by Cydney Posner
The obvious tension between the interests of long-term investors, such as institutional shareholders, and short-term investors, principally represented by hedge fund activists, has been the subject of much discussion of late. Some observers have claimed, as argued in this NYT DealBook column, that the idea behind the financial machinations pushed by hedge fund activists “is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.” Among the victims of these financial machinations identified in studies and reports have been R&D (see this PubCo post), capital investments and domestic jobs (see this PubCo post), human capital (see this PubCo post) and local communities (see this PubCo post). And this short-term myopia appears to be contagious: a recent academic study showed that “three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report.” (See this PubCo post.)
In two recent articles, representatives of asset manager State Street Global Advisers (SSGA) and consultant CamberView Partners (CVP) address this tension, expressing concern that some companies, faced with pressure from hedge fund activists, are too quick to settle with the activists without first engaging with and taking into account the views of long-term investors. They advocate the development of “principles for engaging with activist investors to promote long-term value creation and sustainable economic growth.” (See this SSGA press release.)
SideBar: A number of corporate leaders have likewise expressed apprehension about the scourge of short-term thinking. Earlier this year, a group of CEOs of major public companies and institutional investors developed a list of commonsense corporate governance principles, among which was the recommendation that each “company should take a long-term strategic view, as though the company were private, and explain clearly to shareholders how material decisions and actions are consistent with that view.” (See this PubCo post.) In the same vein was the 2016 corporate governance letter from the CEO of BlackRock asking corporate CEOs, instead of using their annual communications to shareholders to report only on the past year’s achievements, to “articulate management’s vision and plans for the future” by “lay[ing] out for shareholders each year a strategic framework for long-term value creation. Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed those plans. BlackRock’s corporate governance team, in their engagement with companies, will be looking for this framework and board review.” [bold in original] (See this PubCo post.)
Although SSGA “recognizes that activists can bring positive change to underperforming companies, especially when boards or management ignore investor concerns about poor corporate governance practices” — and even acknowledges that it has supported some activist attacks in the past — it is uneasy about the recent increase in rapid settlements between corporate boards and hedge fund activists that reflect “evidence of short-term priorities compromising longer-term interests.” According to SSGA, the data (from Lazard and ISS) shows that, for companies with market caps above $500 million, so far in 2016 (through August), 49 companies have relinquished 104 board seats to activists — approximately 13% of the 816 new board appointments in 2016 — compared with 106 seats relinquished in all of 2015. SSGA also notes that “less than 10% of board seats that were conceded in 2015 and 2016 were through a proxy contest. Most seats were conceded by companies in settlement agreements; by contrast, in 2014, 34% of seats were conceded through proxy contests.” CVP observes that there has also been a significant decrease in the time to settlement: “The average time it takes companies to reach a settlement with activists threatening a proxy contest is currently 56 days from the time of disclosure of the activist’s position, down from 83 days in 2010, according to research firm Activist Insight….The quick rush to settlement means that a significant number of companies facing an activist threat have made strategic board changes with limited input from the investors affected most by the director appointment or change in strategy.” (See also this PubCo post.)
SideBar: As Reuters reported in 2015, the view that companies were too quick to settle has been supported by Scott Stringer, New York City Comptroller (who runs the NYC employees’ pension fund and was the galvanizing force behind the 100+ shareholder proposals for proxy access during the last two proxy seasons), who characterized the trend toward quicker settlement with hedge fund activists as “disturbing”: “Boards have become quick on the trigger to grant seats to activist investors just to avoid a proxy fight….[C]ompanies run the risk of prioritizing short-term expediency at the expense of long-term value,” when shareholders are not allowed their say on these issues.
