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- [00:04]
A
Welcome to Shareholder Primacy from Free Float Media, a podcast about activist investing, securities law, and all the ways the financial legal rules intersect and collide in real life. Ann and I have returned once again. Ann Lipton is a law professor at the University of Colorado. She teaches and researches securities and business law, and she holds up the legal end of the podcast.
- [00:28]
B
And that's Mike Levin, an activist investor who lives and works in Chicago. He covers the financial side of our podcast.
- [00:34]
A
Yes, I do, I think. And you cover the legal side. So we have some, not exactly breaking, well, breaking news on one of the subjects we want to cover today, our old nemesis, Tesla.
- [00:49]
B
Oh, back to Tesla. I can't wait till we could just move on to SpaceX. But now we're still in Tesla.
- [00:55]
A
Right. But there is a really kind of interesting development with Tesla and its domiciles, I think is the best to describe it, where Delaware.
- [01:04]
B
Delaware and Texas.
- [01:05]
A
Delaware kind of washed its hands of the company at this point or something. But we'll plunge into it. So that should be kind of fun.
- [01:12]
B
Yeah. And we're also going to talk about how activists think or what company leadership should know about how activists think.
- [01:18]
A
Yes, I have a little axe to grind on that one. So we can grind it well and then plunge you into it. But before we go there, Ann, the mailbag.
- [01:31]
B
Yes, you can email us at shareholder primacy1wordreefloat LLC and let us know all
- [01:39]
A
of what you think about what we do here. So getting into the meat of the matter, Was it just last week or a couple weeks ago that this was done?
- [01:50]
B
So this is like recording Sunday night. So this is basically six days ago.
- [01:55]
A
Oh, this is a hot news then. This is this past week. And so Tesla received, I suppose you could call it good news if you're Tesla from the Delaware Chancery Court, or
- [02:08]
B
at least for Tesla's board.
- [02:10]
A
For Tesla's board or whatever. So let's explain exactly what was decided and what the matters were that pertain to that. And then we can go off in several different directions on that.
- [02:22]
B
Yeah. So, okay, so this was basically the last of the cases that were pending in Delaware concerning Tesla. I mean, there's a little bit of a stub of something, but this is basically it. And we've mentioned a couple of times before, it was actually a group of complaints, but they were all consolidated into one action and they were all filed just before Tesla moved to Texas. So as we all know, Tesla for a very long time was a Delaware company. And after Chancellor McCormick rescinded Elon Musk's pay package. Morgan Musk announced that he was going to reincorporate Tesla in Texas. And then the board took it to a shareholder vote and they did that. They reincorporated in Texas. But after Tesla announced that.
- [03:03]
A
I have to interrupt, when was that? When did that happen? Timing wise, the reincorporation was 2024. Yes, I believe that was true.
- [03:10]
B
So it was just a couple of months after the opinion came down, rescinding.
- [03:13]
A
So it was later on, later on in 2024 at the AGM, the shareholders, so it's a year and a half ago, they approved the move. And I think the next day,
- [03:28]
B
like as soon as they should get shareholder
- [03:29]
A
approval, you're right, they filed the reincorporation paper and boom, they were in Texas. So that was, I think, I think August 2024 is about.
- [03:39]
B
No, I think it was. Well, the vote was actually, I think in June of 2024.
- [03:43]
A
Okay, great.
- [03:44]
B
So anyway, so after Tesla announced that the vote was gonna take place, but before the actual vote occurred, shareholders filed these last minute complaints against the board and Elon Musk. And it was really last minute. I think one complaint was actually filed the day of the vote, just before.
- [04:01]
A
So shareholders kind of hurried to the courthouse.
- [04:04]
B
Yes.
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A
And they file these cases.
- [04:06]
B
Yes, they file these cases in Delaware while Tesla was still a Delaware company. And they all concerned conduct that had occurred while Tesla was a Delaware company. So Delaware law applied and these cases were all filed in Delaware and they were consolidated. And what they're about, well, I mean, it's actually, it's a grab bag of stuff. But I think the strongest allegations are about how Musk kind of freely allocates Tesla assets to his other companies. So for example, after saying that Tesla's future was artificial intelligence, he ended up developing artificial intelligence in his own private company, xai. He reallocated computer chips. They were slated to go to Tesla for AI and he sent them to Twitter and to xai. He moved Tesla employees to help out with his other companies, that kind of thing. So the claim is that Musk breached his fiduciary duties to Tesla by essentially appropriating Tesla resources for use in his other companies, and that the board breached their duties by allowing that to happen and not overseeing Musk's conduct. And I mean, these claims, I would think on the surface have legs. Like, I'm absolutely not saying that if they go to trial, plaintiffs are sure to win, but I am saying that they're serious allegations, enough so that they would have a real chance in Delaware. They're not frivolous. And they all landed in Chancellor McCormick's
- [05:22]
A
lap because she was, she was like the overall. If it said Tesla on it, it got put in her inbox because they've
- [05:29]
B
changed it since then, essentially because of this problem. But basically, at the time the judges had developed sort of beats, they heard different kinds of cake. Like they all heard certain cases with a theme or cases involving the same. So anything Musk or Tesla related went to Chancellor McCormick.
