Costly Communication, Shareholder Activism, and Limits to Arbitrage

Abstract

Using a unique hand-collected dataset, we show that shareholder activism designed to open U.S. based closed-end funds has become more frequent since the SEC's reform of the proxy rules in 1992 (the 1992 Reform) that lifted restrictions on shareholder communication. We denote this activity activist arbitrage and distinguish it from the standard pure trading arbitrage. We document a dual relationship between activist arbitrage and funds' discounts: a high discount increases the probability of activist arbitrage, while a high probability of ex post activist arbitrage reduces the ex ante discount. We provide evidence that the ease of shareholder communication is a major determinant for the emergence of activist arbitrage. This holds for the time series - activist arbitrage has become much more common following the 1992 Reform - as well as for the cross section - activist arbitrage is more likely in funds that exhibit low costs of communication. Overall, our results provide direct evidence of the presence of arbitrage activities, but also demonstrate how costly communication leads to limits on arbitrage.