Journal of Financial Economics 34 (1993) 31-51.

North-Holland

The hidden costs of stock market liquidity*

Amar Bhide
Haward Unioersity. Boston. MA 02163, USA

Received January 1991, final version received December 1992

The seemingly unrelated problems of stock market liquidity and manager-stockholder contracting
are closely intertwined. Active stockholders who reduce agency costs by providing internal monitor-
ing also reduce stock liquidity by creating information asymmetry problems. Conversely, stock
liquidity discourages internal monitoring by reducing the costs of exit of unhappy stockholders.
The U.S. has exceptionally many actively-traded firms with widely-diffused stockholding because
public policy has favored stock market liquidity over active investing. And, the benefits of stock
market liquidity must be weighed against the costs of impaired corporate governance.

1. Introduction

In 1984, then-SEC Chairman John Shad wrote: Fifty years ago, in the depths
of the depression, the nations securities markets were demoralized. Today they
are by far the best capital markets the world has ever known - the broadest, the
most active and efficient, and the fairest. The Securities and Exchange Commis-
sion has played an important role in the restoration of public confidence
. . . [and] has discharged with distinction its mandate to protect investors and
maintain fair and orderly markets [SEC (1984, p. l)].
The limited liquidity and breadth of many European markets, where secu-
rities regulation is relatively weak, seem consistent with Shads claims. For years,
The Economist (3/30/91, p. 79) reports, investors have complained that the

Correspondence to: Amar Bhide, Baker Library 365, Harvard Business School, Soldiers Field Road,
Boston, MA 02163, USA.
*This article has substantially refined the basic ideas contained in EfJicient Markets: Deficient
Governance (HBS working paper, March 1990). I am greatly indebted to Michael Jensen, who read
numerous subsequent drafts, offered invaluable criticism and suggestions, and provided constant
encouragement. Howard Stevenson was similarly generous with comments and time. Sugato
Bhattacharyya, Warren Buffett, Alfred Chandler, Iain Cockburn, Paul DeRosa, Steve Kaplan,
Arthur Rock, Andrei Shleifer (a referee), Clifford Smith (the editor), and numerous colleagues at
Harvard Business School provided useful comments and suggestions.
Breadth usually refers to the number of issues that enjoy liquid markets.

0304-405X/93/$06.00 c 1993---Elsevier Science Publishers B.V. All rights reserved

32 A. Bhide. @fTcienr gowvnance vs. liquidity

Swiss markets are too fragmented, too illiquid, opaque, and too expensive.
Companies do not reveal quarterly or line-of-business results. They may refuse
share registration, and so voting rights, to anyone they do not like,. . . [and the]
resulting tiered share structure has limited the market and depressed prices.
Transaction costs in the U.S., as fig. 1 shows, are half the level of those in
Germany, Italy, and Japan, which are the next most liquid markets. The block
traders of Wall Street, who can execute trades of millions of shares in a few
minutes without significant impact on market price, have few counterparts.
The apparent success of U.S. market regulation has led regulators in Europe
to establish disclosure requirements, one-shareeone-vote rules, and sanctions
against insider trading. U.S. rules have also apparently provided a model for
Eastern Europe, India, and other countries seeking to establish active stock
markets. The imitators may not fully appreciate the costs, however. My analysis
suggests that U.S. regulators have promoted market liquidity at the expense of
the efficient governance of firms. The U.S. model discourages Jensens (1989)
active investors, who provide valuable internal monitoring and who control
the compensation and tenure of managers. Firms listed on U.S. exchanges (like
virtually all businesses) started out with concentrated active stockholding.
Subsequent generations of stockholders, however, have been increasingly pass-
ive, and today at least half of publicly-listed equities - over a trillion and a half
dollars worth - are owned by investors who do not play an active role in firm
governance.

3 -

Fig. 1. Cost estimates for index trades by country, 1989 (percent of transaction value).
Index trade refers to a transaction of a portfolio comprising the standard local market index. Costs
include commissions, taxes, and average bid-asked spread. Source: Wells Fargo Nikko Investment
Advisers.
 A. Bhide, Efficient gooemance OS. liquidity 33

In the next section I show how U.S. policies designed to protect small
investors and the liquidity of U.S. equity markets have promoted investor
passivity and fragmentation of stockholding. In section 3, I explore the conse-
quence of the regulations that favor market liquidity at the expense of active
stockholding. In section 4, I discuss the implications for research and regulatory
change. The last section offers concluding remarks.

2. The bias of U.S. public policies

2.1. A useful analog?)

The impact of the unusually extensive and well-enforced regulations of equity
markets and investors in the U.S. may be compared to the consequences of bank
deposit guarantees. Without guarantees, wealthy depositors have an incentive to
concentrate their holdings in a few banks whose lending policies they can
monitor and possibly influence. But rules that guarantee small deposits give
wealthy depositors an incentive to open numerous accounts; moreover, incen-
tives to fragment deposits are amplified if special liabilities (such as limitations
on withdrawals) are imposed on large depositors and the transaction costs of
splitting deposits are low.
U.S. securities laws and other rules similarly discourage concentrated
active stockholding. For example, disclosure regulations and restrictions on
insider trading protect small stockholders and reduce the risks of diffuse
stockholding. The same seemingly benign rules increase the costs and liabili-
ties of an active stockholding role. Stockholders who sit on a firms board
are exposed to S.E.C. and class action suits and face greater constraints in
trading shares or providing goods or services to the firm than passive stock-
holders. The disclosure and insider trading rules also reduce the.costs of
breaking up concentrated holdings and diversifying portfolios by sustaining
market liquidity.
Conversely, policies that promote fragmentation of portfolios increase market
liquidity. The liquidity of a securities market refers to the extent to which it is
continuous, i.e., without large price changes between trades, and deep, i.e.,
with many buyers and sellers willing to trade just below or just above the
prevailing price [see Reilly (1985)]. Liquidity increases with the number of
stockholders [Demsetz (1968)]; when stock is held by a few active investors, the
continuity and depth of markets is impaired.

