Barbarians Inside the Gates: Raiders, Activists, and the Risk of Mistargeting.

• Author: Goshen, Zohar

ARTICLE CONTENTS INTRODUCTION 414 1. THE PROMISE (AND THREAT) OF CONTROL CONTESTS 422 A. Raiders and Activists in Corporate Control Contests 424 B. Agent and Principal Costs in Corporate Control Contests 428 II. THE MISTARGETING HAZARD 431 A. Causes of Mistargeting 432 1. Market Mispricing 432 2. Asymmetric Information 439 B. The Mistargeting Model 440 III. THE COSTS OF RAIDERS AND ACTIVISTS 444 A. Raiders and Activists Compared 445 l. Propensity to Intervene 445 2. Likelihood of Destroying Social Wealth 446 3. Cost-Shifting 451 4. Offsetting Effects of Shareholder Screening 452 B. The Empirical Evidence 455 1. Agent Costs in Focus 456 2. Principal Costs in Focus 459 IV. IMPLICATIONS FOR LAW AND POLICY 463 A. Delaware Law 464 B. Federal Law 480 CONCLUSION 485 INTRODUCTION

Activist investor Bill Ackman was supposed to save JCPenney. His hand-picked Chief Executive Officer (CEO) Ron Johnson, the architect of Target's turnaround, announced a bold new strategy: "fair and square pricing."' No more discounts or clearance, just great prices every day of the year. (2) The results were disastrous and almost immediate. Revenue fell by a quarter, the stock price cra-tered by 60%, and thousands of employees lost their jobs. (3) "Penney had been run into a ditch when he took it over," Columbia Business School Professor Mark Cohen said of Johnson, "But, rather than getting it back on the road, he's essentially set it on fire." (4) Nor is that the only high-profile failure by an activist investor in recent years. After nagging Sony for years to spin offentire divisions, (5) Dan Loeb of Third Point finally threw up his hands and sold out two years ago. (6) And when Carl Icahn initially reported a position in Netflix in 2012, he pushed for a sale to a third-party strategic buyer, calling the young company a "great acquisition candidate," (7) only to be later proven wrong about its standalone potential.

After Icahn failed to bring about a sale, Netflix excelled on its own, with its stock price rising by over 1,700% over the following decade. (8) These stories cut against the conventional view of shareholder activists as scrappy visionaries with the pluck and acumen to turn around ailing corporate giants. (9)

What these cases have in common is a shareholder activist who enters the corporate scene with a plan to make things better and instead makes (or almost makes) things much worse. The very name--shareholder activists--evokes the image of faithful foot soldiers in the battle for efficiency and shareholder value. By contrast, their ugly cousins--corporate raiders--evoke greedy Wall Street fat cats: Gordon Gekko screaming into a phone and ruining somebody's life. (10) But as the examples of JCPenney, Sony, and Netflix show, sometimes the image fails to match the reality.

This Article argues that the conventional wisdom--corporate raiders break things and activist hedge funds fix them--is wrong. Activists are no better than raiders; if anything, they are likely worse. Because, as we argue, activists have a higher risk of mistargeting--mistakenly shaking things up at firms that only appear to be underperforming--they are much more likely than raiders to destroy value and, ultimately, social wealth. (11) This insight has important implications for the law and policy of control contests. Delaware and federal law alike have focused on keeping raiders outside the gates, but they ignore the real threat: activists already inside. We thus propose equalizing the regulation of raiders and activists. (12)

The distinction between raiders and activists comes down to a simple observation about their differing business models. Raiders typically acquire 100% of the target's stock at a significant premium above market. (13) By contrast, activists need only buy a relatively small block of shares to push their reforms through via the proxy-voting process. (14) As a result, raiders have a much higher hurdle rate--the rate of return they need to make a target worth their substantial investment. (15) Moreover, as potential 100% owners of the target's stock, raiders cannot shift risk onto other parties, further incentivizing them to invest more in information and take only prudent risks. (16) On the other hand, activists buy smaller blocks, allowing for a much lower hurdle rate and an ability to shift some of the cost of mistakes onto other shareholders. (17) They are thus much more likely to try to shake things up at corporations that are underperforming by only a slight margin.

