The Yale Law Journal

VOLUME
126
2016-2017
NUMBER
6
April 2017
1600-1971
Feature

Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System

Leo E. Strine, Jr.

Few topics are sexier among commentators on corporate governance now than whether activist hedge funds are good for, a danger to, or of no real consequence to public corporations and the people who depend upon them. As befits tradition in this space, catchy pejoratives caught on, and the phenomenon of concerted action by hedge funds and other more traditional money managers, such as actively traded mutual funds who often encourage and support the investment strategy of the alpha wolf, to influence public companies’ business plans has been deemed “wolf pack activism.”

For a term so evocative of dangers to the flesh, the debates over wolf packs, and more generally the topic of hedge fund activism, have a surprisingly bloodless quality—one that uses abstraction and distancing to obscure what may be really at stake. In the back and forth about short-term effects on stock price, Tobin’s Q, survivorship bias, and the like, the flesh-and-blood human beings our corporate governance system is supposed to serve get lost.

But, unless we consider the economic realities of these ordinary human investors and how those realities bear on what is best for them, we are not focused on what is most important in assessing the public policies shaping our corporate governance system. Stated in a somewhat crude but generally accurate way, we started with a system that reflected some implicit assumptions, including that:

·         stockholders had a long-term stake in the company’s best interests; most stockholders owned their shares directly, for their own benefit, and held them for lengthy periods;

·         the stockholders who were most active and vocal were those who had the longest-term stake in the corporation;

·         when corporations became more profitable, they tended to create more jobs, pay workers better, and create positive externalities for the communities within which they operated;

·         corporations had a national, and often regional focus, and their managers, directors, employees, lenders, and even stockholders often had ties of loyalty to those communities; and, finally,

·         corporate managers were well but not lavishly paid, a plan of internal succession was common, and corporate managers tended to live in the community where the corporation was headquartered and be engaged in community affairs.

In recent decades, these assumptions have been undermined and often turned upside down:

·         corporate stockholder bases turn over rapidly;

·         most stock is owned by institutional investors, but represents the capital of largely silent human investors, and many of these institutional investors engage in much greater portfolio turnover;

·         the actual human investors whose capital is ultimately at stake are bystanders and do not vote;

·         the most vocal and active stockholders tend to be the ones with the investment strategies most in tension with the efficient market hypothesis, and often involve hedge funds who only became stockholders after deciding to change the company and who have no prior interest in the company’s well-being;

·         the tie between increasing corporate prosperity and the best interests of corporate workers has been sharply eroded, with corporations not sharing productivity gains with workers in their pay and focusing on offshoring and job and wage cuts as methods to increase profits;

·         corporations increasingly have no national, much less community, identity and are willing to not only arbitrage their communities against each other, but also to abandon their national identity for tax savings; and, finally,

·         top corporate managers have been promised pay packages way out of line with other managers, but in exchange must focus intently on stock price growth and be willing to treat other corporate constituencies callously if that is necessary to please the stock market’s short-term wishes.

Indeed, as we shall see, these human investors are not so much citizens of the corporate governance republic as they are the voiceless and choiceless many whose economic prospects turn on power struggles among classes of haves who happen to control the capital—of all kinds—of typical American investors. And for all the talk of creating an ownership society, close to half of Americans do not have any investments in equity securities, even in the form of 401(k) and individual retirement account (IRA) investments in mutual funds. As or even more important to the current topic, typical Americans who are investors in the equity markets remain primarily dependent on wage employment for their wealth, and the wealth they can deploy as owners of equity capital is not controlled directly by them. Instead, the power of their capital is wielded by others. Most traditionally, of course, we focus on corporate managers as exemplifying that reality, the so-called separation of ownership from control. But now most Americans’ direct investments in equities and debt are controlled by professional money managers,1 from whom escape is virtually impossible. I have called this phenomenon the “separation of ownership from ownership.”2 The republic upon which typical Americans depend is one where the debate is between corporate-manager agents and money-manager agents, both of whom have different interests than ordinary human investors.

The nature of this republic must be understood if we are to assess how to address the emergence of activist hedge funds as a powerful force acting upon public companies. Assuming or pretending that the proxy voting units of institutional investors will reliably identify what is in the best interest of human investors hardly instills peace of mind. Nor is ignoring the “do as I say, not as I do” quality of those who wield power within our corporate governance system, in which claims to have the same perspectives as ordinary Americans are confounded by actions such as rapid-fire portfolio turnover, abandoning ship when you’ve piloted it into rock-filled waters, and demanding the right to do things you then say you don’t have the time or resources to do well.

Most fundamentally, one can’t fail to consider the oddity of a system where the loudest voices mostly represent one interest, that of equity capital, but are not representing the viewpoint of those human investors who entrust their capital to the corporations whose futures are at stake. Now, the voice of equity capital is represented most loudly by those whose investment philosophy the efficient market hypothesis argues is most likely to fail—active speculators trying to outguess the market. Many hedge funds themselves fly a reckless flight plan under the efficient market hypothesis and purport to be good at building long-term engines of economic growth, but are public-spirited enough to leave the resulting growth powerhouses after a few years, even though their influence on the corporation will last far beyond that. Because ordinary Americans are stuck in the market for years and depend on its long-term, sustainable growth for jobs and portfolio gain, they are exposed to a corporate republic increasingly built on the law of unintended consequences. That republic is one where those with electoral power—the money managers with direct control over the shares purchased with human investors’ money—act and, one would thus infer, think based on considerations of gains over periods of one to two years. If out of this debate among those with short-term perspectives comes optimal policy for human investors with far longer time horizons, that happy coincidence would be remarkable.

To shed light on how hedge fund activism, including so-called wolf pack activism, affects human investors, Part I of this Feature highlights the flesh-and-blood attributes of typical American investors—the real people, which this Feature refers to as human investors, who use the capital markets to invest and save for important life events like retirement or college education for their children. Then Part II explains what is meant by the confusing terms “activist hedge fund” and “wolf pack” activism. From there, Part III will describe the corporate republic upon which human investors are dependent but in which they are largely bystanders to a power struggle among two classes of agents, corporate managers and professional money managers. Part IV then explains the two ways in which human investors are subjected to whatever benefits and risks activist hedge funds may cause to our corporate governance system, both as indirect investors in hedge funds and as workers dependent on pension funds, and, more importantly, as human beings who derive most of their wealth from the ability of our economy, including its public companies, to create good jobs and raise wages. Sections IV.A and IV.B will explore these subjects and highlight the critical issues raising doubts that hedge fund activism is likely to be materially beneficial to human investors. Section IV.C discusses how the current corporate governance debate imperfectly addresses these potential harms to human investors.

The Feature finishes in Part V with some modest policy proposals to ameliorate the risks that hedge fund activism poses while still retaining its potential benefits. Notably, these proposals do not involve ascribing to the hedge fund industry itself any opprobrium; rather, as to the hedge fund industry itself, they mostly rest on the proposition that when economically powerful forces are acting on important societal institutions like public companies and taking funds upon which human investors and institutions like charities and universities depend, they should be required to disclose accurate and timely information about their operations and interests. Most fundamentally, this Feature recognizes that it is not hedge funds themselves that pose the major risk to human investors, it is the failure of our overall corporate governance system to represent faithfully the rational, long-term perspective of ordinary American investors who can only gain if public corporations make money the old-fashioned way, by implementing sustainable strategies to sell products and services and not through edgy practices, accounting gimmickry, or never-ending cycles of spin-offs and mergers.

I

Human investors are the least-discussed participants in our corporate governance republic, a reality made more important by the menacing valence the term “wolf pack” takes on when the prey might be human—investor, worker, or otherwise. In this context, the term “wolf pack” was, I suppose, not one adapted by environmentalists who dabble in corporate governance and are seeking to advance their desire to reintroduce a viable population of wolves into the American wild by associating them with a popular group of activist investors. Rather, the term calls on a scarier lineage, in which wolves are seen as dangerous predators capable of ruthless and concerted action to bring down and devour their prey. Visions of cowering children, vulnerable livestock, and half-eaten chickens come to mind,3 or sailors forced to fight for survival in the great deep.4

But, when we talk of wolf packs in the sense of activist hedge funds and their fellow travelers that seek to propose changes in policies at public companies, much of the academic consideration has a bloodless quality, in which the reality that how public companies manage their businesses has an effect on actual human beings is obscured. Lost in the regressions5 and the rote references to stockholder democracy6 are the people most affected by our corporate governance system, in no small part because those people mostly have to live with the outcomes of a system of corporate governance in which they have almost no direct voice.

In this back and forth, terms like “owner” are used as appellations by those who control the capital of others—the money managers at institutional investment firms—and use vehicles to acquire ownership of equity securities.7 These “owners” are not sole proprietors responsible financially for all the costs and risks of a business, nor are they even “owners” in the sense of bearing all the risks of a human being who owns a share of stock in a public company. Money managers’ incentives and risks are materially different than those whose capital they control. Claiming to be an owner may just be the money manager speak equivalent of a wolf putting on sheep’s clothing. Therefore, if the focus when considering the effect of activist hedge funds is on the relative gain sharing among corporate managers, activist hedge funds, and other forms of institutional investors, something fundamental will inevitably be slighted, which is that these inquiries involve a summing up among the agents of the real human beings whose wealth and well-being is supposed to be the focus of our society’s economic policies. The real humans get lost in the shuffle.

If we are to consider in a prudent fashion how our corporate governance system should regulate activist hedge funds or address other analogous matters, we must humanize our lens and remind ourselves of the realities of who living, breathing investors are, the ways in which they are allowed to participate in the system, and the effect these realities have on what corporate governance system would be best for them.

Most essential in this humanizing process is realizing that most Americans owe almost all of their wealth to their ability to hold a job and to secure gains in wages. This is not simply true among the poorer half of Americans; it is true of 99% of Americans. On average, Americans derive 64% of their income from wages and another 15% from either retirement payments or other transfer payments.8 For the middle and upper-middle class, jobs are even more important, as wages comprise 70% or more of income.9 But the importance of labor does not stop there. Those in the eightieth to ninetieth percentiles derive over 75% of their income from their labor, and those in the ninety-fifth to ninety-ninth percentiles still get over 60% from their labor.10 Importantly, the extent to which transfer payments—such as food stamps, unemployment insurance, and the like—comprise an important percentage of ordinary Americans’ annual income underscores the points because it illustrates that in many cases the employment that workers get is not enough to provide for their families, and that others lack consistent employment at all.11 Jobs, jobs, jobs—they still drive American wealth creation for all but the super-rich.

Now, it is also true that many Americans are now “forced capitalists”12—forced by public retirement policies and market developments to turn over a portion of their paycheck every month to the money management industry.13 Under the predominant approach, though, American workers are not able to buy securities in public companies directly. Instead, they are given an option to invest in the funds of whatever mutual fund families with which their employer contracts.14 Although these families may have a seeming breadth of options because the investment choices are numerically diverse, those choices in reality consist only of the menus of funds of the fund families their employer has selected.15 The workers’ version of the Wall Street rule16 involves not being able to sell one stock in the Russell 3000 and buy another, or to move into particular bonds. Instead, it involves being able to move from one fund to another, often of the same fund family. And yes, of course, there is a kind of liquidity, in the sense that the worker is entitled to withdraw her money at any time at the fund’s net asset value.17 But this is not liquidity that allows a worker to live off the proceeds. Rather, for most Americans, once funds are invested in a 401(k) plan, the funds are out of their effective reach until they reach age fifty-nine and a half.18 To withdraw before that time subjects the worker to Castro-like expropriation in the form of confiscatory taxes.19 For this reason, most workers have a substantial interest in the durable appreciation of their portfolio, and do not benefit in any way from stock bubbles arising from gimmicks or unsustainable strategies because these gains will go away and if those bubbles result in economic recessions and diminutions in economic growth, the worker will suffer both at the time of retirement, and perhaps more importantly, during their working careers, as economic slowdowns that result in job losses and wage stagnation threaten their most important source of wealth.

I admit to focusing on 401(k) funds,20 and I do so for good reason. Most Americans are not wealthy enough to buy a lot of securities21 outside of retirement and college savings accounts under 26 U.S.C. § 529.22 In fact, most Americans are not wealthy enough to come near hitting the annual limits for what they may set aside in a 401(k) retirement account. That annual limit is $18,000 per worker,23 or 32% of the median household income in 2015.24 For most people, savings outside of college savings and retirement accounts have to be available in liquid and non-risky form to meet events of life like house and car down payments, air conditioners that need to be replaced, auto catastrophes not covered by warranty, children getting married or needing help, school tuition, or other issues in the general category of “stuff happens.”

