Hedge Fund Activism
Corporations & Activist Hedge Funds
The Conference Board Working Group on Hedge Fund Activism has released its final recommendations for those corporations and institutional investors that may find themselves involved in an activism campaign mounted by hedge funds.
The recommendations were formulated by a heterogeneous group of high-level corporate and investor representatives, instituted under the auspices of The Conference Board Governance Center. They include guidelines on monitoring securities holdings, responding to requests for change, ensuring voting integrity, and overseeing hedge fund management. Working Group members include:
• Major pension funds and asset management firms, including TIAA-CREF, Florida State Board of Administration, and Barclays;
• Corporations at the forefront of corporate governance developments, including Pfizer, American Express, and The Coca-Cola Company; and
• Industry associations and service providers such as Managed Funds Association, the National Investor Relations Institute, ISS-RiskMetrics Group, Standard & Poor’s, and Weil, Gotshal & Manges, LLP.
The group is co-chaired by Stephen Davis, director of the Millstein Center for Corporate Governance and Performance at Yale School of Management and chairman of the board of Hermes Equity Ownership Service, and Jon Lukomnik, managing director of Sinclair Capital and recently-named director of the Investor Responsibility Research Center Institute for Corporate Responsibility (IRRCi) in Washington, D.C. Matteo Tonello of The Conference Board serves as research director and authored the final Report.
To download the recommendations or the full Report, visit www.conference-board.org/hedgefundactivism. A recorded webcast presented by the author of the Report and the Working Group co-chairs is also available.
The Conference Board Working Group recommendations are supported by extensive research findings based on recent notable cases of activism such as those at Yahoo, CSX, Motorola, and The New York Times. “The rise of hedge fund influence means everyone—from corporate boards to pension fund trustees—has to update their coping skills,” says Stephen Davis. “What worked in a simpler capital market could spell disaster in today’s more complex times. The good news: this Report spells out road maps for market players to survive and prosper.”
“There is so much fear, loathing and misinformation in the marketplace that it has made constructive engagement between companies and hedge funds difficult. This Report demystifies hedge fund activism and, by so doing, should improve the communication between companies and hedge funds," adds Jon Lukomnik.
The recommendations were formally endorsed by the National Investor Relations Institute (NIRI). NIRI is the largest U.S. association of investor relation officers with 4,400 members representing nearly 2,100 publicly held companies and $5.4 trillion in stock market capitalization.
“NIRI endorses the recommendations contained in the Working Group’s Report,” said Linda Kelleher, executive vice president of NIRI. “These recommendations represent corporate investor relations best practices encouraging early interaction and proactive engagement with activist investors, and reinforce the findings of our August 2007 NIRI Activist Investor Survey.”
Monitoring Securities Holdings
According to The Conference Board Working Group recommendations, management should actively monitor trading in the company’s securities holdings and pay particular attention to large accumulations and extraordinary stock purchase patterns. Relations among institutional investors and group voting arrangements should also be investigated to determine whether holders are acting alone or in concert with others.
Companies should consider availing themselves of securities surveillance service providers to obtain information that is unavailable through public filings. “Some hedge funds may try to disguise their accumulations by taking the position that not all transactions they enter into are subject to public disclosure,” says Matteo Tonello. “This is what happened in the recent CSX/TCI controversy, where the investor did not disclose its equity swap holdings despite the intention of swap counterparties to vote CSX’s stock in accordance with TCI’s voting decisions”. Hedge funds may try to disguise their accumulations and avoid disclosure of their positions, but they are still required to settle their transactions in three business days and maintain relationships with custodian banks. In certain situations, a company would benefit from specialized services that track these settlements and gather data on the origination of trading orders.
Securities holding intelligence obtained from public filings should also be supplemented and corroborated with non-public information the company can access through ongoing discussions with large investors. For this reason, board members and senior executives are encouraged to maintain proactive relations with the investment community and, within the parameters of applicable laws, seek regular communication with their major shareholders. “If a hedge fund is discretely engaged in securities accumulations or other trading activities, no one better than its peers are likely to know about it, especially if they also already own securities of the company,” concludes Tonello.
Responding to Requests for Change
The Working Group found that activist hedge funds tend to operate as value investors. Instead of poorly performing businesses, they often choose to invest in corporations that are profitable, have sound operating cash flows, and yet are undervalued. The funds’ goal is to act as catalysts for change by creating a triggering event (e.g., a revision in the capital structure, a strategic decision such as the sale of non-core business lines, or a new compensation scheme to better link pay and performance) that will unlock shareholder value and yield investment return. “This is a clear pattern,” says Tonello “and we documented it in the Report by looking at the cases that made headlines over the last few years”.
For this reason, the Group recommends that companies proactively develop an inventory of those strategic, financial, and governance-related vulnerabilities that could undermine their value and single them out as potential targets to activists. As a preventive measure, corporations should specifically renew their focus on financial performance and be prepared to justify their capital availability and liquidity positions vis-à-vis strategic goals.
The recommendations also call for management to work closely with boards in developing an actionable response strategy that clearly explains to all stakeholders why the company decided to resist or concede to activists’ demands.
Ensuring Voting Integrity
The Working Group also addressed the issue of empty voting and other abusive practices that may affect the integrity of the proxy voting process. Empty-voting occurs when hedge funds borrow shares in advance of the shareholders’ meeting record date and for the sole purpose of exercising the shares' voting rights and affect a decision. Assessing the extent of the phenomenon is difficult because of the anonymity of modern trading activities. Although most funds do not engage in empty voting, a few notable examples (including the borrowing of Mylan Laboratories’ shares by Perry Capital to increase voting influence on a controversial merger) are putting pressure on regulators and the business industry to address the issue.
