Hedge Fund Activism, Poison Pills and the Jurisprudence of Threat

Hedge fund activism is to corporate law’s early 21st century what the hostile takeover was to its late 20th century.  Like the hostile takeover, activism threatens incumbent managers and disrupts their business plans by successfully appealing to the shareholders’ interest in immediate returns.  Like the hostile takeover, activism occupies center stage in corporate law policy discussions, posing a choice between short-term gain and long-term investment.  But there is a glaring point of distinction.  Unlike the hostile takeover, activism has precipitated no significant changes in corporate law.  Where the hostile takeover triggered structural changes in state corporate codes and the federal securities laws along with a root and branch reconfiguration of fiduciary duty, hedge fund activism largely leaves corporate law where it found it.  The activists manage to play hostilely without bumping up against the defensive barriers erected in the late 20th century transformation of corporate law because they avoid attempting to take control.   At the same time, law reform initiatives designed to constrain the new mode of hostile intervention have failed to pick up traction.

There is but a single high profile case in which 20th century antitakeover law has come to bear on a management defense against a 21st century activist challenge—the Delaware Court of Chancery’s decision in Third Point LLC v. Ruprecht, better known as “the Sotheby’s case.”  The board of directors of a target corporation, Sotheby’s, lobbed a poison pill in the path of one of the more aggressive hedge funds, Third Point LLC, and its chief, Daniel Loeb.  The pill had a “low threshold” feature, capping a hostile challenger’s block at 10 percent of outstanding shares rather at the traditional 20 percent.  It thereby disabled Third Point from enhancing its vote total in a short-slate proxy contest through additional purchases of target shares. The Chancery Court nonetheless sustained the pill under Unocal v. Mesa Petroleum Co.  The decision implicated an important policy question: whether a 20th century doctrine keyed to hostile takeovers and control can be brought to bear in a 21st century governance context in which the challenger eschews control transfer and instead makes aggressive use of the shareholder franchise.

Resolution of the issue entails evaluation of the gravity of two sets of threats, one at the doctrinal level and the other at the policy level.  The doctrinal threats are exterior threats to corporate policy and effectiveness on which managers justify defensive tactics under Unocal.   Because some threats have greater justificatory salience under Unocal than do others, a question arises as to the nature and characterization of the threats allegedly held out by activist intervention.  The policy threats implicate the new balance of power between managers and shareholders.  Hedge fund activism has operated as a catalyst that enables dispersed shareholders to surmount collective action problems so as to register preferences regarding corporate business plans in connection with voting on competing candidates for board seats.   To the extent that managers wielding low-threshold poison pills disable activist challenges, the power balance could shift back in their favor with potentially negative agency cost consequences.

I appraise the threats in a recently published working paper.  As regards Unocal, the paper demonstrates a serious problem of fit.  The most potent Unocal threats are those involving coercion of dispersed shareholders in connection with hostile tender offers or expropriation from dispersed shareholders by controlling blockholders.  The threats, originally identified on 1980s control transfer fact patterns, show up only tangentially on the new fact patterns.  To the extent that Unocal doctrine relies on the old threats in sustaining poison pills deployed against today’s activists, it ends up as more of a formal rubber stamp than a substantive fiduciary inquiry.

The Sotheby’s opinion, although for the most part staying inside of the inherited framework of Unocal doctrine, does take a tentative step into the 21st century, suggesting that activists hold out a threat of “disproportionate influence,” but without filling in any particulars about the influence’s nature and negative effect.   The paper posits the missing details, conducting a thought experiment that reshapes and extends Unocal so that it provides a robust basis for sustaining management defense against activist hedge funds, even shielding poison pills with 5 percent triggers.  The extension is radical.  Up to now, Unocal has facilitated management actions that protect dispersed shareholders from being railroaded into selling the company for too little.  Under the extension, Unocal would justify management actions that protect shareholders from the consequences of their own collective actions in casting uncoerced ballots at director elections.  Many, perhaps most observers, would view the extension as a perversion of the governance system’s heretofore jealous protection of the shareholder franchise to elect directors.

The paper’s refitted version of Unocal sharply poses the policy threat. Most observers would find the prospect of an easily justified 5 percent poison pill threatening indeed, projecting that it would inhibit activist intervention and thereby damage the corporate governance system.   But the projection of harm rings hollow in the present posture of shareholder-manager politics.  Even if structural changes inhibiting activism would in fact result in economic injury, no significant inhibition is likely to follow from judicial sanction of a 5 percent pill.  A low-threshold pill deters activist block formation only to the extent that it is put in place in advance of the activist’s appearance.  These days very few managers dare to promulgate such “standing” pills.  So powerful have shareholders become that in today’s managerial cost-benefit calculus, the detriments of incurring the shareholders’ wrath by traversing their governance preferences regarding charters and bylaws now outweigh a poison pill’s insulating benefits.

