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).