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Two decades after the heyday of the infamous corporate raiders, a new influence has risen to place the corporate boardroom again under siege: activist hedge funds. These new raiders have increasingly preyed on unwitting companies by hunting in groups that one commentator has described as “wolf packs.” If the group acquires more than 5% of a company’s publicly traded shares, then the pack may act together if they provide full disclosure of this concerted action. But when these wolf packs act together without disclosing that fact-including by seeking to effect control changes in public companies-such actions violate the Williams Act of 1968. Unfortunately, scarce resources limit the ability of the U.S. Securities and Exchange Commission (SEC) to police the formation of undisclosed hedge funds groups, and the private remedies available to protect public companies from control bids by such groups are of limited effectiveness. Companies are not, however, entirely defenseless from attacks by undisclosed groups of hedge funds. Private enforcement of the Williams Act can be prompted by vigilant issuers and effected in the courts, and public enforcement action can be taken by the SEC. In recent months, the financial, legal and political communities-and even the courts-have debated the proper regulation of hedge funds. See, e.g., Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006) (vacating the SEC’s Hedge Fund Rule, 17 C.F.R. 275.203(b)(3)-2(a)). There is no dispute, however, that a narrow set of securities laws remains applicable to hedge funds. This includes the Williams Act, which was passed to “close a significant gap in investor protection under the Federal securities laws by requiring the disclosure of pertinent information to stockholders when persons seek to obtain control of a corporation by cash tender offer or through open market or privately negotiated purchases of securities.” 113 Cong. Rec. 854 (1967) (comments of then-Senator Harrison A. Williams, D-N.J.). Section 13(d) of the act filled the gap by requiring individuals who acquired substantial interests in the equity securities of a company to file a statement with the SEC that alerts shareholders of a large accumulation of stock by a party that might potentially affect the company’s control. 15 U.S.C. 78m(d). It expressly requires any “person” who acquires more than 5% of the outstanding shares of a registered issuer to file a Schedule 13D disclosing, among other things, any understandings, arrangements or agreements among shareholders with respect to the stock of the issuer, and their purposes in so doing. Id. � 78m(d)(1)(E). Under � 13(d)(3), “when two or more persons act as a . . . group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a person for the purposes of this subsection.” The Williams Act was “designed in part, to allow investors an opportunity to know of potential changes in corporate control and to evaluate the situation.” Dan River v. Unitex Ltd., 624 F.2d 1216, 1223 (4th Cir. 1980). The reason for requiring full and accurate disclosure is to protect shareholders whose votes are being solicited from secret understandings among those soliciting them, and to prevent undisclosed groups from acting in ways that significantly limit a board’s ability to protect its other stockholders. Congress recognized that “[w]ithout knowledge of who the bidder is and what he plans to do, the shareholder cannot reach an informed decision. He is forced to take a chance. For no matter what he does, he does it without adequate information to enable him to decide rationally what is the best possible course of action.” H.R. Rep. No. 90-1711 (1968), reprinted in 1968 U.S.C.C.A.N. 2811, 2812. Courts enforcing the Williams Act have found “group” conduct when the parties acted in parallel with an apparent common purpose and prior relationships. See, e.g., SEC v. Savoy Indus. Inc., 587 F.2d 1149, 1164-65 (D.C. Cir. 1978); Wellman v. Dickinson, 682 F.2d 355, 365-66 (2d Cir. 1982). Courts need not find a formal or written agreement; indeed, courts recognize that those seeking to avoid disclosure that they are acting as a group are unlikely to enter into a formal agreement. Bath Indus. Inc. v. Blot, 427 F.2d 97, 110 (7th Cir. 1970). Hence, the Williams Act’s “broad language demonstrates an unmistakable congressional intent to bring pooling arrangements within the purview of section 13(d)(3), irrespective of whether they be formal or informal, written or unwritten.” Savoy, 587 F.2d at 1163. Wolves in sheep’s clothing? With hedge fund coffers bulging with more than $1.2 trillion in assets, and a dramatic growth in their number, this group of sophisticated investors has turned its sights on the management and governance of public companies. The rise of hedge fund activism can be both positive and negative for public companies. On the one hand, by gaining a significant voice in the corporate boardroom-on issues such as executive pay, acquisitions or sales of significant assets-hedge funds can advocate the interests of a heterogeneous group of shareholders hamstrung by collective-action problems and divergent incentives. On the other hand, there can be a critical disconnect between