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Hedge Funds 2007

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hedge fund activism

Paul R. Kingsley

Davis Polk & Wardwell

Hedge Fund Activism
Paul R. Kingsley

Davis Polk & Wardwell

June 6, 2007

I. Hedge Funds as Corporate Activists

In the last three to four years hedge funds have risen to the forefront of shareholder activism.
There are currently over 8,000 hedge funds worldwide, with over $1.4 trillion under management.
There are at least 100 “activist” hedge funds (i.e. 13D filers), with over $50 billion of funds devoted to activism.
13D filings by hedge fund activists have increased dramatically in the past few years:

Year / Initial 13D Filings
2000 / 1
2001 / 3
2002 / 11
2003 / 28
2004 / 41
2005 / 66

Hedge fund activism versus other shareholder activism.
The interplay of corporate governance activism (e.g., seeking majority voting, poison pill redemption, board declassification, independent directors) and corporate financial activism (e.g., seeking a change in leadership/board composition, pursuit of strategic alternatives, opposing or supporting a corporate transaction) enables hedge funds to join with institutional activists and use governance issues as “wedge” issues.
Not subject to the diversification requirements placed on mutual funds and pension funds; able to hold large amounts of stock in their portfolios without penalty.
Highly incentivized, financially sophisticated and able to pursue aggressive economic strategies.
Able to accumulate large blocks of voting rights through buying or borrowing shares on the securities lending market or use of derivatives.[1]
High success rate in achieving their demands. A study tracking hedge fund activism over the period January 2003-December 2005 found hedge funds had an overall success rate of 60% in achieving their demands. This overall rate breaks down as follows:[2]

Stated Purpose in Initial 13D / Success Rate
Changing the composition of the target’s board of directors / 73%(30 out of 41)
Success in causing the target to pursue strategic alternatives / 48% (14 out of 29)
Success in preventing a merger / 56% (10 out of 18)

Increased credibility through partnering with established institutions like Lazard (Icahn/Time Warner) and Blackstone (Pershing Square/Wendy’s International).
Hedge funds are more likely to target profitable, cash-rich, healthy firms, as compared with other activists who tend to target poorly performing firms.

Degrees of Hedge Fund Activism.
The range of hedge fund activists’ goals over the last three years, as reflected in their 13D filings, has spanned the spectrum, including:[3]

Stated Purpose in Initial 13D / Number of Filings
Changing board’s composition / 41
Pursuing alternative strategic goals / 29
Opposing a merger / 18
Supporting a merger / 16
Threatening that hedge fund would like to take over the firm in the future / 12
Replacing the CEO / 3

Examples of particular activist efforts ranging across the spectrum appear in the chart below:

II. Conflicts Presented by the “New” Shareholder Activism.

The investment horizon of hedge fund activists is relentlessly short-term and may be inconsistent with the longer-term perspectives of certain other shareholders.
Hedge fund investments are often accompanied by complex derivative hedging strategies that may separate their voting and economic interests. This so-called “new” vote buying has prompted calls for regulatory reform by some commentators.[4] Moreover, hedge funds frequently borrow shares on the securities lending market in order to hold them as of the record date for corporate voting purposes, while not retaining long term economic ownership.[5]
Hedge funds have attracted scrutiny for theiruse of derivatives in ways that have separatedtheir voting and economic interests, and have resulted in their voting against transactions that are arguably in the interests of other shareholders. In one well known example, when Mylan Labs announced an agreement to acquire King Pharmaceutical, Perry Capital, a sizeable King stockholder, acquired a voting stake in Mylan of almost 10%, but used a hedging strategy to swap away most of the economic risk associated with those shares. The companies eventually abandoned the merger, but Perry Capital’s aggressive activist strategy was the subject of a lawsuit brought by Carl Icahn (which had a significant long position in Mylan and had agitated to defeat the transaction), which was eventually withdrawn, and is the subject of an enforcement action by the SEC. The SEC action appears focused on whether Perry disclosed enough details about its hedging strategy but does not appear to challenge the merits of the underlying transactions themselves.
Once a company becomes the focus of an activist hedge fund, it can attract the interest of other like-minded hedge funds. This activity, sometimes labeled the “wolf-pack” phenomenon, can lead to what appears to be concerted, but undisclosed, action. An example of rapid movement by hedge funds into a company’s stock appears below:

