The hottest topic in many corporate boardrooms today is shareholder activism—or more specifically, the vulnerability of becoming the target of a shareholder activist and what to do about it. Instead of looking at this as something to dread or, worse, have to defend against, boards of directors should be proactive about getting out ahead of it. As insiders, we are in a better position to act on our fiduciary responsibility to represent the interests of shareholders than is an independent party, and we have more tools and power at our disposal to do so. Done right, this might result in some healthy, but managed changes.
Activists today come in many different forms. They can be vocally aggressive, publicizing their efforts through proxy contests, and seemingly short-term in their orientation, like their “corporate raider” and “green-mail” predecessors in the 1980’s. They can also be quietly persistent with management behind the scenes and more long-term in their orientation (e.g. ValueAct Capital, Relational Investors, and even Ben Graham in the 1920’s), engaging with management directly, rather than taking their messages to the public.
The influence the activists are having in the market has never been greater. Simply put, what they are doing is attracting more capital. Assets under management have sustainably outperformed, now estimated at north of $115 billion, ten times the levels of the 1990’s. Distributing their messages has also become easier. They often communicate via social media and business news channels like CNBC to emotionally pressure management and collaborate with other shareholders.
Easy communication and strong performance have caused many long-only, traditional shareholders to take notice and support them. In some cases, activists are now actually getting their ideas from frustrated, traditional shareholders. This means the amount of capital at work for the activist agenda has dramatically multiplied far beyond the power of the capital they directly manage. When combined together, they represent trillions of dollars and strong voting blocks that create powerful voices for change.
The numbers show that the companies being targeted are getting bigger and the contests are becoming more frequent and successful. Institutional Shareholder Services (ISS) estimates a 70% success rate if an activist launches a proxy contest for a short slate, largely due to the sway held from banding together with other investors. Consequently, many companies in the S&P 500 are anticipating that if they haven’t already been targeted, they may well be on the docket in the future.
So what is a board of directors to do? Boards are empowered to protect shareholders, but many shareholders have become sympathetic to activists because they believe the system has inherent conflicts of interest—that directors are more interested in collecting paychecks and preserving their status quo than in exercising their fiduciary duty to shareholders. Whether right or wrong, many feel this can cause directors to “phone it in”, or refrain from challenging the chief executive officer (CEO) when appropriate. They feel that some board members can become entrenched in their positions when others might be better suited for the role.
Conversely, the board’s time horizon for creating value is, by definition, much longer than that of any one activist, and many boards and management teams see activists as too short-term and believe they just don’t get the complexity of the landscape in which corporations operate. Operating realities include balancing the interests of customers, suppliers, employees, and regulators. Implementing well-managed changes, while navigating these factors, often takes longer than investors without operating experience may realize.
As well, sometimes a short-term value consideration that might seem attractive to an activist—such as cutting expenses, like what Eddie Lambert did at Sears or what Elliott Management is reportedly pushing Juniper to do—may result in short-term stock improvements, only to give way to franchise, revenue, and value degradation in the enterprise. The board has to keep its focus on long-term value considerations in such decisions.
But there are many things public company boards can do to better align with their core responsibility to the stockholders—and they can do it in a way that is more proactive and sustainable longer-term, than if it is in response to an activist. What follows are four ideas that boards of public companies can consider. They are meant to be directional rather than prescriptive; possible plays in a playbook that should be weighed against the specific culture and operating considerations at play.
Allow Shareholders To Communicate Directly With the Board
Consider this: most boards only receive input on stockholder views by reading reports by sell-side analysts—who are not their shareholders—and from the CEO and chief financial officer (CFO), who directly talk to institutional shareholders. Imagine, as an executive, never meeting with your boss to get feedback, but instead receiving it filtered from someone on your staff. That is essentially what happens for most boards.
The shareholders are ultimately the “boss” of the board, in the sense that the board serves as their proxy for enhancing intrinsic value, yet boards typically hear about shareholder concerns indirectly and often not attributed to any specific shareholder.
A huge opportunity is missed without direct contact. This is exactly the opportunity the activists are availing themselves of by contacting blocks of shareholders to exchange views on underperforming companies and collaborating on remedies.
Boards should do the same. There are a variety of ways to accomplish this. A less direct, but still effective, way is to solicit input on specific issues through an independent third party. For example, iiWisdom.com collects quantitative and qualitative attributed feedback from proxy voters on strategic, governance, and capital allocation issues for boards.
Similarly, Coca-Cola Co. Director Maria Elena Lagomasino, Chair of the Compensation Committee, met directly with one large shareholder and also considered specific summarized feedback derived from major institutional shareholders of Coke on the issue of executive compensation. This input led to the revised approach to equity compensation that was recently announced. She also communicated directly with shareholders through a letter on the company’s website.
