Is Activism Good or Bad?

By Stephen BornsteinApril 11, 2012

It all depends on your investment time horizon . . .

Statistically, hedge fund activism was off the charts in 2013. It was the top-performing hedge fund strategy by far and its practitioners won more proxy contests, attracted more capital and targeted bigger fish than ever before.

Thanks to their successes, hedge fund activists also began to shed their image as corporate raiders. They softened the tones of their campaigns and enlisted the support of major institutional investors like CalSTRS1. Their targets also became more accepting of activist board representation.

Still at issue, however, is whether hedge fund activists are simply in it for themselves with no interest in the eventual fortunes of their target companies or whether they perform a socially-useful, check-and-balance function – like short-sellers – on underperforming managements?

Against short-termism

Activism’s loudest and harshest detractor has been Marty Lipton (http://aroundwallstreet.com/2012/09/the-first-ten-days-of-an-activist-campaign/), the prominent New York defense attorney who developed the poison pill in the ‘80s to fend off corporate raiders. Poison pills have since been used by public companies to insulate themselves from activists2.

1 Large institutional investors cannot easily jump in and out of shares because they effectively own the whole market, so they are now becoming more inclined to improve their corporate investments than to change them.

2 Sotheby’s, for example, just adopted a poison pill to thwart an activist campaign by Dan Loeb of Third Point who is challenging it in Delaware Chancery Court.

Lipton’s basic premise is that boards of directors should be able to manage their companies free of pressure from shareholders to return uninvested cash through dividends or share buybacks that compromise long-term growth prospects. He argues that economic growth, national competitiveness, innovation and sustained employment require prudent reinvestment of corporate profits into R&D and other value-creating initiatives. Activist pressure to deliver short-term results undermines that objective and is, in his view, at least immoral if not illegal3.

Agreeing with Lipton is Leo Strine, the new Chief Justice of the Delaware Supreme Court4. In a recent Columbia Law Review article entitled Can We Do Better by Ordinary Investors? (http://columbialawreview.org/wp-content/uploads/2014/03/Strine-L..pdf), Justice Strine argues that short-term investors should be reined in because they are incentivizing corporate managements to take excessive risks and cut regulatory corners in order to satisfy shareholder demand for quick returns. He claims that the American economy suffers in the long-term from the divergence of interests between aggressive fund managers, who control shareholder votes, and ordinary fund investors, who are saving for retirement. Strine’s prescription is to make those fund managers accountable to their equity investors just as they insist corporate managers be to theirs.

Should public shareholders have any say?

An even more restrictive view of shareholder rights has been advanced by Lynn Stout (http://aroundwallstreet.com/2012/07/should-shareholders-call-the-shots/) of Cornell Law School. In her book The Shareholder Value Myth (2012), Professor Stout asserts that shareholders should not be considered owners of publicly-traded companies in the conventional sense. Their stockholdings are mere contracts between themselves and their companies which afford them a

3 Moody’s doesn’t like short-term activism either, saying in a report this month that activist-induced cash payouts to shareholders through special dividends or stock buybacks increases the risk of default on outstanding debt which could result in ratings downgrades.

4 Before ascending to the Delaware Supreme Court, Strine spent 16 years as a judge on the Delaware Chancery Court, the last three as its Chancellor.

limited set of rights in a limited set of circumstances. Their claim to a corporation’s residual assets, for example, applies only after all of its other obligations have been satisfied and then only in bankruptcy.

In Stout’s view, shareholders don’t have the right to control or manage the companies whose shares they own. They do have the right to elect their board, but the board makes the decisions on what to do with excess revenue or profits. These profits do not automatically belong to the shareholders. The board can certainly pay dividends to shareholders, but it can also decide to use excess cash for other business purposes such as expanding the workforce, investing in new technologies or entering new markets.

In the real world, shareholders have widely differing goals. Some are day-traders, some are long-term investors, some own small positions and some hold controlling stakes. Since their interests are different, they don’t all view share price in the same way. In addition, Stout argues that companies have responsibilities not just toward their shareholders, but also their employees, customers, creditors, vendors, regulators and society as a whole. How, then, for example, can they reconcile conflicting mantras such as “the customer’s always right” and “shareholder interests come first”?

