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Yvan Allaire's "The Case for and Against Activist Hedge Funds"

Yvan Allaire has posted a new analysis of hedge funds to SSRN:

A subset of so-called hedge funds, henceforth known as “activists”, has latched on the idea that many corporations are not managed or governed in a manner likely to maximize value for shareholders. With the capital they have obtained from pension funds and other institutional investors, they take a small position in the equity of publicly traded companies and push, with a varying degree of aggressiveness, for measures they deem likely to boost targeted companies’ stock price.

This is a fast growing business. The number of activist “interventions”, some 27 in 2000, has reached 345 in 2014 according to the WSJ-FactSet Activism Scorecard. Activist hedge funds have now amassed an estimated $200 billion in managed assets. To achieve more leverage on companies, smaller hedge funds may band in what has been aptly called “wolf packs”. In a by-now familiar scenario, the activist hedge fund calls on the targeted company to name to its board some people of its choosing (threatening a proxy fight if the company is not forthcoming). That is merely a first step, sometimes entirely skipped.

Unless the company swiftly gives in to its demands, the hedge fund will produce a paper, or a long letter, critical of the company’s management and board and outlining the remedial actions that, in its view, would benefit shareholders. That document will be broadcast widely so as to gather the support of the company’s institutional shareholders, even if a tacit one. In due course, if matters come to a proxy fight, the hedge fund will try to persuade the proxy advisors (ISS and Glass Lewis) to come out in favour of the hedge fund’s nominees for the board.

Allaire, Yvan, The Case for and Against Activist Hedge Funds (May 28, 2015). Available at SSRN: http://ssrn.com/abstract=2613154

Here's a key summary of his argument:

That some boards do not perform as well as expected may not be shattering news; the limited power of shareholders to get a reluctant board to act in a shareholder-friendly way has been well documented. However, recent developments in governance (majority election of board members, access to nomination process, elimination of staggered boards, say-on-pay, role of proxy advisors, etc.) have changed the relationship between boards and shareholders, giving the latter a lot more leverage over the former.

Nevertheless, one key argument of activists is valid; the current board governance practices in widely held corporations open the door to the activists. Boards are indeed too often dependent on management, and unable or unwilling to take the vigorous actions needed to create enduring wealth for the company.

That is indeed a problem calling for remedial action but not necessarily of the kind offered by activist hedge funds. Their sort of cure may be worse than the disease. 

Jim Barrall on Calma v. Templeton

Prominent UCLAW alum and Latham & Watkins parter Jim Barrall has posted a very interesting analysis of a recent Delaware decision affecting executive compensation:

In Calma v. Templeton, the Delaware Chancery Court recently denied a motion to dismiss a lawsuit brought by shareholders against Citrix Systems and its directors which alleged that Citrix’s directors had breached their fiduciary duties by paying the company’s non-employee directors excessive compensation from 2011 through 2013. The key holding of the decision is that Delaware’s “business judgment” rule, which affords directors of Delaware corporations discretion in making business judgments and substantial insulation from liability for their judgments, did not apply in the case because the directors were “interested” in the transaction, which therefore required that their decisions be reviewed under the substantially more demanding “entire fairness” standard. The Court also held that the board’s compensation decisions were not “ratified” by the company’s shareholders, notwithstanding that the shareholder-approved “omnibus equity” plan under which their equity was awarded contained conventional (and very high, IRC Section 162(m) driven) limits on the amount of equity that could be awarded to any individual in a single year, because the limits were not “meaningful.” In our Latham & Watkins Commentary,  Director Compensation after Calma v. Templeton:  Proactive Steps to Consider, we analyze the Calma decision and describe steps that companies should consider taking in the wake of the decision. 

In the blog post, Jim goes on to offer a number of thoughts on the decision's impact. Recommended reading.

Congratulations to Jennifer Mnookin: UCLA School of Law's New Dean

UCLA Executive Vice Chancellor Scott Waugh sent around this email today:

I am pleased to announce the appointment of Jennifer L. Mnookin as Dean of the UCLA School of Law, effective August 1, 2015.

