J O U R N A L OF FINANCIAL A N D OUANTITATIVE ANALYSIS VOL. 35, NO.

4, DECEMBER 2000
COPYRIGHT 2000. SCHOOL OF BUSINESS ADMINISTRATION, UNIVERSITY OF WASHINGTON, SEAHLE, WA 98195

Blockholder Ownership and Market Liquidity

Frank Heflin and Kenneth W. Shaw*

Abstract
This paper examines the association between block ownership and market liquidity. Block-
holders are believed to have access to private, value-relevant information via their roles as
monitors of firms' operations. Consistent with this, we find that firms with greater block-
holder ownership, either by managers or external entities, have larger quoted spreads, ef-
fective spreads, adverse selection spread components, and smaller quoted depths.

I. Introduction
We examine the relation between large block ownership and market liquid-
ity. Blockholders, entities holding at least 5% of a firm's outstanding shares,
are thought to monitor a firm's operations (Morek, Shleifer, and Vishny (1988)),
reducing agency costs and increasing firm value (see e.g., McConnell and Ser-
vaes (1990), Barclay and Holdemess (1991), and Bethel, Liebeskind, and Opler
(1998)). However, blockholder ownership is potentially costly, because their
monitoring might provide blockholders with access to private, value-relevant in-
formation. Prior research suggests market makers mitigate losses to informed
traders by charging wider spreads and reducing the number of shares they offer
in response to increases in the probability of informed trading.' If blockholders
obtain superior information about firm value, potential benefits from blockholder
monitoring might be partially offset by reduced liquidity attributable to wider
spreads and lower depths.
Examination of block ownership is complicated by the fact that managers,
who also are believed to possess private, value-relevant information, sometimes
hold large blocks in the firms they manage. We partition total block ownership
* Krannert Graduate School of Management, Purdue University, West Lafayette, IN 47907, and
Robert H. Smith School of Bu.siness, 4467 Van Munching Hall, tJniver.sity of Maryland, College Park,
MD 20742, respectively. Heflin thanks the Yale School of Management and the Krannert Graduate
School of Management for financial support. Shaw gratefully acknowledges financial support from
the Smith School of Business, University of Maryland. The authors thank William Kross, Jonathan
Karpoff (the editor), and Dennis Sheehan (the referee) for helpful comments and suggestions.
' Analytical and empirical research on spreads includes, among others, Amihud and Mendelson
(1980), Stoll (1978), (1989), Copeland and Galai (1983), Glosten and Milgrom (1985), Madhavan
(1992), Lin, Sanger, and Booth (1995), Madhavan and Smidt (1993), Lee, Mucklow, and Ready
(1993), and Huang and Stoll (1997). Lee, Mucklow, and Ready (1993) and Heflin and Shaw (forth-
coming) provide empirical evidence regarding the risk of informed trading and depths.
621
622 Journal of Financial and Quantitative Analysis

into the percentage of outstanding shares held in large blocks by managers and the
percentage held in large blocks by non-managers, allowing us to examine whether
both internal and external blockholders contribute to information asymmetry and
reduced liquidity. Our tests also examine whether aggregate managerial owner-
ship, where no individual manager owns a large block, contributes to reduced
liquidity.
Our findings are as follows. We document strong positive relations between
the percentage of outstanding shares held by blockholders and i) total quoted (rel-
ative) spreads, ii) total effective spreads, and iii) the informed trading component
of the effective spread. We also document a strong negative relation between the
percentage of outstanding shares held by blockholders and total quoted depths.
All of our results hold for both manager and non-manager blockholders, suggest-
ing that both internal and external blockholders contribute to reduced liquidity.
Additionally, the results suggest aggregate managerial ownership, even where no
individual manager owns a large block, is associated with reduced liquidity.
Our evidence is important in understanding the full impact of ownership
structure. Though existing research suggests ownership by blockholders reduces
agency costs and increases firm value, our results suggest blockholder ownership
is associated with reduced market liquidity.

II. Data
A. Sample
We begin with 349 firms included in the 1988-1989 Report of the Corpo-
rate Information Committee (CIC) of the Financial Analysts Federation (FAF).^
A total of 314 firms have transaction data available in the 1988 Institute for the
Study of Securities Markets (ISSM) database. We collect ownership data directly
from proxy statements, deleting two firms for which we cannot locate proxy state-
ments. We delete four more firms, trading as American Depository Receipts,
whose proxy statements do not disclose details on share ownership. Since our
interest is in blockholders likely to monitor management and possibly trade prof-
itably on superior information, we delete 45 firms whose blocks are held entirely
by either employee stock ownership plans, charitable foundations, or trusts. To
ensure sufficient observations to yield meaningful variables, we eliminate three
firms with less than 100 days of ISSM data, yielding a final sample of 260 firms
(259 trading on the New York Stock Exchange and one trading on the American
Stock Exchange).