III. Current Legal Framework

The current legal framework imposes some constraints on, but is not a deterrent to, hedge fund activism.
Section 13(d) Filing Obligations. Any person or group that acquires more than 5% of a class of equity securities of a public company is required to make a filing with the SEC (on Schedule 13D or Schedule 13G, as applicable). Disclosure is based on “beneficial ownership” of shares and may be triggered by membership in a “group” that beneficially owns more than 5%.
Whether to file a Schedule 13D or a shorter and less onerous 13G turns on a number of factors, the principal one of which is whether the purpose or effect of the investment is to change or influence the control of the issuer. Passive investors can file a Schedule 13G; activist investors must file a 13D.
Some hedge funds have acquired more than 5-percent economic ownership in a company without a 13D or 13G filing, to avoid signaling interest in a particular stock to either the company or the marketplace.
It is broadly accepted on the Street that an investor may increase its economic interest in an issuer’s securities beyond 4.9% without the need to make a 13D or 13G filing via a derivative contract that is both by its terms and in fact, cash-settled. The argument is that derivative securities that are cash-settled (either actually or by their terms) do not constitute “beneficial ownership” of the subject securities, for Section 13 purposes. However, while this view is generally accepted in the industry, it has not been tested by the courts.
Running with the pack without being deemed a “group.”
Investors who agree to act with other investors in connection with acquiring or voting securities would be deemed to have formed a “group” for reporting purposes.
If the group owns more than 5% of the issuer, each member of the group or the group jointly must file and keep current a Schedule 13D or 13G reporting the group’s ownership.
If the group owns more than 10%, each member of the group is subject to Section 16 and its short-swing profit disgorgement rules.
Hedge funds will usually exercise care to avoid entering into any agreement or understanding that might be deemed to constitute a “group” for reporting purposes, while nevertheless acting in parallel to bring pressure to bear on a company’s board or management. Brian Breheny, chief of SEC’s Office of M&A has expressed concern about rumored concerted activity among hedge funds in an issuer’s securities (without a group 13D filing) and noted that the staff will aggressively pursue violations of Section 13(d) if it becomes aware of them.
Section 16 Requirements For a 10% Holder.
Section 16(a) of the Exchange Act requires that directors, officers and >10% holders must file with the SEC, the amount of all securities beneficially owned by them and changes in ownership.
Section 16(b) provides that the issuer of equity securities can recover any “short-swing profits” realized by any director, officer or 10% beneficial owner from any purchase and sale, or sale and purchase, of those securities within any period of 6 months (including by way of derivative instruments).
Section 16(c) bars persons that are subject to Section 16 from selling equity securities of the issuer if that person (a) does not own the securities sold, or (b) owns those securities and does not make delivery of them against that sale within 20 days, or mail them within 5 days of that sale. As applied to synthetic sale positions (e.g., an open put position), those positions must be fully covered through actual physical ownership of securities at all times while the position is outstanding.
HSRRequirements. An HSR notification is required for investments resulting in ownership of voting securities or assets with an aggregate value of more than $56.7. Investors may not cross the $56.7 million threshold until it receives DOJ or FTC clearance; the waiting period is typically 30 days (15 for an all-cash tender offer), subject to early termination.
Two notable exceptions to the filing requirement are:
Acquisitions of 10% or less, if the acquisition is made by a passive investor solely for the purpose of investment. Since the passivity standard is vague, potentially activist investors have relied on this exception.
HSR rules applicable to partnerships (including LLCs) are such that the ownership positions of even affiliated partnerships or LLCs are treated as affiliated entities only if they share the same 50-percent owner (i.e., they have the right to 50% or more of either the profits or assets upon dissolution of the LLC or partnership involved). Because hedge funds generally are structured as LLCs or partnerships and parallel funds typically do not have the requisite overlapping ownership, a series of related hedge funds could, in theory, each acquire a 9.9% position (assuming the investment exception is available) without ever having to make an HSR filing.
Shareholder rights plans. Companies may have poison pills in effect that will be triggered when a specified number of shares is acquired, making it difficult for an investor to acquire an influential stake in the company without incumbent board support. Issues such as “group” membership may be a factor when determining whether an investor will be considered an acquiring person for purposes of the rights plan.