 

A member of the UCLA law faculty since 2005, Professor Mnookin is the David G. Price & Dallas P. Price Professor of Law. In addition to her current service as the founding faculty director of the law school’s Program on Understanding Law, Science, and Evidence (PULSE) and as chair of UCLA’s Academic Senate Committee on Development, Professor Mnookin has also served as vice dean for external appointments and intellectual life (2012-13) and vice dean for faculty and research (2007-09). Prior to joining UCLA, she was a visiting professor of law at Harvard Law School (2003-04) and a member of the faculty at the University of Virginia School of Law from 1998 to 2005, serving most recently as the Barron F. Black Research Professor. Professor Mnookin regularly teaches Evidence and Torts, as well as courses in expert and scientific evidence; wrongful convictions; and law and popular culture. She received the law school’s Rutter Award for Excellence in Teaching in 2014.

 

A nationally renowned evidence scholar, with a particular focus in the area of expert and scientific evidence, Professor Mnookin is a co-author of two widely cited treatises, The New Wigmore, A Treatise on Evidence: Expert Evidence and Modern Scientific Evidence: The Law and Science of Expert Testimony. She has published more than a dozen articles on issues relating to forensic science, including latent fingerprint identification, handwriting expertise and DNA evidence, and has advocated for the need for a “research culture” in these areas. She has also written on a wide variety of other evidence-related subjects, including the history of expert evidence; expert evidence and the Confrontation Clause; the rise of photographic and other forms of visual evidence; documentary films and legal evidence; and theoretical and epistemic dimensions of the use of evidence in court. Some of her current research explores innovative ways to increase access to expert social science evidence to educate juries about the potential for eyewitness misidentification and false confessions. She has also written op-eds for a variety of major news outlets, including the Los Angeles Times, The New York Times, The Washington Postand The Boston Globe.

 

Professor Mnookin is a leading expert on a variety of law and science issues outside the academy. She is currently a member of the National Academy of Sciences Committee on Science, Technology, and Law. She has served on a variety of federal and national working groups on issues relating to forensic science and evidence law, including a National Institute of Justice (NIJ)/National Institute of Standards and Technology expert working group on human factors in fingerprint identification; a National Academy of Sciences committee on the Daubert standard and alternatives; and an Office of Science and Technology interagency working group on research issues in forensic science. She has spearheaded amicus briefs on behalf of a group of evidence professors in several recent Confrontation Clause cases before the Supreme Court, and she was the primary investigator on a major grant from the NIJ to investigate the relationship between difficulty and error rate in latent fingerprint identification. She is a member of the American Law Institute, and she received an A.B. from Harvard University, a J.D. from Yale Law School, and a Ph.D. in the history and social study of science and technology from MIT.

 

I want to thank the search/advisory committee for assembling an outstanding pool of candidates and for its role in recruiting Jennifer. The committee was chaired by Franklin D. Gilliam Jr., dean of the UCLA Luskin School of Public Affairs. Other members were: Stephen M. Bainbridge – William D. Warren Distinguished Professor of Law; Clarence H. Braddock III – professor of medicine, chief medical education officer and vice dean for education; Scott Cummings – professor of law; Laura E. Gómez – vice dean and professor of law; Marjorie Kagawa Singer – professor of public health and Asian American studies; Alicia Miñana de Lovelace – member of the UCLA Law Board of Advisors; Alexandria Ruiz – UCLA Law Class of 2016, vice president of the UCLA Law Student Bar Association and co-chair of La Raza Law Students Association; David O. Sears – distinguished professor of psychology and political science; and Seana Shiffrin – Pete Kameron Professor of Law and Social Justice and professor of philosophy.

 

I also want to recognize and thank Dean Rachel Moran for her dedicated leadership of the school since October 2010.

As a member of the search committee, I was pleased that we had a number of strong candidates, and am even more pleased that Jennifer was chosen. I think she'll be a great dean and, with any luck, she'll still be doing a great job when I retire in about 8 years.

Responding to wolf pack activism by hedge funds

John Coffee:

A “wolf pack” is a loose association of hedge funds (and possibly some other activists) that stop just short of forming a “group” (which would require disclosure under Section 13(d)(3) of the Williams Act once the “group” collectively held 5% or more of any class of the stock of the engaged firm). The essence of the “wolf pack” is conscious parallelism without any agreement to act in concert.[3] The market can quickly recognize a “wolf pack” once its leader crosses the 5% threshold and files its Schedule 13D, and the market responds more enthusiastically to a “wolf pack” than to other activist investors, running up on average 14% in abnormal returns on the date of its public appearance.[4] Also, the “wolf pack” acquires substantially more—at least 13.4% in on recent study.[5] But this may understate, as researchers cannot know how many allies the wolf pack leader has. In the Sotheby’s proxy litigation last year, the CEO of a prominent proxy solicitor, testifying as an expert witness, estimated that hedge funds then held over 32% of Sotheby’s (a mid-cap sized firm).[6]This is a near control block.

