The Agency Costs of Activism: Information Leakage, Thwarted Majorities, and the Public Morality

The Agency Costs of Activism: Information Leakage, Thwarted Majorities, and the Public Morality

John Coffee

November 28 2017

Few doubt that hedge fund activism has radically changed corporate governance in the United States -- for better or for worse. Proponents see activists as desirable agents of change who intentionally invest in underperforming companies to organize more passive shareholders to support their proposals to change the target’s business model and/or management. So viewed, the process is fundamentally democratic, with institutional shareholders determining whether or not to support the activist’s proposals.

            Skeptics respond that things do not work this simply. Actual proxy contests are few, and most activist engagements are resolved through private settlement negotiations between the activists, who rarely hold 10% or more of the stock, and corporate management. Driving this process of private resolution is management’s fear of ouster if they allow the matter to go to a proxy contest. But as a result, activists holding often only a small percentage of the stock are imposing their agenda on other shareholders who hold much more. Increasingly, large indexed investors -- BlackRock, State Street and Vanguard in particular -- are objecting that this pattern of private settlements excludes them.

            Against this backdrop, this article attempts to map the “agency costs” of contemporary activism on the premise that any new structure of governance will have its own unique agency costs. We do so by constructing a data set of 475 settlement agreements entered into in relation to the appointment of activist nominees to the board between 200 and 2015, and then studying both the agreements, the market stock price reaction to them, and changes in the bid/ask spread. Basically, we survey four areas in which activists have interests that can conflict with those of the other shareholders:

  1. Private Benefits. Activists do receive private benefits (most notably in the form of expense reimbursement), but to date these benefits have been fairly modest (probably for a variety of reasons).

  2. Information Leakage. The appointment of hedge fund nominees to a corporate board is followed by a significant increase in information leakage in the target firm’s stock price. That is, the target firm’s stock price regularly moves in the direction of a subsequent public disclosure -- and does so significantly more often and more emphatically than in the case of a control group of firms. This can most plausibly be explained as a consequence of informed trading by persons apprised of the material information that is to be released in the subsequent public disclosure. Moreover, this phenomenon of information leakage is significantly greater when the hedge fund’s nominees include a hedge fund employee (as opposed to nominees who are simply independent directors). Further, once hedge fund nominees are appointed to the board, bid/ask spreads widen in comparison to the spreads on stocks in a control group. Again, this pattern is most pronounced when one of the nominees is a hedge fund employee. Finally, we find that the market reacts significantly more positively to the announcement of fund-proposed nominees that do not include a hedge fund employee.

  3. Thwarted Majorities. Activists often have a short-term agenda, to which the firm’s “permanent shareholders” (i.e., its indexed investors) object. Given these disagreements, it is undemocratic (even if predictable) that an organized minority can dominate a larger, more dispersed “silent majority.” This is a “horizontal” agency cost in contrast to more traditional “vertical” agency costs.

  4. Public Morality. Although most institutional investors favor public goals, such as greater gender diversity on the board and a shift from “dirty” to “clean” energy, activists have opposed both and are constraining the ability of public companies to behave in a manner consistent with the public morality.

This article will also discuss proposed reforms intended to minimize these agency costs, without materially chilling shareholder activism. Our bottom line is, however, that our evidence can only be explained as demonstrating systematic informed trading by either activists or their allies.