Holly J. Gregory PARTNER WEIL, GOTSHAL & MANGES LLP Holly specializes in advising companies and boards on corporate governance matters. Opinion PREPARING FOR SHAREHOLDER ACTIVISM In her regular column on corporate governance issues, Holly Gregory discusses recent developments in shareholder activism and provides a basic primer for boards on understanding and preparing for activist approaches. Shareholder activism has long been used to refer to shareholder efforts to influence corporate actions and governance through a wide range of methods, including: Binding and non-binding (or precatory) shareholder proposals. Quiet negotiations to obtain governance or other changes. Campaigns to withhold votes or vote against directors. Proxy contests for a full or partial board slate. In the past several years, however, the term has become associated with situations in which a shareholder, often a hedge fund, purchases a significant but far less than controlling percentage of company stock, and then uses the overt or implied threat of a proxy contest to press for change that the activist believes will increase the stock price or otherwise return value in the relative near term. This particular type of shareholder activism is on the rise and is often in the news. An activist campaign typically imposes significant investor and public pressure on the board and management to justify strategic direction, as well as company performance and leadership. Activists are increasingly prevalent and well-funded, as large pension funds seek to improve returns for their beneficiaries by investing in activist funds. Activist funds have been strategic in attracting these investors by articulating governance reform objectives that resonate with public and union pension funds. Activists are also more successful because they have: Become more selective in choosing targets and in focusing their objectives. Gained tactical experience. Benefitted from the coordinating impact of proxy advisor recommendations. Boards and their counsel need to be aware of these developments and follow shareholder activism activity generally. They should be prepared to evaluate and address any activist approaches in light of the company s strategy and performance prospects, including the likely impact of the activist s objectives on shareholder value. 22 September 2013 practicallaw.com
TARGET CHARACTERISTICS AND ACTIVIST OBJECTIVES Activists do not all seek the same outcomes or use the same tactics. They are neither inherently likely to help to create or to destroy company value. However, some general observations can be made. Activists often use a company s short-term performance problems or perceived governance, compensation, ethics or compliance issues to attract support from institutional investors. Typical characteristics of companies that attract activists include: A declining stock price. Reduced earnings, lowered forecasts and other weaknesses in the company s income statement. Underperformance versus peers. Scandal or management missteps. Operational or disclosure issues. Corporate governance vulnerabilities. Litigation or other issues not fundamental to the company s core business. Leverage potential, for example, a strong balance sheet or excess cash reserves. Perceived unlocked value. A lack of takeover defenses. An unfavorable deal price and terms. The insufficient canvass of the market for buyers. Generally, activists seek to increase the value of their investment in the company by pressing the board and management to make changes. For example, activists objectives may focus on: Capital structure changes, such as: zincreases in leverage; zshare buybacks (for more information, search Issuer Stock Repurchases: What are the Options? on our website); or zspecial dividends (for more information, search Dividends, Redemptions and Stock Purchases on our website). Strategic changes, such as: za company sale or break-up; zthe sale of non-core operations; or zother operational changes. Leadership changes (which may serve strategic or other objectives), such as: zchanges in board seats or control; or zadjustments in the management team. Governance changes (which may serve strategic or other objectives), such as: zthe dismantling of structural defenses; zincreases in shareholder rights; zadoption of perceived best practices (for more information, search Corporate Governance Practices: Commentary on our website); or zother governance changes. SHAREHOLDER ACTIVISM TACTICS There are a number of tactics activists employ when approaching a target company. PUBLIC AND PRIVATE TACTICS An activist will generally begin an initiative by discreetly accumulating a relatively small but significant amount of company stock. The activist may then approach the company to seek information or negotiate about a particular request. Usually this initial approach is made privately, although activists have different styles and use varied tactics. A typical private approach, made to management, individual directors or the board, often begins with a phone call or letter requesting a meeting and describing concerns about a particular issue that typically relates to company performance or a governance issue that the activist would like to discuss. The activist may ask that the board consider a specific course of action at the outset or the request may be developed through additional interaction. Underlying the private approach is the potential that the activist will make its concerns and its activist stance public to pressure the board. Where an activist s private tactics fail or where the activist otherwise determines that media and investor pressure would further the activist s objectives, the activist may make its intentions publicly known. Public tactics an activist may use include: Public letters, media campaigns and Schedule 13D filings. Shareholder proposals. A full-scale proxy contest for one or more board seats (including the potential for full control). Public offers to generate strategic and private equity investor interest in a sale. Litigation over defensive steps taken by the board. Notably, activists often operate in ways that do not trigger real time SEC disclosure. For example, activists may: Checklists Visit PRACTICALLAW.COM for checklists, handy timelines, charts of key issues and flowcharts. These resources are continuously maintained by our attorney editors. Practical Law The Journal Transactions & Business September 2013 23
