The rise of shareholder activism has become a global phenomenon. Shareholder activists are not only present–as they started–in the US, but also in European and Asian Markets. This situation has generated a vast literature about the desirability (or not) of shareholder activism.  In essence, there are two main positions: (i) those who argue that shareholder activists improve the corporate governance of the firm, and therefore they help increase the value of the firm; and (ii) those who claim that shareholder activists only improve the value of the firm in the short-term, and they encourage managers to cut investment in research, development and other long-term projects with higher profitability (but less liquidity) that may best contribute to the promotion of social welfare.
Unlike other topics in corporate law, the discussion about shareholder activism has gone beyond the academic debate. Politicians have started to discuss about the desirability of shareholder activists, and some legislations (particularly in Europe) have even taken steps to prevent the “short-terminism” that activists investors are supposed to generate. Therefore, shareholder activism has become a hot topic even for the public opinion.
Despite the disagreements about the impact of shareholders activists, most corporate law scholars seem to accept that shareholder activists help improve the corporate governance of the firm, at least, if we understand corporate governance as those mechanisms consisting of aligning incentives between managers and investors. Therefore, shareholder activists help increase the value of the firm, at least in the short-run. The immediate questions to be asked, then, are: (1) Does shareholder activism harm the long-term value of the firm? (2) If so, should we be worried from a policy perspective? (3) If so, what should policy-makers do?
The first question is an empirical one. So far, it is not clear the impact of shareholder activism on the long-term value of the firm. Some studies have shown that hedge fund activism does not harm the long-term value of the firm, while other studies have found the opposite result. However, while this question will remain empirical, what would it happen if it were confirmed that shareholders activists harm the long-term value of the firm? Should we be worried from a policy perspective? Unlike the previous question, this is a theoretical question, and it depends on the concept, nature and role of the corporation. Is the corporation a private contract among a group of investors that just creates a nexus of contracts to efficiently operate in the market? Or is it something else that should benefit a variety of stakeholders? In the former case, it is clear that the managers should act in the interest of the investors –no matter what interest is, provided that, of course, it is within the limits of the law, and minority shareholders are properly protected. Therefore, if the group of investors collectively agrees to give an instruction to the managers, they should be able to do so. Nevertheless, if we argue that a corporation is “something else” that should maximize the interest of a variety of stakeholders, it becomes more unclear to whom the directors are accountable. According to this latter perspective, a director could make a decision even when it is unwanted by the shareholders, provided that, according to its own view, it can be beneficial for “society”.
To solve this dilemma, let us use a simple example. Let´s suppose that a person is the sole proprietor of a business. This person decides to hire an employee. Let´s assume that the employee will help maximize, as nobody else can, the best interest of “society”, or even the long-term value of the firm. Even if this assumption were hypothetically met, should the sole entrepreneur of the business be prohibited from firing his employee? Would it change the answer in a corporation where, as it may happen in many countries, there is a single shareholder? And what about in a corporation where the shareholders as a whole or, with the due protection of minority shareholders, the majority of the shareholders decide to fire the employee? In our opinion, denying the right to fire the employee to any of these actors may threaten some of the most elemental foundations of a modern economy: private property, liberty of freedom, and liberty of enterprise. Therefore, unless the legislator clearly defines the primary role of a corporation, and parties can adjust ex ante their business decisions, denying to the shareholders the right to decide their own interest may be harmful for society.
Indeed, a corporation is, or at least it is created by, a (private) contract. Therefore, the parties that originally (or subsequently) enter into (or join) this contract (i.e., the shareholders), should be allowed to agree, among other aspects, the goal of this contract within the limits of the laws. If the parties’ will is not respected, they may be discouraged to enter into these contracts, and if so, one of the greatest inventions of modern times for the promotion of social welfare (i.e., the corporation) may be put at risk. In other words, the imposition of a goal potentially unwanted by the shareholders may discourage the formation and financing of corporations. Therefore, this solution may be harmful for society.
In our opinion, several reasons justify the imposition, as a default rule, of the maximization of the long-term value of the firm as the legitimate goal of the corporation. However, shareholders should be able to opt out this rule. Hence, by allowing investors to change the rule whenever their expectations may differ from the maximization of the long-term value of the firm, policy makers would incentivize, in a better way, the creation and financing of enterprises, and therefore the promotion of economic growth.
However, this theoretical argument based on the contractual nature of a corporation is not the only one to support the empowerment of shareholders, even if they were short-term investors. Many other arguments have been convincingly made to support this view. First, markets should be evaluated as a whole, and therefore including all type of firms and investors. Thus, whereas a potential short-term problem may be local, does not seem to be systemic.Indeed, markets are formed by many types of investors, with different preferences in terms or risks and returns. Therefore, some investors may indeed prefer short-term profits and therefore less risky (and less profitable) projects with more liquidity, while other investors may prefer highly profitable (and highly risky) investment projects with less liquidity. Hence, a regulatory intervention imposing one type of market participants (e.g., long-term investors) may reduce the firms’ ability to raise capital, and therefore the size of the market, since there could be many investors (e.g. short-term investors) who might be reluctant to provide funds.
Second, managers serving long-term shareholders may have incentives to destroy economic value in the short-term, especially in firms which heavily buy and sell their own shares. Therefore, by favoring long-term shareholders, value can be destroyed in the short-term, at the expense of the firm´s ability to generate cash flows, to repay debts (and salaries), and to reinvest benefits in new investments opportunities that may contribute to the promotion of social welfare. Third, while it is not clear that hedge fund activism harms the long-term-value of the firm, it is generally accepted that activist shareholders reduce managerial agency costs, and therefore lead to a better alignment of incentives between managers and investors. Therefore, as shown by several studies, shareholder activists increase the value of the firm –at least, in the short-term. Fourth, some managerial mechanisms inside the corporation, such as compensation schemes, may encourage short-term profits. Therefore, insulating boards from markets would actually exacerbate, rather than mitigate, short-term profits.
Thus, several conclusions can be made regarding the role of activist investors. First, they improve the corporate governance of the firm –at least, if, as it is generally accepted, corporate governance is understood as those mechanisms consisting of aligning incentives between managers and investors. Second, hedge fund activism help maximize the short-term value of the firm. Third, it is unclear that activist investors harm the long-term value of the firm.
Finally, and perhaps more importantly, even if it were hypothetically proved that hedge fund activists (on average) encourage short-terminism, should not they be allowed, as any other investor (sole proprietor, single shareholder or shareholders as a class) to pursue their own legitimate interest, no matter what interests is, provided that it is within the boundaries of law? In our opinion, a negative answer to this question would be the real threat for the global economy.