FORUM: Preparing for and tackling shareholder activism
May 2015 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
Financier Worldwide Magazine
FW moderates a discussion on preparing for and tackling shareholder activism between Ethan A. Klingsberg at Cleary Gottlieb Steen & Hamilton LLP, Chris Young at Credit Suisse, Arthur Crozier at Innisfree M&A Incorporated, and Michael Schwartz at Willkie Farr & Gallagher LLP.
FW: In what ways have the rights of investors increased in recent years?
Young: Reflecting on the last 20 years, the landscape has changed dramatically. Due to pressure from institutional investors, and the proxy advisory services such as ISS and Glass Lewis, structural defences have been largely eliminated or reduced. For example, most large cap companies used to have staggered board elections. Today, 10 percent or less of the S&P 500 have a staggered board. Most companies used to have standing 10-year poison pills. Today, due to pressure from investors and ISS policy, most companies do not have a poison pill in place, opting instead to put a pill ‘on the shelf’. Shareholders increasingly have the right to act outside the annual meeting calendar, either by being empowered to call a special meeting or to act by written consent. All of these changes give shareholders – and hostile bidders – the tools to pressure a target company.
Schwartz: There has been a marked trend toward shareholder democracy in recent years. Majority voting for directors in uncontested elections is now the rule at many companies. Unlike the traditional plurality vote, shareholders can reject director nominees by withholding enough votes. While incumbent directors who fail to receive a majority may ‘hold over’, resignation policies may force those directors off the board. Another shareholder democracy development is proxy access, under which companies must include in their proxy materials director nominees proposed by shareholders that meet set ownership requirements. Although the SEC’s mandatory proxy access rule was overturned in the courts, governance advocates and institutional investors have met with increasing success in encouraging companies to adopt proxy access bylaws or to force such bylaws to be put to a shareholder vote.
Crozier: As investors have become more vocal in recent years, they have also pushed for greater governance rights leading to several significant changes. The first campaigns attacked plurality voting to require companies to implement majority voting by which directors could only be elected by a majority of the shares voted. The next wave sought to declassify boards to require the election of directors annually. Proposals submitted by the Harvard Shareholder Rights Project effectively dismantled classified board structures from 2012 to 2014. By the end of 2014, less than 10 percent of S&P 500 companies had classified boards. By requiring directors to obtain majority support annually, along with mandatory say-on-pay votes, greater transparency and responsiveness has been forced upon boards. A third potential shift today revolves around proxy access, where shareholders would have the ability to nominate and place their own candidates in management’s proxy materials if they meet certain parameters. In 2015, proxy access proposals were submitted by the New York City Comptroller at 75 companies to allow shareholders to nominate if they hold 3 percent of a company’s stock for three years. While still early in the season, this version of proxy access may gain significant traction and would open one more outlet for shareholder dissatisfaction.
Klingsberg: Probably the most important rule change was to the stock exchange rules in the US to eliminate the ability of management to rely on broker non-votes being cast in management’s favour. Corporations themselves have implemented the other major changes. For example, the approach we used to take to poison pills was that it was best to put a 10-year pill in place ‘on a clear day’, but now, except for small-caps and companies with NOLs to protect, corporations are typically reluctant to put a pill in place with a term of more than a year and they will only put them in place on the most ‘stormy of days’ – that is, in response to actual threats to imminently acquire negative control through open market accumulations. Staggered boards have largely disappeared from the corporations in the S&P 500. Majority voting policies are now in place at nearly all US public companies.
FW: Could you provide an overview of the most significant recent developments in shareholder activism?
