Controlling shareholders can thus serve a monitoring function, but they raise their own problems of undue influence. Because of this, the focus in this arena has been on institutional investors. Institutional investors are mutual funds, pension funds, endowment funds, and other professional investing groups.This investor historically does not acquire a controlling interest but rather takes a sizable minority stake in the company. In the early 1990s, many thought that these institutions were the answer to the corporate governance problem. These institutions would provide an independent monitoring function without exacting their own private benefits.8
This has not come to pass. Instead, mutual funds, the largest investors, have remained passive. The reasons for passivity remain diverse, but largely relate to their desire not to be seen as agitators, regulatory constraints that prevent them from taking sizable stakes in companies, and compensation mechanisms that do not adequately award them for this activism. Meanwhile, pension funds in particular have often acted for political purposes rather than economic ones. There are of course, prominent exceptions to both of these general statements, such as the California pension fund CalPERS, which historically has been both political and active as an investor. In the past few years, the new president of that $176 billion fund has notably disavowed the notorious political use of the fund by the prior president, Sean Harrigan, but has continued its activist stance.9 For the most part, though, institutional investor activism has consisted of voting in accordance with corporate governance advisory service recommendations.
By the spring of 2008, the corporate governance movement was in flux. Prior solutions to the agency cost problem had appeared to fail to cure excessive executive compensation in particular. In fact, the agency problem increasingly appeared to be a struggle about curbing exorbitant executive compensation. This jibed with the arguments of some that the agency problem was overstated. After all, the current structure had created our $14 trillion economy; it must be doing something correctly. Against this argument, the financial crisis, though, once again highlighted the problem of compensation and agency costs generally. Executives earned short-term profits for a year or two and then left their institutions in a terrible situation; they profited at their institutions’ expense. The windfalls of Mozilo, O’Neal and Prince are apt illustrations.
It was into this mix, in the spring of 2008, that hedge funds had their most active proxy season ever.
The Rise of Hedge Fund Activism
Hedge fund activism is a legacy of the 1980s exploits of corporate raiders. These were individuals such as Ronald O. Perelman, Carl Icahn, and T. Boone Pickens. They would launch hostile contests to acquire companies in order to engage in a restructuring or liquidation. Fearful companies would oftentimes instead simply repurchase the raider’s shares at a premium, so-called greenmail. The aggressive conduct of these raiders would provide hedge funds a road map, albeit a somewhat outdated one, for their conduct. In fact, many of these selfsame raiders, such as Carl Icahn, reappeared in this new guise, portraying themselves as shareholder champions, a much better public relations moniker than corporate raider.10
Hedge fund activism prominently emerged in the years after the Internet bubble. During that time, firms such as Bulldog Investors, Jana Partners LLC, Pershing Square Capital Management LP, Pirate Capital LLC, and Third Point, LLC began to create a network for hedge fund shareholder activism (see Table 7.1). In 2007, 501 dissident events occurred, with hedge funds participating in 54 percent of all campaigns announced, up from 48 percent in 2006. This number would slightly decline to 479 dissident events in 2008, or approximately 53 percent of all activity.The first six months of 2008, though, actually saw an increase over 2007, but the economic crisis diminished activity in the second half of the year.11 There was no doubt that hedge funds were driving activist shareholder dissident activity.
Table 7.1 Major Activist Hedge Funds and Lifetime Dissident Campaigns (through 2008)
SOURCE: Factset SharkWatch
Hedge funds initiating a dissident campaign typically followed a set pattern. In its most prominent incarnation, the hedge fund would accumulate a position in a company above the 5 percent threshold.This would require the hedge fund to report this interest on a Schedule 13D filing with the SEC. In this filing, the activist would announce its intentions with respect to the target, either in the filing itself or by attaching a previously written letter, known as a poison pen, to management outlining the hedge fund’s agenda.
