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V. Balance of power politics and corporate governance.

Plainly, hedge-fund activists have a role to play in corporate governance. This Article has shown that, when they choose to get involved, hedge funds can be a real force with which to be reckoned. The question then becomes how they fit into current corporate governance theories and, more practically, whether they improve governance or worsen it. The answer requires a look at hedge funds both as shareholders without more and (assuming proxy contest or settlement success) as shareholders with direct board representation.

A. Hedge-Fund Activism Matters

Given how infrequently this Article has found that hedge funds do get directly involved, does hedge-fund activism matter?

Whatever else might be uncertain in our post-Enron world, there would appear to be little room for doubt on this point: We should care about hedge fund activism because the people who run and advise U.S. public companies care. In other words, those most directly affected by takeovers and proxy fights tell us we should care. (181) According to Martin Lipton's recent advice to his clients, for example, "[t]he current high level of hedge fund activism warrants the same kind of preparation as for a hostile takeover bid." (182) The press reports reviewed in the Introduction tell the same story, albeit in somewhat over-wrought terms. (183) Delaware Vice Chancellor Leo Strine has similarly noted "the power of a good example" and predicted that "[r]eplacing a few poorly performing boards will have substantial, beneficial ripple effects on the performance of other boards." (184) Evidently the increasing frequency of publicly reported instances of direct hedge-fund activism is having a still broader, more important, in terrorem effect on an indeterminately wider universe of public companies.

Many successful hedge fund activism negotiations and settlements also happen behind the scenes with little or no publicity. (185) It is still true, as Michael Useem wrote a decade ago, that "[o]pen struggles for control draw attention but also mislead ... [because] most of the traffic between managers and investors transpir[es] out of sight." (186) This kind of quiet activism can be thought of as a kind of Napoleonic military campaign. It is not only the actual battles you fight that count. (187) Real battles cost casualties and money. Battles that the other side can be made to think you are ready to fight matter just as much. Since unfought battles are much cheaper than real ones, you can fight more of them, but with the same expenditure of scarce manpower, time, and money. And quiet, unpublicized shareholder settlement victories are victories nonetheless. (188)

Empirical and other academic studies that review only "proxy fights" while excluding pressure campaigns and most contest settlements miss this considerably larger universe of shareholder activism entirely, and consequently unintentionally understate its significance. (189) In 2005, for example, only 10 of the situations in this Article's survey counted as tracked "proxy fights" in the widely-used Georgeson Shareholder Annual Corporate Governance Review data. (190) Acquiring a better understanding of hedge fund activism means probing deeper into publicly reported hedge fund campaigns--something this Article has taken a first step towards doing--though even then quiet settlements, private negotiations, and some less-reported situations are inevitably missed. (191) It only remains certain that hedge fund activism plays a far more important role in corporate governance than a simple look at the raw numbers would first suggest.

B. Activist Hedge Funds As Shareholders

Taking the reality of all this hedge fund activism and trying to fit it into the various corporate governance theories that have been worked out over the years makes for an interesting exercise. Nothing quite fits.

1. Ownership and Control

As with almost all exercises such as this one, the starting point is the 1932 classic by Adolf Berle and Gardner Means, The Modern Corporation and Private Property, (192) which first clearly articulated and popularized the notion that widely dispersed shareholdings had effectively separated ownership from control in public corporations. "Under such conditions," Berle and Means wrote, "control may be held by the directors or titular managers who can employ the proxy machinery to become a self-perpetuating body, even though as a group they own but a small fraction of the stock outstanding." (193) By the mid 1970s, the principal concern had become how shareholders (the owners) could control and monitor their agents (the directors and managers) while minimizing the "monitoring costs designed to limit the aberrant activities of the agent[s]." (194) Such activities might include almost any imaginable unremunerative sin, including shirking, chasing after perquisites, empire building, and a host of other "rent seeking" crimes. An influential group of scholars writing in this tradition came to see the corporation as a "nexus" or "set of explicit and implicit contracts" among employees, managers and other constituencies, with the shareholders getting "votes rather than explicit promises." (195) According to the theory, "[v]otes make it possible for the investors to replace the managers." (196)

This is where the problems begin. What does it mean to "vote" and "monitor" when, by hypothesis, shareholders are too dispersed and beset by the collective action problems discussed earlier really to do either? (197) If they were somehow to overcome these problems enough to monitor closely, at what point do they start usurping the management role? And what qualifies them to manage better than the managers themselves anyway? Are board members really mere agents?