And for most Americans, how much they have to invest is singularly a function of how much they can make from their labor. The equity and debt capital they acquire comes originally from sweat. Because most of us don’t have a large surplus, it is not surprising that a majority of Americans have relatively little saved for retirement in the form of an ownership interest in funds invested in equity securities.25 “[N]early half of all working-age families have zero retirement savings . . . .26 This results in dire aggregate savings rates: the median family with a head of household between the ages of thirty-two and thirty-seven has $480 across all of its retirement accounts.27 If households without any retirement savings are excluded, the picture is a little better: working-age households that do save have a median retirement account balance of $41,900.28 Even among households whose members are retirement age and have retirement savings, those savings are capable of generating only a modest annuity.29 Not surprisingly, these balances largely track family income.30 But, even the comfortably middle class—American households earning between $88,100 and $133,900 annually—have median account balances of only $60,900.31 Only when looking at the top quartile of American households—earning more than $135,000—do median account balances exceed six figures, demonstrating how critical it is to continue to make good wages through access to a quality job.32 Yet, even for more affluent Americans well above the median, these savings produce a relatively small amount of their total income.33 And regrettably, the wealth gap between white and black Americans that has resulted from our society’s history of racial oppression shows up in a huge way in 401(k) savings assets.34 For starters, black and Hispanic households are less likely than households generally to have access to a 401(k)-type plan through their workplace.35 Where plans are available, black and Hispanic workers have lower account balances.36

A declining but still sizable number of Americans have their wealth invested indirectly in equity and debt capital markets through a more traditional means—a pension plan.37 Every paycheck, part of their effective wage is put toward a supposed guarantee of a defined pension based on years of work and other factors such as salary level. These other factors underscore the importance of wages as driving the pension payments a worker will receive, thus linking the worker’s ability to live comfortably in retirement with her access to good wages during her working career.38 For pensioners, in contrast to 401(k) savers, no investment choices typically must be made. Rather, the trusting pensioners find themselves in the hands of their pension fund and dependent upon considerations such as whether the pension fund is annually funded in an actuarially sound manner and whether the pension fund is investing its assets in a prudent manner that will enable it to meet its promises to its beneficiaries. Even more obviously than 401(k) investors, workers who have been promised a pension should rationally want a corporate governance system focused on sustainable wealth creation. Investments must grow durably and be there when it counts. Not only that, unless the approach to economic growth is one that benefits workers, by generating good jobs and wage growth, the prospective pensioner risks unattractive fates like non-vesting if a job is lost, or minimal growth in pension prospects if promotions and other wage growth options that will generate a higher pension are limited.

Precisely because human investors save for college and retirement, they are also likely to have substantial investments in debt securities and not just equities.39 Why? Because as college and retirement loom, it is prudent that more of your portfolio be in a form less vulnerable to losses in principal.40 For this reason, human investors are particularly vulnerable if the corporate governance system allows excessive leverage, which can threaten jobs through insolvencies, economic shocks such as financial crises, and a reduction in the value of debt securities.

These realities are buttressed by corporate finance theory itself. The mainstream of that theory teaches that the current value of an asset should be based on its expected future cash flows.41 It also teaches that when assets such as stocks are traded in a liquid market with a rich information flow about corporate prospects, an active trading strategy dependent on outguessing the collective judgments of the market is unlikely to succeed.42 That does not mean that you can’t guess right sometimes or over some period, but that the ability to do so durably and consistently over time is slim to non-existent.43

For human investors, these aspects of theory seem to counsel in favor of a corporate governance system that encourages investment in the development of useful products and the delivery of useful services because it is the purchase of products and services that must ultimately be the source of sustainable profits. Over the long term, you must sell something customers need or want. Whether you are a pure play or have a strong stock buyback program won’t matter if you can’t do that. Simply squeezing the corporate lemon to get the most juice right now at the expense of growing future lemons does not help human investors build wealth, as they risk employment opportunities and cuts in long-term portfolio growth. Offshoring jobs to nations with pitiful wages and little protection for labor as shortcuts to more immediate profits, rather than making profits in an ethical, sustainable manner that does not involve externalizing the real costs of business, hurts human investors. Corporate finance gimmicks won’t generate jobs or a retirement fund for workers outside the industry space coming up with the gimmicks, and gimmicks have a way of getting found over time. And over time is how human investors build wealth.

This is not to say that human investors do not want to hold corporate managers accountable. Of course they do. Human investors don’t want self-dealing that diverts profits from the corporation unfairly to insiders. They don’t want empire building that simply makes a corporation larger for its own sake, and does not make it more profitable in the long term. But what human investors are concerned with is not quarter-to-quarter earnings. Rather, they are also concerned when managers and others with power to influence corporate policies can gain substantially if corporations show paper profits that are not indicative of economic reality or leverage themselves up to make immediate payments at the cost of future insolvency or lower returns. If the very economy that human investors count on to provide them with jobs is hollowed out at the insistence of those who wield the power that comes with managing human investors’ equity capital, human investors will likely end up less wealthy in the long run.

In sum, human investors are creatures with special attributes, distinct (as we shall see) from other participants in our corporate governance system. Specifically, human investors are true Benjamin Graham-style long-term investors.44 Their time horizon is the twenty-some years from the birth of a child until college or the even lengthier period from entering the workforce until retirement. The vast majority of human investors are also not primarily investors—most of their wealth is derived from labor and wages, not capital appreciation and dividend income. These two attributes distinguish what is in the best interest of human investors from what is in the best interest of other market participants. Bubbles disproportionately harm human investors because their time horizon means they not only ride the bubble up, but they also ride it back down to a bottom that may be lower than would have been the case but for the inflated egos that caused it. Human investors are also likely to have investments in both equity and debt and so are sensitive to value transfers from debt to equity. Most materially, human investors are exposed to the broader real world consequences of changes in corporate behavior influenced by stock market forces such as hedge fund activism: a short-term increase in productivity and stock price at the expense of long-term reinvestment and wage growth will likely harm the overall “portfolio” of the human investor.45 The point of this Feature is not to vilify hedge funds but to ask questions about basic assumptions by using the perspective of the too-often-ignored human beings for whom the system is supposed to work. If you were one of the many—the average or above average below the ninety-fifth percentile—how would you want the corporate governance system designed? Even if you were way more fortunate than the many, in the ninety-fifth to ninety-ninth percentile, how would you want it designed?

Keeping a close eye on these flesh-and-blood investors, it is time to clarify what exactly terms like “hedge fund” and “wolf pack activism” mean in this context and begin to explore how activists’ incentives and strategies act on the real-world companies they target.

Ii

The term “hedge fund activism” is an odd one. Hedge funds were originally associated more with the tempering, the “hedging,” of risk.46 And that remains true. Many, if not indeed most, hedge funds are involved in trading strategies that do not involve the subject of this Feature.47 Many of them still focus on strategies combining leverage, “long” equity investments, and “short” downside-protecting hedges that gave hedge funds their name.48 But, for purposes of this Feature, I focus on the more oxymoronic part of the industry, which rather than primarily acting to hedge risk, takes an aggressive investment interest in the stock (and other securities and more exotic interests tied to the value of that stock) of a public company and seeks to make returns by influencing the corporation to change its capital structure or business plan. The funds that do this make up a minority of the overall hedge fund industry,49 but they have an outsized role in the debate about corporate governance because they have had an important effect on the manner in which public companies operate. And however attractive it is for politicians to talk about small business being the engine for job growth, the reality remains that public companies are the most vital source of jobs in our economy. Directly, they provide employment for more than 22% of Americans.50 That understates their effect because countless small businesses are profitable because they operate in communities where public company operations exist; they play a role in acting as suppliers of goods and service providers to the public company and its employees.

The information that is available regarding hedge funds is much more limited than about investment firms registered under the Investment Company Act, also known as the “40 Act.51 Until recently, hedge funds were not registered52 and could only take investments from “accredited investors,53 also sometimes known by the moniker of “sophisticated investors.” Because of the lack of disclosure required of hedge funds,54 less-than-ideal information exists about how the hedge fund industry has performed in comparison to traditional mutual funds or market indices. Hedge fund track records are notoriously difficult to assess because the survival rates of hedge funds are much lower than for traditional mutual funds,55 and it is not clear that studies assessing hedge fund performance consistently capture the negative returns of funds that have gone out of business for lack of positive returns.56 The lack of reliable information about hedge fund performance and its effect on the ability of pension funds and other fiduciary investors to protect their beneficiaries also extends to private equity, leading to calls for legislative action to increase the disclosure of issues like the terms of private equity funds’ contracts with investors.57 Of special concern to human investors is the reality that nonregistered funds can strike different deals with different investors, and that those funds most likely to be acting on behalf of human investors may be, on balance, those less likely to benefit from, and thus most likely to suffer from, preferential arrangements.58

Like their tactics, the targets of hedge fund activism cannot be put in one category.59 Scholars and commentators may underestimate the effect that industry growth has in considering this issue in particular. Some of the examples used as characterizing hedge fund success involved companies with rather serious ethical and legal difficulties, which were dealt with on account of unrest by investors (and aid from regulatory revelations).60 This sort of activism is not typical, however, and has become even less so as the industry has grown.61 Although scholars are not in full agreement about how to characterize the companies targeted by hedge funds, with some calling them underperforming,62 and others calling them profitable companies undervalued by the market,63 some common characteristics have emerged. In contrast to when activist hedge funds first emerged as a force, hedge funds now tend to target companies that are profitable, not ones that are not.64 But the companies that they target tend to pay out less of their profits than the industry average and have strong cash flows and balances.65 Some might view the typical target of a hedge fund to therefore be a “value buy,” the kind of fundamentally profitable, but undervalued, firm that someone like Benjamin Graham might have said was a good part of a solid portfolio.66 When going active against these firms, hedge funds will commonly argue that the firms are engaging in excessive expenditures (using executive compensation when possible as a high-saliency example).67 The activists argue that, instead, the firms could reorganize their capital structure to provide higher payoffs to stockholders in the near-term, without long-term cost, because they are merely targeting slack unnecessary to future growth.68

What is commonly accepted about activist hedge funds is that they do not originally invest in companies they like and only become active when they become dissatisfied with the corporation’s management or business plan.69 Rather, activist hedge funds identify companies and take an equity position in them only when they have identified a way to change the corporation’s operations in a manner that the hedge fund believes will cause its stock price to rise. The rise that most hedge funds seek must occur within a relatively short time period, because many activist hedge funds have historically retained their positions for only one to two years at most.70 As shall be discussed, there is some evidence that the more successful activist funds are the ones more likely to take a fiduciary position, by seating a representative on the target board and hold their investments for five to ten years.71 There is also some evidence suggesting that hedge fund holding periods overall have lengthened in recent years.72 One major reason that most hedge funds have relatively short holding periods is that hedge funds have contracts with their investors that allow investors to get their money back after lock-up periods of typically six months to two years.73 A useful contrast is private equity’s typical five- to ten-year lock-up.74 The compensation system for hedge fund managers, which has been the focus of much public debate75 and is not the obsession of this Feature, also creates an incentive for a near-term focus.76 The so-called “2 and 2077 approach provides a great deal of benefit to a hedge fund manager that can lock in a lucrative gain, and is not designed to compensate the manager for a mere market rate of return.78 The high fees are supposed to be justified by the delivery of far superior returns than a buy-and-hold strategy.

Although it is, of course, true that wealthy individuals are the source of a material amount of capital invested in the hedge fund industry, the industry’s growth cannot be attributed solely to the super-wealthy. Rather, institutions upon which ordinary Americans rely—such as pension funds, university endowments, and charitable foundations—have entrusted large amounts of capital to the hedge fund industry. By way of example, institutional investor money constituted 25% of hedge fund assets in 2001, and pension funds were poised to raise their allocations to hedge funds sharply.79 By 2015, one source estimated that pension funds constituted about 40% of the capital invested in hedge funds.80 At the same time as the composition of hedge fund investors has changed, so too have activist hedge funds developed a distinct investment strategy.

