Is trust in large shareholders warranted?

From the Vancouver Securities Law Blog:

Corporate directors are the stewards of a company. The directors are supposed to make decisions in the best interests of the corporation. In instances where a company is not performing as expected, there are certain shareholders who are taking the reins and trying to force the change they feel will best turn around a company’s share price.

[Citing a couple of examples]

... Investors have usually supported the directors placed before them during proxy time; if a company is not performing well or has been subject to a series of significant missteps along the way, then be prepared for a proxy fight. And rightfully so, because if the directors do not seem to be delivering in the best interests of the company, then a large shareholder will bring in directors who will.

But why would an economically rational large investor do so? In my book, Corporate Governance after the Financial Crisis, I explain that:

… the returns to [investor] activism likely are low. Because many companies must be monitored, and because careful monitoring of an individual firm is expensive, institutional activism is likely to focus on crisis management. In many crises, however, institutional activism is unlikely to be availing. In some cases, intervention will come too late. In others, the problem may prove intractable, as where technological changes undercut the firm’s competitive position.

Even where gains might arise from activism, only a portion of the gains would accrue to the activist institutions. Suppose that the troubled company has 110 outstanding shares, currently trading at $10 per share, of which the potential activist institution owns ten. The institution correctly believes that the firm’s shares would rise in value to $20 if the firm’s problems were solved. If the institution is able to effect a change in corporate policy, its ten shares will produce a $100 paper gain when the stock price rises to reflect the company’s new value. All the other shareholders, however, will also automatically receive a pro rata share of the gains.  As a result, the activist institution confers a gratuitous $1,000 benefit on the other shareholders.

Put another way, the gains resulting from institutional activism are a species of public goods. They are costly to produce, but because other shareholders cannot be excluded from taking a pro rata share, they are subject to non-rivalrous consumption. As with any other public good, the temptation arises for shareholders to free ride on the efforts of those who produce the good.

So why do we occasionally see large investors nevertheless engage in proxy activism? One possible explanation would draw on behavioral economics, seeking to explain seemingly irrational behavior as arising out of ego, hubris, and so on.

The other possible explanation is that large investors are behaving in an economically rational way because they expect to reap non-pro rata gains that will not be shared with their fellow stockholders. As I also explain in Corporate Governance after the Financial Crisis, much institutional investor activism seems to be driven by rent seeking:

In several high profile cases, …  activist hedge funds have used financial innovations to pursue private gains at the expense of other shareholders. In 2005, for example, a hedge fund launched a proxy campaign to elect three candidates to the board of Exar Corporation. The hedge fund had boxed 96% of the shares it owned—i.e., had taken offsetting short positions on those shares—and “was thus almost completely indifferent to how the company performed since a ‘boxed’ position is capable of generating no further profit or loss.”  Another well-known case involved Perry Capital’s innovative investments in King Pharmaceuticals and Mylan Laboratories. The hedge fund was a large shareholder in both Mylan and King. Mylan proposed an acquisition of King at a price many industry observers thought excessively high. Perry nevertheless supported the acquisition. As it turned out, Perry had used derivatives to hedge away its economic interest in Mylan. As a result, the only way Perry could make money on the deal was through its investment in King stock. Accordingly, Perry would prefer that Mylan overpay for King, even though that obviously would be detrimental to Mylan’s other shareholders.  Scholars have identified several other examples of such private rent seeking by hedge funds and other activist investors.

In either case, the assumption that the interests of activist large shareholders and those of a firm's other shareholders are one and the same is clearly unwarranted. Activists thus deserve at least as skeptical an assessment as do entrenched managerial incumbents.