Crozier: Shareholder activism continues to evolve as capital inflows increase. Notably, size is no longer a sufficient deterrent and activists are now seeking complete control at the board level. There have been two significant developments of late. Allergan, a $60bn company, was targeted by Pershing Square in a campaign that lasted until late in 2014. Partially because of Allergan’s size, Pershing Square developed a novel co-bidding arrangement with Valeant Pharmaceuticals to acquire a greater foothold. Also, in late 2014, Darden, the now $8bn restaurant operator, was targeted by Starboard, which sought complete control of the board. Starboard won all 12 seats in a campaign that received national media attention. A further development is that shareholders are not only advocating for changes at parent companies, but also companies not yet spun off. Carl Icahn and Gannett recently reached a settlement regarding, in part, the governance of its publishing segment post-spin and Trian has put pressure on DuPont, a $60bn company, to set the governance structure of its Chemours business once it is separated.
Klingsberg: The difficulty of obtaining returns in the low interest rate environment has driven the market to embrace every avenue available to push corporations to boost returns. Activist hedge funds have proven that they can bring about better than average returns, at least for themselves, although not always for the shareholders left in their wake with a company levered into junk status or having just divested its key, countercyclical subsidiary. The amount of money pouring into these activist hedge funds, up over 20 percent in the last four years to over $111bn, coupled with the friendly lines of communication that these funds have with traditional institutional investors, such as T. Rowe Price and Fidelity, and with proxy advisory firms, most prominently ISS, makes for a potent chemistry.
Schwartz: The most significant recent developments in shareholder activism stem from changes in the governance environment. Today, institutional investors are much less deferential to management and are more likely to support activists. Also, there has been an explosion in the number of funds and assets under management that are dedicated to activist strategies. Add to this mix the strong backing of governance initiatives by proxy advisory firms, and you have the most shareholder-friendly environment we’ve ever experienced. One result is that activists have more leverage in negotiating privately with companies for the addition or replacement of directors. Particularly where an activist seeks to address perceived operational deficiencies by adding to the board expertise and skill sets that may be wanting, many companies decide they are better off working with the activist than engaging in a costly and disruptive proxy contest that they could well lose.
Young: By far the most important development in shareholder activism has been the increased ‘buy in’ to activism by ‘mainstream’ institutional investors. In 2004, many long-only investors were curious but sceptical about what was then a relatively new phenomenon: activist investing. Over a decade later, companies must navigate a much more treacherous ecosystem. Mainstream investors have become comfortable not only supporting activism at the ballot box, but also soliciting activists for help. Portfolio managers like to live in a world of free options, and activists provide that optionality. The support of the large fund complexes allows activists to climb up the capitalisation scale and go after larger companies. It also, in practice, has encouraged target companies to settle at higher rates than in the past, fearful that their ostensibly ‘conservative’ shareholder base may have turned against them.
FW: To what extent are shareholder activists using the proxy season to exert their influence? Is this typically the best time for them to do so?
Schwartz: Proxy season provides activists with the most obvious opportunities for wielding influence because it ends with a referendum on some or all of the directors and allows the activist to place other proposals directly before the shareholders. Activism, though, is a year-round phenomenon. Even if a campaign is aimed at proxy season rather than at a special meeting or consent solicitation between annual meetings, an activist will seek to engage with management and shareholders long before proxy season rolls around. Early engagement allows an activist either to negotiate a settlement without launching a proxy contest or to make the case that it has been ‘forced’ into a proxy contest by an unreasonable management.
Young: Proxy season is the most effective time of the year for activists to apply pressure on target companies. The annual meeting provides an activist with its biggest ‘stick’: the threat of a proxy fight for board seats. Although some companies allow shareholders to act outside the annual meeting calendar, most activists prefer the convenience of action at the annual meeting. In addition to board contests, the annual meeting allows for a vote on shareholder proposals. This strategy historically has been deployed less frequently by economic activists like hedge funds, but recently we have observed an uptick in proposals addressing issues like spin-offs, buybacks, and so on. The annual say-on-pay vote also provides an indirect pressure point and a way for shareholders to express displeasure with a particular company. A failed say-on-pay vote may embolden economic activists like a hedge fund to target such ‘failed’ companies.
