Dancing with activists

Abstract

An important milestone often reached in the life of an activist engagement is entering into a “settlement” agreement between the activist and the target's board. Using a comprehensive hand-collected data set, we analyze the drivers, nature, and consequences of such settlement agreements. Settlements are more likely when the activist has a credible threat to win board seats in a proxy fight and when incumbents’ reputation concerns are stronger. Consistent with incomplete contracting, face-saving benefits, and private information considerations, settlements commonly do not contract directly on operational or leadership changes sought by the activist but rather on board composition changes. Settlements are accompanied by positive stock price reactions, and they are subsequently followed by changes of the type sought by activists, including CEO turnover, higher shareholder payouts, and improved operating performance. We find no evidence to support concerns that settlements enable activists to extract rents at the expense of other investors. Our analysis provides a look into the “black box” of activist engagements and contributes to understanding how activism brings about changes in target companies.

Introduction

In August 2013, Third Point, the hedge fund led by Daniel Loeb, disclosed a significant stake in the auction house Sotheby's, criticized the company for its poor governance and its failure to take advantage of a booming market for luxury goods, and called for the ouster of the company's CEO. Third Point launched a proxy fight for board representation, and both sides were preparing for a contested election at the company's upcoming annual meeting. However, the day before the scheduled annual shareholder meeting, the company and the activist fund entered into a settlement agreement in which Sotheby's agreed to appoint three of the Third Point director candidates and Third Point agreed to discontinue the proxy fight. The settlement terms did not require the company to make any of the operational and executive changes that Third Point was seeking. However, ten months later, Sotheby's announced the hiring of a new CEO, the appointment of a new board chairman, and a plan to return capital to its investors.

While such settlements used to be rare, they now occur with significant frequency, and they have been attracting a great deal of media and practitioner attention. Understanding settlement agreements is important for obtaining a complete picture of the corporate governance landscape and the role of activism within it. Using a comprehensive, hand-collected data set of settlement agreements, this paper provides the first systematic empirical investigation of settlements between activists and target companies. We study the drivers of settlements, their growth over time, the terms of settlements, and their impact on board composition, and the stock market reaction accompanying them. We further study the aftermath of settlements in terms of CEO turnover, payouts to shareholders, mergers and acquisitions (M&A) activity, and operating performance.

With the growing recognition of the importance of hedge fund activism, a large empirical literature on the subject has emerged (see Brav et al., 2015b for a recent survey). This literature has extensively studied the initiation of activist interventions—the time at which activists announce their presence, usually by filing a Schedule 13(d) with the Securities and Exchange Commission (SEC) after passing the 5% ownership threshold, and the stock market reactions accompanying such announcements.¹ This literature has also studied extensively the changes in the value, performance, and behavior of firms in the years following activist interventions; among other things, researchers have studied the changes in Tobin's Q, return on assets (ROA), productivity, innovation, payouts to shareholders, likelihood of an acquisition, divestitures, internal capital markets, and accounting practices that ultimately follow activist interventions.² But there has been limited empirical work on the “black box” in between—the channels through which activists’ influence is transmitted and is reflected in targets’ economic outcomes.³ In particular, the determinants, nature, and role of settlement agreements—and the cooperation between activists and companies that they target—have not been subject to a systematic empirical examination. Our study fills this gap.⁴

We begin by quantifying the upward trend in activist settlements. We show that the unconditional likelihood of an activism campaign leading to a settlement increased sevenfold and almost linearly from 3% for campaigns launched in 2000 to 21% for campaigns launched in 2013. This increase in the prevalence of settlement agreements is much stronger than the increase in contested votes during the same period. While contested votes also occurred in 3% of all activism campaigns started in 2000, this ratio only increases to 6% for campaigns started in 2013.

