Not all threats are taken equally: Evidence from proxy fights

• Published date: 01 February 2020
• Author: Jian Huang,Susan M. V. Flaherty,Fang Chen,Gokhan Torna,Lijing Du
• DOI: http://doi.org/10.1111/fire.12220
• Date: 01 February 2020

DOI: 10.1111/fire.12220

ORIGINAL ARTICLE

Not all threats are taken equally: Evidence from

proxy fights

Fang Chen1Lijing Du2Susan M. V.Flaherty2Jian Huang2

Gokhan Torna3

1College of Business, University of New Haven,

WestHaven, Connecticut

2College of Business and Economics, Towson

University, Towson,Maryland

3College of Business, State University of New

Yorkat Stony Brook, Stony Brook, New York

Correspondence

JianHuang, College of Business and Economics,

TowsonUniversity,Towson,MD 21252.

Email:jhuang@towson.edu

Abstract

Previous research shows that activist threats lead to corporate pol-

icy concessions. We find that the threat of proxy fights is responded

to differently based on its credibility. Decomposing proxy fight

threats, we find that only credible threats are associated with more

leveraged, more innovative, and less acquisitive corporate policies.

Management, however, does not respond to noncredible threats.

Further, for materialized fights, the market reaction at announce-

ment is also conditional on the credibility of the threats. Overall,

not all activist threats are responded to equally by management or

the market,and only credible threats achieve disciplinary effects and

favorablevaluation.

KEYWORDS

activist threats, credible threats, disciplinary effects, market

reaction, noncredible threats, proxy fights

JEL CLASSIFICATIONS

G14, G31, G34, G35

[I]n many cases activist investorscan reap the benefits of a ‘win’ with far less than a formal proxy contest.

—The activist revolution, J. P.Morgan, January 2015 (Page 7)

1INTRODUCTION

Quite often, the theory of the firm attributes the survival of the corporate form to devices such as proxy fights that

constrain the potential incentive problems created by the separation of ownership and control. Alchian and Demsetz

(1972, p. 788) state that “the transfer of proxies enhances the probability of a decisive action in the event current

Financial Review.2020;55:145–168. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 145

146 CHEN ET AL.

stockholders or anyoutsider believe that management is not doing a good job with the corporation.” However, activists

do not necessarily need to launch a proxy fight to achievetheir goal of disciplining incumbent management and chang-

ing corporate policies (Brav,Jiang, Partnoy,& Thomas, 2008; Fos, 2017; Gantchev, Gredil, & Jotikasthira, 2018; Klein &

Zur,2009; Zhu, 2013). The report by J. P. Morgan (2015, p. 7) indicates that “in many cases activist investors can reap

the benefits of a ‘win’ with far less than a formal proxy contest.”

Existingstudies help to explain the paradox that while proxy fights are deemed to be effective in constraining agency

issues, only few are observed. However, this stream of literature focuses primarily on the activist threat, which has

already been escalated to the stage of news reports or Schedule 13D filings—that is, methods used by activists to com-

municate their desire to begin a proxy solicitation “but never got to the SEC [Securities and Exchange Commission]

level of an actual solicitation” (Klein & Zur,2009, p. 215). According to Brav et al. (2008), these under-the-spotlight

threats apply to only a small fraction of firms—about 2.68% firm-years of the COMPUSTAT universe. The limitation is

clear—behind-the-scene threats are mostly private engagement, which restricts the data availability.1

We posit that the proxy fight threat exists to a much larger scope, and targeted and yet-to-be-targeted firms are

actively seeking advice from investment banks and corporatelawyers, “with a view towards minimizing vulnerabilities

to attacks” by potential activists, such as monitoring whether any meaningful ownership has been built up by potential

activists or “whether the company’s stock is trading at a discount” (New YorkTimes, November 11, 2013).2Fos (2017,

p. 666) suggests that the disciplinary role for proxy contests is not limited to firms that are actually targeted in proxy

contests—firms can “probably realize that the likelihood of shareholder intervention increases.”3

Regardlessof whether a Schedule 13D has been filed, such a threat exists anytime for any firm. Central to addressing

the impact of such a threat requires an evaluation of its magnitude. In other words, we need to measure the threat of

actually being targeted for firms without initiated proxy fights or activism.

Further,by acknowledging that the proxy fight threat should be an effective disciplinary tool in general (e.g., Brav

et al., 2008; Fos, 2017), we argue that its effectiveness relies on the credibility of the threat. By making concessions

when facing credible threats, incumbent managers share the gains with potential activists. Incumbents avoid manage-

rial turnover and reputation or compensation loss due to the possibility of losing a proxy fight developedfrom a cred-

ible threat (Huang & Yen, 1996), whereas activists avoidthe efforts/costs in building up stakes and initiating a costly

proxy fight (Bhattacharya, 1997). In contrast, incumbents are unwilling to makeconcessions while facing noncredible

threats as managers are likely to survive such a proxy fight evenwhen it materializes. More importantly, the cases in

which dissidents are unlikely to win may be terminated long before they materialize and never get responded to by

management. Such noncredible threats may pertain to, for example,cases where operating/stock market performance

of a firm is deemed to be acceptable and/or dissidents are not able to accumulate significant ownership to push the

proxy fight through. This situation is analogous to litigations in which a lawsuit will succeed in extractinga settlement

(concessions) only with a credible threat (Bebchuk, 2007).

Totest whether a proxy fight threat achieves any meaningful concessions from management and the effect of the

credibility of such threat, our empirical analysis and results unfold as follows. First, we use a two-stage Heckman model

to estimate the probability of proxyfight threat and to decompose proxy fight threats into credible versus noncredible

threats.Proxy Fight Threat is the probability of a firm being targeted by a proxy fight in a given year,which is estimated by

Pr(ProxyFight).4Credible Threat is the probability of a firm being targeted in a proxy fight in the year and at the same time

losing the fight if it is materialized, which is estimated by the interactionof Pr(Proxy Fight)andPr(DissidentVictory|Proxy

1Thelimited research on private engagement, without exceptions, all rely on proprietary data sets and are normally restrained to a single institutional investor

suchas TIAA-CREF (Carleton, Nelson, & Weisbach, 1998) and the Hermes UK Focus Fund (Becht, Franks, Mayer,& Rossi, 2009).

2Seehttps://search.proquest.com/docview/2214204135/fulltext/E4B6507F807F43EEPQ/1?accountid=14378

3Marketparticipants’ and corporate executives’ability to forecast the occurrence of corporate events has been documented for proxy contests as wellasother

events. Forexample, Huang, Jain, and Torna (2018) find policy adjustment before the materialized proxy contests is generally in the interests of dissidents,

inferring that management can forecast such events and outcomes. Likewise, for other corporateevents such as acquisitions, Anderson, Huang, and Torna

(2017)and Anderson and Huang (2017) suggest that acquisitions can be forecasted by characteristics observed as early as the initial public offering.

4Acaveat is that we do not examine the credibility of any specific activist, but rather a firm’s likelihood to be attacked as well as its likelihood to losethefight

shouldone occur. Specifically, we estimate Proxy Fight Threat,t he probability of a firm being targeted bya proxy fight, for all COMPUSTAT firms, targeted and