In recent decades, hedge fund activism has increased considerably. Although hedge fund activism campaigns display some diversity, basic patterns have emerged. First, the hedge fund must secure an equity position that allows it to make sizable gains if its activism succeeds in whole or in part. It can be expensive to get active, particularly if the fund ultimately has to get its way through a proxy fight or similar battle, and the fund must secure enough equity not just to have credible influence, but more importantly to make gains justifying its risky investment with material upfront expenses. Using the antiquated disclosure regime under Section 13 of the Securities Exchange Act, hedge funds can acquire as much equity as they want, so long as they disclose their interests within ten days of reaching a 5% ownership threshold.81 Even then, though, the disclosure regime is incomplete and does not capture all the derivative positions the hedge fund can take.82 These positions must be understood if one is able to tell just how “long”—exposed to increases in equity value—the hedge fund is on the public company.83 Although in some instances a lead hedge fund has come public with ownership stakes of 20% or more—such as in the J.C. Penney situation in 2010 when activist Pershing Square, working with Vornado Realty Trust, surfaced owning 26.4% of J.C. Penney84—the median ownership interest of a lead hedge fund when it goes public has been reported at 6.3% in one study85 and 8.3% in another, more recent study.86

The wolf pack imagery comes in at this stage. There is evidence that when an alpha wolf—the primary moving hedge fund—has begun accumulating shares but has not yet gone public with a Schedule 13D filing, other wolves move into the stock.87 Thus, when the alpha wolf emerges with its teeth into a good-sized piece of its prey, other wolves are also grabbing chunks for themselves.88 This, naturally, has led to suspicion that the alpha wolf has been organizing the hunt with the other wolves.89 Professors Coffee and Palia summarize other studies by observing that “tipping and informed trading appears to characterize both the formation of the ‘wolf pack’ and transactions during the window period preceding the filing of the Schedule 13D.”90

Understanding wolf pack behavior is further complicated because hedge funds are not subject to some important market regulations. Hedge funds are not subject to Regulation FD—a regulation requiring issuers to disclose material non-public information broadly to the market, if the information is disclosed at all.91 Moreover, stockholders do not normally have duties to companies in which they invest and that is almost always true of hedge funds in the stake-building period itself because they typically had no ownership position before and no representation on the board.92 Thus, so long as they are not disclosing nonpublic information which they obtained as a result of an insider’s breach of duty, hedge funds are normally free to tip third parties about their own plans or intentions without running afoul of Rule 10b-5.93 Thus, as a result of the inapplicability of Regulation FD and Rule 10b-5,94 there is often the potential for entirely legal tipping that accompanies activists investing in a target company. The failure of the disclosure laws to demand a full accounting of all interests compounds the complexity of understanding the economic interests of the various activist hedge funds who simultaneously or concurrently move into the target’s stock with the alpha wolf.95 Not only may some wolves own fewer than 5%, so too may disclosing wolves have additional interests not captured by an outdated disclosure regime.

Whether the alpha wolf consciously forms a pack or the other wolves are just good at sniffing blood and being present to get their share of the kill is also not so much the focus of this Feature. But the reality is that, given the lack of stringency in Section 13(d) and its limited reach to concerted activity, it is not uncommon for a public corporation to find itself with a sudden change in investment profile that involves 10 to 25% or more of its stock ending up in the hands of various activist hedge funds without prior public disclosure.96

When viewed from an objective perspective, and not through the lens of anti-activist zealotry, the wolf pack in the more important, high-salience activist campaigns is likely to include not just fellow hedge funds, but actively traded mutual funds. Many sophisticated practitioners note that the fund managers of actively traded mutual funds, who are frustrated with corporate managers who do not listen to their input, share their frustrations and their ideas about improving the corporation with activists whom they find credible.97 Even more commonly, active long-only funds often provide voting and, as important, private (in terms of communicating to the target’s management and board that advisability of listening to the activist) and public support to activist initiatives.98 Without the support of these mainstream funds, the activist hedge fund leader would not have the clout to extract favorable concessions in a settlement, much less to prevail in a contested proxy fight.99

The strategies that hedge funds advocate are not diverse. In a few situations, hedge funds have claimed to have innovative strategies to improve the operations of companies in challenging industries, such as department stores.100 As will be discussed, there are not many stories of this sort of operational innovation systematically creating value. An example of an unusual story along these lines involves Starboard Value’s intervention at Darden Restaurants. Its three-hundred page presentation identified numerous operational improvements including practice changes to ensure only fresh breadsticks came to the table at Olive Garden and to decrease table wait times.101 Some evidence is emerging that when longer-term hedge funds succeed in seating experienced, successful corporate executives on target boards as a result of a settlement or election, the target’s performance improves.102 But, many of the gains from even these longer-term funds have come from putting targets into a sale in whole or in part,103 and, what is missing is a matching of a number of actual stories about management improvement at specific high-salience targets to the overall data in the samples they study.

Thus, what remains more common is that a hedge fund will argue that a corporation with healthy profits is not returning enough of those profits to its investors.104 The hedge fund will argue that the corporation, by dint of excessive costs, is operating inefficiently, and that if it cut its spending or took on more debt, it could pay out more gains to its investors immediately. Thus, arguments to reduce capital and other spending (including headcount) and to increase dividends or do a large stock buyback program are de rigueur.105 Even a giant and massively profitable company like Apple has not been immune from these pressures for short-term increases in returns, as its capitulation to Carl Icahn’s demand for an increased stock buyback program demonstrates.106 Corporate finance plays of another kind are also common, with the hedge fund arguing that if the company is broken into pieces, its value will increase as pure plays.107 As suggested, with arguments for all these strategies is an almost always present hint that a sale of the company should also be considered.108 That sale will not involve a purchase by the hedge fund or its fellow wolves.

Hedge funds, unlike private equity funds, will not buy a company’s entire equity and arrange their own financing, as is typically required when a full change of control happens.109 Rather, hedge funds will not bear that kind of risk and wish for the option of trading out of the company’s equity. If a hedge fund can push a target into a merger with a lucrative target-side premium, that will facilitate the hedge fund’s exit, but the hedge fund has no desire to be the acquirer in that kind of transaction. And when a hedge fund succeeds in changing the target’s business plan in other ways through pressure strategies, the hedge fund typically will make no commitment to remain as a long-term stockholder.110

How hedge funds succeed in their campaigns vary.111 For the most part now, they win by coming public, not so subtly suggesting a willingness to scuffle, and by reaching an accommodation with the target’s management that involves the hedge fund gaining board seats.112 Once inside the boardroom, the activists press for their particular variety of corporate change. In the past few years, most activist hedge fund campaigns resulted in the hedge fund gaining at least some degree of representation on the company’s board,113 and in most of these situations, the victory resulted from a settlement.114 But these settlements would not occur at their current high rate without the industry’s willingness to engage in high-profile proxy fights, “withhold vote” contests, and other pressure strategies.115 High-salience wins by the hedge fund industry involving major corporations116 and the demonstrated willingness of key proxy advisors like ISS, Glass Lewis,117 and mainstream mutual funds to support and vote for activist hedge fund campaigns have made clear to public company boards that activist hedge funds can beat them at the ballot box.

Commonly, these wins arrive well before the ballot box.118 Settlements typically involve a combination of business policy strategy changes, usually involving some increase in immediate returns to investors through dividends or buybacks, and agreement to put directors proposed by the hedge fund (which can include hedge fund managers themselves) on the board of directors to help oversee the policy changes or a determination to sell the company.119 The placement of one of a hedge fund’s managers on the board does not mean that the fund is likely to commit to remain permanently invested, but it admittedly does subject the hedge fund to regulations like prohibitions on short-swing profit taking and insider trading.120 For this reason, settlements that involve a target implementing the policy changes the hedge fund advocates, but denying the hedge fund board seats, might be attractive to the hedge fund because its liquidity will be considerably enhanced. Nonetheless, it is increasingly common for settlements to involve the hedge fund placing one or more of its key employees directly on the board,121 and there is some emerging evidence that when hedge funds are willing to invest long-term, the outcomes for all are more positive.122

Even when activists obtain seats on the board, their strategies may not be adopted, or the strategies may not succeed. In some high-profile situations, this has led to the payment of what traditionally was called “greenmail” as the price of getting a hedge fund to exit.123 This arguably happened in interventions targeting General Growth Properties, Yahoo, and ADT.124 These buyouts have been understandably controversial because the corporation’s willingness to buy the hedge fund’s block arguably confers upon the fund a premium over the block discount it would have suffered if it tried to unload its position in the market while complying with the legal constraints on its selling flexibility attributable to its fiduciary role in the corporation.125 These situations have not been common, however, and it seems likely that most hedge funds exit through the public markets from which they acquired ownership and do so after a period that is brief in terms of the life cycle of a corporation or an ordinary human investor.126 Even when hedge funds exit through public markets, it is sometimes with a helping hand from their former target—when the activist agitating for change at J.C. Penney reached a strategic dead end,127 the board struck a deal with the fund, allowing its board designee to resign and providing the fund with help to enable it to sell the fund’s stake cost effectively.128

Charles Nathan, a distinguished practitioner, has rightly argued that what matters is not that an activist has a short-term holding period but whether the strategy it advocates is sound.129 But, what he slights in his current thinking, which is somewhat different from his past thinking,130 is that if the proponent of a strategy with long-term effects has no intention to hold and suffer the risks of that strategy, there is naturally less reason for that proponent to concentrate on the long term.131 And Nathan is right that activists cannot be held responsible “if shareholders are predisposed to favor shorter-term programs for extraneous reasons (such as concern for quarterly and annual performance rankings on the part of active money managers).”132 But that makes my primary point. Shareholders predisposed to do that are not shareholders in the original sense of being the risk bearers of the equity they control. Shareholders predisposed to make trades out of a concern for Morningstar ratings are conflicted agents, whose incentives are different and not rationally aligned with the human investors whose capital they possess. If it is the case that these money managers are acting for their own short-term motives and if most hedge funds themselves have no incentive to think long term, that illustrates that we are relying on the law of unintended consequences to drive important elements of decision making in a context critical to human investors’ wellbeing.

Studies of the impact of activist hedge fund investing are emerging monthly, and it is hazardous to summarize them. But, there is some emerging evidence suggesting that activist hedge funds prepared to take a long-term position and work as fiduciaries to improve the performance of the companies they target achieve a better market reaction.133 There is also some evidence that hedge funds with a longer-term outlook are less likely to pursue cuts in long-term growth drivers like research and development, when compared to hedge funds looking for a quick pop.134 This is also the space where practitioners say there is genuine symbiosis between traditional active mutual fund managers and activist hedge funds. It is these companies where mutual fund managers who feel their input over the years has been ignored suggest to an activist hedge fund with proven clout that company X might deserve examination. In this context, the activist can go into the fight with more confidence that the existing investors are frustrated and likely to support an alternative to the present regime. This evidence suggests that hedge fund activism is perhaps most valuable when it involves a somewhat rougher form of relationship investing of the kind for which Warren Buffet is known.135 The activist may need to knock a bit loudly, but once let in, assumes the duties and economic consequences of becoming a genuine fiduciary with duties to other stockholders and of holding its position for a period of five to ten years, during which it is a constructive participant in helping the rest of the board and management improve a lagging company. Nelson Peltz and his Trian Fund Management might be thought of in this manner. Peltz is not a recent business school graduate without management experience. Rather, he has been a successful CEO of several businesses for decades,136 and has been applauded for his willingness to get into the thicket of important work when serving on target boards.137 Precisely because in this story the hedge fund is not really short-term, at least in comparison to the rest of the participants in our short-term markets,138 whatever business ideas it has are likely to be ones that have to consider long-term effects more closely.

In this regard, a caution flag should be noticed by both zealots for and against hedge fund activism. If pro-hedge fund zealots point to evidence that the more successful hedge funds are not in fact short-term, but commit to invest for five to ten years, then they should be far less passionate to defend all hedge fund activism as useful when the results from activism overall seem to be more problematic for other stockholders and society as a whole. Meanwhile, anti-hedge fund zealots should not paint with spray cans and suggest that all hedge fund activists are the same. Rather, they should be less worried about activists who 1) bring genuine managerial expertise to bear; 2) are willing to serve as fiduciaries of the target company; and 3) are willing to hold the target’s stock for a lengthy period.

This point, of course, raises another important issue, which relates to the question of scale: namely, whether this sort of activism, which represents a minority numerically, can grow to be the predominant form, with the more common and less successful hit-and-run approaches going away. Right now, actual companies face both, and that is problematic, especially if the hit-and-run approaches induce companies to take shortcuts that harm long-term performance, leading to those companies being targeted later by other relationship activists as a result of poor performance resulting from managing the company to the market rather than in a sound long-term way.

To conclude, whether the corporations that activists leave behind are better or worse positioned to generate sustainable profits in the future is still debatable, as shall be discussed. But what is certain is that the fundamental premise of an activist hedge fund campaign is that the target corporation is able to and should make material changes in the way it does business that will make the corporation more valuable. Nothing genuinely valuable is cost-free, and therefore all commentators likely can agree that the corporations successfully targeted by activist hedge funds, as well as those corporations who preemptively tailor their business plans to fit the typical hedge fund demand for corporate management changes, will be differently positioned to seize the opportunities and weather the risks of the future. Those changes have the potential to affect human investors in multiple ways, as will be taken up in Part IV of this Feature.

Although this Feature focuses on hedge fund activism and its effects on human investors, it is first necessary to consider the system within which hedge funds exert influence over public companies, their stockholders, and other constituencies including human investors. Part III, therefore, discusses the features of this strange corporate republic we have today.

