Activist Shareholders & Their Impact on Takeovers

1. Activist Shareholders & Their Impact on Takeovers Chapter 14

2. background • Berle and Means’ separation of management and control -- the dominant view for decades, assuming a shareholder group made up of dispersed owners each with small ownership stakes. • 1960s and 1970s -- institutional shareholders assembled large stakes, but their governance role was almost always passive. • 1990s to present -- there emerged a subset of activist institutional shareholders who changed how takeovers occur.

3. Factors influencing current scene • Innovations in computing power and electronic communication made it possible to assemble and absorb large amounts of information. • corresponding decreases in costs of communication among investors • new finance reflected high powered incentives in the assembling and management of large pools of capital • Law followed these developments by facilitating the broader spread of information and relaxing prohibitions on communications as to proxies and tender offers.

4. Hedge Fund Activism • Hedge fund business plans (In General) • Investing to deliver above-average market returns • Aggressive economic strategies in various settings • Betting on currency movements, interest rates • Focus on debt securities or distressed firms • Merger arbitrage • Engagement w/ governance as one subset • Seneca, Icahn opposing Blackstone Dynegy deal • CSX/TCI

6. Typology of Hedge Fund Activism • Related to Pending Acquisitions • Blocking acquisition on the Acquirer side • Blocking acquisition on the Target side • Facilitating Target return via Acquirer activism • Related to Changing Company’s Business Plan • Prodding board to make large cash payment • Unbundling i.e. sale/ spin-off • Obtaining board seats (not overall control) • Supporting Generic Governance Changes • Led by other institutional shareholders • Dramatic effect on reduction in staggered boards

7. Pending Acquisitions • Influencing Acquirer Side • What is the motivation? • Managers have paid too much; Empire building • What is the technique? • Exercising acquirer shareholders’ right to vote • Influencing Target Side • What is the motivation? • Management selling too cheaply • Example: Private equity (Blackstone buying Dynegy) • Example: cash out where >50% shareholder • Hedge fund as gatekeeper • What is the technique? • Voting, appraisal, fiduciary duty

8. Pending Acquisitions II: Empty Voting • Influencing Target Outcome via Acquirer Activism • Mylan/King Pharmaceuticals • Where is the profit likely to be? • What is the risk to that profit? • How might investor reduce that risk? • Perry strategy • Protecting a large stake in target • Buy 10% of acquirer • Sell off the financial interest, keeping only the voting interest – problem?

9. Empty Voting • Responses • Self-interest of counterparties • Hedge funds on the other side • Government regulation • Disclosure • Prohibition • How close to other vote buying? • Diversified mutual funds netting out positions

10. Changing the Company’s Business Plan • Prodding cash payments, unbundling assets, board representation • Where have you seen that before? • What kind of bidder? Where will value come from? • Technique to Accomplish this • Credible threat to use full-scale proxy fight if manager doesn’t accept advice • Credible threat that other institutional investors will join • What is it not? Buying the company

11. Activist s/h on corp governance • subset of institutional investors • pursue corporate voting to change governance rules of public corporations more generally • large pension funds, often the pension funds of public employees • Calpersthe California Public Employees Retirement System • NYCERS, the New York City Employees Retirement System) • various other group supporting reform in corporate governance.

12. Corp gov s/h activism • Dramatic decrease in use of staggered boards by public companies • 2004 – Institutional investors started credibly threatening they would vote against directors’ election at annual meetings if they didn’t ditch the staggered boards • 2010 – only a minority of largest US corps have staggered boards • Pills cut back but not so much – pills can be inserted with only BOD action

13. CSX Corporation v. The Children’s Investment Fund Management (UK) LLP • no deal pending for CSX Corporation, one of the nation’s largest railroad companies • But two large hedge funds, including the Children’s Investment Fund (most well‐known hedge fund in United Kingdom) seek to influence management to undertake value‐increasing transactions (i.e. transactions that will produce more cash flow to shareholders.) • two hedge funds launch a proxy fight in which they seek to elect a minority of the board and the right to call a special meeting of shareholders.

