Hedge Fund Activism, Poison Pills, and the Jurisprudence of Threat
William W. Bratton
Activist hedge funds
Short termism
Takeover defences
Hedge fund activism is to corporate law's early twenty-first century what the hostile takeover was to its late twentieth century. Like the hostile takeover, activism threatens incumbent managers and disrupts their business plans by successfully appealing to the shareholders' interest in immediate returns. Like the hostile takeover, activism occupies center stage in corporate law policy discussions, posing a choice between short-term gain and long-term investment. But there is a glaring point of distinction. Unlike the hostile takeover, activism has precipitated no significant changes in corporate law. Where the hostile takeover triggered structural changes in state corporate codes and the federal securities laws along with a root and branch reconfiguration of fiduciary duty, hedge fund activism largely leaves corporate law where it found it. The activists manage to play hostilely without bumping up against the defensive barriers erected in the late twentieth century transformation of corporate law because they avoid attempting to take control. At the same time, law reform initiatives designed to constrain the new mode of hostile intervention have failed to pick up traction.
There is only one high profile case in which twentieth century antitakeover law has come to bear on a management defense against a twenty-first century activist challenge—the Delaware Court of Chancery's decision in Third Point LLC v Ruprecht, better known as "the Sotheby's case." The board of directors of a target corporation, Sotheby's, lobbed a poison pill in the path of one of the more aggressive hedge funds, Third Point LLC, and its chief, Daniel Loeb. The pill had a "low threshold" feature, capping a hostile challenger's block at 10 percent of outstanding shares rather than at the traditional 20 percent. It thereby disabled Third Point from enhancing its vote total in a short-slate proxy contest through additional purchases of target shares. The Chancery Court nonetheless sustained the pill under Unocal v Mesa Petroleum Co. The decision implicated an important policy question: whether a twentieth century doctrine keyed to hostile takeovers and control transfers appropriately can be brought to bear in a twenty-first century governance context in which the challenger eschews control transfer and instead makes aggressive use of the shareholder franchise.
Resolution of this question entails evaluation of the gravity of two sets of threats, one at the doctrinal level and the other at the policy level. The doctrinal threats are exterior threats to corporate policy and effectiveness on which managers justify defensive tactics under Unocal. Because some threats have greater justificatory salience under Unocal than do others, a question arises as to the nature and characterization of the threats allegedly held out by activist intervention. The policy threats implicate the new balance of power between managers and shareholders. Hedge fund activism has operated as a catalyst that enables dispersed shareholders to surmount collective action problems so as to register preferences regarding corporate business plans in connection with voting on competing candidates for board seats. To the extent that managers wielding low-threshold poison pills disable activist challenges, the power balance could shift back in their favor with potentially negative agency cost consequences.
I appraise the threats in a recently published working paper. As regards Unocal, the paper demonstrates a serious problem of fit. The most potent Unocal threats are those involving coercion of dispersed shareholders in connection with hostile tender offers or expropriation from dispersed shareholders by controlling blockholders. The threats, originally identified on 1980s control transfer fact patterns, show up only tangentially on the new fact patterns. To the extent that Unocal doctrine relies on the old threats in sustaining poison pills deployed against today's activists, it ends up as more of a formal rubber stamp than a substantive fiduciary inquiry.
The Sotheby's opinion, although for the most part staying inside of the inherited framework of Unocal doctrine, does take a tentative step into the twenty-first century, suggesting that activists hold out a threat of "disproportionate influence," but without filling in any particulars about the influence's nature and negative effect. My paper posits the missing details, conducting a thought experiment that reshapes and extends Unocal so that it provides a robust basis for sustaining management defense against activist hedge funds, even shielding poison pills with 5 percent triggers. The extension is radical. Up to now, Unocal has facilitated management actions that protect dispersed shareholders from being railroaded into selling the company for too little. Under the extension, Unocal would justify management actions that protect shareholders from the consequences of their own collective actions in casting uncoerced ballots at director elections. Many, perhaps most, observers would view the extension as a perversion of the governance system's heretofore jealous protection of the shareholder franchise to elect directors.
My paper's refitted version of Unocal sharply poses the policy threat. Most observers would find the prospect of an easily-justified 5 percent poison pill threatening indeed, projecting that it would inhibit activist intervention and thereby damage the corporate governance system. But the projection of harm rings hollow in the present posture of shareholder-manager politics. Even if structural changes inhibiting activism would in fact result in economic injury, no significant inhibition is likely to follow from judicial sanction of a 5 percent pill. A low-threshold pill deters activist block formation only to the extent that it is put in in place advance of the activist's appearance. These days very few managers dare to promulgate such "standing" pills. So powerful have shareholders become that in today's managerial cost-benefit calculus, the detriments of incurring the shareholders' wrath by traversing their governance preferences regarding charters and bylaws now outweigh a poison pill's insulating benefits.
Given that, it is worth asking whether 5 percent poison pills could out policy benefits. The policy stakes are traversed in a debate in which activism is associated with value-destructive short termism. The debate's participants argue back and forth based on assumed across-the-board tendencies. But questions about short-term value sacrifices cannot be resolved on an aggregate basis. It depends on the company. Some are appropriate targets for activist intervention, while others are not. The paper suggests that company-by-company dialogue on the point would be good thing, exploring the possibility that a 5 percent standing pill could trigger useful informational exchanges between managers and institutional investors without simultaneously over-deterring activist intervention.
William W. Bratton is the Nicholas F. Gallicchio Professor of Law and Co-Director, Institute for Law and Economics at the University of Pennsylvania Law School.
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