Activist campaigns are on the rise on both sides of the Atlantic. Even large-cap companies are increasingly targeted by activists—particularly hedge funds—with remarkable success. A big reason for that success is the support that activist proposals attract from traditional institutions, such as actively managed mutual funds, pension funds, and passive index-tracking investors. Hence, hedge funds primarily seek targets whose shareholder base features a significant proportion of institutional investors. This does not mean, however, that activists only focus on companies with widely dispersed ownership; they also target controlled companies. Minority-empowering shareholder tools, such as the right to nominate and elect some minority directors on the board, coupled with institutional shareholders’ voting support, can encourage activism at controlled companies.
There’s a widespread view that activism at controlled companies helps discipline controlling shareholders, mitigates the principal-principal agency problem, and supports traditional institutions’ stewardship function. As a result, U.S. scholars have supported giving shareholders unaffiliated with controlling shareholders the right to elect minority directors.
In a recent article, I argue that corporate governance scholars and practitioners have not paid enough attention to the distinction between de jure and de facto controlled companies. A recent case concerning a leading Italian company shows that, where the so-called slate voting system grants minority shareholders the right to appoint some directors on a board, such distinction can be relevant to the corporate governance effects of successful activist intervention. Where a company is under de facto control and minority-empowering devices apply, activist engagement can bring about changes in the governance structure of the firm, particularly at the board level, so substantive that they reverse the balance of power between minority and majority shareholders—an outcome not even conceivable at de jure controlled companies.
In effect, at de facto controlled companies, the interplay of factual circumstances and regulatory tools can render the market for corporate influence so powerful that the majority of board seats shifts from directors appointed by the controller to activist-appointed directors, and control is terminated without any change in corporate ownership or voting rights. Such an outcome may result from a confluence of conditions, including: 1) the presence of a dominant shareholder holding a relatively low equity stake; 2) a significant level of institutional investors in the company; 3) the applicability of legal rules that encourage influence-based activism—specifically, board representation rights such as those based on the Italian regime of slate voting; and 4) the ability of an activist’s proposals to attract sufficient voting support from larger fellow shareholders, thus rendering it likely that the controller’s voting power may be overwhelmed. Under these conditions, which can occur also in the U.S., the exercise of minority-empowering rights at de facto controlled companies may have unexpected consequences.
Perhaps the biggest consequence is that a corporate governance structure can become even less efficient than in situations of de facto control, with a controlling shareholder having higher commitment to the firm and an entrepreneurial vision which could potentially benefit all investors. Majority board representation that is premised on a small equity stake held by the appointing activist, in conjunction with the presence of a much larger, but (theoretically) disempowered shareholder, can result in an inefficient corporate governance structure. That can lead to instability at the corporate-governance level, increasing the chances for conflict within the board over business strategy and making the support of mainstream institutions uncertain. At the same time, the activist may not be able to impose its agenda on firm management without running some potential risk of being considered a de facto controlling stockholder: which might be the case where, based on a strongly factual analysis of contextual factors, the minority shareholder was found to actually dominate the board and the corporate decision-making process.
In addition, in the situation thus brought about, the monitoring role of non-activist institutional shareholders becomes pivotal. It’s unclear, though, that fundamentally passive investors can be effective gatekeepers, exercising oversight over influential corporate decision-makers once activist intervention succeeds. Especially where activism is motivated by disagreement on corporate strategies, active stewardship is a costly endeavor that cannot easily be aligned with non-activist institutional investors’ business models and incentive structures.
Showing the potential unexpected corporate governance consequences of activism at de facto controlled companies can help frame the U.S. debate on shareholder empowerment and refine the claim that activists’ board representation can solve the principal-principal agency problem at controlled companies. These potential corporate governance consequences also complement the skeptical view of the regulatory and self-regulatory tendency—which is apparent in the EU and is on the rise in the U.S.—towards promoting institutional investor engagement without more closely considering the impact of engagement-related costs. Such an approach might prompt institutions to support activist campaigns without ensuring adequate monitoring. At de facto controlled companies, this can fuel the debate into corporate-governance effects of shareholder activism.
This post comes to us from Professor Gaia Balp at Bocconi University’s Department of Legal Studies. It is based on her recent paper, “Activist Shareholders at De Facto Controlled Companies,” available here.