14. CSX • plaintiff is corporation itself • Battle joined is the company’s effort to get a preliminary injunction for the hedge funds’ alleged noncompliance with the disclosure provisions of the federal securities laws. • This is not the Unocal or Revlon pattern of most of our cases, with litigation by representative shareholders. • More like litigation pattern of the 1980s before poison pills and staggered boards insulated a board from having to yield too quickly to contrary shareholder preferences • substance of litigation -- noncompliance with securities regulation requiring disclosure when acquiring 5% or more of a company’s shares or when undertaking a proxy fight.

15. hedge fund’s strategy: political • TCI makes SEC disclosure that it will acquire a significant portion of CSX, even mentioning control • But focus -- replacing a minority of directors to get influence over company • TCI seeks to name two directors and works with another investor who also seeks to elect two directors. • TCI is actively seeking to get other activist investors involved in the fight (sometimes referred to as a wolf pack.) • TCI’s political strategy influenced by seeking support of ISS‐ Institutional Shareholder Services, (now part of RiskMetrics) • has achieved an oversized role in takeovers through its advising institutional shareholders how to vote in proxy solicitations, including those that are part of takeovers.

16. The hedge fund’s strategy: financial • TCI acquired a large part of its interest in CSX not by acquiring shares but through swaps. • This is a contract between TCI on one side and, in this case, eight large financial firms—banks and investment banks. • The promises made between the parties essentially entitled TCI to receive payment from its counterparty equal to what would occur if CSX went up in value (the long position) and the counterparties to receive payment from TCI equal to the change if CSX went down in value (the short position). • The result would be that TCI would be in the same financial position as if it owned the stock, but would have invested only the fees and quasi- interest it paid for the contract, a result that impacts its possible returns and losses in the same way as leverage. • the counterparties would be expected to hedge their exposure should CSX go up in value (when it would have to pay TCI.) To do this it would buy CSX shares.

17. The hedge fund’s strategy: financial 2 • impact of strategy on voting important to hedge fund’s pressure on CSX. • TCI has no voting rights on the investment it has made through the swaps even though it had the economic risk as if it had purchased the stock • The counterparties, because of their hedging, actually will have the right to vote, but having hedged, they have no economic interest propelling that vote. XD • But court notes (496) that were TCI to settle its swaps with the banks, it would remove the practical need for the banks to continue to hedge, thus creating a ready supply of shares should TCI wish to convert its exposure from swaps to actual physical shares • This important to court’s resolution of whether TCI owns the shares for purposes of whether it has crossed threshold requiring disclosure under 13(d). • TCI reducing its counterparties from eight to two reliable parties seems to also influence court’s view of TCI’s control over the shares in the name of its counterparties.

18. Disclosure • Two separate parts of the federal securities law implicated. • disclosure required when proxies are solicited (Section 14(a) of the Securities Exchange Act) • disclosure required when one has acquired 5% of a publicly traded company (13(d) added to the Securities Exchange Act by the Williams Act in 1968). • The materiality questions end up being the same for both, so focuses on 13(d) claims. • 13(d) claims turn not on whether the disclosure made in the filing was sufficient, but whether the hedge funds had delayed nine months in making the necessary filing by arguing they did not have beneficial ownership of the shares to which the swaps related and because they were not part of a group until December.

19. Disclosure holdings • The court finds against the hedge fund on both of these claims. • concludes interests represented by the swaps should be counted in determining whether TCI had crossed the 5% threshold. • (The question of what is a group for purposes for making tender offer filings was high profile issue in tender offer law in the period after enactment of the Williams Act, but has received less attention recently. ) • Here court concludes • that TCI and 3G were a group long before their December filing • thus they did not give the other shareholders the required notice required by 13d.

20. remedies • court finds two violations of the federal disclosure provisions designed to give shareholders information about 5% shareholders that could lead to possible takeovers. • Remedy? • remedy proposed is sterilizationof the shares acquired during the period of the insufficient disclosure • would impact a hostile raider’s effort to win a showdown with management. • Here the impact less since control not at issue. • court concludes that there is not irreparable harm essential to obtain injunctive relief in the form of sterilization. • The court grants injunction restraining further violations of Section 13(d) • more than a slap on the hands? • Cf. Topps case