IV. Recent Developments.

Demandfor inspection of books and records under DGCL Section 220. In recent years, activist stockholders have increasingly used Delaware corporate code Section 220 beyond the traditional context of obtaining a company’s shareholder list for purposes of pursuing a proxy contest or inspecting a company’s books and records in order to pursue a derivative suit. The Delaware courts have facilitated this development, permitting stockholders to make Section 220 demand in such non-traditional contexts as analyzing a corporate merger, securing a forum with the board of directors for discussing proposed reforms or preparing a stockholder resolution.[6] In a recent decision, however, the Delaware Chancery Court broke with this trend and signaled a limit to the circumstances in which Section 220 may be utilized. In Polygon v. West Corporation (Del. Ch. Oct. 12, 2006), the court upheld West Corporation’s right to deny access to its books and records to Polygon, an arbitrage hedge fund that had purchased stock in West shortly after the company’s announcement that it would be going private in a transaction led by Thomas H. Lee Partners and Quadrangle Group. The court found that, although Polygon stated a proper purpose for inspecting the books and records in order to value its stock to determine whether to seek appraisal, in this case all of the necessary information to make such a determination was already available in the company’s public filings. The court also rejected Polygon’s purpose of investigating the board’s alleged breach of fiduciary duty by West’s controlling shareholders and the West directors in approving the going-private transaction. The court found that this purpose was unrelated to Polygon’s interest as a stockholder since Polygon—which purchased stock in West only after the transaction was announced—would not be legally permitted to bring this claim against the board (either in a direct or derivative action).[7]
NYSE proposal to eliminate broker voting in director elections. In June 2006, the NYSE’s Proxy Working Group recommended amendments to Rule 452 which would make the election of directors a “non-routine” matter such that brokers would no longer be able to vote in the election of directors when they do not receive instructions from the actual shareholders, even in uncontested annual elections of directors.[8] Since brokers typically vote with the board and management in director elections, at the growing number of companies which have implemented some sort of majority vote requirement, the proposed amendments could make it dramatically more difficult for directors who are subject to withhold votes to obtain a majority vote.
Proposed SEC “e-proxy” rules will make proxy solicitation less expensive and easier. An activist investor seeking to replace or elect its own slate of directors or to support or oppose another shareholder’s resolution must comply with the proxy rules. The SEC has proposed amendments to the proxy rules that would reduce the cost of engaging in a proxy contest by permitting issuers and other persons conducting proxy contests to furnish proxy materials to shareholders by posting them on an internet site and providing shareholders with notice of the availability of such materials.

