The wolf at the door: the impact of hedge fund activism on corporate governance.

Author:Coffee, John C., Jr.
  1. INTRODUCTION II. THE CHANGED ENVIRONMENT: WHAT FACTORS HAVE SPURRED ENHANCED ACTIVISM BY HEDGE FUNDS? A. The Decline of Staggered Boards B. The Enhanced Power of Proxy Advisors C. SEC Rules D. Broker Votes E. The "Wolf Pack" Tactic F. The Shrinking Concept of "Group" G. Proxy Access H. Tactics: The Game Plans for Each Side III. ARE HEDGE FUNDS SHORTENING THE INVESTMENT HORIZON OF CORPORATE MANAGERS?: FRAMING THE ISSUE A. The Evidence on Activism's Impact on R&D Expenditures B. Case Studies 1. The Allergan Takeover Battle 2. The DuPont Proxy Contest C. The Broader Pattern: From Investment to Consumption IV. A SURVEY OF THE EVIDENCE A. Who are the Targets of Hedge Fund Activism? B. Does Hedge Fund Activism Create Value? 1. Short-Horizon Event Studies of Stock Returns 2. Long-Horizon Stock Return Studies C. What are the Sources of Gains from Activism? 1. Improvements in Operating Performance 2. Increasing the Expected Takeover Premium 3. Wealth Transfers 4. Reduction in Managerial Agency Problems D. Do the Targets of Hedge Fund Activism Experience Post-Announcement Changes in Real Variables? 1. Risk 2. Leverage 3. Investment Expenditures 4. Growth 5. Payouts 6. Cash E. An Initial Evaluation V. IMPLICATIONS A. Closing the Section 13(d) Window B. Expanding the Definition of Insider Trading C. Redefining Group D. Focusing on the Proxy Advisor E. Private Ordering VI. CONCLUSION I. INTRODUCTION

    Hedge fund activism has recently spiked, almost hyperbolically. (1) No one disputes this, and most view it as a significant change. But, their reasons differ. Some see activist hedge funds as the natural champions of dispersed and diversified shareholders, who are less capable of collective action in their own interest. (2) A key fact about activist hedge funds is that they are undiversified and typically hold significant stakes in the companies that comprise their portfolios. (3) Given their larger stakes and focused holdings, they are less subject to the "rational apathy" that characterizes more diversified and even indexed investors, such as pension and mutual funds, who hold smaller stakes in many more companies. So viewed, hedge fund activism can bridge the separation of ownership and control to hold managements accountable.

    Others, however, believe that activist hedge funds have interests that differ materially from those of other shareholders. Presidential contender Hillary Clinton has criticized them as "hit-and-run activists whose goal is to force an immediate payout," (4) and this theme of an excessively short-term orientation has its own history of academic support. (5) From this perspective, the rise of activist funds to power implies that creditors, employees, and other corporate constituencies will be compelled to make wealth transfers to shareholders.

    This Article explores this debate in which one side views hedge funds as the natural leaders of shareholders and the other side as short-term predators, intent on a quick raid to boost the stock price and then exit before the long-term costs are felt. We are not comfortable with either polar characterization and thus begin with a different question: Why now? What has caused activism to peak over the last decade at a time when the level of institutional ownership has slightly subsided? Here, we answer with a two-part explanation for increased activism. First, the costs of activism have declined, in part because of changes in SEC rules, in part because of changes in corporate governance norms (for example, the sharp decline in staggered boards), and in part because of the new power of proxy advisors (which is in turn a product both of legal rules and the fact that some institutional investors have effectively outsourced their proxy voting decisions to these advisors). (6) Second, activist hedge funds have recently developed a new tactic--"the wolf pack"--that effectively enables them to escape old corporate defenses (most notably the poison pill) and to reap high profits at seemingly low risk. (7) Unsurprisingly, the number of such funds, and the assets under their management, has correspondingly skyrocketed. (8) If the costs go down and the profits go up, it is predictable that activism will surge, which it has. But that does not answer the broader question of whether externalities are associated with this new activism.

