Hedge Fund Activism and Corporate Governance: References

References for the series Hedge Fund Activism and Corporate Governance.

Admati, Anat, and Pfleiderer, Paul (2005). The Wall Street Walk as a Form of Shareholder Activism. Stanford University working paper; available at http://ssrn.com/abstract=1015940.

Anabtawi, Iman (2006). Some Skepticism About Increasing Shareholder Power. UCLA School of Law; available at http://ssrn.com/abstract=783044.

Barusch, Ronald (2014). Sotheby’s Proxy Fight Brought Out The Worst In Both Sides. The Wall Street Journal; available at http://blogs.wsj.com/moneybeat/2014/05/05/dealpolitik-sothebys-proxy-fight-brought-out-the-worst-in-both-sides/.

Bebchuk, Lucian A. (2003). The Case for Shareholder Access to the Ballot. Harvard Law School; available at http://ssrn.com/abstract=426951.

Bebchuk, Lucian A. (2005). The Case for Increasing Shareholder Power. 118 Harvard Law Review 833; available at http://ssrn.com/abstract=387940.

Bebchuk, Lucian A. (2014). The Long-Term Effects of Hedge-Fund Activism. Columbia Law Review working paper; available at http://ssrn.com/abstract=2291577.

Bebchuk, Lucian A. and Jackson, Robert J., Jr. (2012). The Law and Economics of Blockholder Disclosure. Harvard Business Law Review; available at http://ssrn.com/abstract=1884226.

Becker, Bo, et al (2012). Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable Challenge. Harvard Business School; working paper available at http://ssrn.com/abstract=1695666.

Benoit, David and Lublin, Joann (2013). Debating Activists Paying Directors. The Wall Street Journal; available at http://global.factiva.com.ezproxy.uta.edu.

Blair, Margaret M. (2002). Post-Enron Reflections on Comparative Corporate Governance. Georgetown University Law Center; available at http://ssrn.com/abstract=316663.

Brav, Alan, et al (2009). Shareholder Activism: A Review. Foundations and Trends in Finance; available at http://ssrn.com/abstract=1551953.

Choi, Stephen, et al (2010). The Power of Proxy Advisors: Myth or Reality? Emory Law Journal; available at http://ssrn.com/abstract=1694535.

Coffee, John C., Jr., and Palia, Darius (2014). The Impact of Hedge Fund Activism: Evidence and Implications, Working Paper No. 489, Columbia University School of Law; available at http://web.law.columbia.edu/law-economic-studies/working-papers.

Copeland, Rob (2014). Activists’ Returns Rise about the Din. The Wall Street Journal; available at https://global-factiva-com.ezproxy.uta.edu/redir/default.aspx?P=sa&an=J000000020140708ea7800038&cat=a&ep=ASE.

Fink, Laurence D. (2014). Letter to Corporate Chairmen and CEOs. BlackRock Investments; available at http://online.wsj.com/public/resources/documents/blackrockletter.pdf.

Foley, Stephen (2013. Activist Hedge Fund Managers Get Board Welcome. The Financial Times; available at www.FT.com.

Gallagher, Daniel M. (2014). Outsized Power and Influence: The Role of Proxy Advisors. Washington Legal Foundation; available at http://www.wlf.org/upload/legalstudies/workingpaper/GallagherWP8-14.pdf.

Gallardo, Eduardo, et al (2014). M&A Webcast: Shareholder Activism. Gibson Dunn; available at http://www.gibsondunn.com/publications/Documents/WebcastSlides-M+A-Shareholder-Activism.pdf.

Gelles, David and De La Merced, Michael J. (2014). New Alliances in the Battle for Corporate Control. The New York Times; available at http://dealbook.nytimes.com/2014/03/18/new-alliances-in-battle-for-corporate-control/.

Gillan, Stuart L. and Starks, Laura T. (2014). The Evolution of Shareholder Activism in the United States. Texas Tech University; available at http://ssrn.com/abstract=959670.

Glassman, James K. and Verret, J. W. (2013). How to Fix Our Broken Proxy Advisory System. George Mason University; available at http://mercatus.org/sites/default/files/Glassman_ProxyAdvisorySystem_04152013.pdf.

Gregory, Holly J. (2014). SEC Guidance May Lessen Investment Adviser Demand for Proxy Advisory Services. Sidley Austin LLP; available at http://www.sidley.com/7-10-2014_Update/.

Guinto, Joseph (2013). Who Wrecked JC Penney? D Magazine; available at http://www.dmagazine.com/publications/d-ceo/2013/november/who-wrecked-jc-penney.

Hedge Fund Research, Inc. (2014). Global Hedge Fund Industry Report; available at www.HedgeFundResearch.com/?fuse=products-irglo.

Hoffman, Liz (2014). Court Ruling Bolsters New Type of Poison Pill. The Wall Street Journal; available at http://online.wsj.com/article/SB10001424052702304655304579548120576221060.html.

