Hedge fund activism is a topic on which most law professors have closed their minds. They learned in student days that activist hedge funds are excellent agents of change that efficiently discipline managements at targeted firms and increase shareholder wealth. Maybe that generally happens, but we cannot stop there.
Even if activism increases shareholder wealth, that still leaves open the question of where these wealth increases come from. The standard view is that activists increase firm productivity, force the “deconglomeratization” of stagnant firms, and expose others to efficient takeovers. Of course, that does happen — sometimes. But the rival view is that at least some of the gains from hedge fund activism are attributable to wealth transfers from other stakeholders, most notably bondholders and employees. On the theoretical level, Andrei Shleifer and Lawrence Summers articulated this theory as early as 1988, arguing that activism was a breach of trust by employers to their employees. In terms of empirical evidence, there has been considerable research on wealth transfers by bondholders and other creditors to the target firm, but the research on wealth transfers by employees to the firm has been more limited and reached mixed conclusions.
Now, however, strong evidence has emerged that wealth transfers by employees significantly fuel hedge fund activism. How does this happen? It only overstates slightly to say that this new research demonstrates that hedge fund engagements regularly “raid” the pension funds of target firms. In a detailed empirical study that is forthcoming in the Journal of Financial and Quantitative Analysis, professors Anup Agrawal and Yuree Lim find that activist pressure causes managers to raid a pension fund in at least four different ways:
- Managers can underfund the pension plan by decreasing employer contributions to the plan;
- Managers can increase the assumed rates of return on plan assets to justify making lower employer contributions;
- Managers can increase the discount rate to make the present value of plan liabilities appear smaller; and
- Managers can freeze or terminate the pension plan.
Their basic finding is that “pension funds of firms targeted by HF activists experience an increase in underfunding relative to their normal levels, compared to increases experienced by otherwise similar control firms.” This underfunding continues “over the two years after activism events.”
All the foregoing techniques appear to be employed. In the case of employer contributions, “target firms significantly reduce employer contributions to employee pensions plans after being targeted by HF activists,” with contributions dropping “by about 16% to 26% relative to their previous levels.” In the case of assumed rates of returns on plan investments, Agrawal and Lim found that targeted firms “tend to increase their assumed rates of return … by about 1.7% to 2.7% of the assumed mean return of 7.2% to 7.6%.” In terms of asset allocation, they find that, under the pressure of activism, “targeted firms tend to invest more in risky assets such as equity.” Targeted firms also “increase the pension discount rate used to compute the present value of pension liabilities,” and this increase is statistically significant. Finally, over the sample period, the authors find 10 pension plans that were frozen following hedge fund activism, but draw no firm conclusions from this small number.
Hedge funds can, of course, invest in a target company for many reasons, including that they simply consider it to be undervalued. But activists invariably file a Schedule 13D, which requires them to identify the purpose of the transaction. Professors Agrawal and Lim find that pension “underfunding increases only in firms targeted by activists for M&A or governance reasons.” For firms targeted for M&A reasons, underfunding increases by about 40.9%, and for those targeted for governance reasons, by about 24.1% (in each case relative to the mean underfunding level). Yet, for the rest of the sample that was not targeted for M&A or governance reasons, the filing of a Schedule 13D resulted in only a 6.8% to 7.6% increase in underfunding. The bottom line here seems unavoidable: An M&A threat from activists results in pension underfunding. Indeed, the authors also find that “the stock price reaction to activism announcement is partly in anticipation of upcoming reductions in employee funding levels.” In the case of defined benefit plans, they conclude that “roughly 7% of the wealth gains to shareholders at activism announcement come from underfunding of employee pensions.”
The evidence is harder to calculate in the case of defined contribution plans, but there is again a statistically significant decrease in contributions after the employer is targeted by hedge fund activists, and it comes to a “whopping 31% to 48% of the mean employer contribution.”
Worse yet, Agrawal and Lim find evidence suggesting (but they reach no firm conclusions) that targeted “firms increase dividend payments to shareholders while employees suffer from pension underfunding.” The authors summarize their findings, concluding that corporate managers “in the face of a strong threat to their careers” raid the pension plan “by way of a quick fix.” Defined benefit plans are more exposed because they are a “soft target” that is typically “under the control of the managers.”
