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June 1, 2016

Bruce Goldfarb in IR Magazine on Corporate Governance and Shareholder Activism

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Shareholder activists are commonly thought of as focusing on financial and operational issues. Like others on the buy side, however, they are upping their focus on governance

At a glance

What is good governance?
From pay ratios to proxy access, the focus on corporate governance has been stronger than ever these past couple of years. While this is largely seen as a positive for investors, the box-ticking culture that can arise isn’t necessarily about good governance, argues Sabastian Niles, partner at Wachtell Lipton Rosen & Katz.

The activist approach
Depending on how you define activists and governance, you can argue either that the activist focus on governance has always been there or that it’s growing. Whichever you opt for, companies should wise up to the fact that whether as a true concern or as a hook to get other investors onside, activists are adding governance to their toolkit.

Defending against an attack
Activist funds rarely promote a single idea of good governance, says Josh Black, editor-in-chief at Activist Insight. This makes it difficult to predict what their governance goals might be. Despite this, what you need to do as an IRO is explain – and justify – your governance profile to investors, says Bruce Goldfarb, president and CEO of Okapi Partners.

There’s been a spotlight focus on corporate governance over the past 18 months as traditionally passive giants like Vanguard and BlackRock went public about what they wanted to see from companies and proxy access became the big (and ongoing) story of 2015.

While companies might have grown accustomed to this scrutiny from traditional institutional investors, however, the impression remains that when it comes to shareholder activists, their concerns remain firmly set in the financial and operational. That view may leave companies at a disadvantage.

How you assess the degree of governance focus among activists depends on how you define a shareholder activist and which issues you see as falling within the definition of ‘corporate governance’. For example, if you consider certain pension funds, unions ‘and even gadfly individuals’ as activists, Bruce Goldfarb, president and CEO of Okapi Partners, says ‘governance [has been] a significant focus for activist shareholders for the last two decades.’ Because of the activity of investors, he adds that ‘we see fewer staggered boards and an increase in majority voting in director elections and the ability to call special meetings, and shareholder votes [tending] to have poison pills.’

Then there’s the question of what governance is. There are issues that would universally be seen as governance concerns, such as those around board independence, staggered boards, remuneration or combined chairman and chief executive roles. And then there are those that focus on board composition – such as gaining board representation or replacing a director – that certainly fall under the corporate governance umbrella but can also have other purposes, explains Josh Black, editor-in-chief at Activist Insight.

Looking at global data from Activist Insight, these ‘straight governance’ issues featured in 10 percent of all activist campaigns in 2010, climbing to a high of 22 percent in 2013 and 15 percent last year. If you add board composition to the equation, a much larger number of campaigns are flagged. Board composition was a factor in 57 percent of activist campaigns in 2010, hitting a low of 37 percent in 2013 (the same year governance hit a 22 percent high) before climbing again to 43 percent last year.

Regionally, these figures vary noticeably, but looking at campaigns since 2010, it’s the US that has seen more of a traditional corporate governance focus from activists. While board composition featured in 37 percent of campaigns there, straight governance issues were seen in more than a fifth of activist campaigns (22 percent). If you view board composition as a corporate governance issue, 59 percent of activist campaigns in the US since 2010 have had a governance component.

Prioritizing governance issues

The data clearly shows that companies need to get their governance in order in case an activist is around the corner, but anticipating which governance issues matter to one activist or another can be difficult. ‘There are very few activists that have a set model of best practice they push,’ explains Black. ‘You could say they’re less concerned about governance than a pension fund that wants to push one clear model.’ That doesn’t mean governance won’t be on the agenda, however. ‘[Corporate governance] has become part of the activist toolbox in the sense that it helps to push the strategic and financial agenda,’ says Black.

It can also be a useful hook for winning the support of institutional investors or performing a variety of other roles and purposes, with different levels of priority.

‘The extent to which governance is positioned as a tip-of-the-spear issue, a wedge issue or a true first priority, top-of-the-agenda point varies according to who the proponent is and the circumstances,’ says Sabastian Niles, partner at Wachtell Lipton Rosen & Katz’s corporate department, where he focuses on shareholder activism, takeover defense and corporate governance.

‘In some cases governance becomes a box-ticking exercise that is a stand-in for the question of how easy it is to take over a company, or replace the full board at any point in time, or count how many special rights shareholders have at a given company – which is not the right measure ofgood governance,’ says Niles, adding that ‘our capital markets need to be attractive to those that want to thrive as long-term- oriented public companies and put the long-term vitality and competitiveness of their company first.’

Fundamentally, Niles maintains that hedge fund activism requires an economic thesis: ‘They seek to articulate something they want to see done differently that will boost the stock price.’

Dodging the shots

Whether or not you can prevent your company from becoming an activist target is one thing – especially as any campaign, whether or not it features a governance element, is likely to have the financials at heart – but you can get out there and explain your governance structure to your investors, says Goldfarb. ‘It becomes critical to be aware of your company’s governance profile and realize there may be aspects that are less popular among investors.’

While staggered boards, for example, are generally frowned upon, Goldfarb points out that there are situations where such a structure is justified: at certain types of specialized companies, such as biotech or medical device providers, for instance, where firms might be concerned about losing the pool of knowledge contained in the board all at once. The key is explaining your structure to investors. ‘If you can’t justify the governance structure of your company, you have to evaluate why it’s there, which puts significant pressure on an IRO,’ he says.

And that comes back to Niles’ issue with governance as a potential box-ticking exercise. ‘Good governance is substantive and very company- specific and circumstance-specific,’ he observes. ‘Check-the-box governance misses the point and potentially makes the company more vulnerable to dysfunction and short-termist pressures.’ As for the impact of governance on the stock price, Niles says ‘governance counts when boards have the ability to make their own decisions and you have practices that support and drive sustainable long-term value creation. It’s not really about the stock price, per se.’

The advice to ‘think like an activist’ is a big buzz phrase for companies preparing themselves for an activist attack. For Niles, however, this is just part of the preparation process. ‘When it comes to deciding what you should do with your company, you need to do more than just think like an activist,’ he says. ‘You need to think like – and be – an active and engaged board and management team, laser-focused on the firm’s strategy for long-term profitability and growth.

‘Think like an activist to understand when, where and how you might be targeted and to get in front of the issues but, when taking action for the company, prioritize what is in the best, long-term interests of the company and all of its shareholders – not just the noisiest ones. Now that’s good governance.’

Read our accompanying Q&A with Joseph De Perio, senior portfolio manager of The Clinton Group.

This article appeared in the Summer 2016 issue of IR Magazine