During the 2014 BCLBE and BBLJ Shareholder Activism Symposium, Larry Sonsini delivered the keynote address directed at the change in the activist climate and how this change should be interpreted.
“Shareholder activism will be around for a while,” Sonsini declared because there has been a shift from a director-centric model to a shareholder-centric model. In this shareholder-centric model, shareholder activists agendas’ have become broader. They are no longer only concerned with battles over defensive measures (e.g., poison pills and staggered boards) and CEO successions, but are now addressing corporate sustainability—taking into account social, environmental, economic, and governmental measures—and are attacking companies on their merits.
Change in Activist Climate
Activism is being embraced by many institutions—not just New York hedge funds. Sonsini further enumerated several visible changes in the activist climate.
(1) Stock Ownership
If you are a beneficial owner of shares—where you are the true owner of the shares however the bank or broker holds the title—you can object to the disclosure of your name and only hold in the broker’s “street name.” Eighty percent of the market is held in street name, so essentially, the board is dealing with shareholders that they cannot identify.
(2) Size and Diversity
The size and diversity of companies has changed. It used to be the case that institutions would only hold these large retail components. Taking Google as an example, even the IPO auction ended up with many institutional holdings despite the dual class structure.
(3) Proliferation of Derivatives and Hedging Transactions
There is a 5% threshold in which shareholders must file a beneficial owner report until their holdings drop below 5%. These files contain background information about shareholders who file them as well as their investment intentions, “providing investors and the company with information about accumulation of securities that may potentially change or influence company management and policies.” However, many shareholders sidestep this filing requirement by obtaining derivatives and synthetics. These tools allow shareholders to maintain a greater economic interest but eliminate the disclosure requirement.
(4) Proxy Advisory
There are two advisory firms that make up the proxy advisory market—ISS with 60% of the market and Glass Lewis with approximately 35% of the market. The reach, impact, and importance of this market has increased. In a 2012 conference board in NASDAQ, 70% of companies confirmed that they were influenced greatly by the proxy advisory board when setting compensation. Some are wary of using advisory boards to fulfill “fiduciary obligations” because they have no economic interest and are not highly regulated.
(5) Politicizing the Board Room
Rule 452 has aimed to make votes in the election of directors more transparent. Rule 452 forbids brokers from voting in election of directors, the reason being that brokers typically vote with management. After the implementation of the Rule 452, a policy shift, which was initiated by the carpenters union, wanted to require majority voting. Typically, directors only require a plurality vote to be elected. However, under this new policy, directors would require a majority vote—if they don’t receive a majority, they are required to submit their resignation. So with the combination of Rule 452 and majority voting, a small majority can have a huge influence over elections; therefore, activists no longer need to hold 20% to be instrumental.
(6) Scrutiny of Contextual Director Independence
A company cannot list on NASDAQ unless its board is independent. The exchanges define independence; however, some courts are going a step further. Courts are no longer just looking at whether a particular matter is really being addressed independently given the circumstances. In a case against Oracle, In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003), the court threw out an analysis by an independent committee because both the trading defendant and two special litigation committee members were professors at Stanford–where CEO Larry Ellison had strong ties. Although they did not socialize, this contact was enough for the court to find that the special litigation committee could not be impartial.
(7) Federalization of Corporate Law
There has been a gradual federalization of corporate law (a checklist of what the board should address and how). However, it causes problems because “one shoe does not fit all.” This checklist does little to advance the strategic planning of where the company is headed.
How Should We Interpret All of This?
Boards now must deal with the fact that activists have become more sophisticated (e.g., submitting shareholder proposals, lobby shareholders, investment bankers, director nominees). Their agendas are largely issue-driven, though some focus more on short-term performance and long-term value asset management.
Many activists are focused on the board’s accountability and informal policies. There is a push towards limiting the amount of time a director may serve on the board (9 years) and how many boards a director may serve on (no more than 3 public boards). Also, executive compensation has become a big issue. There is much debate as to whether to tie compensation to performance—and if tied, how to assess performance. Performance metrics are changing and are now often valued with respect to short-term rather than long-term effects. This in in part due to the nature of the companies’ businesses. As Sonsini analogized, “technology has the lifecycle of a banana, nowadays.”
Boards that want to limit activism look towards dual classes and staggered boards. Having a dual class can set the wrong tone and affect rating value because this creates a tension between shareholders and the company’s board. Tension is already present in the board because a board’s fiduciary duty is to build long-term value and with shareholders pressing for shorter term returns, the board and shareholders are often at odds. On the other hand, shareholders need be wary of the board being too romantically vested in their strategy. In order to overcome the push-back of the board, shareholders have moved towards a greater emphasis on communication and contact. There is a large demand for information and transparency, especially when technology is “highly disruptive” to the market.
Some of the current tension may be alleviated by increasing the focus on succession planning. CEO successions have not historically received enough attention. The successor should not be chosen once the CEO has found out that he is terminally ill or will soon no longer be able to perform his duties. Instead, the successor should be built up from an earlier stage and assessed over time. Further, boards need to evaluate themselves. Sonsini offers peer-to-peer evaluation as one potential method. With this evaluation comes the understanding that, at a certain point, the director may need to step down and move on.
Finally, boards should not look at the federalization of corporate law as a checklist. By the time the board has addressed the checklist, they have exerted all of their energy and efforts into complying with the law and have done nothing to strategically determine where the company is headed.