2. Shareholder Primacy

The predominant theoretical response to these and other related questions has come to be called "shareholder primacy," and means basically what the name implies: shareholders should have the ultimate control over the corporation. (198) Since this demonstrably happens only rarely in the actual everyday world of uncontrolled public companies, two of the main academic inquiries have been into why shareholders do not have this power, and how to give it to them. The arguments over why shareholders usually remain powerless are extraordinarily complex, but basically boil down to the collective action problems already mentioned, (199) insufficient incentives, (200) conflicts of interest, (201) legal obstacles, (202) and management power. (203) Institutional investors consequently generally remain unwilling to spend the time and money to exercise their voting rights fully, that is, to launch proxy fights for control. There is no easy fix. The SEC has proposed letting shareholders put their own director nominees on the official company proxy card at the company's expense; (204) Lucian Bebchuk has taken this one step further and proposed an almost California-like initiative-and-referendum voting procedure that would give shareholders a direct voice in major "rules-of-the-game" decisions currently controlled by boards of directors. (205) The object, in any event, is to help shareholders exercise in practice their power in theory. (206)

For a hedge fund activist, much of shareholder primacy doctrine is already irrelevant or worse, and its fundamental premise that ownership is separated from control seems at best only imperfectly true when it matters most-when the fund is actively investing. A hedge fund that steps in to call the shots for one of its public portfolio companies eliminates the separation and pulls the levers of corporate power directly. By winning board seats, the fund has succeeded in making its voting franchise effective. And as George Dent put it several years ago, an "effective shareholder franchise ... remed[ies] the separation of ownership and control and, with it, most other corporate governance problems." (207) Throwing out an incumbent board refutes the "separation" thesis: control rejoins ownership.

Shareholders willing to wage a proxy fight for control are, by definition, not fundamentally deterred by any of the problems with the current proxy and corporate rules that supposedly need fixing. Otherwise they would not be activists. Specifically, they have enough shares not to be stymied by the collective action conundrum, their holdings are sufficiently concentrated and undiversified to provide an incentive to act in a chosen instance, they do not have trouble attracting like-minded and unconflicted hedge-fund and other allies, they are more than willing to pay expensive lawyers to dodge the legal obstacles, and they care as much about management's power to stop them as General von Rundstedt did about the Maginot Line in the Spring of 1940. (208) Proxy fights cost money, and hedge fund activists can and do pay the price.

Other shareholders are not as willing to pay. The shareholder primacists' proposed solutions to this problem are downright toxic to hedge funds. The main issue is that recently proposed solutions amount to a subsidy for these other shareholders who either cannot or will not pay their own way and, as Roberto Romano recently observed in a related context, "[i]t is textbook economics that parties bearing the full cost of their actions make better decisions than those that do not." (209) For a real-life illustration of this point, we need only note the parties using the SEC's current shareholder proposal rule. Rule 14a-8 lets anyone with only $2000 worth of stock run a 500-word proposal for free in the company's proxy statement. (210) It is not hard to guess what has happened. The rule has been hijacked by those with non-economic agendas: In 2005, for example, more than half (54%) of the governance proposals came from labor unions, religious organizations, and public pension funds; and another 22% came from individual investors having 10 or more proposals, or in other words professional gadflies. (211) An earlier study of the shareholder proposal process reviewed similar statistics and concluded that "nontraditional" sponsors such as these appear "more interested in utilizing the proxy device as a communication or bargaining tool, rather than maximizing shareholder welfare." (212) Detailed studies of union and public pension fund activism have reached the same conclusion. (213) No matter what the outcome of the actual votes on these proposals, and even if we assume that shareholders have gotten pretty good at separating the value-enhancing wheat from the social-agenda chaff, (214) the whole to-do nevertheless remains a significant waste of time and money. Subsidizing these kinds of non-economic agendas does not seem like the most value-maximizing policy imaginable.

Hedge funds would in any event likely not qualify to receive the subsidy. Any politically palatable consolidated directors' ballot, including the one that the SEC has proposed, would likely limit access strictly to long-term, passive holders. (215) Hedge fund activists are never passive and are frequently short-term to boot. Similarly, Bebchuk's initiative and referendum proposal would merely empower other large institutional shareholders whose competence, conflict-free judgment, and frequently overtly political or at least non-economic goals may be highly suspect. (216) In short, empowering these kinds of other shareholders would inevitably bring unwanted and distrusted competition to the corporate governance table. Hedge fund activists therefore paradoxically practice shareholder primacy but cannot believe in it as an academic theory.

