Why Run Away from the Evidence?

Bernard S. Sharfman is an adjunct professor of business law at the George Mason University School of Business. Related research from the Program on Corporate Governance about hedge fund activism includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here), and The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here). An exchange of posts on the empirical evidence on hedge fund activism between Bebchuk, Brav and Jiang, who urged Wachtell Lipton not to run away from the evidence, and Martin Lipton, who responded to their posts, is available on the Forum here.

Back in September 2013, Lucian Bebchuk, Alon Brav and Wei Jiang posted Don’t Run Away from the Evidence: A Reply to Wachtell Lipton on this blog as a means to rebut the criticism they received on an early draft of their empirical study, The Long-Term Effects of Hedge Fund Activism. In a nutshell, their empirical study found hedge fund activism to create long-term value for both shareholders and the companies they invest in while the lawyers for Wachtell Lipton said the results meant nothing. Based on a recent blog posting by Martin Lipton, the most famous of all the Wachtell partners, Further Recognition of the Adverse Effects of Activist Hedge Funds, the post by Bebchuk, Brav and Jiang did not do anything to change their minds.

The partners of Wachtell Lipton are not alone in being skeptical of the Bebchuk, Brav and Jiang study as well the numerous other empirical studies that show hedge fund activism to be wealth enhancing. I also include in the doubter category such notables as Chief Justice Leo Strine and Professor Stephen Bainbridge. If so, then the following question needs to be asked by those who find the Bebchuk, Brav and Jiang study and other empirical studies asproviding strong evidence for the value of hedge fund activism: Why would these preeminent figures in corporate law run away from the evidence? This is the initial issue I address in my new paper, Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value, forthcoming, Columbia Business Law Review.

A plausible explanation for why this impasse has occurred is that these doubters are first and foremost corporate law experts who buy into corporate law’s approach to corporate governance, an approach that is powerfully summarized in Bainbridge’s statement that the “preservation of managerial discretion should always be the null hypothesis.” [1] For those who believe in this authority model of corporate governance, the only thing that can reject the null hypothesis is the judicial review of a Board’s decision for a breach of its fiduciary duties. That is, there is no room for a non-managerial locus of authority in corporate governance if that locus of authority, such as an activist hedge fund, is understood to be shifting decision-making away from the board of directors (Board). Of course, this is not an unreasonable approach, as it has served corporate governance extremely well over the last 100 plus years.

Fortunately, there is no need to reject the null hypothesis in order to argue that hedge fund activism provides significant value for the corporate governance of a public company. What is presented in my article is a new argument in support of hedge fund activism that does not imply that decision making is to be shifted from the Board. In my article, it is argued that an activist hedge fund creates long-term value by both signaling to the Board that its executive management team may be making inefficient decisions and providing recommendations on how the company should proceed. These recommendations require the Board to review and question the direction executive management is taking the company and then choosing which path the company should take, the one recommended by executive management, the one recommended by the activist hedge fund or a combination of both. Critical to this argument is ability of the Board to act as an independent arbitrator deciding whose recommendations should be followed.

Given an adequate level of independence, the Board of a public company has the potential to view executive management not simply as an extension of itself and vice versa, but as a locus of authority for corporate decision making for which it must monitor on an objective basis. It also allows the Board to recognize another part of the organization, if only on a temporary basis, as a competing locus of authority with executive management when it is perceived to add value to the company’s decision making. In the context of the public company, the activist hedge fund may be understood as a competing locus of authority with executive management and have the role of “corrective mechanism” in the decision making of a large organization. Critically, it is up to the Board, in its rightful role of arbitrator, to determine which of these two loci of authority, the executive management or activist hedge fund, has the best advice for moving the company forward. In sum, going through this process of arbitration should lead to the creation of long-term value at public companies.

So far, for those who believe in the authority model of corporate governance, the approach has been that hedge fund activism cannot be tolerated.   However, if hedge fund activism can be viewed in the context of an integrated model of corporate governance where the authority of an independent Board is not being threatened but instead being utilized to arbitrate between the advices provided by the two loci of authority, executive management and activist hedge fund, then perhaps the outright rejection of hedge fund activism can end.

Endnotes:

[1] Steven M. Bainbridge, The Business Judgment Rule as Abstention Doctrine, 57 Vand. L. Rev. 83, 109 (2004).

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