Klingsberg: General counsels used to breathe easy once their advance notice deadline had passed for shareholders to propose slates of directors for the annual meeting. But the focus is no longer on only the annual meeting. Many corporations have given in to demands to amend by-laws to permit shareholders to call special meetings. In addition, about one-third of publicly listed companies in the US permit shareholders to act at any time by written consent. Over the past year, activists regularly threatened, and in some instances actually made good on threats, to attempt to replace directors through off-cycle special meetings and consent solicitations. Some activists proposed holding shareholder referenda, outside any formal meeting, to influence corporations. Nobody has fully executed on this referendum idea yet, but I would not discount it from being used in the coming years as technology advances rapidly.
Crozier: Although special meeting rights and rights to act by written consent have become more prevalent, activism during proxy season is still the preferred choice. Action by written consent generally requires a majority of the outstanding shares to support a proposal, and calling a special meeting is logistically difficult and requires significant lead time. Thus, activists focus on nomination deadlines in advance of annual meetings, and the ultimate campaign for votes in the director election. While public pressure can sometimes be a driving force alone, an activist can obtain a board seat at an annual meeting and declare a mandate for change by simply receiving one more vote than an incumbent director. If they are able to persuade the proxy advisory firms, ISS and Glass Lewis, of the merits of their campaign and get a positive recommendation for just one nominee, it is often enough to clear that low bar.
FW: In what ways are the tactics and strategies employed by shareholder activists evolving? What factors are driving these changes?
Young: As shareholder activism has matured as an asset class, we’ve seen an effort on the part of many of the veteran activists to ‘mainstream’ their brands. Instead of vitriolic poison pen letters, we now see detailed ‘white papers’. Instead of a weak slate of unqualified dissident directors, we now see respected ex-CEOs joining activist slates. Activists are seeking to project a ‘kinder, gentler’ brand to appeal to two important constituencies: mainstream money managers and the corporate community. With a less adversarial reputation, an activist is more likely to get the benefit of the doubt from the long-only PMs. The activist is also likely to get access to senior management and even the board of directors of a company, often behind the scenes, which allows it to work out a compromise that avoids a nasty public fight.
Schwartz: Activists generally conduct campaigns on their own, although multiple activists may pursue the same agenda for a company or even explicitly agree to work together. This past year, in an evolutionary – or perhaps revolutionary – example of forcing the sale of a company, an activist assembled an ownership stake and commenced a public campaign only after identifying and signing an agreement with a potential acquirer. Pershing Square’s agreement with Valeant, which contemplated a bid by Valeant to acquire Allergan, solved a number of problems for an activist seeking the sale of a company. Among them, it immediately put Allergan in play, avoiding a risky months-long campaign to replace the board with directors favouring a sale. Also, it allowed Pershing Square to amass a $4bn stake in Valeant only after knowing that Valeant was likely to make an attractive bid. Though the Valeant bid was topped, Pershing Square reportedly made a profit of more than $2bn on its investment.
Klingsberg: Activists, together with their brokers, are developing new ways to rapidly acquire positions ‘under the radar’, that is, ways that permit activists to delay, minimise or avoid triggering disclosure or regulatory clearance requirements, or market chatter. In addition, the activists are hiring more analysts with industry backgrounds to prepare refined white papers to promote the substantive bases for critiques of targets. Some activists are, following in the footsteps of private equity, putting in place in-house stables of industry experts, such as former CEOs, to lend further support to their image as ‘operational’ saviours, as opposed to mere financial engineers. Finally, the activist hedge funds are now often able to maintain their holdings for periods of four or more years and rely on this data point to help dispel the ‘short-termism’ label.
Crozier: The days of activist raiders seeking greenmail have long passed. Today’s activists run sophisticated screens, looking for undervalued stocks that offer multiple levers for additional value. While going public to put a company ‘in play’ for M&A activity may be the most common strategy, activists will now roll up their sleeves to advocate changes around capital allocation, organisational structure and business operations. It is not uncommon for activists to retain their own investment bank to run models and compile roadshow presentations outlining a detailed strategy. Behind these changes is the understanding that votes are won in the court of shareholder opinion. Large institutional shareholders no longer offer a blank cheque to management, but expect both sides to provide their arguments on the merits and will vote based on which party is more credible. As the large institutional shareholders have become more active with respect to corporate governance, activists have also been sure to gain advance support from them prior to going public. Often, an activist has already secured a comfortable lead in any potential vote by the time they file a 13D, alongside a cadre of allied hedge funds.
