MAASTRICHT

Faculty of Law

Maastricht University

Hedge funds in company law: virus or vaccine?

R.H. Maatman and Geert T.M.J. Raaijmakers

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 Hedge funds in company law: virus or vaccine?

Rene H. Maatman
Radboud University Nijmegen, Faculty of Law
ABP Investments

Geert T.M.J. Raaijmakers

Maastricht University, Faculty of Law
NautaDutilh, Amsterdam (ABP Investments at the time this article was written)

Published in Ondernemingsrecht 2006, p. 256-262

Abstract

Hegde funds cause concerns in company law. They act as activist shareholders: with
their rights as shareholders they force listed companies to split up their business, pay
out a super-dividend or terminate their plans to do a merger. In doing that they both use
and test the company law. Some times that is beneficial, sometimes it is not.

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1. Introduction

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), 1 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). 2 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. In this article we seek to analyse these two views more closely and assess
whether any conclusions can be drawn. First we shall consider the question of what
hedge funds are and how they operate.

2. What are hedge funds?

2.1 Background

The first hedge fund dates from 1949. The man behind it was Alfred Jones. 3 He devised
a form of investment which took advantage of the volatility of American share prices. He
eliminated the market risks in his investment portfolio by using financial instruments, by
hedging those risks. That meant he had a securities portfolio in which the results
depended on his own expertise, rather than on independent movements in the market.

1
Enterprise Chamber 14 December 2005, nos. 1446 and 1847, AA 2006, p. 198 ff.
2
Cf.Het Financieele Dagblad of 15 December 2005: “Activisme in rechtszaal werkt”.
3
Cf. R.H. Maatman and L.F. Palmen, Alternative Investments, in the series Contracteren in de
internationale praktijk no. 6, Deventer 2002, p. 17 ff. See also A. Kovas, Should Hedge Fund
Products be Marketed to Retail Investors? A Balancing Act for Regulators, in: Hedge Funds;
Risks and Regulation, Berlin 2004, p. 95-96.

3
Jones quietly managed his fund for almost two decades. When in 1966 Fortune
magazine focused attention on the Jones Fund and its investment results, the number of
hedge funds increased very rapidly.
Since then hedge funds have had a tempestuous history, with ups as well as
downs. A notorious case was the downfall of the Long Term Capital Management
(LTCM) hedge fund in 1998, which speculated on currencies taking part in the European
Monetary Union. 4 Against the background of those ups and downs, discussions have
taken place on the question of whether hedge funds should be subject to financial
supervision. For example, whereas the discussion following the LTCM debacle mainly
concerned possible regulations to safeguard the stability of the financial system, after
the accounting scandals involving Enron and others the regulators’ attention switched
more to protecting investors against the risks inherent in hedge fund investments. 5
In spite of plans for regulations, the regulators have so far been reticent. Hedge
funds do not as a rule fall under direct supervision, since the parties involved are de
facto mostly professionals who can take advantage of exceptions in securities law. The
size of the minimum investment is often so large as to be beyond the scope of private
investors. 6 Another notable feature is that the investment usually has an upper limit. This
is due to the limited “investment capacity” of the fund; the greater the scale on which a
hedge fund strategy is applied, the lower the financial benefit which can be achieved
with each transaction. 7
Hedge fund strategies are arousing great interest among institutional investors,
particularly pension funds. The slump in the stock markets at the beginning of this
century weighed heavily on the value of their investments. As a result, there was a
greater need to spread risk in investment portfolios, thereby making them less
vulnerable to the results of equities and fixed-income investments. That is a key reason
for the rise of so-called “alternative investments”, i.e. those with an alternative risk
profile, such as real estate, private equity and hedge funds. Although these “alternative

4
For further information on such arbitrage strategies, Maatman/Palmen, p. 37-40.
5
Cf. I. Cullen and H. Parry (ed.), Hedge Funds: Law and Regulation, London 2001, p. 173 ff.;
M.L. MacHarg, Waking Up to Hedge Funds: Is U.S. Regulation Really Taking a New Direction?,
in: Hedge Funds; Risks and Regulation, Berlin 2004, p. 55 ff.
6
According to the SEC Report “Implication of the Growth of Hedge Funds”, (2003), p. 80, the
minimum investment is between $50,000 and $10 million. See also the AFM report on Hedge
Funds: An exploratory study of conduct-related issues, August 2005, p. 31 and p. 46, which refers
to a minimum investment of €100,000.
7
Hedge funds are becoming as it were the victims of their own success. Cf. Hedge fund
performance hit by glut of new money, Financial News 17-23 June 2002.

