The Yale Law Journal

November 2022

Barbarians Inside the Gates: Raiders, Activists, and the Risk of Mistargeting

Corporate Law

abstract. This Article argues that the conventional wisdom about corporate raiders and activist hedge funds—raiders break things and activists fix them—is wrong. Because activists have a higher risk of mistargeting—mistakenly shaking things up at firms that only appear to be underperforming—they are much more likely than raiders to destroy value and, ultimately, social wealth.

As corporate outsiders who challenge the incompetence or disloyalty of incumbent management, raiders and activists play similar roles in reducing “agency costs” at target firms. The difference between them comes down to a simple observation about their business models: raiders buy entire companies, while activists take minority stakes. This means that raiders are less likely to mistarget firms underperforming by only a slight margin, and they are less able to shift the costs of their mistakes onto other shareholders. The differences in incentives between raiders and activists only increase after acquiring their stake. Raiders have unrestricted access to nonpublic information after acquiring ownership of a target company, which allows them to look under the hood to determine whether changing the target’s business strategy is truly warranted. Activists, by contrast, have limited information and face structural conflicts of interest that impair their ability to evaluate objectively what’s best for the target company.

This insight has profound implications for corporate law and policy. Delaware and federal law alike have focused on keeping raiders outside the gates, but they ignore the real threat: activists that are already inside. This Article proposes reforms to both state and federal law that would equalize the regulation of raiders and activists.

authors. Jerome L. Greene Professor of Transactional Law, Columbia Law School and Ono Academic College; Ph.D. Student, Department of Politics, Princeton University; former law clerk to Chief Justice Leo E. Strine, Jr., Delaware Supreme Court, and Millstein Fellow, U.S. Senate Committee on Banking, Housing, and Urban Affairs. The authors thank Farouk Al-Salihi, Yakov Amihud, Julian Arato, Ofer Eldar, Jill E. Fisch, Merritt B. Fox, Stephen Fraidin, Isabella Gerrard, Ronald J. Gilson, Victor P. Goldberg, Jeffrey N. Gordon, Assaf Hamdani, Sharon Hannes, Henry T. C. Hu, Christine Hurt, Robert J. Jackson, Jr., Kathryn Judge, Marcel Kahan, Avery W. Katz, Ray Koh, Ann M. Lipton, Theodore N. Mirvis, Joshua Mitts, Alex Raskolnikov, Edward B. Rock, Patrick Ronan, David M. Schizer, Omari Scott Simmons, Kirby Smith, Guhan Subramanian, Eric Talley, Avi Weiss, Lori W. Will, and the participants in the Columbia Law School Faculty Talk, the Princeton University LEGS Seminar, the Duke Law and Economics Colloquium, the BYU Law Winter Deals Conference, the Tulane Corporate and Securities Law Roundtable, the NYU Law Institute for Corporate Governance & Finance Spring Roundtable, and the American Law and Economics Association’s Annual Meeting for their helpful comments and Eitan Arom for his excellent research assistance. A special thanks to Richard Squire for his help with the first draft and coining the term “mistargeting.” Zohar Goshen is also thankful for the financial support of the Grace P. Tomei Endowment Fund.


Activist investor Bill Ackman was supposed to save JCPenney. His handpicked Chief Executive Officer (CEO) Ron Johnson, the architect of Target’s turnaround, announced a bold new strategy: “fair and square pricing.”1 No more discounts or clearance, just great prices every day of the year.2 The results were disastrous and almost immediate. Revenue fell by a quarter, the stock price cratered by 60%, and thousands of employees lost their jobs.3 “Penney had been run into a ditch when he took it over,” Columbia Business School Professor Mark Cohen said of Johnson, “But, rather than getting it back on the road, he’s essentially set it on fire.”4 Nor is that the only high-profile failure by an activist investor in recent years. After nagging Sony for years to spin off entire divisions,5 Dan Loeb of Third Point finally threw up his hands and sold out two years ago.6 And when Carl Icahn initially reported a position in Netflix in 2012, he pushed for a sale to a third-party strategic buyer, calling the young company a “great acquisition candidate,”7 only to be later proven wrong about its standalone potential. After Icahn failed to bring about a sale, Netflix excelled on its own, with its stock price rising by over 1,700% over the following decade.8 These stories cut against the conventional view of shareholder activists as scrappy visionaries with the pluck and acumen to turn around ailing corporate giants.9

What these cases have in common is a shareholder activist who enters the corporate scene with a plan to make things better and instead makes (or almost makes) things much worse. The very name—shareholder activists—evokes the image of faithful foot soldiers in the battle for efficiency and shareholder value. By contrast, their ugly cousins—corporate raiders—evoke greedy Wall Street fat cats: Gordon Gekko screaming into a phone and ruining somebody’s life.10 But as the examples of JCPenney, Sony, and Netflix show, sometimes the image fails to match the reality.

