Among practitioners, it is a customary cliché to say that all proxy contests—just like all trials—are unique and idiosyncratic. There is some truth to that easy generalization, but it also misses the forest for the trees. Some obvious truths stand out in the recent battle between Trian Fund Management and DuPont that will apply to future contests:

1. What explains DuPont’s Victory? DuPont won only a narrow victory, despite enormous advantages. Press accounts have reported that DuPont won 52% of the vote. This close margin may seem surprising, given (1) DuPont’s very large market capitalization (over $68 billion), (2) DuPont’s very successful recent performance (it has beaten the return on the S&P 500 index for a number of years); and (3) DuPont’s large retail ownership (over 30%, which shareholders usually support management). Add to this the further fact that DuPont’s CEO (Ellen Kullman) ably portrayed herself an “agent of change,” responsive to shareholder concerns, rather that the defender of a Maginot Line. Early on, she agreed to spin off DuPont’s major chemical division (now called Chemours). Finally, Trian Fund did not own that much stock (only about 2.7%). All in all, this was the largest public company ever subjected to a proxy fight for board seats. Hence, the question lingers: given DuPont’s size, success, and flexibility, and the absence of any “wolf pack” with a sizeable stake, why was the margin of victory so close?

One answer has to be that the governance professionals at pension funds and mutual funds now favor (or at least are open to) the idea of a divided, factionalized board. Putting Nelson Petz on DuPont’s board struck many of them as a low-cost means, with little downside risk, of keeping DuPont “in play” and signaling the shareholders’ desire for more spinoffs and less investment in long-term capital projects, including research and development. Consistent with this attitude, two new studies this year show that activists have achieved over 75% success in recent proxy contests, electing at least one director.[1] Indeed, the odds are so stacked in favor of activist investors who run a “short slate” of director nominees that the number of proxy contests has recently fallen. Why? Managements would much rather negotiate with activists over the identities of their nominees (and the size of any stock buyback) than become involved in a hostile fight that they are likely to lose. The activists may obtain a little less in these negotiations than they would win in a proxy fight, but they correspondingly save the $10 million or so in expenses that the proxy contest would cost them. As a result, both sides would rather settle and increasingly do so. Even Martin Lipton, the staunchest of the critics of shareholder activism, has recognized in a recent memo to his clients that if you can’t beat them, you need to join them.[2]

2. How Can a Mature Company With Negative Synergy Win a Proxy Contest? Most larger public corporations are characterized by “negative synergy”—that is, they could be broken up into multiple components whose collective stock value would exceed the value of the original firm standing alone. Thus, activists are often seeking a “restructuring”—by which they mean a sale or spinoff of major divisions. Even though DuPont survived, it was compelled to spin off Chemours, a major chemical division. Complete victories with no concessions to activists are just not possible today.

The balance of advantage in these engagements has shifted significantly, largely because of the development of the new “wolf pack” tactic. A “wolf pack” is a loose association of hedge funds (and possibly some other activists) that stop just short of forming a “group” (which would require disclosure under Section 13(d)(3) of the Williams Act once the “group” collectively held 5% or more of any class of the stock of the engaged firm). The essence of the “wolf pack” is conscious parallelism without any agreement to act in concert.[3] The market can quickly recognize a “wolf pack” once its leader crosses the 5% threshold and files its Schedule 13D, and the market responds more enthusiastically to a “wolf pack” than to other activist investors, running up on average 14% in abnormal returns on the date of its public appearance.[4] Also, the “wolf pack” acquires substantially more—at least 13.4% in on recent study.[5] But this may understate, as researchers cannot know how many allies the wolf pack leader has. In the Sotheby’s proxy litigation last year, the CEO of a prominent proxy solicitor, testifying as an expert witness, estimated that hedge funds then held over 32% of Sotheby’s (a mid-cap sized firm).[6] This is a near control block.

The key advantage of joining a “wolf pack” is that it offers near riskless profit. The hedge fund leading the pack can tip its allies of its intent to initiate an activist campaign because it is breaching no fiduciary duty in doing so (and is rather helping its own cause); thus, insider trading rules do not prohibit tipping material information in this context. If one can legally exploit material, non-public information, riskless profits are obtainable, and riskless profits will draw a crowd on Wall Street.