However, contrary to the message delivered by SSGA and CVP, Reuters attributed the fast pace of settlements to a shift by powerful institutional investors in support of hedge fund activists. Previously, according to the article, management could look to institutional holders for support in proxy fights against hedge fund activists. But in the last couple of years, that trend has reversed to some extent as more institutional holders began throwing in their lot with activist investors. (See this News Brief.) Reuters cites Proxy Insight data showing that, with regard to three large well-known institutional investors, the percentage of dissident proxy cards that they “have voted to support – meaning they supported at least one dissident board candidate – has increased every year since 2011.” (See this PubCo post.)
While settlements may protect companies and managements, SSGA argues, they do not typically take into account the interests of long-term holders. However, SSGA contends, proxy contests — as lengthy, costly and risky as they may be — at least “give long-term investors and other market participants an opportunity to provide their views on long-term strategy, capital allocation and corporate governance issues such as board composition.”
Recognizing that the strategies of hedge fund activists differ by activist and from company to company, SSGA has identified several types of actions that raise “red flags” for long-term investors and trigger concerns about the motivations behind those actions, as well as the “potential implications for sustainable value creation.” These red flag actions include the following:
- Significantly increasing CEO pay without explanation
- Changing executive comp performance metrics to rely primarily on EPS, which SSGA believes “can overly focus management on short-term stock performance and often favors activities such as share buybacks over allocating capital for the long term
- Focusing on financial engineering such as share buybacks, leveraged dividends, spin-offs and M&A, which could add value in the short term but may also undermine long-term value”
SideBar: A recurring demand by hedge funds activists is that the target company return capital to its shareholders by buying back its own stock. Data compiled by S&P and Bloomberg shows that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks. While some applaud these stock repurchases, the concept of stock buybacks has attracted its fair share of media criticism, along with serious scrutiny from academics, claiming that buybacks and related short-term stock price hikes come at the expense of long-term value creation. For example, some academics have contended that, instead of using corporate profits for investment in innovation and “productive capabilities,” companies are spending those profits (and more) on enormous stock buybacks. (See this PubCo post and this PubCo post.) For company executives, one of the more appealing consequences of the buyback trend is that, in some cases where compensation performance metrics are stock-price- or EPS-related, buybacks can juice executive compensation, irrespective of the operational success of the company. In 2016, the AFL-CIO submitted a new shareholder proposal asking several companies to adjust executive pay metrics to exclude the impact of stock buybacks. (See this PubCo post.) See also this PubCo post, discussing the impact of activist-imposed stock buybacks and similar actions on devastating one company and one community.
In view of the increasing prevalence of settlements as a way to resolve threats from hedge fund activists, SSGA recommends a number of provisions that it believes would help to alleviate some of its concerns regarding inadequate protection of the interests of long-term shareholders, in particular, the following:
- Extend the terms of settlement agreements beyond the typical six to eighteen months, which SSGA believes will lead “both companies and activists [to] be more sensitive to long-term factors and incorporate these into the settlement terms and strategic actions.”
- Impose holding periods for shares owned by the hedge fund activists for a stated period after receiving their board seats. While most settlement agreements address standstills, SSGA believes that imposing a holding period would “align the interests of activist investors with those of long-term shareholders, [causing] boards [to] be less concerned about preventing activists from increasing ownership levels and … instead value the activist’s investment and commitment to the company.”
- Impose minimum ownership and director resignation requirements for directors affiliated or not fully independent of the hedge fund activist in the event that the activist’s ownership falls below a minimum threshold. If the board decides that the director has made valuable contributions, it can always re-appoint or re-nominate the director. SSGA believes that the resignation would ensure that a “clean break occurs between activist firms and independent directors identified by the activist.”
- Evaluate and address risk from pledging of activist shares by developing robust mechanisms to oversee and mitigate any potential risk to the stock price from activist pledge positions. Although hedge fund activists are typically prohibited in settlements from engaging in short sales, SSGA determined that they frequently margin their shares. SSGA contends that pledging of shares “could create perverse incentives for the activist firm, which could result in their director nominees pursuing aggressive strategies to maintain share prices in the short term.”
