Blockholders and Corporate Governance

In the paper, Blockholders and Corporate Governance, forthcoming in the Annual Review of Financial Economics, I review the theoretical and empirical literature on the different channels through which blockholders (large shareholders) engage in corporate governance. Berle and Means’s (1932) seminal article highlighted the agency problems that arise from the separation of ownership and control. When a firm’s managers are distinct from its ultimate owners, they have inadequate incentives to maximize its value. For example, they may exert insufficient effort, engage in wasteful investment, or extract excessive salaries and perks. The potential for such value erosion leads to a first-order role for corporate governance—mechanisms to ensure that managers act in shareholders’ interest. The importance of firm-level governance for the economy as a whole has been highlighted by the recent financial crisis, which had substantial effects above and beyond the individual firms involved.

Since the source of agency problems is that managers have inadequate stakes in their firms, large shareholders—otherwise known as blockholders—can play a critical role in governance, because their sizable stakes give them incentives to bear the cost of monitoring managers. Blockholders are prevalent across companies and around the world. Holderness (2009) finds that 96% of U.S. firms contain at least one blockholder (defined as a shareholder who holds at least 5%); this ratio is the 15th highest out of the 22 countries that he studies. Thus, understanding the role that blockholders play in corporate governance is an important question.

Large shareholders can exert governance through two main mechanisms (see Hirschman (1970)). The first is direct intervention within a firm, otherwise known as voice. Examples include suggesting a strategic change via either a public shareholder proposal or a private letter to management, or voting against directors. While most of the early research on blockholder governance has focused on voice, a recent literature has analyzed a second governance mechanism—trading a firm’s shares, otherwise known as exit, following the “Wall Street Rule,” or taking the “Wall Street Walk.” If the manager destroys value, blockholders can sell their shares, pushing down the stock price and thus hurting the manager ex post. Ex ante, the threat of exit induces the manager to maximize value.

Blockholders may also exacerbate rather than solve agency problems. First, even if blockholders’ actions maximize firm value ex post, their presence may reduce value ex ante: the threat of intervention may erode managerial initiative, and their mere presence may lower liquidity. Second, instead of maximizing firm value, they may extract private benefits. While blockholders may alleviate conflicts of interest between managers and investors, there may be conflicts of interest between the large shareholder and small shareholders. For example, blockholders may induce the firm to buy products from another company that they own at inflated prices.

In my paper, I survey the three mechanisms through which large shareholders can affect firm value—improving it by governance through voice, improving it by governance through exit, or worsening it through extracting private benefits or other channels. I start by reviewing the theoretical literature, in particular highlighting empirical implications. While the two governance mechanisms share some predictions—for example, a larger stake generally improves governance through both voice and exit, and such governance in turn enhances firm value—they differ in many others. Most notably, voice theories yield implications for the causes and consequences of activism, while exit theories predict how blockholders affect financial markets and how their effectiveness depends on microstructure factors. I then move to the empirical evidence on the determinants and effects of blockholder structure.

In linking the theoretical and empirical literatures, I emphasize four challenges. First, identifying causal effects is difficult: instead of causing changes in firm outcomes, potential investors may predict changes in firm outcomes and acquire a block accordingly, or unobservable variables may jointly attract large shareholders and affect outcomes. Second, blockholders can exert governance through the threat of exit and voice, rather than only actual acts of exit and voice. The absence of these actions does not imply the absence of governance—on the contrary, the threat of intervening or selling may be sufficient to induce the manager to maximize value, so that the actual act is not necessary. However, such threats are much harder for empiricists to observe. Third, there is no unambiguous definition of a blockholder. While the empirical literature typically defines a blockholder as a 5% shareholder, since this level triggers disclosure requirements in the U.S., theoretical models predict that monitoring increases continuously with block size (up to a point), rather than a discontinuity at 5%. Moreover, the percentage stake required for a blockholder to exert a given level of governance will differ across firms, and the dollar block size may be more relevant in some settings. Fourth, while most models consider a single blockholder or multiple symmetric blockholders, in reality blockholders are a diverse class comprising many different types of investor: hedge funds, mutual funds, pension funds, individuals, and corporations. These different investors may engage in different forms of governance, be affected by firm characteristics in different ways, and have different effects on firm outcomes. Considering blockholders as a homogenous entity may miss interesting relationships at a more granular level.

Far from reducing its attractiveness as a research area, these empirical challenges suggest that blockholder governance is a particularly fruitful topic, as they mean that many first-order questions—including an issue as fundamental as whether blockholders affect firm value—remain unanswered, and many theories remain untested. I close by highlighting open questions for future research, both theoretical and empirical. In particular, while early voice theories spawned an empirical literature on blockholders and corporate control, recent exit theories suggest a different way of thinking about blockholder governance that gives rise to new areas for research—in particular, the link between governance (traditionally a corporate finance topic) and financial markets (traditionally an asset pricing topic).

The full paper is available for download here.