Long-term institutional investors like that companies give them a
mechanism to elect their own directors – but it probably won’t dissuade
them from backing activist funds.
by Ronald Orol
For years, corporations have turned to stock buyback
authorizations and dividend hikes when faced with activists at the gate.
Capital distribution plans have always acted as a quick
mechanism companies can employ to try to appease disgruntled long-term
institutional investors - and in particular keep them from supporting a
dissident slate of director candidates offered up by brand-name insurgent
managers.
However, in 2016 a new corporate response
governance-improvement tactic has emerged. A growing number of corporations
faced with activist investor insurgencies have set up a mechanism known as
“proxy access” that allows long-term investors to nominate one or two
of their own director candidates to corporate boards using a companies’ proxy
card.
The vast majority of corporations that have set up access
regimes are requiring a group of shareholders with up to 20 members to hold a 3%
stake for three years before they can nominate up to 20% of the board
inexpensively on the company’s proxy card.
The mechanism to-date has never been used and many
knowledgeable observers of the issue expect they will be employed only at a minuscule subset of the most poorly-performing and egregiously-managed
publicly-traded companies.
In addition, the use of proxy access in response to an
activist threat has emerged at the same time as the mechanism has emerged over
the past few years in response to campaigns waged by a handful of large public
pension funds as well as some small gadfly investors.
Pat McGurn, special counsel at proxy advisory firm
Institutional Shareholder Services, notes that overall there are over 220 U.S.
companies that have adopted proxy access so far, 77% of them in the S&P
500, a significant increase over recent years. “Two years ago I could
count on one hand the number of companies with proxy access,” he said.
In the activist response realm, most prominently, American
International Group Inc. (AIG) in November set up the mechanism as part of a
wide-ranging response to a campaign launched less than a month earlier by
billionaire Carl Icahn.
In addition, Macy’s Inc. (M) last month adopted proxy
access as part of its self-described “ongoing commitment to corporate
governance best practices.” However, the department store chain didn’t
mention that the move was made after Starboard Value LP’s Jeff Smith escalated
his campaign urging it to separate its real estate and “unlock
value…” Smith never publicly threatened a contest but it is likely that
Macy’s was watching a mid-March deadline for shareholder director nominations
when it Ok’d the access measure on March 3.
More recently, Yahoo! Inc. (YHOO) facing a no-holds-barred
total board takeover contest also orchestrated by Starboard’s Smith installed
proxy access last month. At Yahoo! a stockholder group of up to 20 shareholders
with a 3% stake for three years can nominate the greater of two directors or
20% of the board.
And smaller cap targets, while rarer, are employing the
tool as a defense mechanism as well. iRobot Corp. (IRBT), the maker of the
Roomba robotic vacuum cleaner, instated proxy access and a variety of other
governance improvements after coming into Red Mountain Capital Partners LLC
cross-hairs.
Companies and their advisers hope the mechanism will be
treated as a stamp of good governance by institutional investors - driving them
away from activist fund campaigns. In reality, most observers contend it won’t
have a major impact on insurgency campaigns one way or another.
Geoffrey Sorbello, vice president at Houlihan Lokey in New
York, said it’s easy for corporations, particularly larger ones, to set up
proxy access mechanisms when faced with a hedge fund insurgency. On the margins
the move could help a company pick up some support from certain pension funds
and select institutions that really care about it, he said.
“It’s like giving someone a crumb when they are
looking for a loaf of bread,” Sorbello said. “It’s an incredibly easy
give for a company and they gain some incremental goodwill with certain
investors by putting it in and it costs them virtually nothing. It’s not a
mechanism for serious change.”
Anne Sheehan, chief of governance at the California
Teachers’ Retirement System, or CalSTRS, said she believes that companies
targeted by activists are being counseled by outside advisers to improve their
governance practices and lately that includes installing proxy access.
“After an activist enters the company and decides to
fix up its governance practices proxy access is seen as a best governance
practice,” said Sheehan. “They are trying to improve their
governance.”
She declined to comment on whether CalSTRS would be less
likely to support an activist at a company with proxy access. “It goes to
the activist’s thesis and whether we support them. These activist situations
are all very individual. If activist has a good thesis we will support them and
if they have a bad thesis we wouldn’t support them,” she said.
Probably the largest proponent of proxy access, Michael
Garland, governance director for the New York City Pension Funds, suggested
that he sees proxy access as a counterweight to short-term activism. “We
think it is important to have activists and sometimes we support them and
sometimes we don’t,” said Garland.
Kai Liekefett, a partner and head of the shareholder
activism response team at Vinson & Elkins LLP, acknowledges that most
companies would prefer not to install proxy access. However, he explains to
corporate directors, executives and their other advisers that the measure looks
scarier than it is and in many cases it could help a company stave off an
activist. “It looks frightening at first sight but once you think about it
you realize it won’t be used very often,” said Liekefett. “We take a
variety of actions to try and convince the activist that it might be harder
than they thought to achieve victory and access is one of those actions.”
Liekefett said he doesn’t expect to see more than 10
instances where proxy access will be used in the next five years and that the
main proponents will be labor unions. “It could be useful in a situation
where the activist is wavering and it can help them in their decision against
launching a proxy contest,” Liekefett said.
Investors in small capitalization companies are more
likely to be able to form the group necessary to employ proxy access. As a
result, so far, the vast majority of companies that have set up the system are
large capitalization firms. Investors that make up small capitalization
companies are often different than those in big companies and are more likely
have held significant enough stakes long enough to employ access. Liekefett
notes that smaller companies, for example, could have legacy shareholders, such
as the founder of the company who was forced out, that could have a large stake
and employ access.
