University of Pennsylvania Law School U of Penn, Inst for Law & Econ Research Paper No. 06-16 New York University School of Law NYU, Law and Economics Research Paper No. 06-37 European Corporate Governance Institute ECGI - Law Working Paper No. 76/2006 Hedge Funds in Corporate Governance and Corporate Control by MARCEL KAHAN New York University - School of Law EDWARD B. ROCK University of Pennsylvania - School of Law This paper can be downloaded without charge from theSocial Science Research Network Electronic Paper Collection at:
Hedge Funds in Corporate Governance and Corporate Control Marcel Kahan* & Edward B. Rock** * geo rGe. T wLyosrs oofPerf o w,LaU YNo ohlSc ofwa. L rc elaMh’aasn Kh rrceseawas ed ouprtps byhte ont liMd na armiMrH oinatuF ** ualS. A oxFd ushneiigsDtifoPreos sof unseiss B,L aw vyertUsniiof naivnlaPesnyoS oclhof . wLa Lady vsaDi ,wolleF werbeH ytniUvsire25 (-)6dra wdEoR’s kcrch reseas wads upporte bythe versity Uniof sv’nlnayniseP uettintIso fr waLn ad scimoocnEnad h etu alSo Fxhc raeseR hnTaks o t ntAa ,itadAm Waillmin oA,dsrena I,seryA hlceaiM do,iBinnuaLi ckbue hB,c yraG ,raalCoBb kr,a lConJh ,seotaC caasI ,eorCrv eetSn a,msiEhntaN h,clseiF rniEehg lu,Eae lliJhcs,i F ramaTna rk,Fle rtobRean, Fdermioe J,se tdfnruGd Davire, yermHaaEhud ra, Kam Al, kecKrvliohJ osr,r eneL na lAl ,zlaMoJnh nrb s,Oo atroRbe ,naooRmoJnh ,srogeRos inllArvo h,cSnie vdaDi ,klSeeaL aru ,kratSsoeL nir ,etSNa ncy, imhudenS cErie,lT ayl DealniWf, old anhte pis acntirtpa atopsh rkwso atvd arrHaLaw ,oolhSc werbeH yntUivsire waL ,ytlucaFht ep niyicsrladnrIeit renetC waL ,yutclaFnoadftr S waL ,ohlcoS leT vvAi waL ,uyctalF ytivsrenUiof vnln nyaesiP waLohclSo, Yale Law ool, hScthe Inoin tlanretnigte eM forPsa nretf on,d dSekapsA,r ea,t SleaMgher & oFml, LLP, and at the Second Annual Penn/NYU Conferenceon w Land anFaince rf of hupelle sntmcomand rosninasvt oecd naot aKuls koel hmScand antiA nYue rfo lufplehh craesernecatsissa.
Abstract Hedge funds have become critical players in both corporate governance and corporate control. In this article, we 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 yrotalugerroferm . We argue that hedge dnuf msivitca sreffidrfmo msivitca ybitidartonal 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 intermittent dna xe .)tsop ehT snosaerofr 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 evitca ,sredloherahs rieht esnetniinvolvement in corporate governance and control also potentially sesiar owt sdnik foproblems: 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 yrotalugermetsys ma y ton eb elba ottshtiwand. The resulting ,smelborp ,revewoh erarelatively isolated and narrow, do not broadly 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 ot eveihca amret-trohs ffoyap ta ehtsnepxee of long-term profita .ytilib hguohtlAew consider this a potentially serious problem that arguably pervades hedge fund activism, we conclude that a sufficient case for legal intervention has not been made. This noisulcnoc stlusermorf eht seitniatrecnu tuobawhether 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 our view that market forces and adaptive devices taken 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. ii
Table of Contents noitcudortnI ………………………………………………………………………… 1I. What’s Going on Out There? Some Illustrative (Happy) Stories ……………….. 3 A. Hedge Funds as Activists ……………………………………………….. 4 1. Corporate Governance Activism ………………………………… 4 2. Corporate Control Activism ………………………………………8 a. BlockingAcquirers ………………………………………. 9 b. Blocking Targets …………………………………………11 c. MakingBids ……………………………………………...13 B. Activism by Traditional Institutions Compared …………………………15 C. Hedge Fund Activism in Perspective ……………………………………18 II. Hedge Funds as Institutional Investors ……………………………………. 18 A. Mutual Funds and Monitoring …………………………………………. 19 1. The Plus: Size & Expertise …………………………………….. 19 2. The Minuses: Regulation, Incentive Problems and Conflicts …... 20 a. Regulatory Constraints …………………………………. 20 b. Incentives to Monitor …………………………………… 21 c. Conflicts of Interest …………………………………….. 24 d. Concluding Remarks ……………………………………. 26 .B cilbuP noisneP sdnuF dna gnirotinoM ..…………………………… 62 C. Hedge Funds and Monitoring ……………………………………… 30 1. Size ……………………………………………………………… 30 2. Regulatory Constraints ………………………………………….. 30 3. Incentives to Monitor …………………………………………… 32 .4 stcilfnoC fo tseretnI ...…………………………………………… 33 5. Activism and Stakes …………………………………………….. 35 III. Problems Generated by Hedge Fund Activism: Conflicts and Stress Fractures . 37 A. The Dark Side: Hedging-Related Conflicts …………………………….. 38 1. Buying (Control) v. Selling (Shares) ……………………………. 38 2. Conflicts in Merger Votes ……………………………………… 38 3. Empty Voting ……………………………………………………. 41 B. Stress Fractures …………………………………………………………. 42 1. Undisclosed Concerted Action ………………………………….. 42 2. Overvoting ………………………………………………………. 44 .C ehT ecnesbA oS( )raF fO ahTird Conflict: Paying Hedge Funds Off …..46 IV. Pervasive Short Termism? ………………………………………………… 46 A. A Real Problem? ………………………………………………………... 47 B. Potential Responses? ……………………………………………………. 50 Conclusion …………………………………………………………………………. 53 iii
Introduction 1 egdeHsdnuf have become critical players ni htob etaroproc ecnanrevog dnacorporate control. Over the tsal wef ,shtnom egdeh sdnuf evah derusserp sdlanoDcM ot23spin-off major assets in an IPO; asked Time-Warner to change its business strategy; 456threatened or commenced proxy contests over . Heinz, Massey Energy, ,G&TK 78910,ASUofni Sitel, and GenCorp; made a bid to acquire notsuoH;noitarolpxE dehsup rof11a merger between Euronext and Deutsche Boerse; pushed for changes in management 12and strategy at Nabi Biopharmaceuticals; opposed acquisitions by Novartis of the 13remaining 58% stake in Chiron, by Sears Holdings of the 46% minority interest in Sears 141516Canada, by Micron of Lexar Media, and by a group of private equity firms of VNU; 1 For purposes of this article, hedge funds are funds exempt from regulation under the Investment Company tcAht tavnie tsprmi ylirani pub ylcildart deuces seitir ronifanc laidevira .sevit (defining hedge funds in a similar way). 2 Big Shareholder of McDonald’s Urges Asset IPO, Wall St. J., Nov. 9, 2005, at A6; Hedge-Fund Man at McDonalds’s, Wall St. J., Sept. 28, 2005, at C1 (noting pressure by Pershing Square, a hedge fund, in McDonald’s Corp., to sell company-owned restaurants). 3 Andrew Ross Sorkin & Richard Siklos, Icahn Tries to Form a Team to Take On Time Warner, NYT, Aug. 10 ,002 ,5rpnitou ;tuJ ailwgnAni ,Inhac seussIiTme Warner Challenge – Financier Confirms Alliance With Other Investors to Seek Changes at Media Compna ,yWa ll .tS ,.JguA. 61 ,0250 , ta3A . 4 Janey Adamy & David Reilley, Heinz Says Investor’s Company Plans to Nominate 5 Directors, Wall St. ,.J .raM4, 6002 , taB2 . 5 AP Wire, Investment Company Wants Representation on Massey’s Board, Mar. 17, 2006 6 Seon-Jin Cha, Icahn Group Demands access to KT&G Books, Wall St. J., Mar. 15, 2006 at C4; Laura naSnit ,iIcha nGroup dnaL sKTG& Bodra ,taeSWa ll .tS ,.Jmar. 71 ,6002 taC4 .. 7 nIof ASU sllethsraohelders otgiron ehegd eufdn ,ueRt ,sre yaM4, 0260 . 8 ANAJntraPe srCLL nnAounc se LETISoBdra oNmin seedna nInetoit n otpeRl ecadAdnoitia lBo draMembers, PRNewswire, Nov. 23, 2005. 9 Shareholder Revolt Rocks GenCorp, TMCnet, Apr. 1, 2006. 10 Marietta Cauch, Jana Partners Sets Energy Bid in Unusual Move for Hedge Fund, Wall St. J., June 13, 2006 (reporting bid by Jana for Houston Exploration). 11 Hedge Funds Push for Merger of Deutsche Boerse & Euronext, Hedge Fund Street Newsletter, Nov. 23, 2005; Nick Clark & Vivek Ahuja, Hedge Fund Forces Euronext Merger Vote, Financial News Online US, Apr. 41 ,002 .6 12 Robert Steyer, Hedge Funds Take Aim at Nabi, The , April 26, 2006. 13 ValueAct Refuses to Talk to Chiron about Deal, Wahs .oP ,tsraM. 02 ,0260 ;hSraohelred nIusrrnoitce stcefnIvoNatiri s’s5$1. bnoilli Chnori iBd, llaW .tS ,.J .rpA3, 002 ,6 taC3 . 14 yraGoN ,sirr sraeSoHldgnis syaS ti lliw nwO001 %of sraeSnaCada ,CA EONMone ,ypA .r ,72600 . 1
17threatened litigation against Delphi; and pushed for litigation against Calpine that lead 18to the ouster of its top two executives. 19Even though most hedge funds are not activist, eht seno taht era evah derutpacthe attention. Martin Lipton, the renowned advisor to corporate board s dna naretev fo ehttakeover wars of the 1980s, lists “attacks by activist hedge funds” as the number one key 20issue for directors. The Wall Street Journal, the newspaper of record for executives, bankers, and investment professionals, calls hedge funds the “new leader” on the “list of 21bogeymen haunting the corporate boardroom.” ehTmonocEi ts snur laiceps stroper no22Shareholder Democracy focusing on activism by hedge funds. And several European 23governments are weighing regulations designed to curb activist hedge funds. What shall we make out of the 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 the publicly held firm? Or do they represent darker forces, in search for 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 hedge fund activism where hedge funds ha ev on tnerappa tcilfnocfo interest. We will argue that this hedge fund activism differs, quantitatively and qualitatively, from the more moderate forms of activism that traditional institutional investors engage in. 15 ffeJahCp ,llep egdeH dnuFevnI srots noitseuQeL norciM-rax ,laeDtcecEeNcinorw ,s .rpA ,52 .6002 16 Jason Singer, Knight Presses VNU Overhaul Plan, Wall St. J., Apr. 7, 2006 at C4. 17 Jeffrey McCracken, Delphi Ripped for Bankruptcy Case, Wall St. J., Mar. 17, 2006 at A10. 18 Rebecca Smith, Executives’ Ouster swohS iworGn g dnuF-egdeH ,tuolCaW ll .tSJ ,.eD .c ,1 ,5002 ta .1A 19 eeSarfni itceSo n . 20 Martin Lipton, Wachtell Lipton, Rosen & Katz Client Memo, Dec. 1, 2005; see also Martin Lipton at al., hcaW lletpiLtno ,Rones & ztaKneilCt eMmo ,nieBg rpeperad rofattA skc ybtsivitcA egdeH , 21, 2005 (noting “environment of increased attacks by hedge funds” and advising companies how to deal htiw ;)tinitraM iLptno tala ,.hcaW lletotpiLn, oR nes & ztaKneilCt Memo ,kcattA sby vitcA tsideHge nuFds , .raM7, 2600 neserp(nit ghckce tsil rofneilct s otd laehtiw vitca tsidehge nufds .) 21 Alan Murray, Hedge Funds Are New Sheriffs of Boardroom, Wall St. J., Dec. 14 , ,5002 ta ;2A ees osla esseJnisiEge ,reMmo ot vitcA :stsiniMd OEC ,yaP llaW .tS ,.JnaJ. 11 ,0260 , ta1C hT“( ehsoheralder activists with the most clout these days are hedge-fund managers …”). 22 nilttaBg rofCooprr etamAire ,achT enocE ,tsimo .raM11 ,2600 ta69 . 23 drawdE rolyaT & riatsilAMc ,dlanoD egdeH sdnuFF ecaEus’epor eppilC ,sr llaW .tS ,.J yaM ,32 ,6002 taC1 (regulations considered by Germany and the Netherlands). 2
In Part II, we analyze why hedge funds are so much more active than other institutional investors. eW wohs taht egdeh sdnufevah better incentives, are subject to fewer regulatory impediments and face fewer conflicts of interest than traditional institutions, such as mutual funds and pe noisn ,sdnuf ohw evah reven devil pu ot ehthopes of their partisans. But the activism of hedge funds may also be due to the fact that they follow a different business strategy than traditional institutions. This strategy involves taking high stakes in portfolio companies in order to become activist -- thus blurring the lines between betting on and determining the outcome of contests -- rather than diversifying one’s investment and becoming involved (if at all) only ex post nehwcompanies are underperforming. nI traP ,III ew nrut ot laitnetopborplems 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; because hedge funds usually need the support of other, less short-term oriented, constituents to affect corporate policy; and because, to the extent short-termism generates a problem, adaptive devices taken by 24corporations are a better way to address it than governmental regulation. I. 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 doing so, the bright side holds, hedge funds would enhance the value of the companies they itsevn in rof ehteneb tif fo htob rieht nwoinvestors 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 interests, have confronted managers dema gnidn segnahc nimaegan tnem dna ssenisubstrategies or getting involved in corporate control transactions. This section illustrates eht laitnetop thgirb edisof hedge fund activism. 24 We od not da sserdht euqoitsen fohwhtee rdadnoitia lgeruoitaln sinedede ot prot tcehedge ufdn vnieotsr sfrom either investment risk or unscrupulous managers .hW eliimpornatt nad itmely ,ht siquenoits sibenoy dht eocspe fohtis .elcitra 3
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 déjà vu. Twenty years ago, similar stories erew dlot tuobatonaher set of large and sophisticated investors: mutual funds, publ ci noisnep ,sdnuf etavirp noisnep ,sdnuf25insurance companies, or “institutional investors” as they became called. But while, on the whole, the rise of these traditional institutional investors has pr ylbabo neeb ,laicifenebthey have hardly proven to be a silver bullet. Are there reasons to think that newly prominent hedge funds will be more effective? In section B of this Part, we will start answering this question by comparing the activism of hedge funds to the activism of traditional institutions. We will show that hedge fund activism differs in degree and type from the activism by traditional institutions. In the final section of this Part, we place hedge fund activism in the context of hedge fund investment strategies more ge .yllaren ylnO ams lla noitrop fo egdeh dnufassets are devoted to shareholder activism. Thus, activism does not dominate what hedge funds do. Hedge funds, however, dominate certain modes of activism and – if that activism is profitable and more hedge funds asset become devoted to it – the extent of hedge fund activism could quickly increase. A. Hedge Funds as Activists 1. Corporate Governance Activism egdeH sdnuf evah ylgnisaercni deirtto influence the business strategy and management of corporations. This activism takes a variety of forms, from public pressure on portfolio companies to change the business strategy, to eht gninnur fo a yxorpcontest to gain seats on the board of directors of portfolio companies, to litigation against present of former managers. One of the better known (and more ente )gniniatr tsivitcaeh egd sdnuf si drihT26Point LLC, which has about $ billion under management. Its list of recent targets includes Ligand, Salton, Western Gas Resour ,sec yessaM ,ygrenEoPtlatch, Intercept, 25 See, . nreBdra .SkcalB ,gAne stWahctign gAne :sthT eorPm esiof nIutitsnoita lvnIe rotsoV ,eci39 UCLA .L RVE. 811 (1991); Black, Shareholder Passivity Reexamined, 89 MICH. .L RVE. 520 (1990); Mark .JoR ,e AoP lacitilhToe yron mAnacire oCpr etaroniFanc ,e19 CMULO. .L RVE . 01 .)1991( tuB ,ees . .JosliGn dna ieRn reikaarKmna ,nieRvennit g ehtuOdist eotceriDr : nAgAdnea rofnIutitsitonal Investors, 43 SNAT. .L RVE. 863 (1990); Edward B. Rock, The Logic and (Uncertain) Significance of nIutitsnoita lhSoheralde rvitcAsim, 79 GOE. . 544 ;)1991( eesslao tanA .R itamdAet ,.la egraLhSoheralde rvitcAsim, ksiR hSgnira, dna niFanc lai tekraMuqEbiliuirm . 1 20 .JoP .lnocE .0179 91()49 (developing model of large shareholder monitoring). 26 maJes ylleKJoni shTird oPin t sAdiserP tnena dhC feipOgnitare , ,peSt .7, 002 ,5hpttw//: 4
27Warnanco, Penn Virginia and Star Gas Partners . Star Gas, to pick one of the targets, 28 si a gnitaeh lio .rotubirtsid drihTPoint acquired around %6 fo nI noitidda otseverely criticizing CEO Irik Sevin’s management of the company, Third Point attacked him personally: “It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons 29where you can play tennis and hobnob with your fellow socialites.” The governance practices of Star Gas were a yltnerapp ton .laedi ,suhTThird Point openly wondered: wo]H[ si ti elbissop taht uoy detceles ruoy ylredleraey-87-old mom to serve on the Company's Board of Directors and as a full-time employee pr gnidivo eeyolpme dnaunitholder services? We further wonder under what theory of corporate governance does one's mom sit on a Company board. Should you be found derelict in the performance of your executive duties, as we eveileb si eht ,esac ew od ton eveileb30your mom is the right person to fire you from your tactic worked. Bowing to the pressure generated by Third Point, Sevin resigned one 31month later. Or take the exploits of Barington, another activist hedge fund. In June 2003, Barington nominated three directors to the board of Nautica Enterprises, the sportswear 32company. At the time, it held about percent of Nautica stock. Shortly thereafter, 33the company indicated that it was discussing a possible sale. notgniraB yltneuqesbusconvinced Institutional Shareholder Services, a proxy voting advisory service, to 34recommend that its clients vote for the two Barington director nominees. By July 2003, Barington’s tactics had worked: Nautica agre de ot eb deriuqca ybVF noitaroproCrof 3536$587 million and Barington dropped its proxy fight. ehT gniwollof ,yluJotgnirraB n 27 Innisfree Presentation to Skadden, Arps, Slate Meagher & Flom LLP, Apr. 23, 2006. 28 Third Point Demands That Star Gas CEO, Irik Sevin, Resigns and Returns Keys to Company Car, PR NSWEWERI ,beF. 41 ,0250 , 29 Id. 30 Id. 31 Ron Orol, Fortress GenCorp, D YLIADAEL, March 25, 2005, hpttht//: . hWhtee rht si saw ootttil eloto etal sina nignitseret but pesa etaruqnoitse. retfA a feirbup ,kcit ratS s’saGkcots pr eciocnunite dot d .enilce 32 uSnnaz eKarenp, Bodra Mo evfiLt sNau acit12 rePcne ,. PTSO, June 12, 2003, at 41. 33 Suzanne Kapner, Nautica Rises 11% on News of Suitor, . PTSO, June 21, 2003, at 20. 34 nIutitsnoita lhSoheralde rvreS secioceRnemmd soitcelEn of iraBngtno oCmpna seiuorGp oNmin ,seeRP NSWEWERI ,uJ yl2, 0230 ,hptt: 35 Sundaramoorthy, Nautica Accepts Dollars 587m VF Bid, FCNANILAI TMISE ,uJ yl ,82300 , ta62 . 36 notgniraBComp seina puorG stcaeRaF ylbarov ot desoporP noitisiuqcAof Nautica Enterprises by VF oCprnoitaro, RP NSWEWERI, July 7, 2003, . 5
turned to Steven Madden, Ltd., and urged it to explore “strategic discussions with 37potential acquirers.” Barington, which had accumulated a % stake, sent outside directors a strongl y dedrow rettelmeda gnidn taht tiih er a erom denosaes ,OEC ecuderchange in control compensation, reduce conflicts of interest on the board, and use its 38excess cash to buy back shares and pay dividends. yB yraurbeF ,5002 eht evetSMadden board agreed to spend $25 million in 2005 for share repurchases and/or dividends and to meet with representatives fo notgniraB no araluger basis in order to 39avoid a proxy fight. Carl Icahn, familiar to some from the takeover battles of the 1980s, has returned to the headlines by starting a hedge fund, buying blocks in companies and pressuring 40them to change. Thus, for example, he teamed up with Jana Partners to take a position in Kerr-McGee and push for change. The outcome was a restructuring in which Kerr-41McGee sold off its chemicals unit and its North Sea oil fields. He has more recently put erusserp no ,retsubkcolB erehw eh deniag eerht draob ;staesmiTe Wa ,renr erehw ehtcompany agreed to add some independent directors to its board and increase the size of 42its share repurchase program; and KT&G, where the group he led gained board 43representation. Other examples, many involving household names, abound. Targets of corporate governance activism thus include McDonalds, where Pershing Square has sought a spin-44off of its real estate assets; Wendy’s, where Trian Partners has sought an asset spin-off 45 dna draob;staes Heinz, where Trian has nominated 5 directors to the 12 member 46board; Pep Boys Manny, Moe & Jack, where Barington has sought to induce the 37 Tania Padgett, A Proxy Fight is Brewing for Steven Madden, NYADSWE (NY..), 03 ,0240 , ta54A. 38 Barington Capital Group Sends Letter to Outside Directors of Steven Madden Ltd., PR NSWEWERI, Dec. 13 ,2400 , 39 evetSn eddaMn ,tL ,.d dna ehtgniraBton Capital Group Reach Agreement, PR NWSWEERI ,beF. 2, 002 ,5hpttp//:. 40 uSnas uPmaill, nO ec anoLe oW ,fl lraCnhacI oG sedeHgenuF-d Rout ,eWa ll .tS ,.JguA. 21 ,02 ,50ta A1. 41 Greg Johnson, News in brief, The Daily Deal, March 4, 2005; Patricia Koza, " Kerr pursues revamp," hT eDa yliDe ,lauAug ts9, 002 .5 42 wehttaMaK ,ginhcstinrmiTe ,renraW nhacI hcaeRoccArd – Firm to Step Up yuBb ,skca tsoC gnittuCas Investor Ends Bid for Board Seats, Wall St. J., Feb. 18, 2006, at A3. 43 See supra note 6. 44 See supra note 2. 45 maJe soP ,itildneW s’y seergA htiwnairT, niF. miTe ,sMa .r3. ,2600 , ta15 . 46 Janet Adamy, Heinz Investors to Seek Board Seats, Wall St. J., Apr. 25, 2006, at A17 . 6
