Activist Investors In Minnesota - A Primer For Officers And Directors

Minnesota-based companies have not been immune to attacks by

activist investors. This article discusses what is driving the

trends in investor activism, what companies are susceptible to

activist investors, why activist investors are successful,

strategies of activist investors, target defenses and responses

and other recent developments.

Activist Investors in Minnesota

A number of activist investor campaigns have occurred in

Minnesota, including:

In 2004, Opportunity Partners announced it had taken a

position in the stock of Hector Communications (Hector). In

April 2005, it requested the Hector board consider a sale of

the company. In September 2005, Opportunity Partners offered

to purchase Hector. Hector responded in November 2005, asking

why the purchase was not blocked because Opportunity Partners

was an "interested shareholder" under the Minnesota

Business Combinations Act and had not received the requisite

board approval prior to becoming an interested

shareholder.

In March 2006, Pirate Capital filed a Schedule 13D

announcing its intention to elect a majority slate to the

board of PW Eagle. Caxton Associates filed a Schedule 13D

shortly thereafter also announcing a position in PW Eagle. In

April 2006, PW Eagle entered into agreements with Pirate

Capital and Caxton Associates conferring control of the PW

Eagle board. PW Eagle was subsequently sold.

In July 2007, Pershing Square Capital Management acquired

stock in Target Corporation and filed a Schedule 13D stating

Target's common stock was undervalued and it intended to

explore ways in which that undervaluation could be

corrected.

According to press reports, an activist fund, the Clinton

Group, announced a campaign in 2008 to unseat the CEO of

Select Comfort Corp. The campaign initially began by seeking

cost-cutting initiatives and other marketing

improvements.

Driving Forces Behind Investor Activism

Perhaps the largest force behind investor activism is the

large sums of money available to hedge funds. By some reports,

hedge funds have more than $1.5 trillion to invest. The funds

look for ways to earn high returns, and activist investing has

been one way to do that. Activist investors who seek a sale of

the company also have had the tailwinds of an active mergers

and acquisitions market until recent times, and those tailwinds

will return in the future. The Wall Street Journal

(July 31, 2008) reports that some activists are currently

focusing on operational initiatives given the inactive mergers

and acquisitions market.

In addition, the rising power and influence of ISS

Governance Services (ISS), a division of RiskMetrics Group, has

contributed to the trend of investor activism.1 The

rise of ISS can be attributed to a ruling by the U.S.

Department of Labor that provided that pension funds have

fiduciary obligations when voting proxies. The SEC also

contributed, by adopting a rule requiring that registered

investment advisers vote proxies in the best interest of

clients.

As a result, many of the affected participants determined

the best way to comply was to outsource the analysis for

shareholder voting, and that is the service ISS provides. In

the opinion of some, ISS has a decidedly activist bent.

Over time, the SEC also has made it easier for activists to

engage in hostile proxy solicitations through rule

changes.2 In 1992, the SEC adopted rules allowing

insurgents to solicit not more than ten shareholders (Rule

14a-2(b)(2)), to engage in free communications without SEC

review in certain circumstances (Rule 14a-2(b)(1)), and to use

a procedure when an activist seeks a minority of the board, the

so-called short slate (Rule 14a-4(d)). In 1999, the SEC adopted

Rule 14a-12, which permits unlimited communications before a

proxy statement is filed without SEC clearance, provided that

no proxy card is provided and the written materials are filed

with the SEC. As a result, the proxy battle is usually won or

lost before a proxy statement is filed.

Recently the SEC adopted Rule 14a-16, which permits

insurgents to avoid the expense of printing paper proxies by

making proxy statements available over the Internet. While not

widely used to date, it provides a potent weapon to activist

investors to engage in full-scale proxy battles at reduced

cost.

Objectives of Activist Investors

Typical objectives of activist investors include:

Gaining a minority or majority of board seats.

Replacing the CEO or management team.

Increased dividends or share buy-backs.

Sale of the company.

Sale or spin-off of selected assets.

Business strategy initiatives, including cost-cutting

initiatives.

Preventing a pending acquisition.

Elimination of take-over defenses.

Implementation of perceived better governance

practices.

Realizing value on the balance sheet, such as

"putting cash to work."

What Companies Are Susceptible to Activist Investors?

Surprisingly, activist investors do not necessarily focus on

poorly performing companies.3 The following have

been identified as attributes of companies targeted by activist

investors:4

Low capitalization—it takes less cash to accumulate

a significant stake in a company with lower

capitalization.

Perceived undervaluation—leading to ultimate gains

when the activist strategy is executed.

Ability to cut costs—taking costs out of the income

statement can increase value and be a springboard for other

activist tactics, such as a sale of the company.

Excess cash—large cash balances can be used to

finance buy-outs and share repurchases.

Borrowing availability—the ability to leverage a

balance sheet can be used to finance an acquisition or a

share buy-back. In part, managing a business to maximize cash

flow can therefore be an advantage to activist investors if

unnecessary amounts of cash are retained.

Diversification of asset base—value is sometimes

perceived to be obtained through asset sales and

spin-offs.

Significant institutional ownership—concentration

of holdings in institutions can be a perceived advantage for

shareholders supporting an activist campaign.

Poor disclosure and governance practices—pointing

out poor practices may make it easier for activists to make

their case.

One commentator has posited that certain industries may be

more susceptible to activist investors. In particular,

industries with valuable hard assets but sluggish returns may

be targets.5

Success of Activist Investors

Activist investors are surprisingly successful in achieving

change. Research indicates success rates of 66% to 84%, which

includes any cognizable concession by management to an

investor's demands, no matter how immaterial.6

While these statistics may inflate the notion of success, there

are indications that activist investors historically have

achieved full success approximately 40% of the time.

The success rates can be attributed to the activist

investors making credible demands, a track record of past

success, and the ease with which the investors can go hostile

as a result of relaxation of SEC rules. Success is also

attributable to the so-called wolf pack phenomenon. When one

activist investor announces a campaign, other activist

investors, commonly referred to as the wolf pack, also take

positions in the stock. At that point, long-term investors may

sell...

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