Liquidity and Corporate Governance

This paper discusses the relationship between stock market liquidity and corporate governance. Both concepts are widely investigated from different angles in the literature. It is generally agreed that they are related so that better corporate governance implies higher liquidity for shares of listed companies. However, the importance of good corporate governance for the market liquidity of the share will differ depending on the characteristics of the firm’s business. Good corporate governance will be particularly important in reducing agency problems in firms subject to a high degree of uncertainty. Proper corporate governance, in other words, matters most in cases where external assessment of the firm’s business prospects is difficult, while it is less important for value creation in firms where the business is easier to understand.


Liquidity and Corporate Governance
Liquidity is generally seen as a desirable property for the shares of a listed firm. Better liquidity makes it easier for the owner to sell some of the shares, should an unforeseen need for cash arise. Better liquidity also makes observed prices more reliable since more competition between traders on both sides of the market will cause any temporary mispricing to vanish more quickly. As for corporate governance, good corporate governance is also a desirable feature of listed firms. Good corporate governance implies that the shareholders' interests are reliably taken into account. Good corporate governance will accordingly reduce the share price discount caused by investors' perception of how likely it is that those who run the firm will extract money from it at the shareholders' expense in some more or less sophisticated way. This paper focuses on to what extent high liquidity and good corporate governance, both being in shareholders' interests, do reflect the same fundamental firm characteristics. The value relevance for shareholders of both properties stems from risk caused by information asymmetry as perceived by outside investors. Better corporate governance will reduce information asymmetry and reduced information asymmetry risks will increase liquidity. However, for some firms good corporate governance will be more important for market liquidity than for other firms.
In the following the concept liquidity will be discussed first, in order to arrive at a definition that seems consistent with how the concept has been commonly used in the literature. Next, we will discuss what "Good Corporate Governance" as a concept stands for, with the same goal in mind. Given these definitions, we will then specify how the concepts are related and which firm characteristics are expected to impact the correlation between on one hand measured corporate governance quality of the firm, and on the other hand the stock market liquidity of the firm's shares. The challenges to corporate governance in trying to address information asymmetry issues properly will then be discussed. A brief summary concludes the paper.

Liquidity
Liquidity is an important aspect of any market for financial securities. With the "liquidity" of an asset in general we understand how easy it is to buy or sell the asset at any point in time. The less costly it is to transform the asset into money, or vice versa, the more liquid is this market. A closer look reveals that there are several relevant dimensions to liquidity. Following Kyle (1985) there is what he calls "tightness" i.e. how much it costs to turn around a position in the asset over a short period of time, "depth" i.e. how large an order flow innovation has to be to change prices by a given amount, and "resiliency" which is how rapidly prices recover from a random, uninformative shock. Even if these three aspects are correlated, they are not identical.
A well-established insight from actual markets is that liquidity tend to be related to presumed information asymmetry concerning the asset. Since Akerlof's (1970) seminal paper it is well known that information asymmetry will give rise to expected trading costs for uninformed market participants. The reason is that a higher degree of information asymmetry for an uninformed market participant implies a higher likelihood to end up trading with an informed counterpart, that is a trader who happens to know that the present transaction price differs from the actual value to the informed trader's advantage. This information asymmetry, as Akerlof (1970) explained, may result in a total breakdown of the market for the good. Market failure can normally be avoided, but the information asymmetry must be taken into account by a potential uninformed market participant as part of expected trading costs in that market.
Many formal models that incorporate these expected information asymmetry costs have been presented, the model by Kyle (1985) being among the first. Easley & O'Hara (2004) show that in an incomplete asset market with private and public information an equilibrium exists in which shares with more private information command a higher expected return than shares with less public information, due to the difference in the risk for an uniformed investor to end up making a trade with a better informed counterpart. In a companion empirical paper Easley, Hvidkjaer and O'Hara (2002) show that their measure of the probability of conducting a trade with an informed counterpart, the so called PIN measure, first proposed by Easley, Kiefer, O'Hara and Paperman (1996), indeed provides a significant explanation for differences in future stock returns in large cross sections of stock returns for US firms. The time varying nature of prevailing information asymmetry and how it is captured in a dynamic version of the original PIN-measure is discussed in Easley, Engle, O'Hara & Wu (2008). Easley, Hvidkjaer and O'Hara (2010) report results in support of a significant priced dynamic PIN-factor on US stock returns from 1982-2002. For an example of independent results in support of a priced PIN measure see Agudelo, Giraldo & Villarraga (2015) who find that the dynamic version of the PIN measure seems to capture information asymmetry in six different Latin American markets. However, it is important to keep in mind that all actual measures of the degree of information asymmetry for a given company's shares at a given point in time are likely to contain considerable measurement problems.

