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One of the fundamental issues in modern corporate finance is the problem of separation of firm ownership from control. The gap between management and shareholders is potentially wide and the danger is great for agency problems to divert a widely-held firm's resources from their efficient use. If a shareholder decides he does not like what a firm's management is doing, he has two alternatives: He can intervene or he can exit---that is, he can work directly on changing the behavior of the firm's management or he can sell his shares. Intervention, sometimes referred to as “voice,” includes a variety of possible actions to compel changes in managerial behavior: replacement of boards of directors, support for takeover bids, and proxy initiatives to limit management discretion or to affect management compensation.

However, shareholder activity can also have indirect effects, because the foreknowledge by managers of the possible reactions of dissatisfied shareholders can alter managerial behavior. Thus we are not only interested in exit and intervention as behaviors by the blockholder, we are also interested in how they affect managerial behavior. That is, we are also interested in the ex ante incentive effects on managers of the threats of shareholder exit or intervention.

In this paper we focus on the dual aspect of the intervention mechanism: Intervention can improve the firm ex post (through direct action by the activist) or ex ante (through the threat to management). We build a model in which an activist shareholder can accumulate a toehold of shares. After observing the activist's toehold size, the manager decides whether to consume private benefits at the expense of shareholders. Once the managerial action is taken, the activist decides whether to extend the toehold and intervene, or to sell shares. Thus, the process can improve firm value through two channels: the direct intervention itself, and the effect of the threat of intervention on managerial behavior.

The model shows how ex ante threat and ex post intervention interact and how they are related to economic efficiency. For instance, in the model, more frequent ex post interventions are not necessarily a sign of enhanced economic efficiency. A weaker disciplinary role played by the intervention mechanism leads to lower firm value (because the manager is not disciplined ex ante), which can lead to more frequent ex post interventions, which are costly (both to the activist and the manager) but only partially recover the damage made to the firm value. Thus in this case more frequent ex post interventions are a sign of worsening corporate governance.

Therefore it is important to understand the circumstances in which observed levels of intervention actually correlate with improvement in firm value. Because we endogenize both the activist's decision to engage in activism and the manager's decision to take the bad action, we are better able to track the relation between the effectiveness of intervention and apparent empirical measures of that effectiveness. While the interventions themselves improve firm value, to the extent that they are substituting for the more efficient alternative of an ex ante threat disciplining the manager, the observation of interventions should correlate with decreasing firm value.

We provide conditions under which we predict a positive or negative correlation between firm value and observed degree of intervention. The sign of the correlation will depend not only on the source of the variation but also on the degree to which the two channels act as complements or substitutes. For instance if variation is due to differences in the effectiveness of activists in punishing firm management---as would be the case in business cycle downturns, when loss of a job would have more dire consequences---then the two mechanisms act as substitutes. When the variation is due to differences in the activist's ex post liquidity needs---activists flush with cash will be unlikely to need to sell for liquidity purposes---then the two mechanisms will be complementary. In the latter case, we should observe increases in intervention correlating with increases in firm value.

The model reveals that it is important to distinguish between sources of liquidity trading. Previous work has emphasized the dual nature of liquidity trading: that it makes it easier for activists to accumulate holdings, but also makes it harder to commit not to dissipate those holdings. Liquidity trading that does not interact with the activist's actions has a positive effect on market liquidity and on the activist's trading profits. It therefore leads to larger toehold accumulated by the activist and consequently increases chances of an equilibrium in which the activist intervenes. In contrast, liquidity trading that interacts with activist's actions leads to wider bid-ask spreads and weaker disciplinary role played by the intervention. This result has important implications for the literature that studies the role of market liquidity in corporate governance. To the best of our knowledge, this is the first paper to contrast two phases of liquidity trading and to show their differential effects on economic outcomes.

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