The Wolf in Shareholder's Clothing
Hedge Fund Use of Cooperative Game Theory and Voting Structures to Exploit Corporate Control and Governance
Posted Sunday, January 1, 2006
6 U.C. Davis Bus. L.J. 4 (2005)

Abstract

Hedge funds have emerged as the dominant economic and governance power, achieving maximum investor return by voting their way to the top of Corporate America. Hedge funds have accumulated such large positions in companies that fund managers have the capacity to control issues of shareholder voting and corporate governance, and are exercising this power on an unprecedented scale. However, the funds are not operating under traditional rules. Rather, they are playing both sides of the shareholder-management table in order to maintain double-digit returns as the fund market becomes increasingly crowded. Worse yet, hedge funds have derived their power from the very flaws inherent in corporate voting models.

As a justification for these actions, fund managers preach shareholder advocacy and appear to be industry watchdogs. However, fund managers are abusing the very voting and regulatory mechanisms put in place to guard against this behavior. Essentially, fund managers are acting in the same capacity as the corporate raiders of the 1980s who obtained double digit returns by buying companies and either managing them or selling them for scrap. However, these investment vehicles are very different than their predecessors and require a different level of reform. Fund managers are focusing on game theory voting models in order to predict how other voters will react to any given situation. This methodology allows hedge funds to extend themselves into voting control positions, giving them the power and the motivation to assert control solely for their own good. In turn, fund managers are using their power and leverage to act as change agents, which allow them to further exert unchallenged positions of control.

In the United States hedge fund market, there have been minimal regulatory advances to curtail and prevent potential future problems for investors and companies alike. Foreign markets have chosen to deal with funds in a different manner than the U.S. by including strict limits on fund investments and fund investors. However, the difference in scale between the U.S. and foreign markets provides only limited insight into the effectiveness of these measures. In order to relieve current and future abuse, the Securities and Exchange Commission ("SEC") must institute industry reform by more aggressive means than mere traditional system constraints. Specifically, the SEC must institute rules and regulations that not only focus on the problems that today's market faces, but react preemptively to other likely future iterations.

Introduction

"…Then I'll huff, and I'll puff, and I'll vote myself in!" This is more than simply a play on a classic children's story. Rather, it is a summary of the current state of corporate control and governance. Hedge funds have emerged as one of the dominant economic and controlling power in the American markets, while achieving maximum returns by voting their way to the top of Corporate America. In the past, hedge fund action was fairly benign, but the increasingly competitive nature of the hedge fund market has resulted in the need for increasingly drastic action to maintain the 20%-plusreturns promised to investors.[1] Thus, hedge fund managers are the newest version of Wall Street wolves, always poised to attack new companies while claiming to be acting in shareholder's best interests by operating under a cloak of shareholder clothing.

There is no question that, under any metric, hedge funds are growing. In the first half of 2001 alone, twice as much money was invested in hedge funds as was invested in all other funds in 2000.[2] Even after a short setback resulting from the collapse of the industry monolith Long-Term Capital,[3] the hedge fund market continues to grow relatively unabated.[4] As a result, hedge funds are dominating the investment and corporate settings.[5]

Hedge funds have accumulated such large positions in companies that they have gained exclusive control over shareholder voting and corporate governance.[6] Fund managers claim to be acting as industry watchdogs in the best interest of investors.[7] They also claim to have uncovered the accounting and governance flaws that ultimately toppled both Enron and WorldCom.[8] However, there is more at stake than interested parties will acknowledge, including complete removal of voting from the hands of individual investors.

Unlike other forms of institutional investors, hedge funds are operating relatively unregulated and without fiduciary restraints.[9] This lack of regulation has allowed funds to accumulate enormous leverage in the market.[10] Further, the large positions hedge funds hold, both monetarily and in stock-share, allow hedge fund managers to usurp traditional shareholder voting from the hands of individual shareholders. These factors have granted fund managers access to the majority of decisions that were traditionally left to individual shareholders without beneficiary safeguards.

Part I of this article will provide a brief primer on hedge funds including the reasons why such investments are so tempting to investors. Part II will distinguish hedge funds, mutual funds and pension funds and discuss how each institutional vehicle differs in strategy and investor type. Part III of this article will discuss how the hedge fund market has grown over time and what regulatory and competitive issues have arisen as a result of this growth. In Part IV, this article will provide an overview of different voting models and how their flaws are exploited by hedge funds in order to gain control of corporate voting structures. Part V goes on to discuss how these voting exploits by hedge funds effect non-hedge fund shareholders in hedge fund controlled corporations. Further, Part VI describes how hedge funds have managed to correlate their voting maneuvers with corporate governance in order to become further entrenched in corporate control. Part VII discusses the direction hedge fund regulation is taking in both domestic and foreign markets. Finally, Part VIII provides recommendations for regulating current, as well as future institutional vehicles via modified voting methodologies and tighter domestic regulation.