- [05:45]
A
She was on the Tesla beat.
- [05:47]
B
Yes, she was on the Tesla beat. And the complaints were filed. And then right after they were filed, the Tesla shareholders voted to reincorporate in Texas and Tesla became a Texas company. And at that point, Tesla moved to dismiss the complaints on the ground that Tesla is now a Texas company. And Tesla argued the complaints should be filed in a Texas court.
- [06:11]
A
Aha. Okay. That's how it all started. So we've been kind of, whenever we talk about Tesla here, which is unfortunately too often we talk about cases involving Delaware, we always are referring, oh, and then there's two or three or a couple other cases that are kind of hanging out there that got filed later after reincorporation. Whenever you talk about these are them. And they were three separate cases, though it sounds like they kind of pertain to sort of the same type of kinds of things.
- [06:40]
B
But it was all in the realm. There were some insider trading claims, but a lot of it was revolved. And I think the strongest claims revolve around this reallocation of resources from Tesla
- [06:53]
A
and breaching, essentially, listen to me, breaching the duty of loyalty.
- [06:58]
B
Exactly. You're not allowed to take resources for your private use. And that includes opportunities, which is sort of a vague doctrine, but it really matters. So if Tesla was supposed to be the one developing AI, it is arguably, shall we say, a breach of fiduciary duty that to say, no, I'm not going to have Tesla develop AI, I'm going to put it in my own separate company.
- [07:20]
A
All right, so Tesla moved to not just. You can't like move these cases, just move to dismiss them, Right?
- [07:28]
B
Yeah, exactly. So the idea here, the motion is that Delaware Chancery should dismiss the cases and that plaintiffs, if they want to pursue them, they should be required to file in a Texas court. And this is actually a complex point, cause it's really clear to lawyers, but I know that like non lawyers and my students often don't quite get it. So just to be clear, there is a distinction legally between the court where you file the lawsuit, the form that the plaintiff Chooses and the actual legal standards that will govern the claim. So when it comes to corporations, as we all know, the state of incorporation, that state provides the law that will govern things like fiduciary duties, shareholder lawsuits.
- [08:09]
A
So if you're incorporating evidence or whatever, the whole procedure.
- [08:13]
B
Exactly. Well, no, no, but. But the substantive standards that you have to adhere to as a fiduciary. What counts as a breach of fiduciary duty, whether directors are independent, how you cleanse conflicts, that's all gonna be Delaware law. But that doesn't mean that the shareholder has to actually file a lawsuit in Delaware. Shareholders could theoretically file in courts all over the country, Certainly wherever the company has its headquarters, for example, which is rarely gonna be Delaware. So what happened a few years ago was about 10 years ago now, I guess, was every time there was a big merger that was announced, what would happen is shareholders would file simultaneous cases all over the country alleging that the target directors breached their fiduciary duties. They'd be these simultaneous cases. They were all. And most of these targets were Delaware companies. So you'd have, like, cases filed in multiple courts simultaneously, all challenging this merger under Delaware law. And that created a lot of dysfunction. So corporations started adopting forum selection bylaws. They'd pass a bylaw that said all the fiduciary lawsuits have to be filed in Delaware, the state where we're incorporated. And remember, bylaws can be passed unilaterally by directors. So they would just do that. Like, if the drop of a hat, they would pass a bylaw. And now there's a bylaw that says, if you want to sue us, it has to be in Delaware, where we're incorporated. And then this was funny. A Delaware company passed a bylaw that actually said, okay, we're a Delaware company, but all lawsuits have to be filed in North Carolina. They wanted the cases to be heard in North Carolina because that's where their headquarters were, even though they were a Delaware company. And it was going to be Delaware law that applied. So a North Carolina court would apply, look to Delaware law.
- [09:50]
A
So the North Carolina court, that judge would have to, like, go learn Delaware law.
- [09:55]
B
Yes. And that was the. That's the idea. So if you find. Like, if you file these claims, you can file them anywhere in the country. But what that court is going to do is they're going to research Delaware law, reach their own determination what Delaware law requires, and then hold, and then, you know, adjudicate the case that way. But immediately after this North Carolina thing happened, the Delaware legislature passed A law where they said, yes, you can have form selection bylaws, but you can't deny access to Delaware courts if you're a Delaware company. So the law became, you can have a form selection bylaw that requires Delaware, and you can have a forum selection bylaw that gives a choice to shareholders of Delaware or some other place, but you can't have a forum selection bylaw that denies access to Delaware entirely.
