From PLI’s Course Handbook
Hedge Funds 2007
#11315
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4
HEDGE FUND ACTIVISM
Paul R. Kingsley
Davis Polk & Wardwell
(NY) 98000/200/LEE/HEDGE.FUND.ACTIVISM/kingsley.hedge.fund.activism.materials.doc
Hedge Fund Activism
Paul R. Kingsley
Davis Polk & Wardwell
June 6, 2007
I. Hedge Funds as Corporate Activists

In the last three to four years hedge funds have risen to the forefront of
shareholder activism.
o There are currently over 8,000 hedge funds worldwide, with over
$1.4 trillion under management.
o There are at least 100 “activist” hedge funds (i.e. 13D filers), with
over $50 billion of funds devoted to activism.
o 13D filings by hedge fund activists have increased dramatically in
the past few years:
Year
Initial 13D Filings
2000
1
2001
3
2002
11
2003
28
2004
41
2005
66

Hedge fund activism versus other shareholder activism.
o The interplay of corporate governance activism (e.g., seeking
majority voting, poison pill redemption, board declassification,
independent directors) and corporate financial activism (e.g.,
seeking a change in leadership/board composition, pursuit of
strategic alternatives, opposing or supporting a corporate
transaction) enables hedge funds to join with institutional activists
and use governance issues as “wedge” issues.
o Not subject to the diversification requirements placed on mutual
funds and pension funds; able to hold large amounts of stock in
their portfolios without penalty.
o Highly incentivized, financially sophisticated and able to pursue
aggressive economic strategies.
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o Able to accumulate large blocks of voting rights through buying or
borrowing shares on the securities lending market or use of
derivatives.1
o High success rate in achieving their demands. A study tracking
hedge fund activism over the period January 2003-December 2005
found hedge funds had an overall success rate of 60% in achieving
their demands. This overall rate breaks down as follows: 2
Stated Purpose in Initial 13D
Changing the composition of
the target’s board of directors
Success Rate
73% (30 out of 41)
Success in causing the target to 48% (14 out of 29)
pursue strategic alternatives
Success in preventing a merger
56% (10 out of 18)
o Increased credibility through partnering with established
institutions like Lazard (Icahn/Time Warner) and Blackstone
(Pershing Square/Wendy’s International).
o Hedge funds are more likely to target profitable, cash-rich, healthy
firms, as compared with other activists who tend to target poorly
performing firms.

Degrees of Hedge Fund Activism.
o The range of hedge fund activists’ goals over the last three years,
as reflected in their 13D filings, has spanned the spectrum,
including: 3
1
See Henry T.C. Hu and Bernard Black, “Hedge Funds, insiders, and empty voting;
Decoupling of economic and voting ownership in public companies,” (Working Paper, University
of Texas Law School, March 2006).
2
April Klein and Emanuel Zur, “Hedge Fund Activism,” (Working Paper, New York
University Stern School of Business, October 2006). Study examined 155 initial Schedule 13D
filings by hedge funds, which the SEC requires for investors acquiring a 5% or greater stake in a
publicly-traded firm, during the period January 1, 2003 to December 31, 2005.
3
Id.
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Stated Purpose in Initial 13D
Number of Filings
Changing board’s composition
41
Pursuing alternative strategic
goals
29
Opposing a merger
18
Supporting a merger
16
Threatening that hedge fund
would like to take over the
firm in the future
12
Replacing the CEO
3
o Examples of particular activist efforts ranging across the spectrum
appear in the chart below:
Degrees of shareholder activism
Seek
Corporate
Governance
Changes




Change
Board/
Management
Cash
Dividend/
Stock
Repurchase
Force
Divestitures
K Capital
Partners/
OfficeMax

Pfizer/
Investors for
Director
Accountability
Pershing
Square/
McDonalds

Icahn
Associates/
Time-Warner
CA Inc./Lucian
Bebchuk
Monetize
Other Assets
Frustrate/
Complicate
M&A
Icahn Associates/
KT&G