47company to sell itself or replace its CEO; dna ihpleD ,.proC erehw asoolappAManagement has sought board seats and the creation of (and representation on) and official equity committee to represent shareholder interests in the company’s Chapter 11 48proceeding. In the course of their general corporate governance activities, hedge funds often get involved in various legal disputes with the targets of their activism. While these setupsid era yllausu najdaunct to broader activism – as when Jana Partners sued SourceCorp. to invalidate changes in the company’s by-law in light of an impending 49 yxorptsetnoc or when Mason Capital tried to block the recapitalization of Kaman 50arguing that it violated the Connecticut anti-takeover statute -- litigation is sometimes na laitnesse trap fo eht tsivitca .ygetarts ,ekaT rofmaxe ,elp lanidraC eulaV ytiuqEPartners, which owned about million shares in Hollinger International. When allegations about self-dealing and other improper transactions by Conrad Black, Hollinger’s CEO, and other members of Hollinger’s management started to circulate, 51Cardinal brought a lawsuit in Delaware to obtain records and corporate documents. Six months later, in December of 2003, Cardinal brought a derivative lawsuit for breach 52of fiduciary duty against Hollinger’s board of directors. Cardinal’s action was stayed to 53permit an independent board company to investigate the alleged misconduct. By May of 2005, Cardinal had negotiated a $50 million settlement with the directors not directly implicated in the self-dealing, with Hollinger pursuing the self-dealing claims against 47 Suzanne McGee, US Shareholder Friendly Rankings, Institutional Investor Magazine, Apr. 14, 2006. 48 feJfre yrCcMkcane ,De ihplpiRped ofr naBkrupt yc ,esaCraM. 71 ,2600 ta ;01A eesosla Kare nhciRranosd ,weN Wa yot yalPDirtse dessriFm:s Acquri eht eotSck, Wa ll .tS ,.J yaM1, 0260 , taC1.(reporting that Xerion Capital helped form a ytiuqe eettimmoc nietpahcr 11 which succeeded in increasing the sale price of Riverstone Networks’s assets from $170 to $210 million). For other instances of egdeh dnufanrevog ecnivitcasm, see Alan Murray, Backlash Against CEOs Could Go Too Far, WLA LST. J., June 15, 2005, at A2 (noting that hedge funds ratcheted up pressure on Morgan Stanley board to remove CEO); Henny Sender, Hedge Funds: The New Corporate Activists, W LLAST. ,.J yaM13 ,002 ,5ta 1C (noting hedge fund activism at OfficeMax, Woolworths, and Wendy’s); Knight Ridder Goes Up for Sale, But a Bidding Was in Unlikely, Wall St. J., Nov. 15, 2005, at A3 (noting that Knight Ridder, under pressure from Private Capital Management, a hedge fund and the company’s larges thsoheralde ,rup t flestiup rof .;)elas leetSntraPe sr sksAoBdra of FKBpaC latiot deRmee oPosin ,lliPRP NSWEWERI , .ceD ,612400 , d(ucsinissg vitca msiby leetSpantre srni ;)FKB leetSntraPe srvreS seoN ecit ot FKBpaC latiorGup, nI ,cRP NSWEWRIE ,beF. 41 ,2500 , (same). 49 anaJ traPsren seuS ,procecruoS sallaDisuB ssenJo lanru ,Ju yl ,6 .5002 50 Judge Rules in Favor of Kaman's Proposed Recap ;noitazilati sniojnECl gniso litnUeceDmb re ,1RP eriwsweN ,cO .t ,13 ;5002aKma n dna nosaMeergA ot dnE noitagitiLecnoCrin gn ,noitazilatipaceRRP Newswire, Nov. 3, 2005. 51 Liz Vaughan-Adams, The Independent, July 9. 2003 at 19. 52 miJ ,kriKCh ogaciirTb ,enuaJ .n ,3 ,4002ta 1Cswal(u tifiled on December 10, 2003). 53 oDmini cuR ,ehsuSdn ya ,semiTnaJ. 4, 4002 , ta1. 7
54Black and some of his associates in a separate litigation. Cardinal, moreover, keeps pressuring Hollinger’s board and recently criticized its failure to remove some of the 55settling directors from its ranks. Tellingly, hedge funds have even sought appointment as lead plaintiffs in securities fraud class actions under the Private Securities Litigation Reform Act. What makes these efforts noteworthy is that, ev ne hguoht egdeh sdnufare often among the investors with the largest losses, their appointment as a l dae ffitnialp si thguarf htiwproblems. Because hedge funds often engage in short selling, they face issues of reliance that may render them “inadequate” class representatives. A short strategy is based on the assumption that the current market price is inaccurate. This provides evidence that a short-selling hedge fund did not rely on the integrity of the market price, as required under the fraud on the market theory on which mo ts seitiruces duarf ssalc snoitca era56 57based. Indeed, courts have often, though not uniformly, rejected the appointment of 58hedge funds as lead plaintiff on that basis. 2. Corporate Control Activism Hedge funds have been particularly active in transactions involving potential changes in corporate control. This activism broadly falls into three categories. First, as sredloherahs fo eht reriuqca ro adesoporp etaroproc lortnocrt ,noitcasna egdeh sdnuf 54 oHgnille rnI .l’tnnAnuo seceltteSment by niatreC of stiuCnerr tdna oFmr rednIepednne tiD srotcerof ialCms etressad ni ireDva evitnoitcA deliFby draCnial Value Equity Partners, ., Canada NewsWire, yaM3, 0250 . 55 Richard Siklos, Rebuked, Even Sued, a Board Remains in Place, . Times,, Sep. 26, 2005, at C1. See osla lanidraC eulaV seuSInfoUSA CEO, Yahoo! Finance, Feb. 24, 2006; In re Pure Resources Shareholder gitiLoitan, 0220 .leDCh . sixeL11 6o(ht re sesachw eredraCni lanegaged in gitiloita .)n 56 In re knaB On ehSraohelders ssalCAcnoits ,69 .FuSpp .d2 780 (N .. 002)0 (cuort rejdetce ahegd efund as lead plaintiff who "engaged in extensive daytrading, first shorting Bank One stock, presumably esuaceb ti sawedragerd saeulavrevod ta tekramrpice, and then buying to cover the short position."): aCmd ne tessAmeganaMe ,tn ,. te .la .vmaebnuS oCrp., et al., 2001 . Dist .XELI S11220 ( . .alF2001) (class action brought by hedge fund that hedged its investment in convertible debentures not certified because individual issues of reliance held to predomin ;)eta nIer lacitirC ,htaPInc., Securities Litigation, 156 F. Supp. 2d 1102 (. 2001) (hedge fund which shorted stock held to be inadequate class eserpern evitat niarf du no ehtma tekr ssalc noitcaacebsu e trohs ygetarts si desimerp noinycarucca fo tnerrucma tekr.)ecirp 57 nI ernosyT oFdo ,s ,.cnIuceS seitirgitiLoita ,n0203 . .tsiD SIXEL71409 .(02 )30h(gdee nufds hedl to be qedaua et ssalcneserpervitat seni uces seitirduarf ssalcnoitca); naDi s .v NSUoCmmuniitacons ,In ,.c981 . 193 ,693 N(D. .I .ll991 )9(rejenitcg hcnellage ot ssalcrerpnesevitat s'epytitilac ybades nohs tro ,selasbeuacs e ssalcneserpervitat eosla ol tsmone yon olgn opoitisns; kcaondelwgign ht tahs tronillesg may be inconsistent with fraud-on-the market theory) 58 In an interesting development, Chancellor Leo Strine forced a hedge fund to serve as a defendant class neserpervitat eni geRa lnEniatretmne tpuorG v. mAaranth, LLC, 894 1104 (Del. Ch. 2006). The tceffeof ht si –dna prusemba ylhw yth ehegd ednuf detsiser – siht tanay elttesment mu tsbe pparvo deby ht e truocdna, mooerve ,r sa ssalcerprnesevitat enacnot elttespesa .yletar 8
have tried to prevent the consummation of the transaction. Second, as shareholders of the target of a proposed control transaction, hedge funds have tried to block the deal or improve the terms for target shareholders. Third, hedge funds have themselves – sometimes on their own, sometimes as part of a group – tried to acquire companies. a. Blocking Acquirers Perhaps the best-known example of a hedge fund blocking an acquirer involves eht desoporp noitisiuqca yb ehcstueD esreoB )BD( fo eht nodnoL kcotS egnahcxE .)ESL( gnivaH deirt dna deliaf ot eriuqcaLS Eni ,0002 BD decnuonna a wen noitisiuqca dib ni59December 2004. This quickly spurred Euronext, a competing exchange, to announce its 60interest in LSE. DB’s problems started when, in mid-January, The Children’s Investment Fund 61Management (TCI), a London-based hedge fund which had assembled more than a 5% stake, announced its opposition. TCI argued that using DB’s cash hoard to buy back 62shares “would be far superior in value creation.” Although the bid did not require shareholder approval, TCI held a large enough ekats ot llac na yranidroartxe lareneg63meeting to dismiss DB’s supervisory board. dnuorA ehtmase itme ,sucittA ,latipaC aUS-based fund which then controlled around 2% of DB’s shares, joined TCI in opposing 64the bid. Prompted by TCI and Atticus, by Febr ,yrau BD sredloherahs gnidloh tuoba6535% of its stock (including several mutual funds) were planning to confront DB. TCI started looking for a candidate to replace Rolf Breuer as DB’s chairman, and came up 59 mroN aoChe ,nmereJy narG t &kcirtaP kneJni ,s ESLni th ediB pSohgiltt ,F LAICNANIT SEMI(London), D .ce41 ,0240 , ta23 . 60 Norma Cohen, LSE War Looms as Euronext Confirms Intent, F LAICNANITMI SE(Loodn)n ,D .ce21 ,2400 , ta22 . 61 oSmane d esuaceb flah fo s’ICTanlaun mamegane tn eef fo 1epcr tne si diap otehT erdlihCs’n Investment Fund Foundation. Martin Waller, Fund syaS noitisoppO otesroB’ s ESL diB si ,gnitnuoMTSEMI (London), Jan. 18, 2005, at 43. 62 drahciRyarW, esroBeR lebetaerhTn s ot liareD ESLiBd: Investor’s Call for Return of Cash May Block German Move, GNAIDRAU (Loodn)n , .naJ71 ,0250 , ta12 . 63 To call a meeting, TCI would have to register its share with BaFin and hold them for 3 months. Damian Reece, Borse Could Bid Pounds bn for LSE, Says Deutsche, INEDNEPEDNT (Lnonod ,)naJ. 72 ,2005 ,ta 48. 64 Norma Cohen, Deutsche Borse’s ‘Empire Building’, FNANI LAICTMISE (Loodn)n , .naJ71 ,0250 , ta91 . 65 Louise Armitstead, Shareholders oveR tlni diB ot oT elpp ,trefieSSU YADNTIMES (Lnonod), .beF20, 2500 , ta ssenisuB1; uJ ailoK ,ewelldiFe ytiloJni s D esroBhSoheralde rveRo ,tlIEDNEPEDNTN (Loodn)n ,beF. 52 ,002 ,5 ta37 i(ndignitac ht tadiFe ytilhedl mo erth na a tkats .)e 9
htiw droL bocaJ ,dlihcshtoR ,ohw sa tippahens, is the father of eno fo eht sucittA66partners. nI ylrae ,hcraM s’BD OEC trefieSmac eto London to meet with the largest 67 tnedissidedloherahsrs. They refused. With more than 40 or %05 ro neve %06 fo ehtshares opposing the bid, depending on reports, DB abandoned its bid ni ylrae hcraM dna68morp desi ot poleved analp to distribute the cash. In celebrati gn eht ,yrotciv ehtdivision of labor between hedge funds and traditional institutional investors became clear, “One institution said: ‘The hedge funds have enod ama suolevr .boj oNma rett wohew feel about companies, traditional managers simply cannot move as fast to achieve our aims. We were right behind (the hedge funds), but we couldn't have done it without 69them.’” In May 2005, Seifert resigned after gnivah neeb deredro yb eht yrosivrepusboard “to change the composition of both the supervisory and executive boards in order 70to reflect the new ownership structure of the company.” Other instances where hedge funds as shar sredlohe fo sreriuqca evah thguos otblock an acquisition include Carl Icahn’s efforts to prevent Mylan Laboratories from 71acquiring King Pharmaceuticals; thginK ,ekniV hcihwof dewollmeTpel not si gnisoppo72 s’UNV desoporp noitisiuqca fo SMI;htlaeH Duquesne Capital Management, which 73opposed the proposed acquisition of Public Service Enterprise Group by Exelon; OrbiMed Advisors, which succeeded in blocking the acquisition of EOS by 74Pharmacopia; and Pirate Capital, Omega Advisors, and Jana Partners, who oppose 75 s’tnariM reffo ot 66 oLui esmrAstidaet ,Rothschild to Lead Battle for Borse Rebels, S YADNUTSEMI (Lonodn ,)beF. 27 ,002,5 at Business 1; Grant Ringshaw, Rothschilds Unite in Attack on Seifert, SYADNU TLEGEHPAR (Lno)nod ,.beF ,72 5002 ta ytiC .1 67 Deutsche Boerse Bows to the might of Investment nuFds , TFGlbo laNewswire ,raM. ,7002 .5 68 Id.; Norma Cohen & Patrick Jenkins, Shareholder Rebellion Puts Paid to Borse Chief’s Vision, FICNANIA LTIMES (Loodn)n ,raM. ,72500 , ta30; Dann yoFrtos ,nDeuthcse Bors eorDp s ESLnuHt, DYLIA DLAE , .raM8, 2500 , . 69 uoLi esrAmitsdaet ,vaSed ybht erGwo gniwoPe rfo Hegd enuFds ,SNU YADTMISE (Loodn)n ,raM. 13 ,2500 , taBu ssenis41 . 70 Werner Seifert Resigns As Deutsche Boerse CEO ,Wa ll .tS ,.J yaM9, 5002 ,Wa ll .tS ,.J yaM9, 0250 . 71 eeSarfni itceSo n . 72 eDsinn .KeBmr na &saJ no ,regniSThe :zzuBs’UNV Largest Shareholders Deride Plan to Buy IMS Health, Wall St. J., Oct. 1, 2005, at B3. 73 xEleon greM redezicitirC ,Chogaci nubirT ,e yaM31 ,002 .6 74 ahPrm aipoca dnaEo s llaC ffoeMegrr ,aS nFrancisco Business Times, Jan. 18, 2002. 75 E ammTrnilac, nariMt pU on vitcA tsigAoitatin, The , June 21, 2006. 10
b. Blocking Targets As shareholders of target companies, hedge funds have actively opposed several proposed acquisitions and often succeeded in improving the terms of the transaction. A recent example involves Novartis’ attempt to acquire the 58% of Chiron that it did not already own. Novartis initially offered $40 per share for the Chiron shareholders. An independent committee of Chiron negotiated siht ecirp pu ot 54$ rep ,erahs a%32 76premium over Chiron’s pre-offer share price. One month after the agreement was announced, ValueAct Capital, a hedge fund and the third largest shareholder of Chiron, sent a stinging letter to Chiron’s CEO announcing its opposition. This started a redloherahs tlover htiwmu laut dnuf ggeL ,nosaM eht dnoces tsegral redloherahs foChiron, joining ValueAct’s opposition and Institutional Shareholder Services 77recommending a vote against the deal. To get the transaction through, Novartis had to 78raise its offer to $48 a share, increasing the premium from 23% to 32%. The fate of the Chiron-Novartis deal is not unusual. Other examples of hedge funds opposing acquisitions include Masonite International, where Eminence Capital and Greystone Management Investment succeeding in raising the price from C$ to 79;$C ShopKo, where Elliott Management derailed a proposed acquisition for $24 a 8081share; MONY, where Highfields led the noitisoppo ot sti noitisiuqca yb;AXA 82 ,nosloM erehw sdleifhgiH decrofCoors to improve the sale terms; ,UNV erehw thginKVinke Asset Management opposes its acquisition by a consortium of private equity 83if;smr raxeL ,aideM erehw lraC nhacI dnalE ttoil setaicossAsoppoe the merger with Micron; Sears Canada where Pe gnihsr erauqS deirt ot dlohout against a bid by Sears (itself a company run by hedge fund manager Eddie Lampert) to freeze-out the minority 84shareholders; Titan International, where Jana Partners thwarted its desoporp noitisiuqca 76 oNva sitronnAnu secgAnemeer tot uqcA erimeRanii gn ekatS niCh ,norisserP ,esaeleRoN .v2, 0250 77 vaDi d .PlimaHton, hSoheralde rnIusoitcerr nnI stcef s’sitravoN$5 Chnori iBd, llaW .tS ,.J .rpA3, 0260 , ta .3C 78 David P. Hamilton, Novartis Raises Chiron Bid, Virtually Sealing Deal, Wall St. J., Apr. 4, 2006, at A2. 79 eeSmEnine ecpaC latineserP st retteLto osaMn etiBodra of tceriDor ,sCADANA NSWEWIRE, Jan. 27, 2500 , ;Masonite Shareholders Approve Proposed Acquisition by KKR, CNA ADANSWEWIRE ,Ma .r13 ,0250 , 80 pohSoK gAre seot 2$ 9 ahSra eOffer from nuS paC ,latiuBnise ssoJru lanfo wliMkua ,eeOc .t81 ,0250 . 81 eeSarfni itceSo n . 82 Innisfree Presentation, supra note 27. 83 See supra note 16. 84 See supra note 14. 11
85by a private equity firm; and MCI, which faced a threat of a proxy contest by 86Deephaven Capital to derail its acquisition by Verizon. When hedge funds are dissatisfied with the terms of an acquisition and unable to obtain better terms, they have also resorted to litigation. In ,ralucitrap egdeh sdnuf evah delif yrotutats lasiarppasnoitca, in which shareholders receive a court-determined fair value instead of merger consideration. Take the acquisition of Emerging Communications (ECM) by its majority-shareholder Innovative Communications Corp. 87for $ per share. rG thgilnee ,latipaC a egdehfund, held about 500,000 shares in the company. After the acquisition was announced, it increased its stake and sought appraisal 88for 750,300 shares. As is common-place in minority freeze-out mergers, a plaintiff’s 89law firm had also file d a yraicudif esehT snoitca era netfodelttes rof a90relatively modest recovery (if any). But when a settlement providing for no additional 91payments to shareholders but for $100,000 in legal fees was proposed, Greenlight, 92which had also acquired litigation rights for over 2 million ECM shares, objected. Both the appraisal and the fiduciary duty action proceeded to trial, and the court determined taht eht riaf eulav fo na MCE erahsaws $. Greenlight was awarded that amount, plus compounded interest, on its appraisal shares and damages of $ per share – the difference between the fair value and the merger consideration – in the fiduciary duty 93action. 85 natiT nInretoitana ,lnI .connAnu secmreTnioitan of porPdeso Buuoy ,tnisuBe ssWire ,pA .r21 ,2600 . 86 See Dennis K. Berman & Almar Latour, Major MCI oH redl stratSxorP yhgiF tot trawhTnozireV, WALL ST. J., June 15, 2005, at B3 (noting possible proxy fight by Deephaven Capital Management against Verizon-MCI merger); see also Jason Singer, With gnisiR olCut ,He egduFdn sratS tot wS yaregreM ,sW LLAST. ,.JnaJ. 25 ,5002 , ta1A r(opergnit veseral ninats secwhre ehegd eufdn snifretrede w htiqcauinoitis bi .)sd 87 In re mEgreign oCmmn’cs ,nI .coh’Sdl sregitiL ,.0024 .leDhC . SIXEL70 , ta*3 ,002 4WL 031475 ,5ta *1 (Del. Ch. May 3, 2004, revised June 4, 2004). 88 Greenlight had held shares in ECM before the merger was announced, but increased its stake by 264,700 erahss eewteb n ehtanecnuonm tne dnaht egrem reov .et nI sti13 Ddelif 10 da sy ,retalneerGhgilt diolcs desht ta tinidnet sto kees ppar lasiahgir .st See neerGhgilt paC ,lati ,. larnemetatS tof uqcAoitisin of neBefi laicnwOrehs piroF(m 13D) peS( .t ,82991)8 . 89 nI re mEregign Co’cmmn ,s0240 De .lCh .XELI S70 ta3* ,0240 WL 5031547 , ta1* . 90 eeSnI erCox oCmmn’cs ,oh’Sld sregitiL ,.879 .A2d 604, 622 .leD(hC .02 ;)50oillE tt .JWe ssi &Lawrence J. White, File Early, Then Free Ride: How Delaware Law (Mis)Shapes Shareholder Class oitcAsn, 57 Vand. L. Rev. 1797 (2004). 91 kcirBe ll srentraPv. orP ,resspitSulnoita na dgArmeene tof oCmpormi esan deltteSment ,uJ en27 ,2000 . 92 nI re mEregign Co’cmmn ,s0240 De .lCh .XELI S70 ta3* ,0240 WL 5031547 , ta1* . 93 In re mEregign oCmm’cns ,2400 De .l .hCIXELS 07 ta1*55 ,2400 WL 130475 ,5 ta4* .3 mEreging ha spapdelae ht eujgdment ot ehtaleDware Supreme Court where the case siprnese yltpednin .g eeSosla Prescott Group v. The Coleman Co., 2004 Del. Ch. LEXIS 131 (awarding dissenting shareholders of oCmelan who oshgu tparp ,lasiahwhci indulc dehegd efdnu ,3$ 2 ahsra)e . 12
Other instances of hedge funds exercising appraisal rights include Gabelli Asset 94Managements’s 2004 appraisal action against Carter Wallace, Prescott Group’s 95appraisal against Coleman, and the pending appraisal noitca thguorb yb nhacI dnaothers in Transkaryotic Therapies, where he egd sdnuf dah deirt tub deliaf ot kcolb ehtacquisition and decided to pursue appraisal instead of accepting the merger 96consideration. c. Making Bids Unlike traditional institutional investors, egdeh sdnuf ton ylno egru oiloftropcompanies to be acquired by others, but have themselves made attempts to acquire these companies. These bids can be part of a strategy to improve the governance or capital structure of these companies or to put the ta tegr ni .yalp nI rehto ,secnatsni ,revewohhedge funds have emerged as controlling shar sredlohe fo egral lairtsudni .snoitaroproc As an example of an acquisition offer that induced corporate governance changes, consider GenCorp. GenCorp owned more than 12,000 acres of undeveloped land in 97Sacramento, a holding that attracted the interest of various investors. In November, 2004, Steel Partners (a hedge )dnuf decnuonna taht tiaw s detseretni ni gniriuqca98GenCorp for $17 per share. When the board rejected Steel Partner’s advance, it 99threatened a proxy contest. By February, 2005, GenCorp had entered into an agreement according to which Steel Partners would cast its votes in favor of GenCorp’s nominees in exchange for which a representative of Steel Partners could attend board meetings; and the board would appoint a new independent director expert in corporate governance identified in consultation with Steel Partners; and the board would then consider 100corporate governance changes proposed by Steel Partners. Next consider ShopKo, a retail and pharmacy store chain. ShopKo had agreed to be acquired by Golder Hawn, a private equity firm, for $24 per share. But Elliott 94 sserP ,esaeleRaG illeb stneilC ezilaeR a eroMhT na%04 merPuim nitteSelme tn foaC ecallaW-retrppAr lasiagitiLoitan, oN .v1, 2400 . 95 Prescott Group v. Coleman Co., 2004 Del. Ch. Lexis 131. 96 htaLma nad Wakt ,sniHedg ednuF Acvit tsi M &A vnIetsnig, 002 6rP yxonosaeS pmySosium (o nf elihtiw uaohtr.)s 97 Gene G. Marcial, GenCorp’s Earthly Assets, BSU. WK ,. .naJ42 ,002 ,5 ta01 .0 98 Steel Partners Offers to Acquire the Outstanding Shares of GenCorp Inc. in Letter to Board, PR NSWEWERI, Nov. 11, 2004, . 99 Ron Orol, GenCorp Rejects $700M Offer, D YLIADAEL ,voN. 61 ,002 , . 100 elaD ,relsaKneGCorp hcaeRe surT ectiwh mriF ht taMade oH elitsiBd, SACRAMENTO BEE, Feb. 17, 2005, at D1. 13