- [10:39]
A
Oh, so that was like. That was like helping themselves.
- [10:43]
B
Exactly. Yes. They wanted to make sure that the cases had the Delaware could have.
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A
They're not only interested in Delaware jurisprudence being used around the country, but they want Delaware courtrooms to be full.
- [10:55]
B
Exactly. That was exactly it. They wanted the cases in Delaware where now you can talk about the purity of Delaware law, because Delaware judges know Delaware law, but also, you know, filing fees in Delaware courts. So are there, are there, are there,
- [11:08]
A
are there Delaware companies that require adjudication in Delaware using some other state's law?
- [11:15]
B
You couldn't do that. You literally couldn't do that. I mean, you can't do that for a corporation. You could do that for an llc, actually, but you can't do that for a corporation, corporate. I mean, the whole point of a corporation is if you choose the state where you're incorporated, and that's the law that applies. So there are companies that will have contracts, though, that Delaware law might be applied, like, but in a New York court. I mean, but that's a controversial.
- [11:38]
A
But that's not a bylaw thing. All right. Yeah, right.
- [11:40]
B
It's not fiduciary anyway. So a lot of companies, Delaware companies, started passing these bylaws. They became ubiquitous so that shareholder litigation would have to be filed in Delaware. And Tesla had such a bylaw. I mean, actually, I mean, in this case, obviously, the plaintiffs wanted to be in Delaware. That's why they filed these complaints at the last minute before Tesla reincorporated. But at the time, Tesla had a bylaw that said, if you're suing us for breach of fiduciary duty, you have to file in Delaware. But when Tesla moved to Texas, it had a new bylaw. And the new one said, all cases going forward have to be heard in Texas, where our new incorporation is. And shareholders knew that when they voted on the move, because they saw the documents and they saw we vote to reincorporate in Texas. And also there will be a new bylaw that says cases have to be filed in Texas. And so this is exactly what Tesla argued was the basis for moving these complaints. They were Filed in Delaware before, technically, the shareholder vote. Just before the shareholder vote. But Tesla is saying, look, when these were filed, everyone knew Tesla was moving to Texas. Everyone knew Texas. It's going to have a Texas forum selection bylaw. The shareholders voted for that. So these cases really should be heard in Texas. Right now, if the shareholders refile in Texas, it's still Delaware law. The conduct being challenged occurred when Tesla was a Delaware company. So Delaware law would apply. Texas court would have to go and look at Delaware precedent and apply Delaware law. So the only issue is what court hears the claims. A Texas court would be looking to Delaware case law to decide what. What standard for these.
- [13:13]
A
For these three consolidated.
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B
Yes, exactly.
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A
Based on. Based on what Delaware just decided. Okay.
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B
Right.
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A
All right.
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B
Yeah. So that's where we are. So.
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A
Yeah, so. So there's a couple of different questions that come up. I think you answered the first one, which is, why Delaware. The Chancellor wasn't. McCormick. She, like, moved these case. Someone else.
- [13:35]
B
Well, yeah, that. We haven't gotten to that part. That. That is a fun little thing, but yeah.
- [13:40]
A
All right, so. So what's. So. Okay, we'll talk about that in a minute. So what, the next step then is for these plaintiffs to refile.
- [13:48]
B
Yeah.
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A
These cases.
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B
But they don't want to. I mean. Well, I mean, that would. That's what Tesla wants, that they wants them to refile in Texas. But the problem here is. Well, first, I mean, these plaintiffs don't want to be heard in Texas for at least two reasons. The first, most obvious is, I mean, I think they think with some justification that Texas courts are going to be more sympathetic. Like, it doesn't matter what the legal standards are. They're just going to be more sympathetic.
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A
Doesn't matter what Delaware law says. It's just whatever Tesla wants, Tesla gets.
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B
But the other issue is, remember, under Texas law, Tesla was allowed to adopt a bylaw that says if you want to sue us, you have to hold 3% of the stock.
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A
Oh, so these suits are.
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B
Yeah, exactly. So if the plaintiffs refile in Texas, the first thing that's going to happen is Tesla is going to try to get dismissed because they don't have $37 billion worth of investment. I mean, these are institutional plaintiffs. They have like, at least, like, a lot.
- [14:40]
A
They have some money, but.
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B
Yeah, but they don't have 37 billion.
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A
Right.
