In a recent post, Some Lessons from DuPont-Trian, Martin Lipton identified shareholder voting in a proxy contest as a problem with hedge fund activism. According to Mr. Lipton, “ISS and major institutional investors will be responsive to and support well-presented attacks on business strategy and operations by activist hedge funds on generally well managed major corporations, even those with an outstanding CEO and board of directors.” My interpretation of this statement is that voting for a slate of hedge fund nominees that goes against the recommendations of a well functioning board of directors (Board) is the wrong vote and will not be wealth enhancing. If this interpretation is correct, I am in total agreement with Mr. Lipton’s statement. The problem arises because shareholders and proxy advisory firms utilize the wrong criteria in determining how to vote. In this post I argue that shareholders should not vote in favor of the activist hedge fund’s nominees unless there is clear evidence that the Board lacks independence when evaluating the recommendations proposed by the activist.
In my recently posted article, Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value?, I put forth the argument that “An activist hedge fund can create long-term value at a public company if the Board [board of directors] has enough independence to act as an impartial arbitrator deciding between the advices provided by executive management and the activist hedge fund.” This argument assumes the following integrated model of corporate governance:
First, statutory corporate law provides that the Board is the default locus of authority for the corporation. Second, statutory corporate law also provides that the Board may delegate this authority to the managerial experts, executive management. This locus of authority manages the day-to-day operations of the public company, recommends corporate strategy and uses its management expertise to implement these strategies. Third, the stock market, through value investors, provides signals to the Board that, not only its own decision making, but most importantly, the decision making of its executive management may be suffering from inefficiencies. These signals provided by the stock market should act as a catalyst, encouraging the Board to enhance its monitoring of executive management. Fourth, the stock market, but this time through the activist hedge fund, provides strategic recommendations for the Board to consider in deciding how the company should move forward. This information can be used by the Board in its monitoring of executive management. Fifth, the Board, assuming an adequate level of independence, can arbitrate between the two loci of authority and then determine which path it should take, the one recommended by executive management, the one recommended by the activist hedge fund or perhaps a combination of both.
Yet, this is not necessarily the end of the story. At times, an activist hedge fund, not satisfied with the actions of the sitting Board, may proceed with a proxy contest requiring a shareholder vote on a slate of directors nominated by the hedge fund. Shareholder voting at this point in the process is full of risks as the direction of how the company should strategically proceed is placed in the hands of those who generally understand the company the least, the typical institutional investor. Such investors, while sophisticated in many ways and perhaps up-to-date on the latest corporate governance best practices, are ill-prepared to participate in the strategic decision making of any particular company they invest in. They may utilize index funds as their vehicle for investment or they may be value investors who know a lot about the company but who do not have the interest or the resources available to become actively involved in such company-centric decision making. Unfortunately, in this situation, the locus of authority in the best position to decide, the independent Board, is relegated to the sidelines as a pitchman for its respective position.
However, if institutional investors and proxy advisory services understand the value provided by an independent Board, as described above, then the risks of inefficient corporate decision making resulting from such a proxy contest may be minimized. To implement this understanding shareholders and proxy advisory services must approach voting as a two-step process. First, they must base their votes or recommendations on an evaluation of whether or not they believe the Board is operating with enough independence such that it can act as an efficient arbitrator of the various strategic proposals before it. If yes, then they should vote with the Board and against the nominees of the activist hedge fund. This approach is analogous to how the business judgment rule is applied in corporate law. That is, when a Board decision is not tainted with interest, lack of independence or gross negligence, the Courts, who are uninformed like the typical investor, will not get involved in the business decision. More importantly, for a typical institutional investor with a diversified portfolio of stocks in its portfolio, this is the only rational approach that can be taken. Utilizing the investment strategy of allowing the locus of authority in the best position to make the decision the opportunity to do so should lead the institutional investor to receive the highest returns on its portfolio over time.
The second step comes into play only if there is clear evidence that the Board is not acting independently. If so, then and only then should the shareholders and proxy advisory services be asking the question, “Have the dissidents made a compelling case that change is warranted?” This is analogous to a court proceeding where the plaintiff is able to overcome the business judgment rule with sufficient evidence of taint and thereby requiring the court to utilize an entire fairness standard of review, fair dealing and fair price. Hopefully, investors will not be faced with this type of decision very often.
. Martin Lipton, Wachtell Lipton explains Some Lessons from DuPont-Trian, The CLS Blue Sky Blog (April 29, 2015), available at https://clsbluesky.law.columbia.edu/2015/04/29/wachtell-lipton-explains-some-lessons-from-dupont-trian/.
. Bernard S. Sharfman, Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value?, forthcoming, Colum. Bus. L. Rev. (2015), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2576408. See also, Bernard S. Sharfman, Why Run Away from the Evidence?, Harvard Law Sch. Forum on Corp. Governance & Fin. Reg. (May 7, 2015).
. Bernard S. Sharfman, Activist Hedge Funds, supra note 2.
. Paul Rose and Bernard S. Sharfman, Shareholder Activism as a Corrective Mechanism in Corporate Governance, 2014 BYU L. Rev. ___, ___. .
. Martin Lipton, supra note 1.
The preceding post comes to us from Bernard S. Sharfman, adjunct professor of business law at the George Mason School of Business, a member of the Journal of Corporation Law’s editorial advisory board and a former Visiting Assistant Professor of Law at Case Western Reserve University School of Law (Spring 2013 and 2014). The post is based on his recent article, which is entitled “Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value?” and available here.