What Hedge Funds Can Teach Corporate America: a Roadmap for Achieving Institutional Investor Oversight Robert C
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American University Law Review Volume 57 | Issue 2 Article 1 2007 What Hedge Funds Can Teach Corporate America: A Roadmap for Achieving Institutional Investor Oversight Robert C. Illig [email protected] Follow this and additional works at: http://digitalcommons.wcl.american.edu/aulr Part of the Corporation and Enterprise Law Commons Recommended Citation Illig, Robert C. “ What Hedge Funds Can Teach Corporate America: A Roadmap for Achieving Institutional Investor Oversight.” American University Law Review 57, no.2(December 2007): 225-339. This Article is brought to you for free and open access by the Washington College of Law Journals & Law Reviews at Digital Commons @ American University Washington College of Law. It has been accepted for inclusion in American University Law Review by an authorized administrator of Digital Commons @ American University Washington College of Law. For more information, please contact [email protected]. What Hedge Funds Can Teach Corporate America: A Roadmap for Achieving Institutional Investor Oversight Abstract Hedge funds and other private equity funds are aggressive monitors of corporate America. Their investment strategies are designed to squeeze agency costs and other inefficiencies out of under performing companies. Mutual funds and public pension funds, by contrast, have remained relentlessly passive despite their many resources. Rather than seek to improve the performance of their portfolio companies, they generally prefer to exit any investments that turn sour. Why the difference? In this Article, I compare the business environments and regulatory regimes affecting different types of institutional investors. I conclude that the primary reason that most institutional investors do not better discipline corporate wrongdoing is that their individual fund managers have little incentive to do so. Were they permitted to adopt the incentive compensation structure of a hedge fund, however, mutual funds and public pension funds would compete to provide the oversight necessary to make corporate managers more accountable. The er sult would be a deeper market for good corporate governance. Keywords Hedge funds, Private Equity Funds, Corporation, Investor Monitoring, Public Funds, Private Funds This article is available in American University Law Review: http://digitalcommons.wcl.american.edu/aulr/vol57/iss2/1 ARTICLES WHAT HEDGE FUNDS CAN TEACH CORPORATE AMERICA: A ROADMAP FOR ACHIEVING INSTITUTIONAL INVESTOR OVERSIGHT * ROBERT C. ILLIG Hedge funds and other private equity funds are aggressive monitors of corporate America. Their investment strategies are designed to squeeze agency costs and other inefficiencies out of underperforming companies. Mutual funds and public pension funds, by contrast, have remained relentlessly passive despite their many resources. Rather than seek to improve the performance of their portfolio companies, they generally prefer to exit any investments that turn sour. Why the difference? In this Article, Professor Illig compares the business environments and regulatory regimes affecting different types of institutional investors. He concludes that the primary reason that most institutional investors do not better discipline corporate wrongdoing is that their individual fund managers have little incentive to do so. Were they permitted to adopt the incentive compensation structure of a hedge fund, however, mutual funds and public pension funds would compete to provide the oversight necessary to make corporate managers more accountable. The result would be a deeper market for good corporate governance. * Assistant Professor, University of Oregon School of Law. B.A. 1991, Williams College; J.D. 1996, Vanderbilt University. E-mail: [email protected]. Support for this project was provided by the University of Oregon’s Dean’s Advisory Council Endowment Fund. I am grateful to Royce Barondes, Bernie Black, Tamar Frankel, Don Langevoort, Brian McCall, and Harwell Wells, as well as to my many wonderful colleagues at Oregon, for their helpful thoughts and comments. I also benefited from the insights of my fund manager friends, most notably Jamie Hague of Millburn Corp., and from faculty workshops at Willamette University and the University of Oregon. 225 226 AMERICAN UNIVERSITY LAW REVIEW [Vol. 57:225 TABLE OF CONTENTS Introduction.........................................................................................227 I. Institutional Investor Monitoring.............................................234 A. Background ........................................................................235 B. The “Discovery” of Public Equity Funds............................243 C. Passivity Explained..............................................................248 D. Efforts at Reform ................................................................253 E. The Persistence of Passivity................................................258 1. Shareholder apathy.......................................................259 2. Fewer monitors .............................................................264 3. Index funds ...................................................................266 II. Private Equity Funds..................................................................268 A. Overview and History .........................................................268 B. Regulatory Environment....................................................275 C. Structure and Organization...............................................278 D. Alignment of Interests........................................................282 III. Public and Private Equity Funds Compared—Internal Characteristics ...........................................................................287 A. Size and Resources .............................................................288 B. Use of Leverage ..................................................................292 C. Need for Liquidity ..............................................................293 D. Investment Culture.............................................................297 IV. Public and Private Equity Funds Compared—External Regulatory Environment...........................................................299 A. Rules Limiting Voice ..........................................................300 B. Rules Limiting Control ......................................................306 1. ERISA.............................................................................306 2. The 1940 Acts................................................................312 C. Governance Rules...............................................................315 1. Disclosure rules.............................................................315 2. Eligible investor rules ...................................................316 3. Limits on incentive compensation...............................318 V. Implications for Governance Reform.......................................322 A. Existing Incentives for Fund Managers.............................323 1. Profit growth .................................................................325 2. Growth through advertising .........................................327 3. Incentives to cut costs ...................................................330 B. The Promise of Public Equity Fund Oversight .................332 Conclusion ...........................................................................................336 2007] WHAT HEDGE FUNDS CAN TEACH CORPORATE AMERICA 227 INTRODUCTION Corporate America needs better monitoring. Even in the post- Sarbanes-Oxley era, managers of public companies remain largely insulated from outside influence. They are protected by a combination of takeover defenses and the business judgment rule and have little to fear from either hostile raiders or their own shareholders. The pendulum remains stuck in favor of managerial discretion. It will swing back toward greater accountability to shareholder interests only if managers are subject to more effective oversight. In the early 1990s, a group of corporate governance scholars led initially by Mark Roe and Bernard Black believed they had at last identified corporate law’s white knight. So-called institutional investors—large pools of capital invested by professional fund managers—appeared to have amassed the resources necessary to act as a check against corporate wrongdoing.1 Remove the barriers that make shareholder activism so expensive, they argued, and institutional investors would happily provide the oversight that seemed to be missing from corporate America.2 Among institutional investors, mutual funds and public pension funds displayed the greatest potential as monitors. They therefore received the bulk of the scholarly attention and took on increased 3 importance in America’s overall system of corporate governance. 1. See Robert W. Hamilton, Corporate Governance in America 1950–2000: Major Changes But Uncertain Benefits, 25 J. CORP. L. 349, 353–57 (2000) (tracing the growth of institutional investors from 1950–2000); Edward B. Rock, The Logic and (Uncertain) Significance of Institutional Shareholder Activism, 79 GEO. L.J. 445, 449–51 (1991) (discussing the growth of institutional investors in the 1980s). 2. See Bernard S. Black, Shareholder Passivity Reexamined, 89 MICH. L. REV. 520, 523 (1990) (arguing that “institutional shareholders are hobbled by a complex web of legal rules that make it difficult, expensive, and legally risky to own large percentage stakes”); John C. Coffee, Jr.,