I. A Brief Primer on Hedge Funds

In general, a hedge fund is a private, low regulation, investment pool containing securities and derivatives.[11] Hedge funds allow investors to pool their money and take short or long positions in essentially any investment vehicle, from any issuer, in any sector.[12] Investments may range anywhere from stocks to baseball cards.[13] The underlying investments themselves are almost unimportant as long as the fund delivers an absolute monetary return in any given market conditions.[14] A formal definition of a hedge fund is nonexistent in securities law, resulting in a lack of direct regulation. This permits hedge funds to optimize short selling, derivatives, leverage, and almost any other means to achieve gains.[15] Traders use a variety of exemptions[16] found in the Securities Act of 1933, Securities Exchange Act of 1934, Investment Act of 1940, and Investment Advisors Act of 1940 to avoid registration and, ultimately, disclosure.[17]

Two central characteristics highlight hedge funds and define their investors. First, hedge funds exhibit a strong desire to remain unregulated. Second, hedge funds are exemplified by an element of high risk.[18] Due to U.S. securities regulations related to these two factors, as well as those regulating advertising and distribution, the primary investors in hedge funds were traditionally private, high net-worth individuals.[19] This is not to say that other investors were specifically excluded from investing in hedge funds, but many large investment pools had strict fiduciary duties that historically could not be met because of the structure of some hedge funds.[20] However, as hedge funds have become more socially accepted and control more assets, their investor base now includes corporate pension plans, insurance companies, endowments, foundations, and public funds.[21]

There are a number of reasons investors feel that hedge funds are the best investment tool available at this time, including:

· Enhanced risk-adjusted return potential based on leverage and short-selling;[22]

· Diversification to preexisting portfolios;[23]

· The ability for investors to choose from a variety of different hedge funds based on risk aversion;[24]

· Alignment between fund manager and client interest as managers are not paid unless the fund performs (this may be a drawback by providing incentive to "cheat").[25]

While initially this may appear to be the ideal merger between investor freedom of choice and market return, the following relevant drawbacks must also be taken into account:

· A lack of transparency and accountability based on the low level of regulation in the system;[26]

· Low liquidity levels based on lockup provisions necessary to ensure that hedge funds can plan investment strategies;[27]

· Limited access to investors based on self-imposed capacity limits and high minimum investments;[28]

· Unreliable data on returns for fund evaluation based on the private nature of the funds and reliance on the fund itself to report results;[29]

· Valuation risk resulting from the diverse nature of markets and securities in which a fund may invest, resulting in an imprecise Net Asset Value (NAV);[30]

· Skewed, asymmetric fund return distributions;[31]

· Leverage risk as a result of the fund's ability to invest more than 100% of its assets. Since almost all funds leverage their capital by buying on the margin, overextension or a margin call can result in an amplification of losses and a potential collapse of the fund itself.[32]

II. Different Flavors of Investments

Based on the level of regulation governing institutional actions, each type of institutional vehicle has a distinct strategy and type of investor. Hedge funds, for instance, generally focus on sophisticated, high net-worth individuals and a large variety of investing strategies, which are often high risk. In contrast, mutual funds are generally available to all investors and tend to follow more conservative investment protocols. Further, pension funds, which are frequently the vehicle for individuals' retirement savings, have a very wide range of investors with a high standard of care for investments.

A. Hedge Funds

Prior to some modern hedge funds,[33] fund investors were generally sophisticated, high net-worth individuals with a minimum of one million dollars to invest.[34] Driving these standards of high net-worth and sophistication was the need to utilize a variety of exemptions under the securities regulations.[35] As a result, hedge funds could charge any type of performance fees they desired.[36] As hedge funds have grown, their investors now include corporate pension plans, insurance companies, endowments, foundations, and public funds.[37] In order to maintain proposed returns, hedge funds utilize a variety of methods including short selling, derivatives, and leverage, amongst other means.[38] Hedge funds follow processes that differ greatly from other investment vehicles.

B. Mutual Funds

Mutual funds are generally available to all investors, and rarely require a minimum investment.[39] Over 92 million Americans invest in mutual funds, and the typical investor is a middle-income, middle-aged individual.[40] Further,[41] many mutual funds have no minimum annual investment requirements and may be established with less than $1,000.[42] Mutual funds are required to register with the SEC and are subject to extensive regulation.[43] Currently, mutual funds are regulated by the Securities Exchange Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act.[44] Additionally, at least 75% of a mutual fund's management are required to be independent directors.[45] These directors are responsible for the oversight of the fund's policies and procedures. Furthermore, fund charges and fees are limited by both federal law and the National Association of Securities Dealers ("NASD").[46] This includes complete transparency via the delivery of every prospectus in a standardized format so investors may easily compare fund fees.[47]

C. Pension Funds

Pension funds act as a vehicle for retirement savings for many individuals.[48] As a result, pension funds attract[49] a wide range of investors, including, unions, corporations, and individuals.[50] Pension funds are generally governed by the Pension Benefit Guaranty Corporation ("PBGC"), which is essentially an insurance company for the funds.[51] The PBGC does not have specific authority to intervene in any form of corporate transactions but may intervene in transactions in order to protect its own interests.[52] In terms of oversight and regulation, pension funds are subject to the Employee Retirement Income Security Act of 1974 ("ERISA"), which mandates fiduciary responsibility for fund managers and those who have a controlling involvement in the plan's assets. Essentially, pension fund managers are held to a similar standard of care as in trust law.[53]

III. Growing Pains

The hedge fund market has become increasingly crowded. This competition has created a glut of cash. A number of hedge funds have collected over $10 billion in war chests, while countless mid-sized funds have over $1 billion at their disposal eliminating the need to go to debt or equity markets to complete a deal.[54] Further, the spectrum of funds is now extremely broad and diverse.[55] Small funds are able to apply a number of exemptions while developing niche clients.[56] Large funds may be forced to register by the SEC, and therefore have no incentive to remain incognito since they will already show up on the SEC's radar.[57]

As the funds have grown and diversified, they have gone beyond simply creating volatility in stock prices with short-selling activities based on minor fluctuations in quarterly returns.[58] The funds no longer remain passive investors. Rather, they are taking an active stance in the performance of their stocks.[59] If the funds do not see adequate results, they demand changes in strategy, management compensation, director mix, and will even bid for the companies themselves.[60] Further, with billions of dollars on hand, a fund may conduct a buy-out without seeking funding in the open market.[61] The fund manager's justification for the fund's extreme actions is the same as those expressed by both corporate raiders of the 1980s and institutional investors alike. Specifically, the fund managers claim that they are acting to "help" shareholders reap value.[62] However, hedge funds are not the same breed of investment pool seen in the past.

