Exit as Governance

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2013-08-20


Editor's Note: The following paper comes to us from Sreedhar Bharath of the Department of Finance at Arizona State University, Sudarshan Jayaraman of the Accounting Area at Washington University in Saint Louis, and Venky Nagar of the Department of Accounting at the University of Michigan.
Traditional theories of blockholder governance have focused primarily on blockholder intervention in management decisions. However, recent theories posit that blockholders can govern firms even when they have no intervention power. These theories view blockholders as informed traders who control management through “exit,” i.e., selling a firm’s stock based on private information (Admati and Pfleiderer 2009, Edmans 2009, Edmans and Manso 2011). Blockholder exit in these models exerts downward pressure on the stock price, which hurts management through its equity interest in the firm. Management therefore wants to make sure its actions are such that blockholders are willing to stay with the firm.

When blockholders are informed traders, management undertakes productive effort and investment in order to improve firm value and dissuade blockholders from exiting. The true governance force therefore comes from the threat of blockholder exit, not actual exit. Even if no exit is observed, blockholders could be governing effectively because their exit threat is sufficient to discipline management.

In our paper, Exit as Governance: An Empirical Analysis, forthcoming in the Journal of Finance, we empirically test the governance impact of blockholder exit threats. Since threats cannot be directly observed, this study focuses instead on a key mechanism that facilitates exit threats, namely stock liquidity. The exit threat models suggest that stock liquidity enhances the power of exit threats and improves firm value. For example, in Edmans (2009), the manager is compensated on the stock price and can take fundamental actions to improve firm value. Stock liquidity encourages strategic traders to acquire more information on firm fundamentals and trade on it in larger volumes (or blocks). The manager is sensitive to the resulting stock price, and therefore takes actions to increase firm value and induce (informed) blockholders to stay. Liquidity thus enhances the power of blockholder exit threats and improves firm value. This theoretical prediction forms the basis of our empirical tests.

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R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

08/20/2013, 10:40

Date published:

08/20/2013, 09:15