6/25/2009 6:26:32 Pm

8/14/2019 6/25/2009 6:26:32 Pm

1/27

MCANNAR 6/25/20096:26:32 PM

61

HEDGE FUNDS: WATCHDOGS OR WOLVES INSHEEPS CLOTHING? THE SHAREHOLDER

EMPOWERMENT DEBATE REVISITED

JOHN D. MCANNAR*

This article argues that shifting corporate control from the board of directors and

management to shareholders is not a cure-all for corporate agency costs. Powerful

institutional shareholders, such as hedge funds, are the most likely to use these new

shareholder powers and are much more likely to protect their personal interests as

opposed to the interests of other shareholders in the corporation. Additionally, hedge

funds are structured and motivated in ways that make activist control of the

corporation easier than had been assumed in the years prior to their genesis. For

example, they often develop secret short positions in firms in which they also control

equity interests allowing them to decouple their voting rights from equity and profit

off of voting their shares in a manner harmful to other shareholders. As a result,

shifting control to shareholders would inevitably allow hedge funds to pursue activiststrategies that protect their own personal interests but harm unwitting shareholders of

corporations in the hedge funds portfolio. Given this risk, the question becomes

whether shareholders should blindly accept activism as a cure-all or should push for

some other solution to corporate greed.

I. INTRODUCTION .........................................................................................62

II. SHAREHOLDERACTIVISM .......................................................................66

A. The Shaky Foundation for Shareholder Control: Erroneous

Assumptions ..............................................................................67

B. Threatening Successful Corporate Norms....................................70

III. STRUCTURE, FUNCTION, AND MOTIVATIONS OF ACTIVIST HEDGE

FUNDS ...............................................................................................73

A. Structure ....................................................................................74B. Function.....................................................................................77

C. Motivations................................................................................79

IV. MACHIAVELLI REPRISED: HEDGE FUNDS IN THE REAL WORLD ..........81

V. CONCLUSION ...........................................................................................86

* John McAnnar is an associate specializing in business litigation at Armstrong Teasdale, LLP, in

St. Louis, MO. He earned his Bachelors degree in 2005 at the University of Pittsburgh, after

which he attended the Saint Louis University School of Law, earning his J.D. in 2009. Mr.McAnnar would like to thank Professor Matthew Bodie for his guidance and Kate Mortensen for

her endless hours of research that made this article possible.

8/14/2019 6/25/2009 6:26:32 Pm

2/27

MCANNAR 6/25/2009 6:26:32 PM

62 THE DARTMOUTH LAW JOURNAL Vol. VII:1

Power tends to corrupt, and absolute power corrupts absolutely.

Lord Acton

I. INTRODUCTION

Since its inception, the corporate form has been marked by a

separation of ownership from control. Historically, shareholders have held

an ownership interest in the corporation1 while the board of directors and

management have taken on the day-to-day governance. Allowing agents

in this case, management and the board of directorsto operate in place of

the principalthe shareholdershowever, does not come without agency

costs.2 Controversy arises when the interests of the shareholders and board

of directors diverge, and such instances often create the battlefields of

corporate America.3 Boards of directors and management have typically

had the upper hand in these conflicts.4 These trials have galvanized the

corporate form of strong management and weak ownership.

After the Enron and WorldCom scandals, however, complacence with

the status quo began to sour and calls for reform were heard in increasing

numbers. The tide of reformation began to swell even more after the

options backdating scandals at companies like Broadcom Corp.,

UnitedHealth Group, and even Apple. Golden Parachutes and excessive

executive compensation at places like Disney5 further fueled the fire for

1 Some scholars prefer not to characterize shareholders as owners of the corporation, butrather as owning a property interest in the corporations stock alone. See e.g., Roberta S. Karmel,

Should a Duty to the Corporation be Imposed on Institutional Shareholders? , 60 BUS. LAW. 1 ,1 -

2 (2004) (Under the shareholder primacy model, shareholders are considered owners of the

corporation and are therefore given rights at the expense of other corporate constituents. Inreality, shareholders have a property interest in their shares, not in the corporations assets. . .

The notion that shareholders are owners sometimes expresses the notion that they are theresidual claimants on the corporations assets. This concept also is flawed.).

2 Allen D. Boyer, Activist Shareholders, Corporate Directors, and Institutional Investment:Some Lessons From the Robber Barons, 50 WASH. & LEE L. REV. 977, 983 (1993) (A side effectof the division between ownership and control is agency costs. These include, most significantly,

the costs associated with the risk that managers will fail to act so as to maximize shareholder

returns. Agency costs are the profits made by corporate managers above their contract rights:whatever makes an officers salary or employee perquisites unduly generous. Agency costs also

include the costs of inefficiency and monitoring for inefficiency. As well as these actual outlays,

agency costs may include gains not made by the firm due to managerial laziness. Managers, if notmonitored constantly, may take their responsibilities lightly and not pursue opportunities as

competitively as they should.).3 See ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND

PRIVATE PROPERTY 6 (1933) (The separation of ownership and control produces a conditionwhere the interests of owner and of ultimate manager may, and often do, diverge).

4 See MARK J. ROE, STRONG MANAGERS, WEAK OWNERS: THE POLITICAL ROOTS OFAMERICAN CORPORATE FINANCE 54-145 (1994) (explaining that historically, Americancorporations have been marked by strong managers and weak owners).

5 See In re Walt Disney Co. Derivative Litigation, 907 A.2d 693 (Del. Ch. 2005).

8/14/2019 6/25/2009 6:26:32 Pm

3/27

MCANNAR 6/25/2009 6:26:32 PM

Winter 2009 HEDGE FUNDS 63

change. Most recently, financial institutions came under fire for their

involvement in the secondary mortgage market and the subprime crisis.

Spurred on by such corporate corruption at the highest levels, a move

towards bridging the ownership-control gap through increased shareholderdecision-making power has garnered more support.6 Empowering

shareholders to become active in more corporate decisions, the theory

holds, will put a check on high-level corporate greed and will create more

effective, efficient, and even happy corporations.7 Bolstered in part by

this shareholder democracy8 movement in the academic world, investors,

specifically hedge funds and other institutional investors, have become

more active in their efforts to influence managements day-to-day

decisions. Through the voting power accompanying the shares they have

amassed at an institutional level, hedge funds and others wage proxy battles

against directors who do not agree with their vision for the future of the

company, threaten and pursue litigation against managers, use significant

funds in negative public relations campaigns, and even leverage funds tobuy control of a corporation.

Ironically, however, using shareholders as pawns to attack corporate

hubris has opened alleys for activist hedge funds to profit at the expense of

other shareholders of the company.9 Increasing shareholder power to

6 See e.g., Lucian A. Bebchuck, The Myth of the Shareholder Franchise, 93 VA. L . R EV. 675,694701 (2007) (arguing that the system of election of the board of directors should be changed

to provide more accountability to shareholders); Lucian A. Bebchuck, The Case for Increasing

Shareholder Power, 118 HARV. L. R EV. 833, 836 (2005) [hereinafter Bebchuck, Increasing

Shareholder Power] (arguing shareholders should be allowed to initiate and vote to adopt

changes in the companys basic corporate governance arrangements).7 See e.g., Frank H. Easterbrook & Daniel R. Fischel, The Proper Role of a Targets

Management in Responding to a Tender Offer, 94 HARV. L. R EV. 1161 (1981) (arguing thatmanagements power to decide when to sell a firm should be limited because the market for

corporate takeovers raises shareholder value); Lucian Arye Bebchuck, The Case for Shareholder

Access to the Ballot, 59 BUS. L. 43 (2003) (arguing that shareholders should be permitted to

nominate directors and have these directors listed on the corporations proxy materials); James

McConvill, Shareholder Empowerment as an End in Itself: A New Perspective on Allocation of

Power in the Modern Corporation, 33 OHION. U. L. REV. 1013, 1059 (2007) ("If we accept that

greater personal happiness comes from participation, and the pursuit of happiness is the ultimate

objective of human beings, then participation rather than passivity becomes the rational choice forshareholders.").

8 For articles using this term to describe the movement, see John H. Biggs, Shareholder

Democracy: The Roots of Activism and the Selection of Directors, 39 LOY. U. CHI. L.J. 493(2008); Lisa M. Fairfax, Shareholder Democracy on Trial: International Perspective on the

Effectiveness of Increased Shareholder Power, 3 VA. L . & BUS. REV. 1 (2008).9 For other solutions to the problem of agency costs, see Lynn A. Stout, The Mythical

Benefits of Shareholder Control, 93 VA. L. R EV. 789, 792-798 (2007) (arguing board, notshareholders, should make corporate decisions in part because such a structure protects

shareholders from the influence of a large shareholder.); Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 HARV. L. R EV. 1735, 175758 (2006) (arguingsubstantial efficiency benefits of the current system of separation of ownership and control

justify retaining director primacy in light of proposals to increase shareholder voting powers).

