Addressing shareholder activism
August 2013 | COVER STORY | CORPORATE GOVERNANCE
Financier Worldwide Magazine
The issue of shareholder activism has drawn increased attention in recent years, especially in light of regulatory change such as the Dodd-Frank Act. Since the financial crisis, shareholders have become increasingly vigilant and protective of their investments. But activism can take many forms, both adversarial and collaborative in nature, and may arise from a variety of situations. Although it has acquired somewhat negative connotations, given the well-reported tactics employed by a few prominent investors, there are many investors who engage with boards in a constructive manner, which has a beneficial impact on a company. As activist investors become a major consideration for firms, what steps can management take to prepare for and respond to their demands, and what strategies can they use to limit the potential damage caused by aggressive investors?
High-profile disputes between activist shareholders and well-known public companies have burnt shareholder activism into the public consciousness. Recent examples include the efforts of Greenlight Capital Inc. to force Apple Inc. to distribute more of its $137bn capital to shareholders, and Carl Icahn’s campaign to obtain more-favourable buyout terms for the shareholders of Dell Inc. Major investors such as Greenlight and Ichan have traditionally had the weight to pressure large companies, but in today’s climate even smaller shareholders are making their voices heard. That said, only a limited number of shareholders are true activists, and other shareholders may still use certain mechanisms, such as shareholder proposals, to push for change and to engage proactively with companies. Shareholders have traditionally only launched such campaigns at firms that were performing poorly, but since the financial crisis of 2008, where widespread flaws in corporate governance were revealed, shareholders have become more inclined to flex their muscles.
So what factors, exactly, have given shareholder activists the opportunity to successfully influence, challenge and change boardroom strategies? How have their rights as holders of company stock evolved? “I don’t think that the ‘rights’ of activist investors have changed much at all,” says Neil Whoriskey, a partner at Cleary Gottlieb Steen & Hamilton LLP. “However, the atmosphere in which activists operate has changed substantially over the past few years. Most significantly, institutional investors, some of whom had considered activists to be anathema, are now in general much more willing to listen to and in some cases support activists – and the support has not always been limited to quiet behind the scenes assurances that the institutional investor will vote with the activist. I believe this greater willingness to support, or at least hear out, activists arises from two factors – first, the profitable track record of some, though certainly not all, activists; and second, the pressure the good governance types have been placing on large institutional investors to become more actively involved in supervising the management of their portfolio companies.”
Shareholder rights have remained remarkably consistent over the years, agrees Stephen Lamb, a partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP and former Vice Chancellor of the Delaware Court of Chancery. However, the way in which those rights are exerted, and the frequency with which shareholders raise their concerns has altered. “The causes of these changes are numerous, but I find two main drivers,” says Mr Lamb. “The first is fundamental weakness in performance or corporate governance at a few US corporations, which result in massive, catalytic events or issues that spark and fuel stockholder activism. The second is the rise and convergence of ‘issue’ stockholders, such as academics, individuals and unions; ‘money’ stockholders, such as hedge and private equity funds; and other stockholder representatives, such as proxy advisory firms. The resulting changes in the stockholder-director-corporation relationship has thus accelerated with each crisis over the last decade or so, starting with the internet bubble and the corporate failures that culminated in the enactment of the Sarbanes-Oxley Act in 2002, until now where the heightened stockholder activist response is par for the course in Corporate America.” Public outrage over high executive pay and regulatory reforms have given shareholders greater power, and now they are becoming more acutely aware of how that power can be wielded. In today’s environment, even the largest companies can be targets of activism if their corporate governance is not up to scratch.
Means and methods
The drivers of shareholder activism are varied. For instance, activism can result from the perception that a company’s capital structure is inefficient, observations that the company’s takeover defences are inadequate, or a belief that the company is failing to adapt to certain financial conditions. Shareholder requests may run from simple dividend or stock repurchases to restructurings, management and board changes, or the sale of the entire company. The request may depend upon the class of investor. Institutional activist investors, for instance, often have demands that are based on enhancing tangible shareholder value – whatever that translates into for the company in question. Shareholders may act by requesting meetings for discussions or negation, engaging in public campaigns for change, by making shareholder proposals, or with full scale proxy contests. It may be hostile or proactive, but in either case the methods and tools will vary. One thing is for certain: in recent years technological leaps have made activism much easier and more common. Advances in communications and the rise of social media, for instance, have made organisation and cooperation between activists increasingly efficient. Combined with today’s difficult business environment, and the increasing enthusiasm of shareholders to hold firms to account, a perfect storm of circumstance has formed in which activists can flourish.
Despite the growing strength of activist shareholders, firms can take a number of steps to anticipate and dissipate potentially damaging action. First, company leaders must look closely at their organisation and identify the attributes that make it vulnerable. Financial underperformance, a negative change in the company’s market value, or an abundance of cash on the balance sheet, should raise red flags. “Companies need to develop focused business strategies, yet remain open minded and listen to what their stockholders are saying about possible changes and improvements,” says Mr Lamb. “While I do believe that it is largely due to the failures of a few that we find ourselves in the activist investing environment of today, that activism is here to stay and corporations need to be cognisant of and responsive to that environment. Keeping an ear on the ground is the best early warning system for companies.”
