Derivatives are purely economic interests created through various mechanisms that allow an investor to reap the economic benefits of stock ownership without actually owning any stock. A stockholder can eliminate or reduce its economic risk through the use of derivatives and may become motivated to focus on short-term gains at the expense of long-term growth. The use of derivatives was recently examined by the US District Court for the Southern District of New York1 with regard to the level of disclosure required of investors holding derivative positions. The amendment of shareholder rights plans to account for derivatives was discussed in a previously distributed Corporate Alert. Recently, companies have been focusing on derivatives when drafting bylaw amendments.
Most US companies do not currently have provisions in their bylaws that account for investors holding derivatives. This can leave a company and its stockholders exposed to the threat of voting activities or director nominations by activist stockholders who have hedged their interests in the company's stock and whose interests may not align with those of other stockholders.
There are several reasons why the interests of activist stockholders who have used derivative investments to hedge their interests in a company's stock may not align with the interests of other stockholders. For example, through the use of hedging, activist stockholders can hold a negative economic interest in a company and accordingly become motivated to manipulate the stock price for their own benefit. An activist stockholder may also have a larger economic interest in the company than is evident from its filings with the SEC. These stockholders may shield their true intentions by using complex financial transactions such as derivative investments that separate financial interest in a stock from voting rights.
Such nontransparent stockholder activity can leave a company open to unforeseen negative consequences. For example, in 2004, hedge fund Perry Corporation (Perry Corp.) purchased a roughly 10 percent stake in Mylan Laboratories, Inc. (Mylan Labs) and concurrently hedged the investment. Perry Corp. used its shares in Mylan Labs to sway the vote on the proposed acquisition of a company in which Perry Corp. owned a sizable stake. In voting for the acquisition, Perry Corp. voted against the best interests of Mylan Labs due to its overpayment in the deal but avoided the economic consequences of a drop in the value of Mylan Labs' stock because it had hedged its position.
Recently, many companies have revised their bylaws to account for investors holding derivative positions by requiring stockholders who submit proposals for consideration at an annual meeting or who nominate candidates for election as a director to disclose whether they have reduced their economic risk through hedging or other derivative investments.
Recently Amended Bylaws
This year more than 40 companies listed on the New York Stock Exchange added provisions to their bylaws that require investors nominating directors or proposing resolutions to disclose derivatives or other complex transactions involving the company's stock. Several notable examples of companies that have recently amended their bylaws in this manner include Coach, Inc., Sara Lee Corporation, Monsanto Company and Pfizer Inc. Although each company's bylaw amendments were somewhat different, each bylaw was written to require greater disclosure from stockholders who nominate directors or propose resolutions. The new disclosure requirements in the recently amended bylaws include:
- Disclosure of any hedging activities and any person acting in concert with the stockholder;
- Disclosure of any hedging of ownership or transactions that could have the effect of changing economic risk or voting power with respect to the company's common stock;
- Disclosure of all ownership interests, hedges, economic incentives and rights to vote on shares of any security in the company; and
- Disclosure of any relevant agreements that the stockholder has in place, profit interests, hedging transactions or other derivatives that the stockholder has with respect to the company's stock.
Recent Success With Amended Bylaws
Earlier this year, asset manager Cohen & Steers, Inc. (Cohen) used amended bylaws to help fend off a challenge by Western Investment LLC (Western). On December 21, 2007 Cohen amended its bylaws to enhance disclosure requirements of stockholders who submitted a proposal or nomination of a director. Western sought stock buybacks by the company and board seats at two of Cohen's funds. In challenging the proposal, Cohen was able to notify its other shareholders through its proxy materials that Western owned derivatives tied to Cohen stock, had recently sold a large number of shares in Cohen and was not interested in the long-term interests of Cohen.
Companies should consider amending their bylaws to require a stockholder submitting a proposal or nominating a person for election as a director to disclose whether the stockholder has reduced its economic risk through the use of derivatives or other transactions involving the company's stock. The revised bylaws should provide increased transparency, which could give boards a better understanding of activist stockholders' motives.