8/14/2019 6/25/2009 6:26:32 Pm

4/27

MCANNAR 6/25/2009 6:26:32 PM


increase shareholder wealth is based on the assumption that all

shareholders have the same interest in maximizing returns. Because of that

common interest, each shareholder will exercise his influence in the best

interest of all other shareholders.10

This is not always the case with respectto large activist hedge funds. In this paper, I argue that the interests of such

hedge funds as shareholders can, and often do, diverge from the interests of

shareholders in the portfolio companies. Increasing their ability to be

activist can be harmful to other shareholders in the corporation.

Shareholder oversight, thus, does not serve as the white knight corporate

America has been searching for to protect its shareholders.11

This contention takes on much more significance when considering

the amount of business in which hedge funds engage. In the past two

decades, hedge funds have become more omnipresent and omnipotenta

recent article estimates that hedge funds control about $2 trillion dollars

worth of capital worldwide.12 Another recent study shows that hedge funds

are responsible for nearly thirty percent of fixed-income trades in theUnited States, and fifty-five percent of investment-grade derivatives

trades.13 While there were about 400 funds in 1992, there were nearly

10,000 in 2007.14 With such a commanding presence in the current market,

increased hedge fund power will undoubtedly impact the entire financial

system.

Part II of this article explores shareholder activism in general and

specifically examines some of the arguments for and against this activism.

It discusses the two flawed assumptions upon which the arguments for

increased shareholder activism are based. It concludes that such activism

has the potential to destroy the positive aspects of the traditional corporate

separation of ownership and control by invading the province of the board

of directors and could deny protection to other investors in the corporation.

Part III examines how the specific structure, function, and motivations

of hedge funds lead to particularly dangerous activist positions that can

and often dodiverge from the interests of shareholders in the portfolio

10 In this way, the common interest serves as a natural fiduciary force causing eachshareholder unintentionally to act in the best interest of all other shareholders.

11 In this paper, I intentionally do not discuss other stakeholders in the firm, such as

employees, suppliers, and even the environment. This serves two purposes, simplicity ofargument, and placing the argument on the same playing surface as much of corporate

governance scholarship of the recent past that focuses on shareholder primacy as the defining

characteristic of good corporate governance.

12 Douglas Cumming & Sofia Johan, Hedge Fund Strategies and Regulation, 27 No. 7BANKING & FIN. SERVICES POLY REPORT 1, 1 (July 2008).

13 Steven M. Davidoff, Black Market Capital, 2008 COLUM. BUS. L. R EV. 172, 194 n.66

(discussing study).14 Jennifer Ralph Oppold, The Changing Landscape of Hedge Fund Regulation: Current

Concerns and a Principle-Based Approach, 10 U. PA. BUS. & EMP. L . R EV. 833, 840(2008).

8/14/2019 6/25/2009 6:26:32 Pm

5/27

MCANNAR 6/25/2009 6:26:32 PM


corporations. Given the structure, function, and motivations of most hedge

funds, Part III argues that harmful activism is an inevitable reality of our

current deregulated corporate world.

Part VI discusses some real-world examples of hedge funds in action.It attempts to paint a realistic picture of hedge funds unabashed self-

interest at the expense of shareholders in portfolio firms. The

consequentialist thinking evident at such firms is beyond argument. These

examples call into question the merits of empowering shareholders to be

corporate watchdogs.

It is true that many hedge funds do not employ activist policies. 15

Some funds who do engage in activism have brought about positive

results.16 When their interests inevitably diverge from the interests of

portfolio shareholders, however, funds that employ activist strategies pose

a serious risk to investors in portfolio corporations. It is the recent increase

in such activism that threatens our current financial system. As several

failures, from AOLs inevitable decay to Enrons implosion to the collapseof the secondary mortgage market, have taught us, corporate hubris and

overuse of risky techniques for making massive amounts of wealth in short

periods of time often fail in awe-inspiring fashion.17 Activist hedge funds

15 Marcel Kahan & Edward B. Rock,Hedge Funds in Corporate Governance and Corporate

Control, 155 U. PA. L. R EV. 1021, 1046 (2007) (In assessing the many instances where hedgefunds have adopted an activist posture in corporate governance and control transactions, one has

to keep in mind that only a minority of hedge funds pursue shareholder activism.).16 See id. at 1029-30 (describing $4 billion hedge fund Third Points successful campaign to

remove Irik Sevin from the CEO position at Star Gas Partners because he selected his 78-year-old

mother to serve on the board of directors).17 Scholars have argued that both AOLs and Enrons decays were due at least in part to the

overuse of the practice of granting employee stock options. These options, in turn, led toemployees focusing solely on meeting and beating quarterly projections and ultimately

fraudulent or criminal accounting practices and huge corporate write-offs.For a discussion of AOLs failed merger with Time-Warnersee Matthew T. Bodie, AOL Time

Warner and the False God of Shareholder Primacy, 31 J. CORP. L. 975, 998 (2005-2006) (At

AOL as well as many other dot-com companies, the cycle was clear: executives push to meetshort-term targets; investors push up the price of the stock; and executives (and other employees)

cash out on the options. The cycle continues until the company can no longer meet its targets, but

cheating can prolong the process. Perhaps that is why there was so much cheating at the end ofthe 1990s boom. Like desperate gamblers, executives relied on accounting tricks to keep their

hot streaks alive, in the hopes that they could make up for their losses in future quarters. But the

losses just kept mounting until the tricks were no longer enough.).For a discussion suggesting the proliferation of stock-option compensation packages during

the Enron period contributed to corporate fraudsee Karmel,supra note 1 at 8-9 (Equity-based

compensation focused directors and managements on stock market prices instead of other

traditional metrics used in bonus plans. Pressures by institutional investors for ever higherquarterly earnings made matters worse. The temptation to manage earnings became too great for

many corporations, and issuers were not reined in by their auditors, their investment bankers, or

other advisors. Investors and financial intermediaries were enthralled by equity and equity wasking.).

The subprime mortgage breakdown has been blamed at least in part on the overuse of

8/14/2019 6/25/2009 6:26:32 Pm

6/27

MCANNAR 6/25/2009 6:26:32 PM


have given lawmakers and scholars no reason to believe that they are

immune from just such a tragic fall.18 The shareholders of the corporations

that have been destroyed by these activist funds will be left to clean up the

pieces.

II. SHAREHOLDERACTIVISM

At first glance, increased shareholder activism seems like an attractive

solution to the agency costs that plague the modern corporation. Cloaked

in terms like the shareholder democracy movement19 or shareholder

empowerment,20 activism seems to speak to our sense of patriotism or

general fairness. Couching the argument in these terms gives the

proponent a psychological advantage because it appears that some injustice

has been done to shareholders, those people most similar to a majority of

the public, by management, those considered by the public to comprise the

privileged few.21

Rhetoric and surface appeal aside, the argument for greater activism is

based on two assumptions: (1) activist shareholders will always have an

interest in increasing shareholder value and, thus, will vote their interests

accordingly22; and (2) even if a rogue shareholder did not have increased

share value in mind, it is impractical to believe most shareholders, who

own only a few percent of the outstanding shares of a company, can do

much to influence corporate governance. Because both of these

credit default swaps. Without sufficient capital to back these agreements or sufficient

regulation of them, several large banks got in over their heads. In fact, the failure of the credit

market, due at least in part to credit default swaps, was predicted to some degree by some

researchers and journalists. See generally Janet Morrissey, Credit Default Swaps: The NextCrisis, TIME, March 17, 2008, available at

http://www.time.com/time/business/article/0,8599,1723152,00.html ("Not familiar with creditdefault swaps? Well, we didn't know much about collateralized debt obligations (CDOs) either--

until they began to undermine the economy. Credit default swaps, once an obscure financial

instrument for banks and bondholders, could soon become the eye of the credit hurricane.").18 In this vein, Mark Twain once remarked that [h]istory never repeats itself, but it rhymes.19 For articles using the term "shareholder democracy movement" to describe the current state

of affairs, see Fairfax, supra note 8 at 12; J.W. Verret, Pandora's Ballot Box, or a Proxy With

Moxie? Majority Voting, Corporate Ballot Access, and the Legend of Martin Lipton Re-

Examined, 62 BUS. LAW. 1007, 1028, 1054, 1056, 1057 (2007).20 For articles describing the movement as "shareholder empowerment," see McConvill,

supra note 7; Bainbridge,supra note 9.21 See EDMONDN. CAHN, THE SENSE OF INJUSTICE (1949) (arguing that because everyone

has suffered injustice at one point or another, "[t]he human animal is predisposed to fight

injustice. . . Nature has thus equipped all men to regard injustice to another as personalaggression.").

22 Iman Anabtawi, Some Skepticism About Increasing Shareholder Power, 53UCLA L. REV.

561, 571 (2006) (arguing that the shareholder empowerment movement assumes thatshareholders would use their incremental power to discipline managers, thereby benefiting

shareholders as a class, as opposed to furthering their private interests.).