2.2. Historical origins

Many rules that make large investors passive and equity markets active were,
like deposit insurance, adopted in the New Deal to protect small investors.
34 A. Bhide, ,5JTcirnt gowwwnce DS. liquidifq

Protection of small investors became an issue after the Great Crash. Between
September 1, 1929 and July 1, 1932, stocks listed on the NYSE lost 83% of their
total value, and half of the $50 billion of new securities which had been offered in
the 1920s proved to be worthless [Seligman (1982, p. l)]. The Crash, according
to the SEC, brought the countrys business and financial systems to the verge of
disaster and followed a decade in which some 20 million shareholders took
advantage of the postwar prosperity and set out to make their killing on the
stock market, giving little thought to the inherent dangers in unbridled market
operation [SEC (1984, p. 7)].
Unlike previous panics, the Great Crash led to landmark securities legislation
in the form of the Securities Act and Securities and Exchange Act, as well as the
creation of the Securities and Exchange Commission. A legal expert of the time
observed that until the advent of the New Deal, the law relating to security
markets has been characterized by gradual growth rather than by abrupt
change.. . [W]hat has heretofore been evolution has become revolution [Meyer
(1934, p. 1 l)].
The primary reason offered for securities regulation, according to Phillips
and Zecher (1981) was to protect small investors. Federal intervention was
necessary not only because of the outraged feelings of voters proclaimed in
an SEC pamphlet but also because Americas economy was crippled without
investor confidence [SEC (1984, p. 7)]. A very numerous and widely dispersed
class of small individual and small institutional investors had become,
suggested the special counsel to a House subcommittee on securities acts,
a very important and essential source of investment capital [Hearings
(1944, p. 4)].

2.3. Intended and unintended consequences

The 1933 and 1934 Securities Acts sought to protect small investors in three
ways: ensuring adequate disclosure by firms to their investors, discouraging the
unfair use by insiders of information which is not made public [Meyer (1934,
p. 1 1)] and (as described in Section 2 of the 1934 Act) eliminating manipulation
and sudden and unreasonable fluctuations of security prices. But disclosure
requirements, insider trading rules, and rules to eliminate price manipulation, all
of which are meant to protect small investors, also promote market liquidity and
discourage large investors from playing an active role in firm governance. Each
is examined in turn.

Disclosure requirements. To help public investors make informed trading deci-

sions, the 1934 Act required the registration of publicly-traded securities. The
registration statement required information about the directors, officers, under-
writers, and large stockholders (and their remuneration), the organization and
financial condition of the corporation, and certain material contracts of the
corporation. Issuers were also required to file annual and quarterly reports,
whose form and detail could be prescribed by the SEC [Meyer 1934,
pp. 19-20)]. Over the years the SEC substantially increased the types of reports
required; examples of this expansion include disclosure by bank holding com-
panies, disclosure of management perks, overseas payments, replacement cost
accounting, and segment or line-of-business accounting [Phillips and Zecher
(1981)J
Another objective of regulating disclosure, especially in the area of proxy
solicitations, was to give small stockholders more information about the elec-
tion of directors and other issues put to shareholder vote. Section 14a of the
1934 Act gave the SEC broad powers over any person soliciting a proxy or
consent from another security holder. In its report recommending the adoption
of the section, the Committee on Interstate and Foreign Commerce of the U.S.
House of Representatives stated:

Fair corporate suffrage is an important right that should attach to every

equity security bought on a public exchange. Managements of properties
owned by the investing public should not be permitted to perpetuate
themselves by the misuse of corporate proxies.. . Insiders have at times
solicited proxies without fairly informing the stockholders of the purpose
for which the proxies are to be used and have used such proxies to take
from the stockholders for their own selfish advantage. Inasmuch as only the
exchanges make it possible for securities to be widely distributed among the
investing public, it follows as a corollary that the use of the exchanges
should involve a corresponding duty of according to shareholders fair
suffrage. [Hearings (1944, pp. 12- 13)].

The SECs first rules, adopted in 1935, were, according to testimony by

SEC Chairman Ganson Purcell in 1944, extremely rudimentary in nature
and merely prohibited falsehoods in proxy solicitations [Hearings (1944,
pp. 14-I 5)]. In 1938 the Commission adopted rules requiring affirmative
disclosure. The proxy statement had to show who the candidates were for
directorship, their security holdings, and some of their transactions with the
corporation.
In spite of opposition from representatives of industry and the financial
sector, and complaints about usurping the powers of Congress [Hearings (1944,
pp. 13, 149-159)], the SEC continued to expand its regulation of proxy state-
ments. Revisions of the rules in the 1940s required companies to give the
Commission an opportunity to examine proxy statements for ten days before
they were sent, and broadened the privilege of stockholders to present proposals
and to have them set forth in the management proxy materials. The revised rules
also required disclosure of the compensation of all officers and provided for
36 A. Bhide, Efficient goorvnance US. liquidity