Given that, it is worth asking whether 5 percent poison pills could have policy benefits.  The policy stakes are traversed in a debate in which activism is associated with value-destructive short-termism.  The debate’s participants argue back and forth based on assumed across-the-board tendencies.  But questions about short-term value sacrifices cannot be resolved on an aggregate basis.  It depends on the company.  Some are appropriate targets for activist intervention, while others are not.  The paper suggests that company-by-company dialogue on the point would be a good thing, exploring the possibility that a 5 percent standing pill could trigger useful informational exchanges between managers and institutional investors without simultaneously over-deterring activist intervention.

This post comes to us from William W. Bratton, the Nicholas F. Gallicchio Professor of Law and Co-Director of the Institute for Law and Economics at the University of Pennsylvania Law School. It is based on his recent paper, “Hedge Fund Activism, Poison Pills, and the Jurisprudence of Threat,” available here.

1 Comment

  1. Charles Nathan

    Professor Bratton,

    I read your article with interest. I have a number of comments–big and small–which I would like to share with you. FYI, I am a former M&A lawyer, most recently at Latham & Watkins where I co-chaired the global M&A practice for almost 10 years. I am also an adjunct professor of law at both Yale and Columbia where I teach an advanced M&A seminar.
    1. I think your assumption that a 20% pill is the norm is significantly out-of-date. I believe that the customary threshold dropped to 15% in the 90’s and that a significant number of contemporary pills (although clearly a minority) use 10%. I suggest you go to one of the many data bases on hostile defenses where I’m confident you will find support for my belief.
    2. You assume that the reasons activists are successful is because short-term holders support their short-term proposals. I don’t think that is the case. The vast majority of institutional shareholders–who comprise between 70-90% of the electorate at most public companies–are not short-term owners. Clearly index funds are not. Moreover, most of the larger actively managed funds hold their core positions for years not months. While you can find turn-over statistics that imply the average holding is around 6 months, this is the result of skewing of averages by a small number of quantitative funds that depend on rapid trading strategies. I suggest you look at the analysis by the Investment Institute of America of stock position turn-over by mutual funds for an explanation of the misperception of the turn-over statistics of mutual funds.
    3. I think you also confuse the duration of a shareowner’s holding period and the time it takes to implement fully a management strategy or business plan. The former does not bare any necessary relationship to the latter. For example, if the stock market is at least to some meaningful degree efficient, the market price of a security reflects the NPV of management’s then current strategy and business plans. A short-term holder (what ever that may mean–after all when do you measure the holding period–from the date of inquiry or historically–that is, if a mutual fund decides to reduce or eliminate its holdings in a company, do you measure its holding period from inception of its position which may be years or from the time of the sale decision? If the later, then every seller is a short-term holder) is realizing the value of the company’s long-term plans. For this reason, I don’t agree with your assertion that the difference between a short-term holder and a long-term holder is the incidence of their holding period in the sense that short-termers vote for short-term programs and long-termer for long-term programs..
    4. Because the bulk of institutional owners are long-term owners, there must be a reason other than the duration of their holding period to explain their proclivity to support activists. I would propose that reason is their assessment of the Net Present Value creation differential between management’s plan and the activist’s plan.
    5. I think Laster’s quote is really about NPV. And his assertion that a board’s responsibility is to adopt and execute plans and policies that will create the greatest NPV is hardly startling. If Laster, on the other hand, is confusing the nominal value created by alternative plans with their net present values, it indeed would be revolutionary and wrong-headed. On what basis should a board select one business plan over another without taking into account the need to discount both plans to the present?
    6. It may be that institutional investors are biased to the short-term in their calculation of the NPV of competing strategies. If so, that would likely be attributable to:
    (a) what I understand to be a documented human bias toward shorter-term programs because of an intuitive distrust of one’s ability to project the future which diminishes as the time horizon expands.
    (b) for activist investors, a need to perform (as measured by their investment benchmarks) on a quarterly and annual basis in order to attract and retain assets under management. This pressure is ultimately attributable to the beneficial owners of the funds put at the active managers disposal–that is to say public and private pension fund managers and, to a growing degree, individuals who make investment decisions under their 401K and similar plans. To a very real extent, I believe that to the extent short-termism is resulting in selection of lower NPV business plans, (in the immortal words of Pogo) “we have met the enemy and they is us”.

Comments are closed.