The poison pen accounted for 54 percent of campaigns initiated in 2007.12 Typically, the hedge fund’s poison pen would include proposals for change to the company, including restructurings, sales, and executive replacements. Certain hedge funds, such as Third Point, run by the colorful Daniel Loeb, adopted the aggressive tactics of the 1980s corporate raiders and turned the poison pen into legendary screeds against management. He has branded a CEO a CVD, or chief value destroyer; referred to two great-grandsons of one company’s founder as part of the Lucky Sperm Club; and in a letter to Irik Sevin, CEO of fuel distributor Star Gas Partners LP, wrote: “Do what you do best: Retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites.”13
The public announcement of the hedge fund’s proposal was important, and not just because it publicly notified management of the hedge fund’s agenda. This first filing also often attracted other hedge funds from the activist network to take stakes in the company and join the campaign. This type of pack mentality was common in activist campaigns. One study found that hedge funds coordinated their efforts in 22 percent of a sample of campaigns.14 In many circumstances, the dissident hedge fund would attempt to negotiate with management to initiate their proposed changes. However, if these attempts failed, the hedge fund would often launch a proxy contest for board seats on the targeted company board in order to more directly assert control.
The hedge fund response depended on the reaction of the targeted companies, which varied. One study found that with respect to hedge funds, “target companies choose to accommodate the activists 29.7 percent of the time, to negotiate 29.1 percent of the time, [and] to fight/ resist 41.3 percent of the time.”15 It appears that hedge fund activism was met with more resistance by companies than other activist interventions. In 2007, 108 such events or approximately 21 percent of all events resulted in a proxy contest. In that year, hedge funds accounted for 56.5 percent of these contests (see Figure 7.1).16 The hedge funds had adopted the old hostile tactics of the 1980s corporate raiders.
The hedge funds, though, differed from the corporate raiders in the nature of their ownership. The median maximum ownership of activist hedge funds involved in dissident campaigns was only 9.1 percent of the company.17 The reason for this was probably liquidity. Larger controlling stakes are harder to quickly dispose of for regulatory and market reasons. Hedge funds typically also did not seek to obtain a majority of the board seats of the company. Nor did they seek to acquire all of the company’s shares. Instead, the typical hedge fund would run a campaign for a minority position on the board. The corporate raiders attempted to seize the entirety of the profits by acquiring the entire company for restructuring, partial dismemberment, or liquidation. In contrast and due to their own liquidity needs, activist hedge funds were willing to share the benefits of their activities with the remaining public shareholders (see Figure 7.2).
The growth in hedge fund activity was due to a simple economic fact: Hedge fund dissident campaigns appeared to work (see Figure 7.3). A paper first released in 2007 looked at the stock returns of companies targeted by hedge funds for shareholder activist campaigns from 2001 through 2006.The writers found that activism that targeted the sale of the company or changes in business strategy returned 8.54 percent and 5.95 percent, respectively. Moreover, this paper also found that hedge funds that regularly engaged in this type of activity or other hostile activity also experienced higher returns.18 Other papers found similar beneficial effects.19
Figure 7.1 Domestic Proxy Campaigns Fights 2003-2008
SOURCE: Factset SharkWatch
Figure 7.2 Primary Campaign Type Domestic Proxy Fights (All Proxy Fights in 2008)
SOURCE: Factset SharkWatch
This was remarkable. Activist hedge funds earned returns that substantially exceeded the costs they incurred by engaging in this activity. Public shareholders participated in these gains. Hedge fund activism was found to have other beneficial effects, such as overall improved performance, including increased return on assets and operating margins. It also resulted in reduced executive pay, the bête noire of the agency theorists.The 2007 paper found that the year before the hedge fund activity occurred, the target companies’ average CEO pay was $914,000 higher than the average CEO compensation at the targets’ peer companies. In the year after the hedge fund’s dissident activity, CEO compensation was reduced to a level in line with the target’s peer companies (see Figure 7.3).20
This activism and validating returns created its own self-perpetuating cycle.Announcements of shareholder activism by hedge funds would result in stock price increases. Meanwhile, new entrants, seeing value, entered the field. By January 2008, one estimate put the number of “event-driven” hedge funds that specialize in this type of activity at more than 75, with combined assets under management in excess of $190 billion dollars. This compared with only $95.6 billion in 2004.21 Though the entrance of money validated prior hedge fund activism, it raised the possibility that the easy gains were no longer there and that hedge fund activism would become less focused and earn lower returns.