OPINION Use derivatives to acquire a large stake all at once without prior notice. Ensure that they continue to hold 5% or less of company stock to avoid triggering extensive disclosure (on Schedule 13D) of accumulations and plans regarding accumulations. Work in parallel with other activists, but without forming a group holding greater than 5%, which would trigger disclosure (known as wolf pack activity). Search Filing Schedule 13D and 13G Reports for more on Schedule 13D. While activist funds must file quarterly reports (on Schedule 13F) regarding stock held in their portfolios, these reports are not due until 45 days after quarter-end. Therefore, this information is often out of date. PROXY CONTESTS FOR FULL OR PARTIAL SLATES Activists often use the threat of a proxy contest, coupled with private and sometimes public pressure, to negotiate for change. Actual proxy contests can be expensive, but they serve as a powerful activist strategy to obtain influence through board representation. Activists may propose a full or partial slate of director nominees instead of management s nominees, usually in connection with an annual meeting. Partial slate proxy contests are more common and more successful than proxy contests for a full slate. Activists understand that proxy advisors and large institutional investors are often likely to support some change short of a change in control in board composition. The goals of activists in a proxy contest typically include obtaining seats on the target company s board to: Initiate actions that the activist believes will enhance shareholder value. Effect changes in the company s policies. Reduced reliance on takeover defenses in recent years, such as classified boards and shareholder rights plans, has made the threat of a proxy contest more effective. Search Proxy Contests for an overview of the proxy contest process. SETTLEMENT AGREEMENTS Activist campaigns are often resolved in advance of a proxy contest through settlement agreements. These agreements generally specify actions to be taken by the company, such as nominating one or more of the activist s representatives to the board. Settlement agreements typically include a standstill period during which the activist will refrain from certain activities. For example, during the standstill period the activist may be: Restricted from increasing stock ownership. Prohibited from engaging in certain conduct, such as submitting proposals to be included in the proxy statement. PREPARING FOR ACTIVISM As activists become more adept at promoting their objectives, which may or may not be in the interest of the company and the shareholders in the long term, the challenge for management and the board is to remain prepared to address potential activism, presupposing the value of the initiative. Ongoing attention to the company s governance framework, including the quality of the company s governance rules, and active fiduciary engagement by the board, is critical. In addition, because activists will propose strategies that they believe are preferable to the company s, the board s continuing focus on strategic planning, oversight of risk management and corporate performance are key. THE BOARD S ROLE AND FIDUCIARY DUTIES The board must act in the best interests of the company and all its shareholders. The board s fiduciary duties remain the same during an activist campaign, although the board s decisions and decision-making processes may face scrutiny if litigation is brought regarding the activist campaign. Therefore, as with all board activity, it is prudent to maintain records that show diligence and proper process. The board s decisions about the company s business and operations generally are protected by the business judgment rule. Courts typically will respect board decisions that are made in good faith, on a fully-informed basis and without any conflict of interest. However, if a plaintiff shows that the directors did not act on an informed basis or in good faith, or that a decision was tainted by a conflict, the court will engage in a searching analysis of the board s decision, applying the entire fairness test (in which the board bears the burden of proof). When a board adopts a corporate defense, such as a shareholder rights plan in response to an unsolicited approach, courts are likely to apply an enhanced scrutiny standard to evaluate whether the board is fulfilling its fiduciary duties. To meet this standard, a board must show that: It has made a reasonable, good faith investigation and reached a reasonable conclusion that a threat exists. Its response is not preclusive, not coercive, and reasonable in relation to the threat posed. Its response does not deprive shareholders of a real world shot at electing a new board that can remove the defense. In overseeing management s development and execution of corporate strategy, the board should be aware of alternative strategies or proposals that activists may present and should review them with management. While it is often prudent to engage with an activist rather than risk an activist approach 24 September 2013 practicallaw.com
PROXY CONTESTS FOR BOARD REPRESENTATION Hostile and unsolicited deal activity is on the rise generally, comprising 34.8% of deal value in 2013*, compared to 20.1% in 2012. Proxy contests for board representation are also more common, increasing to 79 in 2013*, significantly above the 63 proxy contests occurring in 2001, but still far below the 2009 peak of 133 proxy contests. The outcomes of proxy contests in 2013 and 2012 for board representation are as follows: *As of July 18, 2013. Source: FactSet. OUTCOME 2013* 2012 Settled 29 (39.2%) 26 (35.1%) Withdrawn 12 (16.2%) 22 (29.7%) Management Win 8 (10.8%) 15 (20.3%) Dissident Win 11 (14.9%) 7 (9.5%) Split 1 (1.4%) 4 (5.4%) escalating into a public campaign and potential proxy contest, the board has no specific duty to: Respond to or engage with an activist. Alter the company s long-term strategy to achieve shortterm shareholder gains. Boards, with the advice of counsel and significant input from management, need to make decisions about whether and how to engage with activists. They must determine what actions, if any, to take in response to activist concerns or demands, based on an analysis of the circumstances. Search Fiduciary Duties of the Board of Directors for more on the board s fiduciary duties. OPERATING WITH DIRECTORS NOMINATED BY ACTIVISTS While it is unclear the degree to which having directors nominated by activists on a company s board is associated with positive changes in shareholder value, at least one study has cited the benefits of a hybrid board. A study published by the Investor Responsibility Research Center Institute and Proxy Governance Inc., Effectiveness of Hybrid Boards (available at irrcinstitute.org), analyzed the impact of activists winning some but not all of the seats on a company s