Hedge Funds in the Netherlands

Hedge funds in the Netherlands

GEERT RAAIJMAKERS, NAUTADUTILH

The activities of hedge funds are the focus of great interest. They file petitions for inquiry if they believe that the Tabaksblat Code is not being properly applied (Versatel), they block acquisitions which they consider undesirable and they dismiss directors who do not share their views (Deutsche Börse). Sometimes they take action against what they view as an unfair buyout (Shell).

Hedge funds appear to have discovered mainland Europe, and developments are now occurring at a rapid pace. They are banging on doors which others have walked past and are thereby seeking to define the boundaries of company law. While the debate on improving shareholders' rights is still in full flow on the Dutch and European level, hedge funds have moved ahead of these developments.

The question is how this development should be assessed from the perspective of company law. Some people believe that hedge fund managers are doing what responsible shareholders should do: using the rights they have in order to assert their interests as shareholders. Others believe they are abusing those rights when they put immense pressure on a company to take steps which only serve their own short-term interests.

Shareholder role

For some time, a stronger role for shareholders has been seen as the solution for improving the system of checks and balances in companies. The idea was that institutional investors would be the most appropriate parties to take on that role. But that has only happened to a limited extent. There appear to be many obstacles.

They have conflicting interests, and they also have a free-rider problem (why incur costs if others are already doing it). Partly for this reason, they often encounter apathy ("I can't achieve anything on my own"). In short, they have no strong incentives to do much with their shareholder rights.

Hedge funds are in a very different position. They become closely involved in the companies in which they invest. They 'hound' the management of the companies in which they invest and (unlike 'traditional' institutional investors) are able to react quickly and flexibly to new developments. Their decision-making lines are shorter. Moreover, unlike institutional investors, hedge funds do not have to meet transparency requirements. They also have less conflicting interests, and indeed they have such strong incentives that any conflicting interests are rapidly pushed aside so as not to miss out on a high reward. They expose the dysfunction of the incumbent management and demonstrate an ability to 'even out' over- and undervaluations of companies.

It is true that hedge funds achieve their returns through investment strategies which often exist only for a short time, even though they sometimes invest in companies for a number of years. But that does not necessarily mean that companies and shareholders with longer-term objectives simply have to suffer. Short-term and long-term objectives can be compatible. Hedge funds track down 'inefficient pricing' and earn their money by eliminating it. As active shareholders they are interested primarily in companies which take – or fail to take – decisions against the wishes of 'the market'. They themselves then help eliminate such 'inefficiencies' by making use of their rights as shareholders.

An example from 2004 was the blocking of the bid by Deutsche Börse for the London Stock Exchange (LSE), which was rated negatively by the market. Other examples include pressuring companies to break up, because the sum of the parts would be worth more than the whole, or the distribution of a special dividend or a share buyback if the company has no clear strategy for its cash pile.

Stakeholders vs shareholders

The activism of hedge funds as shareholders can also be viewed from another perspective. An oft-heard complaint about hedge funds is that they only act from a very short-term perspective. Their results do not necessarily mesh with the interests of other shareholders and stakeholders in the longer term. The failed bid by Deutsche Börse ('DB') for the London Stock Exchange is seen by many as an example of this. Some hedge funds acquired holdings of around 7% in DB and openly opposed the plans. Other shareholders (collectively holding around 35% of DB) joined in. Werner Seifert (the CEO of DB) failed in his attempts to win over the dissident shareholders. DB decided not to pursue a bid and said it would distribute the available resources to its shareholders. In May 2005, Seifert decided to resign because he was unwilling to comply with the instruction from DB's Executive and Supervisory Boards: "to change the composition of both the supervisory and executive boards in order to reflect the new ownership structure of the company."

It is undeniable that hedge funds focus solely on their own objectives, but there is nothing wrong with that in itself. There are nevertheless possible scenarios in which that might cause friction. Hu and Black cited an example from the Deutsche Börse-LSE case. They think it likely that hedge funds were long in DB and short in LSE; hedge funds expected the bid not to succeed. In that case the LSE share price would probably fall, while that of DB would rise. The additional return that could be made on the short side gave shareholders an extra incentive to make use of their position, an incentive which long-only shareholders in DB did not have, or only had to an insufficient extent. But it would be problematic, according to Hu and Black, if the short position in LSE were much larger than the long position in DB. Those hedge funds would have more interest in seeing a fall in the value of LSE than a rise in the value of DB. The result would be a strong incentive to block the bid, even if a successful bid would be in the interest of DB.

It is difficult to assess whether such a scenario is entirely realistic. For a hedge fund it seems far more profitable and 'safer' to anticipate a market sentiment that already exists than to counter such a sentiment. Nevertheless, it is not inconceivable that the involvement of hedge funds might block useful transactions. More research needs to be conducted on this point.

