A watershed moment is coming
for shareholder activism and corporate governance generally, as the
proxy contest brought by Trian Management Fund, seeking effectively to
break up DuPont, enters its final stages (with the vote being less
than a month away). Technically, the contest is to elect four Trian
Fund nominees to the DuPont board, but, as a column in the New York
Time’s Dealbook put it more bluntly, the real fight is over whether to
break DuPont into three parts and “shut down DuPont’s central research
Much about this contest is unusual: unlike other targets of activism,
DuPont has regularly outperformed the S&P 500 Index and virtually all
other metrics for corporate profitability. Its stock price has risen
over 185% since its CEO, Ellen Kullman, took office six years ago
(while the S&P 500 Index rose only 122% over the same period).
The Trian Fund owns only a small stake (less than 3%), but still the
contest is close. This column will use this episode as a stalking
horse by which to approach a key issue in corporate governance today
and also as a case study that illustrates both what we know and still
do not know about hedge fund activism.
Let’s start with what we
know. Hedge fund activism dates back for at least a decade to the
appearance of proactive hedge funds that bought stocks specifically to
challenge the management.
With that development, institutional activism moved to the offense,
departing from a prior history of largely being defensive in nature
(i.e., opposing managerial initiatives). What caused this development?
Some of the answer lies in deregulatory SEC rules, but probably more
of the answer stems from the inability of a hedge fund to consistently
beat the market. If the market is efficient (or even approximately
so), a hedge fund cannot outperform it for long as a stock
picker—unless it buys stocks intending to change existing management
policies and thus enhance firm value. Intense competition and thin
returns probably drove some hedge funds into becoming pro-active.
Relatively quickly, a consistent pattern emerged to characterize this
new activism: on the filing of a Schedule 13D by an activist investor,
the stock price of the target shows an immediate abnormal return of
around 6 to 7%.
Whether this short-run price improvement later dissipates has long
but now there is newer data. The latest study, just released in March,
shows that long-run returns to shareholders depend on the outcome of
the activists’ engagement with the target.
If the activists fail to achieve their desired outcome, the long-term
return is modestly negative.
If, however, the activists succeed, everything depends on what outcome
they were seeking. The market largely ignores changes in corporate
governance and “liquidity events” (such as special dividends or stock
but jumps with alacrity in response to takeovers and restructurings.
This suggests that the real source of the gains to pro-active hedge
funds is not superior corporate strategy, but increases in the
expected takeover premium for the target. Apparently, the market
perceives most corporate governance issues as important only as a
signal of an impending takeover battle. Still, if nothing more
materializes, the target’s stock price will stabilize or decline. Even
if activists present themselves as superior business strategists or
marketing gurus, their success comes largely from jump-starting a
takeover or a bust-up.
Indeed, the Trian Fund
exemplifies this continuity between the takeover activism of the 1980s
and the hedge fund activism of today. Its founder, Nelson Peltz, was a
veteran of the “bust-up” takeover wars of that earlier era, but has
now re-emerged as a champion of hedge fund activism. The more things
change, the more they may remain the same.
Nonetheless, some things
have truly changed. Chief among these is the development of a new
tactic: the “wolf pack” campaign.
The “wolf pack” is a loose association of hedge funds (and possibly
some other activists) that carefully avoids acting as “group” so that
their collective ownership need not be disclosed on Schedule 13D when
they collectively cross the 5% threshold.
It is distinctive in at least three major respects: First, the wolf
pack acquires a much larger stake in the target. In the past,
dissatisfied institutional investors might talk to each other and make
a shareholder proposal or even launch a proxy contest, but they did
not buy stock because of their discontent. The latest study finds that
the typical “wolf pack” acquires 13.44% of the target’s stock as
opposed to an average of 8.3% for other activists.
But this estimate may substantially understate, as only those
belonging to a formal Section 13D “group” are required to disclose
their presence in the target’s stock. The essence of the “wolf pack”
is conscious parallelism among an informal network that deliberately
stops short of “grouphood.” More importantly, because there is no
breach of fiduciary duty when one activist hedge fund invites others
to join with it in a still undisclosed campaign to unseat board
members at the target, tipping such plans within their loose network
does not amount to insider trading (at least if no tender offer is
As a result, the wolf pack’s members can profit from the lawful use of
material, non-public information.
Such profits are nearly riskless.