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B
So. Yes. So, yeah. So, like, here's the thing. Like, and this gets to, like, who. Who decided it? So, like, remember, they. So Tesla moved to dismiss, but after that, and McCormick had this case pending for a while, like, months passed with no ruling. And then this is what you were alluding to. This very weird thing happened. This is so strange. Musk lost a securities fraud trial in California. We've talked about that case before. So he lost the securities fraud trial in California. Federal law, nothing to do with fiduciary breaches. And then mysteriously, Chancellor McCormick's LinkedIn account registered as having liked a post that gloated over the loss. So it, like, it looked like she had said, like, yay. I support someone who was saying, thank God Musk got his comeuppance. Whatever. The Post was right. So immediately, Musk's legal team moved to recuse her, saying that she's demonstrated bias and she shouldn't be hearing any of these Tesla cases. And I gotta agree, if she had liked that post, then that really would have created at least an appearance of bias. But the problem was she denied she ever liked it. She says either it was inadvertent or her account was hacked and she never even saw the post. So I wanna be clear. I believe her. Like, it seems obvious to me that this much is true.
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A
Whatever happened in LinkedIn, she's pretty scrupulous.
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B
She's a straight. She's very.
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A
About this kind of thing.
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B
It's silly to think she would lie about it.
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A
She's very vocal about the Delaware system.
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B
Yeah.
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A
So she. She expresses her. I mean, when she's not expressing her opinions in cases, which is her job, she's vocal. And I tend to support, you know, about, you know, her and Vice Vice Chancellor Last. Laster are outspoken about the virtues of the Delaware system, but that's where their outspokenness, I think, ends. They're not outspoken about plaintiffs or defendants or parties in their courtroom. That's crazy.
- [16:45]
B
They're all very outspoken about the Delaware. So they all defend the Delaware system. But yes, they make a lot of public appearances. But I mean, it's just the idea that a judge would lie. I mean, she didn't lie. She didn't like it either. I mean, maybe it was inadvertent. She definitely didn't see the Post, which she said she never saw it until somebody told her that she had liked this post post. So she refused to recuse herself. But even though they had moved to have her recused because she was biased, and she said, I'm not going to recuse myself. I'm not biased. But then she said that given all the hoopla and publicity surrounding her role in these cases, she was going to step back to avoid Even the appearance of unfairness. And she had this hearing where the attorneys had to pick Scrabble tiles out of a bag to randomly. No, to randomly reassign the cases to different judges.
- [17:30]
A
To other chancellors.
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B
Yeah, because there were actually, there were a couple of different little ones pending, and then this big one, which was the three consolidated, the other ones were nothing, but this big one was the big one. Then there were a couple of others. So they were randomly assigned. And this group of cases that we're talking about, they got reassigned to Vice Chancellor David. And literally one week after the reassignment, remember, they'd been sitting on McCormick's desk for months, but one week after the reassignment, Vice Chancellor David dismissed.
- [17:57]
A
Or. She ruled. She ruled on this motion.
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B
She ruled on this motion, and she held that the Texas forum selection clause should apply and a plaintiff should be obligated to refile their claims in Texas, where, of course, they're going to be dismissed because the plaintiffs don't own $37 billion.
- [18:11]
A
Right. So what was the basis for her saying that? Just because that. What you said that the plaintiffs kind of knew that this was cooking.
- [18:20]
B
That and the Tesla shareholders knew. So, like a lot of her reasoning was Tesla shareholders chose this. I mean, normally bylaws are passed by directors pretty unilaterally, but in this case, the Tesla shareholders voted to move to Texas, knowing that that bylaw was going to be there. But, I mean, but here's the thing about that logic. At the time of the reincorporation vote, Texas's law looked a lot like Delaware's. The proxy statement even had a expert report.
- [18:46]
A
Professor right there said, hey, you're not going to notice anything. It's going to be.
- [18:51]
B
ISS recommended shareholders for the Texas move because it viewed Texas as comparable to Delaware. But after Tesla moved, that's when Texas completely revamped its law. And one of the big changes was this thing where you can, as a company, you can pass a bylaw that requires shareholders to hold 3% before they bring claims. There was no way Tesla shareholders could have anticipated that. Plus.
- [19:12]
A
Oh, no way.
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B
Yeah, no, of course not. And plus, Vice Chancellor David had this thing about how these Delaware plaintiffs should not be viewed as having some kind of inalienable vested right to litigate in a particular forum. Because remember, forum selection bylaws, they can be adopted unilaterally by corporate directors. And that means shareholders are always, in a sense, kind of on notice that they may not get to litigate in their preferred forum. So they can't say they had a Firm expectation they'd always be able to litigate where they want to litigate. But Delaware shareholders do have that right because the Delaware legislature said Delaware corporations have to give shareholders the right to a Delaware forum. So I say they do have a vested right to a Delaware forum in Delaware. And it's at least plausible that the point of that law. Well, I mean, we know the point of that law is to get cases in Delaware courtrooms, but it's also to make sure to reassure shareholders that if you invest in a Delaware company, you can enforce Delaware created rights in Delaware. So I don't really buy Vice Chancellor Davis logic, but here's what's actually so striking to me. Historically, traditionally, Delaware has been very possessive about its right to decide matters of corporate law, and in particular, its right to decide matters of Delaware corporate law, especially in high profile cases where precedent really matters, because Delaware wants to preserve the integrity of its law. And quite frankly, Delaware's always had a little bit of a chip on its shoulder.