Hedge funds are a type of institutional investor. However, certain class differences make hedge funds more influential entities. The primary difference between hedge funds and other institutional investors, such as mutual funds and pension funds, is the lack of redundant regulation or any real regulation at all.[63] Further, most types of institutional investors, such as pension funds and trusts, may owe fiduciary duties to their constituents.[64] Hedge funds, on the other hand, do not have any enhanced legal fiduciary duty to investors because of the private nature of the funds and the resulting sophistication of the investors.[65] Finally, the general hedge fund investment strategy focuses on an absolute net positive return with aggressive utilization of short selling and leverage.[66] In contrast, other institutional investment forms (such as mutual funds) focus on benchmarking an index, which is the traditional means of diversifying away investor risk.[67] This lack of outside control has given hedge funds free reign to operate, which they have done, by utilizing the nuances associated with corporate voting structures in order to completely entrench their control over corporations.

IV. Voting Models

To understand how hedge fund managers use voting as a weapon, it is important to understand voting models and the flaws the models expose. Modern voting analysis in corporations tends to apply some form of game theory analysis.[68] Game theory voting models focus not only on one's own utility maximization, but also on predicting what other voters will do.[69] Accordingly, game theory suggests that a voter will change his or her behavior in order to gain a favorable and decisive vote in an election.[70] However, game theory in voting is compromised by voter apathy resulting from the sentiment that an individual vote on the margin does not truly matter.[71] All these considerations are rolled into a spectrum of models with individual voters in a simple election at one end, and models of complicated elections with little regard for specific individuals at the other. Further, since shareholder voting is based not on the individual, but rather on the number of shares an individual, fund, or entity holds, "weighted voting models" must be considered.

A. Weighted Voting in Practice

Generally, a weighted voting regime is a system where the voter has a specified number of votes (his shares), and some quota is required in order to achieve a successful election.[72] A group of voters voting the same way may form a coalition.[73] If the coalition's aggregate weighted votes exceed the specified quota, an issue passes. If the group does not have the weight to carry an election, the coalition is a losing coalition.[74] The most sought after votes are generally those on the margin that may change the outcome of an election. [75] Given these constraints, a model may be formed defining the probability of coalition formation, and the likelihood that each voter is pivotal in each given coalition.[76]

B. Models for Weighted Voting Analysis

The primary models applicable to corporate voting are the Banzhaf measure, the Shapley-Shubik power index, and the Gilson and Schwartz model. Under the Banzhaf measure of voting, voters vote for the candidate or issue they want to win independently of other voters and with the assumption that any given coalition is just as likely to occur as other coalitions. According to the Shapley-Shubik Power Index, there is voter division based on predefined assumptions of individual strategic power and possession, which does not necessarily reflect individual or per-share equality, but rather participant contribution to a given issue. Finally, the Gilson and Schwartz Model is rooted in a game theory analysis balancing two prongs of assumptions, where first there is perfect voter information, and second, there is a lack of accurate voter information.

i. The Banzhaf Measure

There are a number of assumptions in the Banzhaf measure that must be considered. Banzhaf assumes that 1) each voter votes independently; 2) each voter is as likely to vote one way as he is to vote the other way on an issue; and 3) every coalition is equally likely to occur.[77] If each voter has the same opportunity to be the decisive vote in an election (i.e. the tie-breaker), then each voter has equal weight.[78] Further, the Banzhaf measure applies weighted voting to districts in a manner proportionate to the square root of their populations, not simply in proportion to their absolute size.

For example, assume there is a four-person committee consisting of voters A, B, C, and D. In any given vote, the quota is 6 votes. Further the votes are weighted for A, B, C, and D as 3, 3, 2, and 1 votes respectively (denoted as [6; 3, 3, 2, 1] for the quota followed by the respective weighted votes). The coalitions in which A's presence will win (or loose) the requisite number of votes are considered pivotal. In this case, the answer is 8 and is exemplified in Table 1.

Table 1. Example of A's Pivotal Coalitions

Winning coalitions

Loosing coalitions

AB

B

ACD

CD

ABC

BC

ABD

BD

Further, in the Banzhaf measure, the total coalitions can be defined as two raised to the power of the number of voters, or in this example 2^4 = 16. Finally, the requisite Banzhaf power is defined as the [# of coalitions for which the voter is pivotal] / [total coalitions]. This is summarized in Table 2.

Table 2. Example Summary of Banzhaf Power

Voter

Total # of Coalitions

Coalitions

Banzhaf Power

A

8

ab, b, acd, cd, abc, bc, abd, bd

= 8/16

=0.5

B

8

ab, a, bcd, cd, abc, ac, abd, ad

= 8/16

=0.5

C

4

acd, bcd, ad, bd

= 4/16

=0.25

D

4

acd, ac, bcd, bd

= 4/16

=0.25

There has been some criticism of the Banzhaf measure.[79] The first concern is that this measure of voting strength is inherently inaccurate because voters are not necessarily prudent.[80] Voters do not vote with the mentality that they will get to be the tiebreaker, but rather that they want their candidate to win.[81] In other words, the voter puts more value on the right to vote for his candidate than casting the tie-breaking vote.[82] A second criticism of the Banzhaf measure is that the requisite probability is the probability that a voter will change his vote, which is different than the assumption that each coalition is equally likely to form.[83]

ii. The Shapley-Shubik Power Index

The Shapley-Shubik ("SS") Power Index utilizes the notion of fair voter division based on assumptions concerning the legitimacy of individual strategic power and possession. It then converts this into a voting power index.[84] Consider the following example of how the SS power index applies to corporate voting.

