Activists – The Problem for U.S. Leadership in Global Capital Markets

Joseph W. Bartlett

A lively debate is cascading through the U.S. Capital Markets, triggered by the success of well-heeled investors in public markets labeled “activists.”

Bebchuk vs. Lipton

On the one hand, the applause in favor of activists is led by certain academics, the chief being Professor Lucien Bebchuk, who has reported.

“Empirical studies show that attacks on companies by activist hedge funds benefit, and do not have an adverse effect on, the targets over the five year period following the attack.

“Only anecdotal evidence and claimed real-world experience show that attacks on companies by activist hedge funds have an adverse effect on the targets and other companies that adjust management strategy to void attacks.

“Empirical studies are better than anecdotal evidence and real-world experience.

“Therefore, attacks by activist hedge funds should not be restrained but should be encouraged.”

The opposition has been led by Marty Lipton and his colleagues at Wachtell Lipton, authoring several papers, as has Prof. Bebchuk. Lipton’s position, which I quote at some length, is:

“The shareholder activism movement is destroying the role, focus and collegiality of the board of directors. Activism and the corporate governance changes it has brought about has caused a shift in the board’s role from guiding strategy and advising management to ensuring compliance and performing due diligence. Proliferating lawsuits, certification requirements, and governance rules, as well as the increased threat of personal liability, are forcing boards to spend more time and energy on compliance, due diligence and investigations, and less on the actual business of their companies. This shift in focus tends to create a wall between the board and the CEO. Professor Jeffrey Sonnenfeld of Yale recently noted that boards’ traditional “trusted role as confidante has largely disappeared” because CEOs are wary of sharing concerns with investigative and defensive boards.

“Similarly, even when the board is able to focus on the business of the corporation itself, activist investors create pressure on boards to manage for short-term share price performance rather than long-term value creation. The combination of activist hedge funds and investors who have no interest in long-term value creation puts tremendous pressure on a board to manage for the short-term at the expense of the company’s relationships with its employees, customers, suppliers and communities and at the expense of the company’s investment in research and development and capital projects, all of which are critical to a company’s long-term success.

“In addition to changes in the fundamental role of the board, the everyday functioning of the board has suffered as well. The demeaning effect of the parade of lawyers, accountants, consultants and auditors through board and committee meetings is one example. A corollary of the transformation of the role of the board from strategy and advice to investigation and compliance is an increased reliance on experts in the boardroom. While it is salutary for boards to be well advised, over-reliance on experts tends to reduce boardroom collegiality, distract from the board’s role as strategic advisor, and call into question who is in control – the directors or their army of advisors. Recent suggestions that compensation consultants, rather than informed boards, are responsible for “excessive” executive pay is just one example of the perception that boards are ceding control of their companies to outside advisors.

“Additionally, the balkanization of the board into powerful committees of independent directors and the overuse of executive sessions has had a corrosive impact on collegiality. Stock exchange requirements for executive sessions of the independent directors and that audit, compensation and nominating committees consist solely of independent directors and the special Sarbanes-Oxley duties for the audit committee have separated boards into distinct fiefdoms, each with a different mandate and a different information base. At too many companies, executive sessions have grown in number and length far beyond what was envisaged by the NYSE committee that mandated them in 2002. As CEOs and other management directors are excluded from executive sessions and forbidden from serving on key committees, and as these committees have increased in importance, it takes considerable effort to keep a board from becoming polarized and to maintain a shared sense of collegiality and a common understanding of all the issues facing the company.”

Professor Bebchuk continues to reply, citing studies that indicate that Wachtell Lipton’s propositions are “wrong.” Bebchuk, Wachtell Lipton Was Wrong About the Shareholder Rights Project, posted on April 9, 2013 at 8:51 am., The implication that Wachtell is not a neutral observer in this discussion is open to the counter that neither is Professor Bebchuk’s Shareholder Rights Project, which he heads.