The Agrawal and Lim study does not address one fascinating question: Are the hedge funds pushing managers to loot the pension fund? Or, do the managers do that on their own under the pressure of the hedge funds demanding a quick fix? There is much room for further research here. Still, hardcore defenders of hedge fund activism will respond that it does not matter because the gains from hedge fund activism greatly exceed the losses they cause to employees. Even if this may often be true, no one is claiming that hedge fund activism should be halted based simply on this data. This is one of the first studies to carefully document activism’s impact on employees. What it unquestionably shows is a governance failure: There is no gatekeeper protecting the pension fund. When corporate managers are under pressure, the pension plan resembles an open safe to which they can easily turn for cash to pay those threatening them.
Why is it so easy? One answer may be that the auditors have been captured by management and no longer fear securities law or ERISA liability. Another may be that the Department of Labor, which supervises ERISA, may have been a shut-eyed sentry (particularly during the Trump years). But today, a Biden Administration has no reason to defer, particularly when widespread pension shortfalls could threaten the solvency of the already threatened Pension Benefit Guaranty Corporation. Changes in pension contributions, assumed investment returns, or discount rates are visible events that could easily be identified by the Department of Labor, and these revisions should prompt requests for explanation. To do nothing and ignore this evidence would imply that officials are still asleep at the wheel.
Ultimately, it is unnecessary to characterize hedge funds as “crooked” or “evil.” The better word is “opportunistic.” They will pressure for managers to transfer wealth to shareholders from all possible sources, including the pension fund. Fortunately, corporate managers do not yet have access to the church’s poor box.
 Andrei Shleifer and Lawrence H. Summers, “Breach of Trust in Hostile Takeovers” in CORPORATE TAKEOVERS: Causes and Consequences, (A.J. Auerbach, ed.) (1988).
 For example, see A. Klein and E. Zur, The Impact of Hedge Fund Activism on the Target Firm’s Existing Bondholders, 24 Review of Financial Studies 1735 (2011); J. Sunder, S.V. Sunder and W. Wongsunwai, Debtholder Responses to Shareholder Activism: Evidence from Hedge Fund Interventions, 27 Review of Financial Studies 3318 (2014).
 For one of the few such studies, see A. Brav, W. Jiang, and H. Zim, The Real Effects of Hedge Fund Activism: Productivity, Asset Allocation and Labor Outcomes, 28 Review of Financial Studies 2723 (2015). The author has stated his own views in this area. See J. Coffee and D. Palia, The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance, 1 Annals of Corporate Governance 1 (2016).
 A. Agrawal and Y. Lim, Where Do Shareholder Gains in Hedge Fund Activism Come From? Evidence from Employee Pension Plans (forthcoming in Journal of Financial and Quantitative Analysis (2021)).
 The standard assumption is that employers will freeze an underfunded plan and terminate an overfunded one (to capture the excess). See J. Cocco, Corporate Pension Plans, 6 Annual Review of Financial Economics 163 (2014).
 A. Agrawal and Y. Lim, supra note 4, at 14.
 Id. at 14.
 Id. at 16.
 Id. at 16 to 17.
 Id. at 17. I have elsewhere argued that, under the Black-Scholes model, activists behave like option holders and will pressure a firm to increase the riskiness of its investments. See John C. Coffee, The Future of Disclosure: ESG, Common Ownership, and Systematic Risk (available at ssrn.com/abstract=3678197(2020)).
 Id. at 18.
 Id. at 19.
 Id. at 21 to 22.
 Id. at 22.
 Id. at 27.
 Id. at 22 n.13.
 Id. at 28.
 Id. at 28.
 The PBGC is already severely underfunded, and most pension plans of public corporations were similarly underfunded, even before hedge fund activists made an appearance. See United States Government Accountability Office, HIGH RISK: PBGC Insurance Programs (GAO report No. 17-317)(2017).
This 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.