After over a year of work, which included the review of some 635,450 Form 8-Ks filed by 7,799 public companies from January 1, 2000, to September 30, 2016, we think we know at least one answer to the question in the above title: Informed trading soars! We have just posted our research, which we co-authored with former Columbia Law Professor and now SEC Commissioner Robert Jackson and Robert Bishop, a recent Columbia Law graduate, on SSRN,[1] available here. Above all, it shows that following the appointment of a hedge fund-nominated director to the board, the target firm experiences an abrupt increase in “information leakage” of 25-27 percentage points. By this, we mean that information publicly released in the Form 8-K is anticipated by the market, with the stock price moving prior to the public release in the same direction as caused by that release. But how this occurs (and why it is tolerated) present perhaps even more interesting questions. Possibly, our most surprising finding is that not all activist directors are associated with an increase in informed trading. If the hedge fund places a CEO from the same industry or some other industry expert on the target’s board, there is little increase in “information leakage.” But if it places a hedge fund employee on the board, the increase is immediate and substantial. Although hedge fund employees are a small percentage of directors, we find that they are included on 70 percent of the director slates nominated by hedge funds in our sample.

Their ubiquity on board slates might seem surprising, because the market has a decidedly less favorable reaction to their appointment. We find that the five-day Cumulative Aggregate Residual (“CAR”) is more than twice as high (4.2 percent vs. 1.97 percent) for the announcement of a settlement that places only non-employee directors on the board in comparison with settlements that include a hedge fund employee being added to the board. Seemingly, the market has a strong preference for directors who are not employees of the hedge fund.

Corroborating this interpretation is the impact on bid-ask spreads of placing a hedge fund employee on the board. We find that bid-ask spreads widen by statistically meaningful amounts for firms after an activist director is appointed to their board, but bid-ask spreads do not similarly widen for firms in our control groups. Moreover, this widening in the spread is concentrated in those cases where the new director is a hedge fund employee. Because spreads normally widen in the presence of informed trading, this evidence that the market responds much more positively to activist directors who are not hedge fund employees and that spreads widen when a hedge fund employee is appointed to the board suggests that the market both expects informed trading when a hedge fund employee goes on the board and is not happy with the appointment of such directors.

Given the market’s skepticism of hedge fund employees as directors, one might expect that target managements would resist the appointment of such persons. But they do not. We review some 475 settlement agreements between target firms and activist funds, and we find not only that 70 percent of all fund-nominated slates include such an employee/director, but only a small minority of these settlement agreements contain any provision restricting information sharing between the fund-nominated director (or the hedge fund itself) and other persons. In those cases where there is a confidentiality provision, the market response is decidedly positive.[2] More typical, however, are provisions that seem to authorize information sharing by providing that the hedge fund (or the employee/director) must inform any person with whom it shares confidential information that such information is confidential. Such a provision seems intended more to protect and absolve the hedge fund than to restrict information sharing.[3]

Why do target managements accept hedge fund employees as directors and fail to require confidentiality provisions in settlement agreements? Our hypothesis is that target firms lack leverage in these negotiations because the jobs (and human capital) of management are at stake, as the hedge fund would be favored to win a proxy contest if a settlement could not be reached. Although target managements may disapprove of informed trading, it is not personally costly to them (at least in comparison with the prospect of a defeat in a proxy contest).

Some have raised with us the counter-argument that any tipping that occurs between activist hedge funds and their allies may only be of vague and general information that is not material. For example, the dialogue might be very brief: an employee of another hedge fund asks: “How are things going in your campaign at XYZ Industries?” and the activist answers: “Great, we are making real progress.” This sounds legally immaterial. Still, even if this scenario may be plausible in the abstract, it is inconsistent with the evidence that we gather on options trading in target firms. The existing literature has shown that options trading is generally informed and can predict future stock prices.[4] But it has also shown that such trading usually concentrates on unscheduled events (such as Form 8-K filings). To be successful, such trading in short-term options must be based not only on knowledge of non-public material information, but also on knowledge of the announcement date for such information. In that light, we examine option trading in firms that have recently appointed an activist director, and we find substantial evidence of informed trading in options whose expiration date overlaps with the target’s filing of a Form 8-K. Option trading appears to be a principal mechanism by which information leakage affects stock price in target firms, and it is not the pastime of amateurs.

What is the bottom line impact of informed trading in companies that have recently appointed an activist director? In our view, access to non-public material information at such firms amounts to a subsidy for activism – and thereby likely inflates the number of hedge fund engagements. That is, if the “wolf pack” of hedge funds and others who cooperate in an activist campaign profit only from appreciation in the target’s stock based on their proposals to change its business model, that is perfectly acceptable and the reward is well earned. But if these participants can instead profit from informed trading, they will have much greater incentive to join activist campaigns. In short, more profit (through access to material, non-public information) implies more engagements.