Assume there are five votes, with four shareholders, one with two votes (shares) and the other three with one vote (share). The shareholders are named A, B, C, and D, none of which have special affiliations. The quota and distribution are [3; 2, 1, 1, 1]. We can define a pivotal member by considering the permutations of winning votes and whose vote would have changed the election. There are 24 outcomes as shown in Table 3 where the asterisk defines the pivotal voter.

Table 3. Shapley-Shubik Power Index Example Outcomes


AB*CD

AB*DC

AC*BD

AC*DB

AD*BC

AD*CB

BA*CD

BA*BC

CA*BD

CA*DB

DA*BC

DA*CB

BCA*D

CBA*D

BDA*C

DBA*C

BCA*D

CBA*D

BCD*A

BDC*A

CBD*A

CDB*A

DBC*A

DCB*A

The asterisk occurs 12 times after A and 4 times after any of the other voters. Therefore, the power index is (1/2, 1/6, 1/6, 1/6).[85]

The measure of voting power derived from the SS Power Index is used most frequently by academics and analysts to evaluate corporate structures.[86] However, the notion of fairness in the SS power index depends heavily on predefined assumptions concerning the legitimacy of individual strategic power and possessions.[87] Divisions under this index do not reflect individual or per-share equality. Rather, these divisions reflect equality based on participant contribution to the solution.[88] The utilization of game theory is the proposed manner by which one overcomes the flaw in the SS power index.[89] Unfortunately, this argument hinges upon a perfect knowledge requirement and adequate transparency, which most shareholders lack.[90] Hedge fund managers may exploit this issue based on their leverage in a company. However, if game theory is to be overlaid on a model, the Gilson and Schwartz Model (which already integrates game theory) must be considered.

iii. The Gilson and Schwartz Model

The Gilson and Schwartz Model ("GS") arose out of Ronald Gilson and Alan Schwartz's attempt to apply weighted voting systems to the corporate setting, particularly to proxy contests. The GS model is rooted in game theory.[91] In the GS model, the authors apply a two-prong approach to voting analysis.[92] The first assumes that voters have access to perfectly accurate information. Such information, however, comes with a concomitant cost to the voters.[93] Under this prong, if the minority shareholders have a sufficiently large incentive or a sufficiently low cost of voting, they could potentially create an inefficient outcome in a proxy contest.[94] Here, voters will only vote when both utility and costs of the perceived utility of the vote are assumed to exceed its relevant costs.[95] The perceived utility in the model is based on the probability that the voter's vote will be pivotal.[96] The second prong assumes a lack of accurate information. It also describes how an election with this assumption can fail to produce an outcome equal to that seen in an election with full information, but voting under the second prong, unlike the first, is free.[97] The imperfect information is conditioned on the presumption that the voter assumes his vote is pivotal.[98] These prongs do not interact per se, but rather exist to provide some contrast between a simplistic model of voting and a more complicated model. They also exist to show how the outcome of a vote may be skewed once additional uncertainties are added.[99]

Even with its multi-prong approach and its integration of game theory, the GS model exhibits shortfalls in accuracy. Corporate voting operates as a weighted voting structure and neither portion of the GS model accounts for this.[100] Gilson and Schwartz also fail to recognize the fact that large block holders are obligated or compelled to vote regardless (i.e. pension funds) of their personal utility on an issue. Further, as the voter numbers increase, only the most committed voters will cast their votes. Therefore, regardless of what the minority or zealous voters do, the winner becomes those who have potentially the most at stake. This problem is difficult to distill from the GS model because of the model's general classification structure.

Gilson and Schwartz classify all non-management shareholders into a group called "independent shareholders," who presumably receive only share value from their stock.[101] The other group is the "management shareholders". These shareholders risk both their share value and private benefits such as income and pension plans, which suggests that they will fight for their position more staunchly.[102] Gilson and Schwartz also note that the analysis is complicated when voters vote in blocks because the voters are using private information, thus leading to a failure in the presumption of full and equivocal information.[103] This information is problematic since it is prevalent in corporate voting, and is the very premise that hedge funds utilize.

While these models attempt to simulate how investors will act, each exhibits a sizeable flaw. However, every flaw and overreaching assumption results in a glitch that fund managers may use to institute further control over a corporation. This occurs because these flaws are not just symptomatic of the models, but also of the system as a whole.

V. Effects on Individual Shareholders

The votes of individual shareholders generally do not have power to affect the results in corporate elections.[104] Some statisticians have argued that without at least a 20% block of shares in a corporation, the shareholder does not retain any working control over the company.[105] This model suggests that sheer mass is necessary to force a company to move. While equality requires a corporation's management to listen to the minority, this does not mean that the minority has a right to decide an outcome. This is true for all means of voting; one is trying to make decisions that reflect the perceived "best" outcome for the given voters.[106]

The term "best" within corporate voting can take on multiple meanings. As previously discussed, shareholder voting is dictated by a weighted voting system based on the number of shares held.[107] Therefore, "best" could mean the "most economic" outcome for the majority of outstanding shares based on a substantial rise in stock prices. However, those with an economic interest in the number of shares held may diverge from the voting interest. This arises where all shareholders hold less than an adequate number of voting shares to achieve a majority vote (i.e. three shareholders with 49%, 49% and 2% of holdings respectively).[108] As hedge funds extend themselves into voting control positions, they increasingly have the power and the motivation to assert control. This leads to a non-theoretical definition of "best", because for funds, "best" means the highest return possible for their investors, which could be in the form of long or short positions, and is very often in the form of a short position.[109] Further, hedge funds are getting their "best" results by cooperating with other funds, and not all shareholders benefit from these transactions.