The differences in the incentives of raiders and activists only increase after acquiring their stake. Raiders have unrestricted access to nonpublic information once they acquire 100% ownership, whereas activists have restricted access due to the securities laws and other restrictions. (18) After completing an acquisition and looking under the hood, a raider can always decide to maintain the company's existing business strategy, thereby preserving social wealth that an activist would have destroyed. Moreover, as repeat players whose success in future campaigns depends on their credibility and reputation, (19) activists face structural conflicts that impede their ability to evaluate a target company's business objectively even when they can obtain confidential information. (20) For these reasons, we argue, activists are much more likely to try to "fix" something that is not broken.

The mistargeting risk rests on the idea that investors cannot always accurately identify the true value of the firms they buy into, and when they mistakenly undervalue these firms, they create an opportunity for raiders and activists to (mis)target these firms. There are at least two reasons why outsiders might fail to perceive the true value of a publicly traded firm. The first is market mis-pricing. A company that lags behind its peers may be poorly run, or it may be engaged in an innovative business plan that is hard for investors to understand and value. (21) Investors may also systemically undervalue long-term gains over short-term ones, or else might simply be impatient--the "short-termism" problem. (22) Or investors might overreact (or underreact) to new information, leading to temporary mispricing until the market corrects itself. (23) The second reason why investors might misperceive their companies' value is asymmetric information. A company may possess trade secrets or other private, confidential information that it cannot share with the market, causing its stock price to fall short of its true value. (24)

Notably, the mistargeting is a mistake only from the perspective of long-term diversified shareholders, who are either selling their firm to a raider for too low a price or replacing a successful business strategy with a mediocre one upon a campaign of an activist. Whether the reason for the undervaluation is mismanagement or the market's underappreciation of a high-quality company, it is a bargain for a raider and a profit opportunity for an activist.

Because of their all-in business model, corporate raiders are less likely on all fronts to inflict costly mistakes on long-term shareholders. A short illustration shows how activists might destroy shareholder value to a greater extent than raiders. Suppose an economy is comprised of high-quality, low-quality, and average companies. Low-quality and high-quality firms alike appear to "underper-form" in the sense that current performance is below some relevant benchmark. But while the low-quality firms actually do underperform because of poor management, the high-quality firms only appear to underperform because they are engaged in hard-to-value, long-term, innovative strategies that will produce gangbuster profits in future periods. For the reasons mentioned above, it is difficult for activists to tell low-quality from high-quality companies. When activists target low-quality companies and turn them into average companies by improving management quality, they add value to shareholders and the economy. But when they target high-quality companies and turn them into average companies by shutting down innovation, they destroy value. Raiders, by contrast, are less likely to move companies either from low-quality to average or from high-quality to average. For example, if both high- and low-quality firms underper-form relative to their peers by 10%, 20%, or even 50%, a raider that needs 60% upside to turn a profit will pass. (25) Moreover, in the cases that the raider buys the target, the 100% ownership makes it likelier that the mistargeting is discovered and avoided. For this reason, raiders are less likely to destroy shareholder value or create it.

That shareholder activists and corporate raiders add value, at least in some cases, is beyond dispute. In particular, activists reduce agency costs (or "agent costs"), the value lost to unfaithful managers who take liberties and expropriate the private benefits of control. (26) Imagine a firm whose CEO mismanages the company for private benefits so that the corporation underperforms relative to its peers by 10%. A raider with a 60% hurdle rate will not go anywhere near this company. But an activist who needs, say, a 7% or 8% return stands to make a buck by firing the CEO, replacing them with a loyal agent, and selling. In a world with only raiders, this CEO will get away with their expropriation, but in a world with activists and raiders, they will get the boot.

Moreover, both positive and negative effects ripple across the market. On the one hand, where an activist or a raider can make a buck by firing lazy CEOs who take long afternoon naps and use the company jet for leisure travel, managers across the board are ex ante less likely to do those things. (27) This is a positive externality of shareholder activism. (28) On the other hand, where activists are likely to mistarget firms engaged in profitable but long-term business strategies, CEOs are less likely to take bold positions or...