8/14/2019 6/25/2009 6:26:32 Pm

7/27

MCANNAR 6/25/2009 6:26:32 PM


assumptions are erroneous, activism, even by minority shareholders, may

negatively impact other shareholders of a corporation. Allowing

shareholder activism threatens to undermine corporate norms that have

allowed the American capitalist system to prosper for centuries.

A. The Shaky Foundation for Shareholder Control: Erroneous Assumptions

The first erroneous assumption posits that shareholders will always

vote in the best interest of other shareholders. The argument provides that

shareholders, who have an interest in the firms continued success and

incur most of the marginal costs, are best suited to make the decisions

concerning the daily direction of the firm.23 Additionally, shareholders,

being the only residual claimants of a firm, are the only stakeholders not

protected by a contractual agreement.24 To protect their residual claims,

the argument assumes that shareholders will always vote their shares to

increase these residual claims. Therefore, because all shareholders have aninterest in increasing the residual claims of a firm, preferences of

[shareholders] are likely to be similar if not identical, 25 and all

shareholders will vote in the best interest of other shareholders. 26

According to shareholder democracy theory, increasing shareholder

activism is always in the best interest of all of the shareholders.

This idyllic view of a shareholder cooperative, however, simply does

not accurately reflect reality. Tricky derivative holdings and divided

loyalties have led to the balkanization of shareholders into distinct

groupspublic pension funds, hedge funds, private investorseach with

their own mouths to feed. A hedge fund is an entity separate from other

shareholders with separate investors and private interests.27 The main goal

23 See Frank Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J. L. & ECON.

395, 403, 405(1983).24 This argument, while prevalent among corporate law scholars, is not universally accepted.

See e.g., Brett H. McDonnell, Employee Primacy, or Economics Meets Civic Republicanism atWork, 13 STAN. J . L . BUS. & FIN. 334, 349-50 (arguing that some employees of a firm are residualclaimants because (1) many employees receive part of their salary through stock options, (2) most

employees have claims against the company including pensions and continued employment that

become more valuable if the company does well; also arguing that [i]t is also not clear thatemployees can protect themselves contractually more easily than shareholders because (1) since

employees have made human capital investments that are firm specific, they are vulnerable to

company decisions that reduce the returns on these investments, and (2) while shareholders can

diversify their holdings to reduce their firm-specific risk, employees cannot diversify their jobs).25 Easterbrook & Fischel,supra note 23 at 405.26 See Bebchuck, Increasing Shareholder Power, supra note 6 at 908 ("I have argued that

making shareholder intervention possible would operate to reduce agency costs betweenmanagement and its shareholders and to enhance shareholder value.").

27 See infra Part II.A discussing the structure of a hedge fund.

8/14/2019 6/25/2009 6:26:32 Pm

8/27

MCANNAR 6/25/2009 6:26:32 PM


of a hedge fund manager is to increase the returns for these investors. 28

While making money for their investors often translates into shareholder

value for other groups of shareholders, this is not always the case.

Increasing returns for the hedge fund investor sometimes includes harmingshareholders in a portfolio firm or abandoning a sinking ship.

Hedge funds have employed several ethically questionable techniques

to achieve this goal of increasing returns for their investors. Recently,

hedge funds have employed a strategy dubbed empty voting by Henry

T.C. Hu and Bernard Black.29 This strategy involves holding more voting

power than actual economic interest in a firm30 thus allowing hedge funds

to exercise more influence than is normally allowed by the one-share-one-

vote system. The surplus voting power is empty because it has been

separated or decoupled from any economic stake in the firm. 31 Such

decoupling of voting and economic interest can occur in several ways.

First, a hedge fund could simply borrow the voting rights from a lender

who would retain the economic interest.32 Second, a fund could employ anequity swap in which one party acquires economic ownership, but no

voting rights, from another.33 Third, a fund could sell short a number of

shares equivalent to its equity interest, thus, offsetting any change in share

price while maintaining the voting rights of its equity shares. It is even

possible for hedge funds to vote despite having a net short position in a

firm.34 Accordingly, a funds economic interest necessarily diverges from

other shareholders in the corporation.

Just such a situation occurred late in 2004 when the Perry

Corporation, a powerful hedge fund and owner of 7 million shares of King

28 Indeed, similar to the board of directors of a corporation, hedge fund managers have afiduciary duty requiring them to operate in the best interests of investors in their fund. See

Oppold,supra note 14 at 835.29 See generally Henry T.C. Hu & Bernard Black, The New Vote Buying: Empty Voting and

Hidden (Morphable) Ownership, 79 S.CAL. L . R EV. 811 (2006).30 Id. at 815.31 Id. The simplest example of such decoupling is described by Professors Shaun Martin and

Frank Partnoy:

Consider the simplest case of a shareholder who owns one share and also holds a one-share short position. That shareholders has a residual claim to the corporations income through the share,

but the incentives associated with that claim are directly offset by those attributed to the short

position. An increase (or decrease) in the value of the stock is counterbalanced by an equivalentdecrease (or increase) in the value of the short position. Such a short-holding shareholder retains

a residual claim to the corporations income, but does not have the same

economic incentives as a pure shareholder. Nonetheless, she remains entitled to a vote. Even a

shareholder who owns a single share and simultaneously holds a ten-share short position retains avote, even though her net economic interest is directly counter to that of other shareholders.

Shaun Martin & Frank Partnoy,Encumbered Shares, 2005 U. ILL. L . R EV. 775, 778-79.32 Hu & Black,supra note 29 at 816.33 Id.34 Id. at 815; Martin & Portnoy,supra note 31 at 789.

8/14/2019 6/25/2009 6:26:32 Pm

9/27

MCANNAR 6/25/2009 6:26:32 PM


Pharmaceuticals, nearly single-handedly pushed through a merger with

Mylan Pharmaceuticals.35 As a large shareholder in King, Perry stood to

make almost $30 million profit if the deal closed, however the deal

required Mylan shareholder approval.36

Shortly after the deal wasannounced, Mylans share price plummetedstrong evidence that the

market thought Mylan was getting the short end of the stick in the

merger.37 Not willing to see its profit escape, Perry purchased almost 10%

of Mylan stock and immediately decoupled and sold the economic interest

in Mylan.38 Other funds apparently followed suit and the pack is rumored

to have acquired a full 19% of Mylans votes without holding any

economic stake in the company.39 These funds pushed for the merger even

though Mylans stock price would likely plummet even further.40 Carl

Icahn, veteran of the 1980s takeover wars, and other Mylan shareholders

were spared, however, when the deal fell through because of accounting

problems.41

The second erroneous assumption upon which shareholder activism isbased posits that because most shareholders rarely amass more than a few

percentage points worth of stock in a corporation, one rogue shareholder

cannot affect the corporation all that much.42 Additionally, in the typical

publicly traded corporation, the ownership is dispersed across the United

States and even into foreign countries. In most cases, therefore, it will not

be economically feasible for a shareholder to attempt to influence enough

of the dispersed corporate ownership to push its policy through a proxy

contest.43 This is especially true given the American proxy system in

which it is often the burden of the promoter of a ballot initiative to print

proxy information and contact all the other shareholders.44 The argument

35 Hu & Black,supra note 29 at 828.36 Id.37 Id.38 Id.39 Id. at 828.40 Hu & Black,supra note 29 at 829.41 Id.42 Bernard S. Black,Agents Watching Agents: The Promise of Institutional Investor Voice, 39

UCLA L. REV. 811, 813 (1992) ("In the Berle and Means paradigm, shareholder passivity is

inevitable. Companies have grown so large that they must rely on many shareholders to raise

capital. The shareholders then face severe collective action problems in monitoring corporatemanagers. Each shareholder owns a small fraction of a company's stock, and thus receives only a

small fraction of the benefits of playing an active role, while bearing most of the costs. Passivity

serves each shareholder's self-interest, even if monitoring promises collective gains.").

43 See id. While the board of directors may use company funds to solicit proxies for their re-election, a minority shareholder wishing to run a dissident slate must finance the contest himself.

Traditionally, this prevented most minority shareholders from waging a proxy battle for control of

the corporation.44 See Carl Icahn, 3 Senseless Steps In a Proxy Contest, The Icahn Report,

http://www.icahnreport.com/report/2008/08/3-senseless-ste.html (Aug. 27, 2008, 10:14 AM)

8/14/2019 6/25/2009 6:26:32 Pm

10/27

MCANNAR 6/25/2009 6:26:32 PM


is that even if a hedge fund with three percent ownership were actively

waging a wrong-headed proxy battle to influence the board of directors, it

could not apply much pressure since ninety-seven percent of the ownership

was in other hands.This argument, again, does not take into account the modern actuality

of the activist hedge fund. Important developments, including SEC

amendments in 1992 making it easier for shareholders to attempt to

influence other shareholders votes and the rise of proxy advisory firms,

have made it much easier for hedge funds to exercise vastly more control

than the few percentage points that their ownership implies.45

Additionally, according to Professors Lynn Stout and Iman Anabtawi,

activist hedge funds are less concerned than other institutional investors in

owning interests in diverse firms or investments.46 As a result, instead of

owning small portions of several firms stock, activist hedge funds often

own larger portions of fewer firms.47 This ownership pattern, unique to

hedge funds, also leads to more influence than the typical shareholderenjoys.