Hoffman, Liz and Benoit, David (2014). Activist Funds Dust Off Greenmail Playbook. The Wall Street Journal; available at https://global-factiva-com.ezproxy.uta.edu/redir/default.aspx?P=sa&an=J000000020140612ea6c0002e&cat=a&ep=ASE.

Illian, Matthew (2014). The Rise of Mutual Fund Power. Available at http://adviceiq.com/articles/matthew-illian-rise-mutual-fund-power.

Katz, David A, and McIntosh, Laura A. (March 2014). Shareholder Activism in the M&A Context. New York Law Journal; available at http://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.23255.14.pdf .

Katz, David A, and McIntosh, Laura A. (July 2014) Corporate Governance Update: Heightened Activist Attacks on Boards of Directors. New York Law Journal; available at http://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.23471.14.pdf.

Katz, David A. and McIntosh, Laura A. (September 2014). Corporate Governance Update: Important Proxy Advisor Developments. New York Law Journal; available at http://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.23551.14.pdf.

Khorana, Ajay, et al (2013). Rising Tide of Global Shareholder Activism. Citibank Global Perspectives and Solutions; available at http://citibank.com/icg/global_banking/docs/rising_tide.pdf.

Levi, Shai and Segal, Dan (2014). Does Corporate Governance Make Financial Reports Better, or Just Better for Equity Investors? Tel Aviv University; available at http://ssrn.com/abstract=2439728.

Lipton, Martin (2014). Current Thoughts About Activism, Revisited. Harvard Law School Forum on Corporate Governance and Financial Regulation; available at http://www.lawdragon.com/press-releases/wachtell-memo-current-thoughts-about-activism-revisited/.

Loeb, Daniel (2014). Letter to William F. Ruprecht. Available at http://www.sec.gov/Archives/edgar/data/823094/000119312513388165/d605390dex993.htm.

Millon, David K. (2014). Radical Shareholder Primacy. University of St. Thomas Law Journal; available at http://ssnr.com/abstract=2473189.

Mirvis, Theodore N., et al (2007). Bebchuk’s Case for Increasing Shareholder Power: An Opposition. Olin Center for Law, Economics and Business; available at http://ssrn.com/abstract=990057.

Mirvis, Theodore N. (September 2014). Venturing into the Belly of the Beast: The Ontological Question, presentation to Harvard Law School; available at http://blogs.law.harvard.edu/corpgov/files/2012/01/Mirvis_Corp-Gov.pdf.

Mirvis, Theodore N. (2014). Activist Abuses Require SEC Action on Section 13(d) Reporting. Harvard Law School Forum on Corporate Governance and Financial Regulation; available at http://blogs.law.harvard.edu/corpgov/2014/03/31/activist-abuses-require-sec-action-on-section-13d-reporting/.

Mitts, Joshua (2013). A Private Ordering Solution to Blockholder Disclosure. Columbia Law Review; available at http://ssrn.com/abstract=2180939.

Pankey, David H., et al (2011). Implications of the Second Circuit Decision in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP. McGuire Woods LLP; available at http://www.mcguirewoods.com/news-resources/publications/second-circuit-decision-csx.pdf.

Reynolds, Daniel G. (2010). Comment letter on File Nr. S7-14-10, Concept Release on the U.S. Proxy System; available at http://www.sec.gov/comments/s7-14-10/s71410-57.pdf.

Solomon, Steven D. (2011). Anticlimax in Long-Running CSX Railroad Court Case. The New York Times; available at http://dealbook.nytimes.com/2011/07/19/anticlimax-in-long-running-csx-court-case/.

Stock, Kyle (2014). Sotheby’s and the $16 million, Anti-Dan Loeb Proxy Battle. BusinessWeek; available at http://www.businessweek.com/articles/2014‐05‐07/sothebys‐and‐the‐16‐million‐anti‐dan‐loeb‐proxy‐battle.

Stout, Lynn A. (2012). The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public. Cornell Law School; published by Berrett Keohler Publications.

Strine, Leo E., Jr. (2014). Can We Do Better By Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law. Harvard Law School Forum on Corporate Governance and Financial Regulation; available at http://ssrn.com/abstract=2421480.

Sullivan & Cromwell (2014). Third Point LLP v. Ruprecht: Delaware Court of Chancery Finds Board’s Use of Rights Plan Reasonable Based on Creeping Takeover and Effective Negative Control Threats Created by Activist Shareholders. Available at http://www.sullcrom.com/siteFiles/Publications/SC_Publication_Third_Point_LLC_v_Ruprecht.pdf.

The Conference Board (2008). Hedge Fund Activism: Findings and Recommendations for Corporations and Investors. Research Report; available at http://www.conference-board.org.

Tonelllo, Matteo and Aguilar, Melissa (2014). Proxy Voting Analytics (2010-2014). The Conference Board.

Townsend, Matt (2013). Ackman Takes $500 Million Loss on Penney as Saga Ends. Bloomberg; available at http://www.bloomberg.com/news/print/2013-08-27/ackman-s-pershing-sells-stake-in-j-c-penney-for-504-million.html.

