Soft Shareholder Activism

Posted by Doron Levit (University of Pennsylvania), on Wednesday, December 19, 2018

The modus operandi of a typical activist investor is to target a public company and propose major changes to its strategy, financial policy, operations, and personal. To defend themselves against these proposals, companies use poison pills, staggered boards, dual-class structures, and other measures. Securities regulation and disclosure requirements also limit the power of activists. In practice, activists rarely own a controlling stake. Without control, activist investors cannot force their ideas on their target companies; they must persuade its board of directors or the majority of shareholders that adopting their proposals is in the best interests of the firm. Simply put, shareholder activism requires communication and persuasion.

Consistent with this idea, recent evidence suggests that behind-the-scenes communications between investors and firms is an important corporate governance mechanism, perhaps more important than previously thought (e.g., McCahery et al. 2016). This evidence raises two fundamental questions that have been overlooked by the existing literature. First, what factors contribute to successful dialogues between investors and firms? Second, under what circumstances will investors resort to more aggressive tactics, and when will they choose to exit?

My article Soft Shareholder Activism, which is forthcoming in the Review of Financial Studies, investigates the conditions under which communications between investors and firms is an effective form of shareholder activism. I develop a model in which the activist can communicate (cheap-talk) with the board of the target company, and depending on the reaction to her demand, the activist can either launch a public campaign (i.e., employing a “voice” mechanism) or exit her position. The innovation of the model is the introduction of the possibility of direct communications between investors and firms into a framework with voice and exit, the “traditional” governance mechanisms. Moreover, different from the existing literature, the activist in my model cannot force her ideas on the company; she must either persuade the board to adopt her proposal, or persuade other shareholders to support her campaign. My model emphasizes this important but often neglected aspect of shareholder activism, and as such, offers a new perspective to this important literature.

The challenge of the activist in this model is to convince the board, who is biased and uninformed, to change the status quo of the firm (e.g., spinning off a division). At equilibrium, the board accommodates the activist’s demand either because it is persuaded by her arguments that changing the status quo is in the best interests of the firm or out of fear that the activist will launch a successful public campaign if her demand is ignored. Communication is effective if the activist can use her private information to influence the board’s decision at equilibrium.

My analysis demonstrates that the threat of voice facilitates communication since the most effective way directors can avoid the adverse consequences of a public campaign is by accommodating the activist’s demand. In turn, the expected accommodation of the board increases the incentive of the activist to engage and communicate in the first place. Generally, an activist’s threat is more credible when rallying support from other shareholders is easier (e.g., shareholder base is undispersed), control is contestable (e.g., declassified board, one class of shares, no supermajority provisions), or the reputational and monetary damage to the incumbent directors from a successful campaign is severe. The model predicts that these factors would contribute to more effective communications. Moreover, the analysis suggests that a public campaign is a sign of ineffective behind-the-scenes communications, and vice a versa. Importantly, it implies that factors that predict high frequency of public campaigns would in fact suggest that the employed tactics are not effective enough to induce boards to comply with demands that activists make behind closed-doors. Without explicitly accounting for the possibility of unobserved communications, an empiricist might reach the wrong conclusions.

The effect of exit on communication is more nuanced. On one hand, the temptation of an activist to “cut and run” harms the credibility of her threat to launch a public campaign if her demand is ignored. Therefore, exit has an indirect effect on communication, through its negative effect on voice. On the other hand, the option to exit increases the activist’s credibility through two related but novel channels. First, with exit, the activist insists on changing the status quo only if the benefit from doing so is also higher than what she expects to get from selling her shares. As a result, the board is convinced that whenever the activist demands a change, the benefit to shareholders must be very high. This effect relaxes the tension between the activist and the board and thereby facilitates communication. Second, exit can also increase the credibility of the activist’s threat to launch a successful public campaign. Essentially, the option to exit gives the activist an opportunity to “put her money where her mouth is” by choosing not to exercise this option. Therefore, the activist has more credibility vis-a-vis shareholders and the board, and communication is more effective in equilibrium. These results highlight that exit can complement voice and facilitate communication.

The analysis shows that the trade-off between these opposing forces and the overall effect of exit on communication is determined by the properties of the activist’s proposal and the voice mechanism, which leads to novel empirical predictions on the factors that contribute to successful dialogues between investors and firms. Specifically, if voice is ineffective as a governance mechanism (e.g., the target company has a dual class share, a controlling shareholder, or a staggered board and draconian supermajority provisions) or if the activist’s proposal is risky relative to the status quo (e.g., the target operates in an emerging industry and the proposal is not a standard fix to its balance sheet or corporate governance), the cut and run effect is dominated and exit facilitates communication. However, if voice is effective and the activist’s proposal is relatively safe, the cut and run effect dominates and exit hinders communication. In general, the effect of exit is more pronounced when the stock is liquid, the short-term capital gains taxes are low, anonymous trade is feasible, or adverse selection is mild. The model predicts that these various factors will be associated with the frequency of successful dialogues between investors and firms.

As a whole, my analysis highlights the importance of communications between investors and firms as a form of shareholder activism.

The complete article is available here.