Hedge funds in corporate governance and corporate control.

• Author: Kahan, Marcel

Hedge funds have become critical players in both corporate governance and corporate control. In this Article, Professors Kahan and Rock document and examine the nature of hedge fund activism, how and why it differs from activism by traditional institutional investors, and its implications for corporate governance and regulatory reform. The authors argue that hedge fund activism differs from activism by traditional institutions in several ways: it is directed at significant changes in individual companies (rather than small, systemic changes), it entails higher costs, and it is strategic and ex ante (rather than incidental and ex post). The reasons for these differences may lie in the incentive structures of hedge fund managers as well as in the fact that traditional institutions face regulatory barriers, political constraints, or conflicts of interest that make activism less profitable than it is for hedge funds. But the differences may also be due to the fact that traditional institutions pursue a diversification strategy that is difficult to combine with strategic activism.

Although hedge funds hold great promise as active shareholders, their intense involvement in corporate governance and control raises two potential problems: the interests of hedge funds sometimes diverge from those of their fellow shareholders, and the intensity of hedge fund activism imposes substantial stress that the regulatory system may not be able to withstand. The resulting concerns, however, are relatively isolated and narrow, do not undermine the value of hedge fund activism as a whole, and do not warrant major additional regulatory interventions.

The sharpest accusation leveled against activist funds is that activism is designed to achieve a short-term payoff at the expense of long-term profitability. Although the authors consider this a potentially serious problem that arguably pervades hedge fund activism, they conclude that a sufficient case for legal intervention has not been made. This conclusion results from the uncertainties about whether short-termism is, in fact, a real problem and how much hedge fund activism is driven by excessive short-termism. But most importantly, it stems from the authors' view that market forces and adaptive devices adopted by companies individually are better designed than regulation to deal with the potential negative effects of hedge fund short-termism, while preserving the positive effects of hedge-fund activism.

INTRODUCTION

1. WHAT'S GOING ON OUT THERE? SOME ILLUSTRATIVE, HAPPY STORIES A. Hedge Funds as Activists 1. Corporate Governance Activism 2. Corporate Control Activism a. Blocking Acquirers b. Blocking Targets c. Making Bids B. Activism by Traditional Institutions Compared C. Hedge Fund Activism in Perspective II. HEDGE FUNDS AS INSTITUTIONAL INVESTORS A. Mutual Funds and Monitoring 1. The Pluses: Size and Expertise 2. The Minuses: Regulation, Incentive Problems, and Conflicts a. Regulatory Constraints b. Incentives To Monitor c. Conflicts of Interest d. Concluding Remarks B. Public Pension Funds and Monitoring C. Hedge Funds and Monitoring 1. Size 2. Regulatory Constraints 3. Incentives to Monitor 4. Conflicts of Interest 5. Activism and Stakes III. PROBLEMS GENERATED BY HEDGE FUND ACTIVISM: CONFLICTS AND STRESS FRACTURES A. The Dark Side: Hedging-Related Conflicts 1. Buying (Control) vs. Selling (Shares) 2. Conflicts in Merger Votes 3. Empty Voting B. Stress Fractures 1. Undisclosed Concerted Action 2. Overvoting C. The Absence (So Far) of a Third Conflict: Paying Hedge Funds Off. IV. PERVASIVE SHORT-TERMISM? A. A Real Problem? B. Potential Responses? CONCLUSION INTRODUCTION

   Hedge funds (1) have become critical players in both corporate governance and corporate control. Recently, hedge funds have pressured McDonald's to spin off major assets in an IPO; (2) asked Time Warner to change its business strategy; (3) threatened or commenced proxy contests at H.J. Heinz, (4) Massey Energy, (5) KT&G, (6) infoUSA, (7) Sitel, (8) and GenCorp; (9) made a bid to acquire Houston Exploration; (10) pushed for a merger between Euronext and Deutsche Borse; (11) pushed for "changes in management and strategy" at Nabi Biopharmaceuticals; (12) opposed acquisitions by Novartis of the remaining 58% stake in Chiron, (13) by Sears Holdings of the 46% minority interest in Sears Canada, (14) by Micron of Lexar Media, (15) and by a group of private equity firms of VNU; (16) threatened litigation against Delphi; (17) and pushed for litigation against Calpine that led to the ouster of its top two executives. (18)