FW: What steps can companies take to identify relevant issues to pre-empt shareholder activism? How can firms best identify the attributes which may make them vulnerable to aggressive investors?
Crozier: Increasingly, companies that feel vulnerable are doing self assessments conducted internally, or more often by their bankers, in which they examine the company from an activists’ perspective in order to identify any issues that would make them attractive to an activist. Once those issues are identified the company and its advisers then determine the best way to address them. Often, however, such a self assessment reveals that the company has not adequately communicated all of the elements of its strategic plan. If so, the company can pre-empt the activist by turning what could be perceived as negatives into positives by a more effective communications program. While in our experience the investment bankers are best suited to conduct a self assessment, for the DIYers, there are common themes that cause activists to view stock as undervalued: an underperforming stock price relative to market benchmarks and industry peers, perceived misallocation of capital, a lack of transparency regarding executive compensation and company performance, a collection of non-synergistic businesses and undertaking a controversial extraordinary transaction.
Schwartz: Many of the same issues that concern diligent boards of directors also concern shareholders. Lagging operational and stock performance, missed targets, bloated expenses, poor comparisons to competitors, capital allocation issues and a lack of effective shareholder outreach are all warning signs. Past reports from proxy advisory firms to their clients, pointed questions and comments from shareholders, as well as trading activity, rumours and press coverage, all provide clues. There really is no substitute for monitoring these and other signs and thinking like an activist. Soliciting an external opinion, whether from a banker, proxy solicitor or lawyer can also help. If a company is not aware of its vulnerability to shareholder activism, it probably isn’t paying enough attention.
Young: The key to activism defence is advanced preparation. In our view, part of that process should be a dispassionate review of the company’s business through the lens of an activist. One approach is to hire a financial adviser to evaluate the company ‘outside in’ using only publicly available information, and then present to senior management an unvarnished mock activist attack deck. A lively discussion typically ensues about how the company should either pre-empt likely activist demands or how it can better convince its long-term fundamental investors the status quo plan is the best path to sustainable value. The goal is to remain outside of the activist crosshairs. Once a fight begins, momentum can swing away from the target fairly quickly.
Klingsberg: Forget about the analysts congratulating you on your last quarter, and forget about how supportive the long time directors are. Just look at some cold facts as they appear to the public. How are you performing relative to your peers? Does your ‘sum of the parts analysis’ show certain parts that would trade at a higher multiple if separated from the company? What are more aggressive ways in which you could use your balance sheet? What strategic alternatives may be available? Remember, the hedge fund personnel are sitting in an office on Park Avenue either figuring out the answers to these questions or waiting for their contacts at institutional investors to call to suggest that they do so. Figuring out your vulnerabilities to activism is not that hard. Figuring out what to do once you have identified them is where the value is added.
FW: How does the activism seen in the US compare with that seen in Europe and elsewhere? What factors drive any differences in scope and influence?
Klingsberg: Outside the US, there are a lot more ‘controlled companies’ where, because of the insulated power of a family or other controlling shareholder, an activist would be beating his head against the wall and the effort may not be worth it. Additionally, the links among the proxy advisory firms, the institutional shareholders and the activists are not always as well-established as they are in the US. That said, directors and management in many jurisdictions are talking about the democratisation of corporate governance and the support that their local regulators and exchanges are giving to this trend. Outside the US, the ability of local regulators and listing authorities to influence corporate conduct is often greater than in the US.