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A
They like where they sit.
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B
Yeah.
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A
They like.
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B
We have expertise in this. So I can't describe how incredibly out of character it is for a Delaware court to say this case involving what was a Delaware corporation, Delaware created rights filed at a time when the Delaware legislature required Delaware stockholders be given access to Delaware courts. For a Delaware court to say, and let Texas decide it. I mean, it's very out of character. So it reads a lot. Well, frankly, like the Delaware Supreme Court opinion that we talked about before that restored Elon Musk's pay. It's Delaware kind of punting because it doesn't get into.
- [21:10]
A
We don't want, we don't want to. We don't want anyone to see you anymore.
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B
Exactly. And I can only think, I was thinking that there's one comparison historically and on this, I'm going to give a shout out to Professors Ed Rock and Marcel Kahana at NYU because they wrote a really great paper about this. It's called how to Prevent Hard Cases from Making Bad Laws. So this is a great story. At the height of the financial crisis. We all remember the financial crisis.
- [21:31]
A
Oh, yeah, yeah.
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B
Bear Stearns was going to collapse and it might have dragged the entire US and global financial system down sort of,
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A
kind of a little.
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B
Did people, people thought that this was going to be the end of everything. This is going to be the nuclear bomb of the financial system. So the Treasury Department orchestrated a merger where JP Morgan would swoop in and buy Bear Stearns and save the world economy. The problem is Bear shareholders didn't want the merger and they had to vote in favor of it. But they didn't want to vote in favor of it because they thought they could hold out for more money. So the Bear board agreed to issue a huge amount of new stock to JP Morgan so that JP Morgan could vote the stock in favor of the MER regardless of what public shareholders wanted. Now this was almost certainly illegal under Delaware law. You can't do that. You can't like force a merger down shareholders throat by just issuing new stock and shareholder. And it was. Bear was a Delaware company and shareholders filed lawsuits, one in New York and one in Delaware. And normally again, a Delaware court would absolutely have kept a case of this magnitude. Delaware wants to be able to articulate its own law.
- [22:34]
A
They like this stuff.
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B
Yeah, but, but if they applied their own law, they would take down the financial system and they didn't want to have to distort their law to justify the deal. So instead the Delaware court said, we're not going to decide it, we'll stay out of it and we'll let New York handle it. And that's what this feels like. Delaware didn't want to have to tangle with Elon Musk again, where any reasonable application of Delaware's law would at least possibly hold him liable. So it said let Texas take.
- [22:58]
A
So, so, so, so even Delaware, as we've seen before and probably very well illustrated right here, is kind of subject to sort of the realities of the marketplace or politics or something, as much as they try to stay above it in 98% of their cases when it concerns Tesla. But sometimes they're not immune. Yeah, you'd like them to be, but doesn't always happen.
- [23:28]
B
We'd like them to be, but I mean, here's the thing. Okay, so Tesla shareholders, I absolutely could not possibly have anticipated what Tesla was, what Texas was going to do about new barriers to shareholder litigation.
- [23:41]
A
That was, that was. There was no way to predict that.
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B
But what's also true sort of is, look, don't we all know that the Tesla shareholders in general in the main really did vote to remove Tesla from the Delaware court system? I mean, we can dress it up, but that's the reality. Tesla shareholders, they like their CEO, they like his performance, they don't mind that he has these outside companies. They tend to view them as one big thing.
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A
The success of one is successful.
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B
I mean, Tesla's invested in Xai. The whole reason for the Texas move that shareholders approved was to get away from Delaware oversight, which they thought was too strict. So on that Kind of meta level. Maybe Vice Chancellor David was right. This was fundamentally what Tesla shareholders wanted, and they wanted Delaware to stop policing Elon Musk. But the problem is, and I felt this way about McCormick's decision rescinding Elon Musk's pay. The legal standards for this don't really line up that way. Like, we can all say, come on, don't we know Tesla shareholders love their CEO, they're fine with all this stuff, but that's not how derivative actions work. The derivative lawsuit is the mechanism by which we determine what shareholders want. A court isn't supposed to just. Not shareholder vibes, you know, like. Well, no, actually shareholder votes, but shareholder votes on, like, the actual thing under consideration, not like some separate thing. Like a court isn't just supposed to say, well, my vibes are Tesla shareholders love their CEO, so I should dismiss the case. So the fundamental problem is that the legal standards, the legal tasks that we use to evaluate what's best for shareholders are in some ways disconnected from the reality of what shareholders want. And now we've got this tension where you can either go with the formal legal standards, but that feels artificial. Like the court is superseding the shareholders will, or you can ignore the legal standards. And then it looks like Delaware law isn't real and Tesla is just unconstrained by any law at all. There isn't really a great solution.