Second, the announcement of
the wolf pack’s formation (on the filing of a Schedule 13D) provokes a
much sharper market reaction—a roughly 14% abnormal gain as opposed to
6% for other activists.
Almost certainly, this is because the market perceives a higher
probability of a takeover premium or a “bust-up” sale of assets when a
wolf pack is behind the campaign.
Finally, the prospects of
success are much higher for the wolf pack. Two studies this year place
the likelihood of a successful outcome to a wolf pack campaign at over
75% (significantly higher than the probabilities of success for other
takeovers were largely curbed prior to 2000 by a combination of the
poison pill, state anti-takeover statutes, reduced availability of
financing, SEC disclosure rules, and judicial decisions. But the wolf
pack can evade all of these restraints. So long as no formal “group”
is formed, the standard poison pill will not be triggered, and as much
as 25% or more of the stock can be assembled by the wolf pack by the
time its leader does file its Schedule 13D. Financing is also no
problem as billions are flowing into hedge funds today.
So what then is the issue if
the tactic appears to work so well? Target companies claim that
significant costs are being imposed on them (as DuPont has asserted),
but economists will respond that this does not matter so long as the
target’s stock price goes up. A few critics have asserted that the
gains to hedge fund activism are largely wealth transfers from
creditors and employees. Valid as this critique may be, few hearts
bleed today for them, and this critique will not slow the lemmings in
pursuit of the cliff.
Still, the latest evidence
does suggest that there is a significant externality associated with
hedge fund activism. The claim that hedge fund campaigns are
discouraging expenditures on research and development and other
long-term investments now has stronger evidence behind it. That claim
came to the fore during last year’s takeover bid by Valeant
Pharmaceuticals for Allergan. Valeant is a well-known “serial
acquirer” that buys other pharmaceutical companies with established
products, then cuts expenses to the bone, eliminating or greatly
shrinking expenditures on research and development, preferring to milk
the existing products. Although the Wall Street Journal reported that
large pharmaceutical companies often spend 20% of their revenues on
“R&D,” Valeant, it said, spent only 2.7% of its over $5.7 billion in
revenues in 2013 on R&D.
Valeant pursued Allergan not as an ongoing pharmaceutical firm but as
a one product cash cow whose Botox drug would produce a consistent
cash flow. Indeed, Valeant publicly estimated that, if it succeeded in
acquiring Allergan, it would cut R&D for the two combined firms by 69%
and reduce employment by 20% (or well over 5,000 jobs).
Economists might still scoff
at this example as a mere anecdote. DuPont could also be discounted as
an isolated case (although it is a major firm with an over 200 year
history of successful innovation). But now there is statistical
evidence. Taking the Wall Street Journal and FactSet’s Activism
Scorecard (a data set of recent activist campaigns) and trimming this
sample down to campaigns actually launched by activist hedge funds, a
new study finds that even those targets that escape a takeover still
are forced to curtail their R&D expenditures by more than half over
the next four years.
The following graph shows this pattern and also the revealing fact
that, for a matched control group, R&D expenditures actually rose
modestly over the same period:
Again, this estimate of the
decrease in “R&D” probably understates the decline, because the sample
is limited (by necessity) to those firms that “survived” (i.e.,
escaped a takeover). Firms acquired as a result of an activist
campaign probably experienced an even greater decline.
Presumably, it is
self-evident that if an economy cuts back drastically on its
investment in “R&D,” it will experience less innovation and
technological advances in the future. Over the last forty years, the
American economy enjoyed a comparative advantage over the rest of the
world because of its ability to develop and sustain a Silicon Valley
culture that stressed constant innovation. In the future, a Steve Jobs
who is willing to bet his company on a new product (e.g., an Iphone)
may encounter resistance from hedge funds. That should be a cause for
But what is the answer?
Legislation is unlikely, and the SEC seems reluctant at present to
take action to close the Section 13D window. In a forthcoming article,
Professor Darius Palia (an economist) and I discuss some modest
measures that might subject activists to greater transparency and
possibly shorten the leash on wolf packs.
But the real question for the immediate future is whether mainstream
institutional investors (such as pension funds) will ever resist the
hedge funds’ siren song. The DuPont campaign is significant precisely
for that reason. If the Trian Fund wins, it shows that even iconic and
highly profitable firms can be forced to refocus on the short-run. If
the Trian Fund loses (which is how this author would bet), it implies
that traditional institutional investors are beginning to see the
problem and will not automatically ally with hedge fund activists.