United States Government Accountability Office (2007). Corporate Shareholder Meetings: Issues Relating to Firms That Advise Institutional Investors on Proxy Voting. Available at http://www.gao.gov.

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Conclusion: How Corporations and Regulators Can Respond

Sixth in a series. See Hedge Fund Activism and Corporate Governance.

This paper has examined the phenomenon called Hedge Fund Activism and its effect on the governance of public corporations in the United States.

To advance their agenda, Activists have taken advantage of both:

  • Regulatory changes intended to improve Board accountability to equity security holders; and
  • Loopholes in the SEC disclosure regime and Proxy rules

Hedge Fund Activism is having a significant impact on corporate governance. However, there is disagreement over whether or not the impact is positive with respect to the targeted corporations, all equity security holders and society as a whole.

What Corporations Can Do

There are a few things public corporations can do to protect themselves against Activist attacks.

  1. If the corporation does not have a Poison Pill, it can consider adopting one similar to Sotheby’s, which can offer some protection against “creeping control”. Note, however, that Sotheby’s Poison Pill did not prevent Third Point and its Wolf Pack from accumulating enough shares to force a settlement where its nominees were named to the Board and with the corporation incurring substantial expenses. Also, the effectiveness of such a Poison Pill is still limited by the loophole in Schedule 13D filings which will need to be addressed by the SEC. While there is no requirement under the U.S. Securities Laws to submit Poison Pills to a vote of equity security holders, the corporation will expect to have a negative ISS recommendation on its director nominees in the year it is adopted.[i]
  2. If the Board is not classified, the corporation can consider amending its bylaws to do so. The typical classified Board has one-third of directors elected each year, rather than all of the directors. This limits the ability of an Activist to mount a proxy campaign and take control of the corporation quickly without paying a control premium. Of course, this action will also cause a negative ISS recommendation as long as it remains in place.[ii]

What Regulators Can Do

The Securities and Exchange Commission has authority to update its regulations in response to perceived abuses of the existing disclosure regime Proxy system by Activists.

  1. One reform would be to shorten, or eliminate, the 10 day window between the time an Activist acquires 5 percent of the voting equity securities of a corporation and time it is required to file Schedule 13D. This would provide a level playing field for other investors and prevent the Activist from trading on the material nonpublic information in its possession. It would also warn the corporation that an Activist attack could be imminent, allowing it to contact and negotiate with the Activist.
  2. A second reform would be to eliminate the ability for a person to use Objecting Beneficial Owner status to anonymously own equity securities of public corporations.[iii] Public corporations are too important to the U.S. economy to allow such secrecy in the ownership of voting equity securities. It is also difficult for a corporation’s Board to respond to the wishes of its equity security holders if it cannot even know who they are. This reform could also reduce the ability of Activist’s to use secretive Wolf Pack techniques.
  3. A third reform would be to require that all derivative securities be counted for purposes of determining whether an investor had acquired five percent of the equity securities Specifically, such a rule would preclude use of TR Swaps used by TCI and 3G to avoid the disclosure requirements.
  4. Fourth, the SEC should clarify the definition of a “group”. Any person or entity receiving, and trading on, information received about an acquirer of five percent of a corporation’s equity securities before the Schedule 13D has been filed shall be deemed to be included in a “group” under the U.S. Securities Laws. This would have the effect of weakening the potential for Wolf Pack tactics by Activists, as well as increasing the pool of acquirers when a Poison Pill is triggered.
  5. Finally, the SEC should establish appropriate oversight of Proxy Advisory Firms such as ICC and Glass Lewis. First, the SEC should require Institutional Investors to disclose to their own investors the number of Proxy votes completed and the number of times the Proxy was voted in a manner consistent with the recommendation of the Proxy Advisory Firm. Second, the fees paid to the Proxy Advisory Firm(s) should be disclosed. Third, Proxy Advisory Firms should be required to follow a universal code of conduct, ensuring that their recommendations are designed to increase equity security holder value, increasing the transparency of their methods, ensuring that conflicts of interest are dealt with appropriately, and increasing their overall accountability.

Next: Hedge Fund Activism and Corporate Governance – References

  • [i] If there is no proxy contest initiated by an Activist, then this should not be of much concern to the Board.
  • [ii] This should also be of less concern since the Board cannot be overturned in a single proxy contest. The Activist would have to attempt control via a tender offer, which, if the corporation has adopted the suggested Poison Pill, would have to be negotiated with the Board to ensure a control premium is paid.
  • [iii] See Reynolds (2010).
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Recent Business Case: Third Point LLP v. Ruprecht

Fifth in a series. See Hedge Fund Activism and Corporate Governance.

Sotheby’s Corporation dates its history to 1744, when London bookseller Samuel Baker held his first auction. Today the company operates 90 locations in 40 countries and conducts 250 auctions every year in 70 categories. It is the oldest company listed on the New York Stock Exchange.

