Activists have been targeting corporate directors for many years. Now they are actively searching for their own candidates and pushing for their inclusion on boards, so what do they bring to the table?
Heinz’s historic ‘57 Varieties’ slogan stressed the breadth of its product line, but the company liked just one approach for its board. Hedge fund mogul Nelson Peltz didn’t, however. In 2006 Peltz and his associates acquired over 5 percent of the company and declared their intent to replace five of the company’s dozen board members. Peltz wanted bigger stock buybacks, more marketing, less administrative expenses and higher dividends.
The board fought back with a dog and pony show for institutional investors to convince them that their interests were with the board and Peltz’s were not. His complete slate didn’t win, but by August 2006 Peltz and one associate were on the board, and Heinz ended up listening to many of his suggestions.
For decades, corporate boards have had a free hand in steering their companies. But backlash to corporate scandal and growing shareholder activism have increasingly put them at odds with major shareholders over strategy, policy and the distribution of company wealth. In the litigious and confrontational US, the result can range from useful to distracting to even a serious challenge to normal business operations. Communications can solve a lot of problems, but only if well timed and directed, and for many boards, that will require significant changes in practice and attitude.
Talk to me
Heinz won’t discuss the proxy fight, which in one sense is understandable. But the refusal is also symbolic of a problem facing corporations: a breakdown in communications. ‘The board doesn’t feel like it is getting adequate information from the shareholders and the shareholders don’t feel that they are getting adequate information from the board,’ says Peter Gleason, national director and COO of the National Association of Corporate Directors.
More openly activist institutional investors think that communication does often happen between them and their investments, and that breakdowns tend to be more one-sided. ‘We have a pretty effective engagement program with directors in our portfolio companies,’ says Dennis Johnson, senior portfolio manager at the California Public Employees’ Retirement System (CalPERS). ‘In those instances where we have some concerns about the performance of the company, the effectiveness of the board in certain areas, we have open dialogue with the directors about that. In many instances, there is agreement that a board vacancy needs to be filled or a new skill set and experience is needed to help satisfy the board’s duties going forward.’
But not all companies are so communicative, and Johnson has the impression that in a few, at least, the board and management look after their own interests before those of the shareholders. If such a company was in CalPERS’ portfolio, talk might go nowhere. Should that happen, CalPERS has shown itself willing to crank up the public heat.
For example, last summer it endorsed a dissident slate supported by and including Richard Breeden, whose Breeden Capital Management was investing $414 million for the organization, intending to replace three directors on the H&R Block board. The financial services company opposed the move, even complaining that should it be successful, the selection of Breeden, a former SEC chairman who was a federal monitor for Block’s auditor, KPMG, would be a conflict of interest that would force the hiring of a new auditor at ‘great expense and disruption.’ Breeden’s slate won out.
Say it ain’t so
CalPERS is by no means alone. Many institutions including pension funds, hedge funds and mutual funds are determined to have a greater say in governance. They suggest policies and director candidates, and even occasionally get into proxy fights. But they also want full proxy access, which would allow them to directly nominate directors. ‘As a matter of public policy, CalPERS firmly believes, and has been very public about this position, that all long-term shareholders of a company should have the ability to put directors on a ballot directly,’ Johnson says, calling proxy access ‘our number one corporate governance priority.’
Proxy access has been a ‘polarizing’ issue in the US on and off since 1977, according to Claudia Allen, chair of Neal Gerber & Eisenberg’s corporate governance practice. ‘Over [last] summer, the SEC took … the unusual step to present two conflicting recommendations,’ one in favor and one against. For a long time, the SEC had effectively blocked the attempts of institutional shareholders to add proxy access measures to proxy ballots at any public company.
The American Federation of State, County and Municipal Employees (AFSCME) touched off the latest action, suing AIG for allegedly refusing to let shareholders vote on a proxy access proposal. The insurance giant appealed in the Second Circuit, but AFSCME won on narrow grounds.
The SEC’s attempt at a compromise satisfied virtually no one. Those that didn’t want proxy access for director nomination continued to oppose it, and those in favor thought that the barrier of owning at least 5 percent of outstanding stock shares for at least a year was overly restrictive.
Advocates for more open director nominations approach the issue from a variety of angles. ‘You have that right in most developed markets around the world, expect for the United States,’ Johnson says. ‘We don’t see any evidence that having that fundamental democratic right does any long-term harm to the company.’ And given the problems that institutional investors often perceive, nothing less will do, because lesser measures have not done the job. Suggesting director candidates is fine if the board is open to input, but if not, it has no force. And even when a company decides to use majority rather than plurality voting for directors, those receiving a minority of votes must tend their resignation, so the measure is generally a paper tiger.
‘You have something like two-thirds of the S&P 500 that have adopted majority voting by December 2007, but companies still have an escape clause so they can refuse a director’s resignation if they want to,’ says Deborah Wallace, principal of BrinkPoint Consulting. ‘It looks like they are shifting toward greater shareholder control, but you look at the details and they’re not.’
And so, the institutions say that they need greater ease in putting director nominations forward. Even if only a small portion of companies ignore shareholder needs, however, a rule would have to apply to all publicly-held corporations. That opens the door to any person or group that met the requirements to add a candidate to the director slate of the company’s annual meeting. For many, this is cause for concern.
‘If you look at those kinds of changes, then you really loosen up the proxy nomination machinery to potentially contested elections every year,’ says Howard Steinberg, a partner at McDermott Will & Emery. ‘I think that would be a distraction for many companies, and that could be a loss for shareholders. If you open up the process, where you make it very easy for any shareholders to nominate directors, you’re going to create large expenses in terms of proxy contests. You’re going to create distractions for boards and management because you’re going to create potential uncertainty as to the leadership of the company.’
