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.
- [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).