- [25:27]
A
No, it does not sound like it. Even though. Well, I mean, assuming they can try to refile and they'll be rejected, if they were to be heard, these would be heard in Texas under Delaware law. Did I hear that right?
- [25:42]
B
Yeah, exactly. But, well, well, if they. Yeah, it would be. Well, I think they're going to appeal first, but then.
- [25:48]
A
Appeal, appeal, appeal to the Delaware Supreme Court. Right.
- [25:51]
B
And. And if they do appeal to the Delaware Supreme Court, like, if they. If the Delaware Supreme Court agrees with David and affirms, then they can try refiling in Texas. Now, of course, the first thing they're going to do when they refile in Texas is argue that for some reason or another, the 3% limit shouldn't apply.
- [26:13]
A
It was like.
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B
Yeah.
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A
Or something.
- [26:16]
B
Exactly. And then we'll see what happens from there. But I don't like their chances in Texas. I got it.
- [26:20]
A
No, it doesn't. Does not feel promising at this point. Why don't we leave that there for a minute, take a quick break, and then we can come back and talk about this kind of thing that I had on my mind about how activists think compared to how, like, companies and CEOs think want to do that.
- [26:41]
B
Sounds good.
- [26:42]
A
All right, we'll do that here at Shareholder Primacy.
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C
Shareholder Primacy is brought to you by free flow analytics.com, the only free database of corporate directors, their influence, and their performance. If you own a stock or retirement plan, go to free flow analytics.com and look up which of your elected directors are performing well and which aren't. Use your vote in the alternative democracy and get your data @free flow analytics.com now back to the show.
- [27:13]
B
Welcome back to Shareholder Primacy. I'm Ann Lipton here with Mike Levin, and we're talking about how activists think and more importantly, what activists would like company leadership to know about how activists think. So, Mike, there is this community of advisors to boards that specialize in telling them about activism, defense, and what is it that they should actually be doing to defend themselves from you.
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A
Right. So I mentioned when we introduced this that I have a little bit of an axe to grind. And here's kind of what it is, that there's this whole community, as we said, of attorneys and investment bankers and proxy solicitors sometimes, and consultants and crisis consultants and PR firms and so forth, and they all make a decent living trying to prepare boards for activists and activism. And, you know, because sometimes an activist, you know, files 13D or something and they can. Someone is surprised. It mystifies me why a company's surprised about this stuff. Usually your share price is sufficiently bad that it shouldn't come as a surprise to anybody.
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B
It's because they're 100% sure that that is something that is outside of their control and has nothing to do with their excellent leadership.
- [28:27]
A
Well, I mean, the share price sort of is outside their control, which is. Which is good. I mean, there are no opportunities, but there's things that happen that are that influence share price that they should be well aware of. But anyway, so one of the standard bits of advice that all these firms is think like an activist. Sort of look at your company the way an activist would or sometimes be your own activist. And I went and looked up a bunch of these written pieces about how to think like an activist from BCG was the one I saw most recently. And it's really kind of cliche. Okay. It's like, you know, look at every opportunity to unleash value or think strategically or look at stuff on a quarterly basis or. Or be objective and so forth. I mean, some real vacuous kind of stuff.
- [29:23]
B
I could tell you that. And I know nothing about activism. Think strategically. Okay.
- [29:28]
A
Okay. And clearly none of these people talk to activists. Okay. So I thought I would sort of help people out a little bit and sort of illustrate some of the. The mindset. This isn't kind of why, you know, an activist picks one or another company. This is kind of some of the deep cognitive stuff that goes on that is a little different for activists than from like, companies. And there's five or six different areas that are worth mentioning. Okay. The first is, has to do with how activists think about their investors and how companies think about their investors. And activists are deeply obsessed with their investors, with their limited partners. They think about them way more than they think about their portfolio as much or as more they think about their portfolio companies, which is unfortunate.
- [30:31]
B
Okay, so wait, so that's interesting. So what you're saying is that when act companies may or may not think about their shareholders, but activists are always thinking about the limit.
- [30:40]
A
Their investors. Yeah, exactly.
- [30:42]
B
Their specific investors, not the investors in the.
