The Tension between Hedge Fund Activism and Corporate Law

Abstract

This Article presents the following thesis: The courts will be over-permissive in allowing Boards to mute the activities of activist hedge funds unless the courts start to recognize the value of hedge fund activism (HFA) as a corrective mechanism and thereby feel the need to make an exception to their traditional approach to judicial review: strong deference to Board authority. We have already seen evidence of the courts not recognizing the value of HFA in Third Point LLC v. Ruprecht, a case where the Delaware Chancery court reviewed with approval a discriminatory poison pill meant to keep an activist hedge fund from winning a proxy contest.

In the limited fact patterns where Board actions are taken to mute the activities of activist hedge funds, continued strong deference to Board authority would be a repetition of the mistake made with hostile tender offers and be counter to the objective of shareholder wealth maximization. HFA has a role to play as a corrective mechanism in corporate governance and it is up to the courts to find a way to make sure it continues to have a significant impact despite the courts’ inclination to yield to Board authority. In practice, this means that when the plaintiff is an activist hedge fund and the standard of review is the Unocal test because issues of control are present, a less permissive approach needs to be applied, requiring the courts to exercise restraint in interpreting the actions of activist hedge funds as an attempt to gain control.

If there are no issues of control, then Board independence and reasonable investigation still needs to be the focus. That is, before the business judgment rule can be applied, the courts need to utilize an enhanced level of scrutiny in determining whether the Board is truly independent of executive management or any other insider such as a fellow Board member. As discussed in the Article, Board independence is critical to maximizing the value of HFA. Moreover, reasonable investigation of the activist hedge fund’s recommendations should be required to justify Board action taken to mute the fund’s influence. Like the Unocal test, the burden of proof for establishing independence and reasonable investigation needs to be put on the Board. In sum, what is required in the court’s review of Board actions to mute the influence of an activist hedge fund is something similar to the first prong of the Unocal test except independence and reasonable investigation is now focused on the Board’s evaluation of the fund’s recommendations, not the threat to corporate policy and effectiveness.