In 2013 three Activists: Trian Fund Management, Marcato Capital Management and plaintiff Third Point each filed Schedule 13D announcing their purchases of equity interests in Sotheby’s. In October 2013 Third Point amended its 13D, announcing that it had acquired a 9.4 percent stake in Sotheby’s with an intent to effect corporate change.[i]

Sotheby’s Board adopted a Poison Pill with three key features:

  1. Capped 13D filers at 10 percent, but capped passive 13G filers at 20 percent;
  2. Contained a “qualifying offer” exception, meaning it would not be triggered in the event of a qualifying tender offer; and
  3. Included a proscription of concerted action, meaning it could be triggered by multiple parties that were acting in concert to effect control, even if each party had not exceeded the 10 percent limit.

Third Point announced that it would nominate three new directors to the Board at the May 6, 2014 annual meeting. Third Point entered into negotiations with the Board to have its Chief Executive, Daniel S. Loeb, join the Board to avoid a proxy fight. Concurrently, Loeb continued to clamor publicly for changes in the business and management.[ii]

Third Point demanded Sotheby’s grant it a waiver from the 10 percent trigger to allow it to purchase up to a 20 percent equity stake ahead of the meeting, i.e., to be treated the same as 13G filers. When the Board refused, Third Point filed a complaint in the Delaware Court of Chancery (“Third Point v. Ruprecht”)[iii], asking the Court to enjoin Sotheby’s from conducting its annual meeting and forcing it to abandon the 10 percent trigger in its Poison Pill.

The Court determined that the Board’s decision to adopt the Poison Pill was justified by a perceived, and objectively reasonable, threat that Third Point, in tandem with the other Activists, could acquire “creeping control” of the company without paying a control premium or negotiating with the Board. Specifically, the Court held that the presence of multiple Hedge Funds buying up Sotheby’s equity securities simultaneously, and the input the Board had received that such funds may form a Wolf Pack for the purpose of jointly acquiring large blocks equity securities, supported the Board’s “assertion that its good faith investigation led it to determine that Third Point posed a legally cognizable threat”. Therefore, the Court denied the motion for preliminary injunction.

Shortly after the Court’s decision, Third Point and Sotheby’s settled the lawsuit, with Sotheby’s agreeing to appoint Loeb and two his nominees to the Board and paying Third Points legal and proxy contest expenses. Third Point’s activism cost the corporation and its equity security owners $16 million.[iv]

Third Point v. Ruprecht is significant because it demonstrated substantive legal support[v] for a Poison Pill with two tiers: a lower tier for 13D filers and a higher tier for 13G filers. It provides a way for corporations to enact some defensive measures against predatory attacks by Activists. A Board adopting a rights plan may focus its justifications on the threat to long-term shareholder value posed by Activists, including when multiple Activists collude to build a concurrent stake in a corporation. While Activists may not report as a group under U.S. securities laws[vi], a Board may identify the threat of the activists forming a Wolf Pack or acting through “conscious parallelism” to gain effective control of a corporation without paying a control premium.


Next: Conclusion – How Corporations and Regulators Can Respond

  • [i] The 13D filing included a letter from Loeb to William F. Ruprecht, Sotheby’s Chairman, President and CEO, demanding Ruprecht’s resignation and stating that Loeb was prepared to appoint his replacement.
  • [ii] Public statements and emails were introduced in the trial demonstrating that Loeb made statements to customer, employees and vendors that he would soon be running Sotheby’s. See Barusch (2014) and Stock (2014).
  • [iii] William F. Ruprecht is the Chairman, President and Chief Executive Officer of the Board of Sotheby’s Corporation.
  • [iv] Sotheby’s spent about $5.7 million and Third Point spent over $10 million (reimbursed by Third Point). See Stock (2014).
  • [v] Delaware Chancery Court decisions are important precedents because over half of all U.S. public corporations are chartered in Delaware, and many other states tend to follow precedents establish in Delaware corporate law.
  • [vi] See section CSX v. TCI in this paper.
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Recent Business Law Case: CSX Corporation v. The Children’s Investment Fund

Fourth in a series. See Hedge Fund Activism and Corporate Governance.

CSX Corporation (“CSX”) is one of the oldest and largest railroad companies in North America. Founded in 1827, CSX serves 23 states, the District of Columbia and the Canada provinces of Québec and Ontario.

In 2007 a United Kingdom- based Hedge Fund Activist The Children’s Investment Fund (“TCI”), and another Hedge Fund Activist 3G Capital Partners (“3G”) announced that they had acquired about 9 percent of the CSX equity securities, and derivative securities (“TR Swaps”) equal to another 11 percent of the CSX equity securities. Thus, TCI and 3G controlled about 20 percent of the votes of CSX. TCI and 3G then launched a hostile attack on CSX by initiating a proxy contest, nominating five candidates to the CSX Board.