The key advantage of joining a “wolf pack” is that it offers near riskless profit. The hedge fund leading the pack can tip its allies of its intent to initiate an activist campaign because it is breaching no fiduciary duty in doing so (and is rather helping its own cause); thus, insider trading rules do not prohibit tipping material information in this context. If one can legally exploit material, non-public information, riskless profits are obtainable, and riskless profits will draw a crowd on Wall Street.

[3] For a fuller review of these tactics and the legal and market developments that made the “wolf pack” possible, as well as the concept of “group,” see John C. Coffee, Jr. and Darius Palia, “The Impact of Hedge Fund Activism: Evidence and Implications” (available at http://ssrn.com/abstract=2496518)(Oct. 2014).

[4] See Becht, Franks, Grant and Wagner, supra note 1, at 32. [Full cite: Marco Becht, Julian Franks, Jeremy Grant and Hammes F. Wagner, The Returns to Hedge Fund Activism: An International Study, (available at http://ssrn.com/abstract=2376271)(March 25, 2015).]

[5] Id.

[6] Daniel Burch, CEO of Mackenzie Partners, so testified in the Sotheby’s litigation that hedge funds then held an estimated 32.68% of Sotheby’s. On the basis of the “threat” this constituted, the Chancery Court upheld a special “discriminatory” version of the poison pill. Third Point, LLC, the lead activist, held only 9.62% of Sotheby’s, thus showing the size of the allies that the “wolf pack” leader can assemble. See Third Point, LLC. v. Ruprecht, 2014 Del. Ch. LEXIS 64 (May 2, 2014).

It seems to me that there are several ways of responding to the wolf pack phenomenon.

First, amend Exchange Section 13(d) and the rules thereunder so that conscious parallelism requires filing a Schedule 13D. There is evidence that "wolf pack activity appears to be ostensibly uncoordinated—i.e., no formal coalition is formed—a fact that is usually attributed to an attempt by the funds to circumvent the requirement for group filing under Regulation 13D when governance activities are coalitional." Instead of requiring the SEC and/or the target to undertake the difficult task of proving that ostensibly uncoordinated activity is in fact coordinated, we should amend Section 13(d) to force wolf packs to disclose. After all, isn't sunlight the best disinfectant? In addition, as Wachtell Lipton has been urging for a long time, the 10 day window for filing Schedule 13Ds should be shortened to 2 business days.

Second, courts should be more receptive to arguments that wolf packs constitute a group that "may be liable under Section 16(b) if, in the aggregate, the group’s holdings exceed ten percent of the company’s nonexempt, registered equity securities." 

Third, and perhaps most important, the Delaware courts should validate wolf pack poison pills:

... a traditional poison pill follows the federal securities laws in determining when shareholders are considered a “group” and would generally aggregate their ownership if, and only if, they entered into an agreement to act in concert with respect to their stock in the company. There is no definitive legal authority on whether a poison pill would be legally valid if it aggregated stock ownership of investors who patterned their behavior after one another, but did not have an agreement to act in concert. To avoid potential litigation, companies generally utilize the 13D definition of “group” in their shareholder rights plans although this means that their poison pill may not be an effective weapon against a wolf pack.

The Sotheby’s case may cause practitioners to rethink the desirability of adopting a wolf pack pill. Sotheby’s found that the acquisition of stock by members of a wolf pack could be a threat to the corporation based on a pattern of behavior the court described as “conscious parallelism.” The same analysis may also justify a wolf pack clause in a poison pill.