B. Threatening Successful Corporate Norms

Aside from being based on incorrect assumptions, increasing

shareholder activism will also lead to devastating results. Exposing the

board of directors to the whim of the shareholder assures the public

corporation two things: (1) well-qualified, interested, and experienced

individuals will find lines of work other than director or manager of a

corporation; and (2) directors will become so risk-averse that the

entrepreneurial spirit that has contributed in large part to Americas

continued success will be quashed sufficiently to see us fall farther back

into the pack of global competition.48

(describing the enormous cost for the dissident shareholder in purchasing the shareholder listfrom the target company as a Hobsons choicethe shareholder can pay the excessive amount to

the corporation or hire an attorney to fight the excessive amount).45 See infra Part II.C discussing some such developments; see also Thomas W. Briggs,

Corporate Governance and the New Hedge Fund Activism: An Empirical Analysis, 32 J. CORP. L.

681, 68694 (2007).46 Iman Anabtawi & Lynn Stout, Fiduciary Duties for Activist Shareholders, 60 STAN. L.

REV. 1255, 1279 (2008) ("Activist hedge funds do not attempt to diversify their portfolios.

Instead, they take large positions in as few as two or three companies and then demand that those

companies pay special dividends, launch massive stock buyback programs, sell assets, or even put

themselves on the auction block in order to add 'shareholder value'").47 Id.48 Martin Lipton,Shareholder Activism and the Eclipse of the Public Corporation: Is the

Current Wave of Activism Causing Another Tectonic Shift in the American Corporate World?Keynote Address at The 2008 Directors Forum of the University of Minnesota Law School (June

25, 2008) at 3 available at http://blogs.law.harvard.edu/corpgov/files/2008/06/shareholder-

8/14/2019 6/25/2009 6:26:32 Pm

11/27

MCANNAR 6/25/2009 6:26:32 PM


Although increased shareholder action is initially attractive as a form

of improved corporate governance, its surface appeal disappears upon

consideration of the crucial role of the board of directors. Allowing

increased activism leads to an increase in the amount and cost of litigation,more exacting and unnecessary governance rules and best practices

standards, and an increase in the amount of time spent worrying about due

diligence and personal liability.49 Such distractions deny the board the

opportunity to focus on the governance of the corporation and lead to

corporations that are not run as effectively as possible. 50 Shareholders, as

residual claimants, feel the loss borne out by this corporate inefficiency.

Additionally, directorswho owe fiduciary duties to shareholders

are better suited to make corporate governance decisions than shareholders

in the firm who are free to pursue whatever private interest they wish free

from any duty to the corporation or other shareholders.51 Thus, the board

of directors is in a better position to mediate between the competing

interests of shareholders.52 Because the board of directors has a fiduciaryduty to act in the best interests of all shareholders, directors cannot favor

one group arbitrarily over the others. All shareholders are, thus, protected

from arbitrary decisions of the board. Especially when dealing with strong

entities, such as hedge funds, the board is best suited to decide safe in the

knowledge that they can always retreat behind their fiduciary obligation if

pressured by a hedge fund.

Hedge funds and other activist shareholders, on the other hand, are

free to pursue their private interests with no accountability to other

shareholders. Under the American corporate system, power and

responsibility for actions resulting from that power areand should be

inextricably linked.53 The way our current system is set up, shareholders

have ceded power to the board of directors in exchange not only for the

expertise in business practices of the board of directors, but also for the

protection from accountability for corporate malfeasance. Isolation from

activism-and-the-eclipse-of-the-public-corporation-is-the-current-wave-of-activism-causing-

another-tectonic-shift-in-the-american-corporate-world.pdf.49 Id. at 3.50 Id.51 Anabtawi,supra note 22 at 598 (arguing that while shareholders have widely divergent

interests that may give them incentives to pursue their private objectives at the expense of overallshareholder value, directors who owe fiduciary duties to all shareholders, are more likely to be

able to mediate shareholder conflicts and be able to make decisions on behalf of shareholders as a

class.).

52 See Margaret Blair & Lynn Stout,A Team Production Theory of Corporate Law, 85 VA. L.REV. 247, 271287 (1999) (Proposing and defending a Team Production model for corporate

governance in which the board of directors act as mediating hierarchs.).53 Martin Lipton & Paul K. Rowe, The Inconvenient Truth About Corporate Governance:

Some Thoughts on Vice-Chancellor Strines Essay, 33 J. CORP. L. 63, 66 (2007-2008) ([T]he

statutory scheme recognizes that power and responsibility are two sides of the same coin).

8/14/2019 6/25/2009 6:26:32 Pm

12/27

MCANNAR 6/25/2009 6:26:32 PM


liability through the limited liability form is a benefit for which

shareholders have bargained. In consideration for this protection from

accountability, shareholders have bargained away their power in decision

making. The business system is set up to allow those who wish not toparticipate in this constructive contract to trade away limited liability for

more power in decision making by investing their money in business

entities other than corporationspartnerships, for example. By increasing

a shareholders ability to manage the corporation and not removing any of

his armor against accountability for his actions, courts would be allowing

the shareholder to have his cake and eat it too.54

Throughout corporate history, the courts of the United States have

encouraged a norm of strong boards shielded from daily interference by

shareholders through several legal doctrines. One such doctrine is the

business judgment rule, which acts as a presumption that in making a

business decision, the directors of a corporation acted on an informed basis,

in good faith and in the honest belief that the action taken was in the bestinterests of the company.55 A shareholder bringing a claim against a

director bears the burden of rebutting the presumption that the business

judgment rule applies.56 In effect, the business judgment rule serves as a

defense employed by the directors of the corporation when their action is

challenged by a shareholder or some other party.57 Many claims that could

have been brought in the absence of the business judgment rule are,

therefore, not meritorious. The rule, thus, reinforces the belief that

managers and directors are better placed than shareholders to make

governance decisions because of experience and access to information. 58

54 Indeed, one of the major benefits of the limited liability form is that it allows start-upcorporations to raise necessary capital based on the promise that the investor will lose only his

investment and nothing more. While many shareholders in large, well-established corporationswould be willing to expose themselves to liability for actions of a corporation with a long track

record of good corporate governance, most investors in start-up firms would not be willing to

make such a trade. Imposing liability on the investors of these start-up corporations would, thus,make capital raising a much more difficultif not impossibletask.

55 Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) overruled on other grounds by Brehm v.

Eisner, 746 A.2d 244 (Del. 2000).56 See e.g.,Aronson, 473 A.2d at 812.57 Paul N. Edwards, Compelled Termination and Corporate Governance: The Big Picture, 10

J. CORP. L. 373, 38283 (1985) ("When such a managerial decision is challenged in any type ofsuit (class, direct or derivative), the proper and accepted use of the business judgment rule is as a

means to assert, in defense, that no breach of due care has occurred as to that action, and that

therefore there is no liability on the merits of the claim.").

58 Daniel R. Fischel, The Business Judgment Rule and the Trans Union Case, 40 BUS. LAW.1437, 1441 (1985) (Managers, by virtue of their expertise and superior access to information, are

entrusted to make business decisions for the firm. This specialization of function, which operates

to the benefit of managers and shareholders alike, dictates that managers are better able todetermine the optimal investment in information. Allowing shareholders to challenge business

decisions on the basis that they were not informed has the effect of substituting the business

8/14/2019 6/25/2009 6:26:32 Pm

13/27

MCANNAR 6/25/2009 6:26:32 PM


In 1985 and 1986, the Supreme Court of Delaware decided four cases that

comprise the corporate governance jurisprudence backbone off of which

the ribs of director primacy and business judgment rule protection stem:

Unocal,59

Household,60

Van Gorkom,61

andRevlon.62

In all four cases, theCourt confirmed the power of directors in managing the business of the

corporation.63

Over time, several other doctrines developed to isolate the board of

directors from the shareholders. For example, Delaware allows

corporations to indemnify their directors against any personal liability for

claims involving a breach of the fiduciary duty of care.64 Additionally, in

most states, management of the business and affairs of the firm is

expressly vested in the board of directors.65 A shareholder vote is rarely

expressly required by statute in cases other than election of the board of

directors and approval of organic changes. SEC regulations such as rule

14a-8(i)(8) further protect the board from infiltration through proxy battles.

These legal doctrines developed over the course of several corporategenerations. As witnessed by each of these developments over time, the

courts and legislatures have acknowledged that the isolation of the board

has its merits. Allowing hedge funds and other shareholders to invade the

province of the board of directors threatens to destroy these meritorious

inventions of the corporate form.