The Working Group agreed that a way to discourage empty voting is to create the conditions for institutional lenders to become aware of the items being put to a vote and, if they deem any of them of importance, recall their shares before the record date. To companies, the Group recommends that they publish the meeting agenda and disclose the voting record date in advance of the actual occurrence of the record date, so as to allow lenders enough time to assess whether the items being put to vote are – based on the lenders’ governance policies and fiduciary duties – more important than the economic return derived from lending the shares. To institutional investors in the securities lending business, the Working Group recommends the adoption of rigorous written policies defining the scope and prerequisites of lending activities as well as the internal communication between the stock lending agents and the proxy voting team. In addition, lenders should ensure that the master lending agreements they enter into with borrowers include appropriate economic disincentives of empty voting (for example, by incorporating severe liability and indemnification clauses for damages caused to the value of the shares by empty voting practices).
“The integrity of the voting chain and practical mechanics of proxy voting are of pivotal importance in dynamic activist scenarios and have become more and more critical to the efficient conduct of the capital markets,” says Michael McCauley, senior corporate governance officer at Florida State Board of Administration (SBA), a member of The Conference Board Working Group on Hedge Fund Activism. “One key component is transparency, which serves to protect shareowners. Disclosure of factors such as net holdings, use of derivatives, and borrowing (or hedging) by large investors, as well as company disclosure of upcoming meetings and ballot information in advance of meeting record dates, are all essential to voting integrity,” he concludes.
“Such improvements in transparency would aid investors and companies alike and enable all stakeholders to react appropriately to the behavior of major market players, whether they are activist hedge funds or not. The Working Group recognizes how critical it is to find an effective solution to ‘empty voting’ abuses. This aspect of corporate control is too important for investors and companies not to work together to establish a safe, secure and efficient voting system,” adds Tracy Stewart, corporate governance manager at Florida SBA.
Overseeing Hedge Fund Management
The Working Group does not believe that institutional investors (such as pension funds, foundations, and endowments) should categorically prohibit or restrict asset allocations to activist hedge funds. In fact, the Report states that such restrictions would conflict with the institutions’ fiduciary duty to diversify their portfolio and prudently seek new investment opportunities. However, the Group recommends that institutional investors (considering or) managing such allocations strengthen their ongoing due diligence process and adapt it to the peculiarities of the hedge fund vehicle and those of activism as an investment strategy. Specifically, institutional investors should understand what strategic, financial, and governance changes are perceived by the hedge fund as drivers of long-term growth.
To assist them in this process, Managed Funds Association (MFA) has developed a Model Due Diligence Questionnaire for Hedge Fund Investors, which is included as an appendix to the Report. “MFA appreciates the collaborative effort of The Conference Board Working Group on Hedge Fund Activism to promote investor education. We believe that our DDQ is a valuable tool for investors as part of their diligence process for hedge fund investing,” says Richard H. Baker, MFA President and CEO.
The Conference Board Working Group on Hedge Fund Activism
The Conference Board Working Group on Hedge Fund Activism was instituted in 2007 to provide practical guidance to corporations and institutional investors involved in an activism campaign mounted by hedge funds. The following is the complete list of member organizations:
Donna C. Dabney, Corporate Secretary & Corporate Governance Counsel
The Altman Group
Ken Altman, President
American Express Company
Carol Schwartz, Senior Assistant Secretary
Darla C. Stuckey, Vice President & Senior Assistant Secretary
Steven Harris, Senior Counselor
Jeff Zelkowitz, Senior Vice President
Applebee’s International, Inc.
Carol DiRaimo, Vice President of Investor Relations
Barclays Global Investors
Abe Friedman, Director of Corporate Governance
Philip Goldstein, Founder
The Coca-Cola Company
Carol Hayes, Vice President of Corporate Governance & Secretary
The Conference Board, Inc.
Matteo Tonello, Working Group Research Director
Carolyn K. Brancato, Senior Advisor
Tina S. Van Dam, Senior Advisor
Dade Behring Holdings, Inc.
Louise Pearson, Chief Compliance Officer
Ted Altman, Partner
Florida State Board of Administration
Michael McCauley, Director of Corporate Governance
Tracy Stewart, Senior Corporate Governance Analyst
Luise Welby, Associate General Counsel
Global Advisors, Inc.
Stephen Davis, President
Icahn Associates Corporation
Keith Schaitkin, Associate General Counsel
Lois Peltz, President
RiskMetrics Group, Inc. (formerly Institutional Shareholder Services, Inc.)
Patrick McGurn, Senior VP and Special Counsel
Richard H. Koppes, Of Counsel
Managed Funds Association
Lisa S. McGreevy, Former Executive Vice President and COO
McGuire Woods, LLP
Robert L. Burrus, Jr., Former Chairman and Partner
Moody’s Investors Service
Francis H. Byrd, Former Vice President, Corporate Governance
National Investor Relations Institute
Linda Y. Kelleher, Executive Vice President
OneCapital Management Partners, LLC
Reid Bernstein, Chief Executive Officer
Margaret (Peggy) Foran, Former Vice President of Corporate Governance & Secretary
Rosemary Kenney, Director, Corporate Governance
Leigh Ferst, Principal
Jon Lukomnik, Managing Partner
Julie H. Daum, Senior Director
Julie Norris, Board Services Specialist
Standard & Poor’s
Dan Konigsburg, Director, Corporate Governance
State of Delaware
Cynthia Kane, Special Assistant to the Secretary of State
John Wilcox, Former Senior VP and Head of Corporate Governance
Yale School of Management
(Millstein Center for Corporate Governance and Performance)
Stephen Davis, Project Director and Fellow
Weil, Gotshal & Manges, LLP
Catherine T. Dixon, Partner
Holly Gregory, Partner