more complete information regarding the compensation, dealings, associations,

and principal business of all directors [Purcell, Foster, and Hill (1946)].
The disclosure regulations were backed by a variety of enforcement devices.
The 1933 and 1934 securities laws provided criminal penalties for willful mate-
rial false or misleading statements, and empowered the SEC to suspend or
withdraw the registration of securities for failure to comply with the reporting
provisions of the Acts. Restitution for wrongs was also expected to be obtained
through derivative suits. Here SEC officials observed that although the Com-
mission usually had no official interest in class or derivative actions, the
Commission has had occasion, however, to advise the courts that the purposes
of the statutes it administers can be subserved by a liberal attitude towards class
suits for the enforcement of statutory obligations.. . [The Commission] recog-
nized the abuses of strikers and their raids on the corporate treasury, but
emphasized the general prophylactic and deterrent effect of the stockholders
suit [Purcell, Foster, and Hill (1946, pp. 1 l-12)].
The disclosure requirements raise the costs of active stockholding and reduce
the risks of diffuse stockholding. Active stockholding is discouraged by the
penalties and liabilities which make disclosure laws credible. For example, under
Section 20 of the 1934 Act, a stockholder who exercises domination over
a corporation through ownership of a majority of the stock, or with even less
than a majority, might be liable for the acts of the corporation [Meyer (1934,
p. 127)]. Similarly, rules requiring disclosure of material transactions with
insiders (and the consequent risks of class action suits) discourage active stock-
holding; they make the banks, suppliers, or customers of a firm less willing to
hold large blocks of stock or serve on boards.
Disclosure rules, instituted mainly to protect small investors, also encour-
age large investors to hold diffuse positions in many firms rather than play
an active stockholder role in a few. Mandating reliable, complete, and
timely reports reduces the risks for all diffuse investors, large and small.
Firm managers become more subject to the external discipline provided by
the market for managerial control. Self-dealing by controlling stockholders
is discouraged by the disclosure of material transactions with directors
and officers required in proxy solicitations as well as by the threat of class
action suits. In turn, these incentives to fragment portfolios promote market
liquidity.

Insider trading rules. Section 16 of the Securities Exchange Act seeks to

prevent the unfair use of information which may have been obtained by reason
of his relationship by officers, directors, or major stockholders. Accordingly,
Section 16(a) requires every officer, director, and 10% equity owner to period-
ically file statements showing their ownership of all equity securities. Section
16(b) provides that any short-term profits realized by such persons (i.e.,
due to purchases and sales within any six-month period) shall inure to and be
 A. B/Tide, JZfficienr gocernance ts, iiquidirq 37

recoverable by the company. The law provides criminal sanctions for failure to
report such transactions.
By most accounts, the SEC has zealously prosecuted the insider trading
provisions of the 1934 Act, and, arguably, has expanded the scope of its
provisions. For example, in the 1966 Texas Gulf Sulfur case, the SEC first asked
a federal court to order outsiders to make restitution to shareholders who sold
them stock [SEC (1984, p. 46)]. The agency has thus mitigated the information
asymmetry problem that would otherwise impair market liquidity. Without
effective restrictions on insider trading, prospects for a liquid market in which
many buyers bid for stocks without much regard for the identity or motivations
of the seller would be lower. Transactions would be more likely to require
protracted negotiations between known parties, undermining what Demsetz
calls the distinguishing characteristic of trading on organized exchanges, which
is the willingness of customers to let others buy and sell for them... [and]
conclude an exchange without a personal prior examination of the goods
[Demsetz (1968, p. 50)].
But the benefits of increased market liquidity are not equally shared by all
stockholders; while passive or diffuse shareholders enjoy a more level playing
field, active shareholders face greater restrictions on their trading. For example,
an insider is at risk in selling any stock before an earnings announcement.
Consequently, as Roe (1990) points out, provisions of the 1934 Act such as Rule
lo(b)-5 and Section 16(b), which are intended to discourage trading by insiders,
also act as a deterrent to playing an inside monitoring role. For some stock-
holders the deterrent may be minor; for example, insider trading laws make little
difference to active stockholders who own stock at a low tax basis and face
significant capital gains taxes upon sale. Tax-exempt institutions and other
intermediaries, on the other hand, have strong incentives to avoid compromis-
ing the liquidity of their holdings.
My interviews with corporate and pension fund managers suggest that inves-
tors are often reluctant to receive any private information from managers (let
alone take on board positions) which they believe would compromise their
fiduciary responsibility to protect the liquidity of their holdings. Institutions also
stay below the 10% ownership limit that triggers the Section 16(b) restrictions on
short-term trading. Insider trading and disclosure rules, which promote the
liquidity of passive stockholdings, thus have serious consequences for governance
because they limit liquidity for active stockholders: many large investors who own
sizeable blocks and could play an active role are instead resolutely passive.

2The term market is specified in Section 15 of the Securities Exchange Act of 1934. Per Meyers
(1934, pp. 106-107) interpretation of the section: It is a market which provides facilities for both the
purchase and sale of a security. A broker who stands ready either to buy or sell or to quote the price
at which he will buy or sell conducts such a market. The negotiation by a broker or a dealer of
a single sale or purchase, no matter how large, is not affected [by market regulation].
Rules to eliminate market manipulation. Section 9 (Prohibition Against Manip-
ulation of Security Prices) and Section 10 (Regulation of the Use of Manipula-
tive and Deceptive Devices) of the 1934 Act prohibited several practices
outright3 and subjected others (such as stop loss orders and short sales) to
regulation by the SEC. Section 6 required stock exchanges to register with the
SEC, to agree to comply with the Act, and to help enforce compliance by
exchange members. The SEC could deny registration to an exchange following
an inquiry into the exchanges ability to comply with the Act and the adequacy
of its rules. The SEC soon used its powers to close nine exchanges, and, in the
late 1930s according to Phillips and Zecher (198 1, p. 12), Chairman William 0.
Douglas virtually threatened the NYSE with takeover by the SEC if reforms
were not instituted.
In its public relations, the SEC emphasized its role in maintaining honest
markets. The early years of the SEC, write Phillips and Zecher (1981, p. 1 l),
were marked by [Chairman] Kennedys speeches and efforts to support and
encourage the mainstream of the flagging financial markets. He touted the
SECs better business bureau role and suggested the SEC could protect the
honest exchanges, traders, and investors from the fraudulent dealers.
Unlike policies to promote disclosure and discourage trading on insider
information, the rules against market manipulation do not discriminate against
active stockholders by imposing special liabilities and restrictions. Indirectly,
however, the rules increase fragmentation of investor holdings by reducing
diversification costs. The SECs better business bureau role builds confidence in
the exchanges ability to provide competitive rather than collusive trading and
information about real transactions rather than wash sales. With more trust-
worthy and liquid markets, an active stockholder can more cheaply swap its
holdings for a diversified portfolio.
Restraints on insider trading, disclosure requirements, and manipulative
practices are much weaker in the less-liquid markets outside the U.S. In the
Belgian market, described as a sad, largely deserted place [Bertoneche (1984)],
insider trading is considered unethical but not illegal. Most other countries in
Europe did not have statutes against insider trading until the mid-1980s, when
the European Community directed member countries to adopt a minimum level
of shareholder protection laws by 1992. U.S. occupation forces instituted laws
against insider trading in Japan after World War II, but officials have exercised
benign neglect of the rules [The Economist (5/19/90, p. 91)].