More on the negative effect of shareholder activism on the economy

John Coffee reports that:

[A] recent study suggests that there may be real, but long-term, costs from hedge fund activism for the economy as a whole. These researchers took the stocks included in the Wall Street Journal’s and FactSet’s Activism Scorecard and trimmed this sample down to just those campaigns launched by activist hedge funds. Then, they followed those firms that successfully avoided a takeover. They found that these firms, even though they survived the activists’ engagement intact, were forced to curtail their investments in research and development by more than half over the next four years. Specifically, R&D expenses in this sample fell from 18% of sales to 8.12% of sales over that period.[16] Nor was this a general secular trend, because in a random sample of firms not engaged by activists, they found that research and development expenditures rose modestly as a percentage of sales over the same period.[17]

Although still a preliminary study, this finding should not surprise, because it confirms what activists say they are doing. Trian Fund made clear that it wanted to reduce DuPont’s expenditures on R&D. Similarly, when Pershing Square Capital and Valeant Pharmaceuticals made a bid for Allergan last year, Valeant announced that, if successful, it would cut R&D at the combined firm by 69%.[18] Although most pharmaceutical companies typically spend about 20% of their revenues on R&D, Valeant spent only 2.7% of its revenues on R&D.[19] Its business model was to milk acquired companies like cash cows for their cash flow.

This pattern of cutting R&D expenditures (even at companies like DuPont that have historically profited from R&D) may make sense for investors who will be long gone within a year or so.

[16] See Allaire and Dauphin, supra note 1, (finding an average decline in R&D expenditures as a percentage of sales from 17.34% in 2009 to 8.12% of sales in 2013). [Full cite: Yvon Allaire and Francois Dauphin, “Hedge Fund Activism: Preliminary Results and Some New Empirical Evidence” (Institute for governance of public and private corporations, April 1, 2015).]

[17] Id (finding a modest increase in R&D expenditures from 6.54% of sales in 2009 to 7.65% of sales in 2013).

[18] See Joseph Walker and Liz Hoffman, “Allergan’s Defense: Be Like Valeant,” The Wall Street Journal, July 22, 2014 at B-1.

[19] See Joseph Walker, “Botox Itself Aims Not to Age,” The Wall Street Journal, May 19, 2014 at B-1.

But it sucks for the rest of us.

I await a reply from the activists' academic apologists.

Why do activist shareholders favor factionalized boards?

John Coffee observes of the recent DuPont proxy fight:

... that the governance professionals at pension funds and mutual funds now favor (or at least are open to) the idea of a divided, factionalized board. Putting Nelson Petz on DuPont’s board struck many of them as a low-cost means, with little downside risk, of keeping DuPont “in play” and signaling the shareholders’ desire for more spinoffs and less investment in long-term capital projects, including research and development.

I think that's correct, but the question is why shareholder activists and other institutional investors have developed a tolerance--if not an outright preference--for factionalized boards?

My own view is that factionalized boards are generally bad news. We know a fair bit about factionalized boards from observations of boards elected by cumulative voting. As I observed in The New Corporate Governance in Theory and Practice:

Granted, some firms might benefit from the presence of skeptical outsider viewpoints. It is well accepted, however, that cumulative voting tends to promote adversarial relations between the majority and the minority representative. The likelihood that cumu­lative voting results in interpersonal conflict rather than cognitive conflict thus leaves one doubtful as to whether firms actually benefit from minority representation. There will be a reduction in the trust-based rela­tionships that cause horizontal monitoring within the board to provide effective constraints on agency costs. There also likely will be an increase in the use of pre-meeting caucuses and a reduction in information flows to the board.

So where's the evidence that short slates nominated by shareholder activists will produce better results?

Shareholder Primacy is not a synonym for Shareholder Wealth Maximization

Joan Heminway makes the point, kindly linking some of my work:

A number of scholars [at a recent conference] referenced, in their presentations or in comments to the presentations of others, "shareholder primacy."  As I listened, it was clear these folks were referring to the prioritizing of shareholder interests--especially financial interests--ahead of the interests of other stakeholders in corporate decision-making, rather than the elements of corporate control (few as there are) enjoyed by shareholders.  As I began to recognize this, several things happened in rapid succession.

First, I remembered David Millon's recent paper on this subject, which (among other things) tells a history of the use of the "shareholder primacy" term.  It's well worth a read.  Or a re-read!

Second, I remembered Steve Bainbridge's earlier work on this same topic. Ditto on that paper; read it or re-read it.  His chart in Figure 1 of that paper is an amazing visual summary.