Activism’s defenses

Hedge fund activists today are not the corporate raiders of the past. They don’t want to own and strip their targets or just get paid greenmail to go away. They carefully analyze their targets and provide corporate managements with valuable insight into how their companies are viewed by investors and why their stocks are underperforming. They are focused on creating value for all of the shareholders, not just themselves.

There is also no proof that activist campaigns have in fact hampered the long-term growth prospects of their targets. In a 2013 paper entitled The Long-Term Effects of Hedge Fund Activism, Professor Lucian Bebchuk (http://aroundwallstreet.com/2012/09/the-first-ten-days-of-an-activist-campaign/) of Harvard Law School examined over 2,000 activist campaigns

between 1994 and 2007 and found “no evidence that interventions are followed by declines in operating performance in the long term.” Instead, he found that operating performance actually improved during the five-year period following the most criticized types of activist interventions, namely those that constrained long-term investment by increasing leverage or shareholder payouts and those that employed adversarial tactics.

While it is true that some hedge fund activists have initiated campaigns solely for the initial price spike, most others have built up their positions over time and have advocated strategic changes with long-term implications.

Professor Bebchuk apparently found no evidence that the initial price spikes or even the subsequent exits by activists from target stocks tend to be followed by long-term underperformance. He also found no evidence that activist campaigns during the years preceding the financial crisis rendered their targets more vulnerable to the global meltdown than non-targeted companies.

Open questions

Where does it say that, in determining corporate strategy, the interests of long-term investors should outweigh those of shareholders who buy and sell stock to turn a quick profit? Where does it say that, in order to be considered a worthy shareholder, you have to hold stock for at least a minimum period of time?

Moreover, how do we really know that short-termism impairs companies and reduces their ultimate business output and value to society5. Professor Bebchuk could be right about the favorable effects of activism (whether short-term or otherwise) and Professor Stout could be right about considering the interests of all the stakeholders in a corporate enterprise and not those of just the shareholders. Is the current share price an accurate metric for either of those possibilities?

Lipton backs off, slightly

5 It’s worth noting that the life expectancy of Fortune 500 companies is now only 15 years.

Ironically, pro-activism just got an unexpected shot-in-the-arm from none other than Marty Lipton himself. At a recent industry conference, Lipton conceded that some forms of activism should actually be encouraged. He cited Ralph Whitworth of Relational Investors, Nelson Peltz of Trian Fund and Barry Rosenstein of Jana Partners as activists who have espoused long-term shareholder value as their campaign aims. He put Carl Icahn, Paul Singer, Dan Loeb and Bill Ackman in the opposite camp. He now says “activists’ arguments should be considered on a case-by-case basis.”

So that’s where things stand today. However, if hedge fund activists continue to do as well as they have been, other fund managers will almost certainly get in on the act, potentially with shorter-term objectives than the current crowd. We’ll then have to revisit Marty Lipton’s earlier position if the market gets deluged with what one commentator referred to as “quick hits.”

TAGS: ACTIVISM, HEDGE FUND STRATEGY, PROXY CONTESTS, CORPORATE RAIDERS, ACTIVIST CAMPAIGNS, CALSTRS, BOARD REPRESENTATION, SHORT-TERMISM, MARTY LIPTON, POISON PILL, SOTHEBY’S, DIVIDENDS, SHARE BUYBACKS, UNINVESTED CASH, LONG-TERM GROWTH, LEO STRINE, HEDGE FUND ACTIVISTS, LYNN STOUT, PUBLIC SHAREHOLDERS, THE SHAREHOLDER VALUE MYTH, MOODY’S, BOARD OF DIRECTORS, GREENMAIL, LUCIAN BEBCHUK, STAKEHOLDERS, SHARE PRICE, RALPH WHITWORTH, RELATIONAL INVESTORS, NELSON PELTZ, TRIAN FUND, BARRY ROSENSTEIN, JANA PARTNERS, CARL ICAHN, PAUL SINGER, DAN LOEB, BILL ACKMAN, INCUMBENT MANAGEMENTS, TARGET COMPANIES, CORPORATE GOVERNANCE