A couple of clarifications are in order here. First, hedge fund activists of course believe in shareholder primacy in the sense that they want ordinary, solvent companies to maximize profits for their shareholder owners, as opposed to benefiting communities, workers, or other so-called stakeholders. Hedge fund activists are shareholders after all. Second, hedge fund activists naturally also believe in shareholder primacy in the who-calls-the-shots sense that shareholders' desire, say, to tender into a premium takeover offer should not be thwarted by some pill-wielding and perhaps overly paternalistic board. Again, hedge fund activists are mostly shareholders, not directors. The point here is a different one entirely: as outlined in the preceding paragraphs, shareholder democracy or primacy has often come to be little more than code for what amounts to a subsidy for public pension and union funds and for other "normal" institutional investors unwilling or unable to pay their own way with director election campaigns of their own. It is to this last "code" sense of shareholder primacy that hedge fund activists do not subscribe.

3. Director Primacy

The opposite of shareholder primacy is "director primacy," a theory championed by Stephen Bainbridge and others. (217) According to Bainbridge, this approach remains grounded in the fundamental "nexus of contracts" model but treats the corporation as something the board of directors uses to hire "various factors of production." (218) The directors do and should run the show by fiat as "a sort of Platonic guardian." (219) At most, shareholders react to what the board proposes. Director primacy recognizes this shareholder weakness and actually welcomes it: it contributes to director power, which in turn leads to efficient decision-making and greater shareholder wealth. (220) Director primacy very much draws the line between authority and accountability in favor of authority. (221) The shareholders' right to throw out an incumbent board thus remains only as "an accountability device of last resort." (222)

Hedge fund activists fit into the director primacy paradigm as paradoxically as they did into shareholder primacy. Although they do not practice director primacy, they must believe in it as an academic theory for three reasons. First, boards actually do run most corporations, (223) and any theory that accurately explains reality automatically has some considerable claim to validity. Second, having a strong board in charge is always efficient (224) and usually satisfactory to the shareholders in the sense that activists leave most public companies alone. Third, and most importantly, director primacy provides a theoretical framework for justifying the exclusion of the wider "shareholder activism" community, the big institutions with often even bigger non-economic agendas. (225) What self-respecting hedge fund, for example, would brook for an instant the social and personal agendas often pursued by so many public pension and union funds? (226)

When it comes to actual practice, however, things are very different. Unless an activist hedge fund itself controls a board of directors, it cannot believe in director primacy. Otherwise it would not have become a shareholder activist and would not be trying either to tell the current directors what to do or to replace them outright. For a hedge fund, the shareholders' right to replace directors is anything but an "accountability device of last resort." (227)

A glance at the "principal issues" and "result" columns in the Appendix reveals what this actually means. In almost every case, the hedge funds in the study focused on direct economic issues such as blocking or forcing a corporate sale, or otherwise enhancing value with a stock buy-back, asset sale, or other similar effort. Apart from the "end game" corporate sale issue, which would require a shareholder vote in any event, much of this kind of activity necessarily involves assuming a degree of operational control that is fundamentally inconsistent with director primacy. Setting a dividend rate or determining how many shares to repurchase are matters not normally entrusted to the shareholders. Conversely, purely corporate governance issues seem to take a back seat to the economic issues. Destaggering a board of directors, for example, has hedge fund meaning only to the extent that it leads directly to enhanced economic performance for the fund. Like many academics, (228) hedge fund managers evidently remain unconvinced or agnostic on how directly corporate governance issues correlate with economic profitability and higher stock prices.

An important variant of the director primacy theme, the "team production" theory, similarly places the board of directors at the center of corporate power. (229) Under this theory, the board acts as a trusted referee or "mediating hierarch" holding sway over all the different team members that contribute to corporate success. (230) Shareholder voting generally plays no role at all except as "a safety net to protect against extreme misconduct." (231) But a hedge fund concerned with enhancing value through a stock buy-back or with gaining board seats to run a company more profitably is hardly concerned with "extreme misconduct," or even any misconduct at all. (232) The company's board of directors might be doing a only adequate job where the hedge fund might believe that a real home run might be possible if only it could step into the batter's box itself. (233) The originators of the team production theory, Margaret Blair and Lynn Stout, forthrightly admit that their theory does not really work well here, but argue that real shareholder activism and voting does not figure into how most public companies operate most of the time. (234) The findings of the present Article, however, suggest that hedge fund activists have significantly undermined unfettered director power at more than just a few companies, and much of director primacy theory along with it.

Blair and Stout do not stop here. They intriguingly suggest in the conclusion of their path-breaking article that their approach reveals the "fundamentally political nature of the corporation," and that future scholarship should look into how shareholders and other corporate constituencies use "political tools, in addition to economic and legal tools" to try to capture a larger share of firm profits. (235) Much of the present Article attempts just such an examination of the most active shareholders, namely hedge funds.