Third, and largely as a result of those two papers, I wondered why we use the same term for these two aspects of corporate modeling (whether you label them them radical versus traditional shareholder primacy, shareholder protection versus monitoring,  corporate ends versus means, or anything else).  It's confusing!  I kept wanting to interrupt, as folks were using "shareholder primacy," to ask: "which kind?" to move my understanding and analysis further forward faster.

Here's my pitch.  I advocate moving away from using the term "shareholder primacy" when a more specific term is available.

Works for me.

Can a shareholder of a subsidiary bring a derivative suit against the parent? w/r/t Sinclair Oil

A friend asked whether a minority shareholder of a subsidiary corporation may bring a derivative suit on behalf of the subsidiary against the majority shareholder/parent corporation, with specific reference to Levien's derivative suit against Sinclair Oil on behalf of Sinven. The answer is yes.

Levien’s suing derivatively on behalf of Sinven. As a shareholder of Sinven he has standing to bring Sinven’s claims against Sinclair:

A subsidiary, or its minority shareholder derivatively, may maintain an action against its corporate parent in an appropriate case for breach of a fiduciary duty arising out of a parent-subsidiary transaction, contract or dealing.8

 

8 Sinclair Oil Corp. v. Levien, 280 A2d 717 (Del) (derivative action by minority shareholder of subsidiary against its parent corporation); Getty Oil Co. v. Skelly Oil Co., 267 A2d 883 (Del); Liebert v. Grinnell Corp., 194 A2d 846 (Del Ch 1963) (parent shareholders bringing double derivative action on behalf of subsidiary against parent).

12B Fletcher Cyc. Corp. § 5888. This works because "A subsidiary is a separate entity capable of suing other parties, including its parent corporation, for breach of contract.” 9 Fletcher Cyc. Corp. § 4229, citing Sinclair Oil Corp. v. Levien, 280 A2d 717 (Del 1971) (subsidiary's minority shareholder bringing derivative action against parent for injury to subsidiary); Liebert v. Grinnell Corp., 194 A2d 846 (Del Ch 1963) (parentshareholders bringing double derivative action on behalf of subsidiaryagainst parent).

 

With specific reference to the fact pattern in Sinclair, Fletcher reports that:

A minority shareholder, even a single minority shareholder, has the same right as other shareholders to bring a derivative proceeding. It is not necessary that a shareholder have the support of a majority of shareholders or even the support of all the minority shareholders. A minority shareholder of a subsidiary corporation may maintain a derivative action against the parent corporation for the parent's breach of fiduciary duty owing to the subsidiary.5

13 Fletcher Cyc. Corp. § 5975. Footnote 5 cites: Sinclair Oil Corp. v. Levien, 280 A2d 717 (Del); Liebert v. Grinnell Corp., 194 A2d 846 (Del Ch 1963) (parent shareholders bringing double derivative action on behalf of subsidiary against parent); Marks v. Wolfson, 188 A2d 680 (Del Ch 1963) (minority shareholder of subsidiary suing majority shareholder of parent).

 

New York follows the same rule: Subsidiary's minority shareholders can sue parent derivatively for causing subsidiary to pay dividends, with funds borrowed from parent, on a class of preferred shares that was solely owned by parent, when, though the subsidiary had a surplus, the suing shareholders allege that (1) its prospective earnings won't be enough to repay the loan, and (2) the subsidiary wouldn't have paid the dividend if it weren't dominated by parent. Weinberger v Semenenko, 36 NYS2d 396 (1942).

 

Interestingly, the issue is pending in the area of series LLCs:

The Drafting Committee's current approach: “A series manager of one protected series of a series organization does not in that capacity owe any fiduciary duties to another protected series of the organization or [to] the owners associated with another protected series.” The Committee has instructed the Reporter to draft around “the Sinven problem.” Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) (shareholders of one corporate subsidiary [Sinven] brought derivative claims against the parent in part because the parent had allocated a business opportunity to another subsidiary).

Daniel S. Kleinberger, Series of Unincorporated Business Entities: The Mobius Strip and Klein Bottle of Business Entity Law, Bus. L. Today, February 2015, at 1, 3-4.

General counsels and their outside lawyers

Big Law Business has an interesting interview with my law school classmate David Leitch:

Leitch, a former Supreme Court Clerk, Chief Counsel of the FAA, and White House adviser, recently spoke to Big Law Business about some ... ways firms can do their homework on clients, how the Ford legal department has evolved, and the future of the automotive industry.