Prof. Bebchuk politely points out that Wachtell Lipton is in the business of defending legacy boards against hostile attacks, including poison pills (so-called) and classified boards … only one-third of the board stands for elections each year. He argues that:

“[t]here is a significant body of empirical work that finds that classified boards are associated with negative outcomes for corporations and their shareholders. In particular, classified boards are correlated with lower company value (Bebchuk and Cohen (2005), subsequently confirmed by Faleye (2007) and Frakes (2007), lower returns to shareholders in the event of an unsolicited offer (Bebchuk, Conte, and Subramanian (2002), value-decreasing acquisition decisions (Masulis, Wang, and Xei (2007)), and lower sensitivity of CEO turnover to company performance (Faleye (2007)).”

Lipton’s last sally which I elect to quote as representative of his views was prepared for the Harvard Roundtable on Activist Interventions March, 26, 2014, in which he argues:

“Prof. Bebchuk refuses to accept that the fundamental goal of the business corporation to maximize long-term shareholder value can only be accomplished on a sustainable basis by serving the constituencies that create the value-employees, customers, suppliers and communities. It’s my view that, in the long run, the focus on creating a healthy, sustainable and profitable enterprise benefits all constituencies, including shareholders and the economy as a whole. When the system gets distorted by short-term measures that hurt the long-term profitability and sustainability of the enterprise, it may give players like hedge funds the opportunity to profit, but it’s at the expense of long-term constituencies, including other shareholders. It results in allocating a larger part of the pie to one constituency, but leaving less for the others and shrinking the size of the pie as a whole. There is no reason we should allow that to happen.

All that said, and whatever the merits of the opposing sides, the activists are winning, vide:

“More hedge funds today are styling themselves as activists and they are notching up significant victories. Their demands can vary widely, from the sale of company to share buybacks to an operational shake-up. They may apply their pressure in private, as Jeff Ubben’s ValueAct did to ease out Steve Ballmer as chief executive at Microsoft. Or they may do so in public, as in Nelson Peltz’s campaign to make PepsiCo split off its snacks business. But they have in common a belief in their analysis and a determination to force change, even if it means storming their way on to corporate boards.”

The Root Problem: The Eclipse

The issue which I believe is continually overlooked is the existential problem for investors, asset managers and our capital markets, expressed in an article on the “eclipse” of our public company population, including the views of then Chancellor, now Chief Justice, Leo Strine on what he calls “short termism.” Who cares about the merit/demerits of activism if there are no live animals for the activists to feed on? Let me quote from Chief Justice Strine’s article in the 2010 Business Lawyer.

“The existing model of corporate law focuses solely on the duties the managers owe to stockholders. It does not address the reality that most ‘stockholders’ are now themselves a form of agency, being institutional investors, who represent end-user investors. There institutional investors now control nearly 70 percent of U.S. publicly traded equities, a figure that will continue to grow.

“For a variety of reasons these institutional investors often have a myopic concern for short-term performance … What is even more disturbing than hedge fund turnover is the gerbil-like trading activity of the mutual fund industry, which is the primary investor of Americans’ 401(k) contributions. The average portfolio turnover at actively managed mutual funds, for example, is approximately 100 percent a year … And a rough calculation using transaction activity and market capitalization data from the U.S. Statistical Abstract reveals that turnover across all U.S. exchanges reached approximately 300 percent in 2008.

“There is a limit to the ability to add more to the managerial agenda without compromising management’s ability to effectively perform its most important duties. With the proposal of ‘more’ things to do should come the responsibility to identify those preexisting that are ‘less’ important and should be dispensed with. Absent this sort of mature discipline, the proposal of more mandates will actually harm stockholders and society as a whole, by making it impossible for directors to effectively carry out their responsibilities, giving investors and the public unrealistic expectations about what can be asked of corporate managers, and dissuading qualified candidates from serving on corporate boards.

“In sum, real investors want what we as a society want and, we as end-user individual investors want; which is for corporations to create sustainable wealth. Until, however, the institutions who control and churn American stocks actually act and think like investors themselves, it is unrealistic to think that the corporations they influence will be well-positioned to advance that widely shared objective. So long as many of the most influential and active investors continue to think short term, it is unrealistic to expect the corporate boards they elect to strike the proper balance between the pursuit of profits through risky endeavors and the prudent preservation of value. Rather, to foster sustainable economic growth, stockholders themselves must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock prices.”

