The Coming Shift in Shareholder Activism: From “Firm-Specific” to “Systematic Risk” Proxy Campaigns (and How to Enable Them)

John C. Coffee, Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here); and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System by Leo E. Strine, Jr. (discussed on the Forum here).

A new form of shareholder activism has appeared almost out of the blue. Classic shareholder activism (which I will call “firm specific” activism) depends on an entrepreneur (usually an activist hedge fund) who assembles a 5% (or greater) block of stock, files a Schedule 13D that announces its plans for the target company (which might include changing management, breaking up the company, or increasing its leverage), and then profits on that block when the market responds favorably. But in this new form — “systematic risk activism” — the key actors are index funds and diversified asset managers. Nor do they necessarily expect a positive market reaction in the short-run. Being fully diversified, these investors care little about the specifics of any individual company in their portfolio. For example, State Street Global Advisors holds over 11,000 stocks, all for the long-run.

According to the Capital Asset Pricing Model, the goal of these investors should be to seek to reduce their exposure to “systematic risk” (which is defined as the risk that remains in any portfolio after it is fully diversified). Today, the consensus among investment managers is that the leading systematic risk comes from climate change. I describe the rationale and mechanisms of this new form of activism in an article just posted on SSRN, but its key features are discernible in Engine No. 1’s successful, but problematic, proxy contest this year against ExxonMobil.

Engine No. 1 was a very small (and new) hedge fund that held only 0.02% of ExxonMobil’s stock. Yet, it was successful because it gained the support of the Big Three (BlackRock, State Street and Vanguard) and some major pension funds. Engine No. 1’s budget allocated some $40 million to the expected costs of its proxy fight, but it seems unlikely that it could have recovered this amount on its small stake in ExxonMobil. In fact, the stock market did not react at all to Engine No. 1’s surprising success. Initially, it seemed indifferent, but later the stock price of ExxonMobil did rise, along with the other oil companies, when the price of oil as a commodity soared (as the pandemic seemed to be easing, making travel more likely). The irony here is that Engine No. 1 made its profit only because it misjudged the oil market, as its campaign called for ExxonMobil to diversify away from oil and high carbon fuels.

What then is driving this form of activism? Two hypothesis are feasible: First, there is “portfolio theory,” which argues that, because indexed investors own the whole market, they can profit by causing polluters (and other firms imposing “negative externalities” on the market) to internalize those externalities. That is, ExxonMobil’s loss from such internalizing may be exceeded by the gains to the other firms in a market-wide portfolio that benefit from less pollution. The diversified investor wins if the firms that have stock prices that rise gain more in the aggregate than ExxonMobil’s price falls. See Madison Condon, Externalities and the Common Owner, 95 Wash. L. Rev. 1 (2020).

A second hypothesis is that diversified investors (and particularly the Big Three) believe the market is underestimating and mispricing climate change risk. If they foresee a painful and costly transition ahead, it makes sense for them to mitigate this decline by supporting proxy campaigns that force energy companies to diversify and reduce their carbon emissions. This may cause the stock price of these companies to fall, but fully diversified investors own the market and are looking to the long-run. As “universal owners” for the long-term, they can tolerate present losses if it mitigates a future catastrophic decline when the full cost of climate change is belatedly recognized. For an overview, see John C. Coffee, Jr. The Future of Disclosure: ESG, Common Ownership, and Systematic Risk, 2021 Col. Bus. L. Rev. 602 (2021).

Whichever theory one prefers, systematic change still faces a formidable obstacle: who will run these campaigns? To be sure, the Engine No. 1 campaign showed that only a small stake is needed (0.02% in Engine No. 1’s case). But how is the leader of such a proxy battle to profit if the subject company is likely to incur at least a short-term stock loss? Engine No. 1 may have lucked out when oil prices rose, but others who follow in its wake will also likely need to recoup high costs, and this is hard if you hold only a small stake. In short, the proxy campaign organizer is in precisely the reverse position to the activist hedge fund in “firm specific” proxy campaigns (who expects a rise in the target’s stock price). The result is that systematic risk campaigns make sense for diversified investors, but such campaigns may lack a leader (and thus remain “headless”), unless one can find a substitute for the activist hedge fund.

In my recent SSRN post, I survey and evaluate various alternatives, but the most feasible partial answer is for the insurgents to condition any settlement of the proxy contest with the subject corporation on that corporation reimbursing the campaign organizer’s reasonable expenses. Most recent activist proxy battles have settled, probably because company management has more to lose and is risk-averse. But this answer only takes us half way home. How is the organizer to profit? Activist hedge funds hold small portfolios and cannot expect to make up what they lose on the target from other portfolio companies that gain. For example, Engine No. 1 held a portfolio of only 13 stocks (mostly in the high-tech sector), and any gains on these stocks could not possibly compensate for the losses if ExxonMobil’s stock price had fallen. Nor is it plausible that the proxy campaign organizer could short the stock of the target company. This would have to be disclosed under Rule 14a-9, and the target could ridicule this effort as one asking shareholders to shoot themselves in the foot to benefit the Big Three.

Other problems are equally complicated. How do directors elected in such a systematic risk campaign take actions (such as reducing the company’s carbon emissions) that they foresee will reduce its earnings and stock price? Is this a fiduciary breach? Worse yet, is it a breach of the duty of loyalty on the grounds that they are putting the broader interests of the diversified fund’s portfolios ahead of the company’s own interests? There are answers to these questions, but they require careful lawyering.

Engine No. 1 may well have found its own answer to these problems. After winning its proxy fight, it shortly thereafter announced that it was launching an exchange-traded fund that would sponsor similar contests. In effect, it may capitalize on its success and use it as expensive advertising. Perhaps, this could work. But remember this: Charles “Lucky” Lindbergh achieved world-wide fame by becoming the first to fly solo across the Atlantic. But no one remembers who was the second or third to do this! Those who follow Engine No. 1 have to surmount this problem as well.

The complete paper is available for download here.

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One Comment

  1. Eric Talley
    Posted Wednesday, September 8, 2021 at 4:18 pm | Permalink

    Thinking of ESG activism in its relation to systematic risk is interesting and could well prove generative. For interested readers, my (other!) Columbia colleague Jeff Gordon has also advanced a thesis along these lines in his forthcoming J. Corp. Law paper, . These are terrific companion papers to one another, IMO.