Iii

The corporate governance system to which human investors are now subject and within which activist hedge funds act was in fact built for humans. Although the history is not in a straight line, it can be safely assumed that when for-profit corporations were first chartered under general, not special, legislation, the underlying assumptions of lawmakers were straightforward. Within the corporate polity, the stockholders were the citizens, and they held the managers, the elected officials, accountable through a system of checks and balances, involving republican election principles and elements of direct democracy to deal with certain particularly important subjects. Corporations were originally seen as having identities that were intensely geographic, and their operations, management, and stockholder bases tended to be concentrated.139 Stockholders were mostly human beings, and they invested for the long term, options for trading were limited, and they made their own voting decisions.140

Perhaps most fundamentally, as the corporation concept expanded and larger corporations with diverse stockholders and large-scale operations emerged, corporations began to take on a national importance and identity.141 Gain sharing among corporate constituencies was for the most part assumed, and it was thought, particularly after the New Deal, that the stockholders and workers of a corporation were in a symbiotic relationship, where profits for the corporations would translate into gains for both constituencies and for the communities in which the corporation operated.142 Even though this was the thought, it was also understood that for the most part, the worker and investor class would not overlap and that workers were unlikely to hold much stock. Rather, stock would tend to be held by wealthy individuals or by corporate pension funds responsible for paying pensions to retired workers.143

But from the standpoint of those forced to save for retirement through 401(k) investments, our so-called system of stockholder democracy now works very differently from these original assumptions. Money managers, controlling other people’s money, not human investors, now dominate direct stock ownership. As a human investor, you turn your capital over every paycheck to funds available among fund families chosen by your employer.144 Those funds are effectively available to you only when you hit fifty-nine-and-a-half years old. Thus, for decades or even generations, the money is not available to you to meet your expenses. During that time, you do not get to pick the shares of stock bought on your behalf or to express any view about how those shares are voted. Rather, you are a direct stockholder of a mutual or index fund, a status that in essence means you have no real voice at all. Derivative suits, proxy fights, and all the things that self-proclaimed stockholder advocates believe are too scarce, basically do not exist at the mutual fund level.145 Exit is your only option, and that exit is to another fund in the same mutual fund family or another family selected by your employer, most of which will look the same as the one you exited.146

The funds in which you invest will not vote in a way that is fund specific. If you invest in a fund that is supposed to be “socially responsible,” it is likely to vote on issues in exactly the same way as the other funds in the fund family, however inconsistent that is with the fund’s stated purpose.147 If you are a rational index fund investor and your fund will not exit until the portfolio stock leaves the index,148 you will find you get no independent thinking at all or any separate voice.149 Rather, your index fund will vote the same way as the actively traded funds in the fund complex,150 regardless of the fact that the active funds do not hold long term,151 and regardless of key factors such as whether the issue on the table is a stock-for-stock merger in which the index fund holds both the acquirer and the target.152

Interestingly, a study that focused intensively on mutual funds exiting companies that are the subject of controversy never focused on what the index funds at the same fund families did after their actively traded fund cousins exited.153 If those funds exited because of dangers of insolvency or other serious risks, what did the fund family do for those of its index investors who still faced the risk? Did they voice concerns on behalf of their stuck-in investors? Or just do nothing? The latter seems more likely given the data on mutual fund family behavior.

Regardless of fund, those who manage active funds are likely to have compensation arrangements more based on the fund family’s profits or short-term returns than the long-term returns of the funds they manage.154 Fund managers will not be the ones who make most voting decisions. Because fund managers find most voting a waste of time,155 the fund family will, at best, establish a centralized voting unit comprised of comparatively less expensive employees, who will develop voting policies and make sure government mandates for voting are satisfied.156 In a materially important way, many fund families tend to defer to proxy advisory firms157 on votes, because this gives them a way to say they have made an informed vote—and thus satisfy federal regulatory requirements158—on the thousands and thousands of votes they have to cast each year.159 Even though fund managers may believe the number of votes is wasteful and not good for them or their investors, they remain silent and go along with those, to be discussed, who press for corporations to be governed on a direct democracy, corporate California model—where there is always an opportunity for immediate market sentiments to be heard and where there is no attempt to establish a rational system of periodic votes on issues like executive compensation or to ensure that certain stockholders with trifling amounts of equity do not burden corporate performance with constant precatory proposals, which involve no cost to them and great cost to corporations. The chain separating actual human beings from voting shares in corporations can be long indeed.

None of the participants in this lengthy chain can be meaningfully thought of as anything other than agents, and the ties of their agency tend to be thicker as to the interests of the money manager fund family seeking profit than to the human investors the power of whose capital is being wielded.160 In 2016, the concept of “superdelegates” playing a material role in the presidential nomination process faced renewed criticism,161 and the voice of superdelegates is being turned down substantially.162 In the corporate governance system, however, we have moved to a system almost exclusively comprised of layers of superdelegates, who have the chance to use the delegated power of ordinary human investors to influence public corporations.

Even worse than 401(k) investors who have (limited) ability to vote with their feet, workers who look to pension funds for their retirement have no investment choice at all, much less any voice over how the power conferred by their capital is exercised. The pension fund decides where the funds taken from the workers’ checks are invested. Although most human investors are locked out of investing in private equity funds or hedge funds or other unregistered investments, pension funds get to do so on their behalf, because of their supposed sophistication. Thus, when unregistered investment advisers fail, it is human investors who have no choice in the matter, who bear the costs. Likewise, pension funds have been active163 in proliferating litigation over mergers and acquisitions that involve no conflict of interest, that were overwhelmingly supported by most institutional investors (often including the pension fund’s own investment managers), and where the litigation delivered no benefits to investors as a class,164 but only to the law firms with whom the pension funds’ board had developed an unusually close and not easily explicable relationship.165 As one learned practitioner said to me, the role of pension funds affiliated with labor unions has been disheartening in this story.166 I agree with that point. Labor unions felt burned by their experience when they believed their support of management in fights over constituency statutes and anti-takeover statutes were not rewarded with a commitment by management to address global competition in a way that involved investment in and nurturing of American workers. Instead, unions saw managers using the statutes to give them leverage for higher pay and severance packages. So, pension funds affiliated with labor then joined forces with others to push for an elimination to structural defenses, to push for options-based executive pay, and in general to push for corporate governance changes that make companies immediately susceptible to influence by the stock market.167 At the same time, labor funds did little to encourage companies to improve risk management practices, to embrace sustainable approaches to value creation, or to manage their businesses in ways that involved good treatment of their human capital.168 Rather, they added their voices to the choir of voices that most fervently pushed for stock market direct democracy.169 This is a complicated story, and it is evolving, but this simple rendering regrettably has the ring of truth.

Relatedly, certain pension funds have been consistent advocates for turning the American corporate governance system into a direct democracy, with constant agitation for referenda and frequent stockholder votes on a variety of topics. The symbiotic relationship activist hedge funds have with pension funds that engage in corporate governance activism is well understood.170 At times, scholars have called the changes wrought by corporate governance activism “small,”171 but the large company-specific changes activist hedge funds have made have been facilitated by those governance changes. By making target corporations susceptible to immediate market pressures through the elimination of staggered boards, proliferating stockholder votes on proposals, the move to turn a decision not to vote into a “no vote,” and similar changes in governance, corporate governance activists have made it much easier for activist hedge funds to prevail in a contest with management. Thus, although putatively arguing that corporate executives should be paid in a way that aligns their interests with those of pensioners,172 pension funds have pushed for annual say-on-pay votes that overwhelm the capacity of voting institutions to vote thoughtfully,173 that are clearly inconsistent with any prudent and rational way of contracting with executives, and that result in the views of proxy advisors being the key determinant of outcomes.174 Pension funds vote yes on the same pay plan for four years, and then vote no in the fifth year, because that year was a poor year economically for the company, signaling either that the prior four votes were uninformed or that say-on-pay is being used as a way to express general unhappiness when that spirit moves the market.

Little apparent effort has flowed from pension funds to rationalize the corporate governance republic, or to consider how pushing for corporate California and therefore for corporations to be subject to the immediate influences of stock market sentiment at all times would affect pensioners, most of whose funds should be rationally invested through index funds, who should have parts of their portfolio in debt, and who need continuing access to quality jobs and wage growth to live a dignified and secure life. For them, pension fund activism would have been far better spent on issues like ensuring that corporations have appropriate risk management structures, fundamentally sound accounting and business practices, and proper capitalization to handle the risks of their business plans. For that reason, the obsession of pension funds over recent decades with causes like reducing takeover defenses, shifting executive compensation from cash to stock options, and other issues more directed to the extraction of short-term gains, rather than ones involving more fundamental questions of sustained long-term performance, seems to reflect the fact that those involved in corporate governance policymaking at pension funds have interests quite different from those who are depending on a pension to fund their retirements.175

In this corporate republic, human investors are basically witnesses to a clash of agents. At best, the human investors can hope that their direct agents (the institutional investors) and their indirect agents (the managers of the public companies) will reach some constructive accommodation when push comes to shove. Focusing on just these layers of agency actually simplifies the typical situation. If a corporation makes a bid for another, the human investor will find the layers of agency compounded, because the institutional investors they directly invest in will often own both stocks. Likewise, when a hedge fund launches a proxy contest in support of its expressed desire for a corporation to change policies, a pension fund may well be invested in the hedge fund, at the same time as it is more heavily invested in an index fund committed to holding the target’s stock until it leaves the benchmark index. The pension fund may also own corporate debt securities of the target. And mutual fund families are not immune from these realities. The 2020 target retirement fund may well own the stock of the target and debt securities of the target. In this mix, of course, will be the proxy advisory firms that can tip the balance in even high-salience cases.

If those who get to suit up on behalf of human investors tended to act like human investors would seem to want, the bystander status of human investors might be less a source of concern. But, in the corporate governance game, the most vocal and powerful of the electorate will be those with investment horizons the least aligned with human investors. This is true not just of hedge funds themselves, but even more importantly true of the pension funds and mutual funds. The pension funds making the most noise are often not the most prudently financed or invested.176 And the actively managed mutual funds—that is to say, the ones most likely to underperform as they depend on outguessing the market—and proxy advisors like ISS drive the voting outcomes, not the index funds.

Within this system, the voice of traditional lenders and other creditors has also gone down.177 With the increasing securitization of corporate debt, many companies do not have a traditional lender.178 And outside of distressed situations, the voice of creditors in monitoring corporate financial practices and leverage is comparatively minor.179 A variety of factors, from low interest rates to competition among banks for lucrative underwriting opportunities, has contributed to an easing of terms for companies seeking new loans. With the advent of terms like “covenant lite” to describe diminution in credit protection, reason exists to suspect that the risk-taking voice of equity has been amplified in part because the voice of creditors has reduced its volume.180

I am not revealing some undiscovered, obvious reality about our corporate governance system. This fundamental fact—that human investors are now largely spectators to the game—is known and occasionally kept in mind. Most prominently, it has been reflected in trying to address the reality that who we think of normatively as “owners” in the real sense do not exist. The most high-profile of those efforts was to get CEOs to think like owners rather than as highly, but reasonably, paid salaried workers. Instead of steady captains of safe, stable ships, money managers wanted American CEOs to be risk takers, going hell-bent for equity gains, even if that meant hurting or compromising constituencies like workers through downsizings or communities through plant closings and offshoring.181 Money managers, activists of many kinds, and other interests called for management to get paid in equity, with the growth of stock options being among the first results of that advocacy—to align them with the so-called “owners,” those who hold corporate stock.182 These owners in turn called for more and more independent directors—fiduciaries with no prior ties to the company or its indirect competitors, suppliers, or customers—to check management even more.183 To make them think like owners, independent directors were supposed to be paid in equity.184 The compensation of these independent directors has grown enormously.185 And it creates strong incentives for directors to support transactions that involve a sale of the company and will therefore unlock the capital that they would otherwise be required to keep invested.186 Not only that, because of the influence of proxy advisors and certain vocal institutional investors, independent directors who wish to remain on the independent director circuit—which likely comprises almost all of them—are highly sensitive to resisting institutional campaigns at any company on whose board they serve, for fear that they will be targeted for withhold campaigns at all companies with which they are affiliated. That fear is rational because the leading proxy advisory firms look at director performance at other companies when voting at particular companies, and so do the largest investment fund.187

Less focus, oddly, was on those who claimed to be owners, i.e., the money managers who controlled the funds that held human investors’ wealth, than on the managers and directors of public companies. And the alignment between the interest of fund managers and human investors is, at best, imperfect, and at worst, out of sync.188 Funds under management, short-term performance benchmarks not aligned with fund investors’ horizons, and other factors drive their compensation. Nothing close to a serious attempt to subject fund managers to the risks of truly stuck-in 401(k) investors has been made. Pervading all efforts at alignment is the fundamental question: ultimately, are we good enough at creating efficient and reliable incentives that hold the full chain of agents accountable for representing the interests of the long-term investor to whom they ultimately owe the duties of loyalty? Ordinary people’s wages and wealth have stagnated, while the take of the financial classes—who control ordinary people’s capital—have soared.189 So far, acting as if alignment can be created by giving agents some form of instant, Tang-like ownership—which turns them after-the-fact into what an owner in the traditional sense would already be—has generated big picture results that have been less than outstanding for human investors.190

In this complicated design process, have we lost something? We have spent all kinds of time trying to make managers—a form of worker—have the incentives the stock market wants. But have we forgotten that most Americans would rather the system generate the most wealth for workers? Have we aligned on the wrong dimension? And is this misalignment because of a prior shared sense that “what was good for GM” was good for America,191 when it was thought that with jobs came growth, and as profits grew so did wages?