Richard Breeden/
Applebees

Icahn Associates/
Kerr-McGee

Pershing Square/
Ceridian

Franklin Mutual/
Weyerhaeuser

K Capital/
OfficeMax

ValueAct/ Novartis/
Chiron

Relational/
Sovereign/Santander

Jana Partners/
Deutsche Borse
Icahn Associates/ Motorola
Trian Partners (Nelson Peltz)/
H.J. Heinz Company

Icahn Associates/
Mylan-King

Pardus/Liberation/ Bally Total Fitness


TCI Fund/ Deutsche Borse
Leon Cooperman/
Verizon/MCI/Qwest

Daniel Loeb (Third Point)/ Ligand
Steel Partners/ Pirate Capital/
GenCorp
Sale of
Company



Strategic
Direction

TCI/ ABN AMRO

Jana Partners/
Houston Exploration

Private Capital
Management/
Knight-Ridder

Relational/ Home Depot

ESL/Kmart/Sears

Trian Partners (Nelson Peltz)/ Wendy’s


Icahn Associates/ Kerr-McGee
Cerberus/
MeadWestvaco
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II. Conflicts Presented by the “New” Shareholder Activism.

The investment horizon of hedge fund activists is relentlessly short-term
and may be inconsistent with the longer-term perspectives of certain other
shareholders.

Hedge fund investments are often accompanied by complex derivative
hedging strategies that may separate their voting and economic interests.
This so-called “new” vote buying has prompted calls for regulatory reform
by some commentators.4 Moreover, hedge funds frequently borrow shares
on the securities lending market in order to hold them as of the record date
for corporate voting purposes, while not retaining long term economic
ownership.5

Hedge funds have attracted scrutiny for their use of derivatives in ways
that have separated their voting and economic interests, and have resulted
in their voting against transactions that are arguably in the interests of
other shareholders. In one well known example, when Mylan Labs
announced an agreement to acquire King Pharmaceutical, Perry Capital, a
sizeable King stockholder, acquired a voting stake in Mylan of almost
10%, but used a hedging strategy to swap away most of the economic risk
associated with those shares. The companies eventually abandoned the
merger, but Perry Capital’s aggressive activist strategy was the subject of
a lawsuit brought by Carl Icahn (which had a significant long position in
Mylan and had agitated to defeat the transaction), which was eventually
withdrawn, and is the subject of an enforcement action by the SEC. The
SEC action appears focused on whether Perry disclosed enough details
about its hedging strategy but does not appear to challenge the merits of
the underlying transactions themselves.

Once a company becomes the focus of an activist hedge fund, it can attract
the interest of other like-minded hedge funds. This activity, sometimes
labeled the “wolf-pack” phenomenon, can lead to what appears to be
concerted, but undisclosed, action. An example of rapid movement by
hedge funds into a company’s stock appears below:
4
See supra. note 1.
See generally Mark Hulbert, “One Borrowed Share, but One Very Real Vote,” N.Y.
Times, April 16, 2006.
5
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III. Current Legal Framework

The current legal framework imposes some constraints on, but is not a
deterrent to, hedge fund activism.

Section 13(d) Filing Obligations. Any person or group that acquires
more than 5% of a class of equity securities of a public company is
required to make a filing with the SEC (on Schedule 13D or Schedule 13G,
as applicable). Disclosure is based on “beneficial ownership” of shares
and may be triggered by membership in a “group” that beneficially owns
more than 5%.
o Whether to file a Schedule 13D or a shorter and less onerous 13G
turns on a number of factors, the principal one of which is whether
the purpose or effect of the investment is to change or influence the
control of the issuer. Passive investors can file a Schedule 13G;
activist investors must file a 13D.
o Some hedge funds have acquired more than 5-percent economic
ownership in a company without a 13D or 13G filing, to avoid
signaling interest in a particular stock to either the company or the
marketplace.

It is broadly accepted on the Street that an investor may
increase its economic interest in an issuer’s securities
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beyond 4.9% without the need to make a 13D or 13G filing
via a derivative contract that is both by its terms and in fact,
cash-settled. The argument is that derivative securities that
are cash-settled (either actually or by their terms) do not
constitute “beneficial ownership” of the subject securities,
for Section 13 purposes. However, while this view is
generally accepted in the industry, it has not been tested by
the courts.
o Running with the pack without being deemed a “group.”