These included: wash sales or matched orders, if effected for the purpose of creating a false or
misleading appearance of the market; a series of transactions in which the price of a security is raised
or depressed, or in which the appearance of active trading is created for the purpose of inducing
purchases and sales by others; material false and misleading statements by brokers, dealers, sellers,
and buyers; and circulation of information (even if true) concerning market operations conducted for
a rise or decline.
 A. Bhide. .Eficient gorernance us. liquidit) 39

According to a survey by Ennis, Knupp, and Associates (1991, p. III-41),

disclosure of the ownership positions of principal shareholders, directors, and
officers is not required in markets outside the U.S. Financial reporting is less
frequent in most non-U.S. markets, and the reporting lag is often longer. Firms
in most European countries have broad latitude in creating and allocating
funds into and out of reserves, making interpretation of reported earnings
difficult. Fully consolidated statements and disclosure of individual line-of-
business information are predominant practices only in the U.S.

2.4. Regulation of internzediaries

Besides passing the Securities Acts, legislators also sought to protect small
investors after the Crash by regulating financial intermediaries such as banks
and investment trusts. The Great Crash focused attention on and galvanized
action against the many ways which a number of the nations financial institu-
tions had found to serve competing interests, their own included, writes Bines
(1978, p. l-l 1). For example, one of the purposes of the Glass-Steagall Acts
separation of investment banking and commercial and trust banking was to
eliminate the debasement of the fiduciary obligations towards their customers
possible when underwriting and advisory services are combined.
Nichols (1984, pp. 30-31) describes the events that helped secure passage of
the Glass-Steagall Act in 1933: The Pecora hearings on stock exchange prac-
tices focused attention on objectionable financial practices in the distribution of
securities generally, and, in particular, on the abuses involved in the relationship
between some of the largest banks and their securities affiliates. A full-blown
banking panic developed in late 1932 and early 1933. It culminated in President
Roosevelts declaration of a bank holiday in March 1933. . . . These events,
particularly the public outrage that followed the Pecora hearings, provided the
political environment necessary to pass Glasss proposals.
The Investment Company Act of 1940 was similarly facilitated, reports
Seligman (1982, pp. 222-226) by the widespread failure of the Investment Trusts
during and after the Crash. Until 1926, investment companies had played
a relatively minor role in the economy. In the years between 1926 and 1929,
however, the number of investment companies grew from 160 to 760 and total
assets from less than $1 billion to over $8 billion. The Crash reduced aggregate
investment company assets to $2.8 billion in 1930, and by 1936 approximately
half of the investment companies had gone out of business.
Rules to protect small investors curtailed the role financial intermediaries
could play in firm governance and encouraged the fragmentation of their
portfolios. The Investment Company Act (and the tax code) sets minimum levels
of diversification for mutual funds and precludes them from holding more than
10% of a firms stock. Glass-Steagall prevents banks from owning stock, and
regulations prevent insurance companies from investing more than a small
40 A. Bhide, Eficient gourrnance LS, /iquidirJ

fraction of their investment portfolio into the stock of a single company [Roe
(1990) and Grundfest (1990)].

2.5. Policies in the 1970s

The impact of New Deal legislation on market liquidity and active stockhold-
ing was muted for several decades. Until the 1960s 80% or more of equities were
directly owned by individual stockholders [Schwimmer and Malta (1976, p. 3)]
who faced high transaction costs on their stock trades. The Buttonwood Tree
Agreement of 1792 fixing stock commissions was still in effect. Individuals also
faced federal and state tax rates in excess of 70% on short-term gains and 50%
on long-term gains. Annual deductions for losses were then limited to $2,000
(and have since been raised to $3,000 per year). These high selling costs made
restrictions on insider transactions and other market regulations of little con-
cern. Individuals and families, who often acquire controlling blocks through
inheritance or entrepreneurial activity, were more likely to hold on to them.
Two policy changes promoted stockholder fragmentation and market liquid-
ity in the 1970s. One was the deregulation of stock commissions, which reduced
transaction costs. In April 1971 the SEC determined that commissions in excess
of $500,000 were to be negotiable; in the following year the break point was
reduced to $300,000. With the Securities Act amendments of 1975, commission
rates were made fully negotiable and large investors were able to negotiate fees
down from an average of 26 cents a share in April 1975 to 7.5 cents in 1986
[Report of the Presidential Task Force on Market Mechanisms (1988, p. H-15)].
The other policy change was the passage of ERISA in 1974 which (along with
other factors) increased the share of outstanding equities held by institutional
investors from 18.7% of listed stocks in 1960 to 42% by 1988. ERISA encour-
aged corporate pension fund investments in listed stocks by mandating the
proper funding of pensions and prohibiting plans from holding more than 10%
of the sponsors own stock. Institutional stock ownership also increased as
individuals shifted from direct investment in equities to holding mutual fund
shares and as public pension funds and nonprofit endowments abandoned their
traditional policies against investments in equities. Until 1968, for example,
public: funds in California and 15 other states did not own any stocks [Wall
Street Journal (6/28/90, p. Cl)]. By 1991, 43% of public funds were invested in
stocks, a shift which has been attributed both to studies demonstrating the
superior long-term returns of equities as well as to the discretion afforded
sponsors to underfund plans by making liberal assumptions of expected returns
[Mahar (1991, pp. 13314)].
Institutional investors not only face more restraints on active stockholding
[Roe (1990)], they also enjoy lower transaction costs than individual investors.
Unlike individual investors, tax-exempt pension funds and endowments do not
face high taxation of trading gains and low deductibility of losses. Size allows
 A. Bhide. Eflcienr governance us. liquidity 41

institutions to negotiate attractive commission rates. Consequently, institutions

can take greater advantage than can individuals of the fair and orderly markets
that the SEC has sought to maintain.

