Passive blockholders, informational efficiency of prices, and firm value

• Author: Choonsik Lee,Carl Hsin‐han Shen,Kee H. Chung
• Date: 01 July 2020
• DOI: http://doi.org/10.1002/rfe.1089
• Published date: 01 July 2020

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2020;38:494–512.

© 2019 University of New Orleans

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INTRODUCTION

This paper analyzes the role of blockholders in corporate governance. In particular, we investigate a possible channel through

which blockholders can exert an impact on managerial performance and firm value. When an individual or a group of indi-

viduals acquires beneficial ownership of more than 5% of a class of a company's equity securities, they are required to file a

Schedule 13D or 13G with the Securities and Exchange Commission (SEC). Here 13D filing is required if the filer intends to

exert control over management. If the filer is an investor who is not interested in pursuing an activist agenda, the investor may

file a Schedule 13G instead, which is shorter and requires less information. For expositional convenience, we call the latter type

of investors passive blockholders. Although the role of active (13D) blockholders in corporate governance and its effect on firm

value have been extensively studied, the role of passive (13G) blockholders has been the subject of relatively few studies. This

study is an attempt to fill this gap in the literature. Our main thesis is that passive blockholders exert an impact on managerial

behavior and shareholder wealth by increasing the informational efficiency of share prices.

Shleifer and Vishny (1986) offer an analytical model in which the presence of a large shareholder provides a partial solu-

tion to the free‐rider problem associated with managerial monitoring in a corporation with many small shareholders. Brickley,

Lease, and Smith (1988) analyze the role of blockholders in improving shareholder rights through antitakeover measures.

Barclay and Holderness (1991) and Bethel, Liebeskind, and Opler (1998) show that firm performance generally improves with

the presence of large shareholder blocks. Similarly, Brav, Jiang, Partnoy, and Thomas (2008), Clifford (2008), and Klein and

Zur (2009) show that the formation of activist blocks tends to be accompanied by positive abnormal stock returns. Bertrand and

Mullainathan (2001), Bebchuk, Grinstein, and Peyer (2010), and Kim (2010) analyze the role of blockholders in determining

Received: 5 July 2019

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Revised: 23 September 2019

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Accepted: 29 September 2019

DOI: 10.1002/rfe.1089

ORIGINAL ARTICLE

Passive blockholders, informational efficiency of prices, and firm

value

Kee H.Chung1,2

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ChoonsikLee3

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Carl Hsin‐hanShen4

1Department of Finance,School of

Management,State University of New York

(SUNY) at Buffalo, Buffalo, NY, USA

2School of Business,Sungkyunkwan

University, Seoul, Korea

3College of Business,University of Rhode

Island, Kingston, RI, USA

4Macquarie University, Sydney, NSW,

Australia

Correspondence

Kee H. Chung, Louis M. Jacobs Professor

of Finance, Department of Finance,

School of Management, State University

of New York (SUNY) at Buffalo, Buffalo,

NY14260, USA.

Email: keechung@buffalo.edu

Abstract

This paper analyzes the role of passive blockholders in corporate governance using

data on Schedule 13G filings. We show that firm value increases with the number

and aggregate ownership of passive blockholders after controlling for other possible

determinants of firm value. More importantly, we show that the informational effi-

ciency of prices (IEP) increases with the number and aggregate ownership of passive

blockholders, and IEP is a channel through which passive blockholders affect firm

value. Overall, our results suggest that managers perform better when stock prices

reflect the economic consequences of their actions promptly and accurately through

information‐based trading of blockholders.

KEYWORDS

causal mediation analysis, informational efficiency of asset price, liquidity, passive blockholders, Tobin's

q ratio

JEL CLASSIFICATION

G14; G20; G32; G34

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495

CHUNG et al.

the compensation structure of chief executive officers and directors. Edmans, Fang, and Zur (2013) show that liquidity in-

creases the likelihood of block formation and reduces the likelihood that blockholders govern through voice (intervention).

