Activist Investors are Employing Private Investigators to Ferret Out Juicy Details

If you ever wondered where the new Sam Spade is lurking, look no further than Securities and Exchange Commission filings from activist investors.

Want to find out if director nominees have skeletons in their closets? Hire a private investigator. What about even the most tawdry allegations, such as extra-marital affairs. A private gumshoe may be needed to run down witnesses or hushed-up lawsuits. And it's not just the purview of investors — corporations also make use of investigators' services in the interest of shareholders (it's always in the interest of shareholders.)

The goal of the undercover investigations, activists and their advisers say, is to ferret out juicy, sometimes embarrassing, details that can help build support for their campaign from institutional investors and help prod companies into action. But it may also be used as a way to double-check an activist's theory about what is ailing a company. In addition, background checks, whether performed for activists or targeted companies, are a critical aspect of the vetting process for board director candidates.

Wachtell Lipton Rosen & Katz LLP put a spotlight on private investigators in a recent memo outlining tactics employed by activists. Activists hire PI firms to "establish dossiers on directors, management and key employees" and also conduct "aggressive diligence," the law firm said in its memo.

Though Sahm Adrangi, founder of activist fund Kerrisdale Capital Management LLC in New York, insists that hiring a private investigation firm is not his preferred strategy, he has resorted to their services when he wanted to short Chinese companies that he suspected of playing fast and loose with their financial avowals. Between 2010 and 2012 Adrangi hired a Shanghai-based firm to look into what he deemed to be suspicious acquisitions by ChinaCast Education Corp., an online operator of Chinese for-profit colleges.

"ChinaCast would acquire colleges for reported purchase prices that were different from what the sellers were selling them for," Adrangi says. The investigator "found that one middleman was a farmer in a rural province with only a high school education who was skimming money off the top," he says. "We suspect he was affiliated with ChinaCast, and that someone was stealing money from shareholders."

In addition, the investigative firm found other middlemen operating shell corporations in the British Virgin Islands that were making "tens of millions of dollars" acting as intermediaries for these transactions, Adrangi said. The investigation eventually led Adrangi to accuse ChinaCast of falsifying its financial statements and overstating its revenue and profits.

Kerrisdale, which held a large short position in the company's U.S. listed securities, eventually released a report urging the SEC to take a closer look. The regulator did just that and in 2013 it charged ChinaCast's former CEO with fraud and insider trading. The stock dropped precipitously during Adrangi's campaign and now trades at around a penny in the over-the-counter market.

Elsewhere, Kerrisdale hired a different Chinese investigative firm to determine whether certain factories a U.S.-listed Chinese company owned were operational. The review discovered many were empty and non-functional.

Larger activists also have been known to make use of investigator's services. Pershing Square Capital Management LP founder Bill Ackman made no bones about hiring OTG Research Group as part of his campaign to convince regulators in the U.S. and elsewhere that nutritional supplement company Herbalife Ltd. (HLF) is an illegal pyramid scheme. OTG's Adam Smith-Levin's China investigation eventually led to Ackman's claims that the company violated civil and criminal law there. Smith-Levin acknowledged in an interview that he is still under contract with Pershing Square to do additional research on Herbalife.

Paul Singer's Elliott Management Corp. declined to comment when asked about whether the firm hires private investigators. But a person familiar with the fund says it has hired private investigators he knows from his time at Kroll Inc., an international investigation and due diligence-company, in a division that specifically deals with hostile takeover situations.

"One particular career private investigator was an outside contractor that later worked for Kroll before going to Elliott," this person said. "Two or three years ago I started to hear that he had worked for Elliott and in recent months a company targeted by an activist Elliott campaign found out that this guy was out there talking to former employees of the targeted company."

He added that one private investigator working for Kroll was heavily involved in investigative work for Elliott in connection with Argentina's debt situation. Singer's firm, which is a significant investor in distressed debt, has been embroiled in litigation with Argentina over a dispute about what the dissident considered to be fair value for the country's bonds after it defaulted on its sovereign debt in 2002.

Investigations can take many forms including record searches of all types, digging through court pleadings, searching archived website data, and, when warranted, surveillance. Still, Ken Springer, a former FBI agent and founder of Corporate Resolutions Inc., says simple communication is still the best investigative method. "Talking to people is the most under estimated way of getting information," he says.

Springer recalls that he was retained when an activist became concerned about a company CEO's private life. "The activist on the board needed to know whether the CEO was involved in anything that would inhibit his productivity and success at the company and retained us through outside counsel for privilege and confidentiality," Springer says. Indeed, surveillance and records searches turned up sexual harassment claims and an active divorce case, leading the board to allow the chief executive to step down. "This is a perfect example where the activist took the lead," he says.

Another activist hired Springer to look into whether a director candidate against whom the insurgent manager was competing for a board seat had any issues. It turned out that the activist's competitor hadn't told the company about a regulatory sanction that he had known was in the works until late in the vetting process. That worked in favor of the activist who got his board seat. In addition, Springer says his team often reviews archived websites, using a free online service called the so-called "way back machine," which has helped his firm discover biographical details that individuals had hoped to keep hidden.