The case against Chief Justice Strine’s point of view is made by a colleague of Professor Bebchuk’s at Harvard Law School. Professor Roe argues that Chief Justice Strine and his colleagues are not “well equipped” to make judgments on the pros and cons of the Lipton vs. Bebchuk arguments.

“Fourth, courts are not well equipped to evaluate this kind of economic policy and should leave this task to other regulatory institutions, many of which have better remedies available than do corporate lawmakers and some of which are better positioned than courts to assess the extent, location and capacity for lawmaking to ameliorate the purported problem. For reasons similar to those that underpin the business judgment rule, courts should be as reluctant to make economic policy decisions as they are to second-guess unconflicted board business decisions.”

Bad news for the Delaware judges. After hearing this topic endlessly debated back and forth by $1,000 per hour lawyers and senior academic experts, based on facts on the ground in specific cases, they nonetheless are ill-equipped to decide which side has the better case. Professor Roe’s remedy is:

“Courts are poor places to make this kind of basic economic policy. They may even find it difficult to assess accurately whether the economy is too short-term, too long-term, or just right. If such considerations are to make their way into economic policy, these should be national policies, coordinated with tax policy, and perhaps implemented via the tax code and securities laws, and the rules that influence the size of stockholdings, not via parochial corporate law.”

If I am reading Professor Roe correctly, he would remit decision making to the U.S. Congress. I rest my case.

To sum up, the fear is that, despite a recent flurry as the market has been in a major upward cycle, IPO exits may well remain below their potential until and unless we can fix the problems from which U.S. public company status, of and by itself, suffers. To be sure, there have always been advantages and disadvantages inherent in public registration. The advantages are obvious … a liquid currency enabling Pubcos to make acquisitions, reward employees and raise capital. With prominent exceptions, e.g. Koch Industries, Cargill, behemoth companies are (or at least were) public and the owners (usually) well rewarded. The disadvantages include frictional expense and the loss of proprietary protection on items such as internal strategy, costs, pricing and like metrics of use to competitors, vendors and customers.

That said, the superfluous, non-essential detriments include “activists,” and the relentless criticism of executive compensation, so unpleasant and unproductive (except for the free riders) that it drives talented jockeys into remaining in the private firm space. The problem is exacerbated by the power of U.S. firms to remain (or go) private and yet provide their shareholders liquidity on secondary exchanges …. HPPOs (hybrid public private organizations) in the NVCA’s jargon … buoyed by the ability to remain private despite 1999 shareholders of record. What does this country look like as the world’s financial center if we continue to lose ground? To make the point, see a recent report on Yahoo Finance.

“There are fewer publicly traded companies on American exchanges than at any time since at least 1990. A larger proportion of this narrower market falls into the ‘small-stock; category. And established companies have been aggressively pulling their shares off the market through buybacks. Together, this amounts to a restricted supply of equities. To exaggerate slightly, there might not quite be ‘enough stock to go around’ to meet a slowly rising level of investor demand. No doubt, this is at least a factor for the steady lift in share prices.

“The total number of U.S. exchange-listed companies peaked near 8,800 in 997 and has since sunk to 4,900 as of year-end 2012, according to data furnished by Strategas Group. The ranks of public companies declined slowly into the 2000 market peak and then entered a steep downtrend in the early- and mid-2000s.”

Potential Countermeasures

One remedy is, of course, close at hand and is occasionally exercised as companies line up at the IPO window. To keep the activists in their cages, the vaccine is two series of voting shares … Series A and Series B. Like Facebook, shares of Series A have one vote and shares of Series B have ten votes. The founders of the IPO registrant own the B; the rest of hoi polloi in the IPO are offered Series A and only Series A. Too undemocratic, argue the columnists in the New York Times business section? Well, how about The New York Times itself?

The question is whether investors will buy shares, in an IPO or on the market, if their vote doesn’t count for much of anything. Maybe only in all-stars like Facebook? Or, maybe (and on the other hand), in firms immune from “short termism” because, as Chief Justice Strine put it, control is lodged in the creative types who are umbilically tied to the company’s objective … which means the type of company that can and will think long term. The betting in this corner is founded on the belief that no one has a better objective judgment seat on corporate governance in the public interest than Chief Justice Strine.