B. Dependent Variables

We eliminate each day's opening transaction (which occurs in a call auction),

trades and quotes with reported times outside normal trading hours, non "best bid
and offer" quotes, and trades the ISSM reports as other than "regular" Remaining
trades and quotes are used to compute dependent variables as follows. The relative
•^Inclusion in the CIC reports is not germane to this study (we selected the firms first for use in
another project), and we addre,ss possible selection bia,ses in Section ILD,
 Heflin and Shaw 623

bid-ask spread is the ask price minus the bid price, divided by the average of the
bid and ask prices. Since many trades occur at prices within quoted bid and
ask prices, we measure the effective spread as twice the absolute value of the
difference between a transaction price and the midpoint of the bid and ask quotes
in effect at the time of the transaction.^ We delay quotes five seconds relative
to transactions to reduce time-stamping errors (Lee and Ready (1991)). Total
quoted depth is the sum of the number of shares quoted at the ask and bid prices.
Relative and effective spreads and quoted depths are averaged across each firm
day and then across each firm's daily means to yield one observation per firm.
Recent research attempts to partition the total effective spread into informed
trading, order processing, and inventory holding cost components. To the extent
spread decomposition models successfully isolate the informed trading compo-
nent of the spread, analyses employing an estimated informed trading compo-
nent should be more powerful than those employing total spreads. We employ
Lin, Sanger, and Booth (t995) and Huang and Stoll (t997) estimates, hereafter
denoted as LSB and HS, respectively. We obtain LSB adverse selection spread
component estimates from estimating the following regression for each firm using
ordinary least squares,

(1) 41og[Mv] = (/.,(log[PRICE,-,,_i]-log[M,-,_,]) + e,-,,

where A denotes a change from the previous quote (prior to a transaction), M,-,,
is the quoted spread midpoint at time t for firm i, PRICE,-,,_i is the transaction
price prior to the quoted spread at time t for firm i, and e,;, is an error term.
The coefficient (/>, is the LSB estimate of the percentage of the effective spread
attributable to informed trading for firm /. The LSB estimate of firm f s adverse
selection spread is <pi times the firm's average effective spread.''
We obtain HS adverse selection spread component estimates from estimating
the following firm-specific regression using ordinary least squares,

(2) ZiPRICE,-,, = l3^,iQi,' + P2,iQi,t-\+p3,iQA,t-i+e,,

where A denotes a change from the previous retained trade and 2,,( equals t (-1)
if the trade at time t was a sell (buy). We classify trades at prices above the
prevailing quote midpoint as market maker sells (<2,,( = t) and trades at prices
below the prevailing quote midpoint as market maker buys (Qj^, = — t). Following
HS, trades at the quote midpoint are excluded, and only the last trade in each five-
minute interval is employed in constructing the variables in equation (2).^ We use
an "aggregate" buy/sell indicator, QA,t-\, which equals 1 ( - t , 0) if the sum of
Qi,,-i across all sample stocks is positive (negative, zero) to capture market-wide

'Though unreported, we obtain qualitatively similar results when we deflate effective spreads by
.share price.
"•All results are qualitatively unchanged when we use the percentage of the effective .spread due to
adverse selection rather than multiplying this variable by effective spreads.
'We also estimated equation (2) by employing a tick test (Lee and Ready (1991)) to classify trades
at the spread midpoint. Trades at a price greater than the price at»— 1 are assigned Q,,, = 1 and trades
at a price less than price at f — 1 are assigned Qi,, = — \. The correlation between the adverse selection
component estimates produced by this method and the estimates we employ exceeds 0.98.
624 Journal of Financial and Quantitative Analysis

pressure on market makers' inventory levels."^'' As formulated in equation (2), the

estimate of /9i,,- is one-half the estimated effective spread, and the estimated HS
adverse selection component equals 2{P2,i + P\,i)-

C. Independent Variables

We collect ownership data direcUy from 1988 proxy statements on Lexis-

Nexis Online. These statements disclose ownership by blockholders (owners of
at least 5% of outstanding shares) and managers (officers and directors). We use
the list of managerial owners to identify blockholders who are also managers,
and compute the total percentages of outstanding shares held by each of the non-
manager and manager blockhoider groups. In addition, we collect the aggregate
percentage ownership by managers who each individually hold less than 5% of
the total outstanding shares (i.e., non-blockholding managers).
Prior research suggests share price, retum volatility, firm size, and trading ac-
tivity as control variables in our regressions (see e.g., Hanley, Kumar, and Seguin
(1993) and Corwin (1999)). Price is the average of the bid and ask prices, and re-
tum volatility is the standard deviation of daily close-to-close retums. We use the
average daily number of trades and average trade size to measure trading activity.
Firm size is the natural log (to reduce its skewness) of the firm's market value of
common equity.

