Full Disclosure

By Thom Brom
     
      Shark Tank
      You'd think it was blood in the water instead of ketchup. After a bitter proxy fight at H. J. Heinz Co., activist investor Nelson Peltz's hedge fund, Trian Fund Management, announced in August that its candidates had won two of five contested seats on the company's board. Aided by support from two proxy advisor services, Peltz's successful campaign added fuel to a furious debate in boardrooms, corporate law firms, and academia about the significance of short-term interventions—many conducted by activist hedge funds—in the affairs of public companies. They either are a corrective to obsequious boards, or signal the end of dignified corporate governance.
      To date, there are fewer than 100 funds worldwide with an activist investment strategy. J. P. Morgan Chase estimates that activist funds control only about 5 percent-or $50 billion-of the more than $1 trillion in hedge fund assets. Some of those funds are led by old-school corporate raiders such as Peltz, Carl Icahn, and Kirk Kerkorian. The others may differ in philosophy but have a common approach to achieving short-term shareholder value: intervene in corporate operations by seeking to change business strategy, replace management, sell unprofitable divisions, block a questionable merger, or nominate outside directors—steps all shy of a traditional hostile takeover.
      "The activist funds go directly to the CEO, the CFO, or the independent directors, asserting that management is not maximizing value for the short-term investor," says Jay B. Gould, a partner in the San Francisco office of Pillsbury Winthrop Shaw Pittman who represents hedge funds. "They don't use lawyers extensively."
      Offensive tactics can, however, include litigation. The funds may file various procedural motions in Delaware Chancery Court to force the release of books and records; they may file derivative actions alleging breach of fiduciary duty; or they may be lead plaintiffs in securities class actions. If the funds are dissatisfied with the terms of a company's acquisition, they may file statutory appraisal actions, by which shareholders receive a court-determined fair value instead of merger consideration.
      "Activist hedge funds profess to assist all shareholders, rather than just themselves," says P. Rupert Russell, a partner at Shartsis Friese in San Francisco who represents hedge funds. "That means they will attract the attention of the independent directors, who are not tied to management's policies."
      Such tactics have stimulated new shark-repellent strategies adapted from classic takeover defenses—poison pills, effective staggered boards, golden parachutes—developed more than 25 years ago by Martin Lipton, a founding partner of New York's Wachtell, Lipton, Rosen & Katz. "Some of the old defenses remain valid," says David J. Berger, a partner in the Palo Alto office of Wilson Sonsini Goodrich & Rosati. "But hedge funds can take their time accumulating shares, and choose when to announce their intentions."
      Lipton has compiled a "Hedge Fund Attack Response Checklist" for Wachtell clients; the tips range from updating bylaws to keeping close contact with institutional investors and improving corporate PR. The evolving defenses include stalling, denying access to books and records, calling a special meeting of the board, and canceling an annual meeting to avoid providing activist shareholders with a platform. A target company also may allege that funds are acting as a "wolf pack," with a common purpose, thereby triggering disclosure requirements under section 13(d) of the Securities Exchange Act of 1934.
      Though Peltz's campaign at Heinz was successful, activist funds usually try to avoid proxy fights. They consume time and money, require complicated SEC filings, and involve negotiations with long-term institutional investors who control majority voting rights. In addition, proxy fights invariably get personal. When Third Point challenged the CEO of Star Gas Partner in February 2005, for instance, it asked publicly, "How is it possible that you selected your elderly, 78-year-old mom to serve on the Company's Board of Directors and as a full-time employee providing employee and unit-holder services? ... Should you be found derelict in the performance of your executive duties, as we believe is the case, we do not believe your mom is the right person to fire you from your job." The CEO resigned a month later.
      "You're targeting individuals for their role in an underperforming company," says Chris Young, director of M&A research at Institutional Shareholder Services of Rockville, Maryland. "The shareholders' vote could confirm that judgment. No one wants the stigma of losing a proxy fight." Finally, an activist fund's nominees might actually get elected. "Many activist shareholders don't really want to sit on boards," Young says.
      The larger question here is whether all this infighting matters to the economy. Business, finance, and law school academics wring their hands at the additional pressure on public companies, but they are divided about the need for more regulation.
      In a research paper published in June 2006, professors Henry T. C. Hu and Bernard Black of the University of Texas School of Law contend that hedge funds, using equity swaps and other privately negotiated equity derivatives, have used their voting power to affect takeover battles and control public companies in a half-dozen countries. Hu and Black call for revised disclosure rules.
      Others are more sanguine. "We believe that market forces and adaptive devices taken by companies individually in response to activism are better designed to help separate good ideas from bad ones than additional regulation," write professors Marcel Kahan of New York University School of Law and Edward B. Rock of the University of Pennsylvania in a July 2006 study. But they warn, "One can predict a backlash, although the exact form it takes will depend on what scandal occasions the regulatory intervention."
      For now, the activist shareholders are riding high, achieving as much by their reputation as by their actions. And the lawyers who represent them have little sympathy for their targets. "If you're going to be a public company, you have to run it for the benefit of the shareholders," says Pillsbury Winthrop's Gould. "It's the price you pay."
     

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