Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  Jana’s argument in its complaint was twofold. First, Jana offered a differing interpretation of that bylaw. Jana argued that the bylaw stated that shareholder “may seek” to nominate directors through the board and that may is a permissive word. The bylaw did not prohibit shareholders from making proposals outside this process. Jana thus argued that so long as Jana filed and circulated its own proxy and did not seek to submit the proposal to the CNET board, then the bylaw restrictions did not apply.

  Second, Jana argued that, to the extent the bylaw did apply, the holding period requirements were discriminatory and unreasonable and improperly permitted the CNET directors to be gatekeepers for director nominations. Shareholders were the only persons who could nominate directors. In contrast, the CNET bylaws impermissibly placed this power with CNET’s directors.

  Jana’s second argument was also a good one. In other circumstances, Delaware courts had held that application of a bylaw governing the shareholder franchise is appropriate if it is not applied inequitably and so long as it is reasonable. However, under Delaware law and doctrine as annunciated under the Blasius standard, bylaws must on their face offer a fair opportunity for shareholders to nominate candidates. Here, if this bylaw was interpreted as CNET wanted, it functioned to make the board the gatekeeper of all director nominations. The Delaware courts are protective of the shareholder right to nominate and elect directors. If all nominations were centered through the board, it was probably an unreasonable restriction on the shareholder franchise.

  Ultimately, Jana won a full victory. Referring to Lewis Carroll and the “Bloody Shirt of Blasius,” Chancellor William B. Chandler, the judge presiding over this case, held that the CNET bylaws were unambiguous in favor of Jana.32 He interpreted the corporate bylaws as a contract between the corporation and stockholders. Siding with Jana, he did not find any ambiguity. Rather, he found that, because of the “may” language, these bylaws applied only if Jana sought to include the proposals in CNET’s proxy. Because Jana was going to self-finance its contest, it would, therefore, not be subject to this bylaw. The result cleared the way for Jana to run this contest and was a blow to CNET, which was left bloodied and facing a difficult proxy contest.

  Lost in this bitter legal battle between the two sides was the actual performance of CNET. CNET’s operational performance had been lackluster for several years prior to Jana’s involvement. Its stock price had dropped by 50 percent over the past two years, its projected revenue growth remained weak, and financial observers believed that CNET was overstaffed and poorly managed. On October 3, 2007, Henry Blodget, the infamous ex-analyst from Merrill Lynch, wrote on his blog Alley Insider that CNET was “geriatric.” He suggested that a private equity firm buy the company, stating that “the company’s growth has stalled, its tech-news dominance has been usurped, and its stock is barely clinging to $8.”33

  It was likely that Jana would win its contest if CNET could not find a legal hook to defeat Jana. This explained CNET’s opposition, though it did not excuse its battle against its own shareholders’ arguments for improvement. However, CNET did not wait until its shareholder meeting. On May 15, CNET announced an agreement to be acquired by CBS for $11.50 a share or $1.8 billion in total.34 Jana had purchased its shares at an approximate price of $7.50 a share.The quick profit of Jana was no doubt a boon for future activist shareholders.

  In the long run, the Jana case will have a significant impact on campaigns to replace board directors. The Jana opinion shows that Delaware courts will strictly construe bylaw amendments against the targeted company. This was a forceful reminder that companies should update their bylaws to make any nomination or shareholder proposal requirements and restrictions clear and unambiguous. This is an update that indeed occurred as companies prepared for the 2009 proxy season. Law firms used the Jana case as a marketing opportunity, flooding clients with memos and sample bylaws to be adopted to clarify bylaws, restrict the nominating process, and force greater disclosure upon hedge funds engaging in dissident activity. Here, law firms generally recommended that companies adopt bylaws requiring the reporting of any ownership of cash-settled equity derivatives and wolf pack activity with other hedge funds. The deal machine was acting to protect its steady corporate clients over a select group of hedge fund activists.