Cooperative behavior allows hedge fund managers to raid companies in packs.[110] When there are merely a few players in an arena, the ability for those parties to unite decreases.[111] Two or three hedge funds may unite much easier than thousands of individual shareholders. Thus, fund managers may easily assemble a syndicate in order to exert economic and governance power over a firm or company.[112] While the billions of dollars accumulated by individual funds puts countless companies at risk of hedge fund control, the ability to collusively attack a firm puts every shareholder at a higher probability of a significant loss. If non-hedge fund shareholder interests diverge from those of the hedge funds in any economic or non-economic matter, the hedge funds are the ones with the power to prevail.

While hedge fund managers speak outwardly about controlling the governance of the companies in which they have an interest for the sake of that company's shareholders, they usurp the very rules put in place to protect these shareholders. The complex structure associated with funds allows them to circumvent disclosure rules associated with gaining a large stock or option position in a company.[113] For example, in the Sears/Kmart merger, ESL Investments both brokered the deal and held a stake in both companies.[114] This deal cut out old Kmart shareholders and arguably created a company that is guaranteed to fail over time because of its lack of vertical and horizontal integration.[115] However, this deal did create short-term profits for ESL.[116] Actions such as these differ from the manner in which other classifications of institutional investors may operate, but these worlds are merging.

Regulated institutional investors are beginning to utilize hedge funds to back into higher risk investments. This exposes typically risk averse investors to a higher probability of a significant loss than they had originally agreed to.[117] This is accomplished by investing in permitted hedge funds instead of the underlying securities, which are otherwise prohibited by regulation or implied duties.[118] There are now hedge fund indexes and categories such as "funds of funds of hedge funds" ("F3s") that take positions in supposedly the best performing hedge funds.[119] Supposedly, these vehicles spread the inherent risk by diversifying and are stable investments for regulated institutional investors.[120] However, there is a lack of common fund benchmarking resulting from the lack of transparency and the private nature of funds.[121] Thus, the ability to accurately analyze and diversify away the risk, which is a typical feature of fund indexing, is eliminated.[122] This, in conjunction with the multiple layers of fees associated with these new investments, reduces and often eliminates returns for small, unsophisticated investors.[123] Here, hedge funds are acting indirectly as the conduit to potentially large-scale, unsophisticated individual investor loss. While this is not a direct problem with the funds themselves, it is precisely the tradeoff that was supposed to be avoided in granting a low level of regulation to hedge funds.

VI. Change Agents for Corporate Governance

The manner in which hedge fund managers control corporate decision-making through voting, directly correlates to control of corporate governance. Single investors and a sizable group of shareholders generally do not own enough of the company to effect change. The fund managers are compensating for this by using their power and leverage to act as change agents.[124]

Hedge fund managers force corporate management to admit the actual valuation of assets and real estate and cycle out CEOs who break the rules or do not produce results, thus perpetuating corporate restructuring.[125] For example, Barrington Capital Group, a hedge fund owning shares in the shoe manufacturer Steve Madden, demanded that Steve Madden add an independent director with a retail background to its board in order to maintain checks and balances.[126] When Steve Madden's executives denied the request, Barrington threatened to launch a proxy battle to replace the CEO. As a result, Steve Madden now has an independent director with a retail background on the board.[127] This is just one example of how hedge funds are gaining control under the guise of corporate governance and reform. However, hedge funds have not willed these actions on the market by themselves.

The current business environment has perpetuated the aggressive growth of hedge funds. The scandal and ultimate collapse of Enron, WorldCom, and Global Crossings have resulted in corporate vulnerability to shareholder demands.[128] New SEC regulations and the Sarbanes-Oxley Act mandate extremely rigorous disclosure requirements.[129] As a result, many companies have removed certain protections such as poison pills,[130] and have even ended staggered board terms because they appear negative to the public at large.[131] There is investor demand for more governance and enhanced control, and hedge fund managers claim they are merely meeting the demand for said governance and control.

Hedge funds are not non-profit organizations setup for the benefit of investors at large. Regardless of hedge fund managers' claim that they are helping Corporate America, they are merely finding new and better ways to take a bigger piece of the financial pie. This is exemplified by a situation that arose involving Credit Suisse First Boston ("CSFB"). In CSFB, bankers underpriced shares in Initial Public Offerings ("IPOs") and allocated them to large funds.[132] The hedge funds would then quickly sell the allocated shares in the aftermarket and pay a percentage of the revenue to CSFB through inflated commissions on unrelated stock trades.[133] Again, while this is not a per se problem with the hedge funds, it was the hedge fund's large size and lack of regulation that gave CSFB access to this type of action. The long term implications are such that individual investors are lulled into a false sense of security by relying on hedge funds as the predominant parties in governance control when in actuality, funds are taking every action necessary to get their financial return, including dismantling the company if necessary. This potential for problems necessitates immediate change through proactive rather than reactive measures.

VII. The Current Direction of Hedge Fund Regulation

Hedge funds have been growing with virtually no oversight. There are now over 8,000 hedge funds worldwide with a combined worth of over one trillion dollars.[134] The SEC will require some funds to register under the Investment Advisors Act beginning in February 2006 after conducting a study of the hedge fun industry.[135] However, the extent of this regulation is to grant the SEC review of hedge fund advisors and deny registration to those who have been convicted of a felony or have a disciplinary record.[136] The regulation of hedge funds and their management in foreign markets will provide insight into the nature and scope of future hedge fund regulation in the U.S.

