Rose & Sharfman: Shareholder Activism as a Corrective Mechanism in Corporate Governance (Updated Version)

My co-author and I have just posted a revised version of our article to SSRN.  Here’s the abstract:

Under an Arrowian framework, centralized authority and management provides for optimal decision making in large organizations. However, Arrow also recognized that other elements within the organization, beyond the central authority, occasionally may have superior information or decision making skills. In such cases, such elements may act as a corrective mechanism within the organization. In the context of public companies, this article finds that such a corrective mechanism comes in the form of hedge fund activism, or, more accurately, offensive shareholder activism.

Offensive shareholder activism operates in the market for corporate influence, not control. Consistent with a theoretical framework in which the value of centralized authority must be protected and a legal framework in which fiduciary responsibility rests with the board, authority is not shifted to influential but unaccountable shareholders. Governance entrepreneurs in the market for corporate influence must first identify those instances in which authority-sharing may result in value-enhancing policy decisions, and then persuade the board and/or other shareholders of the wisdom of their policies so that they will be permitted to share the authority necessary for the policies to be implemented. Thus, boards often reward offensive shareholder activists that prove to have superior information and/or strategies by at least temporarily sharing authority with the activists by either providing them seats in the board or simply allowing them to directly influence corporate policy. This article thus reframes the ongoing debate on shareholder activism by showing how offensive shareholder activism can co-exist with — and indeed, is supported by — Arrow’s theory of management centralization which undergirds the traditional authority model of corporate law and governance.

This article provides a much needed bridge between the traditional authority model of corporate law and governance as utilized by Professors Steven Bainbridge and Michael Dooley and those who have done empirical studies on hedge fund activism, including Lucian Bebchuk. The bridge helps to identify when shareholder activism may be a positive versus negative influence on corporate governance.

Available for download here.