3. Consequences of the regulatory bias

3.1. The unusual U.S. equilibrium today

Before the New Deal, large companies in the U.S. (and elsewhere) were
characterized by significant active stockholding and limited liquidity for their
stocks. Securities markets in the U.S. and in Europe during the 19th century
developed around sovereign and other well-secured debt such as railroad and
utility bonds, not equity. Prior to 1920, Baskin (1988, p. 222) writes, there were
no large scale markets in common stock . . . [slhares were viewed as akin to
interests in partnerships and were simply conveniences for trading among
business associates rather than instruments for public issues. Promoters of
canals and railroads ~ the few businesses organized as joint stock companies
~ restricted ownership to known investors whom they believed to be both
wealthy and committed to the enterprise. The public at large perceived equities
as unduly speculative, and tales of the South Sea fiasco evoked instant horror
[Baskin (1988, p. 216)].
Active stockholders played a major role in financing U.S. industry. DuPont
family money helped Durant (and later Alfred Sloan) build General Motors.
Investors represented by J.P. Morgan helped Vail build A.T.&T. and Coffin
create the modern General Electric. The investors were in it for the long haul
_ the DuPonts fought Justice Department efforts to get them to sell their G.M.
stock - and they played an important oversight role. Pierre DuPont watched
over the family investment in G.M. as chairman of its board, in which capacity
he reviewed in a regular and formal fashion the performance of all its senior
executives and helped decide on their salary and bonuses. While he left the
details of financial and operating policy to executives, DuPont took part in the
Finance Committees critical decisions on important capital investments
[Chandler and Salsbury (1971, pp. 573, 580)].
Even today, virtually all new businesses are initially financed by active
stockholders. Financing for start-ups with high capital needs, for example, is
often provided by venture capital funds whose partners, writes Sahlman (1990,
p. 508) sit on boards of directors, help recruit and compensate key individuals,
work with suppliers and customers, help establish tactics and strategy, play
a major role in raising capital, and help structure transactions such as mergers
and acquisitions. ..
But unlike the DuPonts, modern venture capitalists are not long-term inves-
tors: they expect to sell out in five to seven years. Moreover, thanks to U.S.
42 A. Bhide, Ejficient gourrnance us. liquidit)

public policies, the holdings of venture capitalists (and other founders) are more
likely to be sold to diffuse stockholders. Liquid markets and passive institutions
pave the way for founding stockholders to cash in through one-time public
issues, gradual market sales, or a negotiated sale to a company with diffuse
stockholding, instead of selling their interests to other active investors.
Consequently, a significant share of U.S. stockholding has passed from
active to passive hands over time. The considerable attention accorded to
Warren Buffett, chairman of Berkshire Hathaway, reflects his unusual invest-
ment strategy. Berkshire seeks to own large blocks of a few securities we
have thought hard about [Buffett (1987, p. 83)], and Buffett is a director
of the companies that constitute Berkshires core holdings. His counsel is
apparently respected; Katharine Graham of the Washington Post refers to
Buffett as her mentor4 and in a crisis, as with Salomon Brothers in 1990, Buffett
stepped in as chairman to help effect sweeping changes in management. His
favored holding period is forever.. . Regardless of price, we have no interest at
all in selling any good businesses that Berkshire Hathaway owns, and are very
reluctant to sell sub-par businesses . . . gin rummy managerial behavior (discard
your least promising business at each turn) is not our style [Buffett (1987,
p. 52)]. (The turnover of Berkshires portfolio, we may note, is also constrained
by holdings of privately-placed convertible preferred stock, taxes that would be
due on significant realized gains, the costs of negotiating new block purchases,
and formal or informal commitments to firm managements not to sell to
unfriendly investors.)
In contrast, the more typical institutional investors portfolio in the United
States contains hundreds of stocks, each held for about a year.5 Institutions tend
to follow the so-called Wall Street rule: sell the stock if you are unhappy with
management [Brickley, Lease, and Smith (1988)]. They may sometimes own
large blocks of stock, but these holdings are passive and the institutions role in
firm governance is minor. Grundfest (1990, p. 105) observes that in both
Germany and Japan, corporate investors and intermediaries are able to reach
deep into the inner workings of portfolio companies to effect fundamental
management change.. In the U.S., in contrast, when large institutional inves-
tors suggest that they might like to have some influence on management
succession at General Motors - a company that has hardly distinguished itself
for skillful management - they are met with icy rejection and explicit warnings
that presumptuous investors had better learn their place.
Outside the U.S., we see large investors whose holdings are immobilized by
special classes of restricted stock and long-term financing or other business

4Personal correspondence with author.