the long-term growth strategy of many public companies and their general shareholders, and the short-term profit-maximization strategy typically espoused by hedge funds. The emerging practice of activist hedge funds forming undisclosed groups has begun to garner attention of commentators and regulators. See Emily Thornton, “The New Raiders,” Bus. Week Online, Feb. 17, 2005, www.businessweek.com/magazine/content/05_09/ b3922041_mz011.htm. Commentators have noted that “loose networks of like-minded funds often work in tandem, without forming a formal investment group.” Susan Pulliam and Martin Peers, “Joint Venturer: Once a Lone Wolf, Carl Icahn Goes Hedge-Fund Route,” Wall St. J., Aug. 12, 2005, at A1. However, these “loose associations”-while sufficiently solid to constitute a “group” under the Williams Act-are not being disclosed. When these undisclosed groups of hedge funds secretly work together to effect control changes in public companies, their activities threaten to undermine the integrity of the shareholder voting process. Indeed, “activist hedge funds sometimes portray themselves as shareholders’ guardian angels” when, in fact, “they’re anything but.” Justin Hibbard, “Take Your Best Shot, Punk,” Bus. Week Online, Nov. 7. 2005, www.businessweek.com/magazine/content/05_45/ b3958099.htm. “[T]he attackers [try] to achieve the moral high ground by wrapping themselves in the cloak of good governance” while in fact they are “self-seeking, short-term speculators looking for a quick profit at the expense of the company and its long-term value.” See Memorandum from Martin Lipton, et al., Wachtell, Lipton, Rosen & Katz, “Be Prepared for Attacks by Hedge Funds” (Dec. 21, 2005), www.realcorporatelawyer.com/pdfs/wlrk122205-02.pdf. Similarly, SEC Commissioner Roel C. Campos has noted that recent hedge fund activism “has raised the question of whether such short-time investors should be entitled to shareholder rights in outright conflict with long-term investors.” Speech by SEC Commissioner: Remarks before the SIA-Hedge Fund Conference (Sept. 14, 2005). Even large and well-known public companies are vulnerable to attacks by these wolf packs. One prominent commentator recently admonished companies to “[b]e aggressive and prepared to litigate or inform regulators immediately if there is evidence that funds have violated securities laws-including by failing to disclose the formation of a group, the identities of the group members and/or the group’s intention.” Lipton Hedge Fund Memorandum, supra. The SEC’s Division of Enforcement is often not in a position to remedy violations of the Williams Act or abuses of the securities laws by hedge funds until after shareholders have been irreparably harmed. As former Chairman William H. Donaldson has stated: “Because a large number of hedge fund advisers currently are not registered with us, the SEC is limited in its ability to detect fraud and other problems before they result in harm to investors or the securities markets.” Testimony Concerning Investor Protection and Regulation of Hedge Funds Advisors, before the U.S. Senate Committee on Banking, Housing and Urban Affairs. (July 15, 2004, www.sec.gov/news/testimony/ts071504whd.htm). Not only are the enforcement resources of the SEC limited, but there is also a lack of transparency in the hedge fund industry. “[T]he transparency available in most of the hedge fund industry has been likened to a black hole or dark cloud. The information available on hedge funds falls into the category of: you can make the numbers say anything.” Campos speech, supra. The reporting requirements of the Williams Act provide an entr�e for the SEC to embark upon meaningful oversight of hedge fund groups. By bringing one or more Williams Act enforcement actions, the SEC could send a significant message to hedge funds acting in undisclosed groups. Private enforcement A corporate issuer can do what the SEC cannot with respect to monitoring hedge funds’ compliance with the Williams Act. “[P]rivate enforcement of the proxy rules provides a necessary supplement to Commission action.” J.I. Case Co. v. Borak, 377 U.S. 426, 432 (1964). According to the 2d U.S. Circuit Court of Appeals, this is because an “issuer is the only party which can promptly and effectively police Schedule 13D filings.” GAF Corp. v. Milstein, 453 F.2d 709, 721 (2d Cir. 1971), cert. denied, 406 U.S. 910 (1972). Of course, effective private enforcement requires the judiciary strictly to apply the act’s provisions. Courts have held that hedge funds, among other Schedule 13D filers, need not disclose a disputed violation of statutes and regulations, but instead may disclose only the existence of a dispute. This tenet was articulated in Avnet Inc. v. Scope Industries, 499 F. Supp. 1121, 1124-26 (S.D.N.Y. 1980). See also City Capital Assoc. Ltd. P’ship v. Interco Inc., 696 F. Supp. 1551, 1556 (D. Del. 1988), aff’d on other grounds, 860 F.2d 60 (3d Cir. 1988). In cases applying Avnet, the disclosure of a disputed violation of statutes and regulations-wholly separate and apart from the Williams Act-was deemed sufficient because to hold otherwise would improperly allow “the disclosure provisions of the securities laws [to] be used as an indirect vehicle for litigating