The role of blockholders in governance

Alex Edmans, Clifford Holderness

The separation of ownership and control for public firms may lead to fully dispersed ownership where no shareholder has an incentive to engage in governance. This column argues that blockholders (owners of large stakes) play a critical role in long-term governance, partly through a credible threat to sell their stakes. This threat is undermined by well-intentioned policy moves to create holding-period incentives and requirements. If they succeed, these policies will make exit less likely and blockholders will lose a method to discipline managers.

In 1932, Berle and Means famously highlighted the potential problem of diffuse ownership in public firms. They warned that “power over industrial property has been cut off from the beneficial ownership of this property – or, in less technical language, from the legal right to enjoy its fruits… This dissolution of the atom of property destroys the very foundation on which the economic order of the past three centuries has rested.” Berle and Means had an immediate and pronounced impact that continues to this day. For instance, their view of the corporate world in the US shaped current securities legislation.

Berle and Means argued that, when firms are public, ownership could become fractured to the point that no shareholder would have the incentive to monitor management. If true, public corporations would not survive – they would be out-competed by privately held rivals whose concentrated ownership ensured that managers would maximise value. But being public does not necessarily imply diffuse ownership. Even if a firm has a million shareholders, governance may still be strong as long as at least one shareholder has a stake large enough to have the incentive to monitor. This large shareholder is known as a ‘blockholder’.

Indeed, in contrast to the predictions of Berle and Means, public firms have survived. This is probably because, again contrary to the prediction of Berle and Means, virtually all public corporations in all countries have large shareholders. For example, La Porta et al. (1998) study 49 countries and find that even among the largest firms, "dispersed ownership in large public companies is simply a myth". Holderness (2009) reaches a similar conclusion about US corporations. He finds that 96% of domestic corporations have at least one shareholder owning at least 5% of the company. The ownership concentration of US firms is similar to that in other countries.

In a recent paper, we provide a non-technical overview of the role of blockholders in corporate governance, and new evidence on the frequency, size, and board representation of blockholders in US corporations, and their association with firm characteristics (Edmans and Holderness 2016). Our research shows that blockholders are essential in ensuring that public corporations remain private property. This means that there would be at least one owner who has the correct incentives to make residual decisions in a way that creates value.

In our view, blockholder governance works through two channels. The first, traditional, channel is direct intervention in a firm’s operations – otherwise known as 'voice' – for which empirical research that we reviewed has focused on the determinants and consequences of activism. The second, more recent channel would be that the blockholder sells shares if the manager underperforms, otherwise known as 'exit'. Empirical studies on exit highlighted the two-way relationship between blockholders and financial markets, linking corporate finance with asset pricing.

Our major conclusions

Blockholders are ubiquitous. Virtually every corporation, of every size in every country, has them. It is hard to imagine how firms could survive in a market economy without large shareholders.

There is no unambiguous definition of a blockholder. Moreover, there is no theoretical basis for the commonly used 5% threshold (or indeed any threshold).

The dollar value of a block or the concentration of the block in an investor’s portfolio could matter as much as the percentage value of a block.

Blockholders are endogenous. We know of no known credible instruments for block ownership. Insistence on clean identification will result in a focus on narrow questions or the avoidance of research on blockholders altogether; studies should be guided by economic logic, not by econometric virtuosity. Much can be learned by careful analyses of blockholders in different settings, using a variety of methods. Descriptive analyses can be illuminating if researchers are careful not to make causal claims, and to consider alternative explanations.

Blockholders are heterogeneous. They include hedge funds, mutual funds, pension funds, individuals, and other corporations. Each has its own determinants, incentives, and consequences. Most research, however, treats all blockholders as homogenous.

Blockholders are evolving. For example, institutional investors today are more willing to be hostile toward management than they were only 30 years ago. We expect this trend to continue.

Blockholders can govern through exit, not just through voice. This new way of thinking about blockholders – as informed traders, rather than just as controlling entities – suggests new directions for both theoretical and empirical research.

Blockholders can exert governance through the threat of exit and voice, rather than only through actual exit and voice. So blockholders may be exerting governance even if threats are not carried out.