- [30:44]
A
Right, right. We talk about an investor, an investor mindset, a portfolio manager, an activist portfolio manager, or really any hedge fund portfolio, but thinks about shareholders obsessively. Now, this isn't something we love. We would love to think much more about our portfolio companies very frequently, but this is a brutally competitive marketplace. Okay. You know, low fee index funds are taking away money every day. All right? And so we really need to think, like I said, obsessively about shareholders and do that much more in our experience than CEOs and boards do. Okay, sure. You know, portfolio managers, you know, sometimes you think your limited partner's a little bit of a nuisance and so forth, but they're really, you know, kind of why we're here. You know, we're managing their money and we have, you know, the same kind of fiduciary due to them that boards have to their shareholders. But we tend to take that a lot more seriously, I think, than most boards do. So that alone just understanding that kind of environment that investors kind of live and breathe every day, that alone should be kind of helpful to understanding, kind of how to think like an activist,
- [32:08]
B
that activists are always essentially trying to prove to their own investors that they're doing something that's worth their fees.
- [32:15]
A
Yeah, exactly. And by extension, we kind of wish that boards would think the same way. And they don't always. Next thing has to do with how activists kind of run their business, which is activists are really cheap, okay? Very frugal. The fee pressure is unrelenting.
- [32:37]
B
Actually, you know what? The reason I think this is funny that you say that is because, you know, we had mentioned in our prior show that, like, I use certain activist presentations in my class to show them what they're like. And my favorite one is the Olive Garden one. It's long in the tooth.
- [32:52]
A
It's a big. It's iconic. It's iconic.
- [32:55]
B
But here's the thing about it. It is so cheaply put together. Like, it is obvious that somebody who's not a professional, like with Arti, like, you know, like design training, just put up like a cheap PowerPoint presentation. And that would explain why a little bit.
- [33:12]
A
I mean, in Fairness, it was 12, 13, 14. Yeah, exactly. They're probably production values have improved since then.
- [33:18]
B
Well, I think the production values may have improved because the technology proved that they could do in house. They still aren't going to hire someone to design the thing.
- [33:25]
A
Right. So. But, you know, in part because the fee pressure is so unrelenting, in part, and this is a standard complaint, in part, you know, companies drive up activist costs a lot, kind of unnecessarily. Okay. You know, the old saying is that a company on a proxy contest, a company spread spending shareholder money while we're spending our money. So it's just. So activists tend to manage things a lot more tightly than companies and boards and CEOs might. And so when a portfolio company doesn't do that or doesn't kind of share that sentiment, it's a little annoying. All right, so there's the second thing. Activists are cheap. A third has to do with how we have this kind of portfolio mindset. Activists diversify, okay? Or shareholders or investors. We have this very much of, again, a diversification approach to thinking about our investments and so forth. So any good one knows, like, exactly how much a given investment adds to risk and return. We know kind of how much we should allocate to one or another portfolio. But there's, I mean, again, there's people who manage it a little more seat of the pants. But most have, you know, modern portfolio theory is really good at kind of helping with these decisions.
- [34:54]
B
So you're thinking, like, not just like this is a better shot, but more like how it adds to the overall risk profile of the portfolio.
- [35:01]
A
Exactly. And so, so this whole diversification mindset is somewhat distinct from how companies think about it. And companies sort of wave their hands in that direction and say, oh, yeah, we have a portfolio too, but they don't nearly have the understanding of the risk and reward risk and return marginal change that one or another investment makes. And sure, you might want a CEO or a board that says we have a project, we kind of understand how it's going to change our risk profile and so forth. But the kind of rigor that a portfolio manager applies to that decision and the kind of rigor that a board applies to that decision are dramatically different. So a cousin of that sentiment is because we're diversified and we kind of stick within strategy and so forth. Activists are, I will say, coldly unsentimental. We, because we just have this portfolio of investments, everything is highly, it should be and generally is highly depersonalized. Okay? You can have an investment you love that's done really well. When it hits a goal, when the risk profile changes or something, it's gone, okay. Or there's something, there's some opportunity that you, you like and it finally gets to the right price, you grab it. But it's again, it's very depersonalized, okay. Without any kind of attachment to a thesis, to a business or the leadership. So it gets very frustrating to a portfolio manager when a board or a CEO gets just kind of in love with something, you know, and say, oh yeah, and it's understandable, we get it, we just don't like it. And that's not how we work. And we don't think you should work that way either.
- [36:52]
B
Yeah, there's a saying for writers. Kill your darlings.
- [36:56]
A
Yeah, exactly.
- [36:57]
B
If there's a problem that you can't solve, it's usually because you're holding onto something that you like, but that doesn't fit.
- [37:02]
A
Right? And so we hear a lot about MA activism. We think how to sell a division, sell a business, whatever. And it really puzzles activists when a company says, no, no, we can't do that. Or even with cash, excess cash. Most boards and CEOs will be compensated really handsomely when you sell something. So we'll try to sell a division, get rid of something, okay? Sell these assets and you'll get paid, someone else can manage it better and move on. And so we just don't get that this unnatural and sentimental attachment to these assets that if you have this more rigorous portfolio view of things, you just should be really willing to kind of get rid of. So that was another, another attribute.