The second step to protecting against investor showdowns is a strong understanding of the shareholder base and the shareholders’ priorities. Boards and management must be aware of those shareholders who are likely to take action – which may only be a small percentage – and the steps they may take. As activism has become more mainstream in recent years, shareholder activists may emerge in any group of investors including strategic investors, hedge funds, pension funds, investment firms and institutional investors.
An acute awareness of, and adherence to, principles of good governance, will also help to shield firms from shareholder activism, especially given the increasing support of institutional investors for activists. “The reason that the good governance guidelines are important,” says Mr Whoriskey, “is that activists will have an easier time attracting institutional investors to its cause if management is already on the radar of the many large institutional investors who are committed to good governance principles. More generally, a company should know what the views of its key stockholders are on issues that are important to the company – particularly issues that the company has identified as potential openings for an attack by activists. Companies should also closely watch for unusual trading patterns – including options purchases – in their stock and perhaps also monitor the 13F filings of activists that operate in their industry.”
Communication is key
No matter what precautions are taken, at some point all firms will reveal a chink in their armour and will need to respond to activist shareholders. In this case, companies can take many lines of action, however clear communication is always paramount. “In the end, it is management’s story versus the activist’s story vying for the attention and vote of the shareholders,” Mr Whoriskey stresses. “Telling the story well and being prepared to clearly articulate a compelling story about the value of the company and the value of the strategy being followed by the company is in the end the basis for any defence. Legal tactics and structural defences are important in buying the company enough time to respond properly to an activist, but the response, eventually, will have to stand on its own merits.” Management and the board, therefore, must communicate regularly and openly with shareholders, and these communications should be as clear, simple and concise as possible. Moreover, they should enable shareholders to reach out directly to them when issues arise. When working with shareholder activists, boards must be sure to listen to the activists’ concerns before engaging in meaningful dialogue with all parties.
Given the firepower and influence of activist funds, there are very few, if any, public companies that are immune to attack. Accordingly, companies would be well-advised to have a dedicated response team ready to act at all times. However, the strategy adopted by the company will likely need to be customised to each shareholder issue and type of activist. “A clear communication strategy is imperative at all times, not just in responding to activism,” says Mr Lamb. “Often we encounter situations where activism could have been prevented if the company had done a better job of getting its initial message across, whether that message is about its overall business strategy or a particular issue – such as its executive compensation plans. Also, a ‘dedicated response team’ sounds like overkill for most companies, but I recommend that every company think in advance about how they would respond to a possible activist event or any significant corporate event or crises. Even something as simple as keeping an updated working group and contact list can save a lot of precious time on the back end.”
It is critical to develop a sound shareholder communication plan and to remain an active listener and proactive communicator to all shareholders, and an integrated approach is recommended. The identification of potential shareholder issues, assembly of a response team and development of a communication strategy should not be performed in isolation but be integrated as one.
In the years since the financial crisis, the true impact of shareholder activism has been realised. Where once investors were inclined to express their discontent by selling off stock, today’s conditions make it more lucrative to raise issues and intervene. But will the voice of disgruntled investors fade away, or continue to test firms in the years to come? And will investor activism continue to evolve – will the means and methods, and behaviour of concerned shareholders continue to change? “I expect boards to face at least the same if not increasing challenges from stockholders in the coming years,” says Mr Lamb. “I do not think activist behaviour will experience a sea change in the next few years, but tactics and issues will morph on the margins. Every couple of years, a new flavour of issue or strategy seems to come into vogue, and, of course, stockholders and companies will continue to innovate to respond to these changes.”
Having touched upon the issue of non-traditional activists, could their increased involvement be seen as a step forward for shareholders eager to effect change? Perhaps, says Mr Whoriskey, though this development may impact traditional investor activists. “There is a finite number of companies that fit the profile of activist investors,” he says. “In one sense, the fact that more institutional investors, and more hedge funds, are taking on the role of playing the ‘quiet activist’ – having conversations with attentive board members who will act on ideas they consider compelling, regardless of the source, may actually limit the opportunities available for traditional activist funds going forward. This is not to say that traditional activists will lack for targets, just that there may be fewer to choose from, and the targets that they find may be of the type that are less susceptible to the power of a good argument, and may need a more forceful push to act.” In addition, he points out, this trend may result in fewer early settlements being reached between activists and companies.
The truth is that increased shareholder activism is likely here to stay, and, in future, could come to be seen a regular part of business life. But, although the image of the activist-board relationship is often seen as fraught with disagreement, this does not have to be the case. An awareness of shareholder desires should encourage firms to address the issues that are already on their radar, for risk of activism. Where firms fail to address issues, they must display effective communication skills and an ability to turn shareholder discontent into positive change. Shareholder activism is not necessarily a threat, but may present opportunities that can benefit a company. Firms can, and must, learn to work with activist shareholders. After all, investors and boards both want the same thing, and that is profit.
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