  Companies responded to these missives. Morgan Stanley, Sara Lee Corporation, and Coach, Inc., for example, have each in the past year revised their bylaws to ensure that they provide the companies greater latitude to exclude hedge fund proposals.35 Each of these companies also acted to enhance disclosure by any activists, including requiring the disclosure of cash-settled equity derivatives. Other companies have even amended their poison pills to include cash-settled equity derivatives for purposes of determining whether the pill has been triggered. But this was dangerous business, as it could presumably lead to an undue trigger for these pills.

  Companies undertaking these defense enhancements did so with the Jana case and hedge fund activism in mind. Many explicitly imposed clear and extended holding periods for shareholders wishing to nominate directors or make shareholder proposals. However, the Jana case did not address whether CNET’s holding restriction, if applied, would be inequitable and invalid under Delaware law. In other words, is a one-year holding period appropriate under Delaware law?

  The Delaware legislature acted in 2009 to partially address this open question.The legislature enacted a new Section 112, which allows the bylaws of a Delaware corporation to provide that the corporation may be required to include nominations by individual stockholders. The provision also allows the bylaws to implement mandatory holding periods and minimum ownership thresholds. It remains to be seen, though, how Delaware courts will view the effect of this new statute on the question of how long a holding period is appropriate.

  The Jana case was ultimately a good illustration of how bitter these fights can become, as well as how they could turn on legalities. In this battle, the actual issue at hand, the performance of the company, appeared immaterial. The Jana proxy contest was also a good exemplar of how these contests can end in the sale or restructuring of the target company. Jana’s use of cash-settled equity derivatives and coordinated activity with another hedge fund also foreshadowed the battle for CSX.

  Children’s Investment Fund versus CSX

  Children’s Investment Fund is a London-based hedge fund headed by Chris Hohn. It has a publicity-friendly name due to the allocation of a portion of its revenue to a related charitable foundation for children.36 Children’s is also one of Europe’s largest hedge funds, with more than $5 billion in assets under management. It has periodically ventured into shareholder activism in Europe, most recently in the ABN Amro Bank N.V. dispute, where it pressured the company to split up, eventually leading to ABN Amro’s sale to a group of banks including Royal Bank of Scotland Plc, Banco Santander SA, and Fortis Holding SA/NV.37

  Children’s first set its sights on CSX in the second half of 2006. It took an interest in the company on October 20, 2006, by purchasing cash-settled equity swaps. The following months were filled with intrigue, as Children’s repeatedly approached CSX about a restructuring of the company, inquiries that were repeatedly rebuffed.The hedge fund 3G appeared on the horizon, also taking a stake in CSX. During this period, the two funds met several times to discuss investments, though both would later claim that CSX was not discussed at these meetings.

  Children’s had decided to target CSX because it believed that its management was ineffective and that CSX had substantial legacy contracts that were undervalued by the company.38 In addition, CSX had a number of noncore assets ripe for disposition, including the famous Greenbrier resort in West Virginia, described in the Wall Street Journal as one of the nation’s “most lavish and historic resorts,” which CSX had owned since 1910.39

  On December 19, 2007, Children’s was finally ready to go public. The fund announced that it was going to launch a proxy contest with 3G to nominate directors to the CSX 12-membe
r board. At the same time, Children’s and 3G filed a Schedule 13D showing that they had a combined 8.3 percent interest in CSX and that they had agreed to act cooperatively. They also announced a collective 3.5 percent economic interest in cash-settled equity derivatives.40

  CSX’s response was not welcoming. On March 17, 2008, seven days after the Children’s group filed their proxy statement to elect five directors to the CSX board, CSX sued Children’s and 3G in the Southern District of New York, claiming that they had failed to file a timely Schedule 13D reporting (a) Children’s entry into cash-settled derivative swaps above a level equivalent to 5 percent of the outstanding CSX stock and (b) that the two hedge funds were acting as a group as early as February 2007 and had failed to jointly file a Schedule 13D at that time.