Investors who agree to act with other investors in
connection with acquiring or voting securities would be
deemed to have formed a “group” for reporting purposes.

If the group owns more than 5% of the issuer, each member
of the group or the group jointly must file and keep current
a Schedule 13D or 13G reporting the group’s ownership.

If the group owns more than 10%, each member of the
group is subject to Section 16 and its short-swing profit
disgorgement rules.

Hedge funds will usually exercise care to avoid entering
into any agreement or understanding that might be deemed
to constitute a “group” for reporting purposes, while
nevertheless acting in parallel to bring pressure to bear on a
company’s board or management. Brian Breheny, chief of
SEC’s Office of M&A has expressed concern about
rumored concerted activity among hedge funds in an
issuer’s securities (without a group 13D filing) and noted
that the staff will aggressively pursue violations of Section
13(d) if it becomes aware of them.
Section 16 Requirements For a 10% Holder.
o Section 16(a) of the Exchange Act requires that directors, officers
and >10% holders must file with the SEC, the amount of all
securities beneficially owned by them and changes in ownership.
o Section 16(b) provides that the issuer of equity securities can
recover any “short-swing profits” realized by any director, officer
or 10% beneficial owner from any purchase and sale, or sale and
purchase, of those securities within any period of 6 months
(including by way of derivative instruments).
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o Section 16(c) bars persons that are subject to Section 16 from
selling equity securities of the issuer if that person (a) does not
own the securities sold, or (b) owns those securities and does not
make delivery of them against that sale within 20 days, or mail
them within 5 days of that sale. As applied to synthetic sale
positions (e.g., an open put position), those positions must be fully
covered through actual physical ownership of securities at all times
while the position is outstanding.

HSR Requirements. An HSR notification is required for investments
resulting in ownership of voting securities or assets with an aggregate
value of more than $56.7. Investors may not cross the $56.7 million
threshold until it receives DOJ or FTC clearance; the waiting period is
typically 30 days (15 for an all-cash tender offer), subject to early
termination.
o Two notable exceptions to the filing requirement are:


Acquisitions of 10% or less, if the acquisition is made by a
passive investor solely for the purpose of investment.
Since the passivity standard is vague, potentially activist
investors have relied on this exception.

HSR rules applicable to partnerships (including LLCs) are
such that the ownership positions of even affiliated
partnerships or LLCs are treated as affiliated entities only if
they share the same 50-percent owner (i.e., they have the
right to 50% or more of either the profits or assets upon
dissolution of the LLC or partnership involved). Because
hedge funds generally are structured as LLCs or
partnerships and parallel funds typically do not have the
requisite overlapping ownership, a series of related hedge
funds could, in theory, each acquire a 9.9% position
(assuming the investment exception is available) without
ever having to make an HSR filing.
Shareholder rights plans. Companies may have poison pills in effect
that will be triggered when a specified number of shares is acquired,
making it difficult for an investor to acquire an influential stake in the
company without incumbent board support. Issues such as “group”
membership may be a factor when determining whether an investor will
be considered an acquiring person for purposes of the rights plan.
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IV. Recent Developments.

