Hedge fund activism has increased almost hyperbolically. Some view this optimistically as a means for bridging the separation of ownership and control; others are more pessimistic, seeing mainly wealth transfers from bondholders or speculative expectations of a takeover as fueling the spike. Equivalent division exists over the impact of this increased activism, with optimists seeing real gains that do not erode over time and improvements in operating performance, and pessimists predicting shortened investment horizons, increased leverage, and reduced investment in research and development.
In a paper recently posted on SSRN,[1] we take an analytic perspective. We begin by surveying the regulatory and institutional developments that have reduced the costs and increased the expected payoff from activism for hedge funds, including the decline in staggered boards, the increased influence of proxy advisors, and various SEC reforms. Here, we focus particularly on the formation of “wolf packs”—namely, loose knit associations of hedge funds that are formed prior to, or contemporaneously with, the filing of a Schedule 13D. These wolf packs can easily acquire 30% or more of the target’s stock, buying mainly in the ten-day window period before the lead hedge fund files its Schedule 13D. Such buying may be lawful, but it does exploit asymmetric information in a manner that may disadvantage other shareholders. We then look at other new institutional structures that are appearing, as typified by the alliance between Pershing Square Capital Management and Valeant Pharmaceuticals in their bid for Allergan.
Next, we survey the empirical evidence on the impact of activism, analyzing (1) who are the targets of activism?; (2) does hedge fund activism create real value?; (3) what are the sources of gains from activism?; and (4) do the targets of activism experience post-intervention changes in real variables? Although confident claims have been made by some researchers, we find the evidence decidedly mixed on most questions (other than the short term stock price impact). In particular, we find the conclusions about improvements in target operating performance that have been expressed by some to be premature and overextended beyond their actual results. Wealth transfers from bondholders (and possibly employees) and increases in the expected takeover premium appear to account for much or most of the activists’ gains.
Finally, we examine the policy levers that could encourage or chill hedge fund activism and consider the feasibility of reforms. The gains from hedge fund activism may be high both because such activity is relatively low risk (if asymmetric information can be exploited that is acquired before the filing of a Schedule 13D) and requires only a short-term commitment (with the median holding period for the lead hedge fund activist being approximately nine months). Thus, some have proposed SEC rules that would close the ten-day window permitted by the Williams Act before beneficial ownership must be disclosed by those who cross the 5% threshold. Others would redefine the law of insider trading to treat other forms of business combinations equivalent to tender offers and thus within the scope of Rule 14e-3. Still others would redefine the term “group” under the Williams Act to include those who act in a consciously parallel fashion. We have doubts about some of these proposals, but in any event do not believe that an overburdened SEC is likely to act soon in these areas.
In this light, it is important to consider what can be done through private ordering. Here, we propose the use of what we term a “window-closing” poison pill. Such a pill would be triggered by purchases made one day or more after crossing the 5% threshold and before filing a Schedule 13D. But, to give balance to this defensive tactic and make it judicially acceptable, we would allow the acquirer to purchase up to 15% (or potentially higher in the case of a Schedule 13G filer) so long as these purchases were made after the Schedule 13D filing. Effectively, this “closes” the ten-day window under Section 13(d)(1) of the Williams Act without regulatory action, but it is not “preclusive” in any sense (and thus should not offend Delaware judges who appear increasingly sensitive to poison pills with low thresholds).[2]
We do not suggest that this approach will preclude “wolf packs” or aggressive activism by hedge funds, but it is a feasible step towards greater transparency and less exploitation of asymmetric information. To be sure, firms that adopt such a novel pill will face challenges in court and a hostile reaction from their proxy advisors.[3] But, in an era of rampant activism, that is the choice that has to be faced: to do nothing (hoping that activist funds do not appear on your doorstep) or adopt a “standing” pill with a feature that constrains them moderately.
[1] John Coffee and Darius Palia, “The Impact of Hedge Fund Activism: Evidence and Implications” (available at http://ssrn.com/abstract=2496518) (September 15, 2014).
[2] This sensitivity is evident in Third Point LLC v Ruprecht, 2014 Del. Ch. LEXIS 64 (May 2, 2014), in which the Vice Chancellor upheld a poison pill with a two-tier floor (10% for “active” investors who filed a Schedule 13D and 20% for “passive” investors filing a Schedule 13G), but he was clearly troubled by a low floor, which he upheld only because he decided that the formation of a “wolf pack” was a legitimate threat to Sotheby’s. As a matter of full disclosure, Professor Coffee served as an expert witness for Sotheby’s in this litigation.
[3] Institutional Shareholder Services (“ISS”) has a formal policy against any poison pill that would extend beyond one year without a shareholder vote approving it.
John Coffee is the Adolf A. Berle Professor of Law at Columbia University and Director of its Center on Corporate Governance. Darius Palia is the Thomas A. Renyi Chair in Banking at Rutgers Business School.