These numbers point to the likely staying force of hedge fund activism. Even in the down year of 2009, with many shareholder activists leaving the arena, new activists appear to be springing up to take the mantle from those driven away or in hibernation.These new activists will exist side-by-side with the older ones who remain or return in the coming years. Bill Ackman, for example, appeared unchastened, initiating an unsuccessful proxy contest in 2009 to elect five nominees to the Target board, despite the prior significant losses in his fund.
This secular trend towards greater hedge fund activism will be assisted by the proxy advisory services. These services have been criticized for the arbitrariness of their proxy recommendations, which appear to import notions of civic democracy into the corporate realm without firm economic basis.53 Nonetheless, these services have substantial power and appear prone to recommend dissident slates for diversity purposes if for no other reason. This provides comfort to any dissident hedge fund that the substantial expense of a campaign will prove successful.
As for the bugbear of the agency theorists, executive compensation, the financial crisis appears to be forcing boards to rethink the topic. Many of the largest pay packages were paid by financial institutions that received federal government assistance and became subject to compensation restrictions imposed as a condition to their receipt of bailout money. Meanwhile, the public outcry at excessive pay to CEOs whose companies subsequently lost billions increased the focus on reworking financial compensation to emphasize pay for performance and reduce pay that rewarded short-term performance over long-term losses. In the wake of these outcries, many boards cut back on compensation and restructured their pay packages to ensure longer-term pay-for-performance.The ultimate impact and sustainability of this trend remain unknown and may be strongly affected by possible government regulation.
Thus, for the short term and to the regret of those who decry agency costs and view the institutional investor as the perennial solution, hedge funds may turn out to have more potential than pervasive systemic impact. However, when they do act, they are likely to play an increasingly important part in corporate governance and provide a new force to cajole directors to take an active and dissident voice in the corporate enterprise.Their potential to act may therefore be even more game-changing by forcing companies to conduct themselves in anticipation of possible criticism and hedge fund action. And hedge funds are likely to be increasingly successful on account of majority voting requirements and brokers who increasingly divvy up nonvotes among candidates rather than just voting them for the board’s nominees.
Hedge funds thus appear to be the missing actor to spur companies to change and reduce agency costs. Hedge funds also appear to be willing to spend the money to do so. This is not to say that there are not dangers. Hedge funds are acting for their own private interests and do not seem shy about taking contentious positions. Nonetheless, their conduct thus far has not merited increased oversight. Instead, because they usually seek minority board positions, they can be monitored by other board members and by the Delaware courts.
The deal machine has been less receptive to these funds. Instead, the large law firms and investment banks have largely served their traditional corporate clients by arguing for increased disclosure of cash-settled equity derivatives and bylaw amendments to damper this activity. This opposition is likely to decline as hedge fund activism becomes a more traditional part of the capital markets.
Hedge funds will also engender dealmaking in a number of ways. First, hedge funds will drive companies to maximize value through a sale or other corporate transaction. Second, hedge funds themselves can provide capital and operational advice. Here, we may even see the rare occasion where hedge funds are actually invited to invest in companies and serve on their boards. In this regard, expect to see partnering of activist hedge funds and private equity funds as these hedge funds take longer investing stances and begin to resemble private equity funds. This trend will be facilitated by the events of 2008. The mass flight of capital during this time from hedge funds has led some of these funds to adopt private equity strategies like lockups, which allow hedge funds to retain capital for longer periods of time. To the extent that activist hedge funds adopt this feature, it will allow more sustained shareholder activism.
Figure 7.4 Shareholder Activism against U.S.Compagnies 2008
SOURCE: Factset Shark Watch.
Corporations still fight hedge fund activism, though, often arguing the funds’ tactics and menacing potential rather than the facts. In the contests of the future, the Section 13(d) requirements are likely to be a central battlefield.The CSX case showed the hampering role the group requirements of Section 13(d) can impose. Given the strict, subjective test the CSX case imposed on hedge funds, the SEC would do well to clarify this area with specific safe harbors so as not to entirely limit communication.
With respect to cash-settled derivatives, the CSX case is likely to be eclipsed by SEC rule making once the SEC’s attention turns away from the financial crisis. If the SEC does so act, it is likely to require reporting of these derivatives on Section 13(d) as other countries like the United Kingdom have proposed.54 There is a drive to further monitor derivatives, but there are strong benefits to these derivatives, as they provide hedge funds the ability to swiftly act. The harm, though, appears minimal at best. Disclosure may be the best remedy, but anything more is probably overkill. More generally, regulators for now should look at hedge funds as a potentially good force, rather than the nefarious one many corporations portray them as.
Ultimately, the story of hedge funds and activist investing is one of potential. Hedge funds have the capability to be a strong force in disciplining companies, but the industry is still in its infancy. As with mutual funds, the hedge funds may be derailed on the path to becoming a strong force in activist investing. Moreover, hedge funds themselves are transforming to become more like private equity funds. This may change both their tactics and their image as they take longer stakes and are more apt to offer strategic advice on a friendly basis. In other words, the story has a ways to go.