Only a few studies explore the role of passive blockholders who own a material portion (5%) of a company but have no in-

tention of directly interfering with its management. Admati and Pfleiderer (2009), Edmans (2009), Edmans and Manso (2011),

and Edmans et al. (2013) suggest that passive blockholders may provide indirect disciplining of managers through exit gov-

ernance, i.e., selling a firm's shares when they are unhappy with its performance. Appel, Gormley, and Keim (2016) find that

passive institutions affect corporate governance through their large voting blocks. In this study, we examine whether passive

blockholders provide managerial discipline by increasing the informational efficiency of prices. Although Edmans (2009) and

Edmans and Manso (2011) provide analytical models that establish a causal link between blockholdings and firm value through

the channel of the informational efficiency of prices, the authors do not provide empirical evidence for their analytical results.

We provide such evidence in this paper.

Our study also differs from Edmans et al. (2013) in that we focus on the role of passive blockholders as enhancers of pricing

efficiency while their study focuses on the role of passive blockholders as providers of exit governance. In our framework, it is

the higher informational efficiency of prices associated with blockholders' buying and selling of a firm's shares that motivates

managers and improves their performance. In Edmans et al. (2013), the act of selling a firm's shares drives down its share price,

hurting managers ex post to the extent that their compensation and/or wealth is tied to the firm's share price. Edmans et al.

(2013) hold that this threat of exit induces managers to maximize firm value ex ante.

Our empirical analysis is based on the premise that large shareholders collect and trade on private information. Blockholders

have incentives to collect and analyze information about stocks they hold because of their large stakes (Edmans, 2009).

Consequently, blockholders are more likely to trade on superior information than are individual traders (which moves prices

closer to intrinsic values), resulting in the higher informational efficiency of prices. Indeed, Edmans and Manso (2011) show

analytically that the competitive trading of blockholders impounds information into prices, which strengthens the threat of dis-

ciplinary trading, inducing higher managerial efforts. Empirically, prior research provides evidence that large shareholders are

better‐informed traders than other traders (see, e.g., Brockman & Yan, 2009; Bushee & Goodman, 2007; Gallagher, Gardner,

& Swan, 2013; Parrino, Sias, & Starks, 2003; Sias, Starks, & Titman, 2001; Yan & Zhang, 2009). Overall, these results are in

line with our premise.

Our empirical analysis is also based on the premise that managers are sensitive to stock performance due to compensation

contracts (Diamond & Verrecchia, 1982; Jensen & Murphy, 1990) and the market for corporate control (Laffont & Tirole, 1988;

Scharfstein, 1988; Stein, 1988).1

Fishman and Hagerty (1989) show that efficient stock prices can lead to better investment

decisions. Holmström and Tirole (1993) show that stock price reflects information that cannot be extracted from current or

future profit data and this additional information is useful for structuring managerial incentives. Chen, Goldstein, and Jiang

(2007) find a strong positive relation between the amount of private information in stock price and the sensitivity of corporate

investment to stock price. They interpret this result as evidence that managers learn about firms' fundamentals from private

information in stock price and make their investment decisions based on this information.2

To the extent that stock prices reflect the economic ramifications of managerial actions quickly and accurately through

information‐based trading of blockholders, managers are likely to refrain from making decisions that are detrimental to share-

holders. Although blockholders are motivated by their private desire to exploit mispricing, such self‐interested action can have

the social benefit of disciplining managers by raising the informational efficiency of prices. These considerations suggest that

managerial performance and therefore firm value are likely to increase with the presence of blockholders through the higher

informational efficiency of prices.

Using data on Schedule 13G filings by passive blockholders during the 12‐year period from 2001 through 2012, we show

that firm value increases with both the number of passive blockholders and the aggregate ownership of passive blockholders

after controlling for other possible determinants of firm value. We also show that the informational efficiency of prices in-

creases with the number and aggregate ownership of passive blockholders after controlling for other possible determinants of

pricing efficiency. These results support our conjecture that passive blockholders increase the informational efficiency of prices

because they have strong incentives to collect private information and trade on such information due to their large positions.

More importantly, we show that the informational efficiency of prices is indeed a channel through which passive blockholders

improve firm performance using causal mediation analysis.

Our study contributes to the literature in multiple dimensions. First, this paper investigates an interesting and emerging

research topic, i.e., the corporate governance role of passive blockholders through the channel of information‐based trading,

which is particularly relevant for the recent corporate finance literature on blockholders and corporate governance (see Edmans,

2014) and the broader literature on relations between corporate finance and financial markets. This paper provides an empirical

counterpart to theories that claim that blockholders' governance role is not limited to activism and intervention: blockholders