by Professor Adam Meirowitz, University of Utah, and Dr Shaoting Pi, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
In the study of enterprise ownership comparisons between ownership by investors of capital, suppliers of labour, or customers is widespread (eg, Hansmann 1988; Jensen and Meckling 1979; Fama and Jensen 1983). Little attention, however, has been allocated to the connections between governance by owners and the ease with which ownership status can be changed. In our paper, “Voting and Trading: The Shareholder’s Dilemma”, we explore this point in the context of publicly traded firms by studying how market liquidity can impact the ability of shareholders to effectively govern. Several scholars have studied the direct effects of selling on governance (eg, Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011). Our focus is on how opportunities to trade shares impact the incentives for voting and governance by shareholders; thus, we focus on indirect or equilibrium connections.
The informal rationale for governance by shareholder voting is seemingly compelling. Shareholders are united by the concern for return on their investment in the firm they govern, and thus they will have strong incentives to enact policies that enhance the firms’ value. Reflexively, we might then expect that this leads to a problem of common values and although economic theory does provide reasons to be cautious, problem of common values tends to admit institutions that can aggregate information effectively. We contend, however, that this assessment is premature.
This optimistic conception ignores the fact that shareholders may also trade shares in a market, and prices may depend on information revealed from governance decisions. The presence of a market turns out to be particularly relevant. Shareholders may have perverse incentives when voting over firm policy in the presence of liquidity. The key feature in our account is that current shareholders can decrease or increase their holdings in the firm. The desirability of either of these actions depends on the price at which they will transact. Thus, shareholders will not only care about influencing firm decisions, but they will also care about influencing market share prices. If there is any information conveyed by voting, then market prices must also react to votes. This then creates the possibility that strategic voting will allow for the creation of informational advantages over the market, which can be translated into informational rents by strategic voting and trading.
To flesh out the incentives faced by shareholders in the presence of liquidity, we develop a simple model of voting and trading. We find that voting for the policy option that a shareholder believes to be optimal for the firm is only optimal for the shareholder if she turns out to be the pivotal voter (that is the vote is nearly a tie). In all other realisations of the votes by others, her payoffs are maximised by casting a vote for the option she believes to be worse for the firm and capitalising on the informational advantage she has over the market. Equilibrium then requires that voting must be sufficiently noisy so as to balance (i) how the market reacts to votes with (ii) the incentive to select the policy that is seemingly best for the firm. Thus, equilibrium will be consistent with the idea that there is not too much information contained in voting even if shareholders in aggregate possess a lot of relevant information. In the limit, as the number of shareholders gets large, the probability of making the decision that is better for the firm is bounded away from 1; information aggregation fails. In fact, we find that the limiting probability of making the correct decision is lower than the probability that a single agent with one signal would make the correct decision.
One way to think about these equilibria is through a counter factual. If voting were more correlated with information, then incentives to take advantage of informational rents would be too strong, and there would be dominant incentives to vote against one’s information. Rather, in equilibrium, these incentives are either not present or just balanced with incentives to correctly influence policy, and voting is seemingly random not particularly informative. It is instructive to draw an analogy with the absence of arbitrage opportunities in equilibrium to a canonical trading model. Here, incentives to influence market prices through voting can be driving equilibrium behaviour, even though shareholders don’t see desirable opportunities to manipulate prices by voting in equilibrium. If these features were not balanced in equilibrium, a shareholder would see opportunities to deflate (inflate) prices prior to purchasing (selling) shares through casting votes that are seen as strong votes of negative (positive) signal. Interestingly, the model also has equilibria in which voters are very lopsided and completely uninformative. These equilibria may match what we sometimes see in practice when shareholders are seen as rubber-stamps even if they possess strong information.
We contribute to how we conceive of corporate governance. The takeaway is that there is room for scholars to rethink how institutional features impact the motives of shareholders when making firm decisions. Opportunities to behave strategically in one domain may have spill-over effects and distort behaviour in another domain. Thus, there are analytical insights that can be obtained by rethinking a range of questions about governance with a broader eye on available levels of participation. Our primary results are negative in that they point to failures in information aggregation and therefore suggest that shareholders may not accurately steer firm policy or serve as effective controls on management misbehaviour. But more broadly, thinking about the connections between trading and voting makes it possible to better understand how a broad range of institutional features might impact voting and governance in ways that previous work has missed.
We also contribute to a deeper understanding of empirical patterns relating the presence of votes to stock volatility and price. Here there are two points to make. The first point relates to a tradition of modelling how public signals or events impact trading. Empirical work documents a pattern of high volume without high price effects has led to some to fit richer models of information processing to marker behavior after important events (eg, Kim and Verrecchia, 1991, 1994; Kandel and Pearson, 1995; Bollerslev, Li and Xue, 2018). In the case of shareholder votes our model provides an alternative and possibly simpler explanation. The public event of learning how shareholders vote is not very informative, but shareholders all possess private information after the vote and have incentives to trade on this information. In fact, the prediction of our model is that a vote will provide almost no information and so price effects will be minimal, but every shareholder will buy or sell shares after voting and in expectation the number buying will be almost the same as the number selling; thus, even after the spike in trading volume following a vote, we may see minimal price effects.
References
Admati, A.R. and Pfleiderer, P. (2009) “The “Wall Street Walk” and shareholder activism: exit as a form of voice.” Review of Financial Studies, 22(7): 2645-2685
Bollerslev, T., Li, J. and Xue, Y. (2018) “Volume, volatility, and public news announcements.” Review of Economic Studies, 85(4): 2005-2041
Edmans, A. (2009) “Blockholder trading, market efficiency, and managerial myopia.” Journal of Finance, 64(6): 2481-2513
Edmans, A. and Manso, G. (2011) “Governance through trading and intervention: a theory of multiple blockholders.” Review of Financial Studies, 24(7): 2395-2428
Fama, E.F. and Jensen, M.C. (1983) “Separation of ownership and control.” Journal of Law and Economics, 26(2): 301-325
Hansmann, H. (1988) “Ownership of the firm.” Journal of Law, Economics, and Organization, 4(2): 267-304
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Meirowitz, A. and Pi, S. (2021) “Voting and trading: the shareholder’s dilemma.” Social Science Research Network Paper. Available at SSRN 3445233.
Kandel, E. and Pearson, N.D. (1995) “Differential interpretation of public signals and trade in speculative markets.” Journal of Political Economy, 103(4): 831-872
Kim, O. and Verrecchia, R.E. “Trading volume and price reactions to public announcements.” Journal of Accounting Research, 29(2): 302-321
Kim, O. and Verrecchia, R.E. “Market liquidity and volume around earnings announcements.” Journal of Accounting and Economics, 17(1-2): 41-67