ISSN 1936-5349 (print) ISSN 1936-5357 (online) HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS WHO BLEEDS WHEN THE WOLVES BITE? A FLESH-AND-BLOOD PERSPECTIVE ON HEDGE FUND ACTIVISM AND OUR STRANGE CORPORATE GOVERNANCE SYSTEM Leo E. Strine, Jr. Yale Law Journal, Vol. 126, Pg. 1870, 2017 Discussion Paper No. 899 04/2017 Harvard Law School Cambridge, MA 02138 This paper can be downloaded without charge from: The Harvard John M. Olin Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/ The Social Science Research Network Electronic Paper Collection: https://ssrn.com/abstract=2921901 This paper is also Discussion Paper 2017-04 of the Harvard Law School Program on Corporate Governance University of Pennsylvania Law School ILE INSTITUTE FOR LAW AND ECONOMICS A Joint Research Center of the Law School, the Wharton School, and the Department of Economics in the School of Arts and Sciences at the University of Pennsylvania RESEARCH PAPER NO. 17-5 Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System Leo E. Strine, Jr. GOVERNMENT OF THE STATE OF DELAWARE - SUPREME COURT OF DELAWARE; HARVARD LAW SCHOOL; UNIVERSITY OF PENNSYLVANIA LAW SCHOOL This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: https://ssrn.com/abstract=2921901 LEO E. STRINE, JR. Who Bleeds When the Wolves Bite?: A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System author. Chief Justice, Delaware Supreme Court; Adjunct Professor of Law, University of Pennsylvania Law School; Austin Wakeman Scott Lecturer in Law, Harvard Law School; Senior Fellow, Harvard Program on Corporate Governance; and Henry Crown Fellow, Aspen Institute. The author is grateful to Christine Balaguer, Yulia Buyanin, Peter Fritz, Alexandra Joyce, Fay Krewer, and Peggy Pfeiffer for their help. The author also thanks Bill Anderson, David Berger, Jim Cheek, Joele Frank, Ron Gilson, Andy Green, Jim Griffin, David Katz, Rob Kindler, Lou Kling, Don Langevoort, Travis Laster, Marty Lipton, Ted Mirvis, Bob Mundheim, Sabastian Niles, Eileen Nugent, Miguel Padro, Frank Partnoy, Roberta Romano, Bill Savitt, Brian Schorr, Randall Thomas, Antonio Weiss, and Josh Zoffer for the excellent feedback and incisive com- ments on the draft. 1870 who bleeds when the wolves bite? Few topics are sexier among commentators on corporate governance now than whether activist hedge funds are good for, a danger to, or of no real con- sequence to public corporations and the people who depend upon them. As befits tradition in this space, catchy pejoratives caught on, and the phenome- non of concerted action by hedge funds and other more traditional money managers, such as actively traded mutual funds who often encourage and sup- port the investment strategy of the alpha wolf, to influence public companies’ business plans has been deemed “wolf pack activism.” For a term so evocative of dangers to the flesh, the debates over wolf packs, and more generally the topic of hedge fund activism, have a surprisingly blood- less quality—one that uses abstraction and distancing to obscure what may be really at stake. In the back and forth about short-term effects on stock price, Tobin’s Q, survivorship bias, and the like, the flesh-and-blood human beings our corporate governance system is supposed to serve get lost. But, unless we consider the economic realities of these ordinary human in- vestors and how those realities bear on what is best for them, we are not fo- cused on what is most important in assessing the public policies shaping our corporate governance system. Stated in a somewhat crude but generally accu- rate way, we started with a system that reflected some implicit assumptions, in- cluding that: stockholders had a long-term stake in the company’s best interests; most stockholders owned their shares directly, for their own benefit, and held them for lengthy periods; the stockholders who were most active and vocal were those who had the longest-term stake in the corporation; when corporations became more profitable, they tended to create more jobs, pay workers better, and create positive externalities for the com- munities within which they operated; corporations had a national, and often regional focus, and their man- agers, directors, employees, lenders, and even stockholders often had ties of loyalty to those communities; and, finally, corporate managers were well but not lavishly paid, a plan of internal succession was common, and corporate managers tended to live in the community where the corporation was headquartered and be engaged in community affairs. In recent decades, these assumptions have been undermined and often turned upside down: corporate stockholder bases turn over rapidly; 1871 the yale law journal 126:1870 2017 most stock is owned by institutional investors, but represents the capi- tal of largely silent human investors, and many of these institutional investors engage in much greater portfolio turnover; the actual human