D. Descriptive Information

Table 1 presents descriptive statistics. The average firm has a market capi-
talization of $3,389 billion, an average price of $39.08 per share, and experiences
about 77 trades per day, with an average trade size of 1,698 shares. The aver-
age relative spread is about 0.88% of share price, the average effective spread is
16.5^ per share, and the average total quoted depth is about 11,350 shares. Our
sample on these measures is comparable to other microstructure studies that sam-
ple different firms over the same time period (see e.g., Lin, Sanger, and Booth
(1995), Madhavan, Richardson, and Roomans (1997), and Lee, Mucklow, and
Ready (1993)). Median adverse selection spreads from the LSB (HS) method
are about 6.75(i (6.04(i) per share. This corresponds to average adverse selec-
tion estimates of about 38 and 33% of effective spreads, respectively, for the two
methods, similar to estimates found in prior studies (e.g., Stoll (1989), Affleck-
Graves, Hedge, and Miller (1994), Lin, Sanger, and Booth (1995), and Krinsky

'Sometimes large trades are broken up and reported a.s multiple smaller trade.s. In some of their
tests, HS employ a "bunching" technique, where trades occurring at the same price with the same
quote as the trade up to five minutes earlier are aggregated and considered one trade. We do not bunch
trades, .since, as HS indicate, employing only one trade every five minutes helps mitigate this problem
as it is les.s likely two trades five minutes apart are actually one order. In addition, their results suggest
the bunching technique increases the estimated adverse selection component. To be conservative, and
possibly more accurate, we employ the smaller estimates obtained without bunching.
^HS also develop a method employing an estimated trade reversal probability instead of an ag-
gregate buy/sell indicator. We chose the aggregate buy/sell method because HS's results suggest the
trade reversal method is prone to producing negative adverse selection component e.stimates. Neither
in their sample nor ours did the aggregate buy/sell indicator method produce any adverse selection
component estimates less than 0 or greater than 1.0.
 Heflin and Shaw 625

and Lee (1996)). Finally, our sample firms span over 30 different industries, in-
cluding manufacturing, service, and financial institutions, and wefindno evidence
of industry clustering. Though our sample selection is non-random, we find no
evidence suggesting sample selection bias drives our results.

TABLE 1
Descriptive Statistics

Variable Min 01 Median Mean 03 Max

Firm size 43.83 678.9 1,639 3,389 3,393 69,693
Share price 2.97 24.79 32.38 39.08 45.19 335.65
Trades per day 4 28 52 77 97 618
Trade size 213 1,234 1,576 1,698 2,063 4,998
Return volatility 0.009 0.015 0.017 0.018 0.020 0.049
Relative spread % 0.146 0.553 0772 0.875 1.022 4.208
Effective spread 0.090 0.131 0.157 0.165 0.183 0.763
Total quoted depth 504 5,592 8,530 11,346 12,081 186,260
LSB adverse selection 0.002 0.038 0.057 0.0675 0.084 0.451
HS adverse selection 0.001 0.031 0.052 0.0604 0.075 0.510
Total block ownersiiip % 0 0 7.0 12.3 17.6 81.38
Non-manager block % 0 0 5.04 8.05 14.1 81.38
Manager block % 0 0 0 3.80 0 60.70
Non-biock manager % 0 0.89 1.79 2.80 3.50 20.20
The sample consists of 260 firms with quote, price, and trade data on the 1988 ISSM database and share
ownership data available in proxy statements. Each firm contributes one observation.
Firm size (in $miliions) equals share price times number of common shares outstanding, share price is
the average of the quote midpoints, trades per day is the average number of trades per day rounded to
the nearest whole number, trade size is the average number of shares traded in a transaction rounded
to the nearest whole number, and return volatility is the standard deviation of daily returns (computed
using the change in close to ciose share prices). Relative spread % is the ask price minus the bid price,
divided by the average of the bid and ask prices. Effective spread (in cents per share) is twice the
absolute vaiue of the difference between a transaction price and the midpoint of the bid and ask quotes
in effect at the time of the transaction. LSB (HS) adverse selection is the amount (in cents per share)
of the effective spread due to adverse selection, estimated using the Lin, Sanger, and Booth (1995)
((Huang and Stoll (1997)) technique. Total quoted depth is the number of shares quoted at the ask price
plus the number of shares quoted at the bid price.
Blockholders are entities holding at least 5% of a firm's outstanding common shares. Total block owner-
ship % is the percentage of outstanding common shares held by biockholders. Manager (non-manager)
block % is the percentage of outstanding common shares held by entities who are (are not) also officers
or directors of the firm in which they hold a block. Non-block manager % Is the percentage of outstand-
ing shares held in total by officers and directors, where no individual manager holds 5% or more of the
firm's outstanding shares.