any and all of a party’s sins.” Warner Comms. Inc. v. Murdoch, 581 F. Supp. 1482, 1502 (D. Del. 1984). Unfortunately for corporations, what some view as a misapplication of the Avnet doctrine has permitted insurgent shareholders, including hedge funds, to shut down injunctive proceedings in accelerated proxy litigation simply by disclosing the existence of a dispute over a fact-such as the nondisclosure of group activity-instead of permitting the plaintiff (such as a corporation being preyed on by a hedge fund wolf pack) to pursue discovery to uncover the truth in fact. See, e.g., Bally Total Fitness Holding Corp. v. Liberation Investments L.P., No. Civ.A. 05-841-JJF, 2005 WL 3525679 (D. Del. Dec. 22, 2005). Such rulings permit violators to evade the Williams Act’s express requirements and “cure” false and misleading disclosure with more false and misleading disclosure. Other decisions, however, have rejected the idea that a party’s mere disclosure of the allegation of a Williams Act violation can preclude a plaintiff from proceeding to discovery on that issue. These decisions recognize that an effort by an undisclosed hedge fund group to wrest corporate control through a proxy contest directly implicates the Williams Act’s core purpose: alerting shareholders “about who the bidder is and what he plans to do [so the shareholder can] reach an informed decision.” House Report, 1968 U.S.C.C.A.N. at 2812. The U.S. District Court for the District of Delaware recognized as much in Warner, holding that while disclosure of the allegation of Investment Company Act violations was sufficient to satisfy the defendant’s Williams Act obligations, the alleged failure to disclose the existence and intentions of a � 13(d) group was not. As the court stated, permitting mere disclosure of the existence of the dispute to preclude discovery into whether the defendant had in fact violated the Williams Act would “significantly circumvent the disclosure goals of � 13(d). Material facts might often be concealed and omitted from initial 13D Statements, to be cured only by subsequent disclosure of adverse claims which allege the omissions but which are disputed by the disclosing party. As a result, the true facts would often remain obscured and hidden from investors.” 581 F. Supp. at 1501. See also Arvin Indus. v. Wanandi, 722 F. Supp. 532, 538-41 (S.D. Ind. 1989). The 4th Circuit also recognized this principle in reversing dismissal of preliminary injunction proceedings brought to establish the inaccuracy of a shareholder’s disclosure regarding its intent to control the company, observing: “[I]t is plain that section 13(d) requires the making of a completely truthful statement.” Dan River, 624 F.2d at 1223. Stringent enforcement of the Williams Act’s provisions by the courts, prompted by vigilant companies, can send a message to hedge funds that are working in concert under secret understandings that the judiciary will enforce the Williams Act by permitting issuers to “effectively police” 13D violations, and preventing alleged violators from “shutting down” inquiry into their activities by the simple expedient of denying alleged violations. Companies can take pre-emptive measures to mitigate their susceptibility to attacks by hedge fund wolf packs. First, companies should assess their vulnerabilities. Hedge fund activists typically look for companies that are underperforming when compared to their peers, that are underleveraged, that have large cash reserves or that have a low market valuation when compared to asset values. Companies should also be mindful of their vulnerability to proxy contests or other changes in corporate directors. Second, companies should pay particular attention to large accumulations of stock or extraordinary stock purchase patterns. By examining public filings in Schedules 13D, 13G, 16(a) and 16(b), as well as Hart-Scott-Rodino or other regulatory filings on a regular basis, companies can identify significant investors, particularly hedge funds or other institutional holders, their objectives and their changes in ownership. Companies should seek an understanding of the background of the company’s hedge fund investors, as well as each fund’s history of activism with other companies. Third, companies should create a response team and develop a response plan. The team should consist of senior executives, attorneys, investment bankers and public/investor relations advisors. The plan should comprehensively address company vulnerabilities, and should be reviewed periodically. Finally, if there is evidence that a hedge fund group has violated the Williams Act, companies should be prepared to litigate immediately and aggressively, to notify the SEC and/or other regulatory authorities, and to launch a public relations campaign. Laurie B. Smilan is a partner in the Reston, Va., office of Latham & Watkins and is co-chairwoman of the firm’s securities litigation and professional liability practice group. David A. Becker is counsel, and Dane A. Holbrook is an associate, in the firm’s Washington office. Latham represented Bally Total Fitness in Bally Total Fitness Holding Corp. v. Liberation Investments , a case mentioned in the article.

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