Leaving the two-vote structure aside, there are certain other measurers a company can take at the onset of its journey from (to use my phrase) the embryo to the IPO.

  • The first is forum selection, making sure all litigation is subject to Delaware venue and jurisdiction, thereby frustrating plaintiffs counsel’s attempts to avoid Delaware’s rich body of precedent and experienced Chancellors and Vice Chancellors in the Delaware Chancery Court (plus the same in the U.S. District Court), who are prepared to apply discipline to the free-wheeling process. Absent such provisions, plaintiffs’ counsel often files its lawsuits against the Delaware company anywhere other than Delaware.
  • Second, the frosting on the cake … adoption by Delaware domiciled corporations of a “loser-pays” by-law providing that plaintiffs in shareholder derivative litigation are responsible for the company’s attorney fees and costs if the company successfully defends, a by-law (assuming it survives the Delaware legislature’s reaction to an existential threat by the plaintiffs’ bar) which is likely to represent tort reform of and by itself.
  • Third, a system called Tenure Voting. Quoting from a piece in The Wall Street Journal March 17th.

“Not unlike unearthing a lost herbal remedy, Brian O’Kelley recently rediscovered an ancient treatment for cases of raging corporate activism. It’s called tenure voting.

“First deployed in the 1980s and since fallen out of vogue, it’s a simple concept with intriguing consequences for U.S. companies. Under tenure voting, investors who hold their shares a set period of time receive additional votes. A company could, for instance, reward a vote per year, every year, for two years of holding the stock.

“In theory, this should reward long-term shareholding and investment while providing a bulwark against short-termers who roam the markets, looking to force buybacks or an untimely company sale. In the ongoing war to define the purpose of the modern corporations – which managements are losing mightily – this would at least be a stubby billy club.

“Mr. O’Kelley and his idea are worth discussing for a number of reasons, notably because he is the chief executive and co-founder of a hot New York advertising technology firm called AppNexus. The company is currently valued at $1.2 billion, and most indications are that it will go public before too long.

“What if AppNexus were to take the unexpected route and go public with a modern tenure-voting plan?

Mr. O’Kelley wouldn’t comment on any IPO, but as someone who builds and invests in companies, he said the idea has deep appeal. ‘My father is a corporate law professor, and he’s seen companies in different forms of distress. He counseled me for years, saying, “Don’t go public. And if you have to go public, protect yourself from activist investors with different incentives.'”

Let me close with a few Post Scripts.

— First, the attack by activists and their supporters on, e.g., the perceived excessive compensation of Pubcos’ senior managers … say on pay, etc. The irony is that the compensation now perceived as excessive is largely the product of “reforms” in the 1980s; quoting (yet again) from an article of mine.

“… [t]he current reformers ignore, or have forgotten the ultimate irony. The shift, among major public companies, from cash to equity-flavored compensation, mimicking the universal practice in the venture sector, was driven in large part, by bitter criticism in the 1980s from … reformers! Today’s relentless commitment to the pay-for-performance mantra is a response to the chants of critics in the 60s (whom the liberal press applauded as tribunes of the people) of what was then perceived to be entrenched, sedentary and risk averse managers. Much of that criticism was self-serving, propaganda by wolves in sheep’s clothing … i.e., the corporate raiders pretending to defend the moral high ground in aid of their pet greenmail and hostile takeover initiatives. But the notion stuck … tie the managers’ pay to the shareholders’ outcomes. If the company remains stodgy, its stock performance less than outstanding, fire the senior management and replace the same with entrepreneurs.

“In short, ironically, the very option schemes which are now reviled were heralded as the solution, the way to a solid future for Corporate America in the ’60s, the delight of the very ‘reformers’ who are in the vanguard of today’s necktie parties.”

A time out, if permitted, for an old political joke about “reformers” which tie the reforms they advance into their personal interests and outcomes. You are standing on a subway platform and are jostled and reach for your back pocket finding your wallet missing. You wheel around and see someone bolting up the stairs for the exit to the street. Do you chase him?