Into this republic sliding toward full direct democracy, we must connect the role of the hedge fund activists. Now, this corporate republic has a concept of citizenship that is truly remarkable in its liberality. There is no waiting period or application process to be a citizen, or even to be elected to the highest office of this republic; buying stock is all that is required, and you can come and go largely as you please. In the case of activist hedge funds, the evidence of their behavior as corporate citizens is clear. As explained in Part II, activist hedge funds are not dissatisfied stockholders who decide to become active in changing policies of the corporation. Rather, they become stockholders for the first time to act on the corporation, change its business plans, and reap a profit over a period that can be as short as a handful of months, but is typically no longer than two to three years.192 Although the hedge fund will argue to other investors that its plans are durably valuable and maximize long-term returns, the hedge fund will itself not stay and reap the long-term gains for its beneficence. Rather, it will exit, take whatever gains have been baked into the stock price, and leave the actual upside and downside of the change it wrought to others. In fairness to the activist investors, they may actually hold the stock longer than the horizon of the traditional money manager whose votes will determine the outcome of any showdown vote on the proposal. Yes, index funds will also vote, but not using their own “brains” or independent investment perspective. Instead, the actively traded funds’ proxy advisor unit will drive the votes, and if the funds vote on long-term metrics, they will be voting in a way that does not match their investment horizon. Turnover rates reflecting their actual behavior—buying and selling—would suggest they are looking to outguess market movements short-term and to reap gains off price movements in the immediate year or so, not off long-term growth as buy and hold investors—i.e., human investors.

The actual holding strategies of both hedge funds and actively traded mutual funds also act as a real world check on the issue of a key academic model—the shareholder primacy model espoused by advocates of corporate California, which justifies a focus on stockholders’ best interests within corporate governance on the normative ground that it is best for everyone because the stockholders can only win as residual claimants if everyone else, including workers and creditors, have their legitimate claims paid.193 This conception, of course, acts as if there is an ultimate reckoning of accounts, and that stockholders can only gain if that final accounting is one where everyone else is treated as they are entitled.194 But that is not how the world works. Certain stockholders can come in and reap trading profits, even if the underlying corporation’s ability to create value is compromised to the detriment of continuing stockholders, company workers, and creditors.195 In fact, those speculative profits do not come out of residue in any but a momentary sense, and because they do not come out of anything like a long-term summing up, those active traders who seek to reap them have no rational incentive to seek to maximize the ultimate residual value of the target firm, just its ability and willingness to generate gains for those who hold its equity over the active trader’s short-term horizon. And the rationalization that they can only exit favorably if the rest of an actively speculating market believes the target’s discounted cash flow value is attractive is less assuring when the range of company trading prices over short-term periods is far more expansive and shifting than can plausibly be explained by fundamental changes in the company’s earnings prospects.196

If most of the intermediaries influencing corporate policies are in fact acting with a short-term perspective, why is it likely that the things that they advocate for will be wise for human investors? Active trading strategies are unlikely to beat the market.197 In fact, those who purport to advocate for stockholder direct democracy tend to tout the semi-strong form of the efficient market hypothesis in favor of their argument. But they ignore that the claim of the efficient market hypothesis is not that a corporation’s stock price at any time is a reliable estimate of fundamental value, but rather that it is not possible to design a trading strategy that will outguess the guesses of the market as a whole.198 Stockholder direct democracy advocates then compound that by arguing to place more and more immediate power behind the views of marginal traders—i.e., those traders who are most likely to be engaged in active, speculative trading strategies dependent on their ability to outguess the market.

Hedge funds, at least of the kind we are focused upon here, argue that their deviation from passivity can result in higher than market returns because they assume non-diversifiable risks and acquire attributes of control from which they can influence corporate policies and extract alpha.199 They also argue passionately for the right to secure a big stake before coming public because it is precisely the nonpublic information they possess—their plans to influence the target’s business strategy—that is not baked into their pre-13D disclosure purchase price. The reason, therefore, that activists can supposedly beat a market return is that they can keep post-purchase gains based on their ability to change the company’s earnings potential in a way that will increase its share price. The industry’s ability to claim success in that regard is compromised, however, by a few realities. Even at the most optimistic of estimates, the returns generated by hedge funds as a whole do not seem to exceed those of the market on a risk adjusted basis.200 And the most optimistic is not the most reliable. Public CEOs that manage corporations into insolvency do not tend to get second acts. But hedge funds fail regularly,201 and the industry-wide data about their returns is likely overstated in a material way by the failure to consider this reality.202 Of course, it is not surprising that hedge funds would fail more; after all, the argument is that they are taking more risk to get more gain. The question, though, is why anyone who believes in the efficient market hypothesis would embrace the idea that hedge fund managers as a class were likely to beat the market. Sure, there may be the fund manager who types Shakespeare for a decade or so, but that anomaly is likely to be just that. Investors who thought high-flying hedge fund activists were writing A Midsummer Night’s Dream earlier this decade likely found their 2015 reports announcing record-breaking poor performance to read more like a disgraced politician’s “mistakes were made” speech.203 And the hedge fund industry’s overall performance has decreased steadily since the late 1990s,204 raising questions about whether hedge fund activists can continue to grow and find high-quality targets.205 More fundamentally, if it is now the case that hedge funds predominantly focus on consistently profitable firms that they believe should pay out more to their investors now,206 there is less reason to think they are making the economy much more efficient and more reason to be concerned that they are perhaps pushing steady producers of societal wealth on a riskier course that has no substantial long-term upside.

Another worrying trend in this republic is the unmooring of corporate citizenship. Corporate citizenship is not tied to any natural conception of citizenship, and so-called American corporations have a large international investor base and derive large portions of their revenues from off-shore operations. The adage that “what’s good for GM is good for America”207 is likely to induce justifiable eye rolling if it is applied to many American corporations now. In fact, many household names have abandoned the United States as their domicile altogether, putting the chance to secure a tax haven and calmer governance controls over any concern for national identity.208 American institutional investors have been happy to support these abandonments of our nation.

No doubt, it would markedly overstate things to attribute stagnation in median wages, simultaneous explosive growth in executive compensation and pay for financial industry participants, and overall income and wealth inequality to the increasing ability of momentary stockholder majorities to influence corporate behavior through the adoption of corporate governance policies moving corporations toward a form of direct democracy. But it would also be wrong to ignore the influence that enhancing the power of a stock market focused on immediate gratification has on the way public corporations approach doing business. Investing in their workers’ productivity to increase profits over the long term takes more time than offshoring jobs to nations where workers receive pay that none of the advocates of stockholder power would accept for themselves or their children. Keeping the market happy with stock buybacks, special dividends, or a tax-slashing inversion may involve less headache than sticking by a thoughtful, substantial program of long-term capital investment. Shortcuts become comparatively more tempting when those who wield the power seem more focused on near-term returns than cultivating sustainable wealth.

Admittedly, these big picture facts cannot be solely or primarily attributed to policy moves within corporate law itself or to the increasing power of institutional investors and immediate stock market sentiment over public companies. Trends likevigorous international competition that accelerated rapidly since the 1970s, the reduction in legal protections for constituencies like organized labor, and evolving technologies have influenced how American public corporations have done business andhad an effect on key issues like employment and wage growth, income inequality, and the extent to which corporations can engage in gain-sharing between their equity investors and other corporate constituencies, such as workers and the communities in which the corporation operates. Likewise, with the globalization of not only product and service markets, but stock ownership itself, corporations have increasingly lost any genuine national identity.

The intra-agent skirmishes of this corporate republic do not fit nicely with the needs of those agents’ supposed masters—human investors. As Part I explained, real humans are stuck in for materially longer periods of time, and they obtain most of their wealth through wages, rather than the markets. What wealth does come from the markets is derived from a mixture of equity and debt. These special attributes of human investors, distinct from the other members of the corporate republic, give them disproportionate exposure to whatever risks hedge funds generate for our country. As I discuss in the next Part, human investors face two main areas of exposure: as indirect investors in hedge funds themselves and as participants in the real economy businesses in which activist hedge funds intervene.

Iv

Hedge funds, as one peculiar class of agents in this corporate republic, have the potential to cause harm to human investors in two different capacities. One that is too often overlooked is that human investors bear risk as indirect investors in hedge funds themselves. The hedge fund industry’s growth has been increasingly fueled by investments made by pension funds to which human investors are looking for support in their retirement. The other source of potential harm comes from the influence that activist hedge funds have on the policies of public companies. That influence involves, most obviously, the changes hedge funds generate when they target specific companies and those companies accede in whole or in part to the hedge funds’ demands. But both proponents and skeptics of hedge funds agree that the influence of activist hedge funds goes beyond the companies they specifically target because the potency of hedge fund activism has an effect on the policies of companies not yet facing the wolf pack’s direct attack.209 Those who fear the wolf rationally have an incentive to do what it takes to avoid an encounter, by deciding to adopt strategies that make it less attractive to the wolves to mount an attack.

A

Although typically unable to invest in hedge funds on their own, human investors are still frequently directly exposed to hedge fund gains and losses. Human investors are locked out of direct investments in hedge funds themselves by a variety of paternalistic, if well-meaning, rules, which include requirements that investors must be able to change their allocation of investments in 401(k)s at least once every three months,210 and by the reality that almost all hedge funds offer only unregistered securities and are thus prohibited from securing investments from anyone who is not a so-called “accredited investor” under Regulation D.211 But those prohibitions do not mean that human investors, or important societal institutions, such as our hugely subsidized university sector and many charities, do not bear investment risk if hedge funds fail or deliver returns lower than the market, on a risk-adjusted basis. It just means that human investors are dependent on the sophistication and fidelity of pension boards and other fiduciaries. Count me skeptical that there has been an exponential growth in the base of sophisticated pension board fiduciaries, which renders them able to assess the quality and prudence of hedge fund investments well, at least in the absence of better data than are currently available.212

The accredited investor exception has its origins in allowing rich investors to engage in caveat emptor transactions if they wished.213 I think of it as the Thurston Howell exception because that iconic figure from Gilligan’s Island comes to mind as the sort of person policymakers believed could proceed at his own risk because we did not particularly care if he got hurt.214 But that exception has ballooned into one that exposes far more than super-wealthy individuals to substantial risk from making investments about which they know too little. Because pension funds, charities, and universities can qualify and claim to be sophisticated,215 they regularly now expose human investors and society as a whole to the risks that come with hedge fund investing. Many pension funds are not in fact well positioned to prudently select hedge funds or other non-registered investments and may be attracted to those types of investments because they have not prudently funded and invested the pension fund in the past.216 Thus, they chase the impossible dream of using above-market returns to fill a hole left by previous underinvestment and poor investing, creating a probability that when the impossible dream does not come true, the hole is even larger. And although the direct investor who makes these investments is accredited, it is the human investor (who is supposedly unable to invest in these vehicles) who in fact bears the risk of investment losses. Making this system even less rational is the reality that the lack of disclosure puts consumers like pension funds and college investment funds in a poor position to shop knowledgeably because track record information is unclear and unreliable, and fund managers seem to be able to tout publicly return records that put to the side their past failures.