4. Balance-of-Power Politics

Evidently none of these theories accurately describes what activist hedge funds do, which brings us to naked balance-of-power politics as perhaps the most accurate way of thinking about how they actually operate. For activist hedge funds, corporate governance seems most like a kind of war with a putatively failing, slothful, or simply ineffective board of directors as the enemy.

The best starting point for this balance-of-power analysis might be the almost nihilistic "connected contracts" metaphor outlined a few years ago by three professors at UCLA. (236) According to this approach, the "interrelating agreements" among the participants in a business are little more than ad hoc arrangements: "[T]here are no firms, no predetermined hierarchies, no organizations ... and no a priori notions of ownership or control; there is no shareholder or managerial primacy and no centralizing 'nexus.'" (237) In a word, "there is nothing to govern." (238) For a public shareholder, what inevitably ensues is a sort of virtually formless political free-for-all essentially devoid of theoretical principles. But this is not necessarily bad. "[I]nsurgency, contention, and debate are fundamental to effective corporate governance," as John Pound once put it in the conclusion to his aptly titled article The Rise of the Political Model of Corporate Governance and Corporate Control. (239)

This is really little more than the raw balance-of-power politics familiar to any historian of eighteenth century Europe. According to one classic text, statesmen of that era confronted "an anarchic ... society in which expansion was left free until it was checked by conflicting ambitions, expressed in terms of the balance of power." (240) This principle, in turn, was found more useful than international law, which was then "nothing more than a war code." (241) Translated into the language of hedge fund activism, this means that proxy fights and the threat of proxy fights operate far more efficiently to exercise control over directors than the purely legal alternatives--occasionally ephemeral fiduciary-duty legal principles and the vagaries of the market for corporate control. (242)

Reliance on fiduciary-duty principles is misplaced because they are so limited. Duty of loyalty compliance usually requires little more than honesty in fact and a high tolerance for putting up with independent-committee board procedures. (243) Duty of care compliance requires even less. Ordinary workaday director decisions are almost always protected by the business judgment rule, which amounts to a standard of gross negligence. (244) The courts accordingly hardly second-guess any director decisions at all. (245) Reliance on the disciplining effect of takeovers is equally misplaced. Apart from regulatory problems and a host of other issues including sheer size, legal devices such as staggered boards and poison pills can make many companies practically takeover-proof. (246) Like international law in the eighteenth century, fiduciary-duty principles and the supposedly disciplining effect of takeovers appear less than completely satisfactory as instruments of shareholder defense and control.

Yet another paradox lurks here. As noted in the Introduction, many in the corporate community believe that the corporate governance status quo remains fundamentally sound. (247) According to Martin Lipton and Steven Rosenblum, the present system "has developed over many years ... through an ongoing process of experimentation and experience," and already makes "running an election contest through separate proxy materials ... a viable alternative." (248) Gilchrest Sparks, a dean of the Delaware corporate bar, has similarly observed that the current director-centered system appears "robust," and that the possibility of running a stand-alone proxy contest against an incumbent board is "becoming more rather than less real," thanks in part to "the dramatic increase in focused capital available in the hands of hedge funds." (249) This self-satisfied rhetoric is not altogether empty. Hedge funds are rarely mistaken for status quo apologists, but (paradoxically) this is evidently what they believe, too, or else they would not act the way they do. In the hands of a well-financed activist such as a hedge fund, proxy fights make a viable and useful corporate governance tool.

At least in Delaware, takeover defenses generally do not work against proxy fights. (250) For a hedge fund activist, an actual or threatened proxy fight is therefore direct, efficient, and as ultimately determinative as one of Napoleon's battles. Beyond this, theory really does not enter much into it.

C. Activist Hedge Funds With Board Representation

Of course the entire approach changes if an activist fund succeeds in gaining direct board representation, thus joining the "team." At this point, the rules of the game shift, sometimes for the worse. This is especially true when a fund achieves only minority board representation, such as when a company's board is staggered so that all directors are not up for election every year, when the tactical choice is made to run a short slate or when a negotiated settlement is only partially successful.

No matter what the situation, the federal securities laws effectively mandate that any hedge fund with direct board representation become a long-term investor. Such a fund will likely be considered a presumptive "affiliate" sharing in company control, and consequently will not be able to sell shares freely in the market until some indeterminate time after the board relationship ends. (251) If the fund communicates with its board representatives or anyone else at the company about company affairs, as will often be the case, it will probably also find itself precluded from selling or buying any shares because of the insider trading rules. (252) Depending upon the circumstances, there may even be the theoretical or real possibility of short-swing profits disgorgement under section 16 of the Securities Exchange Act. (253) All these rules effectively combine to preclude short-term trading once one or more board seats are obtained.