V. Practical Advice for Companies

Advance Preparation.
Assemble team of small group of key officers and outside advisors (including lawyers, bankers, proxy solicitors and public relations firm); circulate contact list. Team should maintain regular contact and be able to respond quickly in a coordinated manner if and when necessary.
Identify potential vulnerabilities/areas of shareholder focus. Key “warning signs” include:
Stock underperformance.
Opportunities for a quick return -- e.g., special dividend/share buy-back opportunities, excess cash, private equity interest, opportunities for divestitures/spin-offs, etc.
Industry focus -- e.g., activist focus on your peer/similarly situated firms.
Other vulnerabilities – controversial transactions (e.g., unsuccessful acquisitions, serial acquirers, acquisitions outside core business), scandals, executive compensation issues, etc.
Listen carefully to what is being said about your Company, your peers and your industry. Focus on analyst reports, the financial press, etc. Pay attention to perspectives expressed by shareholders in meetings and at conferences. Be aware of “chatter” in the shareholder community.
Develop a consistent and coherent company message, outlining key strategies and address potential concerns/vulnerabilities. Implement an aggressive, proactive IR/PR effort to advance Company positions and strategies. Bottom line: The goal is to run an effective offense and forestall potential shareholder activism by addressing/defusing concerns before they reach a boiling point. Specifics include:
Reach out to/meet with investors to the extent appropriate. This should include even smaller investors who might have been below the IR “radar screen” in the past.
Meet with ISS and other similar groups periodically.
Use investor conferences, etc. to make key points.
Develop policies and procedures for IR activities:
Designate a small group of executives/IR professionals for purposes of investor/constituent meetings.
Ensure Regulation FD procedures are current.
Develop IR protocols – e.g., responses orally rather than in writing, more than one Company representative present at investor meetings, etc.
Keep your Board current and involved.
The Board should be kept informed on key matters including the shareholder environment generally, potential vulnerabilities, Company strategies and messages, etc.
Provide the Board with periodic briefings on relevant legal considerations, as well as policies concerning investor contacts.
In particular, directors should be warned that shareholders occasionally contact outside directors directly and should be reminded that communications should be referred to the CEO or relevant IR personnel.
Track your shareholder base frequently and carefully.
Maintain state-of-the-art stock watch programs.
Involve your stock watch and proxy firms actively. Be certain they are current/keep you fully informed as to movements in and out of your stock by relevant shareholders.
Keep track of participants in conference calls, investor meetings, etc. to try to determine whether relevant investors are becoming “interested” in your Company (possibly even before they become shareholders).
Monitor 13(d) and similar filings.
Review structural defenses on at least an annual basis. Consider the consequences of removing defenses carefully.
Implementation of defensive mechanisms requiring shareholder approval (such as classified boards) is not likely to be viable. However, companies should consider mechanisms that can be adopted by the Board.
Potential benefits of these structures must be balanced with IR/PR negatives and adverse reactions from ISS and similar groups.
Companies should also be mindful of the possibility that taking actions of this sort may result in further focus on the Company.
Specifically, companies should consider:
State of the art advance notice provisions for director nominations and shareholder proposals
Corporate governance principles that address director qualifications, such as “directors should possess the highest personal and professional ethics, integrity and values and be committed to representing the long−term interests of shareholders” and “director nominees should also represent all shareholders rather thanspecial interest groups or any group of shareholders.”
Conform bylaw provisions for setting record dates before shareholder meetings to maximum period permitted by state law.
Eliminate or opt out of cumulative voting provisions under state law to the extent possible.
Although the trend in recent years has been in favor of dismantling takeover defenses (principally declassifying boards and redeeming rights plans), steps along these lines should be evaluated carefully in the current environment.

Responding to Shareholder Approaches.
The traditional legal framework applies.
There is no general legal duty to negotiate in the event of an approach.
Serious approaches should be considered seriously by the Company and its Board of Directors.
There is no general duty to disclose non-public approaches, although a duty may arise in the case of leaks, etc.
Responses to approaches generally should be limited to we will get back to you until the Board has evaluated the matter and taken a position; a stronger response may be appropriate in certain circumstances.
Responses to press inquiries: no comment.
Responses to particular approaches should be evaluated carefully by all relevant constituencies/at all relevant levels (e.g., management, the Board, outside advisors, etc.) as appropriate. Once established, the Company should pursue its position/strategies aggressively.
IR and PR efforts.
Consider pros and cons of available legal strategies:
Litigation
SEC
Other regulatory regimes
State-level legislation
Consider possibility of engaging with activist
Encourage friendly shareholders to recall stock that has been lent out in advance of shareholder meeting record date.
Negotiation/Settlement Agreements.
Key provisions: board representation and/or adoption of a process for putting an “independent” director on board; commitment from board to consider certain topics; standstill provisions.
Issues: effect of public disclosure of settlement agreements.

(NY) 98000/200/LEE/HEDGE.FUND.ACTIVISM/kingsley.hedge.fund.activism.materials.doc