Chapter 8
Microsoft, InBev, and the Return of the Hostile Takeover
Anotable burst of unsolicited, so-called hostile takeover activity occurred in the spring of 2008.The increase was the only highlight in an otherwise moribund deal market and reflected a continuing upward trend in hostile takeovers over prior years. In 2008, 71 unsolicited and hostile transactions comprising $150 billion in value were announced in the United States. This was an increase from $83.4 billion the year before and the highest number of hostile deals since 1999.1 During 2008, 23 percent of all takeovers announced were hostile or unsolicited, and hostile activity rose in relative terms throughout the year, from 21 percent of deals in the first quarter of 2008 to 29 percent in the fourth quarter of 2008.2
The rise in hostile activity during this period was unsurprising. It was due to the confluence of three trends. First, would-be buyers made opportunistic bids for targets with significantly depressed share prices. Target boards resisted these offers. These targets claimed that the decline in their share prices was a short-term, quite downward turn that was due to the financial crisis rather than any fall in the target’s intrinsic value. Even taking into account any share premium offered by the would-be buyer, targets argued that these bids undervalued the company.
Second, due to the efforts of corporate governance activists, companies were less defended than at other times in recent corporate history. For example, 302 companies in the S&P 500 had a staggered (also known as a classified) board in 2003 compared with 172 companies in 2008.3 During 2006-2008, roughly 67 percent of S&P 500 companies with an expiring poison pill had allowed this takeover defense to expire rather than renewing their pill.4 As a result, by the beginning of 2009, only 20.6 percent of S&P 500 companies had a poison pill, and only 34.4 percent had a staggered board in place.5 (See Figure 8.1.)
The decline in staggered boards likely l
eft companies more defense-less. As Professors Bebchuk, Coates, and Subramanian have argued the staggered board can be a more powerful antitakeover device because it requires a bidder to run multiple proxy contests over a span of two years to acquire control of a target.6 The lapse of this takeover defense instead provided hostile bidders the ability to replace the target’s entire board in a given year. Moreover, unlike a poison pill, a staggered board required that shareholders approve its adoption. The defense was therefore unlikely to be resurrected once forgone.
Figure 8.1 S&P 500 Companies with Classified Boards 1998-2008
SOURCE: Factset SharkWatch
Third, the nature and scope of a hostile bid had changed since the 1980s era of the corporate raider. The conventional wisdom from that time was that a hostile offer for a people-based business was notoriously difficult. This was because the target’s human capital could exit at any time, and a hostile bid was viewed as an aggressive tactic that would negatively affect employee morale. This put a large number of companies safely outside the specter of any hostile takeover attempt, particularly technology-based companies that were heavy with people capital, namely, engineers and computer programmers.
This conventional wisdom changed with the success of Oracle Corp.’s hostile bid for PeopleSoft Inc., the enterprise application company, in 2003; Oracle’s second hostile bid for BEA Systems, Inc., an enterprise infrastructure software company, in 2007; and the aging of technology companies. Technology was becoming akin to an old-line industry. It was less people-based and increasingly asset-rich, allowing for hostile transactions to occur. In fact, 7 of the 10 largest deals in the technology industry in 2008 began as hostile offers.7 The reason for the high number of hostiles in the technology industry was probably due to arguments about value, but it was also attributable to the continuing presence in these companies of first-generation CEOs and management who were more resistant to a takeover for personal reasons.They did not want to see their beloved companies and their legacies disappear.
The rise of the technology hostile bid illustrated the changing nature of the hostile bidder. The hostile bid was becoming a tool of strategic buyers rather than more aggressive 1980s-type corporate raiders and financial buyers. Strategic buyers typically looked to preserve the targeted company and create synergies rather than dismember their targets. Strategic hostile bidders emphasized their friendliness to the company’s employees and customers and publicly regretted their hostile activities as an unwelcome necessity. True hostile activity was now left for the activist hedge funds and the history books.8 (See Figure 8.2.)
In the midst of this upswing in activity, two significant hostile offers were announced: Microsoft’s hostile bid for Yahoo, the Internet media company, and InBev’s hostile bid for Anheuser-Busch, the nation’s largest brewery. These transactions would show the nature and potential of hostile transactions, the role of attorneys and legal maneuvers in the success of these offers, and the effect of takeover defenses in determining these contests. These two hostile offers would also once again show the importance of personality for dealmaking.
Figure 8.2 Domestic Announced Hostile Takeover Activity (Value and Percent of M&A Transactions) 2004-2008
SOURCE: Factset Mergermetrics
Microsoft-Yahoo!
On February 1, 2008, Microsoft announced that its CEO Stephen A. Ballmer had delivered to the Yahoo board of directors a written proposal to acquire Yahoo for $31 a share. This type of letter is known as a bear hug letter. A bear hug letter is designed to put an unwilling takeover target on notice that it is no longer safely independent, but it is written to fall short of being overtly hostile.The hug is the offer, but the bear is the implicit threat that the buyer might go hostile if the hug is not returned. Ballmer’s bear hug letter was no different. It contained all the make nice language you typically see in these letters, as well as a warning that there was a bear waiting to come out. Microsoft stated in its letter:
Depending on the nature of your response, Microsoft reserves the right to pursue all necessary steps to ensure that Yahoo’s shareholders are provided with the opportunity to realize the value inherent in our proposal.9
Despite the private address, Microsoft promptly made the letter public. Potentially hostile bidders typically do this to put public pressure on the target’s board of directors to consider the bidder’s proposal. Microsoft was no different, and its disclosure was designed to notify the public of its intentions and use public enthusiasm for a share premium to temper any adverse reaction from the Yahoo board of directors and Yahoo co-founder and then-CEO Jerry Yang. The reason was simple: Without Yahoo’s cooperation, a bid would be significantly harder.