Corporate Governance
In the following I will take it for granted that it is the corporate board that is responsible for the quality of corporate governance of the firm. I will assume that the board is there to promote value creation as the goal for the firm's activities, or more precisely to maximize the long-run value of the equity in the firm. As argued among others by Michael Jensen (2001), if the firm is run in the long-run interests of its shareholders it will normally also act in a way that is consistent with its other stakeholders' interests. Any attempts by a firm, that faces competition in its output, as well as input markets, to exploit customers, employees or other input providers will make these counterparts shun the firm and a loss for the firm and its shareholders will consequently occur.
Promoting value creation by the firm is far from a trivial task, though. The reason for this is vividly described in the following quote from the Economist: AIRPORT BOOKSHOPS teem with guides that promise to teach executives the secrets of success. Read this tome, follow this philosophy, change your habits and you too can be a management titan. As a moment's reflection on business history demonstrates, there is no sure-fire route to glory. Instead, running a company is a permanent exercise in juggling trade-offs. What is the right course of action may vary at different times, and in different industries. The Economist August 28th, 2019 This description of the job that executives are doing highlights why the task of the corporate board is so difficult. The board must regularly judge whether the CEO of the firm and the top management team is doing a proper job in "juggling" the relevant "trade-offs" in the firm's day-to-day business. Shleifer and Vishny (1997), in a widely cited survey article, claim that the main role of corporate governance is to reduce moral hazard on behalf of management, in effect to reduce the likelihood of attempts by managers to enrich themselves at the expense of shareholders. This puts the focus on possible attempts of top managers to enrich themselves at shareholders' expense. In the wake of the much-publicised corporate scandals like Enron and WorldCom in the USA corporate governance came to a large extent to be seen in a more limited sense as a mechanism by which fraudulent activity by the top-management can be discouraged. Increasing the likelihood of early detection of any fraudulent activity will naturally reduce the temptation for the top management to cheat the firm's shareholders.
However, losses of a much larger magnitude than those caused by outright fraud 2 may accrue to the shareholders of a firm if the top management for personal reasons bypasses large projects with huge potential impact on the firm's future profits. Such projects could be radical restructuring in connection to introduction of new technology, acquisition of extensive complementary production capacity, and spinning off major parts of the present operations of the firm to another firm for a significant premium above the value of these parts as presently being used in the firm. The expected value increase to shareholders in these types of projects may simply fail to adequately compensate for the required additional personal effort from management and for exposure to risk of a possible project failure. Since the top management has a superior overview of the firm's business environment it can deliberately play down the likely benefits and exaggerate the risks of the project and thus justify the decision not to embark on the project. For nonexecutives on the board, who are not intimately involved in charting strategic alternatives for the firm, such biases may be hard to detect, and even more difficult to convincingly pinpoint in a board meeting. 3 Of key importance for board efficiency is to safeguard that as much relevant information as possible will reach the board. As pointed out by Adams and Ferreira (2005) the top management is in a position to withhold crucial strategic information from the board. As a result, an overly critical attitude by the board towards the top management will most likely make management less willing to reveal any unfavourable information. An efficient board must pay close attention to how the management can be induced to update the board also on issues that may result from past management mistakes, and about strategic alternatives that management for personal reasons may dislike. 2 Shleifer and Vishny (1997) recognise this too. E.g. they write: "…perhaps most important, managers can expropriate shareholders by entrenching themselves and staying on the job even if they are no longer competent or qualified to run the firm." 3 Avoidance of expected value increasing projects is a particularly relevant form of executive moral hazard in today's world when rapid technological development creates new opportunities and renders old production solutions obsolete at an everincreasing pace. In such an environment, proper judgement on how willing and capable the management is to handle relevant challenges imposed by the rapidly changing business conditions require much more than careful reading of financial reports and other information that the firm is required to disclose. To complicate matters, as argued in Berglund (2014), mandating management to publicly disclose all information needed to make proper judgement on the management's abilities will not always be in the best interest of the firm's shareholders. For instance, pieces of information that would clearly benefit competitors should, in the best interest of the firm's owners, usually not be disclosed.