Young: The US market is unique in several respects. There is more capital devoted to activism in the US versus other markets. The American culture is more forgiving of confrontation than other cultures, and activism inevitably involves some degree of confrontation. In the US, we treat hedge fund managers like rock stars. In Europe, some have described hedge funds as locusts. Furthermore, share holdings in the US are often more dispersed than other markets, a factor which creates a demand for a leader, the hedge fund activist, around which the dispersed shareholder register can rally. Successful activism in Europe and Asia in contrast has tended to take a quieter form. Like in the US, much dialogue takes place behind the scenes, but unlike the US, it typically stays there. We believe that dynamic may change, at least in increments, as European investors search for alpha and become more comfortable with the strategy and its players, as their peers in the US have over the last decade. Some markets like the UK, with highly concentrated ownership, and regulations that are perceived to be looser than the US with respect to shareholder dialogue, allow a few of the top shareholders to effect change at a target company without the need for an activist campaign. In other markets like Asia, factors such as cross-shareholdings, or a visceral cultural aversion to significant change, can deter activism.
Crozier: The underlying economic factors driving activism in the US are applicable around the world. In addition, the recent influx of funds into activist hedge funds is causing many of those managers to seek attractive targets outside the US where many of the best opportunities have already been targeted. A number of commentators are predicting a significant increase in activism in Europe, in particular. To this point, the UK has seen the most activist campaigns due in part to a corporate governance regime that provides shareholders with important rights, such as the ability to call a special meeting and to remove directors, and simple shareholder structures. In certain markets, however, cultural and regulatory factors can inhibit, if not prevent, activism. In Continental Europe, the full throated activism campaigns common in the US may not be well received in corporate cultures that are more accustomed to a more private, consultative approach. Japan has been a notoriously difficult market in which to pursue an activist strategy.
FW: How can companies deal with the power of social media used by shareholder activists?
Schwartz: Traditional communications in activist campaigns – personal contacts, press releases, letters, slide presentations, white papers, town halls and media interviews and coverage – provide a broad and effective channel for communicating with shareholders. By contrast, social media does not appear, to date, to have had a significant impact on activist campaigns. That may change, and if it does, a comprehensive media strategy – which today is a must for companies both before and after an activist surfaces – will be essential to blunt an activist’s use of social media. An activist is not likely to have a broad swath of a company’s shareholder base among its social media audience before surfacing, and will have to build that audience quickly. Companies that already have a social media component to their shareholder communications strategies should have an advantage in reaching out to their existing shareholder audience via social media.
Young: With respect to activist and corporate communications, many argue the playing field is not level. Activists are free to say almost anything they want, in virtually any forum and are free to take a more aggressive tone. Corporate communications are expected to take the high road and remain professional and above the fray at all times, no matter how personal an activist attack becomes. Given that dynamic, most corporates should seek the assistance of external professional PR advisers experienced in contested situations. It’s easy to make mistakes in the heat of battle, and such mistakes can make a meaningful difference on the outcome of a fight.
Crozier: It is hard for companies to match activists’ use of social media due to the various regulatory issues that surround a company’s public disclosures. Companies, however, should not lose sight that their shareholders are the most important constituency in an activist campaign. They need to establish credibility with their shareholders, which has to be developed before the activist appears, and then effectively communicate their key messages directly to their shareholders. Further, since the real impact of social media in this context is the traditional media coverage it attracts, the company needs to have experienced financial public relations advisers who can ensure that the company’s story is effectively communicated in that forum.
Klingsberg: For most mid to large caps, their institutional investors and the proxy advisory firms are the key constituencies in their battles with activists. Social media postings are not going to be a big influence on these constituencies. The company has access to persuasive, inside information and thoughtful, internal business plans. If the company draws on these resources, by disclosing in an illuminating way information about performance targets, operating metrics and business plans and brings out top executives and non-management directors for meetings, then the company can win over these constituencies. In addition, the IR function needs to move beyond managing the market’s reaction to quarterly performance and educate investors about the big picture issues that activists raise. A well organised and counselled corporation should be able to make its case effectively notwithstanding access of the activist to social media.
FW: Generally speaking, how should boards respond to activist shareholders? What is the importance of a clear communication strategy, and at what point should the firm assemble a response team?