 See Bill
George, “Peltz’s Attack on DuPont Threatens America’s Research Edge,”
The New York Times Dealbook Online, April 9, 2015.
See Jason Bunge and David Benoit, “For DuPont’s CEO, High-Stakes Vote
Looms,” The Wall Street Journal, April 14, 2015 at B-1.
For the first serious article reviewing hedge fund activism, see
Thomas W. Briggs, Corporate Governance and the New Hedge Fund
Activism: An Empirical Analysis, 31 J. Corp. Law 681 (Summer
2007). For the most recent review, see John C. Coffee, Jr. and Darius
Palia, The Impact of Hedge Fund Activism: Evidence and Implications
See Alon Brav, Wei Jiang, Frank Partnoy and Randall S. Thomas,
Hedge Fund Activism, Corporate Governance and Firm Performance, 61
J. Fin. 1729 (2008)(finding on average an abnormal short-term return
of 7% over the window surrounding a Schedule 13D filing); Marco Brecht,
Julian Franks, Jeremy Grant and Hammes F. Wagner, “The Returns to
Hedge Fund Activism: An International Study” (Center for Economic
Policy Research Discussion Paper No. 10507 (March, 15, 2015).
For the view that it does not dissipate, see Lucian Bebchuk, Alon Brav,
and Wei Jiang, The Long-Term Effects of Hedge Fund Activism
(forthcoming in 114 Columbia L. Rev. ___ (June 2015)(available at
(2014)). For a view that the evidence is mixed, see Coffee and Palia,
supra note 3.
See Brecht, Franks, Grant and Wagner, supra note 4, at 3-5.
 Id. at 4
(finding annualized value-weighted abnormal returns of 2.3% for
activism without outcomes). When returns are equal weighted, they find
that activism without outcomes yields returns of minus 9.8%.
“Payout changes,” they report, yield returns of minus 0.2 percent. Id.
at 3. This is surprising because stock buybacks are a frequent demand
On an international basis, they report takeovers provide abnormal
returns of 9.7% and restructurings yield abnormal returns of 5.6%. Id.
The term “wolf pack” was used by the Delaware Chancery Court in
Third Point LLC v. Ruprecht, 2014 Del. Ch. LEXIS 64 (May 2, 2014),
and found to constitute a “threat” that justified the use of a special
form of the poison pill.
Section 13(d)(3) of the Securities Exchange Act of 1934 requires a
“group” with holdings in excess of 5% of a class to report in the same
manner as an individual on Schedule 13D. But recent decisions have
been conservative in determining when independent actors form a group.
See Hallwood Realty Partners L.P. v. Gotham Partners L.P., 286
F. 3d 613 (2d Cir. 2012)(declining to find a group).
See Brecht, Franks, Grant and Wagner, supra note 4, at 32.
a “substantial step” has been taken toward a tender offer, SEC Rule
13e-4 becomes applicable, and it does not require a fiduciary breach.
Otherwise, Dirks v. SEC, 463 U.S. 646 (1983), requires a
fiduciary breach or misappropriation to support liability.
This will become even clearer after United States v. Newman,
773 F. 3d 438 (2d Cir. 2014), which reversed insider trading
convictions of hedge fund employees where the remote tippee was not
aware of any “personal benefit” paid by the original tippee to the
See Brecht, Franks, Grant and Wagner, supra note 4, at 32.
See Brecht, Franks, Grant and Wagner, supra note 4, at 32 (finding 78%
probability of success for wolf pack interventions as opposed to 46%
success rate for others); Yvon Allaire and Francois Dauphin, “Hedge
Fund Activism: Preliminary Results and Some New Empirical Evidence”
(April 1, 2015)(finding 75.7% success rate).
See Jacob Bunge and Angela Chen, “DuPont Warns of Costs from Breakup,”
The Wall Street Journal, April 7, 2015 at B-3 (estimating costs of $4
billion plus $1 billion in additional annual expenses).
See Joseph Walker, “Botox Itself Aims Not to Age,” The Wall Street
Journal, May 19, 2014 at B-1.
See Joseph Walker and Liz Hoffman, “Allergan’s Defense: Be Like
Valeant,” The Wall Street Journal, July 23, 2014 at B-1.
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