Shareholder-Creditor Conflicts and Limits to Arbitrage: Evidence From the Equity Lending Market

Abstract

We show that shareholder-creditor conflicts affect equity prices through limits to arbitrage. Using the presence of dualholders -- institutions holding equity and debt of the same firm -- as a proxy for reduced shareholder-creditor conflicts, we find that shareholders are more willing to lend out shares when they face lower conflicts. This effect is stronger when creditor bargaining power is high. Dualholder presence increases non-dualholding blockholders' willingness to lend out shares. Shareholders in firms with dualholders are less likely to recall loaned shares prior to shareholder meetings for voting. Exploiting an exogenous reduction in dualholders' abilities and incentives to facilitate incentive alignment induced by banks ceasing proprietary trading following the Volcker Rule, we find that dualholders can indeed mitigate shareholder-creditor conflicts and thus reduce short sale constraints, leading to more efficient stock prices. Our findings suggest that agency problems due to shareholder-creditor conflicts have real impacts on equity market efficiency.

Keywords: Limits to Arbitrage, Dual Holders, Shareholder-Creditor Conflict; Short Selling, Equity Lending

JEL Classification: G21, G30, G34