Empty voting

There are also indications that hedge funds sometimes use dubious methods to pursue their objectives. Examples could include what the American literature describes as 'empty voting': voting without an economic interest. Securities lending can be a means to do this. Institutional investors often legally transfer shares to a party which has to deliver such shares in the short term, for example due to a short position. In exchange, the 'borrower' undertakes to return the same number of shares at a later time, on payment of a 'loan fee'. It is accepted that this practice fulfils a useful function and contributes to the liquidity and efficiency of the financial markets.

However, there are increasing concerns that this facility is open to abuse. There are suspicions that shares are being borrowed with the sole purpose of influencing the outcome of shareholder meetings. The temptation to do so is great. Securities lending can be used to rapidly acquire a large holding of shares with which a decisive vote can be cast at the shareholders' meeting of the company concerned. The party holding the voting right has no economic interest in 'its' shares. It is therefore a form of vote stripping, or buying of votes. It is questionable whether this is permitted under Dutch law. If the action is initiated by the executive board of the company concerned in order to thwart the regular decision-making process, that may be viewed in subsequent inquiry proceedings as an act of mismanagement. Also, if a shareholder seeks to influence the outcome of a vote by buying shares it is conceivable that this may be a breach of public order.

Conclusions?

We still know too little and it is still too early to draw conclusions. The same applies to the broader question of the extent to which shareholder activity by hedge funds and other institutional investors actually adds value in the broader sense and has a positive effect on individual companies in particular and the economy at large.

The argument on this has not been settled. Set against possible disciplinary effect and the efficiency improvements, there is the view that a "separation of ownership and control" is the logical consequence of the need to give the management sufficient discretion to manage the company in an optimum way. Accountability can turn into an undesirable infringement of the necessary discretion. Here too there is a need for more (empirical) research to help find the right balance. Such research should also address the question of what incentives apply in the current system and the practice of shareholder activism discussed previously.

As a result of hedge funds' increased influence in corporate governance, a shift is taking place from a strongly regulated environment – the listed company in a public market – to a scarcely regulated environment. The question of whether this is a cause for concern is also one we cannot answer at this stage. Anyone who compares the various relevant factors will ascertain that a 'high-risk setting' could easily develop with a growing risk of improper practices. After all, there is scarcely any regulation of the fund as such, there is no central supervisor, large sums are at stake and there is little or no transparency.

Furthermore, high expectations are aroused with regard to future returns and there is accordingly high pressure to perform. The business-critical risk is relatively low, since it is primarily the reputations of individuals – the managers of the respective hedge fund – that are at stake and not those of large, respectable organisations. Moreover, there is no need to disclose any errors or abuses. On the other hand, a company which switches from the public to the private domain is 'released' from the requirements relating to market abuse and insider trading, governance codes, Sarbanes Oxley and the resulting compliance requirements and costs.

An important factor is that there is often an information gap between the hedge fund managers and their principals (the 'end-investors'). This gives rise to agency conflicts and monitoring costs of a specific type. Seen in this way, the combating of one conflict of interests (between the institutional investor and the company) gives rise to a new potential conflict of interests (between the end-investor and the asset manager). The institutional investor must control the resulting risks. He is also under increasing pressure to account for the way in which he does so. In short, the private setting requires that all parties involved remain on their guard and that all the principals in the chain of intermediaries demand constant accountability from their agent.

Notwithstanding the need for more research, it seems desirable to guarantee a better balance between long and short-term interests. Such interests may be compatible, but not always. There is a danger that this field of tension will put excessive pressure on our system of financing based on stock-market listing. That is not in the interests of business, for which this provides an important source of financing. Nor is it in the interests of long-term investors who require long-term investment facilities and a spreading of investments.

The question is whether regulation of hedge funds as such would be advisable. That is doubtful. Since hedge fund strategies cannot be pinned down in definitions, it is difficult in practice to frame appropriate regulations. It is not surprising that previous discussions and initiatives in this direction have not yielded a great deal. It is also questionable whether such regulation will eliminate the obstacles we have outlined. It is probably more useful to consider possible improvements to the existing system in order to prevent it being easily abused.

For example, is it useful to consider misleading 'private' comments on the size of the holding in a company explicitly as a form of market abuse? Should we prohibit abuse of securities lending or other techniques aimed at influencing the decision making at shareholder meetings? Or, going further still, should voting without any underlying economic interest be discouraged?

In any event, a balanced debate is required. Hedge funds give rise to difficult issues, but they also play a useful role in our financial system. In the search for solutions, we must do one thing while not neglecting the other: fight the virus and develop the vaccine.