board from 2005 to 2008. The study concluded that shareholder returns improve by 19% with hybrid boards. Having one or more directors on the board who were put there through an agreement with the activist or by a proxy contest will likely change board dynamics significantly. Boards should take reasonable actions in advance, with the advice of counsel, to help assure that all directors understand and agree to adhere to policies on board confidentiality and director conduct. In particular, boards and their counsel should consider whether it would be prudent to adopt requirements, whether through by-law provisions, contractual arrangements or board policies, that board candidates: Provide information needed to assess independence, including the disclosure of compensation or other special arrangements between the director and a designating or nominating shareholder. Once on the board, do not accept compensation for their board service other than from the company. Agree in writing to abide by all policies applicable to directors, including policies defining and specifying the treatment of company confidential information. In particular: zthe board s confidentiality policy should expressly provide that directors should not disclose outside of the boardroom any confidential information unless specifically authorized to do so, including disclosure of information to a shareholder that designated, appointed or nominated the director, as well as disclosure to investors, the media or anyone else; and zdirectors should periodically be reminded of their strict confidentiality obligations. Agree in writing to resign (for example through a conditional self-executing letter of resignation provided in advance) upon a finding by a court of an intentional breach of fiduciary duty or an intentional failure to comply with company or board policies. Practical Law The Journal Transactions & Business September 2013 25
OPINION ASSESSING PREPAREDNESS FOR ACTIVISM Boards should consider the questions set out below to ensure that directors fully understand the circumstances in which an activist campaign may arise. This assessment involves looking at the company through an activist s lens. Company vulnerabilities. Is the company vulnerable to an activist approach? For example, does the company have an undervalued stock price, internal dissension, business lines and assets that are particularly attractive or poor performance versus its peers? How is the company addressing vulnerabilities? Potential activist strategies. What might an activist identify as a potential strategy? For example, are there structural or other changes that the company should consider to drive shareholder value? What are the merits and risks of each type of approach? Significant shareholders. Who are the company s significant shareholders? How supportive are they of current corporate leadership and strategy? Strategic direction. Does the company clearly explain its strategic direction in its public documents? Activist ownership. Do any known activists own stock? Is management monitoring acquisitions of company stock (for example, through a proxy solicitor or public filings)? Takeover defenses. What takeover defenses are in place at the company? Does the company have a shareholder rights plan in place or on the shelf? How are shareholders and their proxy advisors likely to react if a shareholder rights plan is implemented, and how could implementation be managed? Alerting the board. Is there a clear understanding between the board and management about the need to inform and involve the board at the earliest opportunity of an unsolicited approach or an activist s accumulation of stock or other threat? Handling an approach. Is there a plan in place for handling an unsolicited approach or an activist threat? Has the company identified the team that would play a role should an activist approach the company, including key officers and directors and other advisors, such as public relations firms, legal counsel or proxy solicitors? Communications policies. Does the company have a well-articulated communications policy and an appointed company spokesperson? Search Director Confidentiality for more on the confidentiality obligations of directors. In negotiations with activists about adding their candidates to the board, the company should consider including, in an express agreement, limitations on the ability of their candidates once on the board to provide confidential information to the activist. For example, a recent Delaware Court of Chancery decision underscores the need to focus on confidentiality obligations when adding to the board a director who is associated with a particular shareholder. In Kalisman v. Friedman, C.A. No. 8447- VCL, letter op. (Del. Ch. Apr. 17, 2013), the court ordered that a dissident director be provided with certain information that related to dilution of the shareholder stake that the dissident director represented. The information had been withheld in light of an announced intention by the shareholder to launch a proxy contest. The court dismissed the concern that the director would share the recapitalization plan information with the shareholder, noting that the director had undertaken not to share privileged information with the shareholder. However, the court noted that [w]hen a director serves as the designee of a stockholder on the board, and when it is understood that the director acts as the stockholder s representative, then the stockholder is generally entitled to the same information as the director. Boards should also carefully consider requests from directors that are nominated or designated by activists to form committees to explore strategic alternatives or major strategic transactions. These committees may provide benefits by helping to focus the board and may also serve as a release valve for activist concerns. However, if these committees are not properly formulated and chartered, they may take over the development of corporate strategy from management and the rest of the board. This column is based on an outline prepared by Ms. Gregory with her colleagues, Michael J. Aiello and Audrey K. Susanin, of Weil, Gotshal & Manges LLP. Mr. Aiello is a partner and chairman of the firm s Corporate Department. Ms. Susanin is an associate in the firm s Public Company Advisory Group. The views stated above are solely attributable to Ms. Gregory and do not reflect the views of Weil, Gotshal & Manges LLP or its clients. 26 September 2013 practicallaw.com Use of Practical Law websites and services is subject to the Terms of Use (http://us.practicallaw.com/2-383-6690) and Privacy Policy (http://us.practicallaw.com/8-383-6692).