Laws help keep corporations in check, but they also provide activist hedge funds their business model — to the market’s detriment, a recent paper claimed.
Activist funds use securities laws to their own advantage. Required financial transparency by public corporations leads to activists valuing firms on technical short-term grounds instead of fundamentals, according to Jeff Schwartz, a law professor at the University of Utah. “De facto shareholder primacy causes this short-termism in investment decisions,” he pointed out in his paper for an upcoming issue of the Maryland Law Review. Market-wide emphasis on quarterly reviews and performance metrics incentivizes activist funds to “maximize not just shareholder wealth but shareholder wealth in the short term,” he wrote.
Central to profit maximization is the theory of shareholder primacy, described by Schwartz as, “the idea that corporations should maximize shareholder wealth above all other goals.” All listed companies are affected by it, and corporations have to be on their feet to mitigate the force of activist firms.
“The current legal regime unintentionally compels firms to maximize share price regardless of the implications for long-term shareholders,” said Schwartz. Public corporations feel the ill effects of activist funds, whose specter and influence can exceed their actual campaigns.
The quick fixes are what these funds look for. Actions like “stock buybacks, dividends, layoffs, M&A: those are the most common techniques,” Schwartz told Institutional Investor, as they “alter the financial statements of the companies and make them appear more profitable and that causes a stock price to go up.” Such tactics played a part in the hostile takeover of Etsy by activist fund Black-and-White Capital in 2017, for example.
Etsy’s original mission was to be a platform to market and transact handmade goods to an online audience. After its public debut in 2015, its share price fell 37 percent to a low in 2017, at which time Black-and-White Capital saw an opportunity to intervene. As Schwartz commented, “The fund bought a slice of Etsy and immediately pushed for changes to reverse the decline.” This included installing new CEO Josh Silverman, who would “lay off nearly 25 percent of Etsy’s workforce and let the company’s B Corp certification lapse.”
Schwartz believes there is a solution. If regulators “tweaked these securities laws to get rid of the profit incentive for the hedge funds then we can have transparency without shareholder primacy.” But what would be consequences for corporate governance if regulators removed the activist threat entirely?
[II Deep Dive: The Dangers of Short-Selling Disclosure]
Schwartz sees little downside for stakeholders. “Accountability mechanisms that are already built in align executive interests with shareholders much more than they have been in the past,” and effectively do the governance work that activists portend to do. These mechanisms include performance-based CEO compensation structures and “incentives to align corporate missions with stock prices.”
In Schwartz’s view, “oversight and incentives for management to look out for shareholder value” function effectively without hostile hedge funds. Furthermore, he asked, “Are hedge funds really overseeing companies in a way that we want them to?”