Blockholder ownership varies considerably: 87 firms in our sample have no

blockholders; 118 firms have only non-manager block owners; and 55 firms have
a manager who is also a blockholder. The mean total block ownership is 12.3%
of shares outstanding, and non-manager (manager) blockholders own, on average,
about 8 (3.8%) of shares outstanding.^ In aggregate, managers who individually
do not own blocks own an average (mean) of 2.8% of the firm's stock. Thus, the
mean percentage of shares held in total by all managers is about 6.4% (3.8% +
2.8%). The mean and median number of blockholders (in the set of 173 firms
with blockholders) is two, and the maximum number of blockholders in a single
firm is seven.

*The average for manager block ownership i.s less than 5.0 because only 55 firms have a manager
owning 5% or more of the firm's stock.
626 Journal of Financial and Quantitative Analysis

III. Empirical Results

A. Univariate Evidence

If block ownership provides access to value-relevant information and places

market makers at an informational disadvantage, we expect spreads (depths) to be
higher (lower) for firms with block owners than for firms with no block owners.
Evidence in Table 2, which presents means forfirmswith and without blockhold-
ers, supports this. Relative spreads (effecfive spreads) average 0.68% of stock
price (14.7(iper share) for firms without blockholders (column 2) and 0.97% of
stock price (t7.3(^per share) for firms with blockholders (column 4). Adverse se-
lection spreads also increase with block ownership, averaging about 5^ per share
for firms with no blockholders (column 2) and about 6-li per share for firms
with blockholders (column 4). The p-values (column 3) indicate the mean spread
measures for firms with block owners are significantly greater (0.01 level) than the
means forfirmswithout block owners. Total quoted depth is higher for firms with-
out block owners, where depth averages 12,698 shares, than for firms with block
owners, where depth averages 10,666 shares, though this difference in means is
significant at only the 0.18 level.'

TABLE 2
Univariate Analyses of Block Ownership and Market Liquidity

1 2 3 4
Mean for Mean for
Firms without p-Value for Two-Tailed Firms with
Blockholders (-Test of Difference > 1 Blockholder
Variable (N = 87) between (2) and (4) ( W = 173)
Non-manager block % n/a n/a 12.85
Manager block % n/a n/a 5.64
Non-block manager % 2.20 0.037 3.10
# of blockholders n/a n/a 2.02
Relative spread 0.678 0.001 0.974
Effective spread 0.147 0.001 0.173
LSB adverse selection 0.050 0.000 0.076
HS adverse selection 0.045 0.007 0.068
Total quoted depth 12,698 0.180 10,666
The sample consists of 260 firms with quote, price, and trade data on the 1988 ISSM database, and
share ownership data available in proxy statements. Each firm contributes one observation.
Relative spread % is the ask price minus the bid price, divided by the average of the bid and ask
prices. Effective spread (in cents per share) equals twice the absolute value of the difference between
a transaction price and the midpoint of the bid and ask quotes in effect at the time of the transaction.
LSB (HS) adverse selection is the amount (in cents per share) of the effective spread due to adverse
selection, estimated using the Lin, Sanger, and Booth (1995) (Huang and Stoll (1997)) technique. Total
quoted depth is the number of shares quoted at the ask price plus the number of shares quoted at the
bid price.
Blockholders are entities holding at least 5% of a firm's outstanding common shares. Manager (non-
manager) block % is the percentage of outstanding common shares held by entities who are (are not)
also officers or directors of the firm in which they hold a block. Non-block manager % is the percentage
of outstanding shares held in total by officers and directors, where no individual manager holds 5% or
more of the firm's outstanding shares.