In summary, proper handling of corporate governance issues in today's world is a demanding task. Board members that understand the essential features of the business at hand, and are good at expressing their views, are needed to properly address that task. In addition, these persons have to possess exceptional personal integrity to have the courage to bring up observations that are likely to be unpleasant for the top management of the firm.

How liquidity relates to corporate governance
The relationship between the quality of the corporate governance of a firm and the market liquidity of its shares has been subject of many well-known studies in Finance. In an influential early article Coffee (1991) argues that liquid stock market trading of a firm's shares will discourage institutional block holders from engaging in the corporate governance of the firm. The reason according to Coffee (1991) is that with a liquid market it is cheaper for the block holder to sell its shares than to actively orchestrate a change in cases where the block holder observes corporate governance issues that need to be addressed in that firm. However, this view is challenged by Maug (1998) who notes that with a liquid market a block holder can reap larger benefits from addressing corporate governance issues in a target firm simply by increasing its holdings without a mitigating impact on the share price. Hence Maug (1998) concludes that there is no conflict between market liquidity and vigilant large shareholders that monitor the firm's management. In support of this conclusion Norli, Ostergaard and Schindele (2014) show that higher liquidity of a firm's shares significantly increases the likelihood that the firm will be subject to shareholder activism in a sample of US firms during 1994-2007. Helling, Maury and Liljeblom (2019 show that the impact of large institutional owners on R&D investments is higher in US firms with more liquid shares. John, Xu, Xue, & Zhuang (2019) analyzing the consequences of a reform that substantially increased the liquidity of some shares in the Chinese stock market conclude that large shareholders responded by improving corporate governance of their firms rather than selling off their shares.
Furthermore, Holmström and Tirole (1993) point out that better liquidity allows the board to use the share price to more efficiently reward the top management for decisions that increase firm value. Better liquidity, in other words, allows more precise alignment of interests between top-management and shareholders.
The underlying factor that ties the market liquidity of a listed firm to its corporate governance is information asymmetry. If uninformed investors believe that likelihood of ending up in a trade with a better-informed counterpart is high, they will require an expected compensation for this risk as shown among others by Easly and O'Hara (2004). Thus, a share that is subject to less information asymmetry in the stock market will trade at a higher price than a similar share subject to more 7 information asymmetry. Good corporate governance accordingly mandates that the corporate board should favor timely and accurate information disclosure. Firms with good corporate governance will be subject less information asymmetry than firms with bad corporate governance. Furthermore, since less information asymmetry will reduce expected trading costs from adverse selection, trading in the shares will also be more attractive, resulting in higher liquidity.
The hypothesis of a positive relationship between corporate governance and liquidity is supported by empirical studies. Chung, Elder and Kim (2010), using a broad sample of NYSE and Nasdaq listed firms in the USA, show that there is a clearly significant relationship between a broad based measure of the quality of internal corporate governance, a measure that they construct based on data from ISS, and the liquidity of trading the firm's shares. This relationship is remarkably robust when controlling for confounding factors. Lee, Chung and Yang (2016) show that the same result holds when analysing the informational efficiency of the stock price instead of liquidity. Better corporate governance implies more accurate stock price reactions to new information. This further supports the conjecture that good governance puts stronger pressure on management to release accurate and timely information.
Lehmann (2019) reports results from a natural experiment on this issue in a carefully done study of a "joint indices project" between ISS and Financial Times Stock Exchange (FTSE). This project increased the ISS corporate governance coverage going from 2004 to 2005 in the UK from 212 firms up to 524. He finds that the coverage initiation led to "improvements in governance quality, liquidity, financial analyst following, and investor breadth. These results were stronger for firms that before the initiation had weak governance, liquidity and financial analyst following.