5New York Times (2/17/88, p. D2); quarterly data on holdings and transactions is reported by
institutions in 13(f) filings and is available directly from the SEC or from commercial services like
Spectrum.
 A. B/Tide, Eficient gouemance us. liquidit) 43

relationships. French and Poterba (1989) have estimated that in Japan, 48% of
outstanding stock (by value) is held on a near-permanent basis by a network of
affiliated banks, insurance companies, suppliers, and customers. Corporate
cross-ownership is also reported to be substantial in Germany and Austria, and
long-term family ownership is frequently cited as significant in Italy, Spain,
Sweden, the Far Eastern markets (including Japan), and Turkey. A joint study
by Salomon Brothers and Frank Russell [cited in Ennis, Knupp, and Associates
(1991)] has estimated that large long-term block holdings account for over 20%
of market capitalization in all but two non-U.S. countries.
U.S. institutions do, however, derive considerable benefit from, and contrib-
ute to, market liquidity. Institutions rate of trading has grown even faster than
their share of stockholding. Trading by institutions, which accounted for
17-28% of total NYSE volume in the postwar period through 1963, rose to
52% by 1969 [Seligman (1982, pp. 351-3521 and 70% by 1988.6 Therefore, the
stocks of firms like Digital Equipment Corporation enjoy deep and continuous
markets as they pass from venture capital to institutional portfolios.

3.2. Costs and hewfits

The liquidity promoted by U.S. policies has obvious benefits: investors

can encash their assets quickly and diversify cheaply. The same policies, how-
ever, impair governance by encouraging diffuse stockholding and discouraging
active investing. Diffuse stockholders face more serious collective action
problems [Shleifer and Vishny (1986)] and cannot be provided with confiden-
tial information, included on boards, or given any other active role in firm
governance.
An active inside stockholder role is crucial because evaluating a firms man-
agement is, necessarily, highly subjective. Stockholders have to weigh observed
outcomes against their yuesses about what would have happened if managers
had followed different strategies. Losses do not necessarily establish managerial
incompetence since the alternatives might have been worse. If concrete per-
formance objectives are set, stockholders have to use judgement in evaluating
whether managers are gaming the targets, e.g., if cash flow goals are being met
by skimping on maintenance. Active stockholders who can obtain confidential
data and maintain close contact with managers enjoy obvious advantages in
making these subjective evaluations.

The Securities Industry of the Eighties (1990, pp. 21-23) published by the Securities Industry
Association,
In my March 1990 working paper, I had framed the advantages ofactive stockholding in terms of
the trust and communication that can only develop through close, long-term relationships between
managers and a small number of known stockholders. A similar argument has subsequently
appeared in Jacobs (1991) and Porter (1992).
44 A. Bhide, Eficient governance us. liquidity

The governance problem is acute in the large U.S. firms that are favored by
institutional investors: institutional ownership of the largest 200 firms in 1986,
for example, was over 50%, compared to 28% for all other public firms
[compiled from Business Week (4/17/87,pp. 46657)]. Wealthy.individuals and
families are more likely to concentrate their investments in smaller companies in
which they can hold controlling blocks. A study by Holderness and Sheehan
(1988) shows that NYSE and Amex firms with concentrated individual owner-
ship had, on average, less than one-fifth the market value and one-third the total
sales of all NYSE and Amex firms. In 90% of the firms with controlling
individual ownership, the majority shareholder was either an officer or director
of the corporation.
But monitoring by active stockholders is important for large firms as well.
Large firms in a variety of businesses (mainframe computers, aerospace, and
pharmaceuticals, to name only a few) pursue strategies of preemptive commit-
ment in capacity, R&D, or product development, which they cannot reveal to
public stockholders. Their vertical, horizontal, or geographic diversification also
limits the effectiveness of external monitoring; the complex operations and
results of a firm with global manufacturing and a broad product line cannot be
easily evaluated without inside information.
The market for corporate control has apparently compensated somewhat for
the decline of active stockholding. The evidence suggests [Bhide (1988, pp.
112-l 14)] that with increased institutional stockholding, the external scrutiny
of public firms by Wall Street has risen. Increased liquidity may also have
ameliorated the problem of fragmented stockholding by allowing takeover
specialists to assemble blocks cheaply. But greater external scrutiny and the
lower cost of assembling blocks cannot provide the same level of monitoring
and discipline as active stockholding. It is difficult to sustain Rappaports (1990)
claim that unsolicited tender offers have become (or ever were) the most
effective check on management autonomy ever devised. Acquirers who make
unsolicited tender offers operate under significant informational constraints:
they have to raise money deal by deal, making their case to financiers from
publicly available data [Bhide (1989)]. Even at their peak in 1985-1987, these
acquirers posed a threat to only a small number of diversified firms whose
break-up values could be reliably determined from public data to be signifi-
cantly higher than their market values.
Outside stockholders, analysts, or takeover specialists cannot easily distin-
guish between a CEOs luck and ability and determine appropriate levels of
compensation accordingly. Warren Buffet& who sits on the board of Salomon as
a major investor, could, in the 1991 government bond auction scandal, more
easily assess the culpability of the firms CEO and the organizational conse-
quences of replacing the CEO than could outside stockholders reading press
reports. Judgements by managers, and therefore of managers, are necessarily
subjective and require considerable confidential and contextual information.
 A. Bhide. EfJicient governance vs. liquidity 45

Partisans of regulation could argue that the reduced internal monitoring by

active stockholders is more than offset by the liquidity of stock markets, with the
net result of reducing the cost of capital for U.S. firms. But international
comparisons suggest that the exceptional liquidity of U.S. markets does not
provide its actively-traded firms with advantages in issuing equity. Baskin (1988,
p. 213) finds that large public corporations from all major industrialized nations,
including the U.S., apparently issue common stock to raise funds only in the
most exigent circumstances, and that macroeconomic evidence from all coun-
tries suggests that the quantity of funds raised by new equity issues - especially
by established firms - appears to be relatively insignificant. We cannot, how-
ever, rule out the possibility that the earnings retained by U.S. firms with liquid
stocks are more highly valued by investors, and other potential benefits of
regulation, such as the increased security of pension and mutual funds, are
difficult to measure.

4. Implications for research and public policy

4.1. A research agenda

Several questions need to be investigated to improve our understanding of the

consequences of regulation, including:

(1) What proportions of concentrated and d@use stockholding maximize firm

values?

