IndustryInsights

By David Olson and James MacGregor Senior Counselor and Vice Chairman
The Abernathy MacGregor Group, Inc.

Can your chief executive tolerate not being chairman of the board of directors? Will a hostile takeover bid arrive if you don’t have a poison pill? Will giving investors a “say-on-pay” cost you your star executive performers? Should small groups of shareholders be easily able to call special meetings?

Questions like these are front and center right now – and that’s a worrisome issue for corporate managements. It’s the beginning of the first proxy season since the financial meltdown stopped melting. Activist investors and their target companies are beginning the back-and-forth that will place (or not) proposals on corporate proxies, followed (or not) by proxy contests and shareholder votes. We’re entering a period of heightened energy and visibility for governance-based shareholder activism.

Financial engineering owned the activist spotlight prior to the meltdown of 2008-9. Investors pressed companies to sell, recapitalize or reorganize themselves and to quickly distribute the proceeds to their shareholders. When the rules that bind a company’s owners and managers came into question, it was usually to embarrass management into accepting the proposed financial alternatives. However, except when a company was sold outright, studies suggest financial activism rarely created much value for shareholders.

Governance activists take a different tack. They are often public sector funds (CalPERS is the 800-pound gorilla), whose agenda may be as much political as economic. They have deep pockets. They’re more patient than the fast-return financial activists. They are idealists – they share a deep institutional belief that their definition of good governance leads to good performance.

They are also opportunists. These are good times for governance activists, in part because of the oft-repeated public (and political) perception that the financial meltdown was caused, in part, by overly compliant boards of directors, which allowed managements to make stupid and risky decisions and to stuff their own pockets in the process – and that we need more and tougher rules to prevent this from happening again.

What’s not clear is whether governance activism can do any better job of creating shareholder value than financial activism did before it. There’s a substantial counterargument that effective, responsible management is about people and judgment and experience, not about written rules. There’s little research linking specific governance practices with corporate performance and value creation.

The more and tougher rules proposed by governance activists tend to fall into two groupings:

“Let the owners sell their company, if that’s what they want to do:” a) Eliminate staggered boards of directors; b) eliminate “poison pill” shareholder rights plans; c) make it easy for small numbers of investors to call special meetings of shareholders; d) eliminate supermajority voting; and e) get rid of assorted other takeover defenses. These are familiar topics to those versed in corporate takeover battles — adopting such measures does make hostile takeovers easier, but it’s not clear they generate the best value for shareholders.

“Make the board of directors do its job:” a) Separate the jobs of board chair and chief executive officer; b) require a defined level of independence of board members; c) require majority voting for board members; d) give investors a “say-on-pay” for the most highly compensated executives; and e) other measures to stimulate active board oversight of a company’s strategies and performance. (Two themes in embryonic stages: Standards for directors’ skills and capabilities, and an investor “say-on-risk” for board-level strategic decisions). These measures address some definitions of democracy, but there’s no real proof as yet that they lead to better board functioning, better management, better decision-making, or better value creation. There’s anecdotal evidence suggesting the opposite can be true.

Governance activists typically take moderate stakes in their target companies (large enough to rank in the top 50 investors, but not necessarily in the top 10). Many are quasi-index investors. They almost always seek in-person meetings either with management or, increasingly, with board members. They present their governance manifestos and request that boards embrace the proposed changes. What happens after that depends on the tenor of the discussions with management, if any, and the degree to which they perceive support for their ideas among other significant shareholders.

The first quarter of the year is pivotal: Most annual meetings take place in mid-second quarter, so the beginning of the year is when proposals are placed on proxy agenda, when horse-trading takes place to keep proposals off proxy agenda, and/or when proxy contests begin to gear up. Companies concerned about the prospect of governance activism should consider four key elements:

1. See how your largest investors feel about you. Activists rarely launch shareholder proposals without high confidence in their ability to win a lot of votes. Not necessarily a majority — 30% is enough to get the attention of a board of directors. Happy shareholders tend to go along with management’s recommendations (“Why rock the boat?”). Grumpy shareholders are more likely to think along the lines of “Let’s send them a message” or “What harm could it do?” The best IR people know whether their alwayspolite or always-surly large investors are actually happy or grumpy. This knowledge is essential if a proxy contest is at issue. Memo to PR and IR: Grumpy shareholders are frequently underinformed shareholders. They’re unaware of a company’s progress on its strategic plan or, worse; don’t really know what the strategic plan is.

2. See how your largest investors feel about governance issues. This can be tricky. Some institutions allow portfolio managers to decide how the shares they hold are voted. Some designate non-portfolio managers to make centralized proxy voting decisions. Still others farm the decisions out to external advisors. A growing number of investing institutions in the first two groups send their clients written statements defining their voting policies (being careful not to commit themselves in your particular case). Where there’s nothing in writing, portfolio managers can often provide a heads-up on their firm’s hot-button issues. Memo to CFO and IRO: Don’t walk away from governance discussions. Your relationships with large shareholders will provide early warning if the issue is heating up, and can be decisive if things come to a vote.

3. See how your board and management feel about governance issues. The list of recurring governance issues is widely known. A company’s vulnerability on any of those issues is easily determined. Before an activist appears at the door with proposal in hand, it’s highly valuable for a management to consider which of its vulnerability issues are worth fighting for, and which can be compromised. “Say-on-pay” will have different implications for an investment bank, a movie studio, a fast-food chain and an auto dealership. The ability of a handful of shareholders to call a special meeting could have major consequences for a company midway through a difficult transition. Memo to board members: When painless opportunities can be found, companies that make voluntary “good governance” changes can win themselves investor goodwill and media credibility (which will be useful if a fight later arises).

4. See if dialogue and deal-making can prevent a proxy contest. No one really likes proxy contests. Even for the winners, they’re expensive and distracting. They generate ill will and bad blood, and attract all the wrong sorts of attention. For corporations, the odds of winning aren’t great. One reason: Many institutions defer to proxy advisory services like Risk Metrics, Glass Lewis and Proxy Governance, who generally look favorably on governance reform – activist funds know this and will exploit it. But, constructive dialogue with governance activists is usually possible, and it can lead to mutual understanding and mutually acceptable compromise. When that doesn’t happen, at least you get credit for trying, and you know your enemy a lot better.

That said, some activists are so single-minded and their proposals so potentially disruptive that a full-blown proxy contest cannot be avoided. If that happens, victory isn’t easy or certain, but it is possible. Clients of ours have beaten back high profile withhold vote campaigns, odious by-law proposals and other activist initiatives in the past. But the best medicine is preventative. The four recommendations above are key to winning a fight if it becomes unavoidable.

If you would like to discuss this article, please contact David Olson in our West Coast office at 213-630-6550/ dwo@abmac.com. In our New York office, please contact James MacGregor at 212-371-5999/jtm@abmac.com.