III. STRUCTURE, FUNCTION, AND MOTIVATIONS OF ACTIVIST HEDGE

FUNDS

Hedge funds have evolved into well-oiled activist machines. It is for

this reason that they pose the greatest risk to shareholders. Both internal

and external forces pressure hedge fund managers to plot aggressively

activist courses in day-to-day investment decisions. Internally, a hedge

funds structure and functions gravitate strongly towards activist interests

that diverge from those of shareholders of portfolio companies. Externally,

judgment of some shareholders, their attorneys, and a court on the issue of how much informationshould be acquired for the business judgment of those entrusted, by virtue of their superior

expertise and incentives, with managing the firm's affairs.).59 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).60 Moran v. Household Intl, Inc., 500 A.2d 1346 (Del. 1985).61 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).62 Revlon Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).

63 Lipton,supra note 48 at 2.64 DEL. GEN. CORP. LAW 102(b)(7).65 See e.g., ALASKA STAT. 10.06.450(a); ARIZ. REV. STAT. 10-801B; ARK. CODE ANN.

4-26-801(a); COLO. REV. STAT. 7-48-110 8 DEL. CODE ANN. 141(a); D.C. STAT. 29-101.32(a); GA. CODE. ANN. 14-2-801; HAWAII REV. STAT. 414-191(b); INDIANA CODE 23-1-

33-1; KAN. STAT. ANN. 17-6301(a); LOUISIANA STAT. ANN. 12:81.

8/14/2019 6/25/2009 6:26:32 Pm

14/27

MCANNAR 6/25/2009 6:26:32 PM


competition in an increasingly stagnant market pushes hedge funds toward

activist bents in order to survive. In this part of the paper, I examine these

structural, functional, and motivational aspects in turn with an eye toward

those factors that lead a hedge funds interests to diverge from those ofportfolio shareholders.

A. Structure

Hedge funds have been an ever-increasing part of the financial market

since sociologist A.W. Jones started the first hedge fund in 1949.66 Jones

essentially hedged his bets by investing half of his investors money in

equity interests and short-selling stock with the other half, thus protecting

against overall market increases or decreases.67 Joness strategy lowered

the amount of risk taken on by his clients; hedge funds of today, however,

are marked by high-risk strategies that seek high returns. These hedge

funds cater to wealthy individuals and often have as few as 15 investors. 68

Typically, these investors are very affluent individuals, and their relative

sophistication regarding the stock market as compared to the average stock

purchaser often serves as justification for lax registration and reporting

requirements imposed on hedge funds.69 Hedge funds are willing to

sacrifice the large number of small investors looking to spend on the stock

market for a high amount of flexibility.70

Hedge funds are typically limited partnerships or limited liability

companies run by a single partner or a few general partners. 71 This partner

or group of partners serves as manager and has ultimate discretion over

when and how the money is invested. However, his discretion is not

completely unchecked. As a partner in a partnership, the fund manager

owes a fiduciary duty to investors in the fund who ultimately are limited

partners.72 This sets the stage for a potential conflict of interest where the

interests of the hedge fund investors diverge from the interests of the

portfolio shareholders.

Take, for example, the relative interests of fund investors and portfolio

shareholders that may arise in the context of a merger or corporate takeover

bid. Perhaps corporation A seeks to acquire corporation B. To raise

66 Jean Price Hanna,Hedge Funds and Funds of Funds an Update on Regulations Governing Hedge Funds, and the Duties of Registered Representatives and Investment Advisers in

Recommending Hedge Funds and Funds of Funds, PRACTICING LAW INSTITUTE CORPORATELAW AND PRACTICE COURSE HANDBOOKSERIES, 453, 455 (2007).

67 Id.68 See K.A.D. Camara, Classifying Institutional Investors, 30 J. CORP. L.219,229 (2005).69 See id.70 Id.71 Oppold,supra note 14 at 835 (2008).72 Id.

8/14/2019 6/25/2009 6:26:32 Pm

15/27

MCANNAR 6/25/2009 6:26:32 PM


enough capital to complete the deal, corporation A sells to its shareholders

securities which will either be converted into corporation A stock if the

acquisition takes place, or can be redeemed for face value plus interest if

the deal does not go through. If we assume the value of these convertiblesecurities will increase if the deal goes through, an activist hedge fund that

has a substantial voting interest in corporation B but has developed a short

position in these convertible securities will have a conflict of interest with

shareholders of both corporation A and corporation B.73

Shareholders of corporation A who purchased convertible securities

would want the acquisition to take place. This is obvious because they

want the value of their securities to increase. On the other hand, having

developed a short position in convertible securities, the hedge fund would

not want the deal to go through. This conflict would not be immediately

obvious under the current regulatory regime because the hedge fund would

not have to disclose its short position. The fund is free to use its influence

in any way it sees fit without those parties who are subject to that influenceunderstanding the motives.

Perhaps even more troubling, the hedge fund would also have a

conflict of interest with the shareholders of corporation B. The hedge fund

could simply hedge away its economic interest in corporation B by shorting

an equal number of shares in corporation B as it owns. The fund, therefore,

would have hedged away its risk in corporation B because any increase or

decrease in share value would be offset by a corresponding decrease or

increase in the value of the short position. It is now wholly irrelevant to the

hedge fund whether corporation B stock will be helped or harmed by the

acquisition.

In this case, the hedge fund was using its influence to increase the

value of its short position in the convertible shares without regard to

maximizing the share price of corporation B, a corporation in which it

appears to the typical portfolio shareholder to hold a large economic

interest. Other shareholders of corporation B are likely to be misled by the

hedge funds substantial ownership in corporation B and would probably

believe that the hedge funds ultimate goal was the maximization of the

value of corporation B stock. Again, under current securities regulations,

portfolio shareholder of corporation B would have no possibility of

discovering they were being misled.

In addition to the conflicts that arise between investors in the fund and

investors in the portfolio firms, hedge funds often stockpile large blocks of

73 This example is based largely on the acquisition of MONY by AXA described in Kahan &

Rocksupra note 15 at 1073-74. For a similar conflictsee High River Ltd. Pship v. Mylan Labs.,

Inc. 353 F. Supp. 2d 487 (M.D. Pa. 2005), and its discussion in Anabtawi, supra note 22 at 591-

92.

8/14/2019 6/25/2009 6:26:32 Pm

16/27

MCANNAR 6/25/2009 6:26:32 PM


voting rights. Because hedge funds are pooled investment vehicles run by

a single manager, ultimate discretion over this large block of shares lies at

the discretion of a single person. Although many institutional investors do

not actively vote these shares and rely instead on proxy advisory firms,hedge funds typically take advantage of their voting power.74 Hedge funds,

being pooled investment vehicles, are in the best position to overcome the

collective action problem and consolidate voting power. In fact, to the

degree that the fund owns voting shares of a company, it has already

consolidated voting power into a formidable block. Not only is each

individual fund capable of voting as such a block, but also fund managers

must simply convince another fund manager to vote a similar way to add

another large block of votes. In todays corporate world, this is more of a

realistic possibility than ever before. In fact, the 1990s marked the first

time that institutional investors, as opposed to individuals, controlled more

than fifty percent of interests in public corporations. 75 With such an

ownership pattern, opportunities abound for savvy managers to contactother voting blocks.

Because the collective action dilemma is often presented as a

problem, corporate scholars are free to assume that overcoming such a

problem is always a positive step.76 However, this conclusion ignores

the private interests to which hedge funds inevitably cater. A hedge fund

manager, as a general partner, has a fiduciary duty with respect to the

limited partners who invest in the fund. However, he has no corresponding

duty to the portfolio shareholders.77 Accordingly, he must always have the

best interest of investors in his fund in mind. This often translates into

aggressively pursuing these private interests to the detriment of those

holding shares in a portfolio firm.

Another structural pressure increasing the occurrence of activism is

manager compensation. Compensation of hedge fund managers is typically

tied to both the amount of capital in the fund and the profits made by the

fund.78 The most common payment structure is two percent of the total

capital in the fund plus twenty percent of the profits above an index

benchmark.79 This compensation structure incentivizes managers to act in

two distinct ways that diverge from the interests of a typical portfolio

shareholder: (1) a desire to raise more capital for the fund requires the

74 See Briggs,supra note 45 at 692-93.75 Boyer,supra note 2 at 977.

76 Indeed, some scholars heralded the era of hedge funds as an era of greater corporategovernance and general prosperity.

77 That is, of course, unless the hedge fund has amassed a majority stake in the corporation or,

in some jurisdictions, unless the corporation is closely held.78 Oppold,supra note 14 at 837.79 Hanna,supra note 66 at 455-56.