Firms usually start with fully-concentrated stockholding, with all investors

playing an active role in governance. Their stock, however, cannot be readily
traded in an auction-type market. Market liquidity is impaired because of the
small number of stockholders [Demsetz (1968)] as well as the information
advantages they are expected to possess. The high costs of exit give stockholders
an incentive to demand an active role in firm governance through, for example,
seats on boards of directors. By publicly assuming board responsibilities, inves-
tors further undermine the liquidity of their stock: there is now no question that
they are insiders.
If the proportion of the firms equity held by diffuse investors is subsequently
increased (through, for instance, a public issue), liquidity increases because of the
larger number of stockholders. However, incentives for the blockholders to
provide inside monitoring decline because the blockholders do not receive the
full returns from their investment in monitoring. When stockholding is fully
diffused, the firms stock is likely to be the most liquid, but inside monitoring by
stockholders is out of the question.
We may speculate that value-maximizing firms will try to issue some stock to
diffuse stockholders who can provide liquidity, keeping the rest for blockholders
46 A. Bhide, EfJient governance LS,liquidit?

who can provide inside monitoring. Even modest liquidity can provide great
advantages in raising capital. Price discovery in a public market provides
unbiased (albeit informationally deficient) valuations which are less easily ma-
nipulated than appraisals of private firms. A mutual fund that holds listed rather
than private equities therefore faces lower agency costs in raising funds from
investors, even if its portfolio is not very liquid and redemption costs for the
mutual fund shareholders are high. At the same time, effective monitoring
requires subjective judgements8 based on private information which cannot be
revealed to public stockholders.
The analysis is complicated, however, by potential conflicts between the active
and diffuse stockholders. Controlling stockholders are relatively immune to
takeover threats and have a considerable potential for self-dealing [Holderness
and Sheehan (1988)]. In fact, from the point of view of passive stockholders,
relying on active investors may be more costly in some situations than relying
on the market for corporate control, and gains from better monitoring of
managers might be fully offset by these additional agency costs.

(2) Whatjirm policies are likely to provide an optimal mix of active stockholding
and liquidity?

Liquidity and active stockholding depend not only on the relative proportion
of stock issued to diffuse and concentrated stockholders but on a number of
other policies as well. A firm can encourage active stockholding by selling
blockholders securities that carry superior rights and returns but limited mar-
ketability, such as letter or convertible stock issued at a discount or super-voting
Class A-type stock. Or, firms can invest in liquidity [Amihud and Mendelson
(1986)] through standardization of securities, presentations to stock analysts,
audits by reputable accountants, listing on national rather than regional ex-
changes, stock splits, and so on.
An optimal policy must protect the interests of diffuse stockholders (and other
providers of liquidity, such as market makers) while maintaining adequate
incentives for active stockholding. If the firm cannot provide credible safeguards
for diffuse stockholders against self-dealing by the blockholders, it will remain
a private firm. On the other hand, if the blockholders are not provided with
superior returns, they will have little incentive to provide monitoring and
(especially with a liquid market) will tend to fragment their holdings. In a
crisis, for example, blockholders are more likely to sell rather than intervene if
they have to fully share the benefits of their intervention with the passive

The absence of objective measures is arguably a necessary condition for profits. Knight (1921)
argued that profits ate a reward for assuming responsibility for unmeasurable and unquantifiable
risk, which he called uncertainty. With uncertainty, managerial decisions and subsequent evalu-
ations of their performance requite intuition and judgement.
 A. Bhide, Eficienr governance vs. liquidity 47

stockholders. Therefore, firms that do not provide satisfactory incentives for

blockholders will evolve towards fully-diffused ownership.
The challenge of simultaneously sustaining liquidity and internal monitoring
is illustrated by the case of debt securities. Corporate bonds contain no provi-
sion for inside monitoring by diffuse bondholders and can be freely traded.
Unsecured business loans, in contrast, require bankers to rely heavily upon
their impression and judgment about management and demand background
information that typically makes [the banker]. . . an insider [Cockrum (1970,
p. 852)J. This confidential and idiosyncratic data precludes trading; fear of
lemons [Akerlof (1970)] would deter banks from purchasing claims originated
by other lenders. The agency-cost advantages of inside monitoring and long-
term relationships with a bank are thus necessarily accompanied by illiquidity of
the lenders claims. Efforts to establish liquid markets in debt contracts (such as
syndicated loans and high-yield bonds), while maintaining internal monitoring
by creditors, have not enjoyed widespread success. (As a general rule, we find
liquid markets in tangible commodities or well-secured and standardized claims
such as government bonds or currency futures. Claims for which the judgment
of performance requires private or relation-specific knowledge can rarely be
freely traded.)
Observation of firm policies in the U.S. and elsewhere suggests that there is no
simple formula for solving the problem. Pending more research, we may specu-
late that an optimal policy package will depend on several firm-specific factors
such as the transparency of its business performance and strategy, the reputa-
tion of its active stockholders and managers, free cash flow patterns, and so on.
Optimal policies are also likely to depend on social norms and mass psychology.
For example, in spite of the reputation of the Tokyo Stock Exchange as an
insider traders paradise [The Economist (5/19/90, p. 91)], small investors buy
and sell stocks actively and have apparently not been overly concerned about
self-dealing by stockholders who also provide goods and services to the firms
they control. Consequently, Japanese firms can place high proportions of stock
with active investors and provide few safeguards to diffuse stockholders without
significant loss of liquidity.

(3) Do U.S. regulations help or hinder firms in following optimal policies?

One hypothesis is that U.S. regulations help firms (and exchanges) make
credible commitments to public shareholders to provide, for example, honest
and timely disclosure and protection from market manipulators or traders with
inside information. In this view, regulations constitute a positive externality
without which markets would be less liquid than optimal and firms would face
higher costs in raising capital from small investors.
The alternative hypothesis is that regulation unduly constrains the choices of
firms and investors and prevents efficient contracting. Listed firms that do not
48 A. Bhide, _Ej&ient governance us. liquidily

wish to encourage diffuse stockholding are nonetheless required to provide

extensive public disclosure. Pension funds cannot freely choose to give up
liquidity of their assets for more control rights; they cannot, for example, directly
purchase special securities with superior voting rights. Circumventing these
regulations (for instance, through institutional investments in LB0 partner-
ships) involves additional agency costs. Regulation thus induces an equilibrium
with less-than-optimal active stockholding.