Associates, a hedge fund with a major stake in ShopKo, opposed the proposed deal. Together with Sun Capital, a private equity firm, and some other investors, Elliott made a counter bid of $. After an auction, the Elliott group succeeded in acquiring ShopKo 101for $29 a share. Finally, take Kmart. Kmart had filed for bankruptcy in February 2002. When it 102emerged from Chapter 11 in May 2003, its largest shareholder was the hedge fund ,LSE nur yb drawdE .trepmaL LSE denwo tuoba %05 fo ehtmocp ,yna gnivah deriuqca$2 billion in financial claims (for somewhere around $200 million) which were then 103converted into stock in the reorganization. At the time Kmart emerged from bankruptcy, its stock opened at $15 per share and drifted downwards. But by July 2004, Kmart’s stock was at $76 per erahs dnamaLp ,tre ohw dahat nek revo ehtmaeganme tn fo104Kmart, was the toast of the town. By unlocking the value of Kmart’s real estate 105through selling off stores, Kmart accumulated a $ billion “cash hoard.” yBNovember 2004, Lampert answered the market’s question of what he was going to do 106with all that money: Kmart and Sears agreed to merge. The news of the deal pushed 107Kmart stock up to $109 per share, with Sears shares rising as well. Additional examples of hedge funds making bids include Appaloosa 108Management, which made a bid for Beverly Enterprises; ,sdleifhgiH hcihwma ed a dib109 110to acquire Circuit City; ,tcAeulaV hcihw si gniyrt ot eriuqca,moixcA and Jana 111Partners, which made a bid for Houston Exploration. 101 pohSoK gAre seot 2$ 9 ahSra eOffer from nuS paC ,latiuBnise ssoJru lanfo wliMkua ,eeOc .t81 ,0250 . 102 Which is very quick for a major bankruptcy, and explained by the incentives put in place for management. See Douglas G. Baird & Robert K. Rasmussen, Reply, Chapter 11 at Twilight, 56 SNAT. .L RVE .673 (3002 .) 103 Week in Review, CNIAR’S DIORTE TBSU., May 12, 2003, at 34; Christopher Byron, Short-Sell Scramble; Investors are Betting That Kmart Won’t Bounce Back, . PTSO, yaM19, 0230 , ta73 . 104 Becky Yerak, Exec Lifts Kmart’s Stock into Blue Yonder, CIH. TRIB., July 11, 2004, at C1. 105 boRe trnreB ,reuTnrgni mKar tni ot ahsaC oC ,wBSU. WK ,.uJ yl21 ,4002 , ta18 ., 106 Constance L. Hays, Kmart Takeover of Sears is Set, . TSEMI, Nov. 81 ,0240 , ta1A . 107 Id. ESL had owned a large block of Sears stock since before its investment in Kmart, a block which had nidesaerc to 51 %by ht eit emht emegr re sawnnanuodec. greM re taht e ;llaMmKar tdna sraeSgreM ,, Nov. 18, 2004, . 108 Peter Moreira, Four Funds Bid for Beverly, D YLIADLAE ,naJ. 27 ,002 , In response to the bid, the board of Beverly decided to auction the company, which was ultimately acquired by onathe rbidd .re retePtfoLus ,veBe ylrpretnE sesirot be Acuqderi yBnIveotsr puorG rof$136. oilliBn, Wa ll .tS ,.JguA. 81 ,2500 ,ta A6 ;veBerl ynEpretri sesvieceRe sHihgre diB, Wa ll .tS ,.JuA .g22 ,5002 ,ta C5; Peter Loftus, Beverly Enterprises Agrees to Bid By lliFmo erpseD eti retteB ,reffO llaW .tS ,.JvoN. 22 ,2005, at C4. 109 leahciM,orabraB riCcu titiCy jeR stceHegd ednuF s'hsaC diB, Wahsingtno ,tsoP raM. ,80250 ta0E5; yraGWcMaillims ,ucriC tiC ytijeR stceaTkevore diB, t’noWoCnsid renA yhtOe r ,sreffOW LLAST. ,.J14
B. Activism by Traditional Institutions Compared Over the last 20 years, traditional institutional investors – specifically public pension funds and mutual funds – have also degagne ni redloherahsmsivitca . ehT edomof this activism, however, differs in important respect from the activism by hedge funds. Activism by traditional institutions falls for the most part in two categories. Starting in the mid-1980s, and continuing to a limited extent until ,yadot lanoitidartinstitutions have made sh redlohera slasoporp rednueluR .8-a41 esehT slasoporp erausually precatory resolutions that relate to various aspects of the corporate governance rules, such as poison pills, confidential voting, and board structure. Most of these proposals were introduced by a set of public pension funds – including CalPERS, various New York pension funds, and the State of Wisconsin Investment Board – and by Since the mid-1990s, institutions have increasingly engaged in private negotiations to get boards to make governance changes voluntarily an d evah detroser ot113formal proposals in some of the instances where boards failed to do so. Seeking governance changes through (actual or threatened) shareholder proposals 114has largely been the domain of public pension funds. Other than TIAA-CREF, mutual funds have not themselves been active in introducing proposals, whet reh yllaitini ro retfa deliaf etavirp .snoitaitogen lautuM sdnufhave, however, voted in favor of proposals introduced by others. In addi ,noitmu laut sdnuf evahpodated policies to etov tsniagacertain changes in governance rules that entrench the current board if such changes are Mar. 8, 2005, at A8 (reporting bid by hedge fund Highfields for Circuit City and reporting increasing ni tseretby hegd ednuf s niusrupgni katevo .)sre 110 VaulAe tcodeRbu selAcxiom kaTevore ffEort ,Dir ,tceOc .t4, 0250 . 111 Marietta Cauch, Jana Partners Sets Energy Bid in Unusual Move for Hedge Fund, Wall St. J., June 13, 2006 (reporting bid by Jana for Houston Exploration). 112 ,. ,tSua tr .L nalliG &uaLr a .TkratSs ,proC etarovoGenrna ecorPpos slana dhSheraolde rvitcAmsi: hT eoR elof utitsnIoitna lnIvets ,sro75 .J .niF72 52(000 )p(nesergnit da at foprpo ;)slasonaiD eDel Guercio & Jennifer Hawkins, The Motivation and Impact of Pension Fund Activism, 52 J. Fin. Econ. 293 1(999 )as(m ;)ehciM lea .PmSith, oherahSlde rcAvitmsi by nIutitsoitna lnIvetsor :svEidne ecorfm ,SREPlaC15 .JniF. 227 (6991) (sma)e ;oJhtanna .MKaoprff te ,.laroCpor etavoGenrna ecdna hSraohelder nIvitaiti :sepmEi lacirvEdine ,ec24 .JiFn. ocEn .365 1(699 )mas( .)e 113 otelraCn te ,.lahT eulfnIe ecnof nIutitsnoits no oproCr etaoGvenrna echtguorh virP etageNo:snoitait vEdine ecfrom AITA- ,FERC35 .JiFn. 331 591(98); Gillne &kratSs ,usrp aon et112, ta 972 ;rautSt .L nalliG &uaLr a .TkratSs ,Cooprr etaoGvenrna ,ecoC etaroprnwOehsrip, dna ht e eloRof nIutitsnoita lvnIe :srots AolGba lpsrePvitce ,e .JpApl .Copr . .niF4, 01 ,W/llaFin ret002 .3 114 oM ernecer ,yltnunoi-etailiffad penoisn nufd snignisaerc ylpsnoos rhsoheralde rpropos .sla 15
proposed by the board of directors and sometimes withhold votes (., abstain) in the 115election of directors. These activities differ from activism by hedge funds in a variety of ways. They are directed to changes in the corporate governance rules, rather than to specific aspects of a company’s business or management (such as share buy-backs, spin-offs, mergers, or the composition of the board of .)srotcerid ehT tceffe fo eht ycilop segnahc thguos si116usually minor, either because the subject matter is not very important, esuaceb ehtshareholder resolution is precatory (and a favorable vote is thus not binding), or because a board, even if it agrees to adopt the proposed policy, is free to change ti ta a retal tniopof time. To the extent that the “activism” takes the form of merely voting in favor of slasoporp yb srehto ro( tsniaga slasoporpma ed yb eht s’ynapmoc ,)draob ti tneserper arather passive form of “activism.” Finally, a group of portfolio companies tend to be 117targeted at the same time and often with respect to the same governance changes. Viewed charitably, this mode of activism is designed to achieve small changes in multiple companies at little expense, but is unlikely to result in big changes in specific companies. The prominent role of proxy advisory firms like Institutional Shareholders Services (ISS) is consistent with this focus on small, low cost, systemic changes. The second category of activities by traditional institutions consists of “behind the 118scenes” discussions with company management and board members. morF tahw sahbecome known about these activit sei retfa eht ,tcaf tiraeppas that they seek the same modest changes in governance rules as do shareholder proposals. For example, Carleton, nosleN dnaWe ,hcabsi ohw deniatbo sseccato the private correspondence between TIAA-CREF and firms, report that the chan seg thguos devlovni laitnedifnoc ,gnitov119board diversity, and limitations on targeted stock placements. Known instances of institutions seeking more far reaching changes are rare and often involve unusual fact 120patterns. 115 See Roberta Romano, Public Pension Fund Activism in Corporate Governance Reconsidered, 93 Colum. L. Rev. 795, 834 (1993). Public pension funds, though not mutual funds, have also applied to become lead plnia ffitni uces seitirduarf ssalcoitcans . uceS seitir duarf ssalcoitcans ,hovewe ,r era taht epehpiryre of ocoprr etagovenrna ecdna ocortn lvitca .seiti 116 Roberta Romano, Does Confidential Voting Matter?, 32 J. Legal Stud. 465 (2003)(concluding that ocdifnne laitnitovg prpoos sla era)lairetammi. 117 eeS sserPeleR ,esa SREPlaCcoFu s tsiLaT stegrSix Underperfroming Companies, Apr. 19, 2006. 118 otelraCn ,pusr aon et311 ,nalliG &kratSs ,us arpon et311 , ta10 . 119 notelraC tela ,.su arp eton ,311 ta 3431 – ;84ees laso Allen Myerson, The New Activism at Fidelity, . ,sguA. ,81399 , ta51 on( gnit rettelpoopisng niatrecpa yplna sht tadiFe ytilnest ot 10 0companies). See also Alan Murphy, At AIG, a Fi tsralGn ec ta dooG‘evoGanrn ,’ec llaW .tS ,.JMa y ,712006, at A2 (noting that public pension funds induced governance changes such as separating the posts of chairman and CEO, increasing the number of independent board members, and requiring independent srotceridto me te nie‘cexu evit .)’noisses 120 nalliG dna kratSs , rofxemapl ,epero trhtta diFeytil ha dno eof stimeploy seeppaoint de sa OECof tloCoceleTm. nalliG &kratSs ,us ,arpon et1 .31uB tCo tl sawnuusua lin ht ta ti sawuofnded by diFe ,ytil saw16
As to the activities that have remained non-public, we of course do not know their lluf elacs dna .epocs tuB ew redisnoc tinulikely that such activities resemble the activism of hedge funds. That institutions often succeed in achieving major changes hguorht dniheb eht senecs snoissucsid tuohtiw rieht stroffe ot od osmosemit se gnimoceb121public is implausible. After all, if management is not receptive to the proposed ,segnahc eht noitutitsni tsumie reht evig pu ro og .cilbup And if management knows that institutions are reluctant to go public, they have little incentive to accede to the request for change. Moreover, the leverage that institutions can exercise behind the scenes is limited. If an institution wanted to coordinate its pressure with those of other institutions, it may become engaged in a solicitation or in the formation of a “group,” which would 122often require a public filing. The scarcity of such f sgnili dna eht ecnesba fo ynareports to the contrary, suggest that traditional institutions do not coordinate their “behind the scenes” pressure. We are skeptical rehtehw detanidroocnu erusserp yb a elgnisinstitution will often result in meaningful change. This being said, traditional institutions have recently, in the ekaw fo egdeh dnufactivism, become somewhat more active in matters involving corporate control. Thus, as dessucsid ,evoba nilknarF lautuM ,sresivdAna investment adviser for mutual funds and other accounts, has joined forces with a hedge fund and other investors in making a bid for Beverly Enterprises; and mutual funds have supported the efforts of hedge funds to block the acquisition of the London Stock Exchange by Deutsche Bank, of Chiron by 123 ,sitravoNfo YNOMyb ,AXA dnaof SMI htlaeH And we suspect that here are additional examples where traditional institutions have expressed support for hedge funds in private communications with management. Hedge funds, it thus appears, have not just been activist themselves; they have also been a catalyst for activism by traditional 124institutions conducted jointly with, or in the wake of, hedge funds. olcs eot baknurpt yc ,nad ylilediFhedl 54% of stitsock. eeSoC tl semaNdiFe s’ytilkAni ot peRl eca OECManing, Boston Bus. J., July 24, 2002. 121 fC .noeL razaLfo ,fHedge uFdn Acvit tsiuTrn pu He ,tahCgacio rTubine ,oN .v27 ,0250 uq(onit gnivetsor saniyasg ht tamuut ladnuf s ylerarpr sseundeprofremrnig ocmpna seiot hcgnae ;) lliJiFhcs, oitaleRnship vnIegnits: W lli tipaHpen? lliW tikroW?, 55 hOoi .tS .L .J001 ,81030 991( .)4 122 eeSuceS seitirxEhcgnae tcAof 9143 ,oitceSns (31 )dnad 14 .)a( yBocnt ,tsarhedge dnuf ,sby ocudnnitc ght rievitcamsi ni upb ,cilderuc eht en deeof rpxer sseocdroinaoitn. eeS oslaoitceSn . 123 hT sikind fovitcasim sitalerive ylnove lof rmuut lafdnu .s eeSnAn raCr ,snuPtnma iC set ecirPni nalP ot Vote Against WaMu’s Providian Deal, Wall St. J., Aug. 2. 2005, at C3 (quoting bank analyst as describing pub cilppooitiso nby amuut laufdn to qcauioitisn sa a“elttil b tiunuus .)”la 124 eeSgene yllarWahc ,lletotpiLn, Rones & ,ztaKhSoheralde rvitcAmsi in ht e A&MContxe ,tneilCt emmo , yaM15 , 6002eve“(n anoitidart lmret-gnol itutitsni lanorotsevnis are on occasion becoming more outspoken than they have in the past. The fusion of aggressive hedge fund activism and the power of large niutitsoitna lohdl sre si aopnett mroful aht tanac negrei ezna vitca tsiacmpgian. .)” hT egnilliwne ssof traditional institutions to become involved in activism htiw egdeh sdnufma y ebenhanced by the adoption of geR. ,DFhwhci made tihadr reof rmanagement ot etailaterganias tniutitsoitna lniveotsr sby gneaging in vitceles ediusolcs er foinofmroitan. kcalB ,usrp aon et52 , ta601. 17
C. Hedge Fund Activism in Perspective In assessing the many instances where hedge funds have adopted an activist posture in corporate governance and control transactions, one has to keep in mind that only a minority of hedge funds pursue shareholder activism. Some hedge funds do not own many equity securities because they pursue macroeconomic strategies or because they invest primarily in debt securities. And even most hedge funds taht sucof no ytiuqesecurities are not activist – because they pursue quantitative strategies, because they 125value their relationship with management, or for other reasons. Indeed, according to a recent estimate by . Morgan, only 5% of hedge fund assets, or about $50 billion, are 126available for shareholder activism. Our point in discussing hedge fund activism is thus not that shareholder activism is predominant among hedge funds. It is not. Our point is rather that hedge funds – to the virtual exclusion of traditional institutional investors -- dominate certain modes of shareholder activism. The fact that only a minority of hedge funds engage in such activism makes this point, if anything, even more noteworthy. But the fact that, at present, only a minority of hedge funds are engaged in shareholder activism is important for another reason as well. It indicates that there is a large untapped fund of money that could quickly become available for activism. If activist strategies are profitable, and more so than the other investment strategies hedge funds pursue, it would not take much for the capital devoted to activism to double or even 127quadruple overnight. Thus, whatever the extent of egdeh dnuf msivitca ,yadot ti nacbecome much larger – or much smaller – tomorrow. II. Hedge Funds as Institutional Investors The activities of hedge funds described in Part I give substance to the hope that hedge funds may act “like real owners” and provide a check on management discretion. tuBmis rali sepoh erew detareneg ni eht s0891 nehwtatnemmocors noted that a significant shift in the shareholder profile of public corporations -- from small individual 125 , ,.hciRdra boDb s &iTmoht yoKll ,renI edis adeHge dnuF :nA nivret weiiwht ht enaMaging Partner of Maverick Capital, McKinsey on Finance 6, 9-10, Spring 2006 (explaining that hedge fund avoids pub cildiupst sehtiw managenemt nad lliw llesotsck fibodra od seon tpserdno ot gusgeoitsns of rhcgnae .) See generally The Barclay Group, Hedge Fund Industry – Assets Under Management, at (chart of money under management by hedge fund strategy). 126 , Global Mergers and Acquisitions Review, at 89. 127 nUkil emuut ladnuf ,shw hcihave to badi eby th evnietsnemt op seicildeircsbe d niht riegerinoitarts statement or obtain shareholder approval for a change (see Investment Company Act, sec. 8(b)(2)), hedge dnuf snac quikc ylhcnage htie rpo seicil otpserdno otne worpf tiooppnutr .seiti 18
128shareholders to large institutional holders -- had taken place. The rise of institutional investors generated, starting in the early 1990s, a series of ar selcit gnizylana eht etaroproc129governance implications of institutional shareholdings. nI siht ,traP ew ezylana egdeh sdnufga tsnia eht pordkcab fo eht sisylana fotraditional institutional investors. Our comparison will focus on open-ended mutual funds, both because mutual funds are the most important institutional investor, holding 130about 23% of all corporate equities; and because they are economically closest to hedge funds. But we will also discuss, more briefly, public pension funds, the second 131largest category of traditional institutions, which hold % of corporate equities. A. Mutual Funds and Monitoring 1. The Plus: Size & Expertise Compared to individual investors, mutual funds enjoy a major advantage as corporate monitors: they are .egral ehT egareva ezis foan equity mutual fund was $218 132million in 1990 and $960 million in 2004. The largest mutual funds manage assets in 133the tens of billions of dollars. In comparison, the average capitalization of stocks in eht P&S 005 xednI si 22$ noillib dna focotsks in the S&P MidCap Index is $ billion. Due to their size, mutual funds enjoy significant economies fo .elacs esehTeconomies of scale arise in two ways. For one, yeht lliw dnet otwo n a retaergmun reb foshares of an individual company than individual investors do. To the extent that governance activities entail company-specific costs, thes e stsoc nac eb daerps revo alarger investment. Moreover, mutual funds will tend to own shares in a larger number of companies than individual investors do. To the extent that governance activities entail 128 occAdrgni ot ht edeFe larvreseR eoBdra, ht epenecrgate ownehsrip of ocoprr etauqe seitiby housohelds declined from 88% in 195 to 59% in 1980, while ownership by pension funds and mutual funds increased from 4% to 21%. This trend has continued, with the ownership by households declining to 33% and one ownership by pension and mutual funds increasing to 42%. Bd. of Governors of the Fed. Reserve Sys., Flow of Funds stnuoccA foth ., table , various years [hereinafter Flow of Funds Accounts]. 129 See generally Black, supra note 25; Rock, supra note 25. 130 According to the Flow of Funds accounts, supra note 128, mutual funds in 2005 held $4174 of $18199 boillin 32(% ) foocpr etaroqe .seitiu 131 olFw of dnuF snuoccA ,stus arpon et821 . virP etapensnoi dnuf sheld htonae % foocoprr etauqe .seiti Id. We do not further discuss corporate pension funds both they hold fewer assets than mutual fund, esuaceb ehterutaretil no lanoitutitsnitsevni sro sahex desserpmsicitpeks tuobahwte reh etaroproc sdnuf lliw eb ,tsivitcaa dnaceb esuco etaroprsdnuf, lnuik epub cilnufd ,svahe on tbene vitca .tsi 132 nIvemtsent moCpna ynIutitste ,002 5vnIenemtst oCmpna y tcaFkooB (2005), tables 3 and 5. 133 roFxemapl ,eVangua s’dr P&S5 00dnIex sdnufha s stessaof 01$ 7boillin. eeS hpttgalf//: tsal(videtis on uJ yl91 ,002)6 . 19
costs that are common for several companies, these costs can be spread over a larger number of investments. 2. The Minuses: Regulation, Incentive Problems and Conflicts But mutual funds also suffer from a number of disadvantages that impede their ability to act as effective monitors. These disadvantages fall into three categories: 134regulatory constraints, inadequate incentives, and conflicts of interests. .a R yrotalugeC stniartsno Mutual funds are subject to a number of re yrotalug stniartsnocht ta nac tceffa riehtability and incentives to monitor portfolio companies. For one, mutual funds are subject to special disclosure requirements not applicable to other types of investors. Specifically, mutual funds must file a semi-annual list showing the amounts and values of the 135securities they own. This makes it harder for mutual funds to accumulate positions in portfolio companies without such companies, dna ehtma tekr ta ,egralmocebi gnawar e fotheir activities. In addition, in order to qualify for significant tax benefits, mutual funds must comply with the diversification requirements in subchapter M of the Internal Revenue Code. Accordingly, 50% of the assets of a mutual are subject to the limitation that the fund may own no more than 10% of the outstanding securities of a portfolio company and that the stock of any portfolio company may not constitute more than 5% of the value of the assets of the fund. Moreover, in order to advertise themselves as “diversified,” – 136the preferred mode for most funds -- sdnuf tsum yfsitassa llew eht noitacifisrevidrequirements of the Investment Company Act. Under the Act, 75% of the assets of a mutual fund are subject to the above limitati no taht eht dnufma y nwo onmo er naht %01 fo eht gnidnatstuoirucesties of a portfolio company and taht eht kcots fo yna oiloftropcompany may not constitute more than 5% of the value of the assets of the fund. These diversification requirements, in principle, limit the ability of funds to take large positions in a single company, though the constraints they pose may not be binding for larger mutual funds. Open end mutual funds, by definition and by statute, must also stand ready to 137redeem their shares at the request of any shareholder at short notice. hTe reedtpmi no 134 eeSeneg yllar ,kcalBsu arpon et52 ;Ro ,kcusrp aon et52 . 135 mtsevnIe tnmoCp yna ,tcA noitceS .)2()e(03 nI ,noitiddaednu ryltnecer dessapel ,noitalsigmu lautsdnuf mu tsdiolcs esho wth yeovdet na y serahs foht rieopoftroil ocmpna .sei iDolcs erusof xorP yoVgnit oPseicil and Proxy Voting Records by Registered Management Investment Companies, 68 Fed. Reg. 6564 (Feb. 7, 2300.) 136 oR ,erpus anot e52 , ta4147 . 137 51 U. .§-a085(002)5 .20
