One of the fundamental issues in modern corporate finance is the problem of separation of firm ownership from control. The gap between management and shareholders is potentially wide, and the danger is great for agency problems to divert a widely-held firm's resources from their efficient use. Therefore, it is important to understand what mechanisms are available for reconciling these interests, to what extent they are used, and to what extent they are effective.
In our current paper, ‘The Threat of Intervention’ we focus on the dual aspect of the intervention mechanism: Intervention can improve the firm ex post (through direct action by the activist) or ex ante (through the threat to management). We develop a model in which an activist shareholder can accumulate a toehold of shares. After observing the activist's toehold size, the manager decides whether to consume private benefits at the expense of shareholders. Once the managerial action is taken, the activist decides whether to extend the toehold and intervene, or to sell shares. Thus, the process of shareholder engagement can improve firm value through two channels: the direct intervention itself, and the effect of the threat of intervention on managerial behavior. Our research framework is relevant in modern financial markets, since most publicly traded firms can be subject to governance though the threat of intervention. Recent empirical evidence shows that the threat of intervention is likely to play a strong disciplinary role (eg, Fos, 2017; Gantchev, Gredil, and Jotikasthira, 2018).
The model reveals several key results. The model shows how ex ante threat and ex post intervention interact and how they are related to economic efficiency. For instance, in the model, more frequent ex post interventions are not necessarily a sign of enhanced economic efficiency. A weaker disciplinary role played by the intervention mechanism leads to lower firm value (because the manager is not disciplined ex ante), which can lead to more frequent ex post interventions, which are costly (both to the activist and the manager) but only partially recover the damage done to the firm value. Thus, in this case more frequent ex post interventions are a sign of worsening corporate governance.
The model reveals that it is important to distinguish between sources of liquidity trading. Previous work has emphasized the dual nature of liquidity trading: that it makes it easier for activists to accumulate holdings, but also makes it harder to commit not to dissipate those holdings. Liquidity trading that does not interact with the activist's actions has a positive effect on market liquidity and on the activist's trading profits. It therefore leads to a larger toehold accumulated by the activist and, consequently, increases chances of an equilibrium in which the activist intervenes. By contrast, liquidity trading that interacts with activist's actions leads to wider bid-ask spreads and a weaker disciplinary role played by the intervention. This result has important implications for the literature that studies the role of market liquidity in corporate governance. To the best of our knowledge, this is the first paper to contrast two phases of liquidity trading and to show their differential effects on economic outcomes.
Because we endogenize the activist's choice of toehold, we can examine the relation between observed blockholdings and the use of intervention as a threat. One of the key implications of Shleifer and Vishny (1986) is that the presence of a large blockholder increases chances of blockholder governance through voice. The intuition is that a large block allows the blockholder to capture a larger portion of value creation and therefore to cover the cost of exercising voice – that is, the presence of a large blockholder provides a partial solution to the free-rider problem (Grossman and Hart, 1980). To the best of our knowledge, our model is the first to show that the presence of a large blockholder may lead to fewer incidents of blockholder governance through ex post intervention, to the extent that the threat of intervention is very effective ex ante. In the extreme, one would not observe any intervention events if the threat of intervention were so powerful as to prevent the manager from taking the bad action in any state of the world. Thus, our model argues that the absence of action by large blockholders can in fact be a sign of well-functioning corporate governance.
Vyacheslav (Slava) Fos is Associate Professor of Finance and Hillenbrand Family Faculty Fellow, Boston College, Carroll School of Management.