The other major question is whether hedge fund activism can actually scale in an effective and rational way, if the hedge funds who engage in the activism are to be a prudent investment for socially important institutions upon which human investors depend, such as pension funds, universities, and charities.217 As has been discussed, as hedge fund activism has grown, its targets have shifted to profitable companies that they think can be even more so,218 but there is also evidence that returns from this shift are less substantial.219 At the same time, more money managers and more money are chasing what seem to be a finite set of high-growth opportunities,220 and that competition is vigorous, so it is not clear that hedge funds will be able to find value gaps that will produce the above-market returns required to justify their greater costs and risks as a larger industry,221 and the evidence to date is that industry-wide hedge fund returns generate either a small amount of return over a safer buy-and-hold market-based strategy, or in fact, are lagging the market.222 Because the activist hedge funds are pursuing strategies in strong tension with what the efficient market hypothesis and market data suggest about prudent long-term approaches to investment, these factors suggest reason for concern that it is socially useful to have important institutions that ordinary investors depend upon investing in hedge funds, especially given the dearth of reliable and consistent information available about them.223

B

The other way that human investors are exposed to the risk of hedge fund activism is the one that is more often discussed. That involves the question of whether hedge fund activism has a positive or negative effect on the long-term performance of the public companies it targets. Because human investors bear risk as indirect investors in public companies and, more importantly, as workers dependent on the economy’s ability to create and sustain good jobs, this issue is very important. This exposure is not limited to firms directly targeted by activists. As Professors Coffee and Palia observe, summarizing studies on the topic, “[f]or every firm targeted [by activists], several more are likely to reduce R&D expenditures in order to avoid becoming a target.”224 A detailed survey of top managers and directors found that corporate boards were not only feeling increasing pressure to think and act short-term, but that boards and managers were themselves more and more likely to propose the types of corporate finance moves, such as increasing stock buybacks, that they perceived activist hedge funds would likely advocate.225 Other companies, perhaps including those in this country’s dynamic sectors, try to find ways to avoid the wolf. An incisive market participant argued to me that stockholder activism is having an influence on even the faster-growing segments of the economy.226 He noted that because even the most successful companies have been targeted by activists,227 entrepreneurs in the technology space are insisting on securing a dual-class structure or other strong defenses if they go public, or they consider avoiding activism another advantage to remaining private.228

For human investors, the overall trends as to the factors relevant to the question of if activism harms or helps them are, at the least, worrying. American public corporations seem to be spending much more of their free cash flow on stock buybacks, increasing dividends, and other tactics to guarantee immediate payoffs than on research and development and other forms of long-term investment.229 For the stuck-in human investor, increased dividends have to be invested back into the very companies paying them out, and the same is basically true as to buybacks. And if the sources of those dividends or buybacks are funds that would have otherwise been invested in developing new products or services, which involve the prospect for greater employment opportunities and growth in the future, this choice of current consumption over future growth is problematic.230 Even Professor Brav, who is generally optimistic regarding the effect of hedge fund activism, admits that hedge funds’ tool boxes are limited and tend to be concentrated in corporate finance moves,231 as discussed in Part II. The reason for this, Brav candidly admits, is that most hedge fund managers are financial, not operational or management, experts and “are not experts in the specific business of the target firms.”232

Another important attribute of human investors is that they are also likely to be invested not just in equity securities, but in debt securities.233 Without disparaging them, it is not clear that mutual fund families spend a great deal of time worrying about the implications of corporate governance arrangements on their investors in funds that focus on debt securities. As discussed, the voice of debt capital in corporate governance has decreased and tends to become loud only when firms are in actual distress.234 And under corporate law itself, the corporation’s lenders have no vote and are left to rely on triggering events of default and other extreme measures.235 Perhaps for this reason, some scholars have found that rather than creating additional firm value, hedge fund activism engaged in by equity investors has the effect of shifting wealth from debt capital to equity capital.236 For human investors, especially those in the years when they actually are relying on their investment portfolio to pay for tuition or their expenses during retirement,237 value shifts of this kind are of dubious, and even perhaps negative, value, especially when solvency risks are considered.238

Perhaps more troubling, there is evidence that equity gains from activism come from the workers of the target firm. Because human investors owe most of their wealth to their ability to find and hold a job, and from the wages that they receive from their labor,239 transfers from labor to equity are likely to hurt human investors. In one paper by respected scholars, the authors referred to the activists reducing “labor rents.240 That is an interesting usage, which suggests that the workers at the target firm were exploiting the equity holders. There are other words than “interesting” for this usage, given the overall trends during the last thirty years of American economic history. During this period, the traditional share that workers have received from increases in their productivity has been eroded substantially to their detriment and to the benefit of equity investors.241 Given this undisputed reality, as well as stagnation in median income and wage growth,242 post-activist intervention gains that result from reducing labor rents might well be considered yet another deepening of income inequality that reduces the wealth of the many to benefit the few.243 Human investors care not just about whether corporations make money, but also about how. Gains that come from squeezing out workers and squeezing those who remain do not promise wealth gains for most human investors, but wealth losses.

Another related issue is the potential costs to human investors in the future, in terms of slower job, wage, and overall economic growth, if hedge fund activism tends to result, both for direct targets of activism and, as a systemic matter, for the overall market, in reduced capital investments. Respected scholars have concluded that after hedge fund activists succeed, targeted firms’ research and development spending materially decreases.244 Now, there are of course contradictory arguments and evidence that hedge fund activists increase the short-term harvest on prior investments and make research and development more efficient.245 What is worrying, of course, is that most of us realize that it is possible, over some period, to milk an asset (human or machine) to squeeze out more. When a new coach or boss comes in, when the workforce is terrified by the prospects of job cuts, when output is pushed to the max in a blitz, results can go up.246 But if the changes are not durable and do not involve policies that are sustainable and nurture future growth, the immediate years of robust harvest can portend future famine. Surveys of corporate managers done by scholars have found that: 1) managers feel the pressure to deliver short-term profits and to develop business plans using a horizon that they believe is counterproductively short-term;247 and 2) managers admit to refusing to do projects with very positive long-term prospects because they would involve reductions in GAAP earnings in the near term and therefore a feared negative immediate stock market reaction.248 Other scholars have looked at the effect of short-term pressure on research and development output and found similar trends.249 Admittedly, there is also some evidence that the intervention of activist hedge funds who are willing to place experienced business executives on target boards and remain as investors for a period more like a typical private equity investor is not associated with declines in research and development. In contrast, the results in interventions by hedge funds who are more short-term and less focused on a strategy of improving their targets’ long-term performance is associated with declines.250

Setting aside the effect activism has on the internal workings of its targets, how stock prices increase matters to human investors. For example, a good deal of the stock price gains that scholars claim result from hedge fund activism come in the form of returns from targets pushed or nudged into sale mode.251 It is, of course, the case that hedge funds sometimes come in on the buy side to argue that the buyer is making an improvident acquisition, sometimes an acquisition urged by another activist.252 What seems less clear is that there is anything like symmetry in this context, as it seems unlikely and not borne out by experience that hedge funds have often come into ownership of acquiring firms to block an improvident acquisition.253 By contrast it has often been the case that hedge funds have bought into corporations and pushed them to sell themselves.254 There is evidence, in fact, that activism aimed at encouraging the target company to sell itself provides the best returns for the activists.255 And to the extent that some hedge funds enter the target side to goose up an already large premium, the potential for negative effects to employees and communities grows, as the only way for the buyer to maintain the profitability of the surviving entity is to jack up the “synergy gains” from the merger, gains that often involve cutting jobs, slashing wages, and closing operations in some communities. In other words, activism of this kind can actually increase the dangers of mergers to human investors.

Human investors experience the benefits and risks of this sort of merger or sale differently from their agents. For one thing, target-side gains must be weighed against buy-side losses. A good deal of evidence exists that mergers are often injurious to the buying firm and its stockholders.256 If human investors tend to be diversified and a merger involves two public companies, it will often, if not usually, be the case that the human investor has a stake in both sides of the merger.257 The question for the human investor is whether the costs of the merger outweigh the benefits, a question that cannot be answered without evaluating the costs to the buying firm and whether the wealth that will be generated by the single entity after the merger exceeds that which would have been expected had the firms continued to operate independently. What is likely, as scholars have long detailed, is that the acquirer in a merger will not do well, and for many mergers, it is not clear that the net gains to diversified investors from the premiums paid to them as owners of targets are outweighed by the collective losses.258

Those stock price losses may not constitute the only way human investors lose out in a hedge fund-induced merger. For human investors, of course, the other costs involved in mergers—which can often involve job losses for workers, demands on state and local governments to provide subsidies as a cost of keeping operations, and the diverse harms that can occur when an acquisition is done at such a high premium that the resulting firm cannot pay its creditors from operations after the merger and must enter bankruptcy259—are very real and little focused on by corporate law scholars.

In certain activism campaigns, activists have set off a chain of events that have caused a transfer in wealth from society as a whole to equity investors. For example, to the extent that activists have pushed for inversion transactions that reduce the duty of previously American corporations to pay taxes,260 the burden to fund important American priorities like national defense, health research, transportation, technologies to address climate change, higher education, and other priorities that matter to Americans—and that provide a support structure within which businesses operate—is shifted to others. Not only that, hedge fund activism has spurred mergers and other activities, such as plant closings and consolidations, that involve wealth transfers to the corporations from society.261 That does not just involve the obvious costs, such as increases in government expenditures for unemployment and other dislocation costs when workers are displaced, but also involves the arbitrage corporations engage in with affected communities when they are squeezed by stockholders. In a case that hits close to home for me, in the activism campaigns at DuPont and Dow that resulted in their decision to merge, any resulting gains to equity holders will involve direct shifts from taxpayers in Delaware, Iowa, and Indiana.262 In Delaware alone, DuPont and its to-be-named agricultural spin-off asked for and received subsidies from the state and county governments, costing other taxpayers over $57 million over four years for keeping downsized operations in Delaware.263 These operations are downsized in the important sense of involving operations that employ at least 1,700 fewer workers, many of whom were skilled scientific researchers and technical workers.264 The hedge fund-inspired merger itself was leveraged by DuPont and Dow to extract value from society itself to give to its hungry equity owners. Whether the merger—which involves two huge science corporations becoming one in order to then become three—will generate more jobs and wealth for Americans in the long term remains to be proven. What is certain is that lots of corporate advisors and others will have generated huge fees when the tumult settles, lots of human investors will have lost jobs, and the affected communities will either have to look to their human citizens to make up for the revenues lost or cut the public services they would otherwise have delivered.

Admittedly, no one wants executive rent seeking or empire building for its own sake. Perhaps hedge funds are operating on companies that face slack competitive pressures to otherwise be efficient in deploying capital? Perhaps they squeeze oligopolies? I suppose this story would be more plausible had we not just gone through nearly fifty years of robust and ever-growing international competition. Yesterday’s Japan became today’s China, without lessening the vigor of Japanese competition, or Korean, or German, or Swedish for that matter. Even without hedge funds, private equity firms, strategic acquirers, and institutional money managers have had sharp eyes on American public companies. Without doubting that inefficiency will always tend to creep into some organizations, the overall vigor of competition seems to belie the idea that large pockets of “fat” exist that can be cut, cost-free. Thus, fear that what may be occurring are cuts in investments in “muscle” are not irrational, but instead arise from considering the larger facts about the markets and incentive systems within which American corporations and their managers work. And this is the crucial point often lost in corporate governance debates: Just because a fact is large and systemic does not render it unimportant. That a “law and ampersand” scholar can’t fit it into his model without creating too much noise does not make the uncomfortable sound of reality go away.

Looking at the big and systemic facts from the perspective of an average American human investor, the world is not an optimistic place. Median income has stagnated since the early 1970s.265 Productivity increases have slowed and wages never did fully experience the benefit of the rapid productivity increases of the last two decades.266 Economic growth is stagnant.267 The government has been compelled to provide giant subsidies to corporations engaged in risky commercial conduct.268 At the same time, the number of American public corporations has declined sharply.269 Finally, there is a growing disparity between the pay of CEOs and that of average workers, symptomatic of a general increase in inequality.270 These larger considerations raise an issue about hedge fund activism’s effect on human investors that is serious. If proponents of hedge fund activism disclaim that activists have contributed to these negative trends—things like growing income inequality, inflated executive pay, job losses, wage stagnation, increases in externalities—and instead attribute them to vigorous international and domestic competition in products and services markets, they must consider the consequences of that answer. If that type of competition is already acting on American public companies, does it add socially useful value for activist investors with short-term perspectives to put additional pressure on them, pressures that tend to involve increases in near-term payouts rather than innovative, long-term investment strategies that position the United States and its worker base to thrive in the future? In other words, if competition in products and services markets has already squeezed out most of the slack, the likelihood that pressures that predominantly involve demands for corporate finance moves, like leveraging up, spin offs, or mergers, will create incentives for corporations to focus their energies on ways of making money that are also good for their workers and society seems less probable.

C

In the clash between small, less important facts that the law and ampersand movement can measure and evaluate, and bigger, more important ones the movement seems to slight because it cannot, modesty would suggest grappling with the larger facts in as candid a way as possible and not instead exaggerating the significance of less important facts, such as short-term stock market prices, that law and ampersand scholars can turn into mathematical equations and when the smaller facts you measure are themselves less than assuringly reliable, there is even less basis for failing to challenge your ideological world view against the systemic facts.