price of these shares is based on the fund’s net asset value. There requirements make it difficult for mutual funds to have illiquid investments: illiquid investments cannot be readily transformed into cash when fund shareholders want to redeem their shares and cannot be easily valued. The staff of the SEC therefore issued a guideline limiting the aggregate holdings of a mutual fund in illiquid investments to no more than 15% of the 138fund’s net assets. Last not least, regulations make it difficult for mutual funds to base th e eef diap otthe fund management company on the performance of the fund. Performance fees must be symmetrical, such that if fees are higher than normal after a good year, they must be 139lower than normal after a bad year. But even symmetrical pay-for-performance fees are rendered impracticable by the requirement that performance fees be based on a period of at least one year. Thus, if a fund has a stellar performance in one month, fund managers will earn an increased performance fee for the following 11 months. This, of course, creates incentives for investors to sell their shares at the end of the first month, when they have fully benefited from the stellar performance in that month but only paid 1/12 of the associated performance fee, and discourages investors from buying shares in a fund, when they have to pay 11/12 of the performance fee without get gnit eht stifeneb fothe stellar performance. b. Incentives to Monitor Activism of the variety described in Part I is not cheap. Fund managers first have to identify a company that would benefit from activism and develop a strategy for the company that would raise its share price. nehT dnufma sregnah ev ot erusserp ehtcompany’s management to adopt that strategy. All of this consumes a lot of time for the fund manager and entails significant costs for performing esuoh-ni sisylana dna gnirihoutside advisors. For mutual funds, the incentives to e dnepx secruoser no hcusmsivitca era140limited. The lack of incentives is most pronounced for mana sreg fo dexedni .sdnuf The job of index fund managers is to replicate the performance of the index. An index fund thus competes with other funds replicating the same index princi yllap no eht sisab fofund expenses. As activism is costly and thus raises the funds’ expe sesn ro( srewol ehtmanaging company’s profits), index fund managers will be reluct tna ot egagne niactivism. A similar shortage of incentives is often present for dive deifisrmu laut .sdnuf sA dessucsid ,erofeb yrotaluger sreirrabma ekit difficult for mutual funds to charge 138 maTa rknarFe ,lhT egeRulitao n fonoMe ynaMage ,srov .l3 ta236 elttiL(nworB, 1 )089ocer(mmneding 10 % ;)timilpuSplmene t ta 38n(ognit in esaercot 51 .)% 139 Investment Advisers Act, Section 205. Hedge fund advisors are exempt by subsection (c)(7). 140 oRkc ,pusr aon et52 , ta274 . 21
performance-based fees. As a result, 97% of all funds, accounting for 92% of all mutual dnuf ,stessa egrahc seef desab no atalf percentage of the fund’s assets under 141management. desab-tessA ,seef ,revewohvorpide only small direct incentives to engage in costly activism. The median stock fund in 2004 charged investors total 142expenses of % of assets, of which about half were management fees. ,suhT rofexample, when a manager of a $1 billion mutual fund earns additional profits of $100 million (a 10% return), total annual fees increase by $ million and management fee increase by $750,000. Of course , a noitrop fo esehtsaercni de seefevoc r desaercniexpenses associated with running a larger fund and fees do not increase at all to the extent that investors withdraw some of the profits. To get a sense of how much a fund management company benefits from the increased profits, assume that $1 million of the $ million in total increased fees constitute profits for the fund managers and that investors keep any profits in the fund for three years before they withdraw them. Applying a 5% discount rate, the $100 million in fund profits would then generate $ million in additional profits for the fund management company – equivalent to very modest implicit performance fee of %. Even this rough estimate probably overstates the implicit performance fees as most larg re sdnuf ezilitu ”,stniopkaerb“ erehw eht143marginal percentage fee declines as fund assets increase. Even for the few funds that charge explicit performance fees, incentives are not hcum .regnorts ehT nosaer sithat, in order to avoid the problem of strategic timing of withdrawals and contributions described above, performance-fees in mutual funds are ylevitaler talf neve nehw yeht .tsixe iF s’ytiled nallegaM dnufof r ,elpmaxe segrahc aperformance adjustment of % of assets for each percentage point of outperformance or underperformance relative to the S&P 500 In ,xed pu ot amaixmu m fo sulp ro sunim .%2. sihT si eht tnelaviuqe fo na launnaeprformance fee of 2% of the fund’s profits (as 144long as the profits are within the range where the performance adjustment is made). lautuM ,sdnuf fo ,esruoc nac osla tifenebmorf doogrepfroma ecn .yltceridni seidutS evah nwohs taht sdnuf tahtrofreptuom their peers generally attract inflows of 145new assets. A recent study by Stephen Choi and one of us, for example, finds that a 1% abnormal positive performance by a fund (relative to other funds with the same investment objective) is associated with increased inflows of roughly 1% over the following year, while a 1% abnormal negative performance is associated with outflows of 141 Jesse Eisinger, Long & Short: Pay-for-Performance Bedevils Mutual Funds, Wall St. J., Apr. 13, 2005, ta C .1 142 eeSoMre dnuF soLwer seeFfaret nacSda lin 002 ,3 USA doTa ,y D .ce21 ,2500 . itseTmony of ffeJrey C. Keil, Lipper Inc., Jan. 27, 2004 [hereinafter Lipper testimony]. 143 ppiLre mitsetony ,usrp aon et142, ta51 . 144 orPsputces ,iFde ytilgaMenall nuFd , yaM03 ,0260 . 145 ,eeSe. ,.g nehpetSiohC& Marcel Kahan, The Market Penalty for Mutual Fund Scandals, Working Paper 002( ;)6hciRdra .AppIootil ,oCnsum reaeRcoitn ot M serusaeof ooPr ytilauQ :vEdine ecorfm ht euMtula nuFd nIudtsry ,35 ruoJna lfo waL na docE scimon45 (991 .)2 22
tuoba %6. revo a .raey desaercnI ,swolfniof course, generate management and other asset-based fees. The implicit performance fee generated indirectly by the effect of positive performance on inflows is thus roughly of the same magnitude as the implicit performance fee generated directly by asset-based fees. In one important respect, however, the evitnecni tceffe fomrofrepacn e no tenassets via inflows differs from the incentive effect of performance on net assets via profits. While the latte r si a noitcnuf fo eht sdnufulosbate performance, the former turns 146 no a s’dnufmrofrepa ecnrelative to other funds with similar investment objectives. Activism, however, will increase a fund’s relative returns only to the extent that the fund has a higher stake in the portfolio company (relative to the fund size) than competing sdnuf odand the costs of activism to the fund is less than that differential. For any given portfolio company, this means taht sdnuf htiw a wolebvaerage stake in the company (relative to fund size) have no sevitnecni – ro deedni evitagenincentives – to take action to increase that company’s value, and funds with an above average stake have only 147attenuated incentives to expend resources on activism. For example, Table 1 below lists the 10 la tsegr kcots sgnidloh sa fo hcraM ,132005 of the Fidelity Magellan Fund and the comparable holdings in these companies (as of 12/31/04) of the Vanguard 500 Index Fund. Table 1: Top 10 Magellan Holdings Relative to S&P 500 Index Company Magellan Vanguard Difference Dilution of Investment 500 Index Magellan’s (in %) (in %) Incentives GE 83%Microsoft .487% Exxon Mobil .1 97% Citigroup % 56%Home Depot 36% Bank of America .5 77% Viacom % .2 90% Tyco Int’l 32% All 10 stocks % 18% 69% (weighted) The last column of the table indicates the degree to which the Magellan Fund’s incentives to monitor are diluted by the fact that any increase in the value of these shares would not improve the fund’s performance relative to the S&P 500 index. As the table shows, the 146 ,hcsiFusrp aon et121 , ta0102 . 147 eeSoR ,kcrpus aon et52 , ta74 .3dnA vene ufdn swith an above average stake relative to fund size have ninecvit seot xepedn malairet oser secruno ylfi ht ekats e sigisninacift nibaoslu etmret .s 23
degree of dilution is significant even for the largest holdings of the fund. For smaller 148holdings, the degree of dilution is likely to be even higher. c. Conflicts of Interest Mutual funds also suffer from conflicts of interests between dnufma sregan dna149fund beneficiaries which inhibit their activities as monitors of portfolio companies. Many mutual fund management companies are affiliated with – in effect subsidiaries of and controlled by – another financial institution, such as an investment bank or an insurance company. For example, of the 20 largest mutual fund complexes in 2003, nine 150had such affiliations. Managers in such funds may be reluctant to antagonize present or future clients of their parent company with their governance ac .seitivit ,deednI ehttceffe of such affiliations on governance activism may be both more subtle and more pervasive. Consider, for example a mutual fund affiliated with an investment bank. The mutual fund managers will, ex ante, often not know which portfolio companies have hired, or are about to hire, the investment bank as underwriter or financial advisor. And, ex post, the 151investment banker would, for PR and legal reasons, not want to interfere directly with the governance activism of the mutual fund when an investment banking client becomes the target of such activism. Thus, the easiest and safest way to avoid any problems is for affiliated mutual funds not to engage in governance activism at all. This way, mutual fund managers do not have to distinguish between portfolio companies that are investment banking clients and those that are not, and investment bankers do not have to 148 For example, for the 10 companies in the Magellan Fund’s “Consumer Staples” industry group, which tnuocca rof % foeht dnuf ,stessaeht iewethgd avarege dilution is 78%. As further discussed below, the de eergof dulition ni innec sevit sinegodneuo s sa ti si anufcoitn fo anufd s’vniemtsent opoftroil hwhci flesti lliwbe a ufoitcnn of ehtnufd s’de erisot negage ni vitcasim. eeSin arfoitceSn . roFupoprs seof ht sioitces ,nvewoh ,re ewootk adnuf s’optrofoil sagiven to denimret eht einnecvit eto ne egag nivitcasim give nht eoftroplio hcoi .ec 149 See Rock, supra note 25, at 469; Black, supra note 25, at 601. John C. Bogle, Individual Stockholder, ., Wall St. J., Oct. 3, 2005, at A16 (noting conflicts by mutual fund managers when a proxy proposal is opposed by management and conspicuous absence of corporate governance activism). Conflicts are regarded as particularly pronounced in defined benefit plans, where fund assets are usually managed by designated corporate pension fund managers. The managers of a corporate pension fund are appointed by ht exeucevit seof ht eoitaroprocn ht taopsns sroht epesnion plan. These executives are believed to pressure pension fund managers to cast pro-management votes. Accordingly, corporate pension funds have not been regarded as likely to become active, and have not bmocee ,evitca nico etaropranrevog .ecn calB ,ksu arpnot e52 , ta95 .6 150 The list of funds was derived from Geoffrey H. Bobroff & Thomas H. Mack, Assessing the Significance of Mutual Fund Board Independent Ch ,sria .raM ,01 ,4002 elbaliava 151 hT eopnet laitp sllaftinicafg amuut lanufd eraullitsdetar by ht eupb yticiluacdes hw neueDthcse tessA namagement nI ,.cna tailiffae of ueDthcse naBk, dehctiws stivot seorfm ganias tot of rth emegr reof Hewlett-Packard and Compaq after it learned that Deutsche Bank provided investment banking advice to .PH eeS ,CES CESnirBgs deltteS nEnemecrof toitcAn gAnias tueDt ehcsnaBk vnIetsnemt dAviosyr nU tini oCnnnoitce htiw stIoVgnit of neilCt xorP sei rofMerger Transaction; Imposes $750,000 Penalty (Aug. 19, 2003), at 24
worry about mutual fund managers who are spoiling their business and need to be 152stopped. Of course, many mutual funds companies, including the two largest -- Fidelity dna draugnaV -- eraon t detailiffaw htiot rehfinancial institutions. But even unaffiliated mutual fund managers, especially the larger ones, face potential conflicts. For many mutual fund complexes, the management of corporate pension plans is an important 153source of revenues. Governance activism could lead to a loss of such business, not just 154 htiw tcepser ot eht tsivitca dnufbut for the complex as a whole. nhoJ ,elgoB ehtfounder and former head of the Vanguard, ev ne detseggus tahtme yler gnitov tsniagamanagement could “jeopardize the retent noi fo stneilc fo )k(104 dna noisnep155accounts.” dnA noD ,spillihP ama gnigantcerid ro fo ,ratsgninroM setubirtta eht ecnatculer fo sdnuf ot troppusshareholder proposals to rein ni evitucexe yap ot rieht156“desire to solicit business from corporations.” As in the case of affiliated funds, the effect of such conflicts on governance activism may be to deter strong activism on a broader scale. It is certainly easy to imagine that a mutual fund complex could conclude that having the reputation as a governance trouble-maker in management circles is not conducive to being picked as manager for corporate pension plans, and taht eht stiforp otbe made from managing these pension plans exceed those from governance activism. To assess the significance of these conflicts fo ,tseretni yeht evah ot ebmocperad to the affirmative incentive a fund would have, absent any conflicts, to engage in activism. As discussed in the previous section, activism is costly and fund management companies only profit modestly from any fund profits generated by activism. Thus, in our view, even modest conflicts of interest could easily dissuade a fund management company from pursuing an activist strategy and induce it to rely instead on less conflict prone strategies – such as quantitative research or fundamental value analysis – to generate excess returns. 152 Cf. Gerald F. Davis and E. Han Kim, Business Ties and Proxy Voting by Mutual Funds, __ J. Fin. Econ. __ (2006) (finding that, given policies, voting by mutual funds appears to be independent of whether fund ha sneilct seithtiw optrofoil ocmpna ,yub tnognit ht tadnuf shtiw mupitl elneilct have eragene yllarmoer kil yelot ov etin ovaf r fomanagement .) 153 Gretchen Morgenson, Investors Vs. Pfizer: Guess Who Has the Guns?, Wall St. J., Apr. 23, 2006, at. Sec. 3, p. 1 (noting several mutual funds who own shares of Pfizer and manage one of its retirement plan na dusbsnat lait seefpa diby ocmpna yot esehtufdn .)s 154 eeS ,kcalBsuarp eton ,52 ta .206 155 retteLot CESdetic ni Wailli muaBe ,nitiBg ht e dnaHhT ta :sdeeFuMut ladnuF seiTot oCetaropr neilCt s naCAff tceorPxy oVnit , raM. 01 ,02 50 vabalial eta (citing to Bogle but also to a Fidelity spokesman who disclaims link). 156 Do Mutual Funds Back CEO Pay, Wall St. J., Mar. 28, 2006, at C1. 25
d. Concluding Remarks The actual activities of mutual funds are consistent with our analysis. Mutual funds have shied away from the more costly and more confrontational modes of activism: they have not instigated proxy context, they evah ton dael eht egrahc ni gnihsup rofchanges in business strategy or management, most mutual funds have not even made shareholder proposals, and until recently mutual funds have rarely been active in opposing or triggering corporate control transactions. If they engage in “behind the scenes” communications – and we doubt that they do so extensively – it is largely just that: efforts to coax management to change its ways, without much follow-up if management is not amenable. Capitalizing on their economies of scale, however, mutual funds have developed general policies that have lead them to support shareholder ecnanrevog slasoporp thguorb yb ,srehtoiwthhold votes from board nominees, and oppose some governance proposals made by the board. B. cilbuP noisneP sdnuF dnaM gnirotino Like mutual funds, public pension funds enjoy significant economies of scale. ehT egarevame rebm fo eht licnuoC foutitsnItional Investors, an organization of large public pension funds as well as union and corporate pension funds, has assets of $22 billion. On the minus side, however, the reasons that esiar snrecnoc tuoba eht ytiliba fopublic pension funds to act as effective corporate monitors differ from those related to mutual funds. Public pension funds must make quarterly disclosures of their holdings of 157public equity securities. But, unlike mutual funds, public noisnep sdnuf era ton tcejbus158to specific diversification requirements, face predictable liquidity requirements, and are not subject to regulatory constraints norofrepm ecnaef ,se dna evah on ssenisub seitwith portfolio companies that would be jeopardized by activism. The problem of public pension funds, rather , si taht yeht era lacitilop seititne dnasubject to political constraints and political conflicts of interest. The make-up of the trustees of public pension funds is established by state law and differs from fund to fund. Generally, trustees consist of gubernatorial appointees, elected politicians who serve ex 159 ,oiciffo slaiciffo detcele ybfund beneficiaries, or some combination of these groups. For example, the trustees of ,SREPlaC eht tsegral cilbupuf ,dn edulcni 6me srebm detcele160by beneficiaries and 3 political appointe se dna 4me srebm ohw evres The New York State Common Retirement Fund, the second largest public fund, has the State 157 See infra Section . 158 Public pension funds are subject to a prudent investor standard for diversification, see Romano, supra not e116. Bu tgiven th rie ,ezisht siohsuld on tbe na vitceffe enocsniartt on th rietiliba yot kate gral eposnoitis in pooftr oilocmp .seina 159 oRmano, pusr aon et611 ,ta 28 3 –528 . 160 See 26
Comptroller, a state-wide elected official, as the sole trustee. As should be evident, public pension fund trustees lack significant financial incentives to maximize fund performance. To be sure, public pension funds can hire professional managers compensated by 161performance-based fees. cilbuP noisnep ,sdnufvewoh ,re era tcejbus ot lacitilopconstraints in setting the size of these fees. As officials who are, as some commentators 162have noted, “accountable for their decisions to politicians or to the press”, they avoid calling negative publicity to their activities. The adverse publicity generated by the pay segakcap fo ehtma sregan fo dravraHrevinUsity’s endowment provides some indication of these constraints. Though Jack Meyer, Harvard’s top investment manager, produced 163“stellar investment results,” alumni complained that the pay of Meyer and of some of his top managers was inappropriately high. Meyer and some of his employees ended up 164 gnivael dravraH ot trats a By private sector standards, however -- and 165certainly by hedge fund standards -- Meyer’s pay package ($7 million in 2004) and the one of his top two managers ($35 million in 2003 and $25 million in 2004) was laughably small considering the fact that Harvard’s e tnemwodn fo 22$ noillib dluow evah neeb 21$166billion smaller had Meyer earned median returns. Indeed, the compensation of administrators of public pension funds is less yltneuqerf desab nomrofrepa ecn – dna fi tiis, is less performance sensitive – than the compensation of admini srotarts fo etavirp167plans. Given the potential pitfalls from high pay packages, a politically safer course for pension fund boards that are willing to pay st peemrofrepa ecn seef dluow eb ot tsurtnefunds to an outside entity rather than to pay such fees to in-house managers. This, of course, is exactly what public pension funds do when they manage the indexed portion of 161 CalPERS pays performance fees to some of its external managers. See CalPers Annual investment Report 2005, External Manager Fees Report, available at 162 Kevin Murphy & Karen Van Nuys, Governance, Behavior, and Performance of State and Corporate nePsio nuFdn ,sHarvra dnUrevi ytisWokr gnipaPer, 991 ,4 ta14 . 163 Harvra’d sHihg-Pdia ratS Iotsevnr Is vaeLing, Bonots Gl ebo .naJ12 ,2 .500 164 reteParGn t & accebeR ,namkcuB rettaFaP yeruL snUiv ytisremwodnE tne ,sfeihC llaW .tS ,.JJu en ,722600 , taC1 . 165 eeSarfni itceSo n . 166 tAvraHdra, AuQnoitse fOoCmpnenoitas, Bonots lGbo ,evoN. 92 ,0240 ; eesgene yllar rettaFyaP uLre sUnivreis ytnEwodment hCfeis ,rpus aon et461 . 167 eeS eicarToWdikt ,egAne sthctaWign gAnest? Evidence from Pension Fund Ownership and Firm Vaul ,e36 .JniF. nocE .99 ,401 (002)2 . 27