Nonetheless, DuPont still won a narrow victory. Besides the reasons earlier given—e.g., (1) a strong track record of beating the S&P 500 Index; (2) a market capitalization too big for most activists to take on; and (3) a large mass of loyal retail shareholders—a final reason best explains DuPont’s victory: it gained and held the loyalty of its indexed investors. Vanguard Group, Black Rock and State Street collectively held 16.7% of DuPont,[7] and each supported management. CalPERS, which is also heavily indexed, similarly voted with management. Yet, almost all “stock picking” investors, including Fidelity and a number of major banks, voted with the Trian Fund. In short, the indexed investors accounted for the margin of victory at DuPont, because if any one of these three had voted with Trian, the outcome would have been reversed.

From a corporate governance perspective, this division between largely indexed asset managers (as typified by Black Rock and Vanguard) and “stock pickers” (as typified by Fidelity) seems fundamental. But what explains it? Activist investors claim that indexed investors are simply “lazy,” but the latest evidence shows that indexed investors do press for independent directors and vote generally in favor of corporate government reforms.[8] Where they draw the line is over proposals to force a takeover or restructuring. But why? Here, one must hypothesize, and the most plausible hypothesis is that the large asset managers are concerned about the impact of hedge fund activism on their broader portfolio.[9] In contrast, the activist investors who join the “wolf pack” are usually undiversified and exit on average within a year after the filing of the Schedule 13D by the wolf pack’s lead investor.[10] Conversely, indexed investors are there for the long-term and will suffer the consequences if the activists’ short-term engagement with the firm produces longer-term losses. Beyond this obvious timing point, indexed investors also may be concerned not simply about the stock price of the target firm so engaged, but also about the impact of activism on their entire portfolio. That leads to the next question: what impact is activism having on the economy generally?

3. What Are the Impacts of Contemporary Shareholder Activism? A variety of studies show that on the filing of a Schedule 13D by an activist hedge fund, the target’s stock price rises by 6 to 7% (net of the overall market movement).[11] But, as earlier noted, this price increase will be much greater (around 14%) on an announcement of a campaign by a “wolf pack” of hedge fund activists.[12] This probably reflects the greater prospects of success by such a group, which typically amasses a larger position.[13] The result is to increase the expected takeover premium for the firm so targeted by the activists.

But what happens over the longer term? The latest study, which collects the experience of over 1,700 firms, finds that it all depends on the outcome of the engagement. If the engagement results in a takeover or restructuring, the long-term abnormal gains are significant.[14] But if the only outcome is a “liquidity event” (a major dividend or a stock buyback), the long-term price impact is insignificant to negative.[15] Eventually, if no takeover or restructuring results, the long-term gains erode away.

Alone, this finding would not explain why “indexed” investors vote differently than activist, stock-picking investors. But another recent study suggests that there may be real, but long-term, costs from hedge fund activism for the economy as a whole. These researchers took the stocks included in the Wall Street Journal’s and FactSet’s Activism Scorecard and trimmed this sample down to just those campaigns launched by activist hedge funds. Then, they followed those firms that successfully avoided a takeover. They found that these firms, even though they survived the activists’ engagement intact, were forced to curtail their investments in research and development by more than half over the next four years. Specifically, R&D expenses in this sample fell from 18% of sales to 8.12% of sales over that period.[16] Nor was this a general secular trend, because in a random sample of firms not engaged by activists, they found that research and development expenditures rose modestly as a percentage of sales over the same period.[17]

Although still a preliminary study, this finding should not surprise, because it confirms what activists say they are doing. Trian Fund made clear that it wanted to reduce DuPont’s expenditures on R&D. Similarly, when Pershing Square Capital and Valeant Pharmaceuticals made a bid for Allergan last year, Valeant announced that, if successful, it would cut R&D at the combined firm by 69%.[18] Although most pharmaceutical companies typically spend about 20% of their revenues on R&D, Valeant spent only 2.7% of its revenues on R&D.[19] Its business model was to milk acquired companies like cash cows for their cash flow.

This pattern of cutting R&D expenditures (even at companies like DuPont that have historically profited from R&D) may make sense for investors who will be long gone within a year or so. But indexed investors, who are locked into the market, cannot sensibly take this short-term perspective. They also need to fear that activism will deter investment in R&D at all firms, not just the ones that are targeted. Thus, they resist activist calls for sharp curbs on R&D or for restructurings that break up well-performing companies into their component divisions. Eventually, major R&D cuts must translate into reduced technological superiority and productivity for U.S. companies.

Activists today present themselves as the champions of shareholder democracy, but it is just as arguable that indexed investors are the true heroes.