While the Coke example was in response to public shareholder concerns, this approach could be more proactive. For example, Intel Corp. Chairman Andy Bryant tries to meet with at least three of the top ten shareholders every quarter to keep apprised of specific concerns and issues and these are then reported to the board.
This could even be more formalized. For example, a designated board member (independent Chairman, lead independent director, or Chair of the governance committee) could invite the top ten to fifteen shareholders—who collectively represent more than 70% of the ownership in most public companies—to get together periodically to air their thoughts and concerns.
This designated director could then either summarize that feedback for the board or invite one of the shareholders whose thoughts are broadly representative of the group to join a board gathering to share their perspectives. Critically, the role of the designated director in this case is to listen and create a process to communicate to fellow directors; it is management’s job to own and communicate its strategy.
Berkshire Hathaway Inc. is even more ambitious in this regard. It hosts more than 30,000 shareholders in Omaha annually and allows them more than six hours to ask unfiltered questions. Recently Chairman and CEO Warren Buffett offered this sage advice on the subject, “I believe in running the company for shareholders that are going to stay, rather than the ones that are going to leave.” By contrast, many annual meetings are dog-and-pony shows, with question-and-answer time limited to less than one hour; this forum does not often surface the most important concerns.
If a designated director or a designated third party representing the board were to reach out to shareholders from time to time, both sides would learn and benefit. It would allow key directors to educate shareholders about how the board functions and to build credibility. Having a relationship before problems arise would serve, hopefully, to avert a crisis situation in the first place and, at the very least, would facilitate a productive dialogue if one were to develop.
In addition, shareholders can add insight to the board because they often speak with competitors, customers, and suppliers of the company. This can bring an “outside in” perspective that can be hugely valuable. It would give both the shareholder and the board the opportunity to understand each other and also to exchange ideas that can help the board exercise its fiduciary duties.
Engaging in discussions is not akin to giving up decision-making power. Nor is there a one-size-fits-all solution for all current shareholders. Without a process in place, though, sometimes the loudest shareholders can act like a special interest group. By contrast, a well thought out, institutionalized process to surface shareholder ideas and input can help boards manage the communication and also not get caught up in too many meetings or one-off conversations.
Importantly, boards need to both be able to take and process input from shareholders, but also be strong in their convictions about what is the best long-term course across governance, capital allocation, and strategic direction, leaning heavily on the operating and strategic experience of management.
A second area ripe for improvement in boards involves implementing a process to improve and to refresh the board without creating undue disruption along the way. This means setting up a mechanism for both attracting new directors with some of the skill sets of long-term shareholders, as well as a mechanism for rotation off the board to create the room for new thinking, more diversity, and more women.
For removing directors, the solution that activists primarily advocate is a hard term-limit. As an alternative, many companies instead opt for a retirement age. I am not a fan of either. Why create a system which forces out good board members?
Consider several of the outstanding directors I have been fortunate to serve with, a venerable Who’s Who of corporate America: Berkshire Hathaway Vice Chair Charlie Munger, former Coca-Cola President Don Keough, and former Capital Cities/ ABC Inc. CEO Tom Murphy. All are over 80, and all have served on boards for decades. These directors bring long records of successful business experience and cultural knowledge to the table that affords a wisdom I find invaluable. While before my time on the board, similarly, Intel shareholders benefited from the very long board tenures of luminaries like former CEO Andy Grove and company co-founders Robert Noyce and Gordon Moore.
Then again, most boards have at least one or maybe a few directors who are not adding as much value as a new member might bring and therefore represent an “opportunity cost” without some plan for rotation. Once directors are on a board, it can be extremely difficult to naturally rotate them off. Firing a friend is tough under the best conditions, and even more so because there is no economic incentive. It is emotionally easier just to “wait it out”. This is even more complicated when a CEO inherits a board that was picked and groomed by her predecessor and does not have the collective skills for her new strategy.
My view is that boards would be well served to adopt a process that specifically outlines the rotation process and that is understood and implemented for new directors. In other words, limited terms, but not term-limits. By making this change for all new directors, it sidesteps and grandfathers those already on the board, making it easier to implement on a go forward basis.
These terms should be long enough for a new director to develop an operating understanding of the product(s) and culture, and to contribute to long-term shareholder value, but short enough to prevent stagnation. I lean toward a system in which each new member of the board agrees to hand in their resignation every six to eight years. The idea being that some directors will be asked to serve multiple terms it they are uniquely qualified to help the CEO and company build value, but most will be thanked for their service and move on after that time frame.
The decision regarding whose resignations to keep, or whose to accept, could be made either by an appointed director, or by an absolutely confidential and binding majority vote of the other board members. This latter approach might be easier socially. Regardless of the approach a company decides to take, some system is necessary because this problem does not get solved naturally.