Demand for inspection of books and records under DGCL Section 220.
In recent years, activist stockholders have increasingly used Delaware
corporate code Section 220 beyond the traditional context of obtaining a
company’s shareholder list for purposes of pursuing a proxy contest or
inspecting a company’s books and records in order to pursue a derivative
suit. The Delaware courts have facilitated this development, permitting
stockholders to make Section 220 demand in such non-traditional contexts
as analyzing a corporate merger, securing a forum with the board of
directors for discussing proposed reforms or preparing a stockholder
resolution.6 In a recent decision, however, the Delaware Chancery Court
broke with this trend and signaled a limit to the circumstances in which
Section 220 may be utilized. In Polygon v. West Corporation (Del. Ch.
Oct. 12, 2006), the court upheld West Corporation’s right to deny access
to its books and records to Polygon, an arbitrage hedge fund that had
purchased stock in West shortly after the company’s announcement that it
would be going private in a transaction led by Thomas H. Lee Partners and
Quadrangle Group. The court found that, although Polygon stated a proper
purpose for inspecting the books and records in order to value its stock to
determine whether to seek appraisal, in this case all of the necessary
information to make such a determination was already available in the
company’s public filings. The court also rejected Polygon’s purpose of
investigating the board’s alleged breach of fiduciary duty by West’s
controlling shareholders and the West directors in approving the goingprivate transaction. The court found that this purpose was unrelated to
Polygon’s interest as a stockholder since Polygon—which purchased stock
in West only after the transaction was announced—would not be legally
permitted to bring this claim against the board (either in a direct or
derivative action).7
6
Moreover, in Deephaven Risk Arb Trading v. UnitedGlobalCom, Inc., 2005 WL
1713067 (Del. Ch. July 13, 2005), the Delaware Chancery Court rejected the argument that a
hedge fund was not a beneficial owner for purposes of inspecting the company’s books and
records because it held short positions off-setting its economic ownership of the company.
7
While the Polygon decision may signal an intention by the Chancery Court to narrow
the use of Section 220, it should not necessarily be interpreted it too broadly due to the highly factspecific nature of the court’s conclusions. In particular, practitioners should note the court’s
emphasis on Polygon having purchased West stock only after the announcement of the goingprivate transaction and the fact that it therefore lacked the legal right to pursue a claim for breach
of fiduciary duty. Notably, the court did not address the rights of stockholders who held shares at
the time of the announcement. Similarly, the court’s finding that the information necessary to
Polygon’s determination of whether to seek appraisal was already available was rooted in the
company’s public filings about the transaction and the particularly comprehensive disclosure made
(…continued)
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
NYSE proposal to eliminate broker voting in director elections. In
June 2006, the NYSE’s Proxy Working Group recommended amendments
to Rule 452 which would make the election of directors a “non-routine”
matter such that brokers would no longer be able to vote in the election of
directors when they do not receive instructions from the actual
shareholders, even in uncontested annual elections of directors.8 Since
brokers typically vote with the board and management in director elections,
at the growing number of companies which have implemented some sort
of majority vote requirement, the proposed amendments could make it
dramatically more difficult for directors who are subject to withhold votes
to obtain a majority vote.

Proposed SEC “e-proxy” rules will make proxy solicitation less
expensive and easier. An activist investor seeking to replace or elect its
own slate of directors or to support or oppose another shareholder’s
resolution must comply with the proxy rules. The SEC has proposed
amendments to the proxy rules that would reduce the cost of engaging in a
proxy contest by permitting issuers and other persons conducting proxy
contests to furnish proxy materials to shareholders by posting them on an
internet site and providing shareholders with notice of the availability of
such materials.
V. Practical Advice for Companies

Advance Preparation.
o Assemble team of small group of key officers and outside advisors
(including lawyers, bankers, proxy solicitors and public relations
firm); circulate contact list. Team should maintain regular contact
and be able to respond quickly in a coordinated manner if and
when necessary.
(continued…)
available in a going-private transaction under Rule 13e-3. It is not at all clear that the court would
extend this reasoning to other circumstances such as a Section 220 request arising outside of the
context of a transaction, where all relevant information must be publicly filed. For example, it is
not apparent whether the limits that court set in this case on the proper use of Section 220 would
apply where an activist shareholder was seeking to have the company auctioned for sale or engage
in another strategic transaction or reform where no transaction or reform requiring SEC disclosure
on that matter had yet been announced.
8
In response to company comments, the NYSE has decided to delay the amendments
until mid-2007, with the changes not effective until the 2008 proxy season.
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o Identify potential vulnerabilities/areas of shareholder focus. Key
“warning signs” include:

Stock underperformance.

Opportunities for a quick return -- e.g., special
dividend/share buy-back opportunities, excess cash, private
equity interest, opportunities for divestitures/spin-offs, etc.

Industry focus -- e.g., activist focus on your peer/similarly
situated firms.

