Winner of the 2007 De Brauw Blackstone Westbroek Law Prize

Hedge funds have become critical players in both corporate governance and corporate control. In this Article, Professors Kahan and Rock document and examine the nature of hedge fund activism, how and why it differs from activism by traditional institutional investors, and its implications for corporate governance and regulatory reform. The authors argue that hedge fund activism differs from activism by traditional institutions in several ways: it is directed at significant changes in individual companies (rather than small, systemic changes), it entails higher costs, and it is strategic and ex ante (rather than incidental and ex post). The reasons for these differences may lie in the incentive structures of hedge fund managers as well as in the fact that traditional institutions face regulatory barriers, political constraints, or conflicts of interest that make activism less profitable than it is for hedge funds. But the differences may also be due to the fact that traditional institutions pursue a diversification strategy that is difficult to combine with strategic activism.

Although hedge funds hold great promise as active shareholders, their intense involvement in corporate governance and control raises two potential problems: the interests of hedge funds sometimes diverge from those of their fellow shareholders, and the intensity of hedge fund activism imposes substantial stress that the regulatory system may not be able to withstand. The resulting concerns, however, are relatively isolated and narrow, do not undermine the value of hedge fund activism as a whole, and do not warrant major additional regulatory interventions.

The sharpest accusation leveled against activist funds is that activism is designed to achieve a short-term payoff at the expense of long-term profitability. Although the authors consider this a potentially serious problem that arguably pervades hedge fund activism, they conclude that a sufficient case for legal intervention has not been made. This conclusion results from the uncertainties about whether short-termism is, in fact, a real problem and how much hedge fund activism is driven by excessive short-termism. But most importantly, it stems from the authors’ view that market forces and adaptive devices adopted by companies individually are better designed than regulation to deal with the potential negative effects of hedge fund short-termism, while preserving the positive effects of hedge-fund activism.

Hedge Funds in Corporate Governance and Corporate Control