their portfolio in-house and invest some of their other asse st ni etavirp ytiuqe ,sdnuf168venture capital funds -- and hedge funds. lacitiloP stniartsnoc oslainhibit public pension funds from pursuing some of the more aggressive activist strategies employed yb egdeh .sdnuf tI si eno gniht rof cilbuppension funds to sponsor shareholder resolutions demanding greater board accountability, ot tca sa dael sffitnialp nisecurities lawsuits, or even ot dnamed ecnanrevog segnahc niunderperforming companies. It is quite anot reh rofmeht ot llet a OEC woh ot nur rehbusiness – by opposing major strategic acquisitions, by demanding asset spin-offs, or by recommending a different business strategy – and threatening a proxy contest if management fails to be responsive. Public pension funds just lack the legitimacy to push beyond relatively uncontroversial “motherhood and apple pie” issues. Unlike CEOs or hedge fund managers, they do not have to go out to the market to compete for investment capital; their managers have little financial stake in their success; they are not subject to market penalties for failure; they are ru n yb ,snaicitiloprub ,starcuae dna noinurepresentatives; and as political entities, they are subject to political pressure for overstepping their bounds. Compounding these political constraints are political conflicts of interests. Pension fund trustees who are gubernatorial appointees or elected politicians may be tempted to pursue political ends, rather than the maximization of investment returns. In her 1993 article on pension fund activism, Roberta Romano details several instances of noisnep sdnuf gniusrup lacitilop slaogrehtar than profits. In 1992, for example, the Illinois state treasurer and tr eetsu fo eht noisnep dnufrhteatened not to make future investments into KKR’s leveraged buyout fund unless KKR preserved jobs in an Illinois 169plant it was selling to its employees. The same year, Elizabeth Holzman, the New York City’s comptroller and the trustee of the city’s pension fund, publicized her active approach to corporate governance in her campaign for the Democratic nomination for 170New York’s senate seat. As related by Romano, both th e weN kroY dna eht ainrofilaCstate pension funds have become subject to political pressure to tone down, and indeed 171did tone down, their governance activities. More recently, Alan Hevesi, the very active 172New York State Comptroller who is the sole trustee fo eht 511$ noillib weN kroY 168 See, ., News Release, CalPERS Taps Blackstone Alternative Asset Management as Advisor to $1 oilliBn Hedge nuFd gorPmar, yaM15 ,2 100on(gnit th ta SREPlaCob dragadeer to batsehsil a1$ boillin hegd eufdn prgoram ni Octoreb 2000). 169 Romano, supra note 116, at fn. 6 and 807. 170 Id. at 822. 171 dI . ta8 .918-51 eeSosla yaJn e .WnraB ,drasnIutitoitna lnIveotsr sdna ht eNew proC etarooGvenr ,ecna69 . .LRev. 1153 ,1141 ,n. 39 1(199 )d(ucsi gnissop lacitilo-llafut hw neWiocsnnis pensnoi dnufusbmdetti management lacitirc-prpoos lato MGhwne ocpmna ynocsdidere xepansio nni Winocs .)nis 172 Arden Dale, New York Fund Sues Merck, Citing Vioxx, Stock Drop, Wall St. J., Dec. 1, 2004 (noting ht taveHe is siocnsiddere na vitca tsiocmp rellortdna deiliatng us stihe ha sdelif) . 28
173174State Common Retirement Fund, has been criticized both for pursuing political goals 175 dna rof gnivah eht dnuf erih walmrif s ohwmade large contributions to his campaign. Trustees elected by fund beneficiaries are usually union representatives, who also 176have objectives that may conflict with the maximization of investment returns. For example, CalPERS, the largest and traditionally most active public pension fund, has come under increased criticism for the presence of union representativ se no sti draob dna177the pro-union stance it has taken in various labor disputes. Even to the extent that public pension funds do not pursue political or labor goals, the relatively low pay and incentives of public pension fund executives raises the specter that their governance 178activities are designed more for self-promotion than to enhance returns. The political constraints and conflicts of public pension funds not only make them less likely to engage in certain kinds of activism, they can also make them less effective when they become active. To the extent that public pension fund activism is perceived to be motivated politically or to serve the promotional interests of fund executives, other groups are less likely to support public funds when they become active. Without such support, however, activism is less likely to a tceff segnahc ni eht oiloftropmocpan .sei ,sihT ,niaga tseggus tahtbup cil sdnuf lliw ebmo tsceffe evit nehw riehtmsivitca siperceived to be least affected by political or personal motives – such as with respect to uncontroversial “apple pie” issues – and thus be inclined to limit their activism to those issues. The actual activities of public pension funds correspond to these incentives and constraints. Consistent with their lack of business relations with target companies and the 173 (As of December 31, 2003). 174 Editorial, Pension Fund Blackmail, Wall St. J., Mar. 3, 2005, at A10 (arguing that Hevesi was using his clout as pension fund trustee to aid John Kerry). 175 Karen oDnavon, geLa lofeRrm uTrn s awetSdra nIot naAcvit ,. iTme ,sAp .r16 ,0250 , taC1 ;dEoti ,lairCopmortnillg geLal uAth ,ytiro llaW .tS ,. 1, 2005, at p. A10; Editorial, Hevesi by the retteL, Ne woYkr nuS, pA .r21, 0250 ,onlni : . eeS osla ,ektdioWus arpon et ,761 ta821 noc(ulcding ht tap cilbupension ufdn vitcamsi si motivadet mo erby op lacitilna dsocial goals than by firm performance). 176 eeSgene yllardEoti ,lairnePsnoi nuFd kcalBma ,liWa ll .tS ,.JraM. ,32500 , ta1A 0ra(guign th taeht OIC-LFA“dna stidneirf s erawon usgni pensio ndnuf s otvdaanc eht riepo lacitilgoa ;.)slhciM leaorhcSede ,rCounc liof nIoitutitsna lvnIe srots si teS otoF sucno Mogrna tSna ,yelWa ll .tS ,.JpA .r13 ,2005 . 177 eeSoJnathna ,lieWdaGf ylvitcAmsi taaC SREPldael sto issoP elbtsuO re foediserPn ,tWa ll .tS ,. 1, 2004, at A1 (noting controversial CalPERS actions in interceding on behalf of striking employees of a pooftroil ocmpna ;)ydE ,lairoti SREPlaCnad norCmsiy, Wa ll .tS ,.J .tcO18, 002 ,4 ta81A on(gnit op lacitilnad nunoi seitof SREPlaCobdra memb srenad uccasgni obdra foba gnisnivemtsent doisicen no poacitill goals of labor and the Democratic party)., Jim Carlton & Jonathan Weil, Ouster Isn't Expected To Alter plaC sreoP ,ycilWa ll .tS ,.J .ceD ,22400 , ta3C .on(gnit ht ta SREPlaCha sbene ezicitircd rofm“dedgnil in lacitilop dnaal noinu-robssiu se htiw elttilnnocection to improving shareholder returns.”) 178 Romano, supra note 116, at 822, fn. 822 (suggesting that veteran activist Dale Hanson, the former head of CalPERS, may have been so motiv ;)deta ,kcalBsu arpon et52 , ta895 .29
lacitilop stseretni fo emosrt ,seetsu cilbup noisnep dnufcativism is somewhat more open and confrontational than activism by mutual fund: public funds make more shareholder proposals, publish lists of target companies, and apply to become lead plaintiffs in securities class actions. But the choice of targets – companies that have been underperforming or have been accused of major fraud – and the s ecnatsbu foactivism – gnillac rof retaerg draob ,ytilibatnuoccaisoppo gn evissecxe OECmocpen ,noitas dna ehtlike – insulate the fund from political backlash. And – as they lack the incentives and the credibility to do so -- public funds have steered clear of demanding specific changes in strategy or management, have not engaged in proxy contests, and have so far not even joined forces with hedge funds in opposing or triggering corporate lortnoc .snoitcasnart C. H egde sdnuF dnaM gnirotino .1 iSze Since hedge funds are largely unregulate ,d yllaitnatsbus ssel atad si elbaliavaabout hedge funds than about other institutional investors. However, the available evidence suggests that hedge funds enjoy significant economies of scale. According to estimates, there are approximately 8,000 hedge sdnuf htiw etagergga stessa rednu179management of over $1 trillion. These figures indicate sugge ts taht eht egareva egdehfund had assets of about $100 million. The largest hedge funds have assets of about $10 180billion. While smaller than the comparable serugif rof lautum sdnuf dna noisnep ,sdnuf eseht serugif ylbaborp etatsrednu eht evitceffe stessa fo egdeh .sdnuf ekilnU mutual funds and pension funds, hedge funds regularly use leverage and invest in derivatives which enable them to take positions that are much larger than those of mutual funds with similar net assets. Thus, according to industry sources, 30% of hedge funds use a leverage ratio in excess of 2 – meaning that the total dollars invested are more than 181twice the total equity – and another 40% use leverage at a lower ratio. .2 R yrotalugeC stniartsno Hedge funds are not subject to any specific regulatory constraints. They must, however, comply with rules applicable to i srotsevn .yllareneg sehTe constraints include the disclosure requirements unde r noitces )d(31 fo ehtiruceS seit egnahcxE tcA gniriuqer serusolcsid yb snosrep ohw nwomore than 5% of the equity securities of a public company and the short-swing profit rules under Section 16(b) applicable to 10% shareholders and directors of a company. 179 hT eonocEmist ,deHge uFdn sdna ht e :CES llitS ,eerFuJ yl1, 0260 , ta86. 180 nIutitsnoita lnIveotsr gaManize s’hplA a semaNaFnolarr paC latigM tmth e s’dlroWgraL tsegdeH enuFd riFm ni htrie nAun laHegd euFdn 01 ,0RPNewswire , yaM72 ,0250 . 181 See 30
In addition, all institutional investment manage sr – gnidulcni egdeh dnufmanagers – are subject to the disclosure requirement of section 13(f) of the Securities Exchange Act. Under that provision, certain investment managers (including mutual fund as well as pension fund and hedge fund managers) must make disclosures about rieht sgnidloh no a ylretrauq .sisab ehTidsclosure requirements under Section 13(f) differ, however, from those applicable to mutual funds in two important respects. First, and most significantly, only holdings of registered equity securities – so-called “13(f) securities” need to be disclosed. 13(f) securities include traded shares and options listed on an exchange. Importantly, however, holding s fo rehto snoitpo dna sevitavired deennot be disclosed in one’s 13(f) filings. As a result, hedge funds can use derivatives to accumulate large economic positions in portfolio companies without disclosure unless they become subject to the disclosure requirements under section 13(d). Secondly, no disclosures at all must be ma ed fi s’eno sgnidloh fo)f(31 securities are less than $100 million. Thus, small and even medium size hedge funds can avoid making any disclosures as long as a sufficiently large percentage of their holdings are in debt securities or in non-listed equity derivatives. Hedge funds also have a greater ability to invest in illiquid assets than do mutual funds. While mutual funds are required to redeem shares on short notice and SEC guidelines limit the percentage of assets tahtmu laut sdnuf nac dloh ni diuqilliinvestments, hedge funds are not subject to any similar regulatory requirements. Contractually, hedge fund investors have more limited withdrawal rights than mutual fund investor. Traditionally, hedge fund investors could make withdrawals only after an initial lock-up period of six months. More recently, some hedge funds have extended the 182initial lock-up period to two years or longer. Once the initial lock-up has expired, further restrictions apply. In particular, hedge funds usua yll eriuqeravda ecn eciton rofwithdrawals and sometimes permit withdrawals only at specific points in time and 183impose limit on the amounts an investor can withdraw at any point. In addition, hedge funds may refuse a withdrawal request if the withdrawal would be harmful to other 184investor in the fund or “pay ” a detseuqer lawardhtiw-ni“ ”dnik rehtar naht In conjunction, these provisions make hedge funds much less sensitive to sudden liquidity 185shocks than mutual funds are. 182 , ,.hC-xEariman of . teSot ratS tHedge dnuF ,. miTe ,speS. 31 ,2 500 ta1C (repornitg ht taniveotsr sin ne whegd eufdn nac no yldermee niaiti lfudn s retfa 2 ,sraeydna ht retfaereonl ynaun;)ylla Hegd ednuF sAvoi d CESgeRirtsaoit nuR ,elWa ll .tS ,.JNov. 01 ,02 ,50 ta1C (no gnitht tavesera ldehge funds have adopted a 2-year lockup period, in part to avoid SEC registration rules). The increased lock-up may contribute to hedge fund activism. See Two-Year Lock-Up for hedge Funds Seen as Promoting Acvit tsirtSageti ,seBN A .ceS .geR & .LpeR. ,pA .r3, 6002 ta569. 183 neHny dneS ,redatiCe luP sll pU stiWdhtir lawagdirBe , sAdeHge uFdn smiA ot olBck th exE ,sti llaWSt. J., Jan. 13, 2006, at C1 (noting that Citadel charged penalty on investor who wanted to withdraw more htna 3% fo stimone .)y 184 nIvret weihtiw htaNna ,lehcsiF .naJ2, 02 .60 185 gdeH ednuf sosla have agr retaeba ytilito kate no de tbhtna muut ladnuf .s dnUe rht enIvemtsent Company Act, mutual funds are required to have a three to one asset to debt ratio. Investment Company Act, §18(f), 15 USC 80a-18(f). (As most mutual funds have no debt to speak of, this regulatory constraint 31
3. Incentives to Monitor As we discussed above, traditional institutional investors suffer from impaired incentives to monitor portfolio companies. The incentives to monitor by hedge funds differ in several important respects from those of traditional institutions. First, hedge dnufma sregan era ylhgihnecnitivized to maximize the returns to fund investors. The dradnats egdeh dnufrahc seg a esab eef lauqe ot %2-1fo the assets under management 186and a significant incentive fee, typically 20% of the profits earned. This fee structure gives hedge fund managers very significant stakes in the financial sseccus fo eht s’dnufinvestments. These stakes are even higher when, as is frequently the case, a hedge fund 187manager has invested a significant portion of her personal wealth in the hedge fund. Secondly, many hedge funds strive to achieve high absolute retu ,snr rehtar naht188returns relative to a benchmark. In particular, the industr dradnats-y %02incentive fee is usually based on a fund’s ab etulosmrofrepa .ecn dnAhw eli a wef sdnuf esu a eldruhrate before the incentive fee is payable, this hurdle rate is generally a rate based on the yield of debt securities, not a rate based on the performance of a market index or an index of hedge funds with similar investment objectives. Thus, unlike mutual funds, hedge funds benefit directly and substantially from achieving high absolute returns. For successful managers, the resulting profits can be yranidroartxe .hgih ,suhT eht egareva ekathome pay for the top 25 hedge fund managers in 2003 was $207 million; and the lowest paid manager in that group still earned a 189respectable $65 million. roF ,4002 eht egareva saw 152$ noillim dna eht tsewol diap190received $100 million. Of course, hedge fund managers, like mu laut dnufmaan ,sreg erac osla tuobaretaining existing and attracting new investors through their performance. But even to the extent that hedge fund performance is, for this purpose, assessed relative to a benchmark or to other hedge funds with comparable strategies, their incentives are diluted to a lesser in unlikely to be binding.) Hedge funds are not similarly limited and, by all accounts, often are far more leveraged. 186 . hT si eef siusuall ytsructured to incorporate a retaw-hgihma ,kr tub ton alc waab .kc ., if a fund makes losses, these losses have to be made up before na yninecvit e eef sipabayl eh(hgi retawma ;)krub tfi a fund makes profits and earns an incentive fee, the fee does not have to be returned if the fund suffers subsequent losses (no claw back). 187 E-Mail from David Haarmeyer to Marcel Kahan, Apr. 4, 2006. 188 Financial Services Authority, Hedge Funds: A Discussion of Risk and Regulatory Engagement (June 2500 ) ta01 . 189 hpetSen ,buaThT euBkc potS s ,ereHnIoitutitsna lvnIe ,rotsuA .g2400 , ta47 . 190 hpetSen ,buaTlApha s’poT 25 ,nIutitsnoita lvnIe s’rotsplAha ,nuJ/yaMe 2500 , ta51 . 32
extent than those of mutual funds. The reason is that hedge fund portfolios resemble the relevant index much less than those of mutual funds. Reliable atad no egdeh dnuf sgnidloh era ton elbaliavanisce hedge funds must only disclose their holdi gn ni ytiuqe seitiruces dna detsil ,snoitpo dna ton ynatoher derivatives. We ar e suht ton elba otcalculate the percentage d noituli ni egdeh dnufsevitnecni mis ylrali ot eht yaw ewcalculated Magellan’s dilution in incentives. But hedge fund managers we talked to confirmed that hedge fund investments were definitely much more eclectic and less correlated with a market index or with investments of another hedge fund with a similar 191investment style than those of mutual funds. As one of them put it: Eclecticism “is 192 tahw ew era”.gnilles As a result, hedge funds need not worry much that competitor funds will free-ride on their governance activism and get higher returns with lower costs. And even if the activism by one hedge fund boosts the returns of activist hedge funds more generally, the result may not be all that bad. srotsevnI esu snruter fo sdnufwith a certain investment style to determine the amount of money they invest in this sector of funds. If activism by one activist hedge fund boosts the returns of activist hedge funds more generally, more money will flow into this sector benefiting all activist 4. Conflicts of Interest Hedge funds suffer from fewer conflicts fo stseretni neewteb dnufma sregan dnafund investors than traditional institutional investors. First, most hedge funds are independent investment vehicles and are not affiliated with any other institution. Of the 20 largest hedge funds in 2004, only one was affiliated with another financial institution such as a bank or insurance company. By c ,tsartno sa detroper ,evoba fo eht 02 tsegralmutual fund complexes in 2003, nine were so affiliated. Furthermore, anecdotal evidence suggests that even hedge funds that are affiliated with other financial institutions do not shy away from taking actions that are antagonistic to investme tn gniknab stneilc foieht raffiliates. Recently, for example, the Highbridge Fund, majority owned by . Morgan, accumulated a 25+ percent stake in convertible bonds of Saks Inc. and then sent a “notice of default” when Saks breached a covenant by failing to file financial statements with the 194SEC – even though Saks has an investment banking relationship with . Morgan. 191 nIvretwei fo Hegd ednuF Manager (anonmyous), naJ 03 ,2600 . 192 dI .gdeH enufds psgnizilaice ni megr rebragarti emay be na xepection ni ht sidrager ni ht tarieht investments are highly correlated with those of other hedge funds specializing in merger arbitrage. 193 Moreover, investors in hedge funds tend to be highly sophisticated. As a result, they may tend to use more complex evaluation criteria and channel their investment to the funds that took the lead in activism, dna tonesoht taht .edor-eerf 194 Hibhgrigd euFdn neSt Defau tlNo etto reliateR kaSs ,Wall .tS ,.JnuJe ,020250 ta 5C(the ra elcitufrtreh suggests that Highbridge bets on Saks stock declining and aims to make money from a short position in Saks). 33
Indeed, recently concern has been expressed that investment banks sacrifice the interests 195of other clients in order to cultivate and retain lucrative hedge fund business. Second, unlike mutual funds, hedge funds do not manage companies’ defined contribution plans. They accordingly do not have to be concerned that activism will result in a loss of fund management business. In sum, hedge funds are, to a much greater extent than mutual funds, free from the most significant potential sour sec fo stcilfnoc fo196interest. To be sure, hedge funds may still face some conflicts to the extent they want to attract contributions by defined benefit etaroproc noisnepsdnuf taht era nur ybmanagement-appointed trustees. (Mutual funds, of course, would also face similar conflicts.) But we believe that, at least for egdeh ,sdnuf eseht stcilfnoc dnet ot ebmi .ron For one, hedge funds may not be that interested in capital from private pension funds. If private pension funds, together with public pension funds, account for more than 25% of the capital of a hedge fund, the hedge fund becomes subject to regulations under 197ASIRE – a fate unattractive to a sector that is otherwise largely .detalugernu eroMimportantly, however, we do not think that co etaropr noisnep sdnuf evah neeb ro lliwbecome a substantial source of direct funds for hedge funds . ,yllacirotsiH etaroprocpension funds have not been significant contri srotub ot egdeh .sdnuf ,rehtaR egdehsdnuf have obtained most of their capital from wealthy individuals and institutions such as 198199foundations or university endowments. More recently, corporate (as well as public) pension funds have started to make investments in hedge funds. While we lack precise data, we do not believe that, at this point, corporate pension funds are a major source of 195 Testimony Concerning Hedge Funds by Susan Ferris Wyderko, Director, Office of Investor Education nad natsissA . seitiruceS &xEhc egnaoCimmoissn, erofeBht ebuScommieett on uceS seitirna dvnIemtsent of ht e . etaneSoCeettimm on knaBnig, uoHsgni, dnabrUan sriaffA yaM(16, 02 )60va(abalil e ta ht e CESbewseti , ASF olBhdouodn suPusre gdeH enuFds ;niFancia lvreS seciuAthro ,ytiuceS seitirnIud yrts sweN yaM(61 ,02 .)50 196 fC .Akcatt sfo ht enuHgry Hedge uFdn ,snisuBeWss keenilno ,ebeF. 02 ,0260 n(ognit th tahegd eufdn ,sunkil emuut laufdn ,s eraon tniyrtg ot llesmone ymanagement vres secito ocmpna .)sei 197 Department of Labor, Definition of ``plan assets''-- plan investments (“Plan Asset Regulations”), 29 .(f) .fc(. 198 osaJn gniS ,reIv yvaeL :e elaYraPt sWa sywhti Hegd euFdn ,sWa ll .tS ,.JraM. 92 ,2006 , ta1C (chatr noting that % of Yale’s endowment is invested in hedge funds). 199 sweN ,esaeleR SREPlaCpaTs kcalB enotsnretlAvita e tessAnaMagenemt sadAvios rot $1 oilliBn gdeH ednuF gorPmar, yaM15 ,2100 on(nit ght taaC SREPlobdra gadeer otbatse hsil a1$ boillin dehge fdnu program in Ocbote r0002 .) 34