This agenda is challenging and calls for a multi-pronged research strategy.

Few of the problems are likely to yield closed-form analytical solutions. There-
fore, conventional theory building and testing should be accompanied by careful
field research of alternative institutional structures (such as LB0 associations,
venture capital firms, family trusts, and the Japanese keiretsu firms) and the
regulatory conditions in which they operate.

4.2. Policy choices

Although we lack the theory and evidence to propose a program of reform, we

can describe the basic tensions involved in changing the current U.S. equilib-
rium. Many policy makers and theorists who believe that U.S. firms face
a serious governance problem look to impersonal external mechanisms for
a solution. They seek to align the interests of managers and stockholders by
lowering the costs of mounting proxy contests and making tender offers or, as
recently proposed by the SEC, by allowing stockholders to vote on (nonbinding)
resolutions about managerial compensation. Porter (1992) has suggested that
companies report strategic as well as financial data. These changes purport to
foster better governance, more protection for small stockholders, and liquid
markets.
The analysis in this paper suggests that the governance problem lies in
inadequate incentives for internal monitoring, which may be further eroded by,
for instance, requiring more complete disclosure. The U.S. market provides
more external monitoring than any other; arguably, it provides too much.
Significant improvement in governance requires real tradeoffs: policies to en-
courage more active stockholding will entail less-liquid equity markets and
greater risks for small investors.
The vision of round-the-clock trading, globally-diversified investors, and
computerized matching systems to further reduce transactions costs conflicts
with better governance of firms. Large holdings by active stockholders will
reduce the float of stock that is free to trade. Ceteris paribus, we would expect
less-active and less-continuous trading. Market makers would widen bid-asked
spreads. Brokers would devote fewer resources to stocks with less float, and
trading induced by their phone calls and research reports would be reduced.
 A. Bhide, Effeient governance us. liquidity 49

It is questionable, however, whether high liquidity per se will be seriously

missed. Large pools of capital such as pension funds and endowments, writes
Light (1989, p. 63), dont really need the liquidity the public market offers.. .
[They] can project their cash needs well into the future based on predictable
factors such as employee demographics..
Most individual investors are wealthy and treat stocks as a long-term holding.
[Mlore than three-quarters of all Americans, the Brady Commission noted,
still own directly no stock at all. Less than 1% of Americans own 50% of all the
stock outstanding, and just 10% account for 90% of it [Report of the Presiden-
tial Task Force on Market Mechanisms (1988, p. VIII-l)]. These investors can
easily hold Treasuries, municipal bonds, or bank deposits for their liquidity
needs. Even the less well-to-do appear to hold substantial amounts of other
assets for liquidity. According to one estimate, the average small investors
financial portfolio (i.e., excluding personal real estate) contains 44% cash equiv-
alents (CDs and money market accounts) compared to 31% stock and stock
mutual funds [Money (10/89, p. 78)].
The risk of malfeasance by financial intermediaries poses a more serious issue.
When the assets of mutual and pension fund were relatively small, their free-
riding was not a critical problem; now, improved governance requires these
institutions to play an active role. But allowing mutual and pension fund
managers to concentrate holdings, sit on boards, and purchase untraded con-
vertible preferred stock at a discount increases the risks for their clients. Clients
will therefore have to take greater responsibility for determining, for example,
whether the mutual fund managers are receiving side payments from managers
of the firms on whose boards they sit. Occasionally, we may expect greed, lax
scrutiny, or ingenious fraud to cause serious loss for investors or retirees.
Whether politics will permit the interests of the many stockholders to prevail
over those of the unlucky or imprudent few is an open question.
More active stockholding by intermediaries need not, however, be accom-
panied by a return to what was claimed to be the excessive power of financial
houses. There were only a small number of wealthy investors in the J.P. Morgan
era [Galbraith (1954, ch. X)], who were represented by an even smaller number
of financiers. Wealth is much more broadly distributed today and is channeled
through numerous intermediaries; there are about a thousand investment man-
agers listed in the Money Market Directory, for example. If intermediaries were
to play an active stockholding role, we might expect the number of investment
managers to grow and the assets per manager to decline. Fragmentation in the
investment management business is likely to increase because there are greater
economies of scale in trading securities using information from computerized
data bases or brokerage reports than in the labor-intensive activity of participat-
ing in firm governance. To illustrate, State Street, utilizing what it describes as
quantitative indexed strategies, managed $62 billion of securities with a staff of
61 professionals [Nelsons Money Market Directory (1991)]. In contrast, Jensen
50 A. Bhide, Qficienl gocrrnance cs. liquidit?

(1989) found that the typical large LB0 firm employed 13 professionals to
manage (by my rough estimate) equity portfolios of between $224 billion.

5. Conclusion

The analysis in this paper suggests that enhanced market liquidity has come
at a price. Rules that now fragment intermediaries holdings prevent them from
playing a meaningful shareholder role and may actually have increased the
concentration of power. In place of the Morgan interests, we have the chairmen
of diversified companies like General Electric holding sway over subsidiaries
that dominate hundreds of SIC codes. Moreover, the power of the House of
Morgan was diluted by accountability to its investors, a restraint from which the
chairmen of large firms seem to be relatively free.
The SECs role in protecting investors and sustaining market liquidity must
be weighed not just against the few billion dollars it costs firms to comply with
disclosure regulations, but also against the more serious costs of impaired
corporate governance. Wall Street owes a great and unacknowledged debt to its
regulators; whether the Main Street stockholder has done as well is debatable.

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