Effective Boards Discipline Themselves to Think More Like Activist Outsiders

Thursday, May 5, 2016 - 12:06
In his annual letter to National Association of Corporate Directors (NACD) members, CEO Ken Daly put shareholder activism second on his director watch list for 2016. “Activists aren’t practicing black magic,” he wrote, “they are performing effective due diligence and smart analytics on their holdings. Boards need to think like activists and anticipate the issues these investors may raise.” NACD research director Friso van der Oord here discusses the NACD’s recent report “Director Essentials: Preparing the Board for Shareholder Activism,” which concerns the role of corporate boards in dealing with the rising tide of shareholder activism. His remarks have been edited for length and style.

MCC: NACD has challenged directors of public companies to think more like activist investors. Given that nearly half of them, in NACD’s annual survey, say they are not prepared for an activist challenge, can board members really be expected to think that way? What’s holding them back?

Van der Oord: Directors, given their unique oversight role and duty to help maximize shareholder value, should be comfortable in scrutinizing their companies the same way activists do. It’s not a major leap to put on an activist “hat,” and it may make them even better, more informed, board members. Yet there are a couple of real obstacles.

First, there is a real expectation gap about the role of the director. Operating in a part-time role and cautious not to cross the dividing lines with management, many directors oversee their companies at a very high altitude and may miss the warning signals that professional investors are looking for. Good directors often act as effective “devil’s advocates,” but don’t always possess a detailed understanding of the financials and operations of their companies. Moreover, the time commitment for board service has increased significantly over the past five years. The average now is about 250 hours a year. Are directors using that time effectively? Second, they may receive insufficient or highly engineered information from management that prevents them from spotting areas of underperformance. Third, the current committee model may hinder an effective, collective response from the board, as risk factors that attract activist attention may fall through the cracks. The committee structure surely serves a critical role, but it also prevents most boards from getting a holistic picture of how well or how poorly the organization is performing at all levels – operationally, financially, strategically. We often see boards that are run by committee, and that doesn’t help you be holistic in the way activists are. Activists connect the dots very quickly on issues of underperformance and whether your organization is valued properly in the marketplace. The head of the audit committee doesn’t don the activist hat, so to speak, and review their company’s financial statements as an activist would.

There is also a missed opportunity in how board meetings are held. If you look at their agendas, relatively little attention is dedicated to the issues that hedge fund activists are really worried about, such as execution of strategy, the true value of the organization, and underperforming assets. A lot more time is spent on procedural, regulatory issues that in some ways are creatures of a different era – for example, Sarbanes-Oxley compliance.

Effective boards discipline themselves to think more like outsiders and expect sitting directors to offer and articulate that skeptical outsider’s perspective. They proactively ask management to present financial and operational data differently or demand new metrics altogether to help identify underperforming assets. They understand the composition of their company’s ownership, are proactively informed by IR when that composition shifts, and know whether and what types of activists are current shareholders.

MCC: When people think of shareholder activism, they think of prototypical activists such as Carl Icahn, Bill Ackman and David Einhorn. But as NACD’s new report on shareholder activism recognizes, activists and activism come in many shapes and sizes, ranging from “light” to “heavy” varieties. Please elaborate on the varieties of shareholder activism and what that means for directors.

Van der Oord: Indeed, no company is immune from shareholder activism, but the headline-grabbing attacks by hedge fund activists are relatively rare – it’s a relatively small group – and can be anticipated by tracking the right company performance metrics. It is true that over the last decade, all types of professional investors have become more active – perhaps not activist – including pension funds and the large institutional investment houses, which demand more information from companies they invest in and communications from their respective directors.

We think that approaching the topic of activism with the rigid mind-set that activists are the enemy is misguided. At the end of the day, activists, the board, management and other shareholders want the company to perform as well as possible – they just may disagree about the best way to do it.

NACD has recommended that boards, together with their management teams, adequately communicate their company’s strategy to shareholders and maintain an open dialogue. We believe that directors should make a special effort to stay “communications ready” on topics of key interest to shareholders.

MCC: Obviously, declining stock prices and general company underperformance attract activists. NACD’s “Director Essentials” report emphasizes that a deeper understanding of shareholder activism and its evolution will
better prepare boards. What’s most important for directors to know as they prepare for what increasingly seems like the inevitable shareholder activism they will face?