Of course not. He doesn’t have your wallet. It’s the guy right behind you, yelling, ‘Stop Thief! Stop Thief!’

— Second, I do not claim anywhere near the experience, on the one hand, in the trenches of a Marty Lipton nor have I done the research of the caliber of either Prof. Bebchuk or his colleagues at Harvard Law School. What I can cite, for what it is worth, is a personal anecdote. Many years ago I was assisting Max Gitter of Paul Weiss defending a textile company, Dan River, against a takeover proposal by activist Carl Icahn, during Icahn’s early launch of his activist activities. Dan River resisted Icahn’s proposal and litigation ensued, the case tried in the Federal District Court in Danville, Virginia in the Shenandoah Valley before a district judge with the historic name (no idea of his pedigree) of Jackson. Gitter, representing Dan River, had Icahn on the stand and the Q&A (not verbatim but well stored in my memory) went essentially as follows:

Question: Mr. Icahn. What makes you think that you could do a better job of running a textile company than the current management?

Answer: Well, I believe I have the skill sets to enhance the business significantly.

Question: Mr. Icahn. Have you ever been inside a textile mill?

Answer: No.

Question: Have you ever seen a textile mill?

Answer: (somewhat haltingly) Well, I must have seen one, you know, driving by on the highway.

The upshot was that Icahn, known in those days as a green mailer, was paid a significant bonus for his investment in Dan River and the adversaries parted company

To repeat the fundamental proposition, as the roster of U.S. Pubcos continues to decline, where, to quote Chief Justice Strine again, will the “real investors” in the U.S. go … the “end user individual investors” who want “to invest in companies designed to create sustainable wealth?” Where do the pension funds go in order to meet their burgeoning obligations to retirees? Private equity and hedge funds? I am not sure, other than in Strine’s article, I have seen that question addressed.

Perhaps, and this is a semi-serious thought, we can invest in activists which elect to hunt for big game in the only remaining space available to fueling them. If there are no more listed companies for the activists to attack, might they turn their attention to universities and graduate schools? Would Professors Bebchuk and Roe support an activist attack on Harvard Law School? See the data assembled by one of the authors of a book labelled, College Tuition: Four Decades of Financial Deception? (Blue River Press, 2014). Could the trend towards MOOCs ultimately compel all the branded institutions to open their doors to online customers and adjust their prices (and salary structures) accordingly? A cheap shot, of course; but, as so often happens, the academic shareholder rights advocates might just win the battle and lose the war.


Professor Bebchuk is not only an academic analyst and researcher at the Law School. He has come out of the press box and onto the playing field as the founder and director of the Shareholders Rights Project, which (quoting Professor Bebchuk):

“… assists public pension funds and charitable organizations in improving corporate governance at publicly traded companies. During this proxy season, we represented and advised five such clients – the Illinois State Board of Investment, the Los Angeles County Employees Retirement Association, the Nathan Cummings Foundation, the North Carolina State Treasurer, and the Ohio Public Employees Retirement System – in connection with their submission of proposals for a vote at the annual meetings of more than 80 companies on the Standard & Poor’s 500-stock index.

“The proposals urge companies with a staggered board, which allow shareholders to replace only a few directors each year, to place all board members up for election every year. Such a move to annual elections is viewed by investors as a best practice of corporate governance. By enabling shareholders to register their views on all directors each year, annual elections make boards more accountable to shareholders.”

One has to give Professor Bebchuk credit for translating his analysis and point of view into an action program, promoting what he and his allies perceive as shareholder democracy. No research has been done by the author on how much compensation Professor Bebchuk personally takes home from the Project sponsors; indeed, why should he be any different than a medical school professor who comes up with an Alzheimer’s therapeutic? That said, the problem encountered by anyone who takes the battlefield as a participant is Newton’s Third Law of Motion: “For every action, there is an equal and opposite reaction.”

