Raiders, Activists, and the Risk of Mistargeting

For decades, Delaware and federal law governing contests for corporate control have focused on building walls to keep corporate raiders outside the gates, while doing relatively little to stop activist hedge funds. The prevailing academic view has been similar: Scholars frequently support measures that make life more difficult for raiders, while taking a more skeptical stance toward measures that target activists. In both cases, the conventional wisdom rests on an assumption that raiders pose a greater threat than activists to corporations and their stockholders.

In a recent article, Raiders, Activists, and the Risk of Mistargeting, we argue that this conventional wisdom has it backward. Because shareholder activists have a higher risk of mistargeting – mistakenly shaking things up at firms that only appear to be underperforming – they are more likely than corporate raiders to destroy value and, ultimately, social wealth. We thus suggest equalizing the regulation of raiders and activists.

As corporate outsiders who challenge the incompetence or disloyalty of incumbent management, raiders and activists play similar roles in reducing agency costs at target firms. The difference between these two control challengers comes down to a simple observation about their differing business models. Raiders typically acquire 100 percent of a target’s stock at a significant premium above market. By contrast, activists need only buy a small block of shares to push their reforms through via the proxy-voting process. As a result, raiders have a much higher hurdle rate – the rate of return they need to make a target worth their substantial investment. Moreover, raiders are unable to shift risk onto other parties, since they end up owning 100 percent of the target’s stock, giving them further incentive to invest more in information and take only prudent risks. Activists, on the other hand, buy smaller blocks, giving them a much lower hurdle rate, and they can shift some of the cost of mistakes onto other shareholders. They are thus much more likely to try to shake things up at corporations that are underperforming by only a slight margin.

The differences in the incentives of raiders and activists only increase after the acquisition of their stakes. Raiders have unrestricted access to nonpublic information once they acquire 100 percent ownership, whereas activists have restricted access due to the securities laws and other restrictions. After completing an acquisition and looking under the hood, a raider can always decide to maintain the company’s existing business strategy, thereby preserving social wealth that an activist would have destroyed. Moreover, as repeat players whose success in future campaigns depends on their credibility, activists face structural conflicts that impede their ability to objectively evaluate a target company’s business even when they can obtain confidential information. For these reasons, activists are much more likely to try to “fix” something that is not broken.

The mistargeting risk rests on the idea that investors cannot always accurately identify the true value of the firms they buy into, and when they mistakenly undervalue these firms, they create an opportunity for raiders and activists to (mis)target these firms. There are at least two reasons outsiders might fail to perceive the true value of a publicly traded firm: market mispricing and asymmetric information. Market mispricing involves the undervaluation of a company’s stock based on investors’ evaluation of public information. For example, investors might unduly discount a corporate leader’s idiosyncratic vision, undervalue long-term gains over short-term ones, or overreact (or underreact) to new information, leading to temporary mispricing until the market corrects itself. Asymmetric information refers to the situation in which a company possesses trade secrets or other confidential information it cannot share with the market, causing its stock price to fall short of its true value.

Because of their all-in business model, corporate raiders are less likely on both fronts to inflict costly mistakes on long-term shareholders. In our article, we use an informal model to illustrate how this mistargeting dynamic might play out. We also explain the role of externalities: Both the positive and negative effects of activists and raiders ripple across the market, amplifying the good and the bad alike.

After presenting our theory, we turn to the available empirical evidence. We argue that prior research supports the view that activists pose a greater threat than raiders to shareholder value and the economy. To start, the evidence that activists on average improve shareholder value is equivocal at best. While certain studies have concluded that activism increases shareholder value, other studies have reached different conclusions, with one recent study attributing the earlier studies’ findings of positive effects to flawed research designs.[1] Moreover, other research has found that the value generated by activists comes primarily from those efforts that eventually result in the target’s acquisition.[2] In the words of one private equity manager, the role of activists is not stirring things up within their target companies but “teeing up deals,” resulting in the target firm “being driven into some form of auction.”[3]

