The stock market is a powerful tool for controlling corporation’s behaviour. But what is best:
- Lots of small shareholders who buy and sell in reaction to corporate decisions (i.e. a very liquid market)? or;
- Large blockholders that use their shareholder voting rights to keep the firm on the right path?
The traditional view is that blockholders (large shareholders) exert governance on a firm through direct intervention – otherwise known as ‘voice’ –for example, removing an underperforming manager or blocking a misguided acquisition. Under this view, liquidity is detrimental to governance. After all, a blockholder with, say, a 5% shareholding will bear the full costs of intervention, but will only enjoy 5% of the benefits. Therefore, if a firm is underperforming, rather than engaging in costly intervention the blockholder may simply sell her shares and walk away – otherwise known as the ‘Wall Street Rule’ or ‘Wall Street Walk’).
The blockholder view first came to prominence in the 1980s and early 1990s, when the Japanese economy was booming. The argument was that liquidity encourages shareholders to simply abandon a troubled firm, rather than engage in voice, and is thus undesirable for governance. Both academics (e.g. Coffee 1991, Porter 1992, Bhide 1993) and policymakers argued that its low liquidity was a key contributor to good corporate governance because it locks shareholders into the firm and thus encourages a focus on long-run health.
Concerns about the costs of liquidity have resurfaced in the recent financial crisis. Commentators and politicians have proposed transactions taxes and short-sales restrictions to dissuade ‘excessive’ trading.
The benefits of liquidity
However, it is far from clear that liquidity is detrimental to governance. Indeed, Japan’s ‘lost decade’ of the 1990s raised doubts about the low-liquidity model. The theoretical literature has identified two major benefits of liquidity:
- First, stock liquidity makes it easier for shareholders to acquire a block to begin with (Kyle and Vila 1991, Kahn and Winton 1998, Maug 1998);
By encouraging large shareholders to form, it encourages voice.
- Second, Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011) show that the act of selling one’s shares – engaging in ‘exit’ – far from being the antithesis of governance, can be a governance mechanism in itself;
Such sales drive down the stock price, which hurts the manager whose compensation and reputation depend on the stock price. Ex-ante, the threat of exit induces the manager to maximise value. Liquidity is good for exit – and thus governance – as it induces the block to form to begin with, the blockholder to acquire information once they has established their block, and the blockholder to trade more once they have acquired information.
What do the data tell us?
Although both sides of the arguments about the effect of liquidity on governance contain competing theories, this is ultimately an empirical question. Thus, we turn to the data. In Edmans, Fang, and Zur (2013), we analyse how liquidity affects both the decision to acquire a block and the choice of governance mechanism – exit or voice – once the block has been acquired. We study a particular type of blockholder – activist hedge funds – because they are unconstrained by legal restrictions and thus have both voice and exit at their disposal. Overall, we uncover a positive effect of liquidity on governance.
- Liquidity increases the likelihood that an activist hedge fund acquires a block (a stake of at least 5%) in a firm;
To address concerns that there could be reverse causality from governance to liquidity, or omitted variables driving both, we use the decimalisation of the US stock exchanges in 2001 as a natural experiment to provide an exogenous shock to liquidity.
- Liquidity reduces the likelihood that the hedge fund files a ‘Schedule 13D’ – which conveys an activist intent – upon block acquisition, and correspondingly increases the likelihood that it files a ‘Schedule 13G’ – which conveys a passive intent;
This finding is consistent with the traditional view that liquidity weakens governance as it discourages voice. However, it is also consistent with the exit view that liquidity merely causes a blockholder to adopt a different form of governance – exit rather than voice.
- We find that a 13G finding indeed represents a governance mechanism. A 13G filing leads to a positive market reaction, a positive holding-period return, and an improvement in operating performance; all these effects are stronger in more liquid firms;
These results support the exit view that the 13G filings, that are encouraged by liquidity, represent governance through exit rather than the abandonment of governance altogether (as argued by the traditional view). Also consistent with the ‘exit’ view, liquidity has a particularly large effect in inducing a 13G filing for firms where the manager’s wealth is sensitive to the stock price, and thus the threat of exit.
Our last and final finding concerns voice. Our first result, stated earlier, was that liquidity increases the likelihood of block acquisition, but our second result was that it decreases the likelihood that a 13D is filed, conditional upon block acquisition.
- We find that the first effect outweighs the second; Thus, liquidity increases the unconditional incidence of voice. Coupled with its positive effect on exit, liquidity has an overall beneficial effect on governance.
Overall, our findings suggest that policymakers should not rush into reducing stock liquidity through greater regulations. While the idea that liquidity encourages short-term trading, rather than long-term governance, sounds intuitively appealing, deeper thought illustrates that liquidity can be beneficial by encouraging large shareholders to form in the first place, and by allowing shareholders to punish an underperforming firm through selling their stake. More broadly, the paper contributes to a recent literature on the real effects of financial markets. The traditional view (e.g. Morck, Shleifer, and Vishny 1990) is that financial markets are simply a side-show that passively reflects firms’ fundamentals – for example, a fall in the stock price reflects a deterioration in firm performance. This newer literature, surveyed by Bond, Edmans, and Goldstein (2012), shows that stock prices actively affect a firm’s fundamentals – a fall in the stock price exerts governance on the manager by worsening his compensation and reputation; the threat of such a fall induces the manager to exert effort. Thus, policymakers should take into account the effects of financial markets on real economic activity when designing regulations.
Admati, Anat R and Paul Pfleiderer (2009), “The Wall Street Walk and Shareholder Activism: Exit as a Form of Voice”, Review of Financial Studies 22, 2645–85.
Bhide, Amar (1993), "The Hidden Costs of Stock Market Liquidity", Journal of Financial Economics 34, 31-51.
Bond, Philip, Alex Edmans, and Itay Goldstein (2012), “The Real Effects of Financial Markets”, Annual Review of Financial Economics 4, 339-60.
Coffee, John (1991), “Liquidity Versus Control: The Institutional Investor as Corporate Monitor”, Columbia Law Review 91, 1277–1368.
Edmans, Alex (2009), “Blockholder Trading, Market Efficiency, and Managerial Myopia”, Journal of Finance 64, 2481–513.
Edmans, Alex and Gustavo Manso (2011), “Governance through Trading and Intervention: A Theory of Multiple Blockholders”, Review of Financial Studies 24, 2395–428.
Edmans, Alex, Vivian W Fang and Emanuel Zur (2013), “The Effect of Liquidity on Governance”, Review of Financial Studies, forthcoming.
Kahn, Charles and Andrew Winton (1998), “Ownership Structure, Speculation, and Shareholder Intervention”, Journal of Finance 53, 99–129.
Maug, Ernst (1998), “Large Shareholders as Monitors: Is There a Tradeoff Between Liquidity and Control?”, Journal of Finance 53, 65–98.
Morck, Randall, Shleifer Andrei, and Vishny W Robert (1990), “The stock market and investment: Is the market a sideshow?”, Brookings Papers on Economic Activity 2, 157–215.
Porter, Michael (1992), "Capital Disadvantage: America's Failing Capital Investment System", Harvard Business Review 70, 65-82.