'One of the firms in the group with at least one blockholder ha.s an average quoted depth of more
than 186,000 shares, which is over 15 time.s the mean value of depth for the .sample. When we delete
thi.s one firm, the mean depth for the 172 remaining firms reported in column 4 is 10,417 shares, and
the difference from the mean reported in column 2 is significant at the 0.06 level.
 Heflin and Shaw 627

If managerial ownership provides aecess to value-relevant information, re-

gardless of whether any individual manager holds a large block of shares, we
expect spreads (depths) to increase (decrease) in the level of non-block manage-
rial ownership. To assess this, we partition the 205 sample firms that do not have
manager blockholders into groups below (column 2 of Table 3) or above (column
4 of Table 3) median total manager ownership.
Results in Table 3 suggest liquidity is lower for firms with high managerial
ownership, even if no individual manager owns a large block. Relative spreads
average 0.726% of stock price and effective spreads average 14.9^ per share for
firms with managerial ownership below the median, while they average 0.911 %
of stock price and 16.3(^per share, respectively, for firms with managerial owner-
ship above the median. LSB (HS) adverse selection spreads average 5.1^ (4.6f)
among firms with below median managerial ownership and 6.9^ (5.9^) among
firms with above median managerial ownership. Average total quoted depth is
higher for firms with below median managerial ownership (14,370 shares) than
for firms with above median managerial ownership (10,178 shares). All differ-
ences between means in columns 2 and 4 of Table 3 are significant at the 0.05
level or better. These results are consistent with the notion that managers who
own stock, even when no individual manager owns a large block, pose informed
trading risk to market makers.'"

B. Multivariate Evidence
To examine the relation between blockholdings and market liquidity while
controlling for other factors, we esfimate various forms of the following cross-
sectional regression,
(3) LIQ = ao + a 1 (non-manager block %) -^• a2(manager block %)
-I- a3 (non-block manager %) H- 04 (share price)
+ a5(retum volatility) + a6(trade size)
-(- a7 (trades per day) H- as (size) -\- e,

where LIQ is either relative spread, effective spread, LSB adverse selection spread,
HS adverse selection spread, or depth. Manager block % (non-manager block
%) is the percentage of outstanding shares held by blockholders who are (are
not) managers of the firm. Non-block manager % is the aggregate percentage
of shares owned by managers who each individually own less than 5% of the
firm's shares.'' Share price is the average of the quoted bid and ask prices, return
volatility is the standard deviation of returns computed from the last best bid and
offer quoted midpoint of each day, trade size is average trade size per transaction,
trades per day is the average number of trades per day, and size is the average
market value of common equity. We compute these variables over all available
'"Additional evidence regarding liquidity and managerial ownership can also be found in Sarin,
Shastri, and Shastri (1999), Chiang and Venkatesh (1988), and Glosten and Harris (1988), These
studies do not addre,ss whether block vs, non-block managerial ownership is associated with market
liquidity,
"For example, if managers, in total, own 20% of a firm's shares, and two of the managers each
own 7%, non-block manager % is 6%,
628 Journal of Financial and Quantitative Analysis

TABLE Ci
Univariate Analyses of Non-Block Managerial Ownershiip and Market Liquidity

1 2 3 4
Mean for Firms Mean for Firms
with Belovi/ Median p-Value for Two- with Above Median
Non-Block Tailed f-Test of Non-Block
Managerial Difference Managerial
Ovi/nership between Ownership
Variable ( W = 102) (2) and (4) (W=103)
Non-manager block % 7.50 (0.198) 9.75
Non-block manager % 0.73 (0.000) 4.06
# of blockholders 0.83 (0.015) 1.22
Relative spread 0.726 (0.003) 0.911
Effective spread 0.149 (0.010) 0.163
LSB adverse selection 0.051 (0.000) 0.069
HS adverse selection 0.046 (0.004) 0.059
Total quoted depth 14,370 (0.047) 10,178
The sample consists of 260 firms with quote, price, and trade data on the 1988 ISSM database, and
share ownership data available in proxy statements. This table excludes 55 firms with blockholders who
are also managers of the firm. Each firm contributes one observation.
Relative spread % is the ask price minus the bid price, divided by the average of the bid and ask
prices. Effective spread (in cents per share) equals twice the absolute value of the difference between
a transaction price and the midpoint of the bid and ask quotes in effect at the time of the transaction.
LSB (HS) adverse selection is the amount (in cents per share) of the effective spread due to adverse
selection, estimated using the Lin, Sanger, and Booth (1995) (Huang and Stoll (1997)) technique. Total
quoted depth is the number of shares quoted at the ask price plus the number of shares quoted at the
bid price.
Blockholders are entities holding at least 5% of a firm's outstanding common shares. Non-manager
block % is the percentage of outstanding common shares held by entities who are not also officers or
directors of the firm in which they hold a block. Non-block manager % is the percentage of outstanding
shares held in total by officers and directors, where no individual manager holds 5% or more of the firm's
outstanding shares.

