The Agency Costs of Activism: Information Leakage, Thwarted Majorities, and the Public Morality

Few doubt that hedge fund activism has radically changed corporate governance in the United States – for better or for worse. Proponents see activists as desirable agents of change who intentionally invest in underperforming companies to organize more passive shareholders to support their proposals to change the target’s business model and/or management. So viewed, the process is fundamentally democratic, with institutional shareholders determining whether or not to support the activist’s proposals. Skeptics respond that things do not work this simply. Actual proxy contests are few, and most activist engagements are resolved through private settlement negotiations between the activists, who rarely hold 10% or more of the stock, and corporate management. Driving this process of private resolution is management’s fear of ouster if they allow the matter to go to a proxy contest. But as a result, activists holding often only a small percentage of the stock are imposing their agenda on other shareholders who hold much more. Increasingly, large indexed investors – BlackRock, State Street and Vanguard in particular – are objecting that this pattern of private settlements excludes them. Against this backdrop, this article attempts to map the “agency costs” of contemporary activism on the premise that any new structure of governance will have its own unique agency costs. Basically, it identifies four areas in which activists have interests that can conflict with those of the other shareholders: Private Benefits. Activists do receive private benefits (most notably in the form of expense reimbursement), but to date these benefits have been fairly modest (probably for a variety of reasons). Information Leakage. The appointment of hedge fund nominees to a corporate board is followed by a short-term increase in information leakage in the target firm’s stock price. That is, the target firm’s stock price regularly moves in the direction of a subsequent public disclosure – and does so significantly more often and more emphatically than in the case of a control group of firms. This can most plausibly be explained as a consequence of informed trading by persons apprised of the material information that is to be released in the subsequent public disclosure. Moreover, this phenomenon of information leakage is significantly greater when the hedge fund’s nominees include a hedge fund employee (as opposed to nominees who are simply independent directors). Further, once hedge fund nominees are appointed to the board, bid/ask spreads widen in comparison to the spreads on stocks in a control group. Thwarted Majorities. Activists often have a short-term agenda, to which indexed investors object. Given these disagreements, it is undemocratic (even if predictable) that an organized minority can dominate a larger, more dispersed “silent majority.” This is a “horizontal” agency cost in contrast to more traditional “vertical” agency costs. Public Morality. Although most institutional investors favor public goals, such as greater gender diversity on the board and a shift from “dirty” to “clean” energy, activists have opposed both and are constraining the ability of public companies to behave in a manner consistent with the public morality. Finally, this article will discuss proposed reforms intended to minimize these agency costs, without materially chilling shareholder activism

Ratings Reform: The Good, the Bad, and the Ugly

Although dissatisfaction with the performance of the credit rating agencies is universal (particularly with regard to structured finance), reformers divide into two basic camps: (1) those who see the issuer pays model of the major credit ratings firms as the fundamental cause of inflated ratings, and (2) those who view the licensing power given to credit ratings agencies by regulatory rules requiring an investment grade rating from an NRSRO rating agency as creating a de facto monopoly that precludes competition. After reviewing the recent empirical literature on how ratings became inflated, this Article agrees with the former school and doubts that serious reform is possible unless the conflicts of interest inherent in the issuer pays model can be reduced. Although the licensing power hypothesis can explain the contemporary lack of competition in the ratings industry, increased competition is more likely to aggravate than alleviate the problem of inflated ratings. Still, purging conflicts is no easy matter, both because (1) investors, as well as issuers, have serious conflicts of interest (for example, investors dislike ratings downgrades) and (2) a shift to a subscriber pays business model is impeded by the public goods nature of credit ratings. This Article therefore reviews recent policy proposals and considers what steps could most feasibly tame the conflicts of interest problem

Accountability and Competition in Securities Class Actions: Why Exit Works Better than Voice

The rules of litigation governance in class actions are diametrically different from the rules of corporate governance, in large part because the former works off an opt out rule while the latter employs an opt in rule. This results in higher agency costs in the former context. To address this problem, reformers have long favored remedies such as the lead plaintiff provision of the Private Securities Litigation Reform Act ( PSLRA ), which in theory give class members a stronger voice. Empirically, however, such voice-based reforms appear to have had no more than a modest impact. But an alternative remedy appears to be more promising: exit-based reforms that seek to provoke greater competition between class counsel and attorneys soliciting class members to opt out of the class and file individual actions with them in state court. Unnoticed by academics, a major trend towards institutional investors opting out of securities class actions has developed over the past five years. More importantly, these opt outs appear to be recovering per share amounts that are a multiple of the class per share recovery. This development poses a variety of issues that this paper examines: (1) Why do opt outs do better?; (2) Do the opt outs gains come at the expense of those who remain in the class?; (3) Can defendants feasibly restrict opt outs and how should courts respond to such attempts?; (4) Are pension funds and other institutional investors under a fiduciary or ERISA-based duty to opt out?; and (5) Will greater competition produce greater accountability

Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated

Several commentators have argued that financial “reform” legislation enacted after a market crash is invariably flawed, results in “quack corporate governance” and “bubble laws,” and should be discouraged. This criticism has been specifically directed at both the Sarbanes-Oxley Act and the Dodd-Frank Act. This article presents a rival perspective. Investors, it argues, are naturally dispersed and poorly organized and so constitute a classic “latent group” (in Mancur Olson’s terminology). Such latent groups tend to be dominated by smaller, but more cohesive and better funded special interest groups in the competition to shape legislation and influence regulatory policy. This domination is interrupted, however, by major crises, which encourage “political entrepreneurs” to bear the transaction costs of organizing latent interest groups to take effective action. But such republican triumphs prove temporary, because, after the crisis subsides, the hegemony of the better organized interest groups is restored. As a result, a persistent cycle that this article calls the “Regulatory Sine Curve” can be observed: the legislative success of the latent investor group is followed by increasingly equivocal implementation of the new legislation, tepid enforcement, and eventual legislative erosion. This article traces that pattern with respect to both the Sarbanes-Oxley Act and the ongoing implementation of the Dodd-Frank Act. This article does not deny that “reform” legislation often contains flaws (as does much deregulatory legislation). But these are usually quickly eliminated in the latter half of the cycle. The greater dilemma is instead whether the problem of systemic risk can be satisfactorily addressed in the presence of the Regulatory Sine Curve

Paradigms Lost: The Blurring of the Criminal and Civil Law Models – And What Can Be Done About It

Ken Mann\u27s professed goal is to shrink the criminal law. To realize this worthy end, he advocates punitive civil sanctions that would largely parallel criminal sanctions, thereby reducing the need to use criminal law in order to achieve punitive purposes. I agree (heartily) with the end he seeks and even more with his general precept that the criminal law should be reserved for the most damaging wrongs and the most culpable defendants. But I believe that the means he proposes would be counterproductive – and would probably expand, rather than contract, the operative scope of the criminal law as an engine of regulation and social control. The differences in our analyses follow from differences in our perspectives. Professor Mann\u27s focus is largely doctrinal and basically centers on the question of whether courts will accept candidly punitive civil penalties. My perspective is more behavioral and focuses on incentives: what would regulators and private enforcers do under a legal system that largely overlaid punitive civil sanctions on top of criminal penalties? We also begin from different starting points. Although we both agree that the line between civil and criminal penalties is rapidly collapsing, Professor Mann sees (and favors) the encroachment of the civil law upon the criminal law. I see more of the reverse trend: the encroachment of the criminal law into areas previously thought to be civil or regulatory in character. Thus, I want to resist encroachment, while he wishes to encourage it in order to give enforcement authorities the less drastic remedy of civil penalties

The Future as History: The Prospects for Global Convergence in Corporate Governance and Its Implications

What forces explain corporate structure and shareholder behavior? For decades this question has gone unasked, as both corporate law scholars and practitioners tacitly accepted the answer given in 1932 by Adolf Berle and Gardiner Means that the separation of ownership and control stemming from ownership fragmentation explained and assured shareholder passivity. Over this decade, however, corporate law scholars have recognized that this standard answer begs an essential prior question: if ownership fragmentation explains shareholder passivity, what explains ownership fragmentation? Although the Berle and Means model assumed that large-scale enterprises could raise sufficient capital to conduct their operations only by attracting a large number of equity investors, contemporary empirical evidence finds that, even at the level of the largest firms, dispersed share ownership is a localized phenomenon, largely limited to the United States and Great Britain. Not only does the latest comparative research demonstrate that concentrated, not dispersed, ownership is the dominant worldwide pattern, but in-depth studies of individual countries show that share-holder activism increases in direct proportion to ownership concentration. As a result, these findings, in turn, suggest that the conventional governance norms in the United States may be more the product of a path-dependent history than the natural result of an inevitable evolution toward greater efficiency

Paradigms Lost: The Blurring of the Criminal and Civil Law Models-And What Can Be Done About It

Ken Mann\u27s professed goal is to shrink the criminal law. To realize this worthy end, he advocates punitive civil sanctions that would largely parallel criminal sanctions, thereby reducing the need to use criminal law in order to achieve punitive purposes. I agree (heartily) with the end he seeks and even more with his general precept that the criminal law should be reserved for the most damaging wrongs and the most culpable defendants. But I believe that the means he proposes would be counterproductive – and would probably expand, rather than contract, the operative scope of the criminal law as an engine of regulation and social control. The differences in our analyses follow from differences in our perspectives. Professor Mann\u27s focus is largely doctrinal and basically centers on the question of whether courts will accept candidly punitive civil penalties. My perspective is more behavioral and focuses on incentives: what would regulators and private enforcers do under a legal system that largely overlaid punitive civil sanctions on top of criminal penalties? We also begin from different starting points. Although we both agree that the line between civil and criminal penalties is rapidly collapsing, Professor Mann sees (and favors) the encroachment of the civil law upon the criminal law. I see more of the reverse trend: the encroachment of the criminal law into areas previously thought to be civil or regulatory in character. Thus, I want to resist encroachment, while he wishes to encourage it in order to give enforcement authorities the less drastic remedy of civil penalties