In its article, SSGA advocates that long-term holders, boards and hedge fund activists should together develop principles that protect the interests of long-term shareholders in settlement agreements. SSGA advises that, in its future voting decisions on the election of directors where hedge fund activists have been involved, it will “assess settlement agreements according to how they address these issues. Further, we will engage with companies that pursue unplanned financial engineering strategies within a year of entering into a settlement with an activist to better understand the reasoning behind the strategic change. Finally, we call on boards to view passive investors as long-term partners and to communicate how the company’s strategies, including their engagement with activists and board seat concessions, help create sustainable long-term value for all shareholders.”
In response to SSGA’s article, CVP confirms that, in its view, institutional investors are indeed demanding to be consulted when key strategic decisions are being considered. As a result, “[c]ompanies must engage or risk the ire of their long-term investors.” Accordingly, in the context of potential settlement agreements with hedge fund activists, CVP recommends that companies take the following steps:
- Even before hedge fund activists threaten, companies should develop a proactive engagement program with both portfolio managers and governance teams that allows institutional investors to provide their input on issues such as “long-term strategy and how it relates to board composition, governance and compensation practices.”
- If hedge fund activists do begin to pressure the company, it should consult with its key investors to ensure their voices are heard prior to taking any major strategic, financial or board action in response to the activists. Moreover, companies should recognize that long-term investors may be willing to support the company in opposition to some activist demands and that engagement can help the company identify the issues where investor support may provide the company with necessary muscle:
“Additional engagement with investors will reveal perspectives on key items of the activist agenda and will help identify positions of strength from which the company can engage with the activist. Investors will also provide companies with context for which of the activists’ arguments resonate with them and in which cases they would not support change. A failure to engage, on the other hand, will leave institutional investors frustrated at their inability to have a say in one of the most critical decisions a portfolio company can make. This frustration may be expressed through votes on future director nominees, Say on Pay proposals, or in future contested situations, especially if the activist makes incremental demands in the coming years. Settlements will only ‘keep the peace’ to the extent that new issues aren’t created because the opinions of some investors are not solicited.”
- Where there is conflict between the key investors and the hedge fund activists, CVP advises that companies should consider delaying entry into settlements with the activists or allowing “the first stages of a proxy contest to ‘play out.’” CVP contends that many other major institutions share the views of SSGA about settlements, and the governance teams at these institutions are often instrumental or even decisive in determining the results of proxy contests. Instead of viewing the director nomination deadline as a firm deadline for settlement, CVP suggests that companies consider forcing the activist to divulge its slate of director candidates and its strategy. Allowing the proxy contest to “play out” constructively, CVP argues, could create the leverage necessary to obtain a better settlement: According to CVP, if the company provides “a measured response to the activist’s agenda and an openness to a constructive resolution, [that] may be the optimal way to engage in ‘vote discovery’ with the broader investor base. Moreover, this path does not need to be costly, contentious, or distracting if it is approached in a constructive manner. The feedback generated in the market by gaining insight on both positions can provide leverage to obtain a settlement that narrows the gap between the activist position and that of long-term shareholders.”
SideBar: Interestingly, neither SSGA nor CVP addresses the risk that, from the board’s perspective, more dire consequences may result. According to Reuters, reporting in 2015, “[w]hile every proxy fight is different, the overall odds are not favorable to companies itching to fight, and this can also make them reluctant to participate in a protracted dispute. In proxy fights where board seats were sought at U.S. corporations, the dissident shareholders’ success rate rose to 73.1 percent last year, compared to less than half in 2012, according to data from research firm FactSet.”
- Given that, in CVP’s view, engagement with institutional investors prior to settlements with hedge fund activists is currently “the exception rather than the norm,” CVP advises that, in the absence of pre-settlement engagement, companies should undertake to engage with key investors post-settlement “to explain their decision and why it was in the best interests of shareholders. Moreover, even post-settlement, the company will benefit from gaining investor perspectives before making any significant strategic, financial or governance decision, especially if these decisions are viewed to be a deviation from the company’s pre-settlement path.”