8/14/2019 6/25/2009 6:26:32 Pm

17/27

MCANNAR 6/25/2009 6:26:32 PM


manager to focus on short-term returns at portfolio corporations,80 and (2)

the option-like percentage of the profits the manager receives encourages

the manager to engage in risky behavior to exploit his nearly unlimited

upside.81

First, because a portion of the managers compensation is tied to the

amount of capital in the fund, a manager has a constant incentive to raise

capital. The most efficient way to excite current and new investors and to

raise capital is to show those potential investors strong returns in the recent

past.82 Consequently, a manager is more likely to focus on short-term

returns at portfolio corporations even if that means sacrificing the portfolio

corporations long-term interests.83 Such potentially short-sighted

investments are not in the interest of most portfolio shareholders who are

obviously interested in the long-term success of the corporation.

Second, the percentage of profits the manager receives is comparable

to CEO stock option compensation plans that have been the subject of

much scrutiny in recent years.84 Like stock option compensation, themanager has an unlimited upside as long as the fund continues to profit. 85

More problematically, unless the manager places some of his personal

money in the fund, he stands to lose nothing if the fund underperforms.86

Even if the manager has placed some of his own money in the fund, he still

balances an unlimited upside against a loss that is limited to the amount of

money he placed in the fund. This compensation formula creates perverse

incentives for managers of funds to pressure portfolio corporations to take

risks that would be unreasonable to other portfolio shareholders.87

B. Function

The market share controlled by hedge funds combined with their

business organization structure and manager compensation structure

80 One example of hedge funds pushing a short-term focus upon companies occurred duringthe MCI deal with Verizon. Hedge funds pushed for MCI to combine with Qwest who was

offering a better short-term price. However, committed portfolio shareholders of MCI were

pushing for MCI to combine with Verizon who would better run the company in the long run.

See Anabtawi,supra note 22 at 582-83.81 Cumming & Johan,supra note 12 at 3-4.82 See Anabtawi,supra note 22 at 564.83 Id. at 582-83.84 See e.g., Calvin H. Johnson, The Disloyalty of Stock and Stock Option Compensation, 11

CONN. INS. L. J. 133 (2005); Z. Jill Barclift, Corporate Responsibility: Ensuring Independent

Judgment of the General CounselA Look at Stock Options, 81 N.D. L. REV. 1 (2005); MelissaA. Chiprich & Phillip J. Long, Is Midnight Nearing for Cinderella? Corporate America Faces

Reality With Stock Option Accountability, 39 WAKE FOREST L. REV. 1033 (2004).85 Cumming & Johan,supra note 12 at 3-4 (2008).86 Id.87 Id. at 3.

8/14/2019 6/25/2009 6:26:32 Pm

18/27

MCANNAR 6/25/2009 6:26:32 PM


contribute to the activism practiced by many hedge funds. When combined

with the function and motivations of a hedge fund, activism is an inevitable

result. As opposed to A.W. Joness original plan to sell stocks short with

half of his fund to hedge his bets and give him a chance to profit whetherthe market generally increased or decreased, hedge funds of today tend to

focus on much more risky investment strategies.88 By pooling capital from

only a few savvy investors, hedge funds are optimally structured to make

quick, powerful movements in the market.89 Hedge funds thus function as

savvy, risk-tolerant, pooled asset vehicles.

Hedge funds become involved in a vast array of investments, several

of which stand to differentiate hedge funds from other institutional

investors.90 For example, according to a recent SEC study, unlike mutual

funds, hedge funds invest in illiquid and distressed securities, derivatives,

emerging markets, and arbitrage opportunities.91 The percent of overall

investments that hedge funds devote to these risky opportunities separate

them along a risk-tolerance axis from mutual funds, pension funds, andother institutional investors. At one end of the spectrum are index funds92

with low style drift and other institutional investors who are very risk

averse. At the other end are hedge funds that employ riskier strategies.93

Statistically, these risky strategies tend to give hedge funds a shorter life-

span than other pooled investment vehicles.94

Avoiding the seemingly imminent implosions that a short life-span

constantly threatens provides both a personal and an institutional

motivation to raise capital. As discussed earlier with respect to manager

compensation, the constant need to raise capital increases a hedge funds

short-term focus, which, in turn, tends to provide opportunities for

divergence from the interests of other shareholders.95 Hence, the risky

88 See Implications of the Growth of Hedge Funds, Staff Report to the United StatesSecurities and Exchange Commission 33 (Sept. 29, 2003) available at

http://www.sec.gov/news/studies/hedgefunds0903.pdf [hereinafter Growth of Hedge Funds].89 See Camara, supra note 68 at 229 (discussing the trade-off hedge funds make between

having a large number of small investors that would lower the flexibility of an institutional

investor and a small number of large investors that increases flexibility in the market).90 See Growth of Hedge Funds,supra note 88 at 33-43.91 Id. at 33.92 The term "index fund" encompasses about as many different types of entities as the term

"hedge fund." However, several index funds focus on diversity of portfolios to reduce theultimate risk of the investment. Because many index funds are run by computer programs, they

have the advantages of being simple, cost-effective, and static. The computer program system

also reduces the amount of human interference that leads to changing of the investment strategy.

As such, at least on a functional level, conservative index funds appear to be generally opposite ofhedge funds. See generally, RICHARD A. FERRI, ALL ABOUT INDEX FUNDS (2002).

93 Growth of Hedge Funds,supra note 88 at 33.94 Id. at ix; see Anabtawi, supra note 22 at 580 (discussing the correlation between hedge

fund managers desire to raise capital and short-term focus of such managers).95 Anabtawi,supra note 22 at 580.

8/14/2019 6/25/2009 6:26:32 Pm

19/27

MCANNAR 6/25/2009 6:26:32 PM


investment strategies that modern hedge funds tend to employ will

inevitably lead at least some of their activist policies to favor short-term

gain at the expense of long-term growth. As a result, the interests of

entities towards the riskier end of the risk-tolerance axis would be morelikely to support strategies that boost the portfolio corporations short-term

numbers at the expense of the long-term soundness of the corporation.

The question then becomes where to place other shareholders along

this risk-tolerance axis. A large portion of these shareholders will be

other pooled investment vehicles, such as index funds and pension funds

that tend to make less risky investments than hedge funds. Most of the

countrys personal investors will invest in these index, pension, or mutual

funds. Other personal investors typically do not have the large capital base

necessary to invest large portions of their income or savings in hedge

fundsnor do they have the inside connections to invest in sophisticated

and risky derivatives or emerging markets. As such, the interests of

personal investors, though varied, tend to fall in line with those of index, pension, or mutual fundswho favor long-term growthand do not

always align with the risk tolerant hedge funds and their short-term focus.

C. Motivations

Adding to the internal forces of structure and function that influence

hedge funds toward activism, several external motivations that impact a

hedge fund managers day-to-day investment decisions weigh heavily in

favor of an activist approach. First, in a strongly competitive market,

hedge funds must compete fiercely for gains.96 This motivation increases

as the market slumps and fewer profitable ventures exist. Stiff competition

encourages hedge fund managers to squeeze every last penny out of each of

their investments in order to attract more capital. As a result, managers

may feel the need to take matters into their own hands when it comes to

governance of portfolio firms.97 An example of the results of this external

pressure occurred during the most recent market crisis. Hedge funds, either

feeling the desperation of a slumping economy or sensing a golden

opportunity, snatched up large portions of failing banks.98 These funds

likely were looking to turn a quick profit by efficiently selling off the

banks assets.

Second, deregulation of proxy contests coupled with the rise of the

shareholder advisory industry have made attacks on the board cheaper and

96 See Briggs,supra note 45 at 68384.97 Id.98 Andrew Ross Sorkin & Eric Dash, Vulture Investors Making Plans To Snag Weak Banks

on the Cheap, N. Y. TIMES, September 24, 2008 at C11.

8/14/2019 6/25/2009 6:26:32 Pm

20/27

MCANNAR 6/25/2009 6:26:32 PM


easier.99 Prior to 1992, all items a shareholder wanted to send to another

shareholder regarding proxy votes had to be cleared by the SEC.100

Responding to pressure from activist shareholders, however, the SEC

opened the potential Pandoras box of proxy solicitation by allowing aninsurgent shareholder to send anything it wants without SEC oversight after

its initial proxy ballot is cleared. 101 According to Thomas W. Briggs,

activist hedge funds are now free to disseminate to the world near

telephone books full of essentially unverifiable presentation slides in

support of their proxy ballot.102

Two other 1992 proxy-rule changes exempt activist funds from

shareholder solicitation rules: the ten-or-fewer rule, 103 and the free-speech

rule.104 Under the ten-or-fewer rule, a fund is exempt from all proxy

solicitation rules as long as it solicits fewer than ten shareholders.105 Given

that the shareholders the fund is soliciting often include institutional

shareholders with large blocks of voting stock, this provision can prove to

be material as it allows an activist fund to recruit large chunks of votingstock virtually unregulated by the SEC. Under the free-speech rule, an

activist fund can solicit votes without filing any information with the SEC

as long as it does not send any written information to shareholders and as

long as the solicitation is not for election of directors or other control

transactions.106 This provision allows for the grass-roots word-of-mouth

campaigns that are often used to defeat managements proposals. 107 Add

these solicitation rule exemptions to the competition felt to stay in business

and a hedge fund can hardly compete with others if it is not activist.