In that vein, the most hotly debated topic regarding activist hedge funds does not, however, involve whether it is good for human investors for pension funds and charitable institutions to invest in them or whether human investors benefit from the changes activist hedge funds work on human investors’ employers. Rather, the central topic has been whether hedge fund activism has a positive or negative effect on the stock price performance of public corporations. Specifically, much ink has been spilled on the question of whether companies targeted by hedge funds enjoy durable increases in their stock prices after the activist intervention has occurred, and whether any resulting gains reflect an increase in overall societal wealth or a transfer in wealth from other corporate constituencies to equity holders. These debates are ongoing and vigorous.271

Distinguished corporate practitioners have also jumped into the fray, complicating the lives of those obsessed with regressions by introducing perspectives from those in the trenches.272 Firing back, scholars with their own firm ideological views have in turn vexed the practitioners by taking them up on duels regarding what data is necessary to prove their contending perspectives.273 Although some of the intellectual fisticuffs have a “handbags at six paces” quality, the intensity of the interaction is suggestive of the shared agreement of the participants that the subject they are discussing is societally important.

Empirical data is a very useful thing, and it should not be ignored. But empirical data also involves factual renditions of what is behind a statistic that has been aggregated. For humans interested in knowing about their human world, that means that the story behind statistics matters. And the stories behind the empirical data cited by hedge fund activists seem to mostly involve financial engineering. And what they do not commonly involve is most important. They do not involve tangible stories of technological breakthrough accomplished because hedge funds have identified an innovative new way to make something. They do not typically involve thinking up new services that humans need or even want. They do not typically involve transformational approaches in managing businesses, or in marshalling the productivity of American workers. Even as to interventions by hedge funds led by experienced, proven operators, the scholars have not yet put names of companies to the data, to show how the hedge fund has improved corporate operations in a durably valuable way.274 By contrast, examples of operational failures, such as the interventions at J.C. Penney275 and Sears,276 are widely known.

Of course, if one could peer behind the regressions and consider the human facts, these overall tendencies are not surprising. Hedge fund managers have typically never managed an actual business that makes a product or delivers a service. For the most part, they are the sidewalk superintendents of management, those who by dint of having gotten a prestigious M.B.A. and being good in finance classes, were recruited into the stock-picking business. Finance is what they were taught and what they focus on. This is not a criticism; it is simply an observation, but one that cannot be logically ignored by anyone concerned about facts. Because if the reality is that the ability of corporations that make products and deliver services to generate sustainable profits turns more importantly on talents that do not involve financial engineering, then why would one rationally expect that business strategies shaped by pressures from hedge funds lacking any substantial managerial, technological, scientific, or entrepreneurial expertise would be engines for long-term wealth creation?

Participants in the debate about our corporate governance system often joust about the comparative relevance of examinations of empirical evidence from relatively short-term periods and of arguments based on more descriptive evidence about how corporations and the institutional investors who influence them behave. I have no desire to disparage either source of information, as it seems to me that someone who is open-minded ought to be willing to consider a variety of relevant factors in coming to conclusions about important issues of public policy. But being open-minded does not require paying homage to arguable results from arguable data measuring results inarguably inconsistent with the horizon relevant to human investors and relevant to those who actually manage real businesses. As to the debate about wolf packs, there are several factors that make these studies a dubious guide to good policy.

For starters, the gains to target stock prices from hedge fund activism do not seem that impressive, even when taken at face value. Professor Bebchuk’s five-year analysis of target company stock price performance finds value-weighted abnormal returns of 5.81% over that five-year period (by another measure, investors would have experienced a slightly negative abnormal return).277 But these gains are not measured in a way that makes for easy acceptance on that basis. For example, that study starts with 1,584 companies targeted by activism and ends with 694 companies in year five.278 This is a large drop, and each company’s fate is not tracked and documented.279 Undoubtedly, targets were pushed into sale. Others may have gone insolvent, though. And the overall gains seem largely driven by those targets that did get sold for a premium, rather than by increased productivity or the execution of a new business plan.280 Scholars who bring a non-ideological perspective to the debate have questioned how sufficiently that study’s data supports its findings.281

Duration is another issue. The longest of the studies measure the impact of hedge funds over a period—typically two years, with one important study tracking performance for five years following activist intervention282—that is decidedly not long-term. Human investors save for two primary purposes, paying for college for their kids and paying for retirement for themselves. Determining that hedge fund activism is not associated with any negative impact on stock price during a one- to five-year period is not the same thing as determining that the changes in business policy generated by that activism produce more wealth for human investors than a policy not influenced by their behavior.

The argument, of course, is that if the stock price increase driven by activism endures for one to five years, that means that the activism has not reduced the corporation’s ability to generate sustainable returns over the long term. But proving that is not only difficult, it also seems to me to require a long-term analysis, which scholars have not done. If market prices are dominated by speculation (i.e., traders with short-term perspectives) and thus those involved in marginal trading tend to be focusing on short-term movements in prices, it seems possible that the changes activists cause could, in fact, reduce the firm’s long-term earnings without necessarily causing it to suffer a stock price reduction in the near term.283 That is especially so if activists are targeting so-called value firms that are profitable but pre-intervention are reinvesting more cash in the business or retaining more of it than other firms. It is, of course, possible that changing their financing to reduce capital expenditures and increase current payouts will have no negative impact on the firm’s earnings future, but it is also possible that it will have a negative impact but that the effects are not felt enough in the near term to have a negative effect on the stock price.

As to this point, this is where ignoring long-term trends and the absence of plausible real-world stories comes in. The big picture for human investors entails declining wages, growing inequality, and greater international competition. At the same time, pension money has flooded into the market and demand has met supply with more funds looking for investments and more analysts searching for value gaps. Between these two trends, it is unclear what story hedge funds have to explain how they create long-term value.

V

As the preceding discussion suggests, any policy initiative sensibly designed at better balancing the benefits and risks of hedge fund activism must focus as much, if not more, on the incentives and duties of other institutional investors and other agents who participate in the corporate governance debate, as much as on the activist hedge funds themselves. In this final Part, I offer a measured set of proposals, beginning with regulatory changes that would increase hedge fund disclosure of factors, such as performance, managers’ compensation, and prior manager fund failures, that are relevant to human investors and their agents. Then, in a similar vein, I propose changes to current position-reporting rules so human investors, mainstream institutional investors, proxy advisory firms, target corporations, and other participants in our corporate republic can understand an activist’s overall economic positions in a target—and take them into account accordingly. Expanding my focus from the wolves to their prey, I next turn to what the rise of activism means for public companies and how those concerned about activism’s effect on their investments should think about certain corporate takeover defenses. The balance of this Part considers what other participants in this corporate republic—including the agents who hold human investors’ equity capital—can do to better align their actions with the best interests of human investors. I offer reforms that will best promote a long-term perspective on the part of human investors in how they hold their mutual and index funds and on the part of funds themselves in terms of how they vote and compensate their managers. Finally, I propose that we treat human investors more like adults and give them direct access to invest in private equity funds that have investment philosophies more aligned with long-term investors than those of actively traded mutual funds.

* * *

The primary issues regarding the regulation of activist hedge funds are similar to those faced by many industries when they reach a level of success where they wield power that affects society in a materially important way. When that happens, it is often the case that the emerging industry must be prepared to disclose more about how it works and to be open about its interests.284 To my mind, there is nothing intrinsically worrisome about the philosophy of activist hedge funds. Whether or not I or others believe their approach to investment is sustainable on the scale to which it has now grown is not a sufficient basis to ban the industry. If it were, then actively traded mutual funds would be on regulatory death row. And, as to those hedge funds willing to, as my British friends say, get stuck in, contribute meaningful management expertise for the long term, and eat their own cooking, I harbor little skepticism at all, so long as the fund matches its actions in long-term commitment to its upfront promises.

But what does distinguish all activist hedge funds is not only that they do not have to make anywhere near the level of disclosure required of investment funds registered under the Investment Company Act, but also that the activist funds are not passive investors, and instead have as their goal influencing the business plans of their targets in a manner that therefore affects other investors and other corporate constituencies. Furthermore, because it is not the case that hedge funds take only investments from wealthy individuals who are well positioned to bargain for themselves, but take money from pension funds, universities, charities and other institutions on which ordinary Americans depend, the rationale for allowing them to continue to disclose so little in terms of reliable track records, taking into account past failures, is hard to discern.

To better protect human investors from direct investment risk, it would therefore seem useful to enhance the disclosure hedge funds must provide to those considering investing in them. The additional registration and disclosure mandated by Dodd-Frank285 was a step in the right direction, but it was not sufficient. Recognizing the reality that hedge funds’ main investors are increasingly socially important pension funds and university and charitable endowments on which ordinary Americans depend, rather than wealthy and financially sophisticated individuals, suggests more and standardized disclosure about hedge fund performance should be required. Under this model, institutional investors who are fiduciaries of pensioners, universities, or charities could not purchase hedge fund investments that were not subject to a more extensive disclosure regime. This disclosure regime should require complete disclosure regarding the fund manager’s past track record so that over time better public information about specific fund managers and overall industry performance is known. Especially important is a requirement to identify closed funds and account for their records, including the records of the funds that failed. Likewise, it is vital that regulators develop a standard disclosure regime allowing for reliable comparisons of what the sponsoring fund manager made, considering its profit participation, total fees, and returns, and that of its actual investors, and taking into account their costs, including the manager’s compensation. These should involve clear charts comparing how dollars invested resulted in investment gains, net of fees, over time in comparison to the overall market and to the fund manager itself. As for all investment funds—not just hedge funds, but traditional mutual funds, too—disclosure about average and median holding periods for particular investments would be illuminating, by giving investors and regulators reliable information about portfolio turnover and how much a fund deviates from a buy and hold strategy. These disclosures, in all respects, should not allow for material variations among funds, but rather create reliable information about industry performance and its effect on investors.

Now it may be that some will argue this disclosure regime would lock these institutions out of this sector. There are two answers to that concern. The first is that if those are the consequences of increased disclosure, a departure from the sector might be preferable to a status quo where human investors and society as a whole face risk from fiduciaries poorly positioned to be good consumers of funds whose investment philosophy is unlikely to beat the market over time, especially when risk is considered. The second is that this is a false choice. The hedge fund industry cannot function at its current scale without finding investments from pension funds and the like, and would, as a practical matter, be required to comply with a sensible registration and disclosure regime that takes into account the industry’s unique investment style—no need to disclose the “secret sauce”—but that recognizes that style is no justification for lack of other forms of reliable disclosure. This would help pension fund fiduciaries make more informed decisions about with whom they entrust their real human beneficiaries’ capital.286

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Consistent with the focus on disclosure, more should be known about hedge fund interests by the rest of the market. Scholars have argued that hedge funds are useful in framing debates between themselves and corporate managers, which mainstream investors like mutual funds can then resolve using their voting power.287 This contention, however, is problematic if the electorate does not have full and complete information about the activists’ own economic interests. Just like institutional investors have called for corporate managers and directors to disclose their economic interests, so too is it vital that the electorate know just how long an activist is in the company and any arrangements relevant to its likely holding period. The current reach of Section 13 is incomplete, outdated, and has not kept pace with financial evolutions. It seems a modest and inarguable improvement to require all-in disclosure of financial instruments of any kind—long or short, natural or synthetic—tied to the value of the company’s stock so market participants can understand a fund’s ability to gain from increases or decreases in a target’s stock price. All in, pure and simple, no exceptions. Likewise, disclosure relating to any contractual or other arrangements that relate to the hedge fund’s incentives, commitment, and ability to hold the target stock should be reported so that its likely investment horizon can be evaluated by the electorate. Given the emerging evidence that funds that act as long-term relational investors are associated with better outcomes, disclosure requirements that bear on the hedge fund’s investment horizon and willingness to remain as a long-term investor as well as bear the risks of its proposed strategy as long-term investors would be valuable. This important information would help mainstream investment funds and their proxy advisors evaluate whether activist incentives are really aligned with the best interests of the target’s long-term investors.

In addition, after an activist has come public under Section 13(d), real-time disclosures of changes in position, as are now required in the United Kingdom and the European Union generally, should be expected. Even Professor Bebchuk, an ardent opponent of amending the rule to require more timely disclosure, is troubled by the evidence he has found of substantial rates of noncompliance with the existing disclosure rules.288 An effort by the Securities and Exchange Commission (SEC), similar to its 2014 sweep of routinely late-filing insiders,289 could help increase the baseline level of compliance with the current rule in a way few involved in the corporate governance debates could criticize.