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investments” often have a high risk profile individually, they can lower the risk profile of
the overall portfolio of an institutional investor. That is the case if the results of such
investments move independently or even in the opposite direction to those of the other
constituents of the portfolio. 8 Private individuals have also become interested in
investing in hedge funds in recent years. Investment vehicles have been designed to
enable them to participate without jeopardising the lightly regulated or unregulated status
of the funds.
The activities of hedge funds now vary greatly and they have grown to an
unprecedented size. The volume of assets which they manage worldwide is now
estimated at $1,200 billion. 9 It is generally accepted that hedge funds make a major
contribution to the “efficiency” and liquidity of the market. 10 At the same time, an aura of
mystery and mistrust often hangs over them. They are frequently seen as applying
aggressive methods, taking irresponsible risks and being purely speculative; it is held
that in their quest for profit they regularly cause markets to overheat – in general or just
in a single stock. They are accused of only being out for very short-term gains, often to
the detriment of others.

2.2 Definition

Hedge funds are difficult to define. 11 They are essentially investment funds which are
usually unsupervised and, partly as a result, can use an almost unlimited range of
investment instruments. Unlike traditional investment funds, they make extensive use of
instruments such as short selling, leverage and derivatives. 12 Short selling means selling

8
See also A.M. Ineichen, On Myths, Bubbles and New Paradigms in the Hedge Fund Industry, in:
Hedge Funds; Risks and Regulation, Berlin 2004, p. 17 ff., which also includes a number of
comments.
9
Financial Times 11 January 2006, p. 13; SEC Report (2003), p. 1; Het Financieele Dagblad of
28 December 2005, p. 10.
10
For the market benefits of hedge funds see SEC Report (2003), p. 4-5.
11
Cf. International Organisation of Securities Commissions (IOSCO), The Regulatory
Environment for Hedge Funds; A Survey and Comparison (Consultation Report), March 2006, p.
4;. However, see also G. Spindler and S. Bernarz, Die Regulierung von Hedge-Fonds im
Kapitalmarkt- und Gesellschaftsrecht, Düsseldorf Center for Business and Corporate Law
Research Paper Series, 1/2006.
12
Cf. AFM Report 2005, p. 15 ff.

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securities which they do not own at the time of the sale. It is generally accepted that
short selling plays a useful role in the operation of the financial markets. 13
The basis of most hedge fund strategies involves taking so-called long-short
positions. The principle is as follows. Suppose a hedge fund manager concludes on the
basis of his analyses that company X is undervalued and company Y is overvalued. The
hedge fund then sells shares in company Y, even though it does not own them: it “goes
short” in Y. In order to fulfil its delivery obligation, the hedge fund then “borrows” the
respective shares Y temporarily from an institutional investor who does not “need” them
at that time. In legal terms, this securities lending involves a transfer of the shares to (in
this case) the hedge fund, with the latter being obliged to return the same number of
shares Y at a later time against payment of a loan fee. 14 The hedge fund uses the
proceeds of the sale of the shares Y to buy shares in company X: it “goes long” in X.
If its analysis is correct, the hedge fund gains in two ways: X is undervalued and
will therefore gradually increase in value, as a result of which the value of the holding in
the company also rises. The hedge fund also gains on the holding in Y. This company
was overvalued and has now fallen in value, say from 100 to 80. When the hedge fund
sold the shares Y, it received 100. Now it has to return the shares to the institutional
investor and only has to pay 80 to buy them in the stock market. The loan fee of, say, 1
must then be deducted, so the profit on the short position is 19. The hedge fund can
increase the total profit on this long-short position by contracting a loan and creating a
leverage effect. A fixed rate of interest must be paid on the loan, let us say 6%. If the
hedge fund’s analysis is correct, it will make a much higher return on the transaction,
e.g. 16%. The difference between the two is the additional gain achieved through
leverage. Similar effects can be achieved with certain derivatives, such as options and
futures.
A typical feature of hedge funds is that they can use various investment
strategies based on this type of long-short approach to detect and exploit inefficiencies
in the pricing in financial markets. They are therefore interested in companies that are
undervalued or overvalued. Since their activities cause such price inefficiencies to