In Europe, countries generally do not have specific regulations for hedge fund managers, but rather broad requirements for financial managers of any nature.[137] The vast majority of European hedge funds are located in the United Kingdom, but the number of funds established in France, Switzerland, and Sweden has been increasing.[138] The primary European response has been to strictly limit the minimum capital contribution by a single investor, thus restricting hedge funds as investments for the wealthy.[139] Certain European countries have taken more aggressive steps to restrict some hedge fund activity, especially newer hedge fund structures.[140] For example, Swedish funds-of-funds can invest only in other hedge funds that are domiciled within Sweden's borders.[141] However, even with these varied regulatory and structural differences, the scale of the European hedge fund markets pales in comparison to the United States market. This difference, alone, is enough to warrant a more comprehensive approach in regulating U.S. hedge funds.

VIII. Recommendations

Corporate governance and control mechanisms may be established both internally and externally. Broad, external reform tends to result in requirements that are too varied in scope or scale because of the myriad of interests that must be represented in any large corporation. For example, the Sarbanes-Oxley Act ("SOX") of 2002[142] sought to control corporate governance, but instead, SOX functioned arguably as a reactionary measure.[143] Although corporate controls were tightened, SOX's execution proves to be littered with outside interests as it attempts to cover too many issues at once. Internally, voting systems are subject to manipulation based on the flaws discussed above.[144] Therefore, we must look to a form of "gap-filler" between the internal and external controls.

A gap-filler is necessary to slow the knee-jerk swings between the utter lack of regulation and complete overregulation within markets. Such was the case before and after SOX. However, the gap-filler must also recognize the inherent flaws in internal voting mechanisms, such as large incentives or low costs associated with corporate voting. Finally, this device must lead to more transparency while balancing market efficiency and security. These goals may be accomplished through a multi-part plan.

Since the concern is not just hedge funds, but recurring institutional investor control, shareholders should be able to vote to approve any Schedule 13D purchases. Schedule 13D must be filed whenever a party purchases more than 5% of a publicly traded company's voting securities.[145] Schedule 13D requires the disclosure of an acquirer's actual plan to act as a passive investor, hostile bidder, or take a management stake.[146] Most institutional investment purchases are carried out through this mechanism.[147] Under this system, if shareholders do not want to be involved with companies that have the potential for being dominated by hedge funds, they can vote to keep large, single investors out, or at least be put on notice. This would provide a level of redundancy and vested knowledge even when the vehicle in question remains unregulated. With this additional layer of voting, adverse market positions must also be revealed to existing shareholders in order to keep management in check.

In order to further enhance the transparency of transactions, Form 13F should be required for disclosure of both long and short positions. Form 13F is filed quarterly when there is an investment in publicly traded equity securities with an aggregate market value of at least $100 million.[148] However, the current regulations only require public reporting for material long positions.[149] Those with large short positions also have a vested interest in the performance of a company, albeit adverse, but the disclosure of such short positions is necessary for overall transparency. This information provides shareholders with decision-making ability based on the overall direction of the company from all sides of the market. It can also help expose potential management shortfalls that are leading to extensive short positions.

As with any proposal, there are advantages and disadvantages. This plan would restrict large buyers from making purchases primarily because of the time and effort necessary to execute a vote of a quorum of shareholders to approve a stock transaction of the size that has become commonplace with institutional investors. Furthermore, the transaction fees associated with such deals would substantially increase. However, these drawbacks may be necessary to keep institutional investors in check over the long run. This solution, moreover, may force large investors to become long-term investors. Furthermore, it will give the individual shareholders more control in determining ownership of the company, while slowing large-scale acquisition by investment pools and maintaining the current weighted voting regime.

Conclusion

Wall Street is proving to be stronger than Washington. While the SEC has instituted some controls regarding hedge fund registration, this has only compelled large hedge funds to act more aggressively.[150] While hedge funds are the current "shareholder advocates," they may be tomorrow's corporate raiders. However, the intentions of hedge funds should never be a secret -- they are out to make money for their investors in every transaction.

Voting control has become the fund's weapon of choice. Designing a voting scheme to evaluate the manner in which corporate voting is structured is difficult because of the varied interests in the system. While Banzhaf, Shapley and Shubik, and Gilson and Schwartz have attempted to capture these interests, their models have ignored the very systemic flaws hedge funds have sought to exploit, such as the obligation, based on fiduciary duties, and motivation to vote. However, adding constraints may not be as important as adding redundancy.

There is still only loose regulation of hedge funds on both an external and internal level. Because of the growth of the hedge fund industry, more common individual investors are now investing in these funds.[151] History suggests that the more likely investors in a specific security are to be unsophisticated, the more likely the courts are to interpret investment obligations broadly.[152] Therefore, whether it is instituted by the courts, Congress, or individual companies, change and regulation are inevitable. In order to avoid the inevitable pendulum swing that causes instability in the financial markets, restrictions that address the problem, as a long-term issue, must be developed immediately. Simply regulating today's hedge funds is insufficient. Rather, we must enhance transparency and redundancy to proactively regulate them.

Right now, we have wolves lying at bay in the field, but they continue to creep toward the sheep, this time masked as one of their own. The hope is that long-term reform will be instituted before the collapse of the houses of straw and sticks. But it may not be until the impenetrable brick house is blown down that the market hollers "wolf" loud enough to force the hands of change to integrate checks and balances that will not only address today's problems, but tomorrow's problems as well.



[1] Jane J. Kim, Hedge Funds Target Small Investors, Wall St. J., Apr. 27, 2005, at B1.

[2] Hedge Funds, The Latest Bubble?, Economist, Sept. 1, 2001, at 59.

[3] See generally Roger Lowenstein, When Genius Failed (2001).

[4] Andy Jerwer, Let's Make a Deal, Fortune Mag., June 13, 2005, at 56-58.

[5] Id.

[6] Id. at 57.

[7] Id. at 58.