And, of course, evidence that other hedge funds follow the scent of the alpha wolf supports updating Section 13 to require more prompt disclosure when an investor crosses the reporting threshold. It seems entirely clear to me that the idea of Section 13 was that an investor should come public as soon as reasonably possible after hitting the 5% threshold and that the reporting deadline was due to what it took to type up, proof, and deliver to Washington the required filing in 1968, when word processors and electronic filing with a button push did not exist.290 But, the hedge fund industry wants to grab more stock than 5%. Fair enough, I suppose. But how about then coming up with a sensible higher threshold—say 8%291—and requiring immediate reporting upon hitting that threshold or a requirement to cease further acquisitions until disclosure is made. Opponents of reform vehemently argue that situations when a hedge fund or its fellows in the pack have come public with control of over 10% are anomalous292 and that most hedge fund activists come public with a median stake of 6.3%.293 If that is so, how about using a sensible threshold as the basis for a new rule? Additionally, sophisticated commentators have noted that using a single percentage threshold for all companies, regardless of market capitalization, is a rather blunt instrument, given the variation in market capitalization of U.S. companies. Perhaps, then, it would make sense to have a threshold that is lower—e.g., the current 5% threshold—for purchases of shares in large cap companies and one that is higher for small- and mid-cap companies, where a larger percentage stake is necessary to obtain an economic interest sufficient to reward the activist for its costs.

Furthermore, given the strong evidence that activist accumulations seem to be discovered by other wolves and that these other wolves engage in trading before the alpha wolf discloses to the larger public, there seems to be a strong basis for requirements that address what information an activist can share with others before the activist goes public. A presumption that a tip made between investors creates a 13(d) group might be one way to do it.294 The argument that hedge funds should not have to disclose until they can stake out a position that is sufficiently large to justify the costs of their activism is understandable. What is not understandable is carving out an exception that allows funds to selectively share knowledge of their purchases and other plans with industry colleagues while keeping the larger community of investors in the dark.

Some commentators believe that activist investors should be considered fiduciaries, owing duties of loyalty to their targets on the grounds that they act on their targets, influence their business strategies, and thus wield elements of corporate control that affect all other investors.295 Adolph Berle, no less, presaged the potential power of institutional investors and the need to regulate their power.296 This is a complicated topic, but I do agree that there is more comfort for other investors and corporate constituencies when an activist hedge fund places a representative on the board, and, as a result, is subject to a host of equitable and legal restrictions. These include the state law and fiduciary trading restrictions that result if the fund representative on the board has access to non-public confidential information, both by their status as an insider297 and by typical provisions operating to restrict the fund’s ability to trade apart from regulation.298

Eliminating the unfair tax advantages hedge funds get over other human laborers—e.g., the ability to treat some of their managerial income as capital gains rather than wages from labor under the “2 and 20” model—would also diminish the ability of hedge fund managers to reap profits not shared with their investors and their targets’ other stockholders in the long-run.299 This would therefore shift the activist hedge fund market directionally toward those fund managers able to generate value by contributing managerial expertise that creates durable value for the public companies in its portfolio.

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Under the current Section 13(d) stake disclosure regime, concerns about creeping control from wolf pack behavior are not irrational. In much of the world, the definitions of when an investor or group of investors are considered to have control are triggered at lower levels than is the case in U.S. corporate law. In the European Union, it is common for any group of concerted investors who acquire 30% of shares to be required to make a mandatory offer to all other stockholders to buy their shares.300 The emergence of a bloc of stockholders who can deter other bidders and influence corporate management poses risks for other stockholders. Institutional investors have long salivated for sell-side premiums. Thus, they should understand why it is useful to ensure that control is not bought on the cheap, leaving ordinary investors without a takeover premium and potentially subject to a riskier business plan. Especially in a world where classified boards are increasingly rare,301 institutional investors should rethink their traditional hostility to poison pills. A standard poison pill used by a declassified board can do human investors more help than harm by preventing a creeping takeover where an activist or wolf pack acquires effective negative control over a corporation without paying a control premium. An innovative refinement to the standard pill comes from Professors Coffee and Palia, who have proposed a “window closing” pill structured to force activists to disclose their stakes before the end of the Schedule 13D ten-day period.302

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But the most important changes suggested in this Feature are not within the hedge fund industry itself. Rather, human investors would see great benefit from reforms encouraging the agents responsible for their money to adopt the long-term horizon held by their principals, i.e., human investors.

First, recognizing that mutual funds and other institutional investors face irrational incentives to compete on short-term metrics rather than areas aligned with the interests of human investors is vital. Demonizing fund managers is unfair when they face cost-free fund hopping from their investors and equity investors get credit for holding an asset long-term if they can eke out a year. Adoption of a sensible fractional trading tax on all securities transactions, including transactions by 401(k) investors, and capital gains reform to make eligibility for a long-term rate dependent on long-term investment would help fund managers focus more on long-term returns.303 Not only that, Pigouvian taxes like these discourage speculation, including in derivatives, thus reducing systemic risks and the need for more complex forms of regulation. And they would also raise world government revenues to invest in infrastructure; basic research to address critical issues, such as climate change; and human capital to give workers the skills needed to compete in more technologically advanced societies, thereby fueling long-term economic growth.

At the same time, corporate managers are often hostage—or at least feel hostage—to the metrics they are required to report in securities disclosures, and to which fund managers and stock analysts look when considering if they will invest in or recommend the stock. An interesting proposal has been made to give corporations greater market credit for a type of investment that human investors should care deeply about—investment in human capital, such as job training.304 Unlike research and development spending, which is typically disclosed as a separate line-item on a company’s income statement, expenditures on human capital are lumped in the Sales, General, and Administration (“SG&A”) expense line.305 SG&A is also home to the kinds of general overhead expenses that investors, activist or otherwise, like to see kept to a minimum, and so this disclosure regime creates an incentive for corporate managers to cut back on the all-important investment in human capital.306 Commentators concerned that activist campaigns will put even more pressure on human capital investments have thus urged that the SEC require disclosure of several variables related to human capital investment, including, most importantly, disclosing the total amount spent on worker skills training.307 There are perhaps other changes to public company disclosure that would similarly help align the metrics corporate managers are measured against to the interests of human investors.

The index and mutual funds that are primarily responsible for human investors’ money should vote with their investors’ needs in mind. This is a relatively simple proposition to state but, as discussed elsewhere in this Feature, it gets lost in practice. Index funds should be required to use voting policies and recommendations tailored to the reality that they have only voice, not exit options. Human index investors do not benefit from bubbles or corporate-governance fads. Thus, index funds should be required to think independently and vote in a way that reflects an informed judgment about what is best for their investors over the long haul—not just what the fund family proxy unit or, even worse, a proxy advisor has generically instructed it to do. To that end, index funds should be precluded from relying on proxy advisory firms that do not provide guidance tailored to index funds’ unique buy-and-hold perspective. Admittedly, there are promising developments in this field. A prominent investment manager, Blackrock, has voiced the need for and utility of index funds more assertively voting their stuck-in, long-term perspective.308 And, some important money managers have signed on to a paper arguing for a “new paradigm,” which contains a call for money managers to adopt a set of shared principles predicated on the goal of “economic growth that benefits shareholders, employees and the economy as a whole.”309

Both index funds and mutual funds should also take a fresh look at their policies and how the policies fit with the long-term growth conducive to human investors’ needs. Any fund that accepts 401(k) or college savings money should be required to have voting policies specifically tailored to the long-term purposes of those investments.310 At a minimum, increased disclosure demonstrating, as a practical matter, how much a given fund deviated from off-the-shelf voting procedures would help investors gauge if a fund advertising itself as socially responsible or for the long-term actually behaved that way.

Implicit in these proposals that essentially urge more thoughtful voting behavior is a need for votes only on those matters requiring thought. Rolling back the federal mandate that essentially requires institutional investors to vote on every measure before them would be one way to begin to achieve this end.311 As former SEC Commissioner Gallagher has argued, money managers have approached voting with too much of a “compliance mindset” rather than a “fiduciary mindset,” and he at least partially attributes that shift to the SEC.312 Rule changes allowing institutional investors to make rational decisions about what votes actually mattered to the investment objectives of their human principals, and focusing their limited resources on analyzing the optimal way to vote would be useful.

As important, if proxy advisory firms are going to continue to be an important influence on the behavior of societally important institutions like money managers and public companies, they should be regulated in the public interest. Sensible requirements preventing investment funds from relying upon proxy advisory firm recommendations unless those are tailored to the fund’s investment style and horizon would create incentives for proxy advisory firms to do better; and in particular, force them to develop voting recommendations and policies tailored to index investors, who are uniquely long-term and committed to sustainable wealth creation. A bill in Congress was introduced313 and action at the SEC has been suggested314 to address the responsibility of this industry, which only exists because of changes to federal laws, such as ERISA315 and the Investment Company Act,316 in recent decades mandating that institutional investors have voting policies.

As important, stockholder votes should only occur if the electorate can actually take them seriously and vote on an informed basis faithful to the investors’ interests. It comes with little grace to simultaneously argue that corporations should be inundated with thousands of votes on say-on-pay, 14a-8 proposals, and the like, and then argue that institutional investors cannot possibly be expected to vote on a fund-specific basis because that costs too much. That is inconsistent hypocrisy. Stockholder voting is only valuable if it is thoughtful and helpful to holding corporations accountable for the creation of sustainable wealth. Burdening corporations with constant referenda at the insistence of institutions that do not wish to invest in thinking about voting is a wasteful drag on social welfare. If something is important to do, it should be done only when it can be done well.

The current frantic cycle of say-on-pay votes in particular is not conducive to thoughtful voting and could be made more rational on a systemic basis. The initial legislative mandate for say-on-pay votes did not require that they be held annually.317 Holding say-on-pay votes every third or fourth year would allow investors to cast their votes more thoughtfully, both because they would have fewer votes to focus on in a given year and because they would have an actual management track record to assess. The incidence of costly 14a-8 proposals could be reduced by sensible reform involving a required filing fee, a higher ownership threshold, and a stronger bar on resubmitting proposals that have failed.318 Scholars have noted that as a practical reality, there is “no alternative to stockholder democracy.”319 Taking that as true, they recognize, makes it even more important that the system of so-called stockholder democracy works for those whose capital is ultimately at stake, not just for the agents who control it. The continuing creep toward direct stock market control of public corporations is difficult to reconcile with any sensibly constructed system of accountability toward human investors. Instead, what it maximizes is the disruptive power of momentary coalitions of agent money managers, which may act at any time on a corporation, rather than in a rationally ordered system of accountability focusing on sustainable and ethical wealth creation.

Perhaps fund managers would be more likely to think and invest in a manner more aligned with their investors’ long-time horizon if their compensation was more tied to the performance of the funds they manage than to that of the asset manager who employs them.320 Although, as with compensation for public company managers, this is a complex task, subjecting a material part of a fund manager’s compensation to the same realities that, for example, 401(k) or index investors face, should better align their interests. Moves in this direction would also move in a complementary direction with the incentives that would be created with tax reforms that priced the costs of fund-hopping and portfolio turnover, and together help solid, buy-and-hold fund managers adhere to fundamentally more sensible strategies, without as much fear of losing funds under management because of short-term market sector bubbles or busts.

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Finally, and consistent with these prior thoughts, human investors should have investment options tailored to their long-term investment horizon. Although many of these other proposals would help sharpen money managers’ focus on the longer term, some investments are structurally better suited to the patient money of a twenty-five-year-old starting to save for retirement. A locked-in ten-year investment in a private equity fund of funds would arguably be a more appropriate place for retirement investments the saver will not touch for at least three decades, as compared to an actively traded mutual fund that frequently turns over its holdings in search of benchmark-beating returns. Unfortunately, providing an option to allow for human-investor access to private equity as part of the 401(k) portfolio requires overcoming numerous regulatory barriers.321 But as between actually traded mutual funds and private equity, the latter is clearly a more rational choice for human investors. For this to be feasible, however, the private equity industry must be assured that it can aggregate pools of capital from ordinary investors for lengthy periods. It is an unwise paternalism to facilitate worker access to churning mutual funds, while denying them the arguably most rational choice after index funds.

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Most of all, however, it is time to ask whether we have lost our focus on what is most important in the corporate governance debate. As this concentration on human investors reveals, it is the economy’s ability to create and sustain good jobs that remains most important to most people. The current corporate governance system, however, gives the most voice and the most power to those whose perspectives and incentives are least aligned with that of ordinary American investors.

If empowering short-term investors turns out to be optimal for our society and its human citizens, that seems like a very improbable and unsustainable triumph of the law of unintended consequences. Call me old-fashioned, but it would be more comforting to know that those with the power over the capital—equity, debt, and most important, labor—of ordinary Americans were duty-bound to align their thoughts and actions with those they supposedly represent. American optimism makes me have confidence when we pull together toward a common goal, but be consequently skeptical when the many are asked to accept that what is good for the plutocrats is good for them.