The criteria for selecting new directors are as important as those for removing directors without friction. I have never seen a better list than what Berkshire outlines. It looks for directors with strong business savvy, sustained interest/ passion for the company, and a long-term share owner orientation. If this were the primary lens through which new directors were to be recruited, I am not sure activists would still have a job.
Next, CEO compensation, one of the primary responsibilities of the board, continues to be a hot button topic. While that is the obvious issue, a critical underpinning to it is director compensation. How is a board going to be able to craft an approach to CEO compensation that aligns with creating shareholder value if directors, themselves, are drafting off excess compensation?
On many car rides to the Seattle airport after Costco board meetings, Charlie Munger and I have discussed this topic. His view is that at the most senior levels of leadership in business, one has a duty to be underpaid and to be an “exemplar”. I agree.
I have seen several successful ways of handling this. Berkshire Hathaway keeps its board compensation to a minimum, with directors paid less than $10,000 per year. Berkshire may be unique in its ability to pay so little and still attract committed directors, but other approaches work too.
At Intel, executives and board members receive a good portion of their compensation through “performance-based” shares. These share allocations get reduced if the company underperforms its peers, or increased if it outperforms, aligning compensation with shareholders. Similarly, Coca-Cola’s new system places more reliance on performance-based equity.
Another popular mechanism is requiring directors to own a significant amount of stock in the companies they govern. Why not consider a policy that the CEO and directors are contractually committed to hold all vested shares or options until the end of their terms? This would ensure that they have appropriate skin in the game and help drive alignment with shareholders.
If this policy is seen as too rigid for some companies, then how about a guideline or a suggestion to directors that this be encouraged? While this is not a policy held by any of the boards for which I am a director, I have made it a personal policy never to sell a share while on the board. Getting to the right answer for the CEO is a lot easier if the board sets its own good example.
Deeply Explore Strategic and Capital Allocation Alternatives
Finally, directors must insist on asking management to analyze strategic choices as an activist would: by looking at alternatives to the strategies the CEO is recommending. This is not typical. The more common pattern is for the CEO to consider options and present only the chosen one to the board.
The road not taken is the one the activist will surface, so the board must have analyzed these alternatives in advance. This means understanding what it would mean to get out of underperforming operations, split up the company, and evaluate varying alternatives for measuring and handling excess cash versus the ones being recommended. If these choices are not discussed, the board will be poorly prepared to articulate and defend its alternative course.
To wit, I sometimes wonder if the 2009 Yahoo! search asset deal with Microsoft might have been crafted very differently, had the short-term pressures from an activist not been in the boardroom and had the board fully educated themselves on the strategic options.
This might mean adding board days dedicated to diving deep into these questions or bringing in outside experts to help the board understand the strategic and capital allocation choices—and how the alternative ones stack up, versus those preferred by management.
Importantly, an analysis of the break-up or private transaction value of a company that shows a higher value than where the stock is trading does not oblige a company to make a sale. There have been many times in history where macro-economic or other conditions have made the current stock market and private transaction values poor indicators of intrinsic value. The board’s duty is to enhance the latter, exercising its duty of care, by fully understanding what strategic choices the company is making and why.
Done right, this process will also help the board to be committed to, and aligned around, the explicit and implicit strategy choices of the CEO. It will also give the company the opportunity to proactively address the issue with shareholders.
Berkshire Hathaway has been taking that approach by communicating why the company believes it is best served by remaining a conglomerate rather than by being broken apart. Similarly, Warren Buffett directly addresses why, when it comes to its capital allocation decisions, the company prefers to direct excess cash toward acquisitions rather than dividends. Not every shareholder may agree with this, but the consistent communication and proven performance has earned trust with shareholders and there is no mystery about the strategy.
Directors have the power, the tools, and the knowledge to get ahead of the activists in ways that might create more long-term value for their companies. They also have a duty to make long-term decisions that may hurt short-term profits, but that result in better product(s), vendor relations, employee relationships, and/ or customer trust that builds intrinsic value.
By proactively hearing directly from shareholders, by designing a system that thoughtfully refreshes the board and considers compensation, and by creating a boardroom culture that analyzes strategic alternatives—including sometimes hearing from outside experts—directors can energize the boardroom and build conviction on the right course.
Embracing such diversity of ideas, and seeking it in new board members, all with an orientation to protecting and building long-term intrinsic value, could also help uproot the “same-old, same-old” approach of entrenched thinking. After all, Charles Darwin figured out 150 years ago that productivity improves with increased diversity.
Writer’s note: I currently serve on the boards of Berkshire Hathaway, Costco and Intel. The opinions expressed here are my own and, in some cases, they may differ from others held by my colleagues on those boards.