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Other Voices: Views from Beyond the Barron's Staff The Shareholders' Friend
Other Voices: Views from Beyond the Barron's Staff The Shareholders' Friend
Berlau Article in Barron's
May 22, 2006
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There is a new group of activist shareholders who are holding CEOs' feet to the fire. They are taking on the entrenched management of the companies they own, including big corporate names such as Wendy's and Bally Total Fitness, and insisting they create more value for stockholders. With all the emphasis of the past few years on aggrieved investors, one would think the Securities and Exchange Commission would embrace this new class of corporate watchdogs. But instead, the SEC has taken steps to make it more difficult for these shareholders to hold management of their companies accountable.
Why is an agency whose mission is investor protection putting roadblocks in the way of reform-minded investors?
These particular shareholders are the dreaded hedge funds, blamed by some for everything from high oil prices to shortages of Treasury bills.
But that view overlooks a series of campaigns in which hedge funds are pushing management to increase value for all shareholders. Even the SEC's chief economist, Chester Spatt, says this flexing of hedge-fund muscle is a positive development for investors. "To the extent that some hedge funds have an appetite for an activist role with respect to trying to enhance value, I think that's very healthy," Spatt said at an American Enterprise Institute conference last year.
Yet Spatt's agency has put forth a burdensome new hedge-fund registration rule that could, since it subjects hedge funds to fee limits and frequent inspections -- "asking for everything but proof of your smallpox vaccination" quips Opportunity Partners' portfolio manager Phillip Goldstein -- inhibit the formation of funds and thus prevent the emergence of new actors to hold corporate management accountable.
Not only did SEC chairman Christopher Cox implement the rule in February, but he also hints that more regulation may come. He told a Senate panel in April that after "we internalize this new information"
from hedge-fund inspections, "we will then be prepared with the recommendations of our professional staff on what ought to be [our] next steps."
If Cox still adheres to the free-market principles he articulated as a California Republican member of Congress, he should reconsider. If he wants to do something to show his critics that being pro-market doesn't necessarily mean pro-CEO, there is no better way to do so than repealing this rule (initiated by his predecessor William Donaldson) -- a rule that is imposing costly new mandates on these new active shareholders.
In truth, hedge funds are often better friends to the average investor than most so-called shareholder advocates. It is no coincidence that one of the leaders in this movement is Carl Icahn, the former corporate-takeover artist who now heads a hedge fund. Referring to Icahn's pressuring of Time Warner and other companies to sell off divisions and buy back shares, the New York Times asserts that "Icahn is relishing his new reputation as a friend of shareholders."
Icahn was just as much a friend to shareholders in the 'Eighties, when he was a leader of the hostile-takeover movement. Takeovers, or the threat of them, spurred what distinguished economist Henry Manne has called "the market for corporate control." In the 1980s, CEOs knew that if they wasted shareholders money, either for their own perks or for nonproductive ventures, someone like Carl Icahn could tempt shareholders with a buyout offer. This served as an incentive to keep companies lean and focused.
Now, hedge funds are helping to create a new market for corporate control. Much of their ability to do so hinges on the fact that they are subject to less stifling regulation than other market actors.
Because hedge funds serve a limited number of wealthy investors and don't advertise to the public, they have not been subject to many of the requirements of other investment entities. Unlike mutual funds, hedge funds face no requirements for the diversification of portfolios that can restrict the amount of shares they can buy in a single company.
Hedge funds also have more freedom to short a stock if they don't like what management is doing. All of this makes chief executive officers pay serious attention to their suggestions.
Ironically, because hedge funds' demands are based directly on the bottom line, they end up helping all shareholders. This is more than can be said for the proposals of some other institutional investors.
Unlike state pension funds such as CalPERS, hedge funds don't generally pursue trendy cookie-cutter corporate-governance solutions like expensing of stock options, separating the chairman of the board from the CEO, or having a supermajority of independent directors. You also won't find many hedge-fund managers pushing proxy items with a hidden environmental or pro-union agenda.
The difference lies in incentives. Since hedge-fund managers are typically paid performance fees based on the returns they produce for the fund, they want practical, company-specific action that will boost the share price. "My objective is to unlock value in a company for investors in whatever legal and moral way I can," says Opportunity Partners' Goldstein.
Even though Goldstein and other hedge-fund managers are looking for short-term gains, their strategies often aim to improve a company's long-term prospects. Goldstein says one of the best ways to boost a company's share price today is by convincing management to start making changes to send the market a positive signal about tomorrow.
For instance, after buying a large chunk of stock in clothing catalog retailer Blair Corp., Goldstein persuaded the company to sell its credit portfolio and issue a tender offer to buy back more than half of its shares. This action lifted the company's price from about $25 a share to more than $40, although the volatile stock is now running at about $34.
Goldstein points out that Blair also increased its dividend from 15 to 30 cents per share. Long-term investors in Blair should be happy about Goldstein's action, even if he initiated it for short-term results to his fund.
Goldstein, who is suing to stop the SEC's registration rule, says the new regulation could chill hedge-fund action to correct weakness in a company's management. It contains numerous paperwork requirements, random inspections, and even limitations on performance fees. "If it ties you up with red tape, you could become more institutionalized," he says.
Another concern is that the SEC's inspections of registered firms have been reportedly even more extensive than expected and based on the perceived riskiness of a hedge fund's investment strategy. SEC officials have publicly stated that the agency is conducting "risk-based examinations." This vindicates the warning expressed by the SEC's two dissenting commissioners when the rule was voted on that, because of the agency's lack of knowledge about hedge funds, the rule could lead to inspections targeting novel approaches by hedge fund managers to boost returns. The very activism benefiting shareholders could be a red flag for an SEC bureaucrat unfamiliar with this approach.
This is why Cox should repeal or ease up on the rule. It would be an excellent opportunity to show how feel-good regulations hurt the shareholders they're intended to protect, and how free-market policies can benefit both investors and entrepreneurs.