Other vulnerabilities – controversial transactions (e.g.,
unsuccessful acquisitions, serial acquirers, acquisitions
outside core business), scandals, executive compensation
issues, etc.
o Listen carefully to what is being said about your Company, your
peers and your industry. Focus on analyst reports, the financial
press, etc. Pay attention to perspectives expressed by shareholders
in meetings and at conferences. Be aware of “chatter” in the
shareholder community.
o Develop a consistent and coherent company message, outlining
key strategies and address potential concerns/vulnerabilities.
Implement an aggressive, proactive IR/PR effort to advance
Company positions and strategies. Bottom line: The goal is to run
an effective offense and forestall potential shareholder activism by
addressing/defusing concerns before they reach a boiling point.
Specifics include:

Reach out to/meet with investors to the extent appropriate.
This should include even smaller investors who might have
been below the IR “radar screen” in the past.

Meet with ISS and other similar groups periodically.

Use investor conferences, etc. to make key points.
o Develop policies and procedures for IR activities:

Designate a small group of executives/IR professionals for
purposes of investor/constituent meetings.

Ensure Regulation FD procedures are current.
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
Develop IR protocols – e.g., responses orally rather than in
writing, more than one Company representative present at
investor meetings, etc.
o Keep your Board current and involved.

The Board should be kept informed on key matters
including the shareholder environment generally, potential
vulnerabilities, Company strategies and messages, etc.

Provide the Board with periodic briefings on relevant legal
considerations, as well as policies concerning investor
contacts.

In particular, directors should be warned that shareholders
occasionally contact outside directors directly and should
be reminded that communications should be referred to the
CEO or relevant IR personnel.
o Track your shareholder base frequently and carefully.

Maintain state-of-the-art stock watch programs.

Involve your stock watch and proxy firms actively. Be
certain they are current/keep you fully informed as to
movements in and out of your stock by relevant
shareholders.

Keep track of participants in conference calls, investor
meetings, etc. to try to determine whether relevant investors
are becoming “interested” in your Company (possibly even
before they become shareholders).

Monitor 13(d) and similar filings.
o Review structural defenses on at least an annual basis. Consider
the consequences of removing defenses carefully.

Implementation of defensive mechanisms requiring
shareholder approval (such as classified boards) is not
likely to be viable. However, companies should consider
mechanisms that can be adopted by the Board.

Potential benefits of these structures must be
balanced with IR/PR negatives and adverse
reactions from ISS and similar groups.
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


Companies should also be mindful of the possibility
that taking actions of this sort may result in further
focus on the Company.
Specifically, companies should consider:

State of the art advance notice provisions for
director nominations and shareholder proposals

Corporate governance principles that address
director qualifications, such as “directors should
possess the highest personal and professional ethics,
integrity and values and be committed to
representing the long−term interests of
shareholders” and “director nominees should also
represent all shareholders rather than special interest
groups or any group of shareholders.”

Conform bylaw provisions for setting record dates
before shareholder meetings to maximum period
permitted by state law.

Eliminate or opt out of cumulative voting
provisions under state law to the extent possible.

Although the trend in recent years has been in favor
of dismantling takeover defenses (principally
declassifying boards and redeeming rights plans),
steps along these lines should be evaluated carefully
in the current environment.
Responding to Shareholder Approaches.
o The traditional legal framework applies.

There is no general legal duty to negotiate in the event of
an approach.

Serious approaches should be considered seriously by the
Company and its Board of Directors.

There is no general duty to disclose non-public approaches,
although a duty may arise in the case of leaks, etc.
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
Responses to approaches generally should be limited to we
will get back to you until the Board has evaluated the
matter and taken a position; a stronger response may be
appropriate in certain circumstances.

Responses to press inquiries: no comment.
o Responses to particular approaches should be evaluated carefully
by all relevant constituencies/at all relevant levels (e.g.,
management, the Board, outside advisors, etc.) as appropriate.
Once established, the Company should pursue its
position/strategies aggressively.

IR and PR efforts.

Consider pros and cons of available legal strategies:

Litigation

SEC

Other regulatory regimes

State-level legislation

Consider possibility of engaging with activist

Encourage friendly shareholders to recall stock that has
been lent out in advance of shareholder meeting record date.
o Negotiation/Settlement Agreements.

Key provisions: board representation and/or adoption of a
process for putting an “independent” director on board;
commitment from board to consider certain topics;
standstill provisions.

Issues: effect of public disclosure of settlement agreements.
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