Beware the Counterattack Against Activist Investors: The Group Trap by SchulteRoth&Zabel LLP
Howard O. Godnick, Partner, Litigation
William H. Gussman, Jr., Special Counsel, Litigation
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Activist hedge funds continue to be cast in the role of the villains of Wall Street, and a number of corporate attorneys have been scrambling to advise public companies on how to ward off an “attack” by activist investors. In preparation for the supposedly villainous attacks, numerous companies have been formulating strategies to fend off shareholder activists.
One of the most powerful — and easiest to use — weapons that companies will employ against activist hedge funds is to allege that the activist hedge fund violated Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) by failing to disclose that the activist was acting as part of a “group” of investors with respect to its investment in the company’s stock. Rule 13d-1 of the Exchange Act requires an investor (or a group of investors) to fi le a Schedule 13D within ten days of acquiring benefi cial ownership of more than fi ve percent of a class of voting securities registered under the Exchange Act. (In some cases, the similar Schedule 13G may be fi led.)
Because it is frequently the case that when one hedge fund takes a sizable position in a company, other hedge funds make or increase investments in the same company (the so-called “wolf-pack” effect), companies will often have a perceived basis to allege that the various hedge funds — activists or not — have engaged in suffi ciently coordinated activity to be deemed a “group” under Section 13(d) of the Exchange Act. Companies seeking to repel hedge fund activists will be quick to assert that the hedge funds violated Section 13(d) on grounds that the alleged group members failed to report when their collective positions crossed the fi ve-percent threshold.
While companies cannot sue for monetary damages under Section 13(d), they can bring an action under Section 13(d) asserting violations of the statute. Furthermore, an alleged Section 13(d) violation may have other serious consequences for activist investors, including:
- Forming a perceived basis for fraud claims, including securities fraud claims, against the investors on grounds that they concealed their group activity, sought to avoid activation of a poison pill provision or caused investors to purchase stock at artifi cially high or low prices resulting from the alleged failure of disclosure;
- Constituting a perceived basis upon which to grant a preliminary injunction against a proxy contest or other actions instigated by activist investors who have allegedly violated Section 13(d); and
- Providing a powerful public relations tool for entrenched management against the activist investor through the assertion that the activist investor violated the federal securities laws in connection with its investment in the company.
In addition, any whiff of “group” activity among sizeable investors may also expose activist investors and other hedge fund investors to claims for profi t disgorgement for shortswing trading under Section 16(b) of the Exchange Act. Section 16(b) imposes strict liability on “corporate insiders,” including nonexempt investors who benefi cially own more than ten percent of the issuer’s stock, forcing them to pay back to the company any “profits” made from purchases and sales made within a six-month period.
Importantly, if two or more investors form a “group,” each group member may be liable under Section 16(b) if, in the aggregate, the group’s holdings exceed ten percent of the company’s nonexempt, registered equity securities.
And unfortunately for hedge fund investors, Section 16(b) claims may be instigated either by the company itself or by any shareholder on behalf of the company in a derivative capacity if the company fails to pursue the claims. Thus, group activity may pit the hedge fund activist against the company itself or a cadre of aggressive plaintiffs’ lawyers who need just a single shareholder as a client to pursue the profit disgorgement claims.