February 26, 2021

“Validation Capital”: Your Hedge Fund Bodyguard?

Activist hedge funds are usually considered a potential threat by public company management, but that’s not always the case.  A recent study takes a look at the phenomenon of “validation capital,” where hedge funds take a position in a company and protect management from other activists as they implement the company’s strategy.  Here’s an excerpt from the abstract:

Although it is well understood that activist shareholders challenge management, they can also serve as a shield. This Article describes “validation capital,” which occurs when a bloc holder’s—and generally an activist hedge fund’s—presence protects management from shareholder interference and allows management’s pre-existing strategy to proceed uninterrupted.

When a sophisticated bloc holder with a large investment and the ability to threaten management’s control chooses to vouch for management’s strategy after vetting it, this support can send a credible signal to the market that protects management from disruption. By protecting a value-creating management strategy that might otherwise be misjudged, providers of validation capital benefit all shareholders, including themselves.

These arrangements often involve side payments to the hedge funds providing the muscle, which the authors acknowledge creates the potential for a corrupt bargain – but they conclude that legal and market forces make that an unlikely outcome. They claim that empirical data from hedge fund activism events supports that conclusion. This “Institutional Investor” article discusses the study, and cites Trian’s 2014 investment in BNY Mellon as an example of validation capital.

Board Diversity: Republican Senators Urge SEC To Reject Nasdaq Listing Proposal

Earlier this month, Sen. Pat Toomey (R-PA) & other Republican members of the Senate Banking Committee sent a letter to Acting SEC Chair Allison Herren Lee urging the SEC to reject Nasdaq’s board diversity listing proposal.

While acknowledging the potential benefits of board diversity, the letter contends that Nasdaq’s proposal would interfere with “a board’s duty to follow its legal obligations to govern in the best interest of the corporation and its shareholders,” violate the materiality principle that governs securities disclosure & harm economic growth by imposing costs on public companies and discouraging private companies from going public.  Okay, those may be reasonable criticisms – but I rolled my eyes at this part of the letter:

The materiality doctrine prevents the development of an unstable, politicized securities regime that would be ripe for abuse of power. Without it, political factions could use securities regulations to advance the latest social policy fad, sidestepping democratic deliberation. Securities regulation would become a political football, as all sides of a social policy issue would fight to enshrine their perspective into regulation.

Sen. Toomey & his colleagues undoubtedly intended their statement about securities regulation becoming a “political football” as a warning about a future regulatory dystopia. Unfortunately, it seems more like a pretty accurate description of the past several years at the SEC, where the outcome of virtually all major regulatory proposals has been decided by a 3-2 vote along unbending partisan lines. That’s a situation that seems unlikely to change in the near future.

Contracts: SDNY Says the Pandemic is a “Force Majeure”

This Shearman blog reviews the SDNY’s recent decision in JN Contemporary Art  v. Phillips Auctioneers, (SDNY; 12/20), in which Judge Denise Cote held that an auction house was permitted to terminate an agreement because the pandemic constituted a “natural disaster” within the meaning of the agreement’s force majeure clause. This excerpt discusses Judge Cote’s reasoning:

The Court held that the COVID-19 pandemic and related government restrictions on business activity were “squarely” within the agreement’s force majeure clause, which allowed the auction house to terminate the contract if the auction were postponed due to “circumstances beyond [the parties’] reasonable control.” First, the Court concluded that it could not be “seriously disputed” that COVID-19 constituted a “natural disaster” as the pandemic was an event “brought about by nature” and a “natural event that cause[d] great damage or loss of life.”

Second, the Court determined that the COVID-19 pandemic was the type of “circumstance” envisioned by the clause because the enumerated examples included environmental calamities and “also widespread social and economic disruptions.” The COVID-19 pandemic fell within that category, the Court noted, as it was “a worldwide public health crisis that has taken untold lives and upended the world economy.”

The blog says that this decision is among the first to explicitly hold that the pandemic qualifies as a “natural disaster” under a contractual force majeure clause.

John Jenkins