Figure 7.3 Success Rate for Dissident Domestic Proxy Fights 2001-2008
SOURCE: Factset SharkWatch
Targets and some academics also expressed concern about hedge fund activism. Their primary focuses were twofold. First, the hedge funds were looking for short-term benefits at the expense of the long-term interests of the company. Here, one estimated calculation of the median hedge fund activist position during the period from 2001 through 2006 was for one year.22 Second, the hedge funds would use their board positions to obtain their own private benefits at the expense of other shareholders.
Cries of short-termism have always surrounded hedge fund activities and activist investing generally. In the case of hedge funds, some have proposed that special fiduciary duties to the targeted company should be imposed on hedge funds.23 Yet, the early statistics have not shown any undue impact by their activities. Rather, the benefits for companies appear to be widespread. The nature of the typical hedge fund position, a minority one on the board of directors, also provides a mechanism for oversight of hedge fund activities. The remaining majority directors can not only look out for the interests of the company but also prevent any private gains from accruing to the hedge funds’ activities.
A recent Delaware case, Portnoy v. Cryo-Cell Int’l, Inc., also showed the extent to which the Delaware courts will monitor hedge fund activities and any compromises reached between the company and a dissident shareholder.24 In that case, Vice Chancellor Strine held that the Delaware courts would deferentially review a board compromise that gave a dissident stockholder two board seats. However, he also held that any benefits given by the corporation to a stockholder to compromise a proxy contest would probably be subject to heightened review for entire fairness and good faith to ensure that the company’s shareholders were protected.
Heading into the 2008 proxy season, hedge funds had shown themselves to be disrupters. They were changing the nature of shareholder activism, providing the dissident voice often asked for on boards, and increasingly influencing the corporate governance debate. But hedge funds are also sophisticated financial entities. In their desire to maximize returns and conceal their preliminary efforts, hedge funds innovated by using the tools of the financial revolution. Instead of actually buying the shares of a company, hedge funds began to purchase cash-settled equity derivatives. The use of these derivatives meant that the hedge funds did not purchase the actual stock in the company. Instead, the hedge fund merely placed a bet with a counterparty that the company’s stock would move one way or the other. Presumably, the investment bank counterparty would then also hedge the transaction by purchasing the actual stock. The hedge fund, though, never owned any stock, and the trade was settled for cash.
This was a powerful innovation that permitted the hedge funds to accumulate a large interest in a company without being subject to the usual accompanying regulatory requirements. Normally, a stockholder who beneficially owns 5 percent or more of a public company’s equity securities is required under Section 13(d) of the Exchange Act to report that interest on a Schedule 13D filed with the SEC. The form is required to be filed within 10 days of the buyer going over this threshold.25
Cash-settled equity derivatives, though, are separate from the ownership of common stock. The hedge fund simply has a bet with an investment bank that the stock price will rise. The hedge fund has no right to dividends in the stock or to vote on the election of directors.