13
Cf. SEC Report (2003), p. 39-40; Ineichen 2004, p. 12; FSA Discussion Paper 05/4 on Hedge
Funds: A discussion of risk and regulatory engagement, June 2005, p. 14; AFM Report 2005, p.
35.
14
Under Dutch law this transaction qualifies as a simple loan (“verbruikleen”) within the meaning
of article 7A:1791 of the Netherlands Civil Code. Cf. G.T.M.J. Raaijmakers, Securities lending en
corporate governance, in: Tussen Themis and Mercurius (NGB collection), Deventer 2005, p. 241
ff.

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decrease or disappear, it is said that hedge funds contribute to efficient pricing in the
market. After all, undervaluation simply means that demand is lagging. A “long strategy”
causes demand to increase, thereby also leading to a rise in the price, particularly if
several hedge funds are active at the same time. In the case of a “short strategy”, the
reverse applies. The causes of the inefficient pricing on which hedge funds base their
investment strategies can range from minor differences in the dual listings of companies
to particular situations such as mergers or corporate distress cases. 15
When hedge funds are compared to other asset managers and investment funds,
a sliding scale can be discerned. There are asset managers or investment funds that
invest in accordance with an index. They only have to ensure that each individual
change in the composition of an index (including the weight of a company in the index) is
replicated in the investment portfolio. For that reason they are referred to as “passive”
investors; they follow the market. They incur low costs and charge relatively low
management fees. The more closely they match the index result, the better their
performance. Then there are enhanced index strategies, whereby an investor tries to
“beat” an index by means of underweighting or overweighting. That means they are
somewhat more active and strive for a relative outperformance; their objective is to
achieve better results than the market – in other words the respective index – within
certain limited risk margins known as tracking errors.
There are even more active asset managers who also strive for relative
performance, but who have greater freedom to depart from the index or benchmark.
These include the “stockpickers”. As a rule they only use “long-only” strategies. At the
other end of the spectrum are the hedge funds. They use strategies other than “long-
only” and focus on absolute rather than relative yield. They use a so-called cash
benchmark instead of a market benchmark. 16 That is something they have in common
with more “traditional” asset managers and investment funds.

15
There are also different types of investment strategy, such as market-neutral or arbitrage
strategies, event-driven strategies and so-called tactical trading strategies. See also SEC Report
(2003), p. 34-36; AFM Report 2005, p. 23-24; H. de Ruiter, De plaatsbepaling van hedge funds
binnen een pensioenfondsportefeuille, VBA Journaal 2002, no. 2. These strategies are
sometimes accompanied by very large exposures. With 125 billion of assets, LTCM was able to
enter into off balance sheet liabilities totalling more than 1,000 billion by means of OTC
derivatives. More information on this can be found in Maatman/Palmen, p. 32-33; M. Taylor,
Hedge fund regulation, in: Butterworths Journal of International Banking and Finance Law 1999,
p. 182-187.
16
Cf. Ineichen 2004, p. 22 ff.

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 In short, “hedge fund” is a difficult term to define. Sometimes, faute de mieux,
hedge funds are defined merely as parties which call themselves hedge funds. 17 In this
article we shall use the term in a relatively broad sense: hedge funds in the strict sense
referred to above, but also the extremely active asset managers and funds, since in
practice the boundaries with these parties are fading. Examples of such fading
boundaries can also be found elsewhere. Like hedge funds, private equity funds are
increasingly acquiring holdings in listed companies. 18 Both are also active in public-to-
private transactions, and one functions as a catalyst for the other: for example, when a
hedge fund has blocked an important merger, a public-to-private transaction is an
obvious option. 19 But in spite of these fading boundaries it should be recalled that there
are still differences. For example, private equity funds are by definition deemed to be
long-term investors, while hedge funds are “by their nature” more used to working with
long-short strategies. 20 It is also important to realise that the rise of shareholder activism
is taking place “along a broad front”. Although hedge funds currently appear to be an
important driving force behind this development, other parties are also playing a part,
such as more traditional institutional investors and private equity investors.

