is stronger in firms where the manager is more sensitive to the stock price (and thus the threat of exit), and the market reaction to a 13G filing is significantly positive, particularly among firms with high liquidity. Thus, liquidity causes a switch from voice to exit rather than causing a blockholder to abandon governance altogether. Although liquidity reduces the frequency of voice, conditional on a block being formed, this is outweighed by the positive effect of liquidity on block formation to begin with. Thus, unconditionally, liquidity leads to an increase in both exit and voice and so we demonstrate an overall positive effect of liquidity on governance. We use decimalization as an exogenous shock to liquidity to identify causal effects.

The effect of liquidity on governance is a question that has attracted significant academic and policy debate. The traditional view is that investors govern through direct intervention in a firm (“voice”). Under this view, liquidity weakens governance because it provides the blockholder with the option of selling her stake in a troubled firm rather than bearing the cost of intervening to fix it (Coffee (1991); Bhide (1993)). However, this view has been recently challenged along two fronts. First, even when considering voice as the only governance mechanism, Maug (1998) shows that liquidity encourages blockholders to intervene as they can buy additional shares at a price that does not incorporate the full gains from intervention. Second, Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011) demonstrate that threat of selling one’s shares (“exit”) can be a governance mechanism in itself: if the manager is sensitive to the stock price, he wishes to prevent such selling and so will maximize value. Liquidity increases the threat of exit by inducing blockholders to gather private information (Edmans (2009); Edmans and Manso (2011)), and by encouraging investors to acquire a larger block to begin with (Edmans (2009)).

An analysis of the effect of liquidity on governance faces three key challenges. First, many blockholders are hindered from engaging in voice to begin with, due to legal restrictions or conflicts of interest (e.g. a mutual fund may manage a firm’s pension scheme, and is thus reticent to engage in activism for fear of losing this business). Since they may only have “exit” at their disposal to begin with, liquidity has no effect on their choice of governance mechanism. We thus focus our study on activist hedge funds, who have no legal restrictions or other conflicts. They have the full “menu” of governance mechanisms available to them, and liquidity affects their choice from this menu. Second, in addition to actual voice and actual exit, the threat of voice and threat of exit can also exert governance. Thus, while prior literature typically studies actual instances of intervention or selling, we study a blockholder’s decision to file Schedule 13D or Schedule 13G, which conveys their intent upon block acquisition. Third, there could be reverse causality from governance to liquidity, or omitted variables that jointly determine both governance and liquidity. We use the decimalization of the US stock exchanges in 2001 as a natural experiment to provide an exogenous shock to liquidity.

The full paper is available for download here.

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