observations in 1988. We use natural logarithms of relative spread, quoted depths,

and tirm size to reduce heteroskedasticity.'^
If block ownership by non-managers puts market makers at an informational
disadvantage, then the estimated coefficient on non-manager block %,ai, should
be greater (less) than zero when a spread measure (depth) is the dependent vari-
able. Similarly, if block ownership by managers puts market makers at an infor-
mational disadvantage, then the estimated coefficient on manager block %, a2,
should be greater (less) than zero when a spread measure (depth) is the dependent
variable. Finally, if manager ownership, even if no individual manager holds a
block, puts market makers at an informational disadvantage, then the estimated
coefficient on non-block manager %, a^, should be greater (less) than zero when
a spread measure (depth) is the dependent variable.
Columns 2, 3, 4, 5, and 6 of Table 4 report results of estimating equation
(3) when relative spreads (RS), effective spreads (ES), Lin, Sanger, and Booth
(1995) adverse selection spreads (LSB), Huang and Stoll (1997) adverse selection

'^White's (1980) mi.s.specification test suggests the presence of heteroskedasticity when these vari-
ables are not logged, but indicates no heteroskedasticity when they are logged. Residual plots show the
residuals from the Table 4 regressions are symmetrically distributed. Our inferences are unchanged
when we delete low (less than $5 per share) and high (greater than $150 per share) priced stocks,
truncate all variables at the 99th and first percentiies of their distributions, or delete observations with
large studentized residuals (Belsley, Kuh, and Welsch (1980)).
 Heflin and Shaw 629

spreads (HS), or total quoted depth (DP) is the dependent variable, respectively.
Coefficient estimates on the control variables are in the expected direction and
generally significant at conventional levels.'^ More importantly. Table 4 shows
that spreads (depths) are positively (inversely) related to non-manager block own-
ership even after controlling for block ownership by managers, non-block man-
agerial ownership, and other determinants of spreads and depths. The coefficient
estimates on non-manager block % are 0.222, 0.022, 0.031, 0.034, and -0.280,
respectively, in columns 2 through 6 of Table 4, and each coefficient is signifi-
cant at the 0.05 level or better.''' This is consistent with the notion that external
blockholders increase the risk of informed trading losses to market makers.
The coefficient estimates on the percentage of shares held by blockholders
who are also managers of the firm (manager block %) equal 0.301, 0.032, 0.050,
0.048, and -0.791, respectively, in columns 2-6 of Table 4, and each coefficient
is significant at less than the 0.01 level. These results suggest block ownership by
managers, after controlling for external block ownership, non-block managerial
ownership, and other determinants of spreads and depths, reduces market liquidity
by placing market makers at an increased informed trading risk. Together, the
non-manager block % and manager block % results form the main inference of
this study: block ownership is associated with reduced market liquidity. Both
block ownership by external entities and by managers is associated with higher
total spreads, higher informed trading spreads, and smaller depths.'^
The estimates of the coefficient on non-block manager % are significantly
different from zero at less than the 0.05 level only in regressions where the in-
formed trading component of the spread is the dependent variable (columns 4 and
5). If spread decomposition models are effective at isolating the informed trading
component of the spread, then regressions employing these variables should be
more powerful than those employing total spreads (or possibly depths). Though
not as consistently strong as our evidence regarding block ownership, our data
provide evidence that managerial ownership reduces market liquidity even when
individual managers do not hold large blocks.'^ Together, the manager block %
and non-block manager % results suggest that in certain specifications, consid-

exception is retum volatility, which is significant only in the relative spread regression. We
also employed an alternative measure, the standard deviation of daily share price, and re-estimated
the regressions reported in Table 4. The coefficient on standard deviation of price is in the predicted
direction and significant at the 0.05 level in each regression, and none of our other inferences are
affected.
"All p-values reported in Table 4 are for two-tailed hypothesis tests of whether the coefficient
differs from zero.
"We repeated these regressions after substituting the number of non-manager blockholders and the
number of manager blockholders for their percentage of shares owned, and obtained qualitatively sim-
ilar results. Also, we estimated a regression that included i) the number of non-manager blockholders,
ii) the number of manager blockholders, iii) the percent owned by non-manager blockholders, iv) the
percent owned by manager blockholders, v) the percent owned by managers who are not blockhold-
ers, and vi) the control variables from equation (3). Results suggest the percent owned by external
blockholders, and not the number of external blockholders, is associated with reduced liquidity. Gen-
erally, however, both the number of manager blockholders and percentage ownership by manager
blockholders appear associated with reduced liquidity.
'^Our evidence regarding managerial ownership and the informed trading component of the spread
is consistent with Sarin, Shastri, and Shastri (1999).
630 Journal of Financial and Quantitative Analysis

