Two New Tools For Addressing Activist Hedge Funds – Sunlight Bylaws And Reciprocal Disclosures
Stearns Weaver Miller Weissler Alhadeff & Sitterson, P. A.
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May 20, 2016
Publicly-traded companies have the power to pass sunlight bylaws to address hedge fund activism. Sunlight bylaws would require activist hedge funds to publicly disclose any strategic proposals and their financial interests in companies earlier and at thresholds lower than current securities laws. Sunlight bylaws would also require disclosure of additional information, including: (1) the percentage of the fund’s portfolio invested in the company; (2) the fund manager’s compensation; (3) the fund manager’s investment in the fund; (4) the fund’s portfolio turnover; and (5) the fund’s prior holding periods after any announcements of an ownership interest and a strategic proposal. Academic proponents of hedge fund activism defend activism based on the theory that activist hedge fund managers are systematically better agents for long-term stockholders than the incumbent board and executive management. These proponents argue that fund managers have large stakes in their funds, the funds’ profitability is highly contingent on the financial performance of its investments, and the funds hold relatively few concentrated investments. Sunlight bylaws would target factual information essential to that claim and require its disclosure in succinct, summary form. Sunlight bylaws would also state that if a stockholder violates them, that stockholder cannot nominate a candidate for a seat on the board or propose any issue for the next stockholders’ vote.
But institutional investors and proxy advisory firms support hedge fund activism in the abstract, and a board that passed a sunlight bylaw might precipitate litigation or a proxy fight. Public companies should therefore, on a case-by-case basis, request the same or similar information when an activist that has held shares for a brief period of time makes a strategic proposal. Public companies should negotiate confidential treatment of any disclosures for a period of time so that the activist can reap the full benefit of the short-term increase in share price after the disclosure of its investment and strategic proposal some academics and institutional investors think necessary to incent activism. But public companies should also make very clear that they reserve the right to publish any questions that the activist refuses to answer or for which it insists on confidential treatment. And the other stockholders, who likely invest over longer timeframes, should carefully consider any information that the activist discloses — or, equally importantly — refuses to disclose.
Two New Tools For Addressing Activist Hedge Funds – Sunlight Bylaws And Reciprocal Disclosures – Introduction
Activist hedge funds have repeatedly invested in public companies, successfully pushed for the adoption of their strategic proposals, and then exited within one or two years. Companies can enact sunlight bylaws, which would require such funds to disclose online any such proposal within one day and to disclose any direct and indirect financial interest in the company above 5%. Other information bearing on the fund’s incentives, such as the fund manager’s compensation, the fund and fund manager’s compensation based on performance and the amount of money managed, the percentage of the fund’s assets the investment represents, and the fund’s portfolio turnover, would also be disclosed. If an activist hedge fund violated the sunlight bylaw, its strategic proposal or director nominee could not be proposed for a stockholder vote without board approval.
But support from a public company’s institutional stockholders for a sunlight bylaw may often be lacking, and a sunlight bylaw may precipitate litigation or a proxy fight. Thus, public companies should begin, as a first step, by requesting that any activist making a strategic proposal also make voluntary, reciprocal disclosures in response to the same questions posed by sunlight bylaws. The public company could make the activist’s disclosures confidential for a period of time. That would enable the activist to realize the entire short-term gain caused by its disclosure of a strategic proposal and investment and should not reduce an activist’s short-term profits. The public company, in its request for reciprocal disclosure, should also make clear that it can publish to stockholders any questions the activist refuses to answer, any questions that it has agreed to answer only confidentially, the terms of any negotiated confidentiality agreement, and the activist’s refusal to update answers.
Part I of this Article outlines the debate over activist hedge funds. An activist hedge fund typically identifies a target company it deems ripe for intervention, buys shares in the open market, and then publicly announces its beneficial ownership and a strategic proposal by making a filing under the securities laws. Research has shown about a 5% increase in the company’s share price in the twenty days up to and including the activist’s disclosure, followed by about a 2% increase in share price in the next twenty days. Lead activists frequently communicate with other hedge funds while acquiring a financial interest in the company, and those other funds acquire their own interests and support the lead activist’s strategic proposal. Hedge funds acting collectively have been dubbed “wolf packs.”
Proponents of activist hedge funds claim that hedge fund managers have strong incentives to boost short-term share price and systematically make proposals that increase both net present value and long-term value. They assert that hedge fund managers’ compensation depends highly on performance, hedge funds hold few concentrated investments, and hedge funds use derivatives and other financial instruments to amplify their investments. They assume that the hedge fund managers’ incentives are systematically stronger than the company’s executive management and directors’ incentives to increase share price.
In response, many with enormous practical experience, such as Delaware Supreme Court Chief Justice Leo Strine, corporate lawyer Martin Lipton, and Blackrock Chairman and CEO Laurence Fink, point to activist hedge funds’ short average holding periods of one or two years in the company’s stock and high portfolio turnover to argue that hedge funds’ focus on short-term returns can harm long-term value.
They claim that activists often force cuts in long-term investments like research and development in favor of financial engineering that boosts share price in the short-term to the detriment of net present value and long-term value.
Empirical studies accepted for publication about activists’ intervention and long-term value conducted by those who defend hedge fund activism have shown that over the five years following activist hedge fund interventions firm value sometimes increases and sometimes decreases. Other studies have shown that activist interventions decrease research and development spending and long-term return on assets.
Part II describes the debate surrounding activists’ current disclosure obligations under the federal securities laws. Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) requires activists to publicly report any strategic proposals ten days after acquiring over a 5% beneficial ownership of a company’s outstanding shares, but does not count derivatives or short positions toward that threshold. Activists have increased their ownership up to as much as 27% in the ten days between hitting the reporting threshold and the disclosure deadline. In part because activists in modern financial markets can increase their stake so quickly, Wachtell, Lipton, Rosen & Katz petitioned the United States Securities and Exchange Commission (the “SEC”) to require large stockholders to report any strategic proposals a day after acquiring a financial interest above 5%, counting derivative ownership structures and short positions.The SEC has yet to act on that petition.
But since that petition was filed, the disclosure issues have become more acute. Activists now frequently coordinate in wolf packs where each member owns a smaller stake. Thus, many members of the wolf pack never reach the Section 13(d) disclosure threshold and never need to disclose their net economic positions in the company’s stock. They could even take undisclosed net short positions. And although public companies must disclose material information about their decision-makers’ compensation and interests in the stock, hedge funds have no parallel disclosure requirements. Directors and other stockholders can only guess at any hedge fund’s investment as a percentage of its portfolio, portfolio turnover, prior holding periods, fund managers’ compensation, and the ownership interests held by a wolf pack based on spotty public reporting. Thus, the activist defenders’ assertions about hedge fund managers’ incentives cannot be tested, and the facts bearing on those incentives are unknown and unknowable in any activist campaign.
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