The critical feature of a blockholder is the size of the stake. This size determines both incentives to engage in governance and the ability to do so – a large stake gives more votes in a proxy fight, and more clout in discussions with management – but many policymakers and practitioners focus instead on a blockholder’s holding period. For example, in July 2015, Hillary Clinton proposed an increase in capital gains tax for shares held for fewer than two years. France’s Loi Florange, which was passed in 2014, gives double voting rights for shares held for more than two years. Bolton and Samama (2012) argue in favour of loyalty shares that give financial or voting right incentives to hold shares for a minimum period.

To our knowledge, none of these proposals has been backed up by any theoretical model or any empirical evidence. Instead, they are founded on the hunch that short-term trading by investors must imply short-term behaviour by managers. The conventional wisdom is that short-term trading would allow investors to dump stocks with weak earnings. Therefore managers avoid weak earnings by cutting investment. But why should investors dump stocks with low earnings? Earnings are public information. Once a company has announced low earnings, its stock price immediately drops. An investor has no incentive to sell the stock because its weak earnings are already reflected in the stock price.

Trading is only profitable if it is based on private information that is not reflected in the stock price. Because information on short-term earnings is public, private information typically concerns a firm’s long-term value, such as its intangible assets. If an investor sells a stock because its long-term prospects are poor, it drives down the stock price and disciplines management. Thus, the threat of selling (especially by large shareholders) induces management to build for the long-term. Theories of governance through exit (Edmans 2009) support this. Deterring exit by locking in shareholders removes one of the key tools of governance. Edmans et al. (2013) and Norli et al. (2013) show that liquidity improves governance, and Brav et al. (2008, 2015, 2016) show that even short-term blockholders, such as activist hedge funds, can create long-term value.

The important question is not whether shareholders trade over the short term or the long term, but whether their trades are based on short-term or long-term information. We ensure that it is the latter by encouraging large stakes. Small shareholders will not spend the time and effort to analyse a firm’s intangible assets, but instead will rely on freely available earnings. Large investors have the strongest incentive to do their own research on a company’s long-term value.

There are at least three more disadvantages to holding-period requirements. First, financial incentives to hold a stake for, say, five years suggest that the main requirement for an investor would be simply to hold on to a stake rather than actually govern. Indeed, an investor can now beat the market by simply holding on to shares for five years to collect the reward, rather than engaging in governance. Second, a central tenet of economics is the value of alienable rights and transferability. This allows resources to be allocated to those who can best manage them. Barclay and Holderness (1991) find that trades of large blocks between investors lead to a 16% increase in market value that is consistent with the expected value gain from reallocating the block to a more effective monitor. Third, these requirements hinder blockholders from governing future firms. Once a blockholder has restructured the firm, then – similar to a turnaround specialist – there is no need to stick around. Instead, society is better off if a blockholder can take its capital and target other firms for improvement.

References

Barclay, M J, C G Holderness (1991) “Negotiated Block Trades and Corporate Control.” Journal of Finance 46(3):861-878.

Berle, A, G Means (1932) The Modern Corporation and Private Property. New York: Macmillan

Bolton, P, F Samama (2013) “Loyalty Shares: Rewarding Long-Term Investors.” Journal of Applied Corporate Finance 23(3):86-97.

Brav, A, W Jiang, H Kim (2015) “The Real Effects of Hedge Fund Activism: Productivity, Asset Allocation, and Labor Outcomes.” Review of Financial Studies 28(10):2723-2769.

Brav, A, W Jiang, S Ma, X Tian (2016) “How Does Hedge Fund Activism Reshape Corporate Innovation?” Working Paper, Duke University.

Brav, A, W Jiang, F Partnoy, R Thomas (2008) “Hedge Fund Activism, Corporate Governance, and firm performance.” Journal of Finance 63(4):1729-1775.

Edmans, A, (2009) “Blockholder Trading, Market Efficiency, and Managerial Myopia.” Journal of Finance 64(6):2481-2513.

Edmans, A, V W Fang, E Zur (2013) “The Effect of Liquidity on Governance.” Review of Financial Studies 26(6):1443-1482.

Edmans, A, C G Holderness (2014) “Blockholders: A Survey of Theory and Evidence”, CEPR Discussion Paper DP11442

Norli, Ø, C Ostergaard, I Schindele, (2015) Liquidity and Shareholder Activism. Review of Financial Studies 28(2):486-520