Van der Oord: While it’s important not to overreact, directors – and perhaps more significantly, the board as a collective – can make formal preparations to mitigate or even prevent the potential impact of an activist challenge. Essential hygiene includes analyzing and understanding your company’s vulnerabilities and what the mix is of those weaknesses or opportunities. For example, do we have underperforming business lines, high cash reserves, low dividends, and potential for sell-offs or spin-offs of business units that are more highly valued separately? Do we have corporate governance practices that are outliers? Moreover, boards should have in place a response plan that addresses how the company may approach specific activist demands and outline a strategy for communicating the company’s response to key stakeholders, including other large investors, the media and proxy advisory firms. It should also build on lessons learned from peers in the industry that have been challenged.

MCC: Various studies show shareholders realize sustained gains from activist campaigns. For example, “The Economist” analyzed the 50 largest activist positions in America since 2009 and concluded that, more often than not, profits, capital investment and R&D have risen. Is all the drama around shareholder activism much ado about nothing?

Van der Oord: We have observed that the performance picture is somewhat mixed, and it likely may be too early to tell whether activism contributes to long-term value creation and can help companies stay competitive through longer business cycles. Certainly, activists have recorded some big wins and have gained strong short-term returns, perhaps buoyed by the S&P’s post-recession performance. However, the performance of activist funds in 2015 and early 2016, according to the “Activist Investing” annual review from Schulte Roth & Zabel, has been less than impressive, with stocks targeted by activists declining almost 8 percent compared with gains of 1.4 percent for the S&P 500. They are now facing the stern test for any investor in a highly uncertain market: Can they create sustained value and resort less to financial engineering tactics such as share repurchases to artificially boost short-term stock values?

MCC: A survey by FTI Consulting shows growing institutional support for activist campaigns. What impact is this apparent support of major investors having on shareholder activism and board response to it?

Van der Oord: Certainly, institutional investors welcome activists who help force boards to sharpen their strategic focus and can help catalyze necessary changes in companies, but increasingly, many of the large asset management firms are concerned that even the threat of activism prevents firms from taking a long-term approach to value creation and may come at the expense of long-term shareholders. This was exemplified by the recent news in the Financial Times and other major news outlets that Berkshire Hathaway CEO Warren Buffett, JPMorgan Chase’s Jamie Dimon, and BlackRock chair and CEO Laurence Fink have been meeting privately since August of 2015 with heads of the world’s largest asset-management firms to advocate for a stronger focus on long-term value creation. In an open letter to the CEOs of the S&P 500 companies, Fink wrote that activist investors’ demands for short-term profits could lead boards to conduct “potentially destabilizing actions.” Instead of concentrating on minor deviations from analysts’ earnings expectations, companies should use quarterly reports to show progress made in executing long-term strategies.

MCC: In 2014, Vanguard announced that it would propose “shareholder liaison committees” to the boards of companies in which it is invested. This sparked a lot of discussion about shareholder-director communication. What’s the state of shareholder engagement? Are things moving in the right direction?

Van der Oord: I do think boards are stepping up their direct engagement with the investor community. Every year, the NACD solicits perspectives from the investor community – including the large institutional investors – about this issue, and they observe real progress in board engagement and communications. In our recent director survey, more than 40 percent of respondents indicate that their board met with institutional investors in the past 12 months. Major investors report that they are seeing the quality of dialogue continuing to advance and improve. Conversations are a lot more integrated, with issues like board composition and executive compensation now clearly tied to companies’ strategic objectives. They also noted that more directors are getting to know their companies’ top shareholders, and that discussions now offer more understanding of how board members at specific companies view their role.

MCC: Many shareholders say the information they get from discussions with directors is especially valuable. Yet many directors are passionately against the idea of engaging directly with shareholders, citing concerns over Regulation Fair Disclosure and/or that investor relations is not their job. How do you respond to that?

Van der Oord: Reg FD applies squarely to any communication between a director and a shareholder. Indeed, some directors and board advisors have pointed to Reg FD as a key reason to avoid any and all exchanges between directors and shareholders. However, SEC staff guidance published in 2010 makes clear that directors are not prohibited from holding private meetings with shareholders and provides useful tips for conducting such meetings without running afoul of Reg FD. For example, make sure that directors are trained and authorized to speak on behalf of the company and only entertain private discussions with investors or groups of investors. Additionally, topics for discussions should be pre-cleared and, in certain instances, it makes sense to have company counsel and/or investor relations participate in these meetings.

In general, NACD recommends companies have a board-shareholder communication policy, with a section that focuses particularly on abiding by Reg FD, to lay the groundwork for these discussions. This policy should specify which board members, if any, are permitted to engage directly with investors.