For a positive relationship between corporate governance quality and liquidity it is essential that those in charge of the corporate governance of the firm perceive their role as being equally responsible to shareholders who are buying the firm's shares, as to those present shareholders who are selling 4 . Any attempts to manipulate the share price either up or down will hence be unacceptable. From a corporate governance point of view the firm's information dissemination should give an unbiased picture of the future prospects of the firm. At disclosure of information regarding significant events the guiding principle should be the likely impact on expected cash flows of the firm, in combination with an assessment of any risk exposure impact of that event.
Strict application of this, what could be called, unbiasedness principle will be beneficial for the outside investor that would like to invest in the firm's shares (who lacks any access to classified information). The shares will be attractive since the likelihood of paying too much to an insider who knows that the firm happens to be overvalued is relatively low. As a consequence, the interest among outside investors to buy such shares will be higher than for firms where adherence to this unbiasedness principle is in doubt.
A board that efficiently pursues this principle will carefully monitor that no one within the firm, in possession of relevant news at an early stage, will make any attempts to exploit temporary information advantages. Good corporate governance can in this respect be taken to promote the same objective for the firm as insider trading regulation does for the market as whole. Trading on privileged information is strictly forbidden for the reason that we just discussed. A strict ban on trading based on inside information will reduce the likelihood that an outside investor ends up trading with someone who happens to know that there is a temporary pricing error due to new information that hasn't yet been incorporated in the price. Insider trading regulation addresses the market as whole while corporate governance is firm specific. While insider trading regulation targets misuse of specific value relevant information, corporate governance is concerned with dissemination of information to outside investors about the firm and its prospects in general.
In summary the impact of corporate governance on the liquidity of the firm's shares in the stock market comes from expected reduction of any biases in the information that the firm disseminates to the market. If investors believe that there is a genuine will among those in charge, i.e. the board, to uphold an unbiased picture of the future prospects of the firm, that is to avoid a skewed assessment in one direction or the other, the information asymmetry costs will be relatively small. Consequently, trading in the firm's shares will be more attractive for outside investors than if investors suspect that deliberate attempts by management to distort the prospects will be quietly accepted by the board.

Unbiased information dissemination as a challenge for corporate governance
The most important motives for promoting a biased view of the firm's prospects are likely to be personal motives of the executive management. Even in the absence of share price related compensation schemes executive management may have incentives to promote a biased view of the firm's prospects. The willingness to provide loans to the firm, and in general to conduct business with the firm, is partly dependent on the future prospects of the firm. As a result, there is a natural tendency for the firm's executive management to "sugar coat" news so as to create an overly favourable impression here and now of the future prospects of the firm.
With share price related performance compensation schemes the temptation for management to deliver an overly favourable view of the firm's future business will be strengthened further. From the board's perspective this implies that higher intensity of the share price related incentives for the top management must be combined with more attention to potentially misleading, overly optimistic, information dissemination. 5 One may argue that subtle biases in the information that the firm provides for investors is difficult to avoid, and that attempts to spot such deliberate attempts in advance are likely to be challenging. However, this makes it even more important for the corporate board to handle the challenge appropriately. The main incentive for the board members, in their turn, to tackle this challenge properly consists of potential loss of reputation. In case of a clear failure of the board to prevent disclosure of biased information, which later happens to get exposed by media, the personal costs for the board members could be substantial. The tarnished reputation will reduce their future opportunities, and their expected future personal income.
As the seminal article by Hermalin & Weisbach (1998) clearly explains the role of corporate governance and the board will not be the same in all types of firms. When it is easy for outside investors and financial analysts to estimate the future cash flows from the firm's business, like e.g. in a real estate investment trust, the role of the board in safeguarding unbiasedness will not be that important. In such cases the opportunities for management to promote a skewed picture of the firm's future business prospects will be strictly limited. Any attempts to distort the market's perception would lead to a loss of credibility for that management in the stock market, since such attempts most likely would be detected by independent financial analysts.
In contrast, when there is substantial uncertainty concerning the future, e.g. due to an ongoing industry wide introduction of a disruptive technology, reliable detailed estimates of future profits for individual firms will be difficult to produce. In such situations the temptation for the management to provide overly optimistic assessments of future prospects of the firm could be quite high. Investors that consider going long in such a firm's shares may rationally require the presence of a board with alert members that have their personal reputation at stake to open a long position.