But one of the better known examples of activist investors digging into an executive's past was done with the firm's own computers. When Dan Loeb's activist fund Third Point LLC went after Yahoo! Inc.'s (YHOO) CEO Scott Thompson in 2012, observers believed he had an investigator help him establish that the executive's resume included a degree that his college didn't offer at the time he graduated.

Robert Chapman, a former activist fund manager who occasionally invested together with Third Point on deals, says Loeb told him that a simple Google search was used to figure out that the university didn't offer a computer science degree at the time Thompson had been there.

"It was not complicated," Chapman says, adding that his fund had also hired private investigators in the past on occasion.

Still, Loeb had a lot of interesting anecdotes during his campaign this year against auction house Sotheby's (BID) . Most memorable was one of Loeb's letters excoriating the company on their expenses. Loeb wrote that he had heard of a recent offsite meeting involving an "extravagant lunch and dinner" where the auction house's senior management "feasted on organic delicacies and imbibed vintage wines at a cost to shareholders of multiple hundreds of thousands of dollars." Though it had all the earmarks of the work of a private investigator, people familiar with Third Point's operations said that anecdote came to the activist through its own inquiries and contacts.

Third Point declined to comment for this story, but people familiar with the fund acknowledge that it does engage third-party firms to conduct background checks on employees of targeted companies and others.

Activists, however, should not take comfort in arming themselves with their version of Sherlock Holmes or Mike Hammer. What's good for the goose is good for the gander and companies are also known to employ investigators, both to determine that they are doing the right thing, as well as to be prepared for an activist onslaught.

"You don't want to be embarrassed," says Ethan Klingsberg, partner at Cleary Gottlieb Steen & Hamilton LLP. "You don't want your own directors to be vulnerable. You should know that someone, such as an activist, could do that same research [about the director] against you."

Ernest Brod, managing director of business intelligence firm Alvarez & Marsal, provides advice to both activists and target corporations, though the vast majority his team's work is conducted for companies.

Business has been brisk. Brod, who has a 25-year career in corporate investigations, notes that just in the past two years Alvarez & Marsal has been engaged by eighteen companies — typically with more than $1 billion market capitalizations — that were targeted by activist investors.

The firm is often engaged by a targeted company's external law firm or crisis-communications company and, recently, his advice has been sought earlier in insurgency campaigns, often even before a proxy fight takes place.

"There was a time when we would get most of our calls when the activist had already nominated a slate," Brod says. "These days we often get a call as soon as a company notices that a well-known activist has bought into their stock — in anticipation of a campaign and eventual proxy contest. The team gets put together earlier than it used to."

At this earlier pre-proxy fight stage, the intelligence firm completes a background check on any other deals the activist has been involved in, as part of an effort to get a feel for their tactics, how other companies have reacted and to help identify what has worked to "fend off" the activist and what hasn't.

Once a proxy contest is announced the fund will conduct a "deep due diligence" into the dissident's nominees, including background checks on their resumes and bios for accuracy.

"We look at every company the dissident director candidate was a board member or senior executive of and see what happened to the stock price during his or her tenure," Brod says. "We look to see if they are on too many boards, or if there are reputational or integrity issues in their background."

He adds that details they identify often find their way into corporate fight letters, which the company produces as campaigns heat up. In some cases the information is used behind the scenes to assist the company in its private negotiations with the activist.

Another defense tactic is to check for illegal communication among activists in situations where multiple insurgents are targeting the same company. "We look to see if they are communicating and whether that is a violation of securities disclosure rules," he says.

Bob Brenner, a former state and federal prosecutor in New York, recently moved to K2 Intelligence, a corporate investigations firm launched in 2009 by the founders of Kroll. When advising companies, Brenner says his team will seek to identify what kind of resources an activist has at its disposal. "Do they have the funds to go through a costly proxy solicitation," he asks.

In addition, Brenner says his group figures out the activist's track record to identify if it has succeeded previously at electing dissidents, as well as whether they are acting as a stalking horse for a passive investor that doesn't want to do the "nasty work" of an activist campaign.

Once a battle has advanced to the proxy contest stage, Brenner says his team will comb through a dissident's director nominees to identify any material misstatements or omissions. "They may be omitting that a [dissident] director candidate was involved in a company that had regulatory or financial problems," he says.

Nevertheless, one factor may be holding back some activist funds, particularly smaller ones, from hiring PI firms — the cost. Kerrisdale's Adrangi notes that hiring investigators in China is relatively inexpensive when compared to the going rates in the U.S. He says that a legitimate investigative firm in China could conduct a thorough review of a company and its claims for between $15,000 and $30,000.

However, costs in the U.S. can be more substantial. Brod suggests that Alvarez & Marsal's services to companies seeking to defend themselves from activists range in the neighborhood of $50,000 to $250,000, depending on the level of investigation needed.

Damien Park, managing partner of proxy advisory firm Hedge Fund Solutions LLC, often suggests that his corporate or activist clients hire a private investigative firm. He argues, however, that none of his clients have ever spent more than $100,000 on a PI firm investigation.

"There are different levels of investigation and different costs involved," Park said. "The question is how deep of an investigation are you hoping to get?"

As the 2015 proxy season gets underway, look for the surprise disclosures that may mean an investigator is on the scene. But as you're looking, remember this: Someone may be watching you.

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