TABLE 4
Multivariate Analyses of Ownership and Market Liquidity

Coefficient Estimates (p-Values)

1 2 3 4 5 6
Independent
Variables LIQ = RS LIQ = ES LIQ - LSB LIQ - HS LIQ - DP
Intercept -2.521" 0.245" 0.166" 0.122" 3.083"
(0.001) (0.001) (0.001) (0.001) (0.001)
Non-nnanager block % 0.222' 0.022" 0.031" 0.034" -0.280*
(0.020) (0.040) (0.009) (0.002) (0.044)
Manager block % 0.301" 0.032" 0.050" 0.048" -0.791"
(0.009) (0.001) (0.001) (0.001) (0.001)
Non-block manager % 0.179 0.054 0.125" 0.105" -1.045
(0.635) (0.286) (0.007) (0.017) (0.061)
Share price -0.013" 0.002" 0.001" 0.001" -0.823"
(0.001) (0.001) (0.001) (0.001) (0.001)
Return volatility 6.495" 0.173 0.169 0.418 1.180
(0.008) (0.504) (0.470) (0.064) (0.680)
Trade size -0.008 -0.002" -0.007" -0.006" 0.037"
(0.649) (0.001) (0.003) (0.004) (0.001)
Trades per day -0.008" -0.002" -0.002" -0.001" 0.003"
(0.001) (0.001) (0.001) (0.001) (0.001)
Firn:i size -0.136" -0.007" -0.009" -0.008" 0.243"
(0.001) (0.001) (0.001) (0.001) (0.001)
Adjusted Ft' 87.90 84.28 80.49 83.64 86.06
The sample consists of 260 firms with quote, price, and trade data on the 1988 ISSM database, and
share ownership data available in proxy statements. Each firm contributes one observation.
Firm size (in $millions) equals share price times number of common shares outstanding, share price is
the average of the quote midpoints, trades per day is the average number of trades per day, rounded to
the nearest whole number, trade size is the average number of shares traded in a transaction, rounded
to the nearest whole number, and return volatility is the standard deviation of daily returns (computed
using the change in close to close share prices). Relative spread % is the ask price minus the bid price,
divided by the average of the bid-ask prices. Effective spread (in cents per share) equals twice the
absolute value of the difference between a transaction price and the midpoint of the bid and ask quotes
in effect at the time of the transaction. LSB (HS) adverse selection is the amount (in cents per share) of
the effective spread due to adverse selection, estimated using the Lin, Sanger, and Booth (1995) (Huang
and Stoll (1997)) technique. Total quoted depth is the number of shares quoted at the ask price plus the
number of shares quoted at the bid price.
Blockholders are entities holding at least 5% of a firm's outstanding common shares. Total block owner-
ship % is the percentage of outstanding common shares held by blockholders. Manager (non-manager)
block % is the percentage of outstanding common shares held by entities who are (are not) also officers
or directors of the firm in which they hold a block. Non-block manager % is the percentage of outstand-
ing shares held in total by officers and directors, where no individual manager holds 5% or more of the
firm's outstanding shares.
The equation estimated is LIQ = ao + ai(non-manager block %) + a2(manager block %) +
a3(non-block manager %) + a4(share price) + a5(return volatility) + c»6(trade size) + a7(trades per day) +
aesize + «. In columns 2, 3, 4, 5, and 6, the dependent variables (LIQ) are relative spread (RS), effective
spread (ES), Lin, Sanger, and Booth (1995) adverse selection spread (LSB), Huang and Stoll (1997) ad-
verse selection spread (HS), and total quoted depth (DP), respectively. The estimations use the natural
logarithms of RS, DP, and SIZE. For presentation purposes, the coefficient on trade size has been scaled
by 10 in columns 2, 4, and 5, and the coefficient on trades per day has been scaled by 10 in columns
2-5.
* and ** indicate that the coefficients are significantly different from zero at the 5 and 1% levels, respec-
tively, in two-tailed tests.

eration of the block aspect of total managerial ownership can impact inferences
from ownership structure studies.
Finally, we explored the possibility of simultaneous equations bias. In other
words, a non-manager's decision to become a blockholder might be influenced
by a stock's liquidity (e.g., its spreads and depths). To address this concern, we
 Heflin and Shaw 631

rely upon work by Demsetz and Lehn (1985), Denis and Sarin (1999), and Sarin,
Shastri, and Shastri (1999) to motivate the following set of explanatory variables
for ownership concentration: firm size (market value of equity); retum volatil-
ity (standard deviation of daily retums); leverage (debt to equity ratio); firm age
(number of years publicly traded through the end of 1988); diversification (num-
ber of distinct segments reported in the firm's 10-K); and a dummy variable that
equals 1 if the firm operates in a regulated industry (primary SIC code first digit is
4 or 6). Thus, the two-equation system consists of equation (3) and the following.

