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Shareholder Activism as a Corrective Mechanism in Corporate Governance

Rose and Sharfman, (Ohio State University and Case Western Reserve University School of Law), have just published an interesting article on this interesting topic, which we will follow through in this post.

Shareholders activism exists in a market for corporate influence, not in a market for control. Activism has two main formats: a) Performance-driven activism, which focuses in strategy, finance, operations, and so on, and b) Corporate Governance activism, (which focuses in governance, compensation and social policy, sometimes to pursue performance.

The increase of institutional investors and shareholder power has allowed activism to become more effective during the last years. In their article Rose & Sharfman try to show how aggressive activism can enhance shareholder value.

Shareholder Activism and Corporate Law.

Corporate law, in order to provide firms with a centralized and hierarchical managerial power, grants the board exclusive authority to celebrate explicit and implicit contracts, which itself leaves day-to-day operations to management, thus keeping this power out of shareholder reach.

Moreover, the business judgement rule protects directors from shareholder liability. And as a basis for this, Rose & Sharfman cite Kenneth Arrow, who argues that “information scattered over a large organization must be both filtered and transmitted to a centralized authority in order for a large organization to make informed decisions and minimize error in decision-making”.

There is nevertheless a certain accountability from boards, given the agency costs and a self-interested behavior that may appear. But given the power given to boards and management, shareholders need to face some (not insurmountable) obstacles, thus allowing some room for agency costs in order for “corporate decision making to maximize the value of centralized authority and get as close to shareholder wealth maximization as possible”.

So, activism could be considered to be beneficial in some discrete situations, forcing decision-making power to shareholders, out of the hands of board and management. In a sense, Rose & Sharfman consider this process one of efficient authority sharing.

Activism benefits are different depending on the kind of shareholder

Rose & Sharfman make a difference between several kinds of investors, because of their level of information, skills, and their willingness to interfere in the activities of the firm:

–         Insiders, they don`t participate in activist raids.

–         Liquidity traders don`t participate either, as they don`t have the skills, the interest, nor the information collecting capacities.

–         Noisy traders: low informed, they rarely participate, and they do so often opportunistically,

–         Market makers: they act similarly to the previous ones,

–         Information traders: they try to capture value based on information gaps they discover, as in the case of hedge funds, or in general, value investors.

Offensive Shareholder Activism (OSA)

It can be defined as performance-driven activism initiated primarily by a hedge fund, who targets underperforming firms, invests a large amount of cash, promotes change and eventually higher performance so that stock prices increase, and then makes a profit. Hedge funds are ready to take a hands-on approach, and provide valuable information to the firm, which constitutes the most relevant difference with other value investors:

a)      OSA as a sharing of authority. Rose & Sharfman show how information may sometimes be found not by the firm`s authority, but by other interested parties –information traders, and perhaps hedge funds-, which makes criticism to the authority something valuable, and a shift in decision-making authority in particular cases to shareholders, also valuable.

b)      Disinterested and uninformed shareholders: if shareholders are to vote, their rational apathy should be a problem; nevertheless, activism often has a previous effect, so that voting does not occur, and suboptimal decisions do not necessarily happen.

c)      Empirical approach to OSA: several studies back the idea that offensive shareholder activism enhances shareholder value, perhaps when reaching a sale of the company, a spin-off, or any other major strategy change. And some other studies also back the idea that those benefits persist in time, (not being just a short-term effect). Nevertheless, evidence does not support activism as generating value in “every firm at any time”, so a certain discretion by boards could be recommended if unwanted results are to be avoided. They should be able to adopt changes, or not, and in this latter case, so explain to shareholders.

 Short-term versus long-term investors

This is one of the main topics in the current discussion on the hedge funds`activities, between mainly Martin Lipton and Lucien Bebchuk. Rose & Sharfman separate themselves from this debate, insisting in the following points:

–         Activists provide liquidity, which is apparently welcome by all shareholders.

–         All investors value companies the same way, discounting cash flows, so at the end all of them are interested in the long-term.

–         Shot-term runs in stock prices does not usually disappear with time.

Nevertheless, some critics still persist against OSA, using for example the Intrinsic Value Argument:  according to this argument, there is not relevant information out of the reach of management and boards that can be seized by others, (such as aggressive activist shareholders). Management and boards maximize intrinsic value, which is not always shown in the stock price. The problem with this argument is the fact that sometimes offensive activists “do have” better information on some facts, and empirical studies so suggest.

Based on: Rose & Sharfman, “ Shareholder Activism as a Corrective Mechanism in Corporate Governance”, September 2013.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324151.

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