4. What Will Happen Next in Shareholder Activism? DuPont’s narrow victory should not slow the tide of hedge fund activism. First of all, even if chagrined by its loss, Trian Fund made money on its DuPont investment. Also, Trian Fund’s campaign was not a true “wolf pack” raid. Trian began its campaign two years ago and never assembled a large stake. While it held only 2.7%, the typical “wolf pack” holds approximately 13.4% at the time its leader files its Schedule 13D (well above the roughly 8% held by other activists at the same moment).[20] Sometimes, this stake can border on a control block.

In 2014, there were some 347 activist “engagements” of public corporations, up from around 200 a few years earlier.[21]

ENDNOTES

[1] See Marco Becht, Julian Franks, Jeremy Grant and Hammes F. Wagner, The Returns to Hedge Fund Activism: An International Study, (available at http://ssrn.com/abstract=2376271)(March 25, 2015); Yvon Allaire and Francois Dauphin, “Hedge Fund Activism: Preliminary Results and Some New Empirical Evidence” (Institute for governance of public and private corporations, April 1, 2015).

[2] See Joe Nocera, “The Battle for DuPont,” N.Y. Times, May 9, 2015 at p. A-19 (summarizing Marty Lipton’s “practical advice” that boards “have no choice but to offer them board seats”).

[3] For a fuller review of these tactics and the legal and market developments that made the “wolf pack” possible, as well as the concept of “group,” see John C. Coffee, Jr. and Darius Palia, “The Impact of Hedge Fund Activism: Evidence and Implications” (available at http://ssrn.com/abstract=2496518)(Oct. 2014).

[4] See Becht, Franks, Grant and Wagner, supra note 1, at 32.

[5] Id.

[6] Daniel Burch, CEO of Mackenzie Partners, so testified in the Sotheby’s litigation that hedge funds then held an estimated 32.68% of Sotheby’s. On the basis of the “threat” this constituted, the Chancery Court upheld a special “discriminatory” version of the poison pill. Third Point, LLC, the lead activist, held only 9.62% of Sotheby’s, thus showing the size of the allies that the “wolf pack” leader can assemble. See Third Point, LLC. v. Ruprecht, 2014 Del. Ch. LEXIS 64 (May 2, 2014).

[7] See Heard on the Street, “Why Peltz Didn’t Have Icahn’s Apple Touch,” The Wall Street Journal, May 23, 2014 at B-14.

[8] See Ian Appel, Todd Gormley & Daniel B. Keim, “Passive Investors, Not Passive Owners” (available at http://ssrn.com/abstract=2475150 (April 3, 2014)(studying preferences and characteristics of indexed, “passive” asset managers).

[9] Of course, large asset managers also say this explicitly. Larry Fink, the CEO of BlackRock, has written open letters to several thousand public corporations in his portfolio, expressing this view.

[10] One study finds that activists exit on average within 266 days after the filing of the initial Schedule 13D. See Alon Brav, Wei Jiang, and Hyanseoh Kim, Hedge Fund Activism: A Review, Foundations and Trends in Finance (available at http://ssrn.com/abstract=1551953) at p. 18 and Table 4.2 Panel C (February 2010).

[11] For the earliest such study, see Alon Brav, Wei Jiang, Frank Partnoy, and Randall S. Thomas, Hedge Fund Activism, Corporate Governance and Firm Performance, 63 J. Fin. 1729 (2008).

[12] See Becht, Franks, Grant and Wagner, supra note 1, at 32.

[13] Becht, Franks, Grant and Wagner, supra note 1, find that the “wolf pack” typically amasses a stake of around 14% as compared to 8.3% for other activists. Id at 32.

[14] Id at 4.

[15] Id at 8 (finding that outcomes that merely increase the payout to shareholders (such as a dividend or stock buyback) generate returns of “roughly zero”).

[16] See Allaire and Dauphin, supra note 1, (finding an average decline in R&D expenditures as a percentage of sales from 17.34% in 2009 to 8.12% of sales in 2013).

[17] Id (finding a modest increase in R&D expenditures from 6.54% of sales in 2009 to 7.65% of sales in 2013).

[18] See Joseph Walker and Liz Hoffman, “Allergan’s Defense: Be Like Valeant,” The Wall Street Journal, July 22, 2014 at B-1.

[19] See Joseph Walker, “Botox Itself Aims Not to Age,” The Wall Street Journal, May 19, 2014 at B-1.

[20] See text and note supra at note 15.

[21] See Jacob Bunge and David Benoit, “DuPont Repels Push by Peltz to Join Its Board,” May 14, 2015 at p. 1.

The preceding post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.