Coordination and Monitoring in Changes of Control: The Controversial Role of “Wolf Packs” in Capital Markets

Anita Anand is the J.R. Kimber Chair in Investor Protection and Corporate Governance at the University of Toronto; Andrew Mihalik is a graduate of the Faculty of Law, University of Toronto. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

“Wolf packs” are loose networks of parallel-minded shareholders (typically hedge funds) that act together to effect change in a given corporation without disclosing their collective interest. Wolf packs are able to circumvent disclosure rules typically applied to shareholders that act together by deliberately avoiding being characterized as a “group” for the purposes of US securities laws or as “acting jointly or in concert” for the purposes of Canadian securities laws. The nascent academic literature relating to wolf packs reveals a number of hypotheses explaining their formation, but these models do not easily apply to jurisdictions whose capital markets differ from those in the US. In our paper, Coordination and Monitoring in Changes of Control: The Controversial Role of “Wolf Packs” in Capital Markets, we develop a new model of wolf pack formation that takes into account market characteristics not previously considered in the literature.

We argue that five conditions are necessary to give rise to shareholder coordination in the form of a wolf pack and these conditions undermine the formation of wolf packs depending on the nature of capital markets in a given country. The first condition, or “non-condition,” relates to the nature of the target corporation’s shareholder base. If a corporation’s shareholder base is widely-held, the formation of a wolf pack is more likely. But wolf packs, and activist interventions generally, are likely to be ineffective in controlled corporations, since voting control of the corporation resides with the founder; regardless of the size of the wolf pack’s position, it will always be out-voted by the controlling shareholder (unless the controlling shareholder forms part of the wolf pack). As a result, a proxy contest, or the threat of a proxy contest, may be an ineffective means of agitating for change in the corporation.

Second, in addition to a non-controlled (or widely-held) corporation, the presence of an institutional shareholder can facilitate wolf pack formation. The institution may or may not take on the role of lead activist. Regardless, it is sophisticated and will fulfill a monitoring function, a by-product of which is to allow subsequent members of the wolf pack to free-ride on its efforts. This is especially important in the context of the Canadian capital markets, where corporations’ share ownership tends to be dominated by larger institutional holders. In some cases, pension funds—which are not typically activists—may join together from time to time.

Third, wolf packs by definition will have a lead who must bear the costs of monitoring up-front before convincing other shareholders to join the wolf pack. It is unlikely that the lead activist will begin a campaign for governance reform where any gains are likely to be modest; rather, the lead activist would likely need to present a plan for the corporation that involves a change of control. The lead activist is willing to bear these monitoring costs up-front because the likelihood of a wolf pack achieving at least one of its intended outcomes is significantly higher than that of an individual activist. As a result, the expected benefits of monitoring rise relative to the costs.

We must remember that the lead activist’s position likely sends a signal to other investors. By the time the lead contacts other shareholders, it will have fulfilled at least a portion of its self-imposed monitoring function, thereby allowing subsequent members of the wolf pack to free-ride on its efforts. Because the institutional investors that tend to hold sizable positions in Canadian corporations are not generally activists, they may benefit from a lead activist who has borne the costs of monitoring up-front.

As a result, wolf packs might be more likely to feature alliances between a hedge fund, as lead activist, and one or more institutional investors. These alliances are more readily understandable given empirical work relating to wolf packs which suggests that lead activists may tip off other funds with which they have existing relationships. In other words, and as a fourth condition, wolf packs will typically be comprised of “repeat” groups of shareholders or at least that the presence of a given member of the wolf pack will be associated with a particular group of shareholders that comprises the pack.

The alliances between members of the wolf pack are facilitated by a fifth condition, namely the current legal regime relating to shareholder coordination. In the Canadian context, for example, shareholders can be incentivized to join a wolf pack because of the opportunity for riskless profit provided by the spike in share price that tends to follow the filing of an early warning report. Even without filing the report, the lead activist can manufacture a comparable share price appreciation by notifying potential members of the wolf pack of its intentions to initiate a proxy contest or agitate for a sale of the target.

Indeed, the threat of a proxy contest is perhaps more credible under Canadian securities laws than those in other jurisdiction because these laws allow a dissident shareholder to wage a proxy contest relatively inexpensively without the need to prepare and mail a proxy circular to other shareholders under the public broadcast exemption. In addition, under the 15-shareholder proxy solicitation exemption, a dissident shareholder is permitted to solicit proxies from a limited number of shareholders without having to prepare and mail a proxy circular.

In the absence of the foregoing five conditions, it may be too costly or impractical for a wolf pack to form. From a policy standpoint, our hope is that understanding the conditions underlying wolf pack formation can assist policymakers and regulators in developing regulations to balance the disclosure requirements of influential shareholders, which would tend to discourage wolf pack formation, against the important monitoring function such shareholders can perform in the corporation.

The full paper is available for download here.

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