State laws concerning director fiduciary duties further constrain an activist fund. Once on the board, even dissident directors elected after a proxy fight owe their fiduciary obligations to the company as a whole and to all its shareholders, not just to the activist that nominated them. (254) The fiduciary obligation of loyalty, in particular, cannot be limited or disclaimed, and effectively makes financial hanky-panky with the company impossible, or at least subject to the exacting "entire fairness" standard of judicial scrutiny. (255) This rule can make even otherwise ordinary dealings substantively subject to judicial second-guessing and procedurally difficult to accomplish without cumbersome "independent committee" review and approval. (256) The SEC's rules specifically mandating the disclosure of these kinds of "related party" transactions exacerbate matters by casting perhaps unwanted sunlight into these otherwise dark corners, and recently adopted rules now require disclosure of the company's transaction approval procedures as well. (257) Careful advance planning and detailed consultations with lawyers experienced with these kinds of issues slow decision-making at every turn.

It logically follows that a dissident director's fiduciary duties extend to any information received as a director, and that all this information must be kept confidential and not misused. In the words of the leading Delaware case, if the director "violates that duty, the law provides a remedy." (258) Sometimes corporations even manage to extract an explicit promise that a dissident board member simply will not share anything he learns with his sponsoring fund. (259) Monitoring an investment under these kinds of informational constraints can frequently wind up being neither easy nor even particularly efficient or effective.

If a fund has won only minority representation, the problems deepen. The very structure of the board itself can work against the dissident faction. Boards act collegially. (260) Indeed, "[c]ommon sense tells us that the constantly carping critic ... is unlikely to be effective in persuading any group to effective collective action." (261) The dissidents can find themselves ostracized and left out of caucuses where all the real decisions are taken or, in truly extreme cases, excluded from a newly-formed executive committee with de facto plenary authority to run the company without any dissident input at all. (262) Alternatively, a weak-willed dissident may succumb to cooption or outright capture. (263) Sometimes, too, a dissident board faction can simply find itself outvoted. (264) One of the funds in the survey went so far as to refuse a proffered board seat because it did not see how "[a]s one vote among twelve" it would have "any greater ability to effect change." (265)

The actual experiences of many dissident directors, however, paint a picture not nearly so bleak. Even one dissident can often be highly effective, especially when it comes to killing unwanted mergers or other initiatives. After settling for just one board seat in his fight with Sovereign Bank, for example, Ralph Whitworth told the Wall Street Journal's "Heard on the Street" column that "[v]ocal dissenters ... can have outsized influences in clubby corporate boardrooms, essentially exercising veto power over major strategic decisions such as an acquisition." (266) Sometimes the right dissident can wind up assuming board leadership: according to Carl Icahn, if you lobby carefully "eventually [they] see it your way.... It's human nature. You talk to people. Board members start seeing the other side." (267) Having a big stake does not hurt either, and in the right hands can turn into a big stick. (268) In fact, one theoretical study has concluded that truly independent directors such as those "who own a large block of shares or are employed by a large shareholder" may actually increase the effectiveness of a board because they are thereby "shielded from ... ejection" and the consequent need to accede to management's wishes. (269)

This brings us to the strangest problem. At least some experienced directors and judges believe that when it comes to board service it helps to have "skin in the game." (270) If recent scandals such as those involving Enron, Tyco, and WorldCom have taught us that "being willing to challenge company management may be the most crucial qualification for a board seat," (271) and if having a lot of shares helps foster this kind of independence, then why do the SEC's implementing rules under Sarbanes-Oxley discriminate against board representatives of 10% and larger shareholders? (272)

But despite these problems, many activist hedge funds continue to seek board seats. Unlike some of the larger institutional investors, such as on occasion those associated with governmental entities and unions, they are in business exclusively to make money all the time. They therefore presumably believe that they will make more money with board representation, even minority representation, than without. Otherwise, they would not be activists who seek board seats. In theoretical terms, they consequently believe that vertical (meaning corporate officers) and horizontal (meaning the other directors) monitoring and control must be more efficient and effective from within than from without. (273) And to hear the howls of protest from corporate managements and their lawyers reviewed in the Introduction, (274) they are not the only ones to think so.
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Title Annotation:Corporate Governance and the New Hedge Fund Activism: An Empirical Analysis
Author:Briggs, Thomas W.
Publication:The Journal of Corporation Law
Date:Jun 22, 2007
Previous Article:IV. Conflicts of interest and full disclosure.
Next Article:VI. Conclusion.

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