Moral Hazard and Dynamics of Insider Ownership Stakes

Abstract

The objective of this paper is to provide a rational to the behavior of "large shareholders" and their role in the different stages of the life of a corporation. In this paper I analyze dynamics of ownership stakes of risk-averse corporate insiders by constructing a multi-period, multi-agent model in an economy consisting of two assets: a risky publicly traded firm, and a risk-less asset. The firm's expected cash flows are affected by agents' desire to monitor/manage the firm and, consequently, by the agents' stakes in the company. In parallel with the related one-agent model by DeMarzo and Urosevi (2001), for companies with a high concentration of insider ownership, risk-aversion provides insiders with an incentive to sell repeatedly until the competitive allocation is reached. A solution for the equilibrium share price and the dynamics of the aggregate insider ownership stake is derived in two cases: in the case when the agents can credibly pre-commit not to deviate from their optimal ownership policies, and in the more realistic case when such commitment is not credible (time-consistent case). In the latter case, the aggregate stake gradually adjusts towards the long-run equilibrium. Importantly, the speed of adjustment towards the competitive allocation increases with the number of insiders in the company when the outside investors are risk-averse, and does not depend on it when the investors are risk neutral. Knowing the aggregate stake dynamics is useful for empirical testing since using the aggregate stakes instead of individual ones reduces the estimation noise. Main predictions of the model are consistent with the recent empirical findings.