Third, in a post-Enron world, some hedge funds are motivated to

remove bad directors and officers.108 Restatements of balance sheets do

not serve the stock price well. Therefore, a hedge fund with an economic

interest in a firm should be motivated to remove directors and officers who

engage in fraudulent activities. In fact, some scholars cite this type of

shareholder action as an argument for increasing shareholder involvement

in corporate governance.109 However, as discussed above110 such an

argument relies on the erroneous assumption that hedge funds will exercise

99 See BRIGGS,supra note 45 at 687.100 Id.101 Id.102 Id.103 17 C.F.R. 240.14a-2(b)(2) (2006).104 Id. at 240.14a-2(b)(1).

105 See BRIGGS,supra note 45 at 687.106 Id.107 Id.108 Id. at 684.109 See KAHAN & ROCK,supra note 15 at 102934.110 See supra Part I.A.

8/14/2019 6/25/2009 6:26:32 Pm

21/27

MCANNAR 6/25/2009 6:26:32 PM


their oversight in the best interest of the portfolio shareholders. It does not

take too much creative thought to imagine a situation where a hedge fund

could benefit from removing a director or manager for reasons other than

oversight. Perhaps the fund wants a director more sympathetic to theircause or even a director intimately related to the fund itself. Additionally,

Martin Lipton and Paul K. Rowe argue that very few directors have

actually been untrustworthy in the post-Enron world.111 Therefore, reliance

on removal of untrustworthy directors as justification for hedge fund

activism is misplaced.

IV. MACHIAVELLI REPRISED: HEDGE FUNDS IN THE REAL WORLD

Niccolo Machiavelli, the Florentine philosopher, is well known for his

belief that to maintain order, the sovereign should exercise not only virtue

but also vice.112 According to Professor Isaak Dore, Machiavelli endorsed

the idea that a ruler must act in his own best interest so that he may ruleeffectively and maintain his power.113 Accordingly, to survive in the real

world, one must embrace vice in order to maintain power and control. 114

The powerful tyrant is the best leader. Machiavelli also believed that luck

was not entirely a passive character of the universe but could be controlled

and manipulated by those willing to embrace vice. In short, people can

control their own luck by actively setting up boundaries and channels for it

to run through.

Although authored in the 16th century, Machiavelli could not have

better captured the motivations of modern hedge funds had he tried. Each

day, hedge fund managers employ consequentialist reasoning to justify

their actions. Because of strict competition for capital investments, fund

managers are forced to do whatever it takes to create the image of having

stronger returns in recent quarters than other funds. As such, they will not

hesitate to develop secret short positions in corporations and exploit

decoupled voting rights to their self-interested advantage. 115 Additionally,

111 See LIPTON & ROWE,supra note 53, at 67. (arguing in response to claim that managers

are faithless fiduciaries that as an empirical matter, very few independent directors are everfound, after judicial inquiry, to be derelict in either their duty of care or of loyalty. . . In no other

arena would we give credence to the argument that because of a few bad (or negligent) apples, we

should chop down all the apple trees.).112 ISAAK I. DORE, THE EPISTEMOLOGICAL FOUNDATIONS OF LAW, 444 (2007). Although

falsely, Machiavelli is typically associated with the consequentialist argument that the ends

justify the means.

113 Id.114 Along these lines, Machiavelli states: For a man who wants to make a profession of good

in all regards must come to ruin among so many who are not good. Hence it is necessary to a

prince, if he wants to maintain himself, to learn to be able not to be good, and to use this and notto use it according to necessity. See DORE,supra note 112 at 444-45.115 See supra notes 2944 and accompanying text.

8/14/2019 6/25/2009 6:26:32 Pm

22/27

MCANNAR 6/25/2009 6:26:32 PM


aggressive funds will push for mergers that, while immediately better in the

short run, may have disastrous long-term results.116 Perhaps even more

disturbingly, hedge funds have been accused of developing short positions

in a corporation and then starting a negative whisper campaign to drive thatcompanys stock down.117

Todays hedge funds employ Machiavellian strategies; because they

are almost completely unregulated,118 they are free to construct whatever

reality is best suited for their situation. When the extremely competitive

market for returns is added as an external pressure to meet the capital

raising needs and desires of savvy investors, motivation exists for a hedge

fund to cut corners. In doing so, funds have a perverse incentive to engage

in some of the tactics that were embraced by Machiavellis philosophy and

despised by those who had been destroyed by the Robber Barons during the

Gilded Age:119 deceit, fraud, collusion, and a narcissistic self-interest.

The investments in which hedge funds engage simply increase the

opportunity for fund managers to commit fraud at the expense of portfolioshareholders. Take, for example, the allegations lodged by the Biovail

Corporation against SAC Capital Advisors, a powerful Wall Street hedge

fund, and Gradient Analytics, an investment research firm. 120 Biovail

116 See supra note 80 describing the deal between MCI and Verizon where hedge funds

pushed for a deal with Qwest because of a higher offering price even though an acquisition byVerizon had proven to be a better long-term solution.

117 See infra notes 122132 and accompanying text describing the Biovailcase and the SECs

prosecution of Paul S. Berliner.118 Because of the nearly infinite varieties of business ventures that fall under the umbrella of

hedge fund, savvy managers are capable of structuring their ventures to avoid almost all

meaningful regulations that protect shareholders. Much of the legislation that we rely on to

regulate hedge funds was drafted in the 1930s and early 1940s. This seems like an anachronismconsidering the first hedge fund did not exist until 1949. See supra note 66 and accompanying

text.For example, under the Securities Act of 1933, hedge funds are exempt from all

meaningful regulation as long as they sell their securities only to accredited investors. Because

the term accredited investor has only two requirementsan annual income of at least $200,000and net assets of at least $1 millionsavvy managers easily avoid any regulation under the

Securities Act. 15 U.S.C. 77a et. seq.

Additionally, under the Investment Company Act of 1940, a hedge fund is free ofregulation as long as it does not have more than 100 investors and is not offered to the public at-

large. Even if the fund does attract 100 investors, it can still avoid regulation if it sells only to

qualified purchasers, those individuals with $5 million worth of investments. 15 U.S.C. 80a1 et. seq.

Hedge fund managers, themselves, can also avoid regulation under the Investment Advisor

Act of 1940. As long as the manager does not manage more than 15 clients, he does not have to

register with the SEC. While this appears on its surface to be a low threshold, the fund itself iscounted only as one client regardless of the number of investors in the fund. Thus, as long as a

manager controls fewer than 15 funds, he does not have to register. 15 U.S.C. 80b1 et. seq.119 See generally BOYER,supra note 2.120 In re Biovail Corp. Securities Litigation, 247 F.R.D. 69, 2007 WL 259933 (S.D.N.Y.

2007); In re Biovail Corp. Securities Litigation, 247 F.R.D. 72 (S.D.N.Y. 2007). See also Jenny

8/14/2019 6/25/2009 6:26:32 Pm

23/27

MCANNAR 6/25/2009 6:26:32 PM


CEO, Eugene Melnyk, accused SAC Capital and Gradient of conspiring to

delay the release of a negative report prepared by Gradient so SAC Capital

could profit off of a short position.121 Biovails lawsuit was bolstered by

admissions of Gradient employees who overheard conversations betweenhigh ranking Gradient officials and SAC Capital officials agreeing to delay

the report.122 Additionally, Biovail claimed that SAC Capital had strongly

influenced Gradient to produce the mostly negative report.123 While the

court eventually found insufficient evidence of the conspiracy to support

Biovails subpoenas of non-parties,124 it is undeniable that the potential for

such collusion exists in the current deregulated financial world.

In fact, Biovail is not the only corporation to make such allegations

against hedge funds and their independent analysts.125 On April 24, 2008,

the SEC charged Paul S. Berliner a Wall Street trader at Schottenfeld

Group, LLC with securities fraud and market manipulation for

intentionally spreading false rumors about the Blackstone Groups

acquisition of Alliance Data Systems (ADS) while selling ADS short. 126

According to the SECs complaint, Berliner disseminated a fabricated story

that ADS was renegotiating an acquisition for a lower price than publicly

promised because of troubles in ADSs consumer banking division. 127 The

rumors spread by Mr. Berliner caused ADS stock to plummet seventeen

percent in a matter of 30 minutes before the New York Stock Exchange

was forced to suspend trading of ADS stock. 128 Berliner made a huge

profit off the stocks decline.129 In exchange for entry of a final judgment

enjoining him from future prosecution under anti-fraud securities law,

Berliner settled without admitting or denying the allegations.130 These

funds have shown a Machiavellian willingness to create their own luck.

