The tension between hedge fund activism and corporate law
The attached paper was presented at a Jan. 22, 2016 symposium honoring the work of Henry G. Manne, sponsored by the Law & Economics Center at George Mason University School of Law. This is a draft version, while the final will be published in the symposium issue of the Journal of Law, Economics & Policy.
What role is an activist hedge fund to play in the decision-making of a public company? That question is very simple to answer. If a public company is organized as a corporation, which is very likely, and it has not opted out of the default rule that provides managerial control of the company to the board of directors (board), which is even more likely, then, like any other shareholder, the activist hedge fund can, at most, play only a purely advisory role. That is, even if the activist hedge fund yells and screams about the company’s poor performance, publicly insults the current board and executive management or threatens a proxy contest to replace some or all of the current members of the board with its own nominees, it is not provided any decision-making authority under corporate law.
Therefore, the real corporate governance issue that needs to be addressed is the following: to what extent may a board act to reduce an activist hedge fund’s influence in company decision-making? Like defensive measures that are utilized by the board to defend against a hostile bidder, such as the poison pill, this question will ultimately be answered by the judiciary in its statutory interpretation of corporate law’s default rule that provides the board with ultimate management authority. For purposes of this article, that default rule is Delaware General Corporation Law (DGCL) §141(a):
The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.
The judicial review of board decision-making is built on an approach that provides great deference to board authority. For the overwhelming majority of potential fact patterns, this deferential approach enhances the decision-making of public companies and helps move them to shareholder-wealth maximization, the objective of board authority. However, hedge fund activism (HFA), with numerous empirical studies that attests to its role in enhancing shareholder value and target-company performance, legitimately questions the value of that deferential approach in some exceptional, but very important, fact patterns.
The thesis of this article is as follows: the courts will be overly permissive in allowing boards to mute the activities of activist hedge funds unless the courts start to recognize the value of hedge-fund activism (HFA) as a corrective mechanism and thereby feel the need to make an exception to their traditional approach to judicial review: strong deference to board authority. We have already seen evidence of the courts not recognizing the value of HFA in in Third Point LLC v. Ruprecht, a case where the court reviewed with approval a discriminatory poison pill meant to keep an activist hedge fund from winning a proxy contest.
There are four important observations about corporate law that support this thesis. First, the default rules of statutory corporate law explicitly provide the board with unlimited authority to manage the public company. Without modification of this default rule, there is no place for an activist hedge fund in the decision-making of a corporation. Second, the parties to the corporate contract of a public company never modify the board’s statutory authority in any substantive way. The courts understand that this private ordering is being sanctioned by statutory corporate law and will feel compelled to act aggressively to protect board authority. Third, the courts also understand, because of the inherent limitations of being a judge and not a business leader, that the board and its executive officers are in the best position to determine if a corporate decision is wealth-maximizing and feel compelled to defer to their expertise. Fourth, the first three observations imply that when the courts review a board decision, it will provide strong deference to board authority. Therefore, even though it has created fiduciary duties to constrain the unlimited power of the board, it will apply them in a very gentle way. That is, the plaintiffs will have a hard time satisfying the court that the board has breached its duties. The evidence for this is found in the traditional application of the business-judgment rule and the permissive Unocal test. This traditional approach to judicial review includes being restrained in finding a breach in fiduciary duties when the board takes actions meant to mute the activities of an activist hedge fund, even when it is clear that the activist hedge fund is acting as a corrective mechanism in corporate governance.
The discussion that follows, when it references state corporate law, has been pragmatically framed in the context of Delaware corporate law. Delaware is the state where the majority of the largest U.S. companies are incorporated, and its corporate law often serves as the authority that other states look to when developing their own statutory and case law. Therefore, the primary examples are from Delaware, but the thinking is meant to be global in nature.
This article proceeds as follows: Part I briefly describes HFA. Part II describes how HFA operates as a corrective mechanism in corporate governance. This description closely parallels how acquirers seek control to correct managerial inefficiencies. This part closes by providing a theory of shareholder activism that explains how HFA creates value for shareholders and enhances the performance of target companies. This argument has as its foundation Henry Manne’s remarkable article, “Mergers and the Market for Corporate Control.” Manne argued that control of a public company was a valuable asset in and of itself if used to correct managerial inefficiencies. Shareholder activism, such as HFA, can be thought of in the same manner, a valuable asset in and of itself if the purpose of such activism is to correct such inefficiencies. Part III discusses how the judiciary’s traditional approach to the review of board decisions, strong deference to board authority, could potentially be used to reduce the incentives of hedge funds to act as activists. The judiciary could do this by being overly permissive in allowing boards to mute the activities of activist hedge funds. The judiciary’s strong deference to board authority derives from a strong respect for statutory corporate law’s private ordering of authority and its understanding that the board and its management team, not the courts, are the business experts. Part IV discusses the Unocal test as a permissive standard of review and how the application of the test in Third Point conforms to the thesis. Part V concludes with general recommendations on how the courts should handle the review of board actions meant to mute the activities of activist hedge funds.