200capital for hedge funds. And given the declining impor ecnat fo etaroproc denifed201benefit plans, we are skeptical that they ever will become one. Finally, even to the extent that corporate pension funds invest in hedge funds, they tend to do so through 202funds-of-funds, rath re But hedge fund managers do not know the identity of the investor in eht ,sdnuf-fo-dnuf dnarotsevni s ni eht sdnuf-fo-dnuf odton always know what hedge funds their money flows to. The presence of fund-of-funds thus serves to further insulate hedge funds from pressure by corporate pension funds. Whatever residual conflicts of interest may remain, they have to be compared to the affirmative incentives to enhance investor returns. As explained, hedge fund management firms and managers derive substantially greater benefits from increased fund returns than do mutual fund management mrif s dnama .sregan sA a ,tluser ynaconflict of interest is more likely to be reso devl ni rovaf fo egdeh dnuf .srotsevni On ehtwhole, therefore, we do not believe that conflicts of interests are likely to interfere with activism by hedge funds, or at the very least that they do so much less than in the case of public pension funds and mutual funds. 5. Activism and Stakes nI eht ,dne eht sevitnecniofr a fund to engage in activism depend on its stake in a 203portfolio company. In this regard, it is noteworthy that activist hedge funds usually accumulate stakes in portfolio companies in order to engage in activism. There are numerous examples of hedge funds taking stakes whose value depends on firm actions, and then taking action – everything from trying to influence strategy, running proxy contests, instigating litigation, and threatened to vote against mergers – to determine the outcome. Hedge funds in this regard differ marked ylmorf lautum sdnuf dna cilbup noisnepfunds. Mutual fund and public pension fund activism, if it occurs, tends to be intermittent and ex post: when fund management notes that portfolio companies are underperforming, 200 ehTeHessenn e puorGecer yltn detamitse tahtbuplic and private pension funds combined account for %9 foth eso secru foac latip oteh egd .sdnuf See Hennessee Group LLC Hedge Fund Industry Growth, unaJra y2500 . 201 In 1995, private pension funds held corporate equities of $ trillion, amounting to 15% of the total kram tevaul e fo etaroproc .seitiuqe yB20 ,50virp etapension ufdn shedl ocoprr etaqeuiti seof 1$7. oillirtn, amoungnit ot %9of ht eot latkram tevaul e foocoprr etaseitiuqe. olFw of nuFds Anuocc ,stusrp aon et21 ,8tables L213 and L118. 202 naJe .B yenneK teal ,.hT egdeH euFdn ,nIutitsoitna lnIotsevr ,uJne 1, 0230 M“(uhc of ht ene wpensio nmoney enters the market through funds of hedge funds.”) 203 nI ddaoiti ,nhedge dnuf smay urts erutcht riepooftr soilos ht taht yeprof tiorfm cavitsim ni vairous .syaw As discussed below, for example, it is likely that Highfields stood to profit from a defeat of the MONY – AXA merger both through its holdings on MONY shares and through its holdings of ORANs. On the plus dise ,ht sinac olla whegd eufdn sto ni esaercht rieteru snrmorf lufsseccusmsivitca erehtb ycrevoo gnim lanoitarapyhta ro eerf .gnidir eeSarfni itceSo n . 35
204or that their governance regime is deficient, they will sometimes become active. In contrast, hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position, and then become active. It represents a blurring of the line between risk arbitrage and battles over corporate strategy and control. This suggests that the differences in activism between hedge funds and other institutions may be, at least in part, endogenous. Because (activist) hedge funds pursue activism as a profit-making strategy, they take economic positions in portfolio companies that enable them to make profits from activism and engage in activism. Because traditional institutions do not pursue activism as a profit making strategy, they do not take positions for the purpose of becoming active and accordingly engage in less activism. Put differently, the difference in activism is, in ,trap eud ot ehttcaf taht egdeh sdnuf dnatraditional institutions pursue different profit strategies. Viewed from this perspective, the rele tnav noitseuqmocebe s yhw )emos( egdehfunds pursue activism as a strategy and why (most) traditional institutions do not. In part, the answer to this question may lie 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 in part, the difference in strategies may be due to the fact that mutual fund view and market themselves as vehicles for diversification which enable their investor to gain broad exposure to markets at low costs. To be a successful activist, it is probably helpful for a fund to engage in activism as a principal strategy: activism presumably entails learning, with funds that have done mo er fo timocebi gnebtter at it, and funds with an activist reputation can more easily attract support from other investors and induce management changes. But an activist strate yg seod tonme hs llew htiw a noitacifisrevidobjective because strategic activism is relatively expensive and requires a fund to take ylevitaler egralsnoitisop ni ylevitaler wefmocp .seina egdeH ,sdnuf yb ,tsartnoc od tonsee themselves as vehicles for diversification dna egagne ni detegrat ,segdeh rehtar naht205diversification, to eliminate unwanted risk. More narrowly tailored strategies -- such 206as activism – are thus more appropriate for hedge funds than for mutual funds. 204 See, ., Smith, supra note 112, at 231 (describing target selection process used by CalPERS). 205 Perhaps more importantly, hedge funds have less of a need to diversify because investors in hedge dnuf ,snukil enamy niveotsr sni muut laufdn , eraladaer ybussnat yllaitdivedeifisr htuorgh ht riehtoe rholdings. Put differently, hedge fund investors have a greater tolerance for risk generated by their hedge dnuf vniemtsent htna muut ladnuf vnie srotshave htiw tcepserot ht riemutu lanufd vnienemtst . 206 vEne n-novitca tsihegd ednuf sdnet ot upusre more narrow tailored investment strategies such as merger bragarti edna ocvnbitre elbdno brartiga .e fOuocr ,esosme “mugetarts-itly ”hegd eufdn spuusre orbade ro( r aocmbnioita nof na )reworretartsgies and some mutual funds, such as sector funds, offer lesser diversification benefits. (By the same token, of course, some mutual funds, such as Mutual Beacon, are vitaler ylevitca ).tsi nO ht eohwl ,eho ,revewht emuutal fund sector is dominated by funds with broadly divedeifisr oftrop soilhw eliht ehegd enufd rotcessi hcdeziretcara by ufdn s htiwna ylworroliatder .seigetarts 36
III. smelborP detareneG ybH egde dnuFActivism: Conflicts and Stress Fractures Although hedge funds hold great promise sa evitca ,sredloherahs rieht esnetnimevlovnie tn ni etaroproc ecnanrevog dnatnocrol also raises some concerns. Hedge funds are set up to make money for their investors without regard to whether the seigetarts yeht wolloffenebit shareholders generally. A hedge fund who owns shares in, say, company A, may try to use that position to increase the value of another position, say in company B, rather than to maximize the share price of company A. Indeed, because hedge funds frequently engage in hedges and other sophisticated trading and arbitrage strategies, such conflicts of interest are likely to arise more frequently for hedge funds than for other institutional investors. We examine these “hedging related conflicts” in noitceS .A In addition to these direct conflicts, we also address a secondary problem related to hedge fund activism. Hedge funds combine high powered incentives with great sophistication and access to vast pools of capital. Together, this can put great stress on the existing governance system. We examine some of these potential “stress fractures” in 207Section B. We conclude this Part by commenting in Section C on the absence, so far, of a third set of problems: managers buying off activist hedge funds through the payment of greenmail or similar devices. We leave the most common, and potentially most serious, criticism leveled against hedge funds -- that hedge funds, due to their short-term trading horizons, aggravate an already serious problem of “short termism” in the executive suite – ot eb dezylana ni traP .VI In assessing the need for a regulatory response to these problems, there are several .snoitaredisnoc ,tsriF othwat extent does the existing regulatory structure adequately address the concerns? Here, we consider whether the problems are of a familiar type, and then whether the increased pressure on the system imposed by hedge funds overwhelms the existing tools. When a problem is a standard corporate law problem, we presume that the existing regulatory structure is adequate unless some specific aspect of hedge fund mevlovnie tn segnahc ehtsisylana . ,fI no eht rehtoahnd, problems are of a new type, they may require new tools. If one concludes that the current structure is inadequate, one then needs to consider which of the various tools available is most appropriate. In this regard, there are three general categories of potential responses. One can rely on market forces (. 207 We do not concern ourselves with the extent to which the interests of hedge fund managers may diverge from the interest of hedge fund investors, or what to do about any such divergence. Although an important queoits ,n ti sioyebdn ht eocsp e foht si .elcitrA 37
competition among hedge funds, reputation), employ self-help (charter amendments, contracts), or resort ot .noitaluger While the specific response obviously depends on the specific nature of the problem, it is critical to bear in mind that egdeh dnuf msivitca si ton .citats egdeH sdnufare among the most nimble market actors, with a track record of coming up with new strategies, some of which are designed to exploit imperfections in the very responses developed to the old strategies. Moreover, hedge funds are not only clever, but quick. So in choosing a mode of response, speed and flexibility are very important. This suggests that the market forces and self-help are better designed to deal with these problems than noitaluger .si ehT nosaer si .dlof-owt roFone, private actors can generally react more quickly than regulators. Sec ,dno etavirp srotca evah aetaergr ability to learn from each other in devising a proper response. As we will see, many of the problems discussed in this Part are familiar and classic corporate law problems. Despite the increased pr erusse deilppa yb egdeh ,sdnufour general view is that the traditional solutions, perhaps with increased enforcement, and supplemented by market responses and possibly some additional disclosure requirements, should suffice. We are not indifferent to the possibility of illegal or improper behavior; rather our view is that the current regulatory structur e nac eldnah ,ti htiwmiron exceptions. A. ehTDkra :ediS Hedging-Related Conflicts 1. Buying (Control) v. Selling (Shares) As the earlier anecdotes show, hedge funds are sometimes potential buyers, not sellers. When a hedge fund is a potential buyer of a company in which it has a stake, its stseretni ylraelc dna ylsuoivbo egrevidmorf esoht fo sti wollefhsareholders: the hedge fund wants to buy at the lowest possible price while the other shareholders want to sell at the highest possible price. A hedge fund’s activities may not be so much directed at making sure that the target is sold at the highest price, but rather at increasing the likelihood that the hedge fund succeeds in its acquisition attempt. This is a very old problem in corporate law that is analyzed under the rubric of the duty of loyalty. While hedge funds’ interest s ylraelc egrevidmorf eneg larredloherahs stseretni nehw yehtrae seeking to buy control, this c tcilfno si ,suoivbo htiwmameganetn and other shareholders being aware of it and on guard against it. Moreover, hedge funds will generally have no control over the target company they are trying to buy. We therefore believe that no speci la esnopser si .yrassecen 2. Conflicts in Merger Votes A more subtle conflict can arise in control transactions when a hedge fund owns other securities the value of which depends on whether the transaction is consummated. Such conflicts featured prominently in the proposed acquisition of MONY, a publicly 38
traded life insurance company, by AXA, the large French financial conglomerate, where 208hedge funds both favoring and opposing th e laed dah stcilfnoc Highfields -- a hedge fund with nearly 5% of MONY -- led the opposition by MONY shareholders, running full page ads in the Wall Street Journal urging MONY sharehol sred ot tcejer eht209emrger, gnicnivnoc lanoitutitsnI redloherahSSe ,secivr a yxorp yrosivdamrif , ot210recommend a “no” vote on the deal, dna gnihsilbatse aew ( ) ot dia YNOMerahsholders in exercisi gn rieht lasiarppa211rights. But Highfields’ interests were not pure. In order to finance its cash acquisition of MONY, AXA had issued a convertible debt security, known as “ORANs”, to its shareholders which would convert into AXA shares on completion of the acquisition but be redeemed at face value plus interest if the acquisition was not completed by December ,12 .4002 neviG eht evitaler seulavdevlovni , eht sNARO dluoweb significantly more valuable if the AXA-MONY deal went through. Highfields held a large short position in 212ORANs, a position that would become more valuable if the merger did not close. Other hedge funds favoring the merger, in ,nrut erew gnol noROsNA dna yltnerappa213 desahcrup YNOM kcots ta amuimerp in order to vote for the merger. Eventually, after a postponement in the meeting (which dewolla sredloherahs ohw dah thguob kcots 208 nI er YNOMorGup nI .coh'Sdl regitiL ,.583 661, 668 .leD(hC . lirpA9 2400 ,verides pA .r41, 2400 .) 209 Sara Hansard, MONY Delays Vote as Dissidents' Effort Gains Steam; C NIARCOMM., Feb. 23, 2004, at 25. Highfields even mailed a letter to shareholders urging them to vote “no” on the merger and enclosed a etacilpud fo eht etaroprocproxy card so that shareholders, should they choose, could easily cast a no vote. hT si sawht eusjb tce fodefe larocur tgitiloitan htiw ht eussi ebegni hwhtee rht sinocsutitdet na xemept solicitation under Rule 14a-2(b)(1). MONY Group, Inc. v. Highfields Capital Mgmt., ., 368 138, 141 (2nd Cir. 2004). Highfields won in the District Court, but the decision was reversed by the Second Circuit which held that, under the circumstances, th e etacilpudmaeganme tn yxorpca drsaw amrof“ fo overnoitac” dna uhts dnerdere ht eositaticilon onxe-nmept. Id. at 145 ; see also nI re OMYN orG puInc. h'Solder gitiL ,.58 ta669; A tessganaMement Demands hT taOM/AXANY Dilcso esInformation Regarding Arbitrage of AXA Bonds [hereinafter Southeastern Asset Management Demands]; BSU. WIRE ,Apr. 03 ,0240 , 210 Hansard, supra eton ,902 ta .34 “I SS diasth e elas ecirp‘i suodist eth eobdnura yof reasonableness when mocp derato tnedecerptrasna snoitccoelpud htiwepom-nark te seitinutroppo ot llesab evo eht reffo”’.ecirp Id. 211 Highfields Capital Establishes Web Site for MONY Shareholders Exercising Appraisal Rights, PR NSWEWERI ,Mar. 13 ,0240 ,htptw//:. 212 nI er YNOMorGup nI .ch'Solde rgitiL ,.853 ta866 . 213 erfsinnI eerPs ,noitatne arpus eton .72 nI aprneseoitatn ot ht e YNOMboadr , ,BFSCht eoB s’draindependent financial advisor, “noted that as of the Board meeting, anyone long ORANs would receive an paorpxima et46 % tiforp fiht emegr re sawocusnmmaetd, compared to a % profit if it was not.” 853 at 671 . 39
after the previous record date to vote) and much litigat ,noi eht YNOM regrem dekaeuqs214through, with % of the outstanding shares voting in favor. In a world in which more than fifty percent of all equities are held by institutional shareholders, such conflicts are pervasive. But, while pervasive, they are not necessarily bad. Index funds, for example, will own shares on both sides of many mergers between public companies. In such cases, their financial interest will be to maximize the value of their portfolios and should approve a merger if it is value enhancing, without regard to the magnitude of the premia paid to shareholders, even if shareholders of individual firms, qua shareholders, might prefer higher premia. Where hedge funds differ, and potentially exacerbate the pervasive conflicts, is that they choose to invest in both sides of a deal and acquire stakes in order to influence the outcome, in contrast to index funds which simply find themselves on both sides. etaroproC wal sah gnol devil ,htiw dnaelotrated, conflicts of interest in voting by shareholders. Hedge funds may be more likely to have such conflicts than traditional institutional investors and may choose to create such conflicts , tub eht stcilfnoc fo egdehfunds pale compared to the conflicts of controlling shareholders in freeze-outs, whose votes will usually be outcome-determinative. And controlling shareholders are entitled to vote their shares in their (conflicted) self-interest, unencumbered by any fiduciary duties 215to minority shareholders. As such, we see little need to impose stricter duties on hedge funds or on voting 216conflicts more generally. tnesbA ytpme ,gnitov ehtffeect of conflicted votes is self-217limiting; conflicted funds are often on both sides fo eht detsetnoc eussi dna rieht setov218thus cancel each other out; the market is often aware ,fo dna nac dnopser ,ot esehtconflicts; all diversified shareholders, including all institutional investors, will often find themselves with similar conflicts; and the board of directors, which does have fiduciary 219duties, can take measures to counteract any dangers. 214 olFyd ,sirroNoHld sreof MO YNppArvo e$15. oilliBn elaSot , TSEMI ,aM y19, 2500 , ta4C on(gnit htta ness]e[“ laitot pparvo lama yhave bene ablock of percent of the shares owned by Deutsche Bank”). 215 reBsha d .vruCW-ssitrihg tCopr ,535 840 (D .le1)789 . 216 We susp tce taht amo er nommocerrucco ecn siht taeh egd sdnufah evmonocei cni stseret taht eradioporpsnoitrate ot ht rievognit ni tseret sa auser tlfo options of other derivatives which have a value that ocrr setalew htiht etsoc krp eciub ton ovnit grihg .st 217 As logn saht enoceom cinirete tsfo ahegd efdnu ocrrdnopse s ta tsaelto ehtovnit gright ,sht ehegd eufdn lliwus reffporpnoitroa yllhtiw othe rhsoheralde srorfm na yvaul ednilce .e 218 eeSslao itceSo n ( noissucfo oc stcilfnni gniKnalyM- megr revot .)e 219 In our working paper, “The Hanging Chads of Corporate Voting,” we address potential responses to empty voting and other conflicted voting in greater detail. 40
.3 E ytpm gnitoV A particularly extreme form of a hedgi detaler-gn tcilfnocraose in the proposed Mylan/King merger. In July 2004, Mylan Laboratories entered into a merger agreement with King Pharmaceutical, according to which, subject to shareholder approval, Mylan would acquire King for Mylan shares. Perry, a hedge fund, was a large shareholder in King (approximately 7 million shares) and supported the merger. While the deal was seen as favorable to King, the market reaction to the merger for Mylan was negative and some large shareholders of Mylan, including Carl Icahn, threatened to vote against it. As 220a result, approval of the merger by Mylan shareholders was in doubt. Perry then acquired % of Mylan’s shares. At the same time, Perry apparently entered into “equity swaps” with Bear Stearns and Goldman Sachs which fully hedged its economic exposure to Mylan’s share price. As a result, Perry acquired shares -- and votes -- in Mylan, which, because it had no economic stake in Mylan, it could vote purely 221 no ehtba sis fo sih tseretni sa aniKg rahs redlohe – dna suht ni rovaf fo Indeed, this was presumably Perry’s purpose. The divergence between the interests of Perry and those of other Mylan shareholders is evident. If the merger is good for King but bad for Mylan, as many Mylan shareholders apparently felt, Perry would still vote its sizeable position in Mylan in favor of the merger and could help push it through. As it happened, King had to restate its earnings, which caused Mylan management to terminate the merger agreement. 222The success, and legal validity, of Perry’s strategy thus was not tested. “Empty voting” is an example of an old problem – conflicts of interests created by exploiting the separation of legal and beneficial ownership – aggravated by modern financial innovation. Perry took advantage of modern financial instruments to acquire .setov Wh ,eli ,yllanoitcnufrreP s’y snoitca raeppa ot eb aform of “vote buying,” legally they do not seem to fall with the existing jurisprudential framework. Indeed, as we argue 220 treboR ,reyetSeN w reyalP snioJ gniK-nalyMFr ,yaTh , Nov. 29, 2004. 221 The issues relating to empty voting are extensively discussed in Shaun Martin & Frank Partnoy, Encumbered Shares, 2005 U. Ill. L. Rev. 77 ,5dna Hern y . &Bernrad kcalB, Empty Voting and Hidd nenwOhsrepi :oxaTon ,ymImplications, and Reforms, (April 2600), U. of saxeTwaL, waL dna nocE hcraeseRaPep r .oN ,07av elbalia taRSS : 222 htOe ,rmo erdartoitina loc stcilfnof in tseretni ovnitg were also present. Icahn had a stake of about 10% in Mylan, both in terms of economic exposure and in terms of voting rights. But Icahn also had a shorted million shares of King stock. Icahn Wins as Mylan-King deal Dies, Newsletter, Mar. 4, 2005. Icahn could thus have an economic interest to oppose the merger, even if ht egrem re erewni hte ni tseret fonalyM, salogn saht emakr tehtuohg tht taht egrem reuowld be ngisnacifi yltmo erbene laicifot gniK . nI th tavene ,tnhacI owuld ga nimo erorfm ade taefof ht emegr rethuorgh hi s trohsopnoitis nigniK naht ehlo ts no tnuocca fo sih gnol noitisop ni .nalyM esoppuSacIh nhsorted the King shares at $30 per share, that the shares would go up to $40 per share if the merger is completed but down to $20 per share if the merger fails. Icahn would then profit from defeating the merger if his profits from shorting are greater than the increase in the value of his Mylan stake from approving the merger. 41
