The Year of the Activist Hedge Fund (page 2)

Discreet Accumulations and Tag-Team Campaigns

For an activist investor, timing is everything.  The primary objective is to accumulate enough ownership in a targeted company to influence change while securing a tidy profit.  The trick, of course, is to purchase sufficient shares without drawing attention from the target and without attracting too many tag-along investors—unwittingly driving up the stock price and making it too expensive to accumulate additional stock. 

Clever activist investors have found new ways of maintaining the element of surprise through the use of complex financial derivatives and by working as teams.

Under SEC regulations, investors owning 5% (or more) of a company’s equity are required to disclose their ownership within 10 days of an acquisition.  For an activist investor wishing to remain undetected until enough shares are purchased to promote change in a targeted company, this can be a very low threshold.

Unresolved Activist Campaigns (January/February 2008)

Company Industry Investor(s) Demand
Biogen Idec Inc. biotech Carl Icahn three board seats; explore a sale
Brinks Co. security MMI Investments, Steel Partners business unit spin-off; $500M share buyback
Charming Shoppes Inc. retail Crescendo Partners, Myca Partners three board seats; explore sale; buyback shares
CNET Networks, Inc. internet media Jana Partners, Sandell Asset Management seven board seats
CSX Corp. railroad The Children's Investment Fund five board seats
Dillard's Inc. retail Barington Capital, Clinton Group remove dual-class voting structure; terminate poison pill
Enpro Industries Inc. industrial Steel Partners explore sale; share buyback
Gencorp Inc. industrial/real estate Steel Partners six board seats
Motorola Inc. communication equipment Carl Icahn four board seats
New York Times Co. media Harbinger Capital, Firebrand Partners four board seats
Phoenix Cos. insurance Oliver Press Partners three board seats; explore sale
Rowan Cos. oil & gas drilling Steel Partners three board seats; explore business unit spin-off
Target Corp. retail Pershing Square Capital sell real estate; sell credit card unit
Unisys Corp. information technology MMI Investments explore a business unit spin-off
Wendy's International restaurant Trian Fund eight board seats; business sale

So, in an attempt to secure adequate ownership without tipping their hand, savvy activist investors have begun using “cash-settled derivative transactions” also known as “swap agreements” in order to accumulate shares without having to disclose the ownership with the SEC.

This is how it works:  An activist investor enters into a multifaceted swap arrangement with at least one investment bank whereby the bank buys shares on behalf of the investor, but never actually transfers the full ownership to them. Under the terms of the agreement, the activist agrees to repurchase the shares from the bank at a predetermined time and price, at which point the ownership will have to be disclosed to the SEC. 

The big question is who controls the votes attached to the shares that are part of the derivative transaction?  In theory, since the activist does not own the shares, they technically don’t own the voting rights.  However, by establishing a timeframe in the swap agreement to repurchase the shares before the election of directors, the activist can confidently own the votes when it matters most.

One recent example illustrating this phenomenon is with CNET Networks in early January.  Two well-known activist investors—Jana Partners and Sandell Asset Management—began purchasing a small portion of the company’s equity while simultaneously entering into a variety of swap arrangements with investment banks.  Apparently, before anyone realized the serious nature of the activists’ intentions, they had accumulated more than 20% of CNET’s stock, filed as an investment group with the SEC and declared their intention to obtain control of the board at the upcoming annual meeting.  The company countered by installing a poison pill defense mechanism hoping to stop the accumulation of shares by these unwelcome shareholders.  But by that time it was too late—the activists had finished accumulating the number of shares they felt were necessary to promote their desired changes.

This example also highlights the tag-team approach to activist investing that has become much more popular over the past year.  More than ever, activists are teaming up with wealthy individuals (who often own a large percentage of a company’s stock), private equity groups, and other activist investors for the purpose of making buyout offers or instigating value improvement initiatives.  A few recent examples include Harbinger Capital and Firebrand Capital at The New York Times; Crescendo Partners and Myca Partners at Charming Shoppes; Steel Partners and Newcastle Partners at Fox & Hound Restaurant Group (and the subsequent follow-on acquisition of Champps Americana), and Barington Capital and Clinton Group at Dillard’s Inc. 

In the last case, the two activist investors sent a joint letter to Dillard’s board of directors demanding cost improvements, management evaluations, changes to compensation arrangements, and radical changes to corporate governance, including (i) the elimination of the company’s dual class share structure, (ii) the separation of the Chairman and CEO positions, (iii) the termination of the poison pill, and (iv) an amendment of the company’s voting procedures to change from plurality voting to a majority voting standard.

Changing Rules Favoring Activists

Activist investors are masters of the proxy contest and rarely launch campaigns they cannot win.  Consequently, one of the most important components of being a successful activist is their overall command of how the shareholder voting process works.  In fact, some say having a clear understanding of how shareholders will likely cast their vote—if a proxy contest goes the distance—is the only thing that really matters.  If calculated accurately, vote projections can create a sense of security early on for insurgents embarking on a costly crusade to remove directors, and later on, provide increased leverage during negotiations closer to Election Day.

Many factors can influence the shareholder vote projection, including: (i) the ownership interest of like-minded investors (i.e., tag-along investors who often follow activists into an investment); (ii) the makeup of a company’s institutional shareholder base; (iii) the extent to which these institutional investors will be influenced by third-party proxy advisory services (such as RiskMetrics/ISS or Glass Lewis); and (iv) the retail investor base and the associated broker discretionary vote.

During 2008, the New York Stock Exchange is expected to eliminate the broker discretionary vote for the election of directors.  If this occurs, the net effect will shift additional power to activists in director elections, particularly at the more than 44% of the S&P 500 companies who have adopted a majority vote election standard. 

Until recently, directors of most public companies were elected by a plurality of the votes cast in the election of directors.  In plurality voting, the nominees for available directorships who receive the highest number of affirmative votes cast are elected irrespective of how small the number of affirmative votes is in comparison to the total number of shares voted (i.e., all affirmative votes and withheld votes).  Under the plurality voting system, a nominee could be elected as a director with one affirmative vote and several million withheld votes.  In companies that have adopted the majority vote requirement for directors, nominees are typically required to receive the affirmative vote of at least 50% of the votes cast in order to remain in office for another term. 

Hence the importance of the possible amendment of NYSE Rule 452 on discretionary voting in director elections.  Currently, if a retail shareholder (often considered an individual investor) fails to vote their shares in director elections at New York Stock Exchange-listed companies, brokers holding those shares (called broker non-votes) are generally empowered to vote them at their discretion because director elections are considered “routine matters” under Rule 452 today.  Brokers typically vote these shares in-line with management’s recommendations, including for incumbent directors. 

A few years ago, this rule change would have little effect since nearly all companies had a plurality voting system.  But today, many companies have adopted a majority voting standard, with the trend still continuing at a rapid pace under pressure from shareholders.  The combination of Rule 452 being changed so that director elections are no longer a “routine matter” and the use of a majority vote standard will give disgruntled investors a much better chance at launching successful “just vote no” campaigns to remove incumbent directors.

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