Meanwhile, the skewed distribution of returns in the stock market highlights the potential for activists to impose substantial costs on shareholder value and the economy. Research in finance has found that returns in the stock market are not normally distributed – they are positively skewed.[4] A small number of firms account for most of the return in the stock market. In fact, one study found that some 4 percent of companies have generated the entire equity premium in the stock market over the past 90 years.[5] This finding suggests that there is only one top performing firm for every 20 low/medium performing firms in the stock market. Suppose that even just a quarter of those growth-driving companies (i.e., 1 percent of all companies) have at some point fit the mold of underperforming companies whose long-term vision would eventually lead to explosive growth. If activists had nipped these firms in the bud because they were not generating optimal short-term results, they would have destroyed a quarter of all economic growth. Moreover, there is no telling how many companies would have been among the 4-percenters were it not for mistargeting by activists.

These observations suggest that the law’s efforts to lock the gates against corporate raiders while letting shareholder activism go relatively unchecked are exactly backward, and the regulation of both control challengers should be equalized. If shareholder activists are potentially more harmful than corporate raiders, it would seem the barbarians are already inside the gates. The insight that activists are more likely than their ugly cousins to mistarget companies has profound implications for corporate law. In fact, the main value of hedge fund activists is not in fixing targets’ operations, finances, or governance, but rather in overcoming the barriers created by Delaware’s takeover jurisprudence – side-stepping targets’ legally allowed defenses and facilitating mergers and acquisitions. Our analysis has timely implications for debates currently taking place in the courts and among regulators about how to address – and how to evaluate efforts by boards of directors to address – shareholder activism.

In particular, our analysis is highly relevant to the Delaware Court of Chancery’s recent decision to invalidate an “anti-activist” poison pill in In re Williams Companies Stockholder Litigation,[6] which is currently on appeal before the Delaware Supreme Court[7] and was previously debated on the pages of this blog by Columbia Law School Professor Jeffrey Gordon and Wachtell, Lipton, Rosen & Katz attorney Eric Robinson. As we explain in greater detail in our article, the Court of Chancery effectively held that hedge fund activism could never be a valid threat to corporate policy, substantially limiting the ability of corporate boards to defend against legitimate activist threats. In so ruling, the court affirmatively distinguished precedents allowing the use of poison pills against raiders on the ground that they involved takeover attempts, not pure activism. Our analysis suggests that this is exactly the opposite of how courts should evaluate activists vis-à-vis raiders. Activists pose the greater threat when they urge operational or financial changes, not a sale of the target company.

ENDNOTES

[1] Ed deHaan, David F. Larcker & Charles McClure, Long-Term Consequences of Hedge Fund Activist Interventions, 24 Rev. Acct. Studs. 536 (2019).

[2] Robin Greenwood & Michael Schor, Investor Activism and Takeovers, 92 J. Fin. Econ. 362 (2009); deHaan, Larcker & McClure, supra.

[3] Andrew Ross Sorkin, Will the Credit Crisis End the Activists’ Run?, N.Y. Times: Dealbook (Aug. 27, 2007), https://dealbook.nytimes.com/2007/08/27/will-credit-crisis-end-the-activists-run.

[4] Hendrik Bessembinder, Do Stocks Outperform Treasury Bills, 129 J. Fin. Econ. 440 (2018).

[5] Id. at 441.

[6] In re Williams Cos. Stockholder Litig., C.A. No. 2020-0707-KSJM, 2021 WL 754593, at *4 (Del. Ch. Feb. 26, 2021).

[7] Opening Br., Williams Cos. v. Wolosky, No. 139, 2021 (Del. June 25, 2021).

This post comes to us from Zohar Goshen, the Jerome L. Greene Professor of Transactional Law at Columbia Law School, and Reilly S. Steel, a Phd student at Princeton University. It is based on their recent article, “Raiders, Activists, and the Risk of Mistargeting,” available here.

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