The advent of the poison pill in the mid-1980s transformed the nature of a hostile transaction. A poison pill effectively prevents a corporation from being acquired without the consent of the target’s board of directors. The reason is that under Delaware law a board can just say no and refuse to accept a takeover offer. Only the target board’s directors can redeem the pill and allow an acquisition to proceed. This provides the target board the ability to block a takeover. Hostile bidders, therefore, complement their hostile bid with a proxy contest to remove the target’s directors and replace them with the bidder’s chosen directors. When elected, these new directors then vote to remove the poison pill and agree to a transaction with the bidder.
The need to complement a hostile bid with a proxy contest thus drives the timing of hostile offers. It effectively means that a hostile offer must come at a time when a company’s directors can be replaced. Opportunities to replace the board of directors can come at an annual meeting of the shareholders, a special meeting of the shareholders called for that purpose, or outside the annual or special meeting because of action by written consent of the shareholders. The majority of public companies, approximately 79 percent, either do not permit the calling of special meetings by shareholders or otherwise prohibit shareholders from acting by written consent. In particular, only 45 percent of U.S. public companies provide their shareholders with the ability to call special meetings, and only 30 percent allow their shareholders to act by written consent.10 In companies that prohibit such actions, shareholders can remove directors only at the company’s annual meeting. The annual meeting has its name because it happens only once a year. Thus in such a circumstance, a hostile bidder must time its bid to coincide with this meeting and allow the bidder to nominate directors. Targets know this timing necessity and so have the remainder of the year to plan for any impending proxy contest and hostile offer.
Yahoo was in the majority of U.S. companies. Yahoo’s bylaws and certificate of incorporation prohibited actions by written consent and the calling by shareholders of special meetings. Yahoo also had a poison pill with a 15 percent trigger.11 As a result, Microsoft could not effectively acquire an interest in Yahoo above that threshold unless it obtained prior approval from Yahoo’s board.
HOW THE POISON PILL WORKS
The most popular type of poison pill plan, [is] a call plan, under which the holder has a contingent right to buy securities of the target or the acquirer at a deep discount from their market value… . There are two types of call plans, the older “flip-over/flip-in” plans and the newer automatic “flip-in” plans… .
To implement a call plan, a company issues to its stockholders one contingent share right for each share of common stock outstanding.The issuance is in the nature of a dividend authorized by the directors and need not be approved by the shareholders. The typical call right entitles the holder (once the right becomes exercisable due to a triggering stock acquisition) to buy stock at half price in certain situations. In the case of a merger between the rights issuer and acquirer, the rights holders can buy, at half price, the stock of the company surviving the merger (whether the survivor is the issuer or the acquirer), a flip-over. If an acquirer of the issuer’s shares does not pursue a back-end merger but engages in certain kinds of self-dealing transactions with its new subsidia
ry, the rights holders can purchase shares of the target at half price, a flip-in. The call right thus allows the issuer’s stockholders to block a squeeze-out second-stage merger or other methods of self-dealing.
The right is initially “stapled” to the common stock; that is, it trades together with the common stock. The rights vest 10 days after a third party acquires a specified percentage (often 15 percent or more) of the company’s stock or has started a tender offer for 15 percent or more of the shares (the “triggering events”). Once vested, the company issues separate rights certificates, and the rights become exercisable and transferable separately from the common stock. The unvested rights have a stated term of 10 years and target directors may redeem them at a nominal price (for example, 10 cents) at any time before they vest. This means that the plans have built-in “sunset” provisions and must be periodically re-issued. The redemption feature allows the board to remove the plan to negotiate an acquisition of the company.
The vested rights permit holders to buy a share of the common stock of the issuer or acquirer (depending on the circumstances) at a price that is typically a multiple of the market price (usually three) of the common stock on the date of issuance of the right. This option is seriously out-of-the-money (the exercise price is much higher than the value of the underlying asset) and holders will not exercise it….
The … more powerful call plans omit the “flip-over” feature entirely and eliminate the contingent part of the “flip-in” provisions. The flip-in rights become exercisable to buy stock of the issuer or an acquirer at a fraction of market value whenever the acquirer buys more than a threshold amount of the issuer’s stock, even if the acquirer does not engage in any coercive or self-dealing transactions. The acquirer who triggers the options for the other shareholders does not have such an option herself. The other shareholders, exercising their new options, substantially dilute the value of the acquirer’s stock. In extreme forms, the acquirer simply loses much of the value of the triggering stock purchase (at minimum, the value of fifteen percent of the voting stock)….
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 22