Activism and Informed Trading

Hedge fund activism has transformed the corporate governance landscape – possibly for better, possibly for worse. But as activist funds emerge as the newest and most potent players in corporate governance, there is one certainty: New agency costs also arise. The activist firm has the de facto ability today to buy a significant block of stock in a target firm (typically 5 percent to 8 percent), announce a new business strategy for the target (often involving increased leverage and asset sales), and then demand board representation (generally two directors, sometimes more) to implement its strategy. Increasingly, the activist gets what it wants, because management is justifiably fearful that it might lose a proxy contest. With their human capital locked into the firm and exposed to loss, target managements are behaving in an increasingly risk averse fashion, usually entering into private settlement agreements that change board composition without the participation of the other shareholders.[1] Given the leverage that the activist firms now possess, the extraction of private benefits from the target firm becomes predictable. But is it really occurring?

In a recent article just posted on SSRN (and available here), I attempt to map these new agency costs. In this post, I will focus on only one aspect of this issue: the use of material, nonpublic information. Studying 475 private settlement agreements that resulted in the appointment of hedge fund nominees to the boards of target firms, my co-authors and I find that an increase in information leakage quickly follows the appointment of fund-nominated directors to the board, with the result that the firm’s stock price anticipates subsequent public disclosures.[2] Whether the subsequent public disclosure has positive or negative impact, the market price will already have drifted in this direction – in sharp contrast to a control group of similar firms that lacked such nominees on their boards. The most plausible explanation for this pattern is informed trading, which seemingly begins at or about the time of these directors’ appointment.

An especially interesting characteristic of this pattern of information leakage is that it is much more pronounced when the hedge fund’s nominees include a hedge fund employee. In short, hedge fund employees leak more (or are at least associated with a much stronger pattern of information leakage) than independent industry experts appointed to the board on the hedge fund’s nomination.

One of the clearest findings in this study involves the bid/ask spread. Bid/ask spreads widen (in comparison with the spreads for control groups) when activist-nominated directors are appointed to the board. But, once again, the widening is far more pronounced in the case of activist directors who are hedge fund employees.[3] Spreads for the treatment and control groups are similar and parallel prior to the appointment of an activist director, but then diverge sharply after that appointment (with the spread widening only in the case of the board with an activist director). Widening spreads imply that the market expects informed trading, and market traders are protecting themselves by expanding the spread defensively.

One must be cautious here and not jump to the conclusion that the hedge fund employee/director is engaging in unlawful insider trading. That inference of illegality cannot be drawn from this data. But whether the spreads widen because of unlawful behavior or simply because of negligent handling of confidential information, the increase in spread width is still an agency cost borne by the other shareholders.

One other correlation deserves special emphasis. Our data set consists of 475 private settlement agreements (extending up until 2015), and a high correlation is evident between information leakage and how the settlement agreement addresses the handling of confidential information by the new directors. In some of these private settlement agreements, there are strict controls on information sharing by the nominee directors (i.e., no sharing without the target company’s consent). But in the majority, there is nothing similar to such a rule. Guess what? Both information leakage and the widening of bid/ask spreads are concentrated in those settlements that lack an explicit rule on information-sharing (either in the settlement agreement or a separate confidentiality agreement). A reasonable inference is that these cases are ones in which target management lacks the leverage to insist upon a stricter rule on information sharing by nominee directors.[4]

Beyond this initial point that shareholders pay a hidden price for activist-nominated directors, there is a larger, more macro-economic conclusion that logically follows from our data. The ability to engage in informed trading based on access to material, non-public information from fund-nominated directors represents a significant subsidy to activist hedge funds. To be sure, we do not know whether this benefit accrues to the activist hedge fund itself, to its employees, or to allies in its “wolf pack” network. But someone benefits. This, in turn, implies that hedge fund activism is receiving a subsidy. Subsidies by definition increase the level and volume of the subsidized activity. Thus, it seems a fair prediction there will be more hedge fund engagements under rules that permit easy information sharing than under a system that restricted the ability of activists to profit from access to material, non-public information. To see this point, consider this example: An activist fund proposes a change in the business model of a target firm. Its proposals are highly debatable, and many other investors are not convinced that the proposals will enhance shareholder value. But they also know that if they join the “wolf pack” and support this effort, they will have access to material, non-public information about the target firm during a very volatile period in which its stock price is likely to fluctuate sharply. Access to inside information promises to be very profitable during such period. If so, other hedge funds may want to stay in the “wolf pack” and remain at least loosely affiliated with the lead activist, even if they doubt the wisdom of its proposed changes in the target’s business model. This premise leads to a generalization: Access to material, non-public information may be the social glue that holds together the “wolf pack” (which otherwise would be a very unstable and short-term entity). Empirically, only the filing of a Schedule 13D that announces the lead activist’s presence and plans elicits a significant abnormal gain (usually 6 percent to 7 percent).[5] But if one knows what will be disclosed publicly in the near future, “wolf pack” members can make lucrative profits, even if the stock moves erratically and with no ultimate net change.