at greater length elsewhere, the existing regulatory structure does not prohibit it. If empty voting turns out to be a significant problem – and it is not clear that it is – new measures will be required, either through regulation or by common law decision making. That said, how exactly the law should be changed, if it shoul d ,eb si a ylhgihcomplex question. This complexity arises from several directions: multiple mechanisms can generate empty votes; current legal rules do not treat these mechanisms equivalently; other problems related to compilation of broker votes interact with the concerns raised by empty voting; and, at present, neither the market, nor companies, nor regulators have the information necessary to determine the presence and extent of empty voting schemes. The development of a proper response is made even more complicated by the fact that companies and investors have an interest in determining the outcome of a vote speedily. Thus, any more intrusive legal regime that involves protracted litigation generates special problems in the context of voting rules. Moreover, it is unclear to what extent market responses (such as the increasing costliness fo gnigdeh seigetarts dnuoracritical votes) temper empty voting. We address these issues in a companion paper in which we examine the extent to which the existing technology and regulation of voting is sufficient given the pressures imposed by current activity. For the purposes of this Article, we agree with Henry Hu and Bernie Black that not e hguon si nwonk tuoba ehtextent of empty voting to prescribe anything more than possibly an increase in disclosure 223of schemes generating empty votes. B. Stress Fractures With billions of dollars available, and super high powered incentive compensation structures, hedge funds put stress on the existing governance structures. In doing so, they highlight and exacerbate existing structural weaknesses, albeit not necessarily in a manner that generates a conflict of interest with other shareholders. nI siht ,noitceSew address two such potential weaknesses: undisclosed conc detre noitca 1. Undisclosed ConcertedAction In many of the battles between managers and hedge funds described earlier, the shareholder base of companies can change almost overnight with hedge funds collectively sometimes ending up with more than 50% of the shares. Managers and their counsel have speculated that hedge funds act in concert, both in the acquisition of their shares and in the subsequent pressuring of management, without gnilif eht deriuqerdisclosure statements under Section 13(d) of the Securities Exchange Act. Indeed, say some, there is a pervasive problem of section 13(d) underenforcement by the SEC. We do not know whether this is true or not. If there is, in fact, a problem of underreporting, it presents an interesting parallel with the 1980s. During that period in which hostile tender offers assumed prominence, management complained that hostile 223 uH &kcalB ,usrp aon et122 . 42
bidders and their allies operated behind the scenes to the disadvantage of shareholders and companies. Now, again, one hears complaints that it is hedge funds (some run by the same raiders who managers complained about ni eht )s0891 tahtrae operating behind the scenes. But there is an important difference between non-disclosure by raiders in the 1980s and any non-disclosure by activist hedge funds today. The acquisition of a 5% stake by a raider was highly material, market-moving information. By delaying a 13(d) filing, raiders and their allies would be able to acquire additional shares at a substantially lower price. By contrast, hedge fund activ msi sah hcum ssel fo na etaidemmi tekramimpact. Moreover, hedge fund corporate governance activities, in any event, are usually conducted publicly , with hedge funds issuing sserp sesaeler gnol erofeb yeht hcaer eht evif tnecrep gnilif dlohserhtunder Section 13(d). Finally , egdeh sdnuf ekilnu( tsomraiders) must disclose their equity holdings quarterly under Section 13(f). Thus, while hedge funds, like all other investors, ought to comply with 13(d), one wonders what all the fuss about a failure to disclose is about. oT eb ,erus a )d(31 gnilifcan yield information that dluow esiwrehto tonmocebe public. Specifically, a 13(d) filing could reveal the presence of a conflict of interest, such 224as an empty voting scheme. Indeed, it was this 13(d) remeriuqe tn tahtfo decr yrreP otreveal its hedging positions in the Mylan King battle. Where such conflicts exist, and would have to be disclosed in a 13(d) filing, a failure to make the filing constitutes a serious problem. But it does not appear that such c stcilfno era .nommoc In addition, most poison pills incorporate the 13(d) concept of a group into the pill trigger. Thus, it may sometimes be the case taht na desolcsidnu noitamrof fo a ”puorg“would trigger the pill – to the serious harm of the participating hedge funds and, one 225assumes, to the delight of management and their lawyers. In that case, however, management is in a good position to respond: it can argue that the hedge funds have formed a group, declare the pill triggered, dilute down the members of the alleged group, and wait to be sued. Given the incentives rofmamegane tn ot eusrup hcus ,sesac sihtseod not seem to be area to which the SEC need devote its limited enforcement resources. The key issue here thus seems to us not a failure of the SEC to bring enforcement actions but the vagueness of the concept of “group” underlying section 13(d) and the nosiop .llip eluR 5-d31edivorp s taht nehw“ owt romo erep snosr eerga ot tca rehtegotfor the purpose of acquiring, holding, voting or disposing of equity securities of an issuer, 226the group formed thereby shall be deemed to have acquired bene laicif”.pihsrenwo 224 Section 13(d) requires the disclosure of any contracts and other arrangements in which hedge fund dispose of their economic interests. uceSri seitxEhcna egAc,t oitceSn 31d(1()().)E uB toitcesn 13d( )doe snot have a per se requirement to disclose conflicts of interest. 225 hP sillyhctilP, sreywaL eeSoN oP nosi lliP otdeeF gdeH euFdn oW‘l fkcaP ,’sproC etarovoGenrna ,ecD .ce12 ,0250 , ta4. 226 Rule 13d-5(b)(1). 43
Section 13(d)’s reporting obligations are thus triggered by concerted conduct, but not by lellarap .noitca ehT tcaf taht a yteirav fo egdeh sdnuf dworcinto the shares of a company at the same time does not per se establish the formation of a group any more than the mere fact that competing manufacturers raise their prices at the same time can establish a price fixing agreement in violation of the Sherman Act. Proving that parallel conduct is concerted action is difficult, both in the antitrust and in the 13(d) context. oT taht ,tnetxe egdeh dnufmsivitca ma yraise a somewhat novel problem. Up to recently, the issue of unaffiliated parties acting in parallel to influence a public company – and the accompanying evidentiary ambiguity as to whether a group has been formed --has not arisen that often. Rather than bring more enforcement actions, the SEC may want to provide regulatory clarification of when a group is formed. .2 O gnitovrev The current voting technology is seriously flawed. Some argue that it is so flawed that, in any reasonably close corporate vote – the number of which are increasing with increasing hedge fund involvement – it would be impossible to prove which side has prevailed. Since 1973, to avoid the overwhelming record gnipeekmelborps of paper shares, companies use a book entry system, with share certificates held by the Depositary Trust and Clearing Corporation (DTCC). Individual brokerage houses each have accounts with DTCC in which, under the standard arrangements between customers and their brokerage firms, holdings of customers are commingled in a single, fungible mass. DTCC’s records simply indicate that Merrill Lynch, for example, has 20,000 shares of Firm X, without indicating how many shares specific customers of Merrill hold. As Merrill Lynch’s customers buy and sell, Merrill’s net holdi sgn lliw ,egnahc tub ti si s’llirreMresponsibility to keep track of its customers’ holdings. When it comes time for the shareholders of X Corp. to vote, the company will typically retain a firm, usually ADP, to handle the distribution of proxy materials, the 227solicitation of proxies, and the tabulation of the votes. ADP receives a listing of holdings by brokerage house from DTCC and a list of customers’ accounts from the participant firms. It will then send out proxy materials, including proxy cards indicating the number of shares in a customers account, to all those who appear on brokers’ lists. Customers will fill out their cards, return them to ADP, with the results then passed on to the firm. This system breaks down when there is si tnacifing trohs ,gnilles sa si netfo ehtcase when hedge funds are involved. Consid re tahw sneppah nehwmose eno ”strohs“ a 227 pyTi ,yllacmrifs lliw niater PDAvnIetsor oCmmuniacoit sn secivreS hcihwmialcs a %59ma 44
228stock. In a short sale, a brokerage house typically arranges for a short seller to acquire serahs morf a naidotsuc knab hcihw sdloh serahs ni( aignuf elbma )ss rof sti laidotsucclients (such as mutual funds, pension funds and insurance companies), subject to an 229obligation to return a share at some later date. The short seller will then sell the shares to some third party, who will take full title and be entirely oblivious to the source of the shares. Because a short sale involves an actual transfer of shares, it creates substantial difficulties in determining who has a right to vote shares, principally because tracing is 230not possible, and record keeping and communication is incomplete. esoppuS taht llirreM sah 000,02 serahs fo X ni sti CCTDaccount, while Goldman has 30,000 shares in sti .tnuocca A egdeh dnuf FH“borrows” 5,000 shares from Merrill and, to go short, sells them to a customer of Goldman. Once that sale is completed, DTCC records will show that Merrill has 15,000 shares of X while Goldman has 35,000 shares. The problem is now clear: DTCC’s omnibus yxorp lliw refsnartthe right to vote 15,000 shares to Merrill, and inform ADP of this. But Merrill will give ADP a list of all its customers’ holdings in Firm X for a total of 20,000 shares. ADP will then send out proxy materials according to the brokers’ customer lists, with the result that it will send out proxy cards for more shares than are in fact entitled to vote. In this example, although Merrill and Goldman collectiv yle ylno dloh 000,05 ,serahsht rie sremotsuc lliw eviecerproxy cards representing 55,000 shares. Because the shorted shares are often not attributed to specific customer accounts, it is unclear which customers are entitled to vote. If fewer than 000,51 llirreM serahsare voted, this problem is shoved under the elbat yb gnidneterp taht ehteM llirrmotsuc sre ohw denruterproxies were all entitled to vote and some of those who did not return proxi se wohyna erew tontneitled to vote. But if more proxies for more shares are returned than are entitled to vote – because the level of short-selling was high and the abstention etar saw wol – ti si raelcnu tahw dluohseb done. There are several possible effects of this system for collecting votes. First, it may mean that some people who are shareholders are unable to vote their shares. Second, it may mean that others who may not in fact own any shares (because they lend them out) will nonetheless be able to vote. Finally, it may result in a situation in which there is no rewsna ot eht noitseuq fowho is entitled to vote. ehT AXA/YNOM ,laed dessucsid ,evoba sian example of a contested transaction that illustrates these problems. The cont laisrevor tuoyubwa s devorppa yb ama nigr fo 228 For an excellent account, eeseboR tr .C ,lefpA nhoJ .EsraPons, G. William Schwert & Geoffrey S. ,trawetShS tro ,selaSmaDage snad ssalCoitacifitreCn ni b015- oitcAns ,kroW gnipaPe ruJ yl0210, elbaliavamorf .NRSS 229 Christopher C. Geczy, David K. Musto & Adam Reed, Stocks are Special Too: An analysis of the equity neldign markte ,66 .JiFn. nocE .42 102(02) . 230 ereH ewof wollht exenellect diucsnoiss in Apfel et al., supra note 228. 45
million votes out of a total of million shares at a time when somewhere around million shares had been shorted. 232 Though the overvoting problem has been noted for a long time, it is becoming erom etuca won esuaceb egdeh sdnufsivitcam makes close votes more likely and hedge sdnuf egagne ni trohs gnilles ta ehtmit efo votes. We discuss the problem in greater detail, and examine possible solutions, in a separate paper. C. The Absence (So Far) Of a Third Conflict: Paying Hedge Funds Off It is worth noting that we have not found any evidence for the existence of a third potential conflict between hedge funds and ot reh :srotsevni egdeh sdnuf dnamaan sregmaking a side deal in which the firm pays the hedge fund to go away, such as greenmail. We are not aware of a single instance of hedge funds receiving greenmail, one of the 1980’s classic instances of “dark side” behavior. The absence of greenmail is interesting in its own right. One possible explanation is that greenmail got such a bad name during the 1980s that hedge funds are too embarrassed to touch it, or perhaps more plausibly that boards are too embarrassed to offer it. Alternatively, the absence of greenmail or similar devices may reflect the fact that there are so many hedge funds around that greenmail or similar devices will not provide firms with yna noitcetorp dnama y llew ticile nevegreater interest. Or finally, accepting greenmail may not be in the long-term interest of activist hedge funds because it would undermine their credibility and their ability to obtain the support of other investors (which they may need to succeed in their activism) the next time around. IV. Pervasive Short Termism? Although many of the “dark side” problems identified in Part III have generated comment and controversy, the sharpest and most comprehensive criticism of hedge fund activism is that they exacerbate an already serious problem of “short termism” in the executive suite. In this Part, we take that criticism seriously. 231 Bob Drummond, Corporate Voting Charade, oolBmbreg raMk ,stepAr li2600 , ta69 . 232 A9119 oH esupero trnemmocerded ht taht e CESprmoulga eta ur elot hadn elth siutisoitan, na ,dps ,yllacifice aur elht tahorpib stibroke srnad d srelaeorf“m osicilnitg prxo yvognit niurtsoitc sn morfor giving proxies at the direction of beneficial owners for more shares than the net amount owned beneficially by each beneficial owner, as shown on the books and records of the broker or dealer, after subtracting the hs tro ytirucesposnoitis of hcae bene laicifowne ”.rhS“onilleS-trg itcA ytivni ht eotSck kraM :tekraM te stceffEdna ehtdeeN of rgeRulnoita, ” traP ,IeRpor t foht eoCeettimm on voGenrment pOnoitares , . of Representatives, Dec. 6, 1991, at 33. More recently, the New York Stock Exchange has also dinedeifit th si sa aprbomel and sikrowgni on aosulnoit. eeS ESYNofnImroitan eMom oN .405-8 oN(v . ,52004) (“Several recent special examinations of member organizations’ proxy departments have discovered significant areas of concern involving an apparent systemic over-voting of proxies and a general lack of vitceffe epusevrnoisi. )” 46
A. A RealProblem? 233 egdeH sdnufmoce esolc ot gnieb ehtarchetypical short-term investor. For mose ,sdnuf gnidloh serahs rof a lluf yaderpresents a “long term” investment. Short-termism may thus pervade much that he egd sdnuf ,od gnidulcni rieht etaroprocgovernance and control activism. Leading opponents of hedge fund activism, such a Martin Lipton, argue that hedge fund short-termism could cause managers not to make 234crucial long-term investments. dnA eht namreG ecnanifmi yrtsin tes pu a lenap otassess the impact and consider regulations of “short-term profit oriented foreign 235investors.” One’s views about whether hedge fund activism, on eht ,elohw si elbarised236or undesirable are likely to turn on one’s stand on the short-termism problem. Looking at the specific activities of hedge funds, there is often an inherent ambiguity as to whether they sacrifice valuable long-term projects in favor of short term .sniag redisnoC ehcstueD s’esreoB)BD( failed attempt to acquire the London Stock ,egnahcxE dessucsid .reilrae s’BD OECtnawed to acquire the LSE and convinced the draob taht gniod os saw a doog .aedi egdeHf sdnu ohw dah deriuqcaal egr sekats ni BDdisagreed. They maintained that the plan to acquire the LSE represented wasteful managerial empire building and that DB’s cash hoard should daetsni eb detubirtsid otshareholders. Now, if the investment in acquiring the LSE was a valuable long-term ,tcejorp neht ehtmevlovninet of the hedge funds had the effect of pushing the company 233 atiRgaaR sa eDmaRo ,snoCcnres vO regdeH enuFd s esiR sakraM teoVlatilit y sesiRolGba ,yll llaWtS . ,.JnuJe 31 ,002 ,6 taC5 (nonit ght tahedge ufdn smake up 40 % ot05 % fovarega e ylyadrtdain govlu emni major financial markets. 234 eeSnilttaB g rofCopr etaromA acire -oherahSlde rdemo ,ycarchT eocEnom ,tsihcraM 11 ,2600 .( dEoiti ,)n ta ;96nitraM piLtno ,kcattA yBvitcA tsigdeH euFdn ,s hcraM7, evEn fi yeht erash-troterm oriented, hedge funds’ short term strategies may perform valuable functions. For example, when hedge funds are playing their traditional role of arbitraging market inefficiencies, their pursuit of short-term prof ti lliwbe one of th emhcenamsis ht tapleh s otbr gniht emakr tepr ecini otgilanmne ttiwh ht evaul eof the firm. Thus, for example, when prices are too high because of excessive optimism, hedge funds can be expected to short the stock thereb y gnittupmose yrassecendownward pressure on the price. Moreover, even if the interests of short-term and long-term investors may occasionally conflict, their interests will ofnet ocindice . oT ht taxe ,tnethegd enufds ,by htrufegnir ht rienwo ohsrmret-t ni ,stseret lliwosla betifen long-term shareholders. 235 eHegd sdnuF ecaFEuepor s’sreppilC ,suarp eton ,32 ta .5C 236 erehT si osaf relttil emciripa lveidence on the effect of activism on company value. A recent study by gitiCorpu look s taht emip tca fohegd euf dnvitcamsi on ht etsoc k ecirpof gratte ocmpna seidaujdets rofkram te .snruter gitiCuorp ,deHge dnuF s taht e ,etaGpeS. 22 ,2500 . hT eutsdy vniolve s amsa llasmpel , ontnoc ,slor dna on lacitsitats .sisylana tI swohs tahtgrat tefo hegd efdnu svitcasim eirepxen ecab evoavegare uternr s retfath ennanuomecen t foht evitcaism, but htta these returns evaporate in the two months following ht eonnanunemec thwne ht evitcasim sinot A&Mdetaler. The study, however, also shows that stock price fomsivitca ratg steeptuomrofrs ehtma stekr ni eht owttnom shrpeceding the announcement of the hedge dnuf vitcasim. oT ht exenett ht taht sini esaerc siabirttut elbaot ht emakr tenapicitnitag ht sinnanuonemec tor to price pressure from hedge fund purchases, ev nenon A&M-detaler vitcasim siossadetaic htiw bavo eaverage returns during the study period. Given the design of the study, it obviously does not address the ussi eof hwrehte hegd efdnu sarggav etamret-trohssim. 47
