Conference Board Proposes Best Practices on Hedge Fund Activism

A Conference Board working group has issued proposed recommendations for companies and institutional investors facing hedge fund activism. The Hedge Fund Activism working group suggested a number of practices that could be employed by public companies and institutional investors that find themselves involved in activism campaigns mounted by hedge funds. After comments, the working group plans to issue a final report by June 2008.

As they proliferate, hedge funds have been exploring new investment policies. Among others, a number of hedge fund managers have undertaken an activist role within their portfolio companies, attempting to influence financial and strategic decisions and effect corporate governance changes. Hedge fund activism has focused on a few very different courses of action. Hedge funds may, for example, leverage a company’s balance sheet so as to return cash to shareowners; or they may assume an operating role, blurring the lines between themselves and private equity. At other times, they may advocate for a quick sale of the company or seek a change in top management.

As such activism grows, the working group recommends that companies be aware of their strategic, financial and governance vulnerabilities. To facilitate such awareness, they should designate a corporate governance officer reporting to the board on emerging best practices. Similarly, senior internal auditors should apprise the board of financial conditions that could make the company attractive to hedge fund activists, such as a substantial cash balance. When there is excess cash, management should disclose what it is going to do with it, such as share repurchases, returning it to shareholders through a special dividend, or reinvesting it.

The working group also suggests that boards should understand the rationale behind emerging governance standards and practices arising from recent proxy seasons or supported by proxy advisors or major shareholder interest groups. Directors should also encourage voluntary changes necessary to avoid being a target.

Boards should be open-minded, advised the report, and not assume that requests for change from a hedge fund always reflects hostility or short-term investment goals. The board should review any hedge fund demands in light of the company’s current strategy and financial condition, as well as the activist’s profile and the long-term interests of shareholders. While management should meet with hedge funds, said the working group, they must also consult with counsel on the impact of shareholder communication rules and Regulation FD.. It may sometimes be appropriate to request the hedge fund to execute a confidentiality agreement.

The company should also formulate a consistent response strategy to hedge fund requests and fully equip management to carry it out. In this pursuit, boards could form a special execution team composed of, for example, finance and governance officers and outside and inside counsel.

As for institutional investors, the working group urges them to consider the suitability of capital allocations in an activist hedge fund in the context of their overall portfolio and in light of their financial objectives. They should also seek regular communication with portfolio hedge funds on any activism agenda. Importantly, fiduciaries of pension plans, as well as other institutional investors should ensure that the decision to invest in an activist hedge fund relies on a thorough due diligence process.