The hedge fund owns no interest in the company. On this basis, hedge funds took the position that the Section 13(d) reporting requirements did not apply. A hedge fund could therefore acquire a large interest in a target without alerting the market. The hedge fund could then quickly convert this derivative position into actual stock because it was likely that the investment bank counterparty would have taken a position in the target’s stock to hedge its risk. This tactic would put hedge funds in the spotlight in the 2008 proxy season, as they were repeatedly accused of using these cash-settled equity derivatives to avoid the early-warning requirements of Section 13(d).26
The 2008 Proxy Season
The 2008 proxy season was expected to be an eventful one. It did not disappoint (see Figure 7.4). In the period from January 1 to February 1, 2008, 79 dissident events occurred, compared with 49 in the comparable period in 2007. In particular, there were 123 proxy contests in 2008 compared with 108 in 2007. Again, activist hedge funds were the focal point of this activity. Hedge funds initiated 273 dissident events, and 53.7 percent of proxy fights involved hedge funds.27 I have set forth the more significant hedge fund activist campaigns during this time in Table 7.2.
During this time period, the two most prominent instances of shareholder activism were Jana Partners’ targeting of CNET Networks, Inc. and Children’s Investment Fund and 3G Capital Partners’ targeting of CSX Corp. These two dissident actions would reshape the securities laws and alter the way these contests would unfold in the future. They would also show the perils, potential, and limitations of hedge fund activist investing, as well as provide a case study of the modern hedge fund activist campaign.
Jana versus CNET
Jana Partners is a $5 billion event-driven hedge fund founded by Barry Rosenstein. It specializes in activist shareholder investing and is most famously known for partnering with Carl Icahn in 2005 to force the energy company Kerr-McGee Corp. to restructure. Jana’s actions ultimately resulted in the sale of Kerr-McGee and a more than $160 million profit for Jana. Rosenstein is also known as one of the more level-headed of the shareholder activists; he is a devotee of vinyasa yoga, a more active form of the discipline.28
Table 7.2 Significant Domestic Proxy Campaigns 2008
SOURCE: Factset SharkWatch
In the case of CNET, Jana began its battle early in the 2008 proxy season. On the morning of January 7, 2008, Jana filed a Schedule 13D with the SEC.29 Jana’s Schedule 13D was loaded with new information for the market. First, Jana disclosed that it owned 8.1 percent of CNET’s stock. Second, Jana disclosed that it was a party to cash-settled equity derivative contracts equivalent to another 8.2 percent of CNET’s stock. Third, Jana announced that Sandell Asset Management Corp. had agreed to support Jana’s efforts. Sandell itself also disclosed a 3.4 percent interest in CNET through cash-settled equity derivatives as well as a beneficial ownership stake of 1.31 percent of CNET. Through their use of cash-settled derivatives, Jana and Sandell had a
n approximate 21 percent economic interest in CNET, but only a 9.4 percent ownership stake.
Jana’s 13D filing also stated that Jana had had contacts with CNET management in October through December about implementing a restructuring program. The discussions had gone nowhere, and on December 28, 2007, Jana delivered a notice to nominate 7 new directors to CNET’s board. CNET had a staggered board provision in its bylaws requiring that only a portion of its eight directors be put up for election in any given year. In 2008, 2 CNET directors were up for election, and Jana nominated replacement directors for those two seats. In this notice, Jana also proposed to amend CNET’s bylaws so that the board would be expanded by 5 directors, bringing the total to 13 directors. The other 5 directors Jana was nominating would fill these new positions. If Jana were successful, it would obtain control of the CNET board.30 This was a highly aggressive move by Jana. Instead of nominating a minority slate of directors, Jana was deviating from the hedge fund playbook to take full control of CNET.
CNET rejected the Jana nomination and proposal by relying on a strict reading of the advance notice provision in its bylaws. Article III.6 of the CNET bylaws stated with respect to director nominations that:
Any stockholder of [CNET] that has been the beneficial owner of at least $1,000 of securities entitled to vote at such meeting for at least one year may submit a director nomination to the Board of Directors or, if designated by the Board of Directors, a Nominating Committee.31
Jana’s bylaws contained a second provision limiting stockholder proposals along the same grounds. CNET thus rejected Jana’s proposals and nominations by claiming that Jana was not the beneficial owner of at least $1,000 worth of stock for at least one year. Jana had first acquired shares of CNET in October 2007, far from the one-year deadline.
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 20