towards the lower value outcome, an outcome worse for long-term shareholders than acquiring the LSE. If the hedge funds were right that the investment was simply a bad investment driven by delusions of grandeur, their opposition benefited both short-term 237and long-term shareholders. For the short-term trading horizon of hedge funds to generate a short-term investment outlook for hedge fund managers, the stock market must suffer from “myopia:” that is, it must undervalue long-term investments relative to short-term investments. If the market does not itself suffer from such a bias, then the interests of srotsevni htiwmret-trohs gnidart snozirohiw ll ton tcilfnoc htiwsoht e fo srotsevni htiwlong-term trading horizons. In the case of the DB’s attempt to acquire LSE, for example, a tcilfnoc neewteb egdeh sdnufwith short-term trading horizo sn dna rehtoi srotsevn htiwlong-term horizon would exists only if the market myopically fails to incorporate the long-term benefits of acquiring LSE into the stock price of DB. Whether and under what circumstances the market suffers from myopia has been the subject of substantial analysis and debate. Many managers, directors, private equity funds, investment bankers and others involved in the management and sale of companies are convinced that the market is myopic. Others believe that the short-term/long-term 238distinction is a foil for managerial failure to deliver results. Academics have developed theoretical models showing that market myopia can result in a number of 239circumstances. Much of the current research in finance starts from the assumption that 237 hT sina sisylani yleculli setartsht edi tnereff syaw nihwhci hegd euf dnniovvlmene ,thw ne tiorc sessa lacitirc ,dlohserht nactceffa shareholders. Were hedge funds only to hold a small percentage of either DB or LSE, and the market overvalues the value of the transaction to the companies, yeht dluoc tebtsniaga ehtDB bid for LSE by shorting DB stock. If they could be short for a long enough time, they would make mone y fi tiutnr deuo tht ta yeht erewhgir tht taht si sawmepi erbudli ;gniht yeuowl d esolmone y fi titunr deout th taht si sawvaul ehneanicng. hW ,eliin ht e BD ,esacht ehegd ednuf s erewkil ylehgir ,tht ere eraothe r sesac nicihw h yeht teb tsniaga amocp xel ygetarts dnalo .tsTh eeraelcs t esacmees s ot ebLamp tre dnaKmart and Sears. When Lampert acquired control of Km ,traht eotsck sawhvae ylidetrohs. uB tnihtiw a year, the stock had gone from $15 per share to $108 per share. Had those with the short view held a ocntorgnill posoitin, ht yema yhave blocke dth egetartsy ,to hsoheralde ’srirtedmne .t 238 eeSrraB ynesoRsniet ,Acvitism siGodo fo rA llhSraohelreds ,niF. miTes, raM. 01 ,6002 . 239 ,eeS . drahciRmortslhiK & leahciMWa ,rethc“Why Defer to Managers: A Strong Form Efficiency oMde ”,l (wkroign paper 6002); reJemy etSin, kaTeover hTr staedna naMageri laoyMp ,ai96 .JoP .locEn. 61 (1988) (presenting model of myopia under asymmetric information); Jeremy Stein, Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate behavior, 104 Quart. J. Econ. 655 (1989); dnAr iehS refiel &Robe trhsiVny ,uqEbiliirmu hSor tmreT noziroHs of vnIe srotsna dmriF ,s80 mA .ocEn .veR. 841 1(099); eesosla uLnaic kuhcbeB &raLs tSol ,eDo ohSr mreT-tnaMageri laObjvitce sedaeL otunder- or vo-reivnmtsene tni noLg-Trem prjostce? ,84 .JniF. 17 91()399 (mode lwh ereohsr-tretm fosuc leads to overinvestment in long-term projects). 48
240capital markets are not perfectly efficient. But the empirical evidence on the extent 241and magnitude of myopia is sketchy at best. Arguably, the phenomenal growth of private equity funds, whose basic business model includes taking companies private so that they can be reconfigured away from the short term pressures on public companies, indicates that there may well be a serious problem of myopia. KKR, Blackstone, Carlyle, Apollo and TPG have all raised, or are 242currently raising, new funds in excess of $10 billion. But then again, the business model of private equity funds also includes providing high-pow dere sevitnecni otmanagers and monitoring them closely. Whether private equity a dn tsivitca egdehsdnuf pursue complementary strategies for maximizing firm value (with both targeting managerial agency costs in a different fashion), whether they are competitors in the same markets (as private equity funds open hedge sdnuf dna egdeh sdnuf ekatmocp seina 240 For ashor tsuvrey, se eciMhea lWachret, Takevore waLhw neniFanc laikraM ste eranO(l )yvitaleR yleEfficient ,151 U. Pa. L. Rev. 787 (2003). 241 oSme of ht eutsdi seofuc son th e tceffeof utitsniitonal nive ,srotshwhci have bene ugrade ot ha eva shorter-term trading horizon that other investors, on managerial myopia. See, ., Brian Buschee, The ulfnIen ecof nIutitsoitna lvnIe srotsno Myopi c D&RnIvemtsent eBhavior ,73 .tccAveR. 503 1(899 )niutitsoitns nege yllaruder ecoympi cpr ,erusseub tniutitsoitns htiw high tuonrve rht tagneage ni momentum dartgni neuocrga emyopi ;)anuS liWaha l &hoJn .JoCCMnn ,lle ODnIutitsnoita lnIveotsr sxEbrecaa etnaMage lairoyMpia? , .6 .JoCpr .niF. 207 002( )0c(ulcnodi gnht taneserp ecof inutitsoitna lvnieotsr ,sregardless of investmern style, permits companies to invest more in long-term projects); M. Bange & W. DednoB ,tD&R gduB stedna proCro etaraEnin sggrat ,ste4 .JCopr .niF. 351 991()8 (l sseninraegs namagement of r D&Rhwne niutitsoitns own highe rkats ;)se uSm ti .KMajumdra &unArhdaa gaNajaran, hT enoLgmreT- neirOtoitan of nIutitsoitnal vnIetsor :snA mEpi lacirbOvresnoita if(nding ht taniutitstunois pr refeot vnie tsni mrifs tiwh olmret-gn orneitoitan) (7991) hT[e Impa tcof hCgnai gnotSck nwOhsre pinrettaP sni th enUdeti :setatShToe laciterpmIoitacilns and Some Evidence, Revue D'Economie Industrielle, 82 ,4, 395- ].4 htOe rduts seiofuc sno ht e tceffe foht eht taerof ht eoh elitskateove ,srhwhci piLtno nad others have suggested generates undesirable short-termism, on R&D expenses and similar measures of olgnmret- nivetsment .s hW elione duts yuofnd ht ,tanocsisnett htiw ht ehsmret-trosim hopyht ,siseR& Dexpenses increase after the enactment of anti-takeover legislation, two other studies found that R&D senilcedetfa r eht noitpodafo nakat-itevo eeSMu kceorble te ,.la krahSeRstnallep na dManagerial Myopia: An Empirical test, 98 J. Pol. Econ. 1108 (1990) (finding that R&D expenses decline retfapodaoit nof nakat-itevo reproviison ;)kraM nhoJnos &maRehs oaP, hT emIp tcaof nAkatiteover Amendments on Corporate Financial Performance, 32 niF. veR. 956 1(799 )(smae); but see Pugh et al., etatSnAkatiteove rgeLioitalsn nad hSheraolde r ,htlaeW13 .J .niF .seR221 991( )0if(nding th tahtye increase). Yet others look at other aspects of myopia. See, ., Anup Agrawal & Jeffrey F. Jaffe, The Post-Merger Performance Puzzle (rejecting EPS myopia as explanation for negative long-run stock returns after mergers); Federico Ballardini, Do stock Markets Value Inovation? A Meta-Analysis (finding that the market values $1 invested in R&D more than $1 invedets in gnatbi el ;)stessa giarC .WloHd ne & dranoeLLundstrum, Costly Trading, Managerial Myopia, and Long-Term Investment (finding that introduction of long-term options (LEAPS) is associated with incresae nimret-gnol mtsevnie )stn ieM gnehC te ,.lainraEn sg ecnadiuG dnaanaM lairegyMopia (finding that firms dedicated to giving earnings guidance enage in more myopic R7d investments); Jeffrey S. Abarbanell & Victor Bernanrd, Is the US Stock Market Myopic? (concluding that stock prices do not generally exhibit myopic behavior) . 242 Peter Smith, Texas Pacific raises record $14bn for wen ufdn ,niFanc laiiTme sApr li3, 0260 (TGP has desiar mo erhtna 1$nb4 of r tsetalufdn ;kcalBotsne iarsde ta tsael$13nb5. of r sti tsetalufdn ;opA ollManagement recently raised over $10bn and KKR is doing os .oot eroM naht052$bn is estimated to have neebesiard ybirpv etauqe ytiufdn sin 0250 .) 49
,)etavirp ro rehtehw egdehfunds aggravate market imperfections and thus drive firms into the arms of private equity remains unclear. Short-termism thus presents the potentially most important, most controversial, most ambiguous, and most complex problem a detaicoss htiw egdeh dnufmsivitca. ehTother dark side problems represent relatively isolated and narrow c snrecno taht od tonmuch relate to hedge fund actmsivi sa a .elohwmret-trohSsi ,m yb ,tsartnoc ylbaugrapervades hedge fund activism and the accusation that hedge funds induce managerial short-termism has become the main line of attack for hedge fund critics. At the same time, the very existence of a short-termism problem is least proven; its manifestations, if it does exist, are most manifold; and potential solutions are least evident. B. Potential Responses? Let us assume that hedge fund managers tend to prefer that companies engage in projects with short-term payoffs even if there are projects with longer term payoffs that are more valuable. Should the wal enevretni ,dna fi ,os ?woh The answer to this question depends on a number fo .srotcaf iFrst, even if hedge funds have short-term biases, to wh ta tnetxe siehdge funds activism driven by evissecxeshort-termism? Activist hedge funds are agents of change with specific goals that depend on the particular company. When the company is diversified, hedge funds often push for divestitures. When it is underperforming, they often push for the sale of the company or a change in management. When the company has excess cash on hand, they push for stock repurchases or dividends. When the company has assets on its balance sheet that can be monetized (., real estate), they push to monetize esoht .stessa nehWmocp seinaare pursuing capital intensive investment plans, hedge funds sometimes oppose the plans and push for the cash to be returned to shareholders. In the control area, hedge funds sometimes make bids, sometimes oppose deals on the acquirer side (but sometimes try to push for deals), and often try to get better terms for the target. Is it always the case, when a egdeh dnuf steg ,devlovnitaht it is pushing for business st seigetarw hti a mret-trohspay-off over strategies with a more valuable long-term pay-off? Or is the short-term payoff preferred by hedge funds sometimes the more valuable one? And how often is hedge-fund activism motivated by altogether di tnereff ,snrecnoc hcus a dabmaegan ,tnem243an ill-advised strategy, or an insufficient price in an acquisition? Is the controversy really about different investment horizons or does it instead reflect a substantive dispute over the appropriate course of action for the firm? Second, how long is the horizon of managers? A plausible story can be told that it is managers, and not (just) markets, whic h reffus eseht syadmorf myopia. Many CEOs are close to retirement age and, even among younger CEOs, turnover is high. Executive stock options continually vest and are exercised or hedged, if only to diversify their 243 See, ., Janet Adamy, Investor Peltz urges Heinz to Shed More Lines, Pare Payments, Wall St. J., May 24, 2006 (hedge funds asking company, among other things, to shed line of Italian baby food and use new forms of marketing to increase ketchup consumption). 50
.oiloftrop sesunoB era netfo desab no-trohsterm performance goals. Is it sometimes management’s failure to invest in valuable long-term projects that created the opening for hedge fund activism? Third, when and to what extent do hedge funds succeed in affecting corporate policy? Though hedge funds have become highly active in the corporate governance area, they have generally not become powerful enough to exercise control over the targets of 244their activism. Rather, they purchase a sizeable but far from controlling stake – rarely 245more than 5% to 10% -- and then seek to influence corporate strategies. nevEhwne hedge funds commence a proxy contest, they usually seek only minority representation on the board. Activist hedge funds often have a chair at the metaphorical table where corporate strategy is set: an opportunity to have their views heard and paid attention to. 246But in order to see their views prevail, he egd sdnuf yllausu deenthe support of others -247 - hcihw tonnac eb nekat These others include, ni ,ralucitrap etaroprocmanagement, independent directors, traditional institutional investors with large stakes, and other large shareholders. To the extent that the largest shareholders are effectively indexers, a strategy that results in a short term increase in share prices (that benefits hedge funds) but a long term loss (that hurts long term shareholders) will not be attractive. More generally, over time, the degree of support that hedge funds receive will likely depend on whether long term shareholders benefit. Fourth, if the determination of corporate policy once hedge funds are involved depends on multiple constituents, how do these constituents interact? At present, it seems that hedge funds often act as a counterweight to the substantial power of management, with the consequence that the effective power is partly shifted to other ,spuorg hcus sa tnednepedni srotcerid dnaidarttional institutional investors. Independent directors and large shareholders, of course, may sometimes make mistakes, but management is not infallible either. We are inclined to be optimistic about the resulting interaction, which often results in a compromise rather th na thgirtuo yrotciv rof egdeh248funds or management. But another possibility – though one that we have so far not 244 eeSherahSol redvitcAmsi ni ht e A&MContxe ,tpusr a eton 421“( nI regralartn snoitcas eht[su ssecc fohegd eufdn sin blockign ad ]lae lliwnetfo uqer erihtta ht evitca ’stsiopoitis nbe usoppdetr by moer dartoitina linutitsoitna linvetsor sdna )”.SSI 245 eeSpusr aoitceSn ;. eesosla hP sillyhctilP, aL sreyw eeSoN oPnosi lliPot deeF deHge dnuF floW‘Packs’, Corporate Governance, Dec. 21, 2005, at 4 (h egde sdnuf yllacipyt“ eriuqcaa ekats fo sselth na10%”). Even when several hedge funds become active in a specific portfolio company, they generally do tonco lortn .ti eeSsu arpitceSo n . 246 See Rosenstein, supra note 238 (characterizing hedge fund activism as a “campaign between hedge fdnu sna dmanagers of rht epusrop tfo ht emoCpna’y srtue woners , stihsheraolders)” 247 eeSniFa laicnnIutitsnoits veDepolmne ,sthcaW ,lletpiLton ,oRnes & ,ztaKbeF. 22 ,2600 ta4 n(nito g sseccus yb emosmrif niidausrep gn egralni lanoitutitsloherahs sred ot troppusaob .)dr 248 Attacks of the Hungry Hedge Funds, supra note 156 (noting that “there is scope for the warring parties ot ifnd amuut yllabene laicifoserulnoit. )” 51
dessentiw – si taht egdehfunds will enter an unholy alliance, either by being bought off by management through the payment of greenmail or its functional equivalent or by teaming up with other large shareholders to advance their respective parochial interests to the detriment of shareholders at large. Given these questions, a sufficient case for legal intervention has not been made. Our conclusion partly results from the uncertainties, about whether short-termism is a real problem, about the nature of the problem, about how much it affects hedge fund activism, and about how hedge fund activism relates to potential managerial short-termism. It partly results from our observations that, at present, he egd sdnuf ecneulfni tub od ton lortnoc etaroproc ,ycilop taht yeht dneped no ehtus tropp fo rehto ,sredloherahsand that they have shied away from extracting greenmail and other similar unsavory tactics. But our conclusion rests to a large extent no ruo ,weiv hcihw ew evah depoleved249elsewhere, that companies (and the market more generally) will take what we have called “adaptive devices” to deal with the potential negative effects of hedge fund short-termism. To see the shape of some of these devices, one need look no further than the “Hedge Fund Attack Response Checklist” mailed by Martin Lipton to the clients of his mrif . nI siht ylediw detalucricme ,omiL notpmmocersdne tahtmocp seina eraperp niadvance for hedge fund activism by: periodic updates of the board fo ;srotcerid weiver fodividend policy; improved financial public relations; consistency in one’s strategic message; proactively addressing reasons for yna llaftrohs ni reepmocp ynamhcnebar ;skregular, close contact with major institutional investors; a review of basic strategy with 250the board; and so on. These are terrific ideas, not just to deal with act tsivi egdeh ,sdnufbut in general. If companies follow Lipton’s advice, hedge funds will already have made significant positive contributions to the management of . companies. Moreover, if hedge funds can succeed despite companies taking these measures, we think that chances are reasonably high that they have a good point. One adaptive device missing from Lipton’s list – but one which merits particular attention – is private equity. Vast sums are now available to take companies private, sums largely provided by the same (allegedly myopic) institutional investors who hold eht serahs fo cilbup seinapmoc -- dnatsevni ni egdeh .sdnuf dnA sa ew evah detonabove, private equity can be an escape mechanism for companies that suffer from 249 lecraMhaKan &dE draw .BoRkc ,oH w InraeLe d otpotS gniyrroW na doLve eht :lliPdApavit epseRno sesot kaTevore waL, 69 .UIHC. .LVER. 78 102(02) . 250 Martin Lipton, Attacks by Activist Hedge Funds, Wachtell, Lipton, Rosen & Katz, Mar. 7, 2006. See osla gdeH enuFd dna nIutitstiona lhSoheralde rvitcAmsi 7, reyaM nworBewoR & ,waM lirpA ,120026 (recommending that companies review their dividend policies, proactively address reason for any shortfall ni peofrmrna ,ecdna maniiatn olcs eocnt tcahtiw majo rniveotsr ;)shSoheralde rsivitcAm ni ht eM& AContext, supra note 124 (recommending that companies in M&A context be proactive in explaining the reasons for and the benefits of a trsna ,noitcasneu er taht eht s’draobposition be accurately understood, and engage and early and open communication with significant stockholders).. 52
251excessive short-term pressures in the public market. fI ti si deedni egdeh sdnuf tahtcontribute substantially to such short-term pressures, it is no small irony that hedge funds and traditional private equity funds are nowadays converging. In an increasing number of high-profile deals, hedge funds have taken on the type of long-term control investing that 252has previously been the exclusive domain of private equity funds. fI egdeh sdnuf erapart of the problem because their activism exacerbates short-termism, they may be also part of the solution, as they develop private ytiuqe .esitrepxe hTis by itself shows how multi-faceted hedge funds are as an investment vehicle, and should caution against gnitpoda ytsah .noitaluger Conclusion We are observing an evolutionary process in real time. Hedge funds -- highly incentivized, mostly unconflicted, and largely unencumbered by regulatory constraints -- have become the prime corporate governance and control activists. yehT eusrup msivitcaas a profit-making strategy, make investments in order to become activist, rather than as an afterthought to a failed portfolio investment, and thus blur the line between risk arbitrage and governance and control battles. The emergence of, and the role played by, hedge funds proves that there is money to be made from being an active shareholder. One of the most intriguing developments we are starting to observe is the division fo robal neewteb eht egdeh sdnuf dna ehtomre traditional institutional investors. Because hedge funds are typically relatively undiversified, they show little interest in agitating for systemic changes such as anti-poi nos llip ro dereggatsboard campaigns. On eht rehto ,dnah egdeh sdnuf – ylhgih dezivitnecni dna tcejbus ot wef stcilfnoc fo stseretni-- engage in firm specific agitation to a degree unheard of among traditional institutional investors, with traditional institutions sometimes tagging along. As one traditional institution said, in connection with the battle to stop Deutsche Boerse’s attempt to acquire the London Stock Exchange, “The hedge funds have done a marvelous job. No matter how we feel about companies, traditional managers simply cannot move as fast to achieve our aims. We were right dniheb eht( egdeh ,)sdnuftub ew'ndluoc t evah enod ti253 tuohtiw”.meht But there is also a laitnetop edisnwod ot .msivitca ehTeretni sts fo egdehsdnuf sometimes diverge from those of their fellow shareholders and activism creates stress fractures for the regulatory system. The most serious accusation leveled against activist funds, however, is that activism is designed to achieve a short-term payoff at the expense 251 eeSgdeH enuFd dna nIutitsoitna lnIvetsor vitcAmsi n(onit ght tapriv etaqeu ytinufds eraolkogni to kate private targets of shareholder activism). 252 See Woodrow W. Campbell & Jennifer A. Spiegel, Hybrid Vehicles, The Deal, June 18, 2005; Innisfree neserPoitatn, us arpon et72 . 253 Louise Armitstead, Saved by the growing power of hedge funds, Sunday Times (London), March 13, 2500 . 53
of long-term profitability. It is here where the challenge for boards, traditional institutional investors, and the market as a whole lies. If the proposals made by hedge funds are sometimes valuable and sometimes misguided, how good are we in figuring out hcihw siwh?hci Wh eli ew od toneterp dn ot wonk eht rewsnaot this question, we believe that market forces and adaptive devices taken by companies individually in response to activism are better designed to help separate good ideas from bad ones than additional regulation. egdeH sdnuf era ereh ot .yats yehTrae prominent in control transactions and elsewhere. Their influence is being felt. But the future is uncertain. As hedge funds grow, will they retain their separate identity (and get stronger) or will (some of them) morph into high-fee mutual funds? Will activist investment opportunities for hedge funds dry up as more money chases these opportunities, or will more hedge funds become activist in response to the profits to be earned? If smart hedge fund investors keep hedge fund managers honest, will expansion of investor base reduce the monitoring of hedge fund managers and make them less good agents for their investors? Finally, one can predict a backlash, although the exact form it takes will depend on what scandal occasions the regulatory intervention. We are already beginning to see a regulatory reaction with the SEC, with a (failed) attempt to adopt rules requiring the 254regulation of hedge fund advisers, dna noitaraperp rofuger noital ni .eporuE Wh nethere is the inevitable crisis, there will be pressure to regulate further. At this point, the most important injunction, obvious in a period of calm but less so after an explosion, is to regulate cautiously and carefully. 254 Hedge uFdn sna dht e ,CESusrp aon et971 .54