Who’s the boss?
The essential question is one of control. Is a company best served by the tradition of boards being in control and largely insulated from shareholders, although bound by fiduciary responsibility to owners of stock? Or is the company better off with shareholders having greater access and influence? This issue rests on one that is even thornier, however. Just what, exactly, does the interest of shareholders mean? That term can include extremes ranging from the Warren Buffett buy-and-hold school to a Carl Icahn shake-up, break-up and divvy-up philosophy.
‘The system is not built to handle both objectives of both shareholders,’ Gleason says – but it must. Each can just as legitimately own significant portions of corporations as the other. If you enable only one to easily nominate directors, the SEC would effectively create and enforce two classes of ownership, and government – a bad precedent. And if both are able to run candidates for board positions, with their divergent philosophies, then director appointments really could turn into a circus. Imagine the emotional turmoil of the markets meeting the American political process.
It’s not as if the director candidates are necessarily focused on that illusive good of all. Mike Kelly, a managing partner at executive recruiter CTPartners, has worked on a director search for a hedge fund. ‘You want someone who is an independent thinker, who has the intellectual capital to make good decisions and has the experience to draw on, but these institutional investors want you to keep in mind their investments,’ he says. ‘You have to buy into the agenda. And if you don’t buy in, you aren’t a candidate.’
It seems credible that an institution would not recruit a candidate unless it felt reasonably certain that it would favor the decisions the person would make. But institutions and organizations, with very different goals and strategies, could name different director candidates. Think a presidential campaign can become enervating? Imagine opposing financial factions butting heads in one proxy vote after another – less pervasive than a national campaign, but far more personal impact.
Worlds apart
One of the major arguments of those in favor of more open director nominations is that the process has worked successfully in the rest of the world. And it has, under circumstances significantly different from those between the Atlantic and Pacific shores. In Germany, for example, corporations have boards that include representatives of labor and investors – stabilizing influences with longer-range views. ‘My sense is that there still tends to be more autonomy, more separation between the company and the investors [in the UK than in the US],’ says Matthew Andrews, a UK partner in CTPartners. The concept of directly representing investors would have been ‘anathema’.
In other words, in many parts of the world, the ability of institutional investors to nominate directors rarely if ever comes to the test, because they don’t need to. ‘There are a limited number of [US] companies that have proxy access, but we haven’t seen anyone try to use them,’ says Allen. But the thresholds for action are high; according to Allen, the companies that opted to let directors place issues on a proxy statement generally required 5 percent ownership – the same level that many said was restrictive in the SEC proposals.
It could be that open action is rare because naming a director is usually a tool intended to bring a board or management to the negotiating table. That seems a fairly dysfunctional tactic, however, and it sums up the underlying problem: getting investors and directors to really talk and listen is anything but guaranteed.
‘If you have a CalPERS knocking on your door suggesting candidates, you might want to listen,’ Gleason says. ‘But you don’t have to.’ Situations like that at H&R Block show that conferences will sometimes be declined, which makes the big investors want to name director candidates, which brings the situation full circle.
War of words
‘For the moment, the status quo exists, which is to say that the institutions can’t force their nominees on the board and they can’t force a change on the way nominees are voted for,’ Steinberg says. He reminds us, however, that we are ‘in a presidential year. If there’s a change in the administration, [SEC] chairman [Christopher] Cox is likely to be stepping down.’
A change in the Commission could mean different policies in areas like proxy access. Institutional investor power in determining board lineup might well be on the increase, which would bring other potential changes. ‘Recruiting directors is probably one of the toughest recruiting assignments a search firm can have, and it’s only going to get tougher and tougher,’ Kelly says, because competing interests would mean more demand on the total pool of director candidates.
‘[The whole question] certainly has us looking at directors’ and officers’ exposure,’ says Steve Shappell, managing director of the legal and claim practice at Aon Financial Services Group. ‘What happens if there is disagreement? When boards don’t adopt, don’t succumb to pressure from an investor? Will this translate into disagreements that will end up in court? Or is this just wrestling between shareholders and boards [that won’t] result in an increase in claims?’
So far, no enormous bullseye has appeared on the backs of directors. However, given the level of distrust that has developed between investors and corporations, a board may find that it’s damned if it does and damned if it doesn’t. What companies need is to go back to the fundamental issue: each side thinks that the other doesn’t bother to listen to its needs and views of reality.
The solution is better communications. Gleason thinks that some companies are particularly good at keeping in touch with institutional investors, satisfying their needs and eliminating the frustration that can result in attempts to replace a board. ‘[Pfizer corporate secretary] Peggy Foran and the governance crew in the counsel’s office do an exceptional job,’ he says. ‘But there are some companies out there that say, We will talk to our long-term shareholders and institutional shareholders, but we’ll do it on a limited basis.’ That helps create the shareholder sense of being ignored.
Of course a company can’t jump through every hoop. ‘The directors are scattered all over the country,’ Gleason says. ‘Sometimes all over the world. One of your smaller shareholders says, I need to meet with all your independent shareholders because I need to be heard. Is that an effective use [of their time], or is there a better vehicle?’ When it comes to the institutional investors with the largest stake, perhaps flying directors to see them might make sense. Or perhaps what is needed is an occasional web-based video conference, keeping in mind the legal need for equal investor access to information, so no one need fly anywhere. But something will have to give, or it may be that the directors who aren’t willing to cooperate may not be around to argue next year.
