Shareholder Monitoring with Strategic Investors

This paper provides a generalization of the theory of shareholder monitoring, originally developed by Admati, Pfleiderer, and Zechner (1994). An activist shareholder can trade with a finite number of strategic passive investors. If there are only a few investors, then their strategic behavior leads to an allocation of shares that increases the activist investor's incentive to monitor, which is socially desirable. This is because they take into account the effect of their purchases on the incentives of the large shareholder, so they buy fewer shares. On the other hand, a large number of investors leads to free-riding and less monitoring. In the limit, as the number of investors grows to infinity, a similar equilibrium as in Admati, Pfleiderer, and Zechner (1994) emerges. The model formalizes the idea that a financial market with a small number of shareholders provides stronger incentives for shareholder monitoring. The prediction is consistent with empirical findings which show that in countries where monitoring is important, e.g. because of weak legal protection of investors, shareholder concentration is high and stock market participation is low.