CSX filed a lawsuit in the United States District Court in New York against TCI and 3G (“CSX v. TCI”) with two claims[i]:

  1. That TCI and 3G had violated the Williams Act by failing to timely file Schedule 13(d) when it had attained 5 percent control of CSX voting equity securities. Even though TCI and 3G each had less than 5 percent direct ownership of the voting equity securities, CSX claimed that the TR Swaps gave TCI and 3G effective voting control beyond 5 percent; thus, Schedule 13(d) should have been filed.
  2. That TCI and 3G acted as a “group” by coordinating their actions; thus, the Schedule 13(d) should have been filed when the “group” exceeded 5 percent voting control.

In June 2008 the Federal District Court agreed with CSX that TCI and 3G had violated the Williams Act Schedule 13(d) filing requirements. The Court noted that TCI and 3G effectively controlled the voting securities through their TR Swaps since they had arrangements with the banks on the other side of these derivatives, which had hedged their own positions by taking long positions in the equity securities. In addition, the Court agreed that the coordinated timing of their purchases and public announcements made it clear that TCI and 3G were acting as a “group”.

However, the Court held that, despite this finding, the only penalty that could be imposed on TCI and 3G was injunctive relief; meaning, he ordered TCI and 3G to make their Schedule 13(d) filings, which they had, by then, already done. The Court said that it was powerless to grant the relief sought by CSX, which was to nullify the 20 percent voting control held by TCI and 3G.

Thus, the annual meeting was held and TCI and 3G elected four of their five candidates to the CSX Board. The result was a disaster for the corporation and its equity security holders: CSX shares declined by 50 percent after the annual meeting. By that time, TCI and 3G had sold all their shares. All of the TCI and 3G Directors then resigned from the CSX Board.

Two years later, in 2011, the United States Court of Appeals for the Second Circuit released its opinion in the appeal of CSX v. TCI. By that time, the parties had ceased to have interest in the outcome. The CSX v. TCI decision did not rule on whether the holder of the TR Swaps should be considered a beneficial owner. The Court also ruled that the District Court did not have sufficient basis to find the concerted actions of TCI and 3G formed a “group” as required under the Williams Act. However, the Court did concur with the District Court decision that the shares held by TCI and 3G could not be “sanitized”.

CSX v. TCI was important to the development of case law because it essentially cleared the way for other Activists to use collusive Wolf Pack tactics to amass substantial voting ability in a target without making public disclosure of their intentions. The only relief available to a targeted corporation and its shareholders is an injunction preventing the Activist from acquiring more securities until the appropriate filings had been made, which, of course, the Activist typically has no intention of doing anyway. It also left open whether or not TR Swaps or other derivative securities would be counted for purposes of requiring the mandated disclosure.[ii]


Next: Recent Business Law Case – Third Point LLP v. Ruprecht

  • [i] See Pankey, et al (2011).
  • [ii] See Pankey, et al (2011) and Solomon (2011).
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How Activists Use the Corporate Elections Process

Third in a series. See Hedge Fund Activism and Corporate Governance.

Corporations in the United States are chartered by the individual states. Each state has its own laws concerning corporate governance. However, for public corporation elections, there are additional rules promulgated by SEC pursuant to the U.S. Securities Laws (“Proxy Rules”). [i] Since most equity security holders do not attend corporation meetings, the equity security holder gives their voting instruction to a designated person (a “Proxy”) who attends the meetings.

Corporation meetings are usually held each year (“Annual Meeting”) to elect one or more directors to the Board and conduct other corporate business. Normally, the Board will nominate the number of candidates to the Board equal to the number of seats; for example, if there are five seats open then the Board nominates five candidates. Any equity security holder can propose a nominee, but if the Board refuses to put that nominee on the election ballot, then the equity security holder has to hire a proxy solicitor, make file Schedule 14A with the SEC and wage a campaign to have their nominee elected.

To ensure that investors receive complete and accurate information, the Proxy Rules strictly regulate communications between and among the corporation and its equity security holders. From the time they were enacted until 1992, there were few changes to the Proxy Rules. However, in 1992 the SEC changed the Proxy Rules to make it easier for equity security holders to communicate with each other. Specifically, as long as these equity security holders did not explicitly request Proxy authority[ii], they were free to communicate with each other.

Over the past two decades, the amount of equity securities held by Institutional Investors has steadily increased[iii]. Historically, these Institutional Investors have usually voted based on management’s recommendations, except in certain cases[iv]. However, in 2003, the SEC adopted a rule[v] requiring these Institutional Investors to disclose how they had voted equity security shares they held on behalf of the ultimate beneficiaries. As previously noted, this caused a problem for Institutional Investors because of the diversity of investments held. They claimed it would be too costly to review and decide how to vote on hundreds of different corporate elections every year.

In 2004, the SEC staff issued a letter indicating that these Institutional Investors could rely on recommendations of a “Proxy Advisory Firm” to fulfill their due diligence requirements, instead of researching the corporate election materials themselves.[vi] Thus began the rise of Proxy Advisory Firms such as Institutional Shareholder Services (“ISS”) and Glass-Lewis as the primary arbiters of corporate elections in the U.S.