[8] See generally Bethany McLean & Peter Elkind, the Smartest Guys in the Room (2003).

[9] Roberta S. Karmel, The SEC at 70: Mutual Funds, Pension Funds, Hedge Funds and Stock Market Volatility - What Regulation by the Securities and Exchange Commission is Appropriate?, 80 Notre Dame L. Rev. 909, 912 (2005).

[10] Martin Hutchinson The Bear's Lair, Washington Post, Feb. 28, 2005, http://www.washtimes.com/upi-breaking/20050225-020706-9695r.htm.

[11] Hedge Fund Primer, CitiGroup Alternative Investments 2, (2004), available at http://www.smithbarney.com/pdf/HedgeFundPrime_0305.pdf.

[12] The Regulatory Structure Affecting Over-the-Counter Derivatives Transactions: Hearing on H.R. 1161 and H.R. 2924 Before the Comm. on Banking and Financial Services, 106th Cong. (Apr. 11, 2000) (statement of Michael A. Watkins on behalf of the ABA Securities Association), http://financialservices.house.gov/banking/41100wat.htm.

[13] Ben Mezrich, Ugly Americans 86-90 (2004).

[14] Alternative Investments Glossary, Altegris Investments, (2005), http://www.managedinvestments.com/alternative_investments_glossFJ.html#h.

[15] Jerwer, supra note 4, at 54.

[16] A summary of some exemptions utilized by hedge funds can be found in Appendix A of this paper.

[17] Id.

[18] See supra note 11, at 2.

[19] Id.

[20] Id.

[21] Id.

[22] Id. at 6.

[23] Id.

[24] Id. at 7.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

[29] Id.

[30] Id.

[31] Historically, stocks follow an approximate normal distribution, while hedge fund performance is often skewed either positively or negatively, depending on the market strategy employed by the hedge fund. Id. at 7-8.

[32] Id.

[33] Kim, supra note 1.

[34] The Differences between Mutual Funds and Hedge Funds, Investment Company Institute (Mar. 2005), available at http://www.ici.org/funds/abt/faqs_hedge.html.

[35] See Appendix A.

[36] Karmel, supra note 9, at 923.

[37] See supra note 11, at 2

[38] Jerwer, supra note 4, at 54.

[39] See supra note 34.

[40] Id.

[41] Id.

[42] Id.

[43] Id.

[44] Id.

[45] Id.

[46] Id.

[47] Id.

[48] Karmel, supra note 9, at 913.

[49] Id.

[50] Id. at 921.

[51] Id. at 920.

[52] Id.

[53] Id. at 918-19.

[54] Emily Thornton & Susan Zegel, Hedge Funds: the New Corporate Raiders, Bus. Wk., Feb. 28, 2005, at 32.

[55] Id. at 34-35.

[56] Julie Creswell, Hedge Funds Hog the Spotlight, Fortune Mag., Mar. 7, 2005, at 28.

[57] Id.

[58] Id.

[59] Id.

[60] Id.

[61] Between late 2003 and late 2004, ESL Investments bought Sears for $13 billion; Cerberus Capital Management bought LNR Property for $3.8 billion; Highfield Capital bought Circuit City for $3.2 billion; Cerberus Capital Management bought MeadWestvaco for $2.3 billion; Cerberus Capital Management bought Mervyn's for $1.6 billion; D.E. Shaw bought FAO Schwarz for $40 million. Thornton & Zegel, supra note 54, at 32-33.

[62] Jerwer, supra note 4, at 58.

[63] Generally, mutual funds are regulated by the SEC and the Investment Company Act. Pension funds are regulated by the Pension Benefit Guaranty Corporation (PBGC), the Department of Labor and the states; bank collective trust funds are regulated by the Comptroller of the Currency; and commodity pools are regulated by the Commodity Futures Trading Commission (CFTC). Karmel, supra note 9, at 912.

[64] Id.

[65] Id.

[66] Kim, supra note 1.

[67] Karmel, supra note 9, at 927.

[68] Paul H. Edelman & Randall S. Thomas, Corporate Voting and the Takeover Debate, 58 Vand. L. Rev. 453, 489 (2005).

[69] John Von Neumann & Oskar Morgenstern, Theory of Games and Economic Behavior 8-31 (1955).

[70] Id.

[71] Richard L. Berke, On Eve of Election Mostly Apathy, N.Y. Times, Oct. 28, 1998, at A16.

[72] Iannucci v. Bd. of Supervisors, 20 N.Y.2d 244, 251 (1967).

[73] Andrew Gelmany, Forming Voting Blocs and Coalitions as a Prisoner's Dilemma: A Possible Theoretical Explanation for Political Instability, Contributions to Economic Analysis & Policy, Vol. 2, No. 1, Art. 13, at 1 (2003).

[74] Id.

[75] R. Alta Charo, Designing Mathematical Models to Describe One-Person, One-Vote Compliance by Unique Governmental Structures: The Case of the New York City Board of Estimate, 53 Fordham L. Rev. 735, 776-85 (1985).

[76] Id.

[77] Andrew Herd and Tim Swartz, Empirical Banzhaf Indices, 97 Pub. Choice 4, 701-02, (1998).

[78] Charo, supra note 76, at 778-79.

[79] Charo, supra note 76, at 782.

[80] Id.

[81] Id. at 783.

[82] Id.

[83] Anthony J. McGann and Teresa Moran, The Myth of the Disproportionate Influence of Small Parties in Israel, Center for the Study of Democracy, Paper 05-08, 6 (May 11, 2005), available at http://repositories.cdlib.org/csd/05-08.

[84] Martin Shubik, Just Winners and Losers: The Application of Game Theory to Corporate Law and Practice: Game Theory, Law, and the Concept of Competition, 60 U. Cin. L. Rev. 2, 296 (1991).