investors whose capital is ultimately at stake are by- standers and do not vote; the most vocal and active stockholders tend to be the ones with the in- vestment strategies most in tension with the efficient market hypothe- sis, and often involve hedge funds who only became stockholders after deciding to change the company and who have no prior interest in the company’s well-being; the tie between increasing corporate prosperity and the best interests of corporate workers has been sharply eroded, with corporations not sharing productivity gains with workers in their pay and focusing on offshoring and job and wage cuts as methods to increase profits; corporations increasingly have no national, much less community, identity and are willing to not only arbitrage their communities against each other, but also to abandon their national identity for tax savings; and, finally, top corporate managers have been promised pay packages way out of line with other managers, but in exchange must focus intently on stock price growth and be willing to treat other corporate constituencies cal- lously if that is necessary to please the stock market’s short-term wish- es. Indeed, as we shall see, these human investors are not so much citizens of the corporate governance republic as they are the voiceless and choiceless many whose economic prospects turn on power struggles among classes of haves who happen to control the capital—of all kinds—of typical American investors. And for all the talk of creating an ownership society, close to half of Americans do not have any investments in equity securities, even in the form of 401(k) and individual retirement account (IRA) investments in mutual funds. As or even more important to the current topic, typical Americans who are investors in the equity markets remain primarily dependent on wage employment for their wealth, and the wealth they can deploy as owners of equity capital is not controlled directly by them. Instead, the power of their capital is wielded by others. Most traditionally, of course, we focus on corporate managers as exem- plifying that reality, the so-called separation of ownership from control. But now most Americans’ direct investments in equities and debt are controlled by 1872 who bleeds when the wolves bite? professional money managers,1 from whom escape is virtually impossible. I have called this phenomenon the “separation of ownership from ownership.”2 The republic upon which typical Americans depend is one where the debate is between corporate-manager agents and money-manager agents, both of whom have different interests than ordinary human investors. The nature of this republic must be understood if we are to assess how to address the emergence of activist hedge funds as a powerful force acting upon public companies. Assuming or pretending that the proxy voting units of insti- tutional investors will reliably identify what is in the best interest of human in- vestors hardly instills peace of mind. Nor is ignoring the “do as I say, not as I do” quality of those who wield power within our corporate governance system, in which claims to have the same perspectives as ordinary Americans are con- founded by actions such as rapid-fire portfolio turnover, abandoning ship when you’ve piloted it into rock-filled waters, and demanding the right to do things you then say you don’t have the time or resources to do well. Most fundamentally, one can’t fail to consider the oddity of a system where the loudest voices mostly represent one interest, that of equity capital, but are not representing the viewpoint of those human investors who entrust their capital to the corporations whose futures are at stake. Now, the voice of equity capital is represented most loudly by those whose investment philosophy the efficient market hypothesis argues is most likely to fail—active speculators try- ing to outguess the market. Many hedge funds themselves fly a reckless flight plan under the efficient market hypothesis and purport to be good at building long-term engines of economic growth, but are public-spirited enough to leave the resulting growth powerhouses after a few years, even though their influ- ence on the corporation will last far beyond that. Because ordinary Americans are stuck in the market for years and depend on its long-term, sustainable growth for jobs and portfolio gain, they are exposed to a corporate republic in- creasingly built on the law of unintended consequences. That republic is one where those with electoral power—the money managers with direct control over the shares purchased with human investors’ money—act and, one would 1. By “money manager,” I mean the mutual funds, pension funds, other investment funds, and others whose business is deciding how to invest someone else’s money to achieve a return, as opposed to corporate managers who run businesses that make products and deliver services to their customers.