  The issue gripped Wall Street: Were cash-settled equity derivatives subject to Section 13(d)’s beneficial ownership reporting requirements under Section 13(d), triggering joint reporting of their holdings? And when could two hedge funds acting together be deemed to be a group? In answering these questions, the court would decide the future playing field for hedge fund activism.

  A two-day bench trial was held in New York on May 21 and 22, 2008. Three weeks later, on June 11, Judge Lewis A. Kaplan of the Southern District of New York issued his opinion. He ultimately ruled that Children’s entered into the swap transactions to avoid reporting under Section 13(d). He also found that 3G and Children’s had formed a group at least 10 months before they publicly stated they were one and filed a Schedule 13D. Since they formed a group earlier, their securities holdings were aggregated at that time for purposes of 13D, topping the 5 percent threshold. Another violation thus arose—the failure to jointly file a Schedule 13D reporting this group interest.

  This has always been a troublesome issue under Section 13(d).When do two actors form a group acting in concert trigger the Section 13(d) filing requirements? Section 13(d)(5) provides: “When two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a ‘person’ for the purposes of this subsection.”41 In such circumstances, the “group’s” holdings will be aggregated for purposes of the Section 13(d) filing requirements, and they will be required to jointly file as a group any required Schedule 13D.

  To find the funds were a group, Judge Kaplan found that the close relationship of the parties, patterned buying, and references to the other in e-mail messages created an inference of a group. This is a tough call. Children’s and 3G met, knowing the danger of acting as a group, and appeared to structure their conduct accordingly, trying desperately not to form a group and even stipulating that they were not a group at the beginning of their few meetings. The alleged group conduct here was rather light and mostly drawn from inferences and patterns. In this case, it was primarily based on the judge’s finding that the two funds had a prior close relationship.

  Going forward, this presents a dilemma for any hedge fund. How do you communicate with other shareholders without running afoul of these rules? This is particularly true when any finding of a group appears so subjective and at the mercy of a judge’s broader views of the funds’ conduct. Generally speaking, the purpose of these shareholder communications is to share information that each may act upon. This may then appear to the outside world as coordinating, and it very well may be. But in the hands of a judge and the broad Section 13(d) standards, this effectively means that any contact creates liability under Section 13(d) if no joint Schedule 13D filing is made.

  Despite his ruling for CSX, the decision was a victory of sorts for Children’s and 3G. Judge Kaplan found a violation of the Section 13(d) requirements but ordered that the remedy be curative disclosure by Children’s and 3G.42 Here, he was hampered by a precedent that limited the remedy to this type of cure and foreclosed harsher penalties such as disgrogement. CSX had argued that Children’s and 3G be forced to divest their shares or that they otherwise be prohibited from voting at CSX’s upcoming election of directors. Precedent dictated a different outcome. Judge Kaplan was forced to limit CSX’s remedy, but he clearly didn’t like it and in his opinion practically begged CSX to appeal the case to overturn this precedent and more harshly punish Children’s and 3G.43

  Nonetheless, the consequences of Judge Kaplan’s ruling are likely to be broad. Holders will now tend to read this opinion as forcing them to report cash-settled derivative swaps. The alternative is not to file a Schedule 13D and risk a court battle and adverse judgment, hopefully safe in the knowledge that the court’s injunctive remedy for finding a violation is apt to be a weak one—more disclosure. This will trouble hedge fund general counsels for a while. And it is because of this that the main effect of this decision is likely to be to push the SEC to act and propose Section 13(d) reforms to address the issue of reporting cash-settled derivatives.

  Shortly thereafter, CSX held its board election. Instead of its usual luxury location at the Greenbrier or a similar place, CSX held the meeting at a remote location in a railroad yard outside New Orleans. The maneuver did not deter shareholders from attending and voting. After a four-hour meeting, four Children’s group directors were elected to the board.44

  Children’s victory came in the wake of a recommendation by the proxy advisory service RiskMetrics for its candidates, again showing the power of these services. Importantly for future contests, RiskMetrics premised its recommendation on the poor performance of CSX but made this conclusion based on CSX’s “aggressive” response to Children’s and 3G.45 Many criticized RiskMetrics for this finding, as the service was endorsing a set of candidates that had been found by a court of law to be less than truthful. But RiskMetrics had presumably weighed this factor in its opinion and come down against a hostile company response.