Thus, Commissioner Gallagher of the SEC, in a paper co-authored by a former Commissioner and Professor at Stanford Law School, Joe Grundfest (disclosure: the author is acquainted with and has great respect for Professor Grundfest), visibly criticizes the Shareholder Rights Project. Their criticism is summarized in a NY Times piece:

“Mr. Gallagher and Mr. Grundfest suggest that companies are dropping their staggered board structures – and shareholders are voting to eliminate them – based, in part, on the faulty research by Harvard’s Shareholder Rights Project.”

Worse, the authors, as per the Times summary, suggest Professor Bebchuk’s project may have committed fraud by not fully disclosing the extent of contradictory research, which Gallagher and Grundfest say is a ‘material omission’ by SEC standards.

“‘It takes some fancy footwork even to argue that the Harvard Proposal with its glaring omissions, complies with S.E.C. regulations,’ Mr. Grundfest wrote in a blog post in response to an attack on the paper from a Yale law professor, Jonathan R. Macey.”

“Harvey Pitt, a former S.E.C. chairman, weighed in over the holidays: ‘When arguments made by proponents in support of their shareholder proposals rely upon studies and statistical analyses they claim demonstrate the positive attributes of the proposal, it is misleading not to indicate the existence of studies and statistical analyses that reach the opposite conclusion.’ He continued: ‘A single violation can seriously harm investors; seven is extreme and reflective of recidivism; and 129 is cause for alarm and effective action.'” …

The Times article then quotes Professor Bebchuk.

‘The paper’s spurious allegations are unworthy of a sitting S.E.C. commissioner and a former commissioner,’ Mr. Bebchuk, who learned about the paper the night before it was published, said in an email. ‘I was also surprised that the authors chose not [to] give me an opportunity to correct the paper’s reckless factual and legal errors.'” …

And, of course, Marty Lipton had something to say, as per The Times piece:

“‘Legalities aside, it is unfortunate and wrong that a major American university has allowed its name to be invoked in a tendentious, unacademic and quasi-political campaign against staggered boards,’ Mr. Lipton wrote in a note to clients. ‘If nothing else, the commissioner’s article makes a persuasive showing that the scholarship claimed to underlie the Harvard campaign is bogus, or at least one sided.'”

One final (and that’s a promise) note. The contest has taken on the flavor of a Harvard Yale football game. Professor Bebchuk, of course, is carrying the Crimson banner into the fight. (Disclosure. The undersigned, Harvard Class of 1955.) The latest academic to take the field is Professor Jeffrey Sonnenfeld, a professor of management and senior associate dean of leadership studies at the Yale School of Management. With the ball in his possession (the “ball” being the ability to write an Opinion piece in the April 2, 2015 Wall Street Journal), he advances goalward, wearing Yale Blue, as follows, quoting from his article:

“For all the talk about activist shareholders – usually large hedge funds – getting seats on company boards and pushing to make strategic, value-enhancing changes, these activists haven’t fared especially well. Investing in index funds would have yielded better returns over the past few years than most activist funds.

“How much better? In 2013 the RFR Activist Index posted a total return of 16%, less than half the S&P 500 Index’s total return of 12.4%. In 2014, the RFR Activist Index saw returns of 4.8%, far below the S&P 500’s 13.7%.

“Contrary to their rhetoric, many activist investors lack the Midas touch. Their recent returns may exceed the performance of other hedge funds, but they still lag behind the broader market. Ironically, the major companies targeted today, including Apple, PepsiCo, Dell, Dow and DuPont, generally deliver returns that soar above that of activist funds.” …

…”[w]ith activist funds now boasting $120 billion under management – up 30%. In the past year – there is no harm in asking what their own investors are getting back. The most aggressive activists court governance advocates and state pension funds with costly media campaigns against target companies that, paradoxically, outperform them. Perhaps they should be more active in raising their own shareholder value.”

At this point, the only common sense position is, of course, to stay tuned and sit in the stands and cheer for either Crimson or the Blue at Yale Bowl and/or Soldiers Field; maybe carry a banner which reads “Bebchuk” (in crimson letters) or Sonnenfeld (in royal blue).

One thought on “Activists – The Problem for U.S. Leadership in Global Capital Markets

  1. Pingback: Activists Redux | VC Experts Blog

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