3. Activism of hedge funds: vaccine…

Steadily shrinking margins and the saturation of “traditional” hedge fund strategies have
recently prompted hedge funds to shift their attention to acquiring substantial holdings in
companies. A new factor is that hedge funds are no longer speculating “passively”, but
are actively promoting the desired situation by using their shareholder rights. The growth
in their assets means they now have resources with which to back up their wishes. This
development has both positive and negative implications from the company law
perspective.

3.1 Positive: new-style shareholder activism

17
Cf. Kovas 2004, p. 97.
18
The term PIPE transactions is used (Private Investment in Public Equity).
19
Cf. also J.M. Tannon and R. Johnson, Transatlantic Private Equity: Beyond a Trillion Dollar
Force, The Journal of Private Equity 2005, p. 77 ff.; H.L. Kaemingk, Private Equity en haar plaats
in het ondernemingsrecht, Ondernemingsrecht 2005,-17 p. 572 ff.
20
Cf. SEC Report (2003), p. 5-8, which refers to a number of differences which still apply.

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For some considerable time, a stronger role for shareholders has been seen as the
solution for improving the system of checks and balances in companies. In a recent
article, Kahan and Rock referred to the quest for the “Holy Grail of corporate governance
(…): an actor with the incentives and the expertise to protect shareholders’ interests in
the publicly held firm with widely dispersed ownership”. The idea was that institutional
investors would be the most appropriate parties to take on that role. 21 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. 22
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. 23 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. 24 They expose the dysfunction of the incumbent management and
demonstrate an ability to “even out” over- and undervaluations of companies.
Hedge funds fulfil what the Tabaksblat Committee, according to the preamble to
the code, expects of shareholders: calling the executive and supervisory boards to
account, “exerting pressure on the executive and supervisory boards to change the
corporate governance structure”, making use of the rights available to them, with the
21
M. Kahan and E.B. Rock, Hedge Funds in Corporate Governance and Corporate Control,
Preliminary Draft, January 2006, www.law.upenn.edu, p. 3.
22
See on this subject B.S. Black and J.C. Coffee, Hail Britannia?: Institutional Investor Behavior
under Limited Regulation, Michigan Law Review 1994, p. 2059 ff.; B.B. Black, Shareholder
Activism and Corporate Governance in the United States, in: The New Palgrave Dictionary of
Economics and the Law (1998) (also available for download at ssrn.com); A.F. Verdam,
Stemmen van institutionele beleggers en tegenstrijdig belang (VU lecture), The Hague 2003; R.S.
Karmel, Should a duty to the corporation be imposed on institutional shareholders, The Business
Lawyer 2004-60; G.T.M.J. Raaijmakers, Beleggers, aandeelhouders en de AVA,
Ondernemingsrecht 2005, p. 110 ff.; S.M. Bainbridge, Shareholder Activism and Institutional
Investors, UCLA Research Paper No. 05-20 (October 2005), ssrn.com, p. 10 ff.
23
To the displeasure of some. See e.g. Executive Board Chairman Elverding of DSM in Het
Financieele Dagblad of 10 February 2006, although this relates more to private equity funds.
24
Cf. Kahan/Rock, p. 19; H.T.C. Hu and B. Black, Hedge Funds, Insiders, and Decoupling of
Economic and Voting Ownership in Public Companies, ECGI – Law Working Paper, January
2006, ssrn.com, p. 28-29.

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ultimate consequence of “dismissing the supervisory board and/or the executive board”
and possibly instituting legal proceedings, such as petitions for inquiry or annual
accounts proceedings.” 25 Hedge funds do this with verve, sometimes to the displeasure
of executive and supervisory directors. Hedge funds can thus offer a solution to the so-
called rational apathy 26 that prevails among shareholders, and they show themselves to
be a powerful adversary of the company’s management. In this way they help bridge the
conflict of interests between power and economic ownership. 27
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. 28 But that does not 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 is 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.
Essentially, institutional investors and private individuals who entrust their assets
to hedge funds assign their participation rights to better informed and specialist
operators. 29 Because they apply maximum pressure, they also bring about a better
allocation of financial resources in the financial markets and the economy itself. Their
actions cause resources to flow from poorly managed companies to other companies
which are rewarded for developing innovative strategies. Hedge funds often have a great
deal of expertise, particularly in the financial field. That makes them attractive financial

25
Preamble points 7 and 8. See also Principle IV.4 of the Code.
26
Cf. J.W. Winter, De governance van pensioenfondsen, in: Vergezichten (Frijns collection),
Driebergen 2005, p. 217; Kahan/Rock, p. 16.
27
Cf. E.A. Posner, Agency Models in Law and Economics, working paper (2000), p. 11:
“Corporate raiders, despite their unsavory reputations in some quarters, are the solution to an
agency problem, and on this view should be celebrated rather than reviled.” Cf. also A.W.A. Boot
and R. Soeting, De onderneming in een spagaat, MAB 2004-4.
28
Cf. the statements by the senior executive of the hedge fund Centaurus in Het Financieele
Dagblad of 10 March 2006, p. 13.
29
Cf. Kahan/Rock, p. 31; Hu/Black, p. 5.

