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.
- [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.