- [37:53]
B
I mean, yeah, I can understand it. The boards, as compared to the activists, is a much longer term investment. So you can see why.
- [38:01]
A
But there's, but there's activists that have plenty of, of long term, I mean, long term, three to five years. No, you know, same, same investment horizon for a lot of companies. So there's a couple other aspects of this that are worth bringing out. So we talked about getting paid for, you know, whatever activists. There's always this kind of pay for performance idea that everyone pervades that CEOs talk about, oh yeah, we pay for performance boards, hire comp consultants and so forth and create all sorts of. They can't hold a candle to the pay to performance environment that exists within a hedge fund or with an activist fund. Okay. I mean, and it's sort of, that's true also for kind of investment banks and so forth. But you know, you really, you know, eat what you kill and if you make money for your limited partners, you, you, you get a very specific percentage of it. And you know, sometimes percentage is really healthy, sometimes the percentage is obscene. It's a lot of money. But the pay per for performance environment that exists in an investment fund is very clear, very stark, and you know, does not offer a whole lot of room for interpretation and for, for flexibility. Well, you know, we see kind of pay for performance in a public company and it's just, it's comical about how, you know, people overlook problems with pay for performance or, you know, set really easy goals and it gets really kind of, kind of vague. So the whole pay for performance culture that companies purport to adopt is something that is, you know, a fact of life every day at a fund. Okay, okay. There's one other aspect to this. Again, it's sort of a cousin of the portfolio thinking, which is just activists think about risk kind of differently. Okay. If you ask a CEO, you talk to a CEO about risk, you know, talk to the board, you got to, you know, and you know, they'll, they'll say, oh, risk is, risk is, you know, bad stuff. It's downside. It's, it's, you know, that's why we have a risk management group and a risk management executive. That's why we have all these risk disclosures and then we have a risk committee for them. Risk is like hazard. Risk is threats. Okay? To a portfolio manager, risk is just variability. Risk is the inability to predict with precision. Exactly. Kind of how something's going to work out. It's not hazard, it's not bad stuff. Risk is not bad. To a CEO, risk equals bad. To a portfolio manager, risk is just uncertainty or really variability. But importantly, the way to manage variability is with diversification. We talked about that a minute ago. You talk about how you diversify and how big the portfolio is and so forth and you know, diversifying risk and so on, not like, you know, really strict controls. If risk is Hazard. You know, the way to manage it is to create a big bureaucracy, to kind of find all these little risks and make them go away or to hedge and buy lots of insurance. Okay. Because of this difference in mindset about what it means to kind of take and bear risk, activists think most CEOs and boards are just kind of risk averse. I said in the piece empire builders that just want to protect themselves and, you know, with, you know, and create as much absolute certainty as they can from some really remote kind of hazards, rather than just, you know, accepting that you have a portfolio of projects and there's going to be some ups and some downs and they're going to hopefully add up to profit. So there's all these different, you know, ways that kind of activists think that none of these advisors really, I thought, really kind of uncovered.
- [41:58]
B
They're not thinking in terms of the activist's own incentives.
- [42:01]
A
Right. Or how the activist. Or how the activist thinks as a portfolio manager.
- [42:07]
B
Yeah. Like their own incentives for their portfolio, their own issues with their own limited partners. Like that. Like thinking like an activist means not like how an activist looks at a company, but also the actual pressures that are on the activists.
- [42:19]
A
Yes. And I contend that if CEOs and boards had a deeper understanding, just like activists try to have a deeper understanding of what makes CEOs tick, we really do. We sit on boards, we interview lots of CEOs. I don't sense that CEOs and boards take the same care and effort to trying to understand what makes investors tickets. And I've just listed five or six things related to diversification and what we mean by risk and pay for performance and so forth. All these things I think would help maybe contribute to a little bit more of a convergence between what company leadership and their shareholders are trying to accomplish and maybe create a little more common ground. I don't know. So it was my little contribution to trying to help CEOs really understand how to think like an economist, I guess.
- [43:15]
B
How's that?
- [43:16]
A
All right, all right, enough of that. Let's maybe wrap up and move on to some other good stuff for next week, shall we?
- [43:25]
B
Okay.
- [43:26]
A
All right, let's do that. All right. This is Shareholder Primacy, hosted by Ann Lipton and me, Mike Levin. I am an independent activist investor. I think like an activist, an advisor to investors about their activity, activist situation. Ann, who also thinks a little bit like an activist, is a professor of law, somewhat is professor of law. Oh, think like a lawyer. Fine. And is professor of law and Lawrence W. DeMuth, chair of business Law at the University of Colorado Law School. You can find me mike@theactivistinvestor.com you can find Ann at Law Colorado. Edu. Our podcast is, as always, produced and distributed by our friends at Free Float Media. Thanks for listening. We'll talk again soon.