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and business partners, particularly for companies which have difficulty attracting capital
because of their nature or size. 30 For individual companies, this development probably
has a disciplining effect. In general, companies can be expected to face greater pressure
to perform, compete and innovate, and that can provide a powerful boost for a stronger
economy.
At the same time it is clear that in their role as shareholders hedge funds are not
acting in isolation. They are part of a broader trend in which other institutional investors
are also making more active use of their rights and position.

3.2 Some practical examples of shareholder activism

US and UK institutional investors have long been accustomed to talking to companies if

they have doubts about their corporate governance. This generally takes place outside
the context of the AGM, in letters to the management and motions from shareholders to
be placed on the agenda for AGMs. 31 Dutch institutional investors have been treading
the same path, albeit somewhat hesitantly, since the end of the 1990s. 32 Such activities
have generally taken place out of the glare of publicity.
The “friendly” approach adopted by institutional investors contrasts with the
intensity with which some hedge funds pursue such activities. They publicly expose
cases of gross abuse and demand immediate improvement. Kahan and Rock cite
various examples of US practice in their article. In the Netherlands, we have seen similar
actions by hedge fund managers at RD/Shell and Versatel. The fact that other
institutional investors are now also adopting a stricter, active approach, can be seen
from the recent events involving VNU: two “ordinary” investment funds blocked VNU’s

30
Cf. H. Avery, Why CFOs should stop mistrusting hedge funds, Euromoney Vol. 36, No. 439
(November 2005), p. 59 ff.; D.J. Bropghy, P.P. Ouimet and C. Sialm, Hedge Funds as Investors
of Last Resort, ssrn.com, 1 March 2006. See also S-J. Spanjaard, Sprinkhanen en barbaren,
Ondernemingsrecht 2005, p. 571.
31
So-called “vote no campaigns” can also be included here. The best-known example of these is
Disney, where 42% of votes were cast against Michael Eisner as chairman of the board. Within a
few hours of the result of the vote Eisner was replaced as chairman and a few months later he
resigned as CEO. Cf. J.W. Eisenhofer and M.J. Barry, Shareholder Activism Handbook, New
York 2005, § 3.04.
32
Cf. the approach of institutional investors towards Ahold. Between 1998 and 2002 Dutch and
foreign investors repeatedly called in writing for an improvement to the corporate governance at
Ahold, with criticism being directed particularly at the voluntary application of the two-tier board
structure. See also Het Financieele Dagblad of 16 May 2001: Beleggers krijgen niet meer greep
op Ahold; P. Frentrop, Een brief aan Ahold, in: Vergezichten (Frijns collection), Driebergen 2005,
p. 315 ff.

11
acquisition of IMS Health at the end of 2005 because they believed the transaction
would be of no benefit to the company. It also seems likely that the changes that
occurred in the corporate governance of RD/Shell in 2005 resulted in part from pressure
exerted by the hedge fund Knight Vinke. 33
Knight Vinke’s communications activities are accompanied by the taking of a
substantial equity stake. The same applies to the Focus Funds that are managed by
Hermes. 34 Hermes then seeks to gain influence in the company management itself, for
example by claiming a seat on the board. Sparx Asset Management pursues a similar
investment strategy in the Japanese market. 35 Relational Investors is a well-known
operator in the United States. 36 Its name derives from the term “relationship investing”:
that begins with “shareholders taking a real interest in a company – asking questions of
the board and not trading the stock like pork bellies – and goes all the way to taking a
big stake, a board seat, and maybe even some debt.” 37 The idea behind it is that by
fulfilling this “monitoring role”, shareholders are better able to counter conflicts of interest
and reduce agency costs.
The activities of some private equity funds are an extension of this. They conduct
investment strategies that are akin to those of the hedge funds described in this paper.
When a private equity fund acquires an interest in an undervalued listed company, it
usually does so in order to conduct a public-to-private transaction. They expect the
company concerned to generate greater value for shareholders as a result of the
“discipline” brought about by “private monitoring” instead of the open market. A public-to-
private transaction is often followed by a break-up of the company and the sale of
separate businesses. Hence there is a seamless connection between the activities of
“traditional” institutional investors, hedge fund managers and private equity investors.
That connection is illustrated by the events at Vendex KBB.