This Article argues that the conventional wisdom—corporate raiders break things and activist hedge funds fix them—is wrong. Activists are no better than raiders; if anything, they are likely worse. Because, as we argue, activists have a higher risk of mistargeting—mistakenly shaking things up at firms that only appear to be underperforming—they are much more likely than raiders to destroy value and, ultimately, social wealth.11 This insight has important implications for the law and policy of control contests. Delaware and federal law alike have focused on keeping raiders outside the gates, but they ignore the real threat: activists already inside. We thus propose equalizing the regulation of raiders and activists.12

The distinction between raiders and activists comes down to a simple observation about their differing business models. Raiders typically acquire 100% of the target’s stock at a significant premium above market.13 By contrast, activists need only buy a relatively small block of shares to push their reforms through via the proxy-voting process.14 As a result, raiders have a much higher hurdle rate—the rate of return they need to make a target worth their substantial investment.15 Moreover, as potential 100% owners of the target’s stock, raiders cannot shift risk onto other parties, further incentivizing them to invest more in information and take only prudent risks.16 On the other hand, activists buy smaller blocks, allowing for a much lower hurdle rate and an ability to shift some of the cost of mistakes onto other shareholders.17 They are thus much more likely to try to shake things up at corporations that are underperforming by only a slight margin.

The differences in the incentives of raiders and activists only increase after acquiring their stake. Raiders have unrestricted access to nonpublic information once they acquire 100% ownership, whereas activists have restricted access due to the securities laws and other restrictions.18 After completing an acquisition and looking under the hood, a raider can always decide to maintain the company’s existing business strategy, thereby preserving social wealth that an activist would have destroyed. Moreover, as repeat players whose success in future campaigns depends on their credibility and reputation,19 activists face structural conflicts that impede their ability to evaluate a target company’s business objectively even when they can obtain confidential information.20 For these reasons, we argue, activists are much more likely to try to “fix” something that is not broken.

The mistargeting risk rests on the idea that investors cannot always accurately identify the true value of the firms they buy into, and when they mistakenly undervalue these firms, they create an opportunity for raiders and activists to (mis)target these firms. There are at least two reasons why outsiders might fail to perceive the true value of a publicly traded firm. The first is market mispricing. A company that lags behind its peers may be poorly run, or it may be engaged in an innovative business plan that is hard for investors to understand and value.21 Investors may also systemically undervalue long-term gains over short-term ones, or else might simply be impatient—the “short-termism” problem.22 Or investors might overreact (or underreact) to new information, leading to temporary mispricing until the market corrects itself.23 The second reason why investors might misperceive their companies’ value is asymmetric information. A company may possess trade secrets or other private, confidential information that it cannot share with the market, causing its stock price to fall short of its true value.24

Notably, the mistargeting is a mistake only from the perspective of long-term diversified shareholders, who are either selling their firm to a raider for too low a price or replacing a successful business strategy with a mediocre one upon a campaign of an activist. Whether the reason for the undervaluation is mismanagement or the market’s underappreciation of a high-quality company, it is a bargain for a raider and a profit opportunity for an activist.

Because of their all-in business model, corporate raiders are less likely on all fronts to inflict costly mistakes on long-term shareholders. A short illustration shows how activists might destroy shareholder value to a greater extent than raiders. Suppose an economy is comprised of high-quality, low-quality, and average companies. Low-quality and high-quality firms alike appear to “underperform” in the sense that current performance is below some relevant benchmark. But while the low-quality firms actually do underperform because of poor management, the high-quality firms only appear to underperform because they are engaged in hard-to-value, long-term, innovative strategies that will produce gangbuster profits in future periods. For the reasons mentioned above, it is difficult for activists to tell low-quality from high-quality companies. When activists target low-quality companies and turn them into average companies by improving management quality, they add value to shareholders and the economy. But when they target high-quality companies and turn them into average companies by shutting down innovation, they destroy value. Raiders, by contrast, are less likely to move companies either from low-quality to average or from high-quality to average. For example, if both high- and low-quality firms underperform relative to their peers by 10%, 20%, or even 50%, a raider that needs 60% upside to turn a profit will pass.25 Moreover, in the cases that the raider buys the target, the 100% ownership makes it likelier that the mistargeting is discovered and avoided. For this reason, raiders are less likely to destroy shareholder value or create it.