Anderson, True or False: A Hedge Fund Plotted to Hurt a Drug Maker? N.Y. TIMES, March 26,

2006.121 See ANDERSON,supra note 122.122 Id. (Mr. Smith [a gradient employee] listened eagerly, he says, but was troubled by what

he heard: his boss was agreeing to delay the release of a report that was largely negative about apharmaceutical company, Biovail, in order to allow SAC to build a position to profit should that

report then cause the stock to fall. Even worse: that report, he contends, was essentially created

by SAC).123 Id.124 Id. By all accounts, Biovail had a difficult year even without SACs alleged collusion. The

company reported $7 million in revenue losses, and the SEC instituted an investigation of itsaccounting practices. Additionally the Ontario Securities Commisssion investigated suspicious

trading activity. Id.125 See, e.g., Overstock.com v. Gradient, 151 Cal. App. 4

th, 688 (Cal. App. 2007).

126 SEC charges Wall Street Short-Seller With Spreading False Rumors, available athttp://www.sec.gov/news/press/2008/2008-64.htm (last visited Dec. 13, 2008).127 Id.128 Id.129 Id.130 Id.

8/14/2019 6/25/2009 6:26:32 Pm

24/27

MCANNAR 6/25/2009 6:26:32 PM


One response to such situations is to impose a fiduciary duty of good

faith on institutional shareholders with respect to their dealings that involve

other shareholders.131 Instead of relying on outdated legislation or anti-

fraud provisions, the courts should require a duty of good faith in alldealings regarding ownership, transfer, or sale of stockand including

negative whisper campaigns. To comply with this duty of good faith,

shareholders would be required to conduct themselves with honesty in

belief or purpose, in observance of reasonable commercial standards of

fair dealing in the securities trade, and with the absence of intent to

defraud or to seek unconscionable advantage.132 Violation of such a duty

of good faith would be subject to a preponderance of the evidence standard

as opposed to the more rigid and harder to prove clear and convincing

evidence needed to win a civil fraud claim. Proving such bad actions by

hedge funds and their advisory firms would become less burdensome.133

As such, shareholders would have teeth to protect them from the

Machiavellian hedge fund wolves.Consequentialist reasoning and creation of luck are not exclusive to

the American hedge fund world. According to Philip Richards, one of

Londons top hedge fund managers, funds reaped close to 1 billion profit

from the near collapse of Northern Rock, a large British bank.134 While the

endsmassive profits in spite of others demiseare not unheard of, the

means employed were strictly Machiavellian. According to Richards,

several funds in collusion sold Northern Rock stock short at the same

time.135 Some funds even took the risk of exposing themselves to a stock

rally by selling shares they had not yet borrowed. 136 This move became a

self-fulfilling prophecy as others in the market attempted to make up for

their own apparent lack of knowledge and sold their stock causing the share

price to plummet. Hedge funds profited off of Northern Rock shareholders

by falsely creating a panic. After the price plummeted, three U.S. hedge

funds were there to divide Northern Rocks 100 billion mortgage book

leaving the companys shareholders with almost nothing.137

131 Such a duty of good faith is not unheard of in the law. For example, many contracts aresubject to an implied duty of good faith, and Delaware has applied a fiduciary duty of good faith

to actions of managers.132 Blacks Law Dictionary, 712 (8th ed. 2004).133 Though, they would not become easy. Proving where a rumor starts may be very difficult.134 Patrick Hosking, Predatory Hedge Funds Take 1 Billion Windfall From Northern Rock

Misery, TIMESONLINE (Sep. 22, 2007), available at

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/articles.135 Id.136 Id.137 Douglas A. McIntyre, U.S. Hedge Funds to Take Over Trouble Mortgage Firm Northern

Rock? 24/7 WALL ST. (Sep. 23, 2007), available at http://www.247wallst.com/2007/09/us-

hedge-funds-.html.

8/14/2019 6/25/2009 6:26:32 Pm

25/27

MCANNAR 6/25/2009 6:26:32 PM


In the aftermath of the near financial collapse of global markets

following the subprime mortgage crisis, the SEC took note of the dangers

of short positions developed by hedge funds by temporarily suspending

short-selling of certain financial stocks including Goldman Sachs.138

Whilearguments can be made that a permanent ban on short-selling would be

advisable to protect investors and the financial markets as a whole, counter-

arguments exist that even a temporary ban will drive hedge funds overseas

to countries where such regulation is still non-existent taking valuable tax

dollars with them. Both sides are persuasive. Therefore, the best approach

to short positions is not an outright ban or a complete lack of regulation,

but a middle road approach that requires modest disclosure of short-

positions by hedge funds. For example, the SEC could require reporting of

substantial short positionssay $1 million worth of pre-sold securities or

derivativesunder the Exchange Act 13(f) coupled with a delayed public

disclosure of such reports.139 Such a solution would adequately balance the

hedge funds interest in privacy with the publics interest in protection frommisleading activism.

It is true that hedge funds have a legitimate interest in keeping their

short moves private. Successful funds always have to deal with others

piggy-backing on their moves. If one assumes that a fund has done its

research and the fund has a history of economic success, it is in ones

interest simply to save money on ones own research and make the same

moves as the successful fund.140 The piggy-backing fund, thus, receives all

the benefit of the successful funds research and can expend its research

money on some other venture. Delaying public disclosure of the 13(f)

filing for a certain time period90 days for examplewould give the

hedge fund adequate time to capitalize on its short position while still

allowing the SEC to be aware of potential conflicts of interest.

In tension with the hedge funds interest in preventing piggy-backing,

138 Wall Street Journal News Roundup, Hedge Funds Wrestle With Short-Sale Ban, WALLSTREET JOURNAL (Sep. 22, 2008), available athttp://online.wsj.com/article/SB122229997080673311.html?mod=googlenews_wsj.139 In response to the subprime crisis, the SEC required daily disclosure of short positions on

certain stocks for the period between September 22 and October 2, 2008. Under the temporary

scheme, the SEC would not disclose publicly the short positions for 14 days.

http://www.sec.gov/news/press/2008/2008-217.htm. Under an extension to the rule, funds thatcontrol at least $100 million of assets must disclose short positions until August 1, 2009.

http://www.sec.gov/rules/final/2008/34-58785.pdf. Making this a permanent requirement would

serve to protect investors in the future. However, the size of the short position, not the size of

total assets controlled by the fund should govern disclosure. It is the size of the short positionthat poses the greatest systemic risk. While enforcing such a rule may be difficult, it is not

impossible. The SEC could create an enforcement task force of accountants and attorneys to

examine short positions that appear to be close to the limit.140 Warren Buffet has proven the piggy-backing effect by showing that the market fluctuates

based solely on the moves of his company, Berkshire Hathaway.

8/14/2019 6/25/2009 6:26:32 Pm

26/27

MCANNAR 6/25/2009 6:26:32 PM


there is a strong competing public interest in letting shareholders know who

is behind the moves and what their real motives are. Without some public

disclosure, hedge funds are free to buy votes, decouple their voting rights

from economic interest, or encourage a vote that is not in the interest of theshareholders.141 In order for the 13(f) reporting scheme described above to

work, the SEC would have to do more to enforce the amended provisions

of the Exchange Act. Coupled with increased disclosure, the SEC would

have to do a better job than it has in the past of enforcing section 13(f). It

may be necessary in the future to add attorneys to the SEC specifically to

monitor the short positions in the market. While this may be an added cost

to the SECs budget, it is a small price to pay for the consumer protection

that the agency was formed to provide. 142 Without such oversight,

Machiavelli may win, and luck, too, may be a buyable commodity.

V. CONCLUSION

The Chinese character forcrisis combines two other charactersone

meaning danger and the other, opportunity.143 Given that the most recent

credit crisis following the collapse of the secondary mortgage market will

usher in a new era of systematic regulation overhaul, Congress can choose

to do one of two thingseither it can ignore increased hedge fund

influence or it can use the systematic overhaul as a chance to address a

previously unregulated problem area. The former path will expose

shareholders to the danger that is greedy, savvy hedge fund control. A

walk down this path is tantamount to trading the agency costs of managers

who may use control for personal profits for the potential costs of

governance by activist institutional shareholders who use control for

personal profits at the demise of all other shareholders. The latter path

presents an opportunity for Congress or the SEC to regulate the previously

free hedge funds and avoid another potential crisis while still maintaining

the possibility of promise for some shareholder oversight.144

In recent years, the battle over control of the corporation has shifted

141 See supra notes 2941 and accompanying text.142 See http://www.sec.gov/news/press/sec-actions.htm (stating [t]he mission of the Securities

and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets,and facilitate capital formation.).143 BOYER,supra note 2 at 981.144 Effective September 18, 2008, the SEC promulgated new rules regarding naked short

sellingor short selling before locating shares to be borrowed. However, these naked shortselling provisions do nothing to prevent the decoupling of interests that occur on a regular basis.

As such, these new regulations do not solve the problems presented in this paperconflict of

interest between the hedge fund and portfolio sh

Date post:	30-May-2018
Category:	Documents
Upload:	airb13
View:	219 times
Download:	0 times

6/25/2009 6:26:32 Pm

Documents