Indeed, access to non-public information may be the social cement that holds together the “wolf pack.” Although it is universally recognized that the filing of a Schedule 13D by the lead activist leads to a predictable and positive abnormal stock return (generally in the range of 6 to 7 percent), further significant gains in the stock price after this initial bump are dependent on a successful outcome to the activist’s campaign (typically, a merger or a sale or spinoff of a significant division). These outcomes are uncertain, and, in their absence, the stock price will eventually decline.[5] Hence, the other members of the “wolf pack” may have little incentive to hold the stock for the longer term, and if they depart and sell their shares, the lead activist loses much of its ability to threaten a credible proxy campaign to oust management. Thus, providing continuing access to material information may be an inducement to persuade the other members to stay in the “wolf pack.”

In turn, this may explain why private settlement agreements rarely contain meaningful confidentiality provisions – that is, activists are reluctant to agree to such provisions and target managements do not suffer any personal loss if they are omitted. Given a choice between tolerating informed trading or risking ouster in a proxy contest, managements seem to consider the former to be the more tolerable outcome. Although this may be a rational choice for risk-averse management, we hypothesize that this practice might serve as a subsidy, inducing an inflated amount of activism. We also suggest that the higher bid/ask spreads associated with placing hedge fund employees on target boards may represent an unnoticed agency cost of activism.

What reforms are desirable? We review several possibilities, including increased SEC disclosure concerning confidentiality arrangements when a hedge fund nominee goes on the board. Although Delaware law recognizes a duty of confidentiality on the part of directors, a respected Delaware vice chancellor in a well-known article has suggested that fund-nominated directors may share confidential information with their hedge fund sponsor.[6] In light of our findings, we suggest that the legal standard should be more exacting: namely, a fund-nominated director should be able to share confidential information with the director’s sponsoring fund (or others) only when the director has a reasonable basis for believing that adequate confidentiality provisions are in place to curb information leakage.

In closing, we emphasize that our findings do not prove that criminal behavior is occurring in any individual case. But the law on insider trading has recently changed (at least in the Second Circuit), as the Newman decision has been overturned and the more recent Martoma decision implies that any “gift” of information to a person foreseeably likely to trade violates Rule 10b-5.[7] The practice of information sharing may be pervasive, but its legality is growing more risky. Activists need to recognize that current practices place them in peril.

ENDNOTES

[1] See John C. Coffee, Jr., Robert J. Jackson, Jr., Joshua R. Mitts and Robert E. Bishop, “Activist Directors and Agency Costs: What Happens When an Activist Director Goes on the Board?” (available at https://ssrn.com/abstract=3100995) (last updated January 19, 2018).

[2] We find that settlements that contain an explicit confidentiality provision receive a more favorable market response: a five-day CAR of 2.02 percent versus only 0.42 percent for those that do not contain such a provision.

[3] Regulation Fair Disclosure, 17 C.F.R. § 243.100(b)(2)(ii), recognizes that disclosure of material information may be made to a person “who expressly agrees to maintain the disclosed information in confidence.” Thus, the activist fund may believe that it is protected if a “wolf pack” ally gives such an undertaking. It is unresolved, however, whether this provision applies to Rule 10b-5.

[4] See Martijn Cremers et al., “How Do Informed Options Traders Trade?: Options Trading Activists, News Releases, and Stock Return Predictability,”(available at https://ssrn.com/abstract_id=2544344) (last revised September 17, 2017).

[5] For the empirical finding that activist engagements without a “successful outcome” do not increase shareholder value, see Marco Becht, et al., “Returns to Hedge Fund Activism: An International Study” (available at https://ssrn.com/abstract_id=2376271) (last revised May 22, 2017) (finding that the stock price of the target only appreciates significantly following the initial jump after the Schedule 13D filing if there is a “successful outcome”).

[6] See Travis Laster & Mark Zeberkiewicz, The Rights and Duties of Blockholder Directors, 70 Bus. Law. 33, 48-51 (2014)

[7] In United States v. Newman, 773 F.3d 438 (2d Cir. 2014), the Second Circuit mandated a very specific showing of “personal benefit” to the tipper, but this position has been expressly reversed in United States v. Martoma, 869 F.3d 58 (2d Cir. 2017). Martoma is a 2-1 decision, and we offer no views on how other circuits will rule, but the law of insider trading has been largely made and enforced in the Second Circuit.

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, and Joshua R. Mitts, an associate professor at Columbia Law School. It is based on their recent article, co-authored with Robert Jackson and Robert Bishop, “Activist Directors and Agency Costs: What Happens When an Activist Director Goes on the Board?” available here.