(4) Non-manager block % = ao + a\ (LIQ) + a2(firm size)

H- 0:3 (leverage) -\- a4(firm age)
H- a5(retuni volatility) -t- a6(diversification)
+ a7(industry regulation) -i- e.

To ascertain whether non-manager block % or our liquidity variables are en-

dogenous, we perform an endogeneity test (see Wu (1973) and Hausman (1978))
on equations (3) and (4). This test uses the residuals from a first stage regression
of a (potentially) endogenous variable on all the exogenous variables as an addi-
tional explanatory variable in a second stage estimation of the other endogenous
variable. In our case, we are most interested in the significance of the residu-
als from estimation of non-manager block % on all the exogenous variables in
equations (3) and (4) as an added explanator in estimations of equation (3). If
non-manager block % is (is not) endogenous, the coefficient on the first stage
residuals in the second stage will be non-zero (zero). We find that in all estima-
tions of equation (3), the coefficient on the residuals from the first stage is not
different from zero. Hence, the Hausman-Wu test rejects the notion that non-
manager block % is endogenous. Thus, we conclude it unlikely our estimations
of equation (3) are unduly influenced by simultaneous equations bias.'^
Our regression coefficients from columns 4 and 5 of Table 4 suggest an in-
crease in the informed trading spread of about 3.25 (3.1 employing LSB estimates,
3.4 employing HS estimates) one hundredths of a cent for each increase of one
percentage point in non-manager block ownership and about five one hundredths
of a cent for each increase of one percentage point in manager block ownership.
For example, spreads for a firm with 20% non-manager block ownership would,
ceteris paribus, be (0.20 x 0.0325 = 0.0065) 6.5 tenths of a cent higher than
for a firm with no block ownership, or about $13 more on a 2,000 share trade.
Spreads for a firm with 20% manager block ownership would, ceteris paribus,
be (0.20 X 0.05 = 0.01) one cent higher than for a firm with no manager block
ownership, or about $20 more on a 2,000 share trade.
These numerical estimates, however, likely understate the full extent of costs
of blockholder ownership. For example, results in column 6 of Table 4 suggest
quoted depths are lower as block ownership rises, but extant theory provides no
method to combine spreads and depths to measure the costs of illiquidity. Further,
though prior research suggests market illiquidity is associated with higher costs of
capital (e.g., Amihud and Mendelson (1986) and Chalmers and Kadlec (1998)),

" A S expected, the Hausman-Wu test suggests the liquidity variables are endogenous.
632 Journal of Financial and Quantitative Analysis

there are no generally accepted methods for computing the impact of illiquidity
on costs of capital and firm value. Our objective is simply to document how block
ownership impacts market liquidity, thereby increasing our understanding of the
economic forces at work.

IV. Conclusion
We conduct empirical tests to determine whether spreads and depths are as-
sociated with the proportion of the firm owned by blockholders, i.e., entities own-
ing 5% or more of a firm's shares. Although blockholders may provide a moni-
toring function that helps reduce agency costs and increase firm value, they also
potentially have access to, or can develop, private, value-relevant information.
Theory suggests market makers increase bid-ask spreads and decrease depths as
expected losses to informed traders increase. If market makers perceive block-
holders have better information regarding firm value, then spreads should increase
and/or depths should decrease as the level of block ownership increases.
We find that both relative and effective spreads increase as the proportion
of the firm owned by blockholders rises. Further, we construct estimates of the
portion of the spread due to adverse selection using two different spread decom-
position models, and find both estimates increase as the level of ownership by
blockholders increases. We also find total quoted depths are inversely related to
the level of block ownership. Our results hold both for blockholders who are
managers of the firm in which they hold blocks and non-manager blockholders.
In sum, the results suggest higher blockholder ownership, regardless of
whether the blockholders are managers, is associated with reduced liquidity for
the firm's stock. Although a higher level of ownership by blockholders might be
useful in reducing agency costs, it appears to be accompanied by reduced market
liquidity.

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