   Even though most hedge funds are not activist, (19) the ones that are have captured attention. Martin Lipton, the renowned advisor to corporate boards and veteran of the takeover wars of the 1980s, lists "attacks by activist hedge funds" as the number one key issue for directors. (20) The Wall Street Journal, the newspaper of record for executives, bankers, and investment professionals, calls hedge funds the "new leader" on the "list of bogeymen haunting the corporate boardroom." (21) The Economist has run a special report on shareholder democracy focusing on activism by hedge funds, (22) and several European governments are considering regulations designed to curb hedge fund activism. (23)

   What should we make of this spate of shareholder activism by hedge funds? Are hedge funds the "Holy Grail" of corporate governance--the long sought-after shareholder champion with the incentives and expertise to protect shareholder interests in publicly held firms? Or do they represent darker forces, in search of quick profit opportunities at the expense of other shareholders and the long-term health of the economy?

   In this Article, we analyze and evaluate the implications of the rise of hedge funds for corporate governance and corporate control. In Part I, we examine and categorize a variety of presumptively "happy stories"--that is, examples of different kinds of activism where hedge funds have no apparent conflict of interest. We argue that this hedge fund activism differs, quantitatively and qualitatively, from the more moderate forms of activism that traditional institutional investors engage in.

   In Part II, we analyze why hedge funds are so much more active than other institutional investors. We show that hedge funds have better incentives, are subject to fewer regulatory impediments, and face fewer conflicts of interest than traditional institutions, such as mutual funds and pension funds, which have never lived up to the hopes of their partisans. But the activism of hedge funds may also be due to the fact that many follow a different business strategy than traditional institutions. This strategy involves taking high stakes in portfolio companies in order to become activist, rather than diversifying and becoming involved (if at all) only ex post when companies are underperforming, thus blurring the lines between betting on and determining the outcome of contests.

   In Part III, we turn to potential problems generated by hedge fund activism. We first examine the "dark side" of activism--instances where the interests of activist hedge funds conflict with those of their fellow shareholders--to see whether regulatory intervention is warranted. We then discuss other problems that arise from the stress that hedge funds put on the governance system.

   In Part IV, we turn to the most severe attack leveled against hedge funds: that hedge fund activism increases the pressure for short-term results over more valuable long-term benefits. We accept that short-termism by hedge funds can aggravate short-termism in the executive suite. But we nevertheless conclude that, at this point, no regulatory intervention is warranted because: it is unclear to what extent hedge fund activism is driven by excessive short-termism; hedge funds usually need the support of other, less short-term oriented constituents to affect corporate policy; and, to the extent short-termism generates a problem, adaptive devices adopted by corporations are a better way to address it than regulation. (24)

1. WHAT'S GOING ON OUT THERE? SOME ILLUSTRATIVE, HAPPY STORIES

   Hedge funds are emerging as the most dynamic and most prominent shareholder activists. On the bright side, this generates the possibility that hedge funds will, in the course of making profits for their own investors, help overcome the classic agency problem of publicly held corporations by dislodging underperforming managers, challenging ineffective strategies, and making sure that merger and control transactions make sense for shareholders. In so doing, if one looks at the bright side, hedge funds would enhance the value of the companies in which they invest for the benefit of both their own investors and their fellow shareholders. In the first Section of this Part, we examine and categorize the different ways in which hedge funds, without any apparent conflicts of interest, have confronted managers. This Section illustrates the potential bright side of hedge fund activism.

   But the bright-side story of hedge funds--of large and sophisticated investors standing up to management for the benefit of shareholders at large--has an element of deja vu. Twenty years ago, similar stories were told about another set of large and sophisticated investors: mutual funds, pension funds, and insurance companies--or "institutional investors," as they became known. (25) While, on the whole, the rise of these traditional institutional investors has probably been beneficial, they have hardly proven to be a silver bullet.

   Are there reasons to think that the newly prominent hedge funds will be more effective? In Section B of this Part, we start answering this question by comparing the activism of hedge funds to the activism of traditional institutions. We show that hedge fund activism differs in degree and type from activism by traditional institutions.

   In the final Section of this Part, we place hedge...