So, what should be done? In my article posted on SSRN, I make some suggestions, including expanding the definition of “group” under the Williams Act to cause the sharing of information to trigger an earlier Schedule 13D filing. Still, as usual, the sunlight of disclosure may be the best disinfectant. Once it is widely recognized that hedge fund employees are associated with much higher rates of informed trading, this may embarrass or shame activists into ceasing to place their own employees on corporate boards. That would be a step in the right direction.

One further step is also possible. By analyzing our data, it should be possible to identify which activist firms are more closely associated with information leakage and widened bid/ask spreads – and, by implication, informed trading. That is not our goal, and we are seeking to avoid such finger-pointing. But, over time, target managements may begin to employ this tactic, and it will be comparatively simple to analyze leakage and spread width on an activist-by-activist basis.

Predictably, there will be some counterattacks on our findings. Diehard academic proponents of activism (hereinafter called, the “Running Dogs”) will argue that widened spreads are a small price to pay for the enormous gains they believe are realized from hedge fund activism. From the Running Dogs’ perspective, Ivan Boesky and Raj Rajaratnam (who both obtained material information from friendly directors) are martyred heroes of the efficient market. Such “the-end-justifies-the-means” arguments should embarrass legitimate activists. Activism itself can survive without the subsidy of a steady supply of material, nonpublic information. But perhaps not all contemporary activists can make that leap.

ENDNOTES

[1] In 2016, Lazard finds that there were some 149 campaigns initiated by activists to obtain board representation, and they obtained some 131 board seats in that year. But 95 percent of these seats were the result of settlement negotiations, with few actual contested proxy contests. See Lazard, “Review of Shareholder Activism in 2016” (February 2017) at p. 1.

[2] See Robert Bishop, Robert J. Jackson, Jr. and Joshua R. Mitts, “Activist Directors and Information Leakage” (2017). This author was not part of this first study, but has joined this project with Professor Jackson’s departure to the Securities and Exchange Commission. Although the initial study focused mainly on information leakage, we are now seeking to relate the widened bid/ask spread to other factors. Although there are 475 private settlement agreements in our data set, not all of them have codable data on all the variables we are seeking to measure and relate. Not infrequently, the parties to the settlement agreement place all provisions on confidentiality in a separate agreement that is not publicly filed.

[3] This is shown in Figure 7 of the Bishop, Jackson, and Mitts study, which is shown in my article posted on SSRN and linked to this column. Basically, the spreads on both the treatment and control groups are similar and parallel up until the appointment of the directors nominated by the hedge fund. After that point, the spreads diverge over time, with only the spreads in the treatment group widening.

[4] Alternatively, it may be that target firm executives, with their careers at stake, simply do not care much if the bid/ask spread widens and so do not insist on stricter provisions on confidentiality in order to appease the activist firms. Most settlement agreements, we find, simply recite a formula that all parties will obey the law.

[5] Basically, a number of studies have found that there is an abnormal return of 6 percent to 7 percent on the filing of a Schedule 13D by an activist, but no further abnormal price spike results unless a merger or similar transaction follows. I assess these studies at length elsewhere. See John C. Coffee and Darius Palia, “The Wolf at the Door: The Impact of Hedge Funds on Corporate Governance,” 41 J. of Corporation Law 545 (2016). The point here made is that, even if there is no long-term price movement, the activist and its allies can profit off of short-term fluctuations.

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance. It is based on his recent article, “The Agency Costs of Activism: Information Leakage, Thwarted Majorities, and the Public Morality,” available here.

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