Liekefett notes that he has advised a couple targeted
smaller market capitalization companies that decided ultimately not to install
the mechanism, partly because setting it up wouldn’t have made a substantial
difference in improving their governance scores as set by the major proxy
advisory firms ISS and Glass Lewis. “You have to take a look at how many
brownie points will you get from ISS and Glass Lewis,” he said.
On occasion it may be possible for an activist in a large
capitalization company to seek out proxy access because the mechanism could
save them potentially millions of dollars in proxy material distribution costs.
However, Liekefett warns that it would be rare for an activist to find
themselves in that situation because they rarely hold stakes in companies for
three years prior to launching a campaign.
Glenn Welling, founder of Engaged Capital LLC, said he
wouldn’t be deterred by any company that decides to set up a proxy access
system after he launched or threatened a proxy contest. “We are supportive
of proxy access in principal - the democratization of the election process is a
positive for shareholders. However, sophisticated institutional investors
aren’t likely to be mollified by access,” Welling said. “It’s
possible less sophisticated institutions will believe that the company is
becoming more shareholder friendly even though proxy access may actually stall
change.”
Welling added that he doesn’t think Engaged Capital will
employ the mechanism anywhere, largely because of the three-year ownership
requirement. Instead, he would prefer a 3% one year holding period.
“Having to wait for three years of underperformance as a large shareholder
is too onerous, says Welling. "One year of ownership would work because it
gives you a year to try and work with the company collaboratively before taking
any action.”
Andrew Freedman, partner at Olshan Frome Wolosky LLP in
New York, said companies are trying to build up goodwill with their
institutional holders by adopting what he calls the “low-hanging
fruit” of governance. Access, he notes, can make for talking points when
companies go meet with long-term shareholders in meetings and road shows, he
notes. “Adoption of majority voting in the election of directors and more
recently the adoption of proxy access bylaws are both low-hanging fruit,”
he said. “They’re trying to show how the board is supposedly committed to
governance best practices.”
However, Freedman, who advises activists, notes that in
many cases corporations will set up proxy access to appear governance friendly
even though they also have other more important shareholder-unfriendly
governance provisions. He noted that Yahoo! set up access even though it
already had an onerous provision making it difficult for shareholders to call a
special shareholder meeting. Activists often seek out special meetings because
they can be used to expedite a director-election contest to drive change at a
corporate board.
The trend of companies responding to activist funds with
access measures can be traced to the phenomenal growth of institutional
investor support for proxy access shareholder proposals over the past couple
years.
ISS’s McGurn notes that over 18 months the number of
S&P 500 companies with proxy access has grown from less than 1% to 34%. In
2015, 91 proxy access proposals received the backing, on average, of roughly
55% of shares voted. And there is no indication that support is slowing down.
In 2016, so far, there are more than 200 proxy access proposals up for a vote
at U.S. corporations-the vast majority of them were submitted by shareholders.
The largest protagonist among smaller funds for proxy
access is New York City funds’ Michael Garland. In 2015, the NYC pension funds,
which have roughly $160 billion in assets, submitted proxy access proposals at
75 corporations. In 2016, ISS calculates that NYC funds submitted 72 proposals.
However, smaller funds, including individual investors Jim McRitchie and John
Chevedden, submitted more than 100 proposals. In an interview, Garland said he
is “on the path” to withdrawing roughly 50 proposals after coming to
agreements with targeted companies. The goal for 2016, he noted, was to focus
on new companies and some that were unresponsive in 2015. In some cases, he
said, the NYC funds filed binding proposals to shift bylaws down from 5% to 3%
of outstanding shares needed to access proxies.
“Our two year effort has changed the landscape,”
Garland said. “Now we are seeing dozens [of companies] putting in bylaws
without investors pushing for it,” Garland said.
James McRitchie, a prominent investor gadfly, said he’s
taking a tougher tack than Garland with his proposals in 2016, and as a result
he has had less success with adoption.
McRitchie, who has submitted dozens of proposals in 2016,
said he’s not willing to settle for what he calls “proxy access
lite,” measures that cap the number of shareholders who can participate in
a group to reach the 3% stake at 20 investors. McRitchie worries that investors
would need more than 20 participating shareholders to reach the 3% threshold.
He notes that among investors who might agree to participate, the largest U.S.
public pension fund, the California Public Employees’ Retirement System,
typically doesn’t own more than 0.5% of any company and most other potential
participants are much smaller. “The limit of 20 investors isn’t
good,” McRitchie said. “You can’t count on the mutual funds to
participate.”
In addition, he notes that the SEC has let a number of
companies withdraw his tougher proposals because they had already set up the
aforementioned “proxy access lite” bylaws. However, his measures,
where they were included, received a modicum of success this year so far.
McRitchie received 40% of the vote at Whole Foods Market Inc. (WFM) and 33% at
Apple Inc. (AAPL) and his measure was approved at Costco Wholesale Corp. (COST)
with 65% backing. “It will take a while for funds to realize that proxy
access lite isn’t good enough,” he said.
In any event, Garland and small investors like McRitchie
will continue to press in the years to come, with expectations that proxy
access will become a generally accepted governance protocol in the years to
come. As that happens, expect more companies to set it up when faced with
activist hedge fund managers at the gate.