On November 8, 2017, Fordham University School of Law’s Corporate Law Center, in partnership with Morgan, Lewis & Bockius LLP and the SEC Historical Society, hosted the 18th Annual A. A. Sommer, Jr. Lecture on Corporate, Securities, and Financial Law. The Sommer lecture series was started to commemorate A. A. Sommer, Jr., a Commissioner on the SEC from 1973–1976, and who also began the Morgan Lewis securities practice in 1979.[1]
This year’s lecture, entitled “The Agency Costs of Activism,” was delivered by John C. Coffee Jr., Adolf A. Berle Professor of Law and Director of the Center on Corporate Governance at Columbia Law School. Professor Coffee lectured on the rise of hedge fund activism and the potential costs to public company shareholders: information leakage, thwarted majorities, and public morality.
Hedge fund activism has created a new landscape for corporate governance. Once an activist hedge fund identifies an underperforming company, it asks for representation on the target company’s board in order to implement a new business strategy. If opposed, the hedge fund threatens a proxy fight to secure board representation. Shareholder democracy may be maximized because activist hedge funds identify underperforming firms and then implement changes in the company’s business models. Ideally, this maximizes shareholder democracy by allowing the shareholders to once again vote on the composition of the board, but as Professor Coffee explained, things usually do not work out that way.
In his research, Professor Coffee observed that in 2016, activity funds initiated 149 campaigns to secure board seats, and of that number, 131 board seats were captured. Ninety-five percent of those seats were the result of private settlement negotiations, resulting in what is “the opposite of democratic.” Minority shareholders thwart the majority shareholders, pushing companies in directions they do not want to go. Firm management ultimately grants the activist fund board representation through private settlement negotiations because management is risk-averse; losing a proxy fight for even one seat would likely mean forced departure of their CEO within two years.
Professor Coffee mapped the agency costs of activism that arise from this new structure in corporate governance, grouping them into four categories: private benefits, informed trading, thwarted majorities, and retreat from public interest positions favored by beneficial holders.
Professor Coffee’s research on the ramifications of informed trading indicates that there is a pattern of information leakage unique to boards with fund-nominated directors. In a control group of firms that did not have fund-nominated directors on their boards, stock prices generally moved immediately after disclosure of new directors. On the other hand, when fund-nominated directors were appointed via private settlement agreements, increases in information leakage resulted in the target firms’ stock prices moving several bumps in the direction of subsequent public disclosures. The stock prices essentially anticipated the disclosures. This pattern was even more pronounced when a fund-nominated director was also a hedge fund employee rather than an industry expert or some other independent director. Professor Coffee’s research also demonstrates that bid-ask spreads, or the difference between the ask and bid price, was wider when activist directors are appointed to the board, and the pattern is more pronounced in the case of activist directors who are hedge fund employees.
According to Professor Coffee, informed trading by those who have access to material, non-public information explains the widening of the bid-ask spread. Professor Coffee remarked that while illegality cannot be inferenced from his data, even negligent handling of confidential information results in other shareholders having to bear agency costs. He offered the hypothesis that access to material, non-public information through a fund-nominated director who is also a hedge fund employee, may be the social glue that holds together the “wolf-pack” network of hedge fund activists. While fund-nominated directors may not be engaged in insider trading, someone in the “wolf-pack” is exploiting this information. This is harmful because nonpublic information acts as a subsidy to activism, which encourages a proliferation of nonpublic information.
While it is possible to identify which activists are most associated with information leakage, Professor Coffee’s goal is less censuring and more academic, in hopes that eventually target companies’ defense counsel will learn to study the data to attack their adversaries. In addition, Professor Coffee proposed that permanent shareholders should adopt bylaws that give them veto power over expansion of board size and vacancy appointments. He also noted, however, that these existing practices may be so lucrative they may be hard to reign in. Professor Coffee believes that “wolf-packs” may escape disclosure because the only shareholders who need to file a schedule 13D disclosure are those that have above a certain percentage of shares. Professor Coffee concluded that “sunlight might be the best disinfectant.” If public attention is focused on these patterns of informed trading, activists may perhaps be embarrassed and shamed into not appointing their own employees to the boards of target companies.
[1] A. A. Sommer, Jr. Lecture on Corporate, Securities, and Financial Law, available at https://www.fordham.edu/info/23050/public_lectures/6099/aa_sommer_jr_lecture_on_corporate_securities_and_financial_law (January 26, 2018).