33
An interview with the founder Eric Knight appeared in Het Financieele Dagblad of 27 December
2005.
34
Cf. www.hermes.co.uk
35
The description of that strategy is illustrative: “The investment objective of the strategy is to
achieve above-market returns and create long-term shareholder value by making concentrated
investments in undervalued public securities of mid to large cap Japanese companies that are
willing to work with SPARX to focus on shareowner interests. SPARX actively communicates and
collaborates with management to eliminate inefficiencies, improve transparency, and
optimize their balance sheets as appropriate.”, cf. www.sparxgroup.com.
36
Cf. www.rillc.com, covered in BusinessWeek online, 20 September 2004: Meet the Friendly
Corporate Raiders.
37
Cf. Ira Millstein, cited in Eisenhofer/Barry, § 3.03. See also S. Bhagat, B. Black and M. Blair:
Relational investing and firm performance, working paper 2003; I. Ayres & P. Cramton, Relational
Investing and Agency Theory, Cardozo Law Review 1994 no. 15.

12
 From the end of the 1990s, investors and analysts repeatedly stated that Vendex
KBB was underperforming financially. 38 It was suspected that the value of Vendex KBB’s
real estate alone largely exceeded the group’s market value. The Dutch investors’
association VEB and institutional shareholders called for corporate governance
39
improvements at the 2002 and 2003 AGMs. They wanted greater transparency and a
correction mechanism, but the company management was fairly immune to the wishes
of the capital providers due to a combination of a two-tier board structure, shares
certification and protection preference shares. At the 2002 AGM a “relationship investor”
(Guy Wyser-Pratte) alleged that Vendex KBB’s undervaluation was partly due to
shortcomings in its corporate governance; referring to a “Dutch discount”, he sought
voting rights for capital providers. In 2003, K Capital Partners, a hedge fund, 40 asked the
management to consider breaking up the group in order to rectify the undervaluation. 41
The market capitalisation of Vendex KBB at the end of 2003 was €1.03 billion. 42
On 15 February 2004 Vendex KBB announced that it had been approached by
investment companies “in connection with a possible public offer for the company”. This
was followed by a public offer worth €2.4 billion which took effect in the summer of 2004.
43
The bidders (including Kohlberg Kravis Roberts & Co., Change Capital and Alpinvest)
stated their wish to end the stock-market listing of Vendex KBB as soon as possible. In
November 2005 the sale of Vendex KBB’s real estate was announced. The sale price
was reported to be around €1.4 billion. Having regard to the stock-market value of
Vendex KBB and the book value of the real estate (€800 million) 44 the “discount” had
already been partly eliminated by this transaction. If those same investment companies
succeed in restructuring the store chains belonging to the Vendex KBB group and create
the conditions for healthy, long-term value growth, Vendex KBB will be an example of

38
Cf. the reports on 10 and 12 April 2002 in Het Financieele Dagblad.
39
The criticism related to insufficient information on matters such as the value of the real estate,
the handling of a divestment (FAO Schwarz) and the accounting for pension expenses and
directors’ fees in the balance sheet and income statement.
40
K Capital is a hedge fund that conducts an “event-driven” strategy: arbitrage techniques in the
case of mergers and acquisitions (“short” in the bidder, “long” in the target), arbitrage between
different financing instruments in the same company and the “catalysing” of “corporate events”
which in turn provide possibilities for arbitrage techniques.
41
Cf. the letter of 27 February 2003 to the management of Vendex KBB,
www.prnewswire.co.uk/cgi/news/release?id=99632
42
Source: Factset.
43
Press release dated 28 June 2004. www.vendex.nl.
44
Het Financieele Dagblad, 26 November 2005.

