Optimal Corporate Governance in the Presence of an Activist Investor
The Harvard Law School Forum on Corporate Governance and Financial Regulation 2013-03-08
In our paper, Optimal Corporate Governance in the Presence of an Activist Investor, forthcoming in the Review of Financial Studies, we provide a model of governance in which a board arbitrates between an activist investor and a manager facing reputational concerns. Shareholder activism to force policy changes at publicly-traded firms represents an increasingly important dimension of the market for corporate control. While activist investors represent a source of corporate governance that is external to a firm's power structure, they differ dramatically from the corporate raiders that are the focus of earlier theories of external governance. In most cases, activist investors accumulate relatively small stakes and so cannot exert direct control. Rather, they must rely on persuasion and the firm's internal governance mechanisms to implement changes. As Brav et al. (2008) show, activist hedge funds are often successful in influencing managers and boards, and their efforts have a substantial impact on firm value.
How does the presence of such an external governance force affect internal governance policy? To address this question, we analyze a model in which a board, recognizing that an activist shareholder may exert discipline on a manager, chooses an appropriate level of internal governance. To our knowledge, this is the first theoretical article to consider the interaction between an activist, the board, and a manager. We argue that the possibility of disputes between an activist and management creates a natural but novel role for the board of directors that has not been considered previously: It functions as an arbitrator between different stakeholders who wish to take the firm in different directions.