Defusing Hedge Fund Attacks: Directors and executives can play an active role in preempting activist hedge funds' agendas and bolstering shareholder support.

Activist hedge funds may represent the most significant threat to the ability of public companies to control their long-term strategies since the corporate raiders of the 1980s. Although defensive measures and case law developed during and since the 1980s provide boards of directors with ample means to reject and resist unsolicited acquisition proposals, they are not necessarily effective for responding to non-concerted exercises of stockholder voting power and the post-Sarbanes-Oxley shift in the fundamental corporate governance paradigm.

Activist hedge funds try to exploit this vulnerability by demanding, often under the cloak of "shareholder democracy," that boards take specific actions, underscoring those demands with an implicit or explicit threat to campaign for changes in the composition of the board.

These tactics have proven to be effective for a number of reasons, including:

* The agenda of a typical activist hedge fund is focused on creating near-term increases in stockholder wealth, and frequently advocates an immediate payout to stockholders by means of a special dividend, share repurchase, sale of the company, or divestiture of a unit;

* The instigating fund typically acquires a significant amount of the target's stock while staying below triggering thresholds set in short-swing profit forfeiture laws, shareholder rights plans, takeover statutes, and other defensive measures;

* Other hedge funds frequently act in a parallel move with the instigating fund, effectively enhancing its voting power, although they claim they are not creating an investment "group" - which has to be reported to the SEC under the federal Williams Act - or aggregating an ownership position that would subject them to short-swing profit forfeiture laws and the company's own defensive measures;

* The prospect of a near-term liquidity event, such as a sale, may be attractive to some stockholders, including institutional investors with substantial holdings, further magnifying the influence of the instigating hedge fund; and

* Thanks to market dynamics, a substantial portion of the target's stock may accumulate rapidly in the hands of stockholders, supporting the instigating hedge fund's agenda once it has been made public.

It's a mistake for boards of directors to consider hedge fund activism as a passing fancy that will disappear in time. In fact, it's imperative that directors and management of public companies proactively assess their vulnerability to attack by activist hedge funds and take appropriate steps to manage that …