These Proxy Advisory Firms are in the business of reviewing Proxy materials and making recommendations to Institutional Investors on how they should vote in corporate elections. Though unbinding, the “safe harbor” provided by the 2004 SEC Staff Letter is a strong incentive for these Institutional Investors to simply vote as recommended by the Proxy Advisory Firm they use.

Though unregulated, these Proxy Advisory Firms have established their own guidelines about what they consider “best practices” in corporate governance. Heavily influenced by Activists, these Proxy Advisory Firms have declared standard corporation takeover defenses such as shareholder rights plans[vii] (“Poison Pills”) and classified Boards[viii] to be “anti-investor”. As such, corporations that have such defenses will see ISS and Glass-Lewis recommend “no” votes on their management recommendations for Proxy voting. With the safe harbor created by the SEC, the Institutional Investors have dutifully followed these recommendations. Unsurprisingly, corporations have been steadily removing these defenses over the past decade, making them increasingly vulnerable to attacks by Activists.

ISS, in particular, has been criticized for a lack of transparency in how it decides on voting recommendations and adopting “one size fits all” governance criteria. Furthermore, ISS has a division providing “consulting services” to corporations willing to pay for its advice on how to “improve” their governance practices to improve their chance of gaining ISS support in Proxy contests.[ix]

Under the U.S. Securities Laws, when a person or group of persons acquires beneficial ownership of more than 5% of a voting class of a company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D with the SEC. Schedule 13D reports the acquisition and other information within ten days after the purchase.  A shorter Schedule 13G can be filed by a qualified institutional investor when the acquisition is made with neither the “purpose nor with the effect of changing or influencing the control of the issuer”.[x]

The 10-day window between the time an Activist acquires 5 percent of the voting equity securities and the deadline for filing Schedule 13D was established in 1968, when stock market technology was much less advanced than today. With today’s high speed computers and electronic trading, there is not a good reason why such a delay should still be allowed.[xi] It allows the Activist to accumulate additional equity securities well beyond the 5 percent level at market prices that do not reflect the material nonpublic information possessed by the Activist, nor does it provide adequate warning to the corporation or its other equity securities holders of the Activists intentions.[xii]

Another way Activists use the corporate elections process to further their aims is the vague definition of “group” in the U.S. Securities Laws. Though the SEC rules[xiii] provide that a “group” must be disclosed if it is formed for the purpose of voting equity securities in a corporate election, some judicial decisions have weakened these rules.[xiv]

In addition, the U.S. Securities Laws allow a person who acquires voting equity securities to instruct their stockbroker to hold the securities in an account deemed “Objecting Beneficial Owner”. Subject to the other provisions of the U.S. Securities Laws such as Schedule 13D, for example, the true owner of such securities is invisible to the public as well as to the corporation. This allows an Activist to assemble a Wolf Pack of numerous persons in virtual anonymity, until the Activist is ready to strike. For example, 11 persons or Institutional Investors could agree among themselves to each acquire 4.56% of the voting equity securities of a corporation. They could do this using Objecting Beneficial Owner status and refusing to file Schedule 13D. Due to the aforementioned weakness of the “group” provisions, this Wolf Pack could collectively control 50.1% of the voting equity securities, effectively gaining complete control of the corporation.

A more recent development has been the use of short-selling tactics by Activists. Here, the Activist takes acquires voting equity securities in the Corporation shortly before the Record Date for the Annual Meeting.[xv] However, the Activist hedges the investment risk by short-selling the very same securities. Therefore, the Activist has the ability to vote in the Annual Meeting, while having no economic risk if the results of the Hedge Fund Activism are negative on the market price of the equity securities.


Next: Recent Business Law Case – CSX Corporation v. The Children’s Investment Fund 