We build on the insights generated by the economics of litigation and settlements to put forward hypotheses concerning the determinants of which cases will produce a settlement rather than end up without either a contested vote or a settlement. We hypothesize that settlements are more likely in cases in which the activist has good chances to win board seats should a contested vote take place, and we find evidence consistent with this hypothesis. We also hypothesize that settlements are more likely when a contested vote could impose larger reputational costs on incumbents, and we find evidence that is also consistent with that hypothesis. As to timing, we hypothesize that settlements are more likely to take place closer to the time of the target's shareholder meeting, as the arrival of information regarding the outcome of the expected vote narrows any divergence of expectations between the parties, and we provide evidence that is consistent with this hypothesis.

Turning to the terms of settlements, we argue that the terms of settlement agreements can commonly be expected to focus on board turnover rather than to stipulate directly the kind of operational and leadership changes that activists ultimately seek and on which they base their hopes for value appreciation. We put forward three reasons—incomplete contracting that make some direct action commitments infeasible, face-saving benefits, and informational asymmetry—that combine to preclude or discourage the incorporation of commitments for direct action. We provide evidence that is consistent with the hypothesis that settlement terms tend to focus on board composition and avoid commitments of direct action. We also find evidence that face-saving benefits, as well as informational asymmetry, at least partly contribute to the documented patterns.

We then turn to investigate systematically the effects of settlements on board composition. We demonstrate that settlements are a key channel through which activists bring about board changes. In particular, we find that settlements are associated with an increase in the number of activist-affiliated, activist-desired, and well-connected directors and decrease the number of old and long-tenured directors.

Next, we show that settlements are accompanied by positive abnormal stock returns on average. We find that the positive market reaction is especially large when the settlement is of “high impact” in terms of creating a high volume of board turnover or providing for an immediate strategic transaction. We also find that activist engagements that produce settlement agreements are associated with higher abnormal stock returns at the time of the activist's initial 13(d) filing. These patterns are overall consistent with the view that the market views favorably the boardroom composition and other changes that activist settlements produce and are inconsistent with the view that such changes can be expected to be disruptive and detrimental to target shareholders.⁵

Why do activists settle on changes in board composition if their ultimate goal is to bring about operational or leadership changes? We argue that introducing individuals into the boardroom who are aligned with the activist, or at least open to the changes sought by the activist, is an intermediary step that often facilitates such changes. Consistent with this view, we show that, while settlements generally do not stipulate a replacement of the CEO, settlements are followed by a considerable increase in CEO turnover and in the performance-sensitivity of CEO turnover. Thus, the evidence is consistent with settlements planting the seeds for a subsequent CEO replacement. Similarly, while settlement agreements generally do not require any specific operational changes, settlements might facilitate such changes: consistent with the presence of such an effect, we show that settlements are followed by increased payouts to shareholders and improvements in operating performance.

Finally, we also investigate concerns raised by some practitioners and commentators that settlements between activists and targets enable activists to extract rents at the expense of other shareholders who are not “at the bargaining table.”⁶ We examine two suggested channels for such rent extraction and find little evidence that settlements distribute significant rents to activists at other shareholders’ expense. First, we find no evidence to support concerns that settlements enable activists to put on the board directors that are not supported by other shareholders.⁷ In particular, we show that directors who enter the board through settlements do not subsequently receive less voting support at the following annual general meetings than other directors. Second, we also find little evidence that settlements produce a significant incidence of “greenmail” through the target's purchasing of the activist's shares at a premium to the market price. Buybacks of activist shares occur in a very small fraction of settlement agreements, and when they do occur, they are typically executed at the market price.

Our analysis is organized as follows. Section 2 discusses the institutional background. Section 3 describes the data collection and sample construction. Section 4 examines the determinants and timing of settlements. Section 5 focuses on the terms of settlements and, in particular, on the prevalence of director turnover and the infrequent specification of direct actions. Section 6 examines the director changes on which settlement terms focus and analyzes their effects on board composition. Section 7 considers the stock market reactions that accompany the announcements of settlements as well as the initial stock market reactions to the initiation of campaigns that ultimately end up in settlements. Section 8 focuses on the economic aftermath of settlements. In particular, we examine the changes in CEO turnover, shareholder payouts, likelihood of a strategic transaction, and operating performance that follow settlements. Section 8 also examines concerns about rent extraction by activists, and we find no evidence for such extraction. Finally, we present our conclusions in Section 9.