Governance through trading: Does institutional trading discipline empire building and earnings management?

Abstract

This paper empirically identifies an important external corporate governance mechanism through which the institutional trading improves firm values and disciplines managers from conducting value-destroying behaviors. We propose a reward-punishment intensity (RPI) measure based on institutional investors' absolute position changes, and find it is positively associated with firm's future risk-adjusted returns and Tobin's Q. Importantly, we find that firms with higher RPI exhibit less subsequent empire building and earnings management. Our results suggest that the improved firm values can be attributed to the discipline effect of institutional trading on managers, which is in line with the argument of 'Governance Through Trading'. Furthermore, we find that the exogenous liquidity shock of decimalization augments the governance effect of institutional trading. We also find that the discipline effect is more pronounced for firms with lower institutional ownership concentration, higher stock liquidity, and higher managers' wealth-performance sensitivity, which further supports the governance role of the RPI.