Ownership Structure, Liquidity Demand, and Shareholder Monitoring

Major shareholders can choose between undertaking costly actions that improve firm value (quot;monitoringquot;) and trading on private information. If investors face some chance of liquidity needs, share prices do not fully reveal how much monitoring occurs; thus, higher liquidity demand makes selling out more attractive than monitoring, decreasing monitoring and firm value. Higher liquidity demand also increases a major shareholder's incentive to gather additional costly information for use in trading; since informed trading is zero sum, this further decreases overall social welfare. Increasing the large shareholder's stake in the firm may not reduce this problem if the benefit/cost ratio for gathering speculative information exceeds that for monitoring. If other large investors can also gather speculative information, the major shareholder's gains from informed trading decrease, making monitoring more attractive. Nevertheless, such additional speculative activity is costly, offsetting its positive impact on monitoring. We discuss the implications of these results for the choice of ownership structure and market liquidity across firms, industries, and financial systems