  • [i] Two primary laws enacted during the Great Depression were the Securities Act of 1933 and the Securities Exchange Act of 1934. The Investment Company Act of 1940 regulated investment companies. The Williams Act of 1968 amended the Securities Exchange Act of 1934 to require mandatory disclosure of information regarding tender offers. I refer to this body of legislation and amendments as “U.S. Securities Laws”.
  • [ii] Meaning the authority to vote on behalf of the equity security holder. Under Exchange Act Rule 14a-2(b)(2) a person can only solicit the votes of up to ten other persons without having to file Proxy materials with the SEC.
  • [iii] For example, the relative share of U.S. equity securities held by Institutional Investors rose from 7 percent to 60 percent between 1945 and 2005, while the percentage held by household investors declined from 93 percent to 40 percent over that same time period. See Illian (2014).
  • [iv] This included non-routine matters such as whether or not to accept a sale or dissolution of the corporation.
  • [v] See United States Securities and Exchange Commission (2003) Final Rule: Proxy Voting by Investment Advisers. 17 CFR Part 275; available at http://www.sec.gov/rules/final/ia-2106.htm.
  • [vi] See United States Securities and Exchange Commission (2004) Staff Legal Bulletin No. 20 (IM/CF) Proxy Voting:  Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms; available at http://www.sec.gov/interps/legal/cfslb20.htm.
  • [vii] A shareholder rights plan, or Poison Pill, is established by the Board. Typically, such a plan provides that any person or entity (the “Acquiror) that acquires more than a threshold amount of the corporations’ voting equity securities (usually somewhere between 5% and 10%) will trigger the conversion of stock purchase rights that accompany each share of voting equity security, except for those held by the Acquiror. This has the effect of substantially diluting the Acquiror, serving as a strong deterrent. The intent is to avoid a “creeping acquisition” where an Acquiror buys just enough voting securities to exercise control, without paying the typical control premium that would be typical in a standard tender offer.
  • [viii] A classified Board is sometimes called a staggered Board. The directors are elected in “classes” each year, usually one-third of the Board each year. The director then serves a three-year term. This arrangement was thought to provide stability and encourage appropriate long-term thinking by directors. However, as discussed in this paper, the classified Board has recently fallen out of favor with Activists eager to gain quick control of a corporation, and with academic theorists who think it serves to insulate directors from accountability.
  • [ix] See Choi, et al (2010), Gallagher (2014), Glassman and Verret (2013), Gregory (2014) and Katz and McIntosh (September 2014).
  • [x] See United States Securities and Exchange Commission, Exchange Act Sections 13(d) and 13(g) and Regulation 13D-G Beneficial Ownership Reporting; available at http://www.sec.gov/divisions/corpfin/guidance/reg13d-interp.htm.
  • [xi] Academic theorists have suggested that being able to trade on such asymmetric inside information is an appropriate incentive for Activists to do research on their targets. See Bebchuk (2012).
  • [xii] See Mirvis (2014).
  • [xiii] See CFR 240.13-4(b)(1) which adds “voting” to the terms used in defining a “group”.
  • [xiv] See Hallwood Realty Partners LP v. Gotham Partners LP. 286 F.3d 613 (2nd Cir. 2002) where the Court decided that two 13D filers and a 13G filer did not constitute a “group” under Section 13 even though one of them was a known corporate raider and all three parties discussed among themselves the strategy to be used against the corporation.
  • [xv] A date is set by the Board several weeks in advance of the Annual Meeting to determine the list of eligible votes (the “Record Date”). This is done in accordance with state laws, and allows time to distribute the Proxy materials and collect all the votes via Proxy.
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Public Policy Implications of Hedge Fund Activism

Second in a series. See Hedge Fund Activism and Corporate Governance.

The Activist has an economic incentive to engage in Hedge Fund Activism. If its strategy is successful then it can earn a relatively quick return on its investment. Quick returns are important to the Activist because the typical hedge fund manager is compensated based on a percentage of its profits (typically 20%) each year.[i]

The Case For Hedge Fund Activism

Supporters of Hedge Fund Activism believe it tends to improve corporate governance. From a public policy perspective, the case for Hedge Fund Activism is derived from the academic case for enhanced equity security holder power. A number of academic theorists, led by Professor Lucian A. Bebchuk of Harvard Law School[ii], have argued that giving more power to equity security holders relative to the Board will mitigate “agency costs”.[iii] In this view, the relationship between equity security holders and the Board is characterized as an agency relationship, where the Board simply acts as the agent for the collective group of equity security holders. Likewise, in this view the Board has no other such agency relationship with any other of the corporation’s stakeholders, such as customers, employees, suppliers or creditors[iv].

This “agency” view assumes that all equity security holders[v] have a single, common interest: maximizing the current market price of the equity securities. Since these equity security holders possess neither the time nor the skills to properly direct the corporation’s affairs, they hire “agents” in the form of the Board to do it for them. However, since members of the Board may not have the same direct economic interest as the equity security holders, they may not devote themselves to this price maximization goal as much as the equity security holders would like. Therefore, these academic theorists argue, more power should be given to equity security holders to override certain Board decisions, as well as to make it easier to replace one or more directors who haven’t performed to the equity security holders’ satisfaction.

Historically, though, most equity security holders have remained passive. Individual equity security holders typically do not own enough shares to have much influence on the voting results in a corporate election. Mutual funds, pension funds and insurance companies (“Institutional Investors”) may consolidate the individual investments of millions of individuals, and, thus, hold a substantial number of voting shares. However, because Institutional Investors hold so many different investments, the Institutional Investors do not have time or incentive to be knowledgeable participants in the corporate elections process. Historically, since it has been somewhat costly to mobilize the support of all these passive equity security holders, it has been difficult to use the corporate elections process to replace directors, and successful challenges used to be rare.[vi]

Over the past two decades, these academic theorists have promoted regulatory changes by the Securities and Exchange Commission (“SEC”) intended to lower the cost of access to corporate elections, with the intention of enhancing equity security holder power. However, those same regulatory changes have also made it much easier for Activists to pursue their strategies.[vii] We review specifically how Activists use the corporate elections process in the next section.