Proper institutions are important in corporate governance. Since talented managers must be quite skilled in convincing people around them of what to do, it is important that there are strictly enforced fixed rules that limit their power. Otherwise they are 5 The temptation to manipulate the share price in order to increase the value of executive call options is, of course, well known. Perhaps the best-known example is the Enron case (see e.g. Salter (2008)). In practice the main way in which this potential problem has been addressed is through requiring a long enough vesting period before the executive stock options can be exercised, the idea being that strategies to boost the stock price in the short run are relatively easy to come up with but most of them will generate a reversal later on when evidence that reality is less favourable accumulates.
Electronic copy available at: https://ssrn.com/abstract=3519588 Electronic copy available at: https://ssrn.com/abstract=3519588 likely to entrench themselves over time and make initiation of required changes more difficult when the business environment in which the firm operates evolves.
Institutional rules that embody what has proved beneficial in this respect have been recorded in official corporate governance recommendations for listed companies around the world 6 . In spite of considerable differences in how the recommendations are structured and formulated their main proposals are largely similar. One such recommendation is for the presence of independent members on the board. Having members on the board who are independent of management is essential in trying to safeguard that the management avoids decisions that would benefit themselves at the shareholders' expense.
Compliance with all corporate governance recommendations is not, however, a guarantee for good corporate governance. For instance, formally independent board members can differ a lot in terms of how efficiently they are doing their job on the borad. Ferreira, Ferreira and Raposo (2011), using a highly simplified model in the spirit of Hermalin & Weisbach (1998), show that the relationship between board independence and price informativeness is likely to be ambiguous. The reason according to them, in essence, is that board monitoring is an expensive activity. To do a good job, the persons involved have to spend substantial effort on the task. They also have to possess scarce talent that is likely to carry a high alternative cost in the market. The specific optimal characteristics of independent board members will on one hand depend on how difficult the task is and on the other hand on how efficiently the market for corporate control, being a substitute for board activity, is working. The cost of a given level of effort by a person with the required level of talent will furthermore depend on how unique the required talent happens to be.
The results reported by Alam, Chen, Ciccotello and Ryan (2014) also support the conclusion that the optimal characteristics of independent board members will differ depending on the business that the firm is operating. What they find is "..that directors tend to reside closer to headquarters when the intangibility of a firm's assets (a proxy for the need to gather soft information) is high." They also find that "more distant" boards base their decisions of CEO dismissals on measured poor performance and they use performance related compensation to larger extent than more proximate boards. In cases where the firm's assets are to a larger extent tangible, and the business thus easier to evaluate for an outsider, application of straightforward performance measures will make the task of the board simpler than in cases where the firm's business is subject to more of genuine uncertainty.
In general, we can conclude that the role of the board in safeguarding unbiasedness of the information disclosed by the firm will differ between firms. If the firm's business is easy to understand and the firm is active in stable markets, there is less scope for management to try to manipulate the market in their own favor than in cases where the firm is producing complex goods for markets subject to rapid development. In the latter case good corporate governance is more important. A board consisting of knowledgeable persons with untarnished reputation may in that kind of a case have a substantial impact on outside investors willingness to trade the firm's shares and accordingly on the liquidity of the market for these shares.

Summary
This paper argues that properly understood good corporate governance will be beneficial for the liquidity of a listed firm's shares. An essential role of the corporate board that shoulders the responsibility for the governance of the firm, is to safeguard that the information dissemination to outside investors is unbiased and timely. An efficient board will in this fashion contribute to reducing the adverse selection risk for an outside investor who lacks privileged information and would like to trade the firm's shares. This should naturally increase the interest of a broader group of investors to trade in the firm's shares and as a result increase the share's liquidity at the stock exchange.
Safeguarding that the information is as unbiased as possible is far from a simple task for the board. There is the obvious issue of adjusting explicit incentives for the top executives of the firm so as not to promote short sighted attempts to manipulate the share price. Over and above that, proper knowledge of the business and vigilance on behalf of board members is required in combination with a clearly articulated preference for unbiased assessments of the future prospects of the firm's business. For a maximum beneficial impact on the liquidity of the firm's shares in the stock market this preference for unbiasedness should be the guiding principle in external as well as internal communication of the firm.