Elliott Management Corp.’s recent campaign to oust the CEO of Southwest Airlines furnishes us with a rough measuring rod by which to judge just what activists can (and cannot) achieve. Among activists, Elliott is probably regarded as the hardest nosed and most aggressive (it is often described as a “bully” by its critics). At the outset, Elliott seemed determined to wage a blitzkrieg war, calling for a special meeting of Southwest shareholders on Dec. 10th and nominating a 10 director slate for a 15 director board that would give it an absolute majority. Elliott had purchased a nearly 11% stake in Southwest, and seemed unwilling to negotiate or even to discuss its plans with Southwest.
All this is atypical. Few activist funds can afford an 11% block of a major airline, and many do not want to cross the 10% threshold of Section 16(b) (of the Securities Exchange Act). Even fewer hide their plans from target management or investors, because they would normally prefer to settle than to conduct a costly proxy contest (particularly if the outcome was uncertain). Finally, activists rarely seek control of the board at the outset. More typically, they seek a three or four seat presence on the board. Why? Because other institutional investors may not want the activist to capture a majority of the board and thereby hold a controlling position. If control is to be sold, these institutions want to share in the control premium.
In fact, this last factor may have forced Elliott to trim its sails. Originally, it sought ten out of fifteen directors. Later, it reduced its demand to eight directors and finally it settled for six directors (including a still to be appointed independent chair). Thus, Elliott neither obtained a clear majority of the Southwest board nor did it force the resignation of Southwest’s CEO, Bob Jordan. Still, Elliott did seemingly compel the resignation of former CEO, Gary Kelly, who had become chair of Southwest’s board. And someday Elliott may yet obtain control. So the ultimate outcome still hangs in the balance.
It was no surprise that Southwest became the target of activists. As of mid-October, its share price was down 43.6% from where it had traded five years ago. Although all airline stocks were hurt by the COVID pandemic, Southwest has had greater problems in recovering. Yet, even with this poor track record, the Southwest board would not fire Jordan, and Elliott decided to call off the special meeting it had set for early December.
Here, we face something of a mystery: what forced Elliott to compromise? One answer may involve the attitude of another group of Southwest’s shareholders: its indexed shareholders. Recent research shows that indexed investors hold a much larger share of the typical public company’s stock than previously estimated. Chinco and Sammon place the share held in public corporations by indexed investors at 33.5%. See Alex Chinco and Marco Sammon, The Passive Ownership Share is Double What You Think It Is, 157 J. Fin. Econ. 103860 (2024). Such a level exceeds Elliott’s ownership by more than three times.
But why can’t activist investors and indexed investors agree and link arms? Presumably, both want to maximize the value of their portfolios. In fact, however, they often do not agree or cooperate. Here, all we can infer from the Elliott compromise is that some important group of shareholders did not support Elliott’s efforts.
At least three reasons can be given for why the Big Three (BlackRock, Vanguard and State Street) and similar investors might be unenthusiastic about supporting Elliott’s campaign at Southwest. First, indexed investors (such as the Big Three) are not subject to much firm-specific risk to the extent that they are fully diversified. Thus, a business issue such as whether Southwest should change its well-known seat selection policy has little impact on the value of a fully diversified investor’s portfolio. In principle, indexed investors are concerned mainly with minimizing systemic risk (which is technically defined as those risks that cannot be eliminated through diversification – such as, for example, climate change risk).
A second reason is that some indexed investors (most notably, BlackRock) do communicate their policy preferences regularly to their portfolio firms (such as their views on DEI or climate change). If such a major indexed investor were to side with an activist seeking to replace senior managers, it might jeopardize this relationship (even if replacing the senior executive did increase the issuer’s share price).
Finally and most importantly, if indexed investors voted with Elliott to give it a majority of the Southwest board and to oust its CEO, they would give Elliott de facto control without receiving any control premium in return. Once it held control, Elliott could conceivably merge Southwest with another airline (including a foreign one), or sell off key assets, in either case in a way that did not benefit all shareholders equally. Limiting Elliott to minority representation on the board (as in fact happened) minimizes this danger.
Of course, outsiders do not know what factors held back Elliott in its desire to remove Southwest’s CEO. But given Elliott’s large block and its reputation as a boardroom bully, one is led to suspect that some powerful shareholders were not happy with Elliott’s desire to seize majority board control.
Clearly, Elliott had support for change. After all, Southwest’s stock price had declined over 43% from where it was five years ago. Yet, Southwest avoided the ouster of its CEO (although its former CEO and board chair did retire). One suspects that Elliott must have concluded that its ability to win the ouster of Southwest’s CEO was too uncertain to force the issue at the outset. Someone must have led the resistance, and members of Southwest’s board seem unlikely candidates for that role. That points to the tentative conclusion that indexed investors were not prepared to give Elliott everything it wanted.
From my academic perspective, this explanation is interesting only if it seems likely to be a recurring phenomenon. And it may. The possibility of recurring frictions between activist investors and indexed investors has not received adequate attention. Indexed investors are not inherently “passive” (as many describe them); they are just less interested in firm-specific issues (from which they are largely protected by diversification). But they are not eager to cede a controlling position to a new player on the scene. If they are adroit, target corporations may be able to fend off activists (at least for a time) by motivating indexed investors to prefer delay to a speedy change of control.
When and how activists and indexed investors can best strike an alliance deserves more attention than it has received. Although such alliances do occur, there may be standard protocols that Elliott ignored.
That said, let’s connect these speculations to some empirical bedrock. Probably, the most important development in American corporate governance over the last twenty-odd years has been the extraordinary concentration in share ownership. Dispersed ownership is a thing of the past. Today, on a value-weighted basis, institutional investors own 73.7% of the U.S. public corporation, while the top 25 institutional investors in the firm hold 49.8% of its stock. See Jonathan Lewellen and Katherina Lewellen, The Ownership Structure of U.S. Corporations, (available at https//ssrn/abstract=4173466)(posted June 1, 2022). Concentrated ownership means that the old-fashioned deal structure in which a bidder or proxy contestant attempts to deal only with target management ignores where the power really lies.
Although the board certainly has a role, we may in the future see negotiations that involve three key parties: the bidder, the target, and a committee of institutional shareholders. The last group’s goal might be to limit target management’s self-interested efforts to either kill the deal or demand high special compensation and/or golden parachutes as a price of their acceptance. Institutional investors may also fear that bidders may promise such special rewards to management in return for a reduced deal price. Both sides have a self-interest that can be advanced at the shareholders’ expense, and deal structure may need to respond to this by giving an enhanced role to the institutional owners. New ownership structures may imply a different negotiation process in the future.
John C. Coffee, Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.