Klingsberg: Boards should not count on crushing activists or even being lucky enough to avoid activists. Each board needs to be prepared to say “no” when an activist is threatening to interfere with an internal plan that the board believes is in the best interests of the shareholders. At the same time, boards ought to look for opportunities to build and leverage constructive relationships with activists. But, as a first step, before a board can feel comfortable that it will be able to reject an activist or develop a constructive relationship with an activist, the board needs to understand its own profile, both structurally and substantively. The structural profile will typically show a number of vulnerabilities, only some of which can be addressed. Understanding the company substantively will require a lot of focus on the business plan, and that’s how effective boards emerge.
Schwartz: Boards and managements should prepare for an activist shareholder before one arrives on the scene. A team of company and outside professionals should be put in place to proactively address the possibility that an activist may surface. The company’s vulnerability to activist agendas should be assessed on a regular basis, and stock trading and other potential red flags should be monitored. A well-prepared company will already have a comprehensive shareholder communications program in place that will allow it to build relationships and credibility with key constituencies, including shareholders, analysts, proxy advisers and the press. Feedback from this program should make its way into the boardroom so that it can inform board decisions. If an activist does surface, the relationships and credibility built through these efforts are likely to be helpful in addressing the activist’s criticisms.
Crozier: The board must be open to engaging with the activist, if only to understand clearly what the activist sees as the problems at the company and to gain a sense of their commitment to a campaign. Obstructionist tactics usually backfire since the company will be perceived by other shareholders as closed to new ideas and legitimate shareholder concerns. Also, such engagement has occasionally defused the situation entirely by educating the activist on the company and demonstrating that their concerns are misplaced. A clear and, most important, credible communications strategy that focuses on the company’s strengths is critical to success. Taking the high road in public with respect to the activist is the most effective way to gain support from other shareholders – the company’s ultimate goal. Personal attacks, while they may feel good to management, will be perceived negatively by the shareholders at large. The company should assemble a response team as soon as it determines it is vulnerable. It is vitally important to develop a comprehensive program that can be put in place as soon as the activist appears.
Young: In our view, every company should have both an internal response team and an external team of specialised advisers on standby to ensure the company is undertaking the advance preparation that is key to success. A beefed up IR process also is critical. Attracting and retaining ‘true believers’ in your share registry can be a significant deterrent to activism. Management also needs to ensure the board is kept up to date on the latest activism developments and the results of the activist audit conducted by management and its financial adviser.
Ethan Klingsberg has been repeatedly named ‘BTI Client Service All-Star’ based on the survey of general counsels of the Fortune 1000; ‘Most Valuable Practitioner’ in M&A by Law360; and a top corporate lawyer by Chambers. His recent clients include Google, Goldman Sachs and Family Dollar. He can be contacted on +1 (212) 225 2588 or by email: email@example.com.
Chris Young is a managing director at Credit Suisse in the Investment Banking division, based in New York. He is Head of Takeover Defense in the M&A Group, responsible for takeover defence, contested M&A transactions, shareholder activism and corporate governance matters. During his career, Mr Young has advised a large number of companies from around the world and across various sectors. He can be contacted on +1 (212) 325 2000 or by email: firstname.lastname@example.org.
Arthur B. Crozier is chairman of Innisfree M&A Incorporated of New York and of Lake Isle M&A Incorporated, Innisfree’s wholly-owned UK subsidiary. Mr Crozier’s practice includes the representation of US and international clients in a wide variety of transactions and proxy contests, as well as annual and special meetings. In addition, he counsels an international roster of clients on corporate governance and executive compensation issues. He can be contacted on +1 (212) 750 5837 or by email: email@example.com.
Michael A. Schwartz is a partner in the Corporate and Financial Services Department, specialising in mergers and acquisitions, shareholder activism and the investment activities of hedge funds and other significant investors. He can be contacted on +1 (212) 728 8267 or by email: firstname.lastname@example.org.
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