13
successful shareholder activism by hedge funds and private equity investors. 45 This is
part of a broader picture: EU Commissioner McCreevy recently described them as
“formidable watchdog on management teams that are underperforming” and added: “at
the very least we know that Private Equity boosts economic growth, underpins
46
innovation and creates jobs.”

4. … or a virus?

4.1 Conflicts of interest?

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. 47 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.” 48
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.

45
According to reports in Het Financieele Dagblad of 22 March 2006 a break-up is not on the
agenda at this stage: “First we must create value and profitability. That determines our timeline.”
46
C. McCreevy, The way forward for European private equity, speech to the House of Commons
on 9 March 2006, available for download at http://europa.eu.int/comm/internal_market. In a
similar vein see Myners Report: P. Myners, Institutional Investment in the United Kingdom, A
Review, London 2001 (www.hm-treasury.gov.uk), no. 12.1 ff.; and more recently A-K. Achleitner,
Employment contribution of Private Equity and Venture Capital in Europe, Research Paper for the
European Private Equity & Venture Capital Association (EVCA), November 2005. Specifically
with regard to the financing of companies by hedge funds, see: Bropghy/Ouimet/Sialm 2006.
47
Cf. Kahan/Rock, p. 23 ff.; A. Verdam, Diversiteit in institutionele beleggers: verschil in opstelling
als aandeelhouder?, TvOB 2005, p. 203 and the references stated therein.
48
Kahan/Rock, p. 8-9.

14
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. 49 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. 50
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. 51 More research needs to
be conducted on this point.

4.2 Methods used by hedge funds

There are also indications that hedge funds sometimes use dubious methods to pursue
their objectives. Kahan and Rock talk of “the dark side of hedge fund activism”. 52
Examples could include what the American literature describes as “empty voting”: voting
without an economic interest. 53 Securities lending can be a means to do this. As was
seen in section 2.2, 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. 54

49
Hu/Black 2006, p. 26.
50
Cf. Hu/Black, p. 51. See also Verdam 2005, p. 203, where he comments that it is tiresome for
company managements that hedge funds act “against the market”.
51
Cf. W.J. Slagter, Een bedreiging voor de continuïteit van de vennootschap (to be published
shortly in NJB, the Netherlands Law Review).
52
Kahan/Rock, p. 23 ff. On this subject see also the extensive coverage in Hu/Black.
53
Kahan/Rock p. 26-28; Hu/Black p. 14.
54
The Minister of Finance also shares that opinion, cf. TK 28122, no. 19, p. 7, footnote 2. Cf. also
AFM Report 2005, p. 35 specifically on the positive aspects of short selling.

15
 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. 55 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. 56 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. 57
Voting without an economic interest can also occur – at any rate in theory – when
a shareholder has transferred the economic interest by means of a swap or similar
transaction. Share purchases with a view to record date capture are another example.
The shares can be sold immediately after the record date, with the voting rights
remaining with the seller. It is not known whether such methods are actually used by
hedge funds. 58 There are many other manifestations of voting without an economic
interest: these include Dutch trust offices and German banks which exercise voting
rights in respect of their account holders’ shares.
Other examples of dubious hedge fund methods include “pumping and dumping”.
Hu and Black cite the case of Carl Icahn, who quietly built up a holding in the company
Temple-Inland. He then publicised the fact widely, saying that he would push for the
appointment of like-minded directors. Icahn’s reputation and his publicly expressed

55
Cf. Financial Times 15 February 2006: “Henderson stock lending fears *Unusually heavy
volumes of borrowed shares ahead of decisive vote *Critics claim the practice is a form of market
abuse”. See also point 1.9 of the Report of 9 July 2004 of the ICGN Securities Lending
Committee; Review of the impediments to voting UK shares, Report by Paul Myners to the
Shareholder Voting Working Group, Progress – one year on, March 2005, p. 13; Kahan/Rock;
Hu/Black who report on various cases in which this was an issue. See in more detail G.T.M.J.
Raaijmakers, Securities lending and corporate governance, in: Tussen Themis en Mercurius
(NGBcollection), Deventer 2005, p. 241 ff.
56
Cf. Hu/Black, p. 3-4.
57
Cf. Handboek Van der Grinten (12th impression), no. 217.1; E.M. van Ardenne-Stachiw,
Effectenleningen (NIBE series, no. 26), Amsterdam 1995, p. 42-43; Verdam, lecture, p. 28. Cf.
also HR 18 April 2003, JOR 2003, 110 (RNA), in which the independence of the executive board
of the SBBR foundation was seen as crucial for the judgment that financial support by the board
in a proxy fight did not constitute mismanagement.
58
Cf. Hu/Black, p. 9.