  The Children’s group’s win was based on receiving the vote of the shares CSX sought to have Children’s and 3G disgorge. If Children’s and 3G’s shareholders didn’t count, then the CSX board’s two nominees would be seated instead. CSX was, at this time, appealing the lower court ruling, arguing that Children’s shares should be excluded for purposes of this election. Notably, CSX did not dispute the election of the Children’s other two nominees, Gilbert H. Lamphere and Alexandre Behring. These two would have been elected with or without Children’s interest.46

  On September 15, 2008, the Second Circuit rejected Judge Kaplan’s plea to enjoin Children’s and 3G from voting shares of CSX stock.47 Children’s two other directors were thus seated, and the hedge funds took control of one-third of CSX’s board. The final outcome of this dispute, though, was less successful for the hedge funds. As of March 2009, the stock price of CSX was down almost 66.7 percent since September, and the famous Greenbrier had been put into bankruptcy. Faced with these significant loses, Chris Hohn decided not to again seek reelection to Children’s board in order to maintain flexibility to sell the fund’s remaining CSX shares. At the time Hohn was quoted as saying: “Quite frankly, activism is hard.”48 This was true—and it also required staying power.

  The Future of Hedge Fund Activism

  The Jana and Children’s battles show the perils and potential of hedge fund investing. In both instances, the companies appeared to have limited defenses and lagging historical performance against their peers. In Jana’s case, a nice, quick profit was also had. Companies saw these dissident contests and, aware of their own vulnerabilities, responded. But they did not do so with welcoming arms or corporate restructuring and reform. Rather, most companies responded by adopting amendments to their bylaws to impose significantly increased shareholder disclosure and other restrictions on shareholder activism.

  These actions will probably have their intended result and chill activity. Companies argue that these measures prevent short-termism. However, hedge fund activity has resulted in increased shareholder value and reduced excessive executive pay. Thus, the battle over hedge fund shareholder activism seems more abo
ut hedge fund tactics than about their results. Here, the recommendation of RiskMetrics in the CSX battle is likely to affect companies’ response. Although companies may arm themselves and even attempt to fight off hedge fund activism, they will probably do so in a manner that appears to be at least receptive to the ideas of their new hedge fund shareholders.The consequence is to again make the public relations campaign, and the choice of a PR firm, one of the central elements in these battles.

  Hedge funds may become a more sustained force, but there are countervailing trends that probably mean they are unlikely to become ubiquitous. First, there are a limited number of easy targets. Second, activist hedge funds have been terribly hurt by the financial crisis. These funds typically invest in distressed companies to begin with, and the returns in 2008 were not pretty on account of the exacerbated impact of the financial crisis. Children’s results were negative 42.8 percent for the year.49 Most spectacularly, Bill Ackman’s specialized $2 billion fund to invest as an activist shareholder in retailer Target Corp. lost 89.5 percent of its value in less than two years.50 These are hardly encouraging returns to fund significant expansion, despite the increased opportunity. In the wake of these returns and the financial crisis, many funds were also hit by investor redemptions, and Jana alone was rumored to have redemption requests for 20 to 30 percent of its assets.51 These hits are likely to set back the growth of these funds by several years and may result in the liquidation of many funds.

  Still, despite the general economic downturn and the huge losses sustained by many corporate activist funds, the 2009 proxy season experienced the sustained activity of 2008. As of March 25, 2009, there were already more shareholder proposals than in the comparable period a year ago. So far, 283 shareholder proposals were disclosed, compared with 252 for the same period last proxy season. In the most contentious arena, proxy contests, it appears that as of March, the pace was set to surpass 2008’s record total. As of March 25, 2009, 71 proxy fights for board seats at U.S. companies have been announced. At the same point in 2008, 69 had been announced.52