That shareholder activists and corporate raiders add value, at least in some cases, is beyond dispute. In particular, activists reduce agency costs (or “agent costs”), the value lost to unfaithful managers who take liberties and expropriate the private benefits of control.26 Imagine a firm whose CEO mismanages the company for private benefits so that the corporation underperforms relative to its peers by 10%. A raider with a 60% hurdle rate will not go anywhere near this company. But an activist who needs, say, a 7% or 8% return stands to make a buck by firing the CEO, replacing them with a loyal agent, and selling. In a world with only raiders, this CEO will get away with their expropriation, but in a world with activists and raiders, they will get the boot.

Moreover, both positive and negative effects ripple across the market. On the one hand, where an activist or a raider can make a buck by firing lazy CEOs who take long afternoon naps and use the company jet for leisure travel, managers across the board are ex ante less likely to do those things.27 This is a positive externality of shareholder activism.28 On the other hand, where activists are likely to mistarget firms engaged in profitable but long-term business strategies, CEOs are less likely to take bold positions or invest in projects that fail to yield immediate returns. This is a negative externality of shareholder activism.29 While raiders are likely to produce similar externalities, the model presented here suggests these externalities will be significantly lower than the externalities generated by activists.

The critical question is whether activists are doing more economic harm than raiders and, if so, whether we should be more on guard about activists than raiders, conventional wisdom be damned. More specifically, we must examine whether activists create more value by sacking unfaithful managers than they destroy by firing good ones.30 The latter sum—the value destroyed by mistakenly firing good managers—can be deemed a “principal cost” because it originates with the principal (the shareholder) rather than the agent.31 Determining the value that activists add requires subtracting the principal costs they create from the agent costs they avoid. Is this net value greater for activists or for raiders? There are no easy answers to these questions, but the long-term course of the market provides some hints.

In particular, market trends suggest that the cost of mistargeting might be higher than the benefits that activists provide, at least under the current regulatory regime. In other words, the principal costs activists generate might exceed the agent costs they reduce—although we do not take a firm position on this issue. While empirical studies assessing whether activists reduce agent costs are equivocal,32 activists’ effects on principal costs are concerning. Start with the financial economist Hendrik Bessembinder’s empirical observation that the returns in the stock market are not normally distributed but, instead, are positively skewed.33 A small number of firms account for most of the return in the stock market. Much like a venture-capital fund’s portfolio, where the general rule of thumb is that one successful startup compensates for the failure or poor performance of nine other startups,34 in the stock market it is about one successful firm for every three.35 This finding suggests that the cost of breaking a high-quality firm is greater than the benefit of fixing three low-quality firms.

Bessembinder’s study also found that some 4% of companies have generated all the equity premium in the stock market over the past ninety years.36 This finding suggests that the ratio is one successful firm out of twenty for the top performers in the stock market. Suppose that even just a quarter of those growth-driving companies (i.e., 1% of all companies) have at some point fit the mold of a company that appeared to underperform but whose long-term vision would eventually lead to explosive growth. If activists had mistargeted these firms because they were not generating optimal short-term results, they would have destroyed a substantial part of the economic growth. Moreover, there is no telling how many companies would have been among the four-percenters were it not for mistargeting by activists.

These observations suggest that the law’s efforts to lock the gates against corporate raiders while letting hedge-fund activism go relatively unchecked should be
adjusted.37 If activists are no better than raiders—and potentially even more harmful—then it would seem the barbarians are already inside the gates. The insight that activists are more likely to mistarget companies than their ugly cousins has profound implications for corporate law, which, we argue, should equalize the regulation of raiders and activists. In fact, the main value of hedge-fund activists is not in fixing targets’ operations, financing, or governance, but rather in overcoming the barriers created by Delaware’s takeover jurisprudence—sidestepping targets’ legally permissible defensive measures and facilitating mergers and acquisitions. Our analysis has timely implications for current debates in the courts about how to evaluate corporate efforts to guard against hedge-fund activism.

This Article proceeds in four parts. Part I provides background about how raiders and activists operate; it also introduces the concepts of principal and agent costs. Part II explains the mistargeting hazard and introduces an informal model that shows how the presence of control challenges may either decrease or increase the net sum of principal and agent costs. Part III analyzes the relative effects of activists and raiders on principal and agent costs in light of our model and the available empirical evidence; it concludes that activists are likely to impose greater costs than raiders. Part IV examines the implications of these findings for law and policy. The model presented in this Article suggests that, contrary to conventional wisdom, lawmakers and courts should be more skeptical of hedge-fund activists and avoid providing them with preferential treatment relative to raiders.