    Others have criticized hedge fund activism, but their predominant criticism has been that such activism amounts in substance to a "pump and dump" scheme under which hedge funds create a short-term spike in the target stock's price, then exit, leaving the other shareholders to experience diminished profitability over the long-run. (9) This claim of market manipulation is not our claim (nor do we endorse it). Rather, we are concerned that hedge fund activism is associated with a pattern involving three key changes at the target firm: (1) increased leverage, (2) increased shareholder payout (through either dividends or stock buybacks), and (3) reduced long-term investment in research and development (R&D). The leading proponent of hedge fund activism, Harvard Law Professor Lucian Bebchuk, has given this pattern a name: "investment-limiting interventions." (10) He agrees that this pattern is prevalent but criticizes us for our failure to recognize that "investment-limiting interventions" by hedge funds "move targets toward ... optimal investment levels" because "managers have a tendency to invest excessively...." (11) We think this assumption that managements typically engage in inefficient empire building is out of date today and ignores the impact of major changes in executive compensation. The accuracy of this assertion that managements are systematically biased towards inefficient expansion and investment becomes the critical question, as the scale and magnitude of "investment-limiting interventions" by activists have begun to call into question the ability of the American public corporation to engage in long-term investments or research and development (R&D). Is the new activism a needed reform to curb a serious managerial bias towards empire building, or a hasty overreaction--or something in between?

    This Article has three basic aims: first, we attempt to understand and explain the factors that have caused the recent explosion in hedge fund activism. Second, we focus on the impact of this activism, including in particular whether it is shortening investment horizons and discouraging investment in R&D. Finally, we survey possible legal interventions, and evaluate them in terms of our preference for the least restrictive alternative. Although others have conducted lengthy surveys, the landscape of activism is rapidly changing, and thus we have doubts about the relevance of empirical papers that study hedge fund activism in earlier decades. (12) We also suspect that the recent success of such activism may be fueling a current "hedge fund bubble" under which an increasing number of activist funds are pursuing a decreasing (or at least static) number of companies that have overinvested (that is, made allegedly excessive investments in R&D or other long-term projects). This Article is particularly focused on those market and legal forces that may be driving this bubble.

    Here, a leading cause of increased hedge fund activism appears to be the development of a new activist tactic: namely, the formation of the hedge fund "wolf pack" that can take collective (or, at least, parallel) action without legally forming a "group" for purposes of the federal securities laws (which would trigger an earlier disclosure obligation). (13) This new tactic, of course, explains our title. Hedge funds have learned that to the extent they can acquire stock in the target firm before the "wolf pack" leader files its Schedule 13D, announcing its proposed intervention, significant gains will follow for those who have already acquired that stock. Also, as later explained, this tactic allows activists to acquire a significant stake and negotiating leverage without triggering the target's poison pill.

    Of course, new tactics are not necessarily bad and may be efficiency-enhancing. All studies have found that activist campaigns result, on average, in short-term gains for shareholders, but the evidence (as we will show) is decidedly more mixed with respect to long-term gains. (14) Here, a word of caution needs to be expressed at the outset about these studies and the reliance that can be placed on them. Even if all these studies were to show long-term gains over an extended period, they would still not resolve the key policy questions because of the following limitations on them:

    (1) The distribution of the returns from hedge fund activism shows high variance, with a significant percentage of firms experiencing abnormal stock price losses; (15) thus an individual company may be well advised to resist an activist's proposal, even if such proposals enhance shareholder value on average;

    (2) The positive abnormal stock returns on which the proponents of hedge fund activism rely do not necessarily demonstrate true gains in efficiency, (16) but may only indicate that the market has given the target firm a higher expected takeover premium; that difference is important because not only may this temporary increase later erode if no takeover results, but in any event it does not demonstrate a true efficiency gain; (17)

    (3) These studies overlook (or give only inadequate attention to) the possibility that whatever shareholder wealth is created by hedge fund activism may reflect only a wealth transfer from bondholders, employees, or other claimants; (18) and

    (4) Above all, the impact of hedge fund activism on American corporations (and long-term investment) cannot be adequately measured by looking only to the post-intervention performance at those companies that experience a hedge fund "engagement." Such tunnel vision ignores both (a) the deterrent impact of such activism on the...

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