16
intention led to a sharp rise in the price of the share. A month later he announced that he
would not be nominating any directors. Several months later it emerged from his SEC
filing 59 that he had sold his stake. The Temple-Inland share price then fell back to its
original level. 60 Other forms of market abuse or related acts are: making misleading
announcements on the size of the holding represented by one or more hedge funds or
other methods of manipulating takeovers. For example, the French financial markets
regulator AMF recently announced an investigation into possible market manipulation by
hedge funds in relation to a possible merger of Euronext and Deutsche Börse. The
grounds were that in their communication with Euronext the funds may have
exaggerated the combined size of their holdings in order to give extra force to their
demands. 61
Kahan and Rock cite examples of hedge funds involved in securities fraud class
actions. 62 Thomson and Thomas have conducted research into securities litigation.
They state that a new “litigation strategy” has emerged in the last few years, whereby
directors are held personally liable with regard to their actions during takeovers. Their
analysis points towards the involvement of hedge fund managers in this strategy. 63
Although in the Netherlands we are intuitively inclined to view such activities
negatively, 64 Thompson and Thomas come to rational conclusions on the basis of
empirical research: in general, the benefits (reduction of management agency costs)
counterbalance the costs of litigation.

5. Conclusions?

We still know too little and it is still too early to draw conclusions. 65 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

59
Cf. R.H. Maatman, Disclosure van beleggingen in Amerika, Ondernemingsrecht 2002-9.
60
Kahan/Rock, p. 30-31.
61
Het Financieele Dagblad 26 January 2006, front page and p. 17.
62
Cf. R.B. Thompson and R.S. Thomas, The Public and Private Faces of Derivative Lawsuits,
Vanderbilt Law Review 2004-57, p. 1751.
63
R.B. Thompson and R.S. Thomas, The New Look Of Shareholder Litigation: Acquisition-
Oriented Class Actions (working paper 2004), p. 54.
64
However, see T. Hartlief, Leven in een claimcultuur: wie is er bang voor Amerikaanse
toestanden? (Maastricht foundation day speech), 14 January 2005, see also NJB 2005, p. 830 ff.
65
Cf. also Hu/Black (2006), p. 51.

17
this has not been settled. Set against the disciplinary effect and the efficiency
improvements described in Section 3.1, 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
66
undesirable infringement of the necessary discretion, as Bainbridge recently said.
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. 67 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

66
Bainbridge 2005. Cf. also R. Romano, Less is More: Making Institutional Investor Activism a
Valuable Mechanism of Corporate Governance, in: Corporate Governance Regimes;
Convergence and Diversity, Oxford 2002, p. 507 ff.
67
Cf. SEC Report (2003), chapter VI; AFM Report 2005, p. 65.

18
pressure to account for the way in which he does so. 68 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. 69 We stated earlier that such
interests were often very 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. Pieterse recently called for an
extension of voting rights for shareholders who are prepared to lock up their shares for a
minimum period. 70 We do not advocate any breach of the key principle whereby voting
rights and capital contributions must be in proportion, but we do have similar ideas which
we wish to investigate further. Anyone who wants shareholders to commit themselves to
a company for a long period is asking them to take more risk. After all, a lock-up
prevents the shareholder from selling his shares. Because risk and return are interlinked,
such a lock-up must be rewarded by means of an additional risk premium, for example in
the form of an extra dividend. This immediately gives them a stronger financial interest in
remaining intensively involved in the company and exercising the associated
shareholder rights. Conversely, the company has a more stable shareholder base and
the possibility of achieving a better balance between short- and long-term interests. 71
The question is whether regulation of hedge funds as such would be advisable.
We have our doubts. 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. We
believe it would be 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

68
See on this subject S.C.J.J. Kortmann and R.H. Maatman, Uitbesteding door
vermogensbeheerders, Ondernemingsrecht 2005-9.
69
See Bhagat/Black/Blair for a similar suggestion. See also Verdam 2005, p. 206.
70
Het Financieele Dagblad 21 February 2006.
71
Cf. our article in Het Financieele Dagblad of 1 March 2006.

19
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.

20