Governance Through Threat

The following post comes to us from Massimo Massa, Professor of Finance at INSEAD, Bohui Zhang of the Australian School of Business at the University of New South Wales, and Hong Zhang of the Finance Area at INSEAD.

The last decade has witnessed a renewed interest in the role of financial markets in disciplining managers. Shareholders—particularly blockholders—may induce good managerial behavior by exiting and pushing down stock prices when bad managerial actions are taken (e.g., Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011). In this regard, informed trading (“exit”) provides an alternative governance mechanism that shareholders can adopt in addition to the traditional “intervention” type of internal governance (e.g., Parrino et al., 2003; Chen et al., 2007; McCahery et al., 2010). Indeed, to some extent, exit and intervention offer substituting governance mechanisms that shareholders can select based on their trade-off between benefits and costs (e.g., Edmans and Manso, 2011; Edmans et al., 2013).

In our paper, Governance Through Threat: Does Short Selling Improve Internal Governance?, which was recently made publicly available on SSRN, we study how “trading-based governance” affects internal governance through the channel of short selling. Using a simple model, we argue that the threat of short-selling attacks triggered by bad managerial actions pushes existing shareholders to better control management, either through improved internal governance or via enhanced equity compensation. Thus, short-selling-based discipline mechanisms are complementary with, instead of substituting for, internal governance.

We consistently find a significantly positive relationship between short-selling potential (our empirical proxy for the threat of short selling) and the ISS index (our empirical proxy for the quality of internal governance) in our empirical tests. The effect is stronger for firms that are more financially constrained and in economies with less market-oriented institutions, such as civil-law systems, lower quality financial disclosure, poorer securities regulation protection, and less developed accounting standards.

In addition, short-selling potential increases the sensitivity of management compensation to performance and boosts the monitoring role of the board. All the results are robust to an instrumental variable specification in which ETF ownership is used as an instrument that affects the number of shares available to be lent in the market but is unrelated to (bad) information that may lead directly to short selling.

Finally, we show that short-selling potential in general enhances firm profitability (ROA). More importantly, we document that the part of internal governance that is directly explainable in terms of short selling enhances firm profitability.

Our results provide evidence in favor of the beneficial effect of the short-selling market on the corporate market. The relationship between short selling and internal governance—the threat of short selling causing investors to practice better internal governance—may help us better understand and regulate the contemporaneous development of financial markets and corporations.

The full paper is available for download here.

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