Liquidity and Shareholder Activism

In our paper, Liquidity and Shareholder Activism, forthcoming in the Review of Financial Studies, we provide new insights on how stock liquidity influences shareholder activism. Blockholders’ incentives to intervene in corporate governance are weakened by free-rider problems and high costs of activism. Theory suggests activists may recoup expenses through informed trading of target firms’ stock when stocks are liquid. We show that stock liquidity increases the probability of activism—but, does less so for potentially overvalued firms for which privately informed blockholders may have greater incentives to sell their stake than to intervene. We also document that activists accumulate more stocks in targets when stock is more liquid. We conclude that liquidity helps overcome the free-rider problem and induces activism via pre activism accumulation of target firms’ shares.

Through their voting rights, shareholders have the formal power to affect the governance of public companies. But shareholder activism is a rare event, a fact often attributed to its considerable costs. Election contests demonstrate how costs can be substantial. A shareholder seeking to replace existing board members in a proxy contest must run a public campaign, hire legal expertise, and pay for producing and distributing his own slate of directors to the company’s other shareholders. The biggest European pension funds have been lobbying for proxy access in U.S. companies and have pointed to the high costs of nominating individuals for election to the board as a factor behind their growing focus on non-U.S. stocks (cf. “Plea for democracy in corporations,” The Financial Times, January 22, 2007). Even if the overall value added exceeds the costs, a large shareholder’s incentives to monitor and intervene are hampered by free-riding minority shareholders who reap the benefit of increased value, but do not bear any of the costs.

Theory suggests that liquidity may help to overcome the free-rider problem and strengthen the incentive of large shareholders to engage in costly activism (voice). If a firm’s stock is liquid enough, a shareholder planning an intervention can profit from informed trading and recoup the cost of activism by purchasing shares at a price that does not yet reflect the future increase in company value created by his privately known actions (Maug, 1998; Kahn and Winton, 1998; Winton and Li, 2006). In contrast, Coffee (1991) and Bhide (1993) view liquidity as an impediment to intervention because it allows blockholders to sell their shares without incurring large trading costs. Liquidity, in this case, makes exit more attractive than voice.

In our paper, we investigate empirically whether liquidity induces shareholder activism in the form of voice through informed trading. The mechanism of voice rests on the assumption that voice is costly. We therefore hand-collect data on contested proxy solicitations in connection with shareholder meetings. These are activist events that involve considerable costs as documented by Gantchev (2013).

Our analysis is based on shareholder activism events in a sample of U.S. listed firms. Activist events represent, for the most part, contested proxy solicitations. We start the analysis by documenting that at the time their intervention becomes publicly known, activists own sizeable blocks of equity in the target firms, on average 9%. Activist shareholders therefore tend to be blockholders, and the free-rider problem is likely to be relevant in our sample, leaving a role for liquidity.

Our paper contributes by providing four pieces of evidence on the role of liquidity that all are consistent with the mechanism in the theories of Maug (1998), Kahn and Winton (1998) and Winton and Li (2006).

First, we investigate the effect of liquidity on the likelihood of shareholder activism. We find a statistically and economically significant positive effect of stock liquidity on the probability of activism. The results imply that a discrete increase in liquidity from the 10th to the 90th percentile more than doubles the likelihood of activism.

Second, Kahn and Winton (1998) and Wint and Li (2006) point out that private information sometimes gives incentives for exit rather than voice: when a blockholder privately observes a managerial problem and the stock is overvalued, his profit may be higher if he sells his stake rather than intervenes to improve firm value. The higher liquidity, the stronger is the incentive for blockholders to unwind their positions. Our estimates show that the effect on activism of a discrete increase in liquidity from the 10th to the 90th percentile is around 50% lower for the decile of firms most likely to be overvalued, compared with the decile of firms least likely to be overvalued.

Third, we directly examine shareholder activists’ pre-event trading of target firms’ stocks. We hand-collect transactions data from activists’ 13D filings made with the SEC and record transactions up to one year prior to the announcement date of activism. Our evidence shows that activists trade extensively prior to activism: 76% of activists trade, and almost all trades (95%) are purchases. On average, activists that trade accumulate 54% of their stock holdings during the 12-month period prior to the announcement day. The trading profits earned are substantial; on average, activists earn a return of 8.5% on the capital invested.

Finally, we document a link between the liquidity of a stock and the extent of activists’ trading. Because the ability to trade without affecting the price is the source of the activists’ trading profits, the voice mechanism implies that activists will accumulate more shares when target firm’s stock is more liquid. This is exactly what we find. We show that liquidity has a direct positive effect on the pre-event accumulation of target stocks.

Overall, our results suggest that informed trading is a substantive driver behind the positive effect of liquidity on activism. The ability to trade in target firms’ stocks appears to be an integral part of many shareholders’ intervention strategies, and our results highlight the importance of being able to recoup the costs of activism in order for intervention to be worthwhile.

The SEC has not succeeded in its recent attempts to provide shareholders with easier access to proxy solicitations of their alternative plans for a company, such as nominating directors. The SEC proposal of a new rule, Rule 14a-11, allowing shareholders to use company management proxy statement to nominate directors and solicit votes for their election (under certain conditions), was vacated by the U.S. Court of Appeals for DC in July 2011. This suggests that stock liquidity will continue to be a determining factor of activism and that shareholders of less liquid firms may be hesitant to intervene in governance because of their inability to reclaim their outlays.

The full paper is available for download here.