Hedge Funds  |  Deal Professor

A Truce at Sotheby’s After a Costly and Avoidable Battle

By STEVEN M. DAVIDOFF   May 5, 2014, 6:40 pm

Really, Sotheby’s?

Did you really have to spend well over $10 million to fight off Daniel S. Loeb’s Third Point only to cave at the last minute to give Mr. Loeb almost everything he demanded?

Have we really learned nothing about how activism works these days?

For the past few years, Sotheby’s has done reasonably well, but it was also clearly lagging in some measures. Sotheby’s, founded in 1744, has only one real global competitor — Christie’s — and so seemed well placed to ride the boom in ultra-wealthy individuals. The number of people in this class — those with $30 million or more in investable assets — has reached a high, according to a presentation prepared by Third Point. They control more than $16 trillion in wealth, the firm said.

That’s a fair bit of cash, and you would think these people would be spending their excess billions on art, but Sotheby’s has not been able to lure these customers. Art sales at the auction house are relatively up in recent years but still below where they were in 2007.

Sotheby’s stock price is up about 70 percent since 2008, but revenue still hasn’t approached 2007 levels. Meanwhile, Sotheby’s expenses rose to $597 million in 2013, from a low of $395 million in 2009. More than $100 million of this added expense was because of increased employee costs, according to Bloomberg L.P. On top of this, the firm’s chief executive, William F. Ruprecht, was paid $6 million last year, a rather high figure for a company with a $3 billion market capitalization.

In a world where hedge fund activists are everywhere, it was only a matter of time before Sotheby’s would be on the defensive.

And in April 2013, Mr. Loeb and Third Point arrived. Third Point eventually took a 9.6 percent stake, while other hedge funds like Marcato Capital Management entered the picture. Mr. Loeb’s arguments for change at Sotheby’s varied over time, but they essentially boiled down to the complaint that Sotheby’s was spending too much and not seizing opportunities to expand its business.

What happened next was a year of dancing. Sotheby’s did what companies usually do in these situations: The art house announced some changes to corporate governance and some shareholder-friendly moves — in its case, a $450 million share buyback.

Mr. Loeb was not satisfied. Although he was twice offered a board seat, he turned it down. It is here that the competing narratives take place: Sotheby’s says it always wanted to compromise, but Mr. Loeb stated at the time that one seat was not enough to effect change.

Things became heated when Third Point nominated three directors and Sotheby’s responded by adopting a poison pill, limiting Mr. Loeb’s stake to less than 10 percent.

What happened next was more wasted money and time as the parties litigated the validity of the poison pill. Sotheby’s knew that it had the upper hand and Delaware law was on its side. But for Mr. Loeb, winning the litigation wasn’t as important as deposing the Sotheby’s directors in the hope that he could find some ammunition for his fight. In other words, Sotheby’s overreached with the poison pill and gave Mr. Loeb an opening to inflict damage.

Mr. Loeb came up a winner in the litigation tactic that Sotheby’s handed him. Mr. Loeb lost the case, but in the hearing before a court in Delaware, emails sent among the Sotheby’s directors came out with some damning stuff. Steven B. Dodge, the lead independent director, stated that the board “is too comfortable, too chummy and not doing its job” to another director. Another email stated that at least in part Mr. Loeb was “right on the merits.”

In truth, these words led to more public-relations problems than anything else and yet another lesson that people need to be careful about what they write in an email. The emails were perhaps the tipping point, but didn’t change the truth that Sotheby’s was most likely going to lose the election.

Sotheby’s two largest shareholders (and four of the top 10) were hedge funds, according to Capital IQ. Institutional Shareholder Services, the proxy advisory firm, came out in support of two of Mr. Loeb’s nominees. And institutional shareholders have a tendency to support dissidents when there are identifiable weaknesses in a company (although others would say they are just following the herd).

In these situations, the rule is to compromise and give the hedge funds the seats.

According to FactSet’s corporate governance database, SharkRepellent, there were a record 16 campaigns in the first two months of 2014 in which an activist was granted a board seat. Last year, 80 percent of activists were granted a seat before a proxy campaign was even completed. And 60 percent of proxy contests that went the distance were won by activists. According to SharkRepellent, even Carl C. Icahn has stated that he is “surprised” that he is being offered board seats so often to forestall a campaign.

This not only means that compromise is the preferred route, but it is becoming the case before a proxy contest gains traction.

Last week, Abercrombie & Fitch settled a board contest with Engaged Capital, an activist investor that held only 0.6 percent of the company. According to Capital IQ, Engaged was not even one of the top 25 holders of Abercrombie stock.

Faced with a challenge, the Abercrombie board recognized that it had let its chief, Michael Jeffries, treat the company as his playground. When the results failed to follow and an activist came in, the board rushed to reorganize. At Abercrombie, seven of 12 directors have left since January. The activist has placed four new directors, though Craig R. Stapleton, the chairman who presided over Abercrombie’s shortcomings, remains as a director for now.

As Abercrombie did with a less-threatening adversary, the Sotheby’s board could have spent its time more fruitfully just by seeing whether its directors would work. Instead, Sotheby’s handed Mr. Loeb a public victory, possibly by aggressively adopting the pill. Sotheby’s also knew those emails would come out and could have simply taken steps to avert the trial, even after adopting the pill.

So the question is, what happens next at Sotheby’s?

Mr. Loeb has elected his three directors, but two of the independent nominees that Sotheby’s named during the fight, Jessica Bibliowicz and Kevin C. Conroy, are being kept on as a face-saving move for Sotheby’s. This makes for an unwieldy 15-person board. Sotheby’s poison pill — which cost millions to litigate — will also be terminated, but Mr. Loeb is limited to a 15 percent stake in the company.

Sotheby’s will try to move forward, but the issue of credibility will remain with so many directors staying on.

Sotheby’s statements on Monday were about reconciliation. “We welcome our newest directors to the board,” said Mr. Ruprecht, the firm’s chief, adding that Sotheby’s “will benefit from five fresh voices and viewpoints.”

One still has to wonder whether the board can shake up the company’s performance, given the board’s inability to recognize what just happened. Faced with these dynamics, boards may not want to be so obstinate in the face of the obvious flaws.

Steven M. Davidoff, a professor at the Michael E. Moritz College of Law at Ohio State University, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.” E-mail: dealprof@nytimes.com | Twitter: @StevenDavidoff

A version of this article appears in print on 05/06/2014, on page B5 of the NewYork edition with the headline: A Truce at Sotheby’s After a Costly and Avoidable Battle.

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