More recently, these academic theorists joined forces with Activists; lobbying the SEC to enact a rule enabling Hedge Fund Activists to use corporate funds to nominate their own director candidates. Though the SEC adopted the rule, it was struck down in Federal Court.[viii] In addition, these academic theorists have proposed changes to state corporation and Federal securities laws that would, among other things, give security holders the right to change the corporation’s charter, authorize mergers and other transactions.[ix]

The emergence and growth of Hedge Fund Activism, with a primary strategy of using the corporate elections process to further an investment objective, has given strength to this initiative. Hedge Fund Activism serves as a vehicle for expanding the power of equity security holders over the activities of a corporation.

The Case Against Hedge Fund Activism

Opponents of Hedge Fund Activism do not believe it tends to improve corporate governance. The primary concerns are that:

  • Activists have only a short-term focus;
  • Hedge Fund Activism has negative public policy ramifications; and
  • The stock market provides a superior oversight function.

Short-term focus. There is a concern that Hedge Fund Activism does not enhance long-term value for most equity security holders because it tends to encourage a myopic focus on short-term swings in the market price of a corporation’s equity securities. Rather than improve performance, Activist demands divert valuable corporate resources away from building long-term value and into activities that only create short-term profits for the Activists.

Research has shown that equity security holders with short-term investment horizons (such as Hedge Funds) will tend to support policies that inflate current security prices such as:

  • Reducing or eliminating research and development;
  • Disposing of new divisions, products or other initiatives that, while currently unprofitable, may have long-term potential; and
  • Borrowing money to pay dividends or repurchase equity securities.[x]

By taking such actions, the Board may forego other policies that are intended to create long-term value. Experts such as Delaware Supreme Court Justice Leo Strine[xi] and BlackRock Investments Chairman Laurence Fink[xii] have noted this problem.

Public policy ramifications. There are negative public policy ramifications when Hedge Fun Activism over-emphasizes the Board’s responsibility to the equity security holders in relation to its responsibility to the corporation itself. The Board owes stewardship responsibilities to other stakeholders, including customers, creditors, suppliers, employees and the communities in which the corporation operates. In this way, Hedge Fund Activism may tend to work against the best interests of society as a whole.

Stock market oversight. The stock market already provides a mechanism to ensure the Board’s promotion of appropriate policies for the corporation: Dissatisfied equity security holders can simply “vote with their feet” and sell their equity securities.[xiii] If too many investors sell their equity securities, it will drive down the market price of those securities, which, in turn, raises the corporation’s cost of capital. Because this oversight is exercised by a wide range of investors in an open, market-based process, it may be a superior way to address the potential “agency” problem compared to the more narrow approach of Hedge Fund Activism.


Next: How Activists Use the Corporate Elections Process

  • [i] See The Conference Board (2008).
  • [ii] Professor Bebchuk’s research has been invaluable in this paper. See Bebchuk (2003), (2005), and (2014) as well as Bebchuk and Jackson (2012).
  • [iii] “Agency costs” refer to the potential for the corporation’s directors to act in their own best interests rather than the corporation’s interests.
  • [iv] See Millon (2014).
  • [v] At any given point in time; the list of equity security holders for a corporation can change several times each second due to the existence of high frequency trading
  • [vi] See Bebchuk (2003).
  • [vii] See Bebchuk, (2005).
  • [viii] In 2010 the SEC enacted such a shareholder proxy access rule. However, this rule was struck down by the U.S. Court of Appeals for the D.C. Circuit in 2011. See Business Roundtable v. U.S. Securities & Exchange Commission, No. 10-305.
  • [ix] See Bebchuk (2005).
  • [x] See Anabtawi (2006).
  • [xi] See Strine (2014).
  • [xii] See Fink (2014).
  • [xiii] Studies have provided evidence that selling of shares by Institutional Investors can have disciplinary effects on corporations that lead to changes in governance. See Admati and Pfleiderer (2006).
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Hedge Fund Activism and Corporate Governance

I’ve completed a new term paper project for my Business Law 5330 course at the University of Texas at Arlington.

The purpose of the paper is to examine the phenomenon called Hedge Fund Activism and its effect on the governance of public corporations in the United States.

Though it isn’t the most thorough and complete paper I have written (I only had about two weeks to focus on the research and drafting), the material seemed interesting enough to share publicly. It’s a business and legal topic that is current and fast-changing, and should be worth a future research project (if I ever have the time).

Update: the complete paper is now available on Social Sciences Research Network.

This paper will be posted on my blog in six parts corresponding with the course of my research:

Part 1 – What is Hedge Fund Activism?

Part 2 – Public Policy Implications of Hedge Fund Activism

Part 3 – How Activists Use the Corporate Elections Process

Part 4 – Recent Business Law Case: CSX Corporation v. Children’s Investment Fund

Part 5 – Recent Business Law Case: Third Point v. Ruprecht

Part 6 – Conclusion: How Corporations and Regulators Can Respond

References


Next: What is Hedge Fund Activism?

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