Cornell Law Review Volume 104 Issue 2

Activist Directors And Agency Costs: What Happens When an Activist Director Goes on the Board?

We develop and apply a new and more rigorous methodology by which to measure and understand both informed trading and the agency costs of hedge fund activism. We use quantitative data to show a systematic relationship between the appointment of a hedge fund-nominated director to a corporate board and an increase in informed trading in that corporation’s stock (with the relationship being most pronounced when the fund’s slate of directors includes a hedge fund employee). This finding is important from two different perspectives. First, from a governance perspective, activist hedge funds represent a new and potent force in corporate governance. A robust debate continues as to whether activist funds reduce the agency costs of corporate governance, but this is the first attempt to investigate whether activist hedge funds also impose new agency costs through widened bid-ask spreads and informed trading. Second, although insider trading is almost universally condemned, it has only been studied in individual cases. Using instead a quantitative approach, we develop a tool that enables regulators (civil and criminal) to identify suspicious trading patterns: both to demonstrate such a pattern and to map these new agency costs, we assembled a data set of 475 settlement agreements, between target companies and activist funds relating to the appointment of fund-nominated directors, from 2000 to 2015, in order to focus on what happens once such a fund-nominated director goes on the board.

Among our principal findings are:

  1. Prevalence of Hedge Fund Employees on Slates. Approximately 70% of fund-nominated director slates include a hedge fund employee.
  2. Increase in Information Leakage. Once a fund-nominated director goes on the board, an abrupt increase in “information leakage” follows, with the result that the target corporation’s stock price begins to anticipate future public disclosures. Specifically, we examine some 635,450 Form 8-K’s filed by 7,799 publicly traded companies over the period of January 1, 2000 to September 30, 2016, and we construct a control group for each of the corporations subject to an activist intervention. We find that firms appointing an activist nominee or nominees experience a difference-in-differences increase in leakage of twenty-five to twenty-seven percentage points.
  3. Hedge Funds Versus Other Activists. We next consider whether post-appointment increases in leakage depend on the identity of the activist investors (i.e., hedge fund versus other activist investors). We find that the leakage effect is clearly driven by hedge fund activists (and no other type of activist).
  4. Leakage and Hedge Fund Employees. We investigate whether leakage increases depend on the identity of the director appointed to the target firm’s board, distinguishing between hedge fund employees and non-hedge fund employees. We find that the increase in leakage is driven by the appointment of activist fund employees to the corporate board (and not by the appointment of other persons, such as industry professionals).
  5. Leakage and Confidentiality Provisions. We consider whether post-settlement increases in leakage are associated with confidentiality provisions restricting information sharing in the settlement agreements. The majority of settlement agreements have no confidentiality provisions, and information leakage is concentrated in these cases.
  6. Market Response to Settlement Agreements. We next examine whether the stock market’s response to settlement agreements depends on (a) whether a hedge fund employee is on the director slate, and (b) whether the settlement agreement contains or refers to a confidentiality provision. We find that the five day CAR is more than twice as high (4.2% vs. 1.97%) for settlements with only non-employee directors and also significantly higher (2.02% vs. 0.42%) for settlements with an explicit restriction on information sharing.
  1. Effect on Bid-Ask Spread. Bid-ask spreads increase by statistically meaningful amounts in our treatment group after an activist director gains access to the boardroom. Bid-ask spreads do not widen for the control groups. Further, we find that the increases in bid-ask spreads are concentrated in those cases in which (i) a hedge fund employee is appointed to the board, or (ii) no confidentiality pro- vision is referenced in the settlement agreement.
  2. Options Trading. We find that options trading in- creases significantly after the appointment of an activist director and in a manner consistent with informed trading. Consistent with earlier research on informed trading, we find that options traders focus on unscheduled Form 8-K filings.
  3. Implications. The foregoing pattern is most plausibly explained as the product of informed trading. Material, nonpublic information appears to be incorporated into the market price prior to public dis- closure. We reach no conclusions about who is trading or its legality in any individual case. Yet, the widened bid-ask spread strongly suggests that the market expects such trading, and the much more positive market response to director slates without a hedge fund employee (or with a confidentiality provision) suggests that the market suspects that informed trading is closely associated with the appointment of a hedge fund employee to the board.
  4. Hypothesis. Our data suggests that the ability to engage in informed trading may serve as a subsidy that inflates the rate of hedge fund activism (producing more engagements than if stronger controls on information sharing were imposed) and may even encourage activists to pursue inefficient engagements. Further, a potential beneficiary of this informed trading may be the “wolf-pack” of activists that follow the lead activist in the engagement. But we stop short of attempting to estimate the size of such impacts.
  5. Reforms. We consider and evaluate a variety of possible reforms that are consistent with an energetic various degrees) the subsidy of informed trading.
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