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Hedge funds often push company management around. But they may not be as tough as they seem.
Helen Shaw, CFO.com | US
January 26, 2007
Activist hedge funds are an intimidating lot.
There are many examples of the chaos a demanding hedge fund can create when a company refuses to bend to its wishes. For instance, the $8 billion hedge fund Atticus Capital, a 10 percent shareholder in Phelps Dodge last year, was a thorn in the copper miner's side for most of 2006 as it urged a stock buyback and opposed Phelps's proposed acquisition of Inco.
Investor pressure on corporate management is nothing new; activist hedge funds are a new twist on the corporate raiders of the 1980s. Today, they use their stakes to pressure management for dividend payouts, buybacks, and other actions. And, increasingly, hedge funds have been leveraging their power even further by using borrowed shares to change the outcome of shareholder votes. Such "empty voting" is certain to result in regulatory action, Securities and Exchange Commission chairman Christopher Cox told The Wall Street Journal on Friday.
But company management — particularly finance executives — face a more subtle problem: What if hedge funds simply claim they have a controlling stake — borrowed or otherwise — to make demands of management? Or what if they tell management they are ganging up with other hedge funds? Short of waiting for a hedge fund to make good on its threat in a shareholder vote, how does management know whether a fund's claim to stock ownership, or the power to sway votes, is truthful?
"In my experience, people that claim they have the power to bring a certain amount of shareholders' votes often don't have any formal arrangements, or they're not even telling the truth," comments Richard Rowe, a partner in law firm Proskauer Rose.
Figuring out whether a hedge fund really controls the shares it claims to can be a challenge for a company. If not stymied by the lengthy deadlines for filing after-the-fact notices of beneficial ownership forms with the SEC, companies also face the problem that hedge funds often do not hold stock in their own names, but rather in the name of their broker, usually one of the large brokerage firms, industry observers note.
The SEC requires different ownership forms to be filed when anyone reaches certain shareholder milestones in a public company. For example, anyone that acquires more than 5 percent of a firm's equity and intends to be an active investor must file Schedule 13D with the SEC and the issuer within 10 days, notes Adam Gale, an attorney at Orrick, Herrington & Sutcliffe. The detailed form reveals the purpose of the acquisition and other related contracts, such as hedging contracts.
But there are many ways for hedge funds to foil such scrutiny. For example, say a hedge fund manages more than $100 million in equities: it must file Form 13F — which discloses its equities ownership — with the SEC on a quarterly basis, within 45 days after the last day of each quarter. But a hedge fund can hide its identity by requesting confidential treatment from the SEC to protect its investment strategy, says Gale, who notes that such treatment is difficult to obtain.
And, given the fast pace of hedge-fund trading, the information provided by these forms is often outdated by the time they are filed. "Many hedge funds will use the 13F to swing their sword," says an anonymous industry observer who notes that a hedge fund could point to the amount of stock it held in a previous quarter when threatening a company, but that it could have already sold its position.
For example, a hedge fund that manages more than $100 million in stocks could purchase a company's stock over several days in mid-December, only to sell it in early February, before it is required to inform the SEC of the purchase. In mid-February, filings about the December stock purchase will make the hedge fund appear to be a shareholder of that company, even though it has sold its stake.
"It really is a game of cat and mouse," says the industry observer.
"If there are enough abuses, maybe the SEC will step in," says Proskauer Rose's Rowe. But until that happens, companies do have another way to identify who its shareholders are. The Depository Trust Corp. (DTC), the clearing system for brokerages, has lists that show the number of an issuer's shares held at each custodian bank. Only public company fiduciaries, such as the finance chief, have access to their own company's information. When issuers need to pay more attention to their stock, they can hire a stock-surveillance service to act as an agent to access their confidential information in the DTC.
Stock-watch services emerged from the corporate proxy business as companies tried to analyze the number of shares voted through the DTC system. Such services are offered by a number of firms, including Georgeson Shareholder Communications, Thomson Financial, and Miller Tabak.
Between 2005 and 2006, stock-watch services helped McDonald's when hedge-fund investor Pershing Square Capital Management advocated that the company sell part of its company-owned restaurants to the public and then conduct a stock buyback. McDonald's hired Thomson Financial to determine whether other hedge funds that could bring more pressure to bear on the restaurant chain were buying the company's stock. With the service, McDonald's gauged that other hedge funds owned only about 5 percent of its stock. Pershing Square's demands ended when McDonald's announced plans to sell some of its restaurants in early 2006.
While the information that can be gleaned from DTC lists does not name exactly who is buying or selling a stock, it can indicate whether the investor is a hedge fund or an institutional investor such as a mutual fund or a pension fund. Institutional investors tend to use custodian banks because they need their services to settle trades, notes an unnamed stock-watcher. However, hedge funds usually hold their stocks at large prime brokerage firms such as Goldman Sachs, Lehman Brothers, and Morgan Stanley.
In addition, stock-surveillance firms can narrow down a list of possible investors based on their familiarity with investors' trading styles and investment strategies. "For example, if we begin to see major trading in derivative contracts as well as purchases of stock, a name like Atticus could be involved," says one stock-watcher.
At least a company can consult stock-trading spies to learn more about their investors when faced with a grown-up schoolyard bully with a lot of capital. "We understand the different hedge funds, who has staying power, and which names to look out for," says the undercover equity-market snoop.