[85] See id. at 295-96.

[86] Dennis Leech, An Empirical Comparison of the Performance of Classical Power Indices, 50 Pol. Stud. 1 (2002).

[87] Shubik, supra note 85, at 295-96.

[88] David Crump, Game Theory, Legislation, and the Multiple Meanings of Equality, 38 Harv. J. on Legis. 331, 350 (2001).

[89] Id.

[90] Id.

[91] Game theory is a method of analysis that observes strategic interactions between participants in which one participant's choice depaneds upon how other participants choose. Ronald J. Gilson & Alan Schwartz, Sales and Elections as Methods for Transferring Corporate Control, 2 Theoretical Inq. L. 783 (2001).

[92] Id.

[93] Id.

[94] Id.

[95] Id.

[96] Id.

[97] Gilson & Schwartz, supra note 92.

[98] Id.

[99] Edelman & Thomas, supra note 68, at 462-463.

[100] Edelman & Thomas, supra note 68, at 475-76.

[101] Id.

[102] Gilson & Schwartz, supra note 92.

[103] Edelman & Thomas, supra note 68, at 475-76.

[104] Dennis Leech, Shareholder Voting Power and Ownership Control of Companies, University of Warwick, Department of Economics 19 (April 2002).

[105] Id.

[106] Karen M. Gebbia-Pinetti, Statutory Interpretation, Democratic Legitimacy and Legal-System Values, 21 Seton Hall Legis. J. 233, n.192 (1997)

[107] Edelman & Thomas, supra note 68, at 456.

[108] Id.

[109] Hedge fund trading is cited as the primary reason for record short positions in current U.S. markets. Peter A. McKay, Short Positions Reach Record Highs, Wall St. J., May 12, 2005, at C3.

[110] Thornton & Zegel, supra note 54, at 32.

[111] Tim Brennan, "Vertical Market Power" as Oxymoron: Getting Convergence Mergers Right 8 (Aug. 2001), available at http://www.rff.org/Documents/RFF-DP-01-39.pdf.

[112] Och-Ziff Capital Management, Berkshire Hathaway and White Mountain Insurance Group paid $1.35 billion for Safeco. Thornton & Zegel, supra note 54, at 32.

[113] Id. at 35.

[114] Id.

[115] Amy Merrick, Can Sears and Kmart Take on a Goliath Named Wal-Mart?, Wall St. J., Nov. 19, 2004, at B1.

[116] Jesse Eisinger, Is Lampert Jumping into Quicksand?, Wall St. J., Nov. 24, 2004, at C1.

[117] Karmel, supra note 9, at 946.

[118] Id.

[119] Kim, supra note 1.

[120] Id.

[121] Id.

[122] Id.

[123] Id.

[124] Id. at 32.

[125] Thornton & Zegel, supra note 54, at 34.

[126] Id.

[127] Id.

[128] Id.

[129] Id.

[130] Poison pills are merger deterrents that, when triggered by the purchase of a large block of shares, give the company's other shareholders the right to purchase additional shares at a deep discount. This will dilute the shares of the potential acquirer making his cost very high and the target much less attractive. Arguably, removal of a poison pill is not as bold a maneuver as many believe because the poison pill can be reinstated very easily if a valid threat arises. Robin Sidel, Where are all the Poison Pills?, Wall St. J., Mar. 2, 2004, at C1.

[131] Bhattiprolu Murri, More Boards May End Staggered Terms, Wall St. J., June 8, 2005, at B2.

[132] Lucas C. Townsend, Can Wall Street's "Global Resolution" Prevent Spinning? A Critical Evaluation of Current Alternatives, 34 Seton Hall L. Rev. 1121, 1160 (2004).

[133] Id.

[134] Amanda Cantrell, Take My Hedge Fund ... Please, CNN Money (Oct. 14, 2005), available at http://money.cnn.com/2005/10/14/technology/hedgefunds/.

[135] Id.

[136] See supra note 34.

[137] The Regulation and Distribution of Hedge Funds in Europe, PriceWaterhouseCoopers, 10 (May 2003), available at http://www.pwcglobal.com/images/gx/eng/fs/im/060603hedge.pdf.

[138] Id.

[139] Id. at 12.

[140] Id.

[141] Id. at 14.

[142] 15 U.S.C.S. § 7241 (2005).

[143] John Dexheimer & Carla Haugen, Sarbanes-Oxley: Its Impact on the Venture Capital Community, 2 Minn. J. Bus. Law & Entrep. 1, 1 (2003)

[144] See Section IV of this article.

[145] 1934 Exchange Act, § 13(d)(1); Exchange Act, Rule 13d-1(a).

[146] See Sonesta Int'1 Hotels Corp. v. Wellington Assocs., 483 F.2d 247 (2d Cir. 1973); Otis Elevator Co. v. United Techs. Corp., 405 F. Supp. 960 (S.D.N.Y. 1975).

[147] James E. Heard, Institutional Shareholder Services (June 13, 2003), available at http://www.sec.gov/rules/other/s71003/iss061303.htm.

[148] Exchange Act Rule 13f-1; 17 C.F.R. § 240.13f-1 (Feb. 18, 1999).

[149] Id.

[150] Creswell, supra note 56, at 28.

[151] Kim, supra note 1.

[152] For example, as the bond market shifted from primarily unsophisticated investors to sophisticated investors, the courts relied more and more on the terms of the contract ad opposed to implied duties. See Aladdin Hotel Co. v. Bloom, 200 F.2d 627 (8th Cir. 1953); Metropolitan Life Ins. Co. V. RJR Nabisco, 906 F.2d 884 (2d Cir. 1990).