Paul Dunbar is a corporate partner at Vinson & Elkins, and the U.K. Head of Vinson & Elkins Shareholder Activism Response Team. He has been a corporate lawyer for over 10 years and advises public company clients on shareholder activism matters, corporate governance and M&A. He is recognized in the U.K. Legal 500 2016 rankings for M&A: Upper Mid-Market and Premium Deals.
The V&E Shareholder Activism Response team is headed globally by Kai Liekefett and works with companies across all industries in the U.S. and U.K. involved in activist matters. V&E was ranked No. 1 among all law firms for defending public companies against activists in the Thomson Reuters Global Shareholder Activism Scorecard for 2016.
Christopher P. Skroupa: What developments have been seen in board/shareholder engagement in recent years?
Paul Dunbar: There have been two key developments in the U.K. with respect of board/shareholder engagement in recent years. The first has been a gradual increase since the financial crisis in “soft activism” by institutional investors, driven initially by political and media pressure and related regulatory developments, and more recently by developments in the asset management market forcing changes on institutional investors. The focus of such soft activism tends to be on corporate governance—principally board/management structure and executive pay. The U.K.’s corporate governance framework comprises laws, codes of practice and market guidance, the most important being the U.K. Corporate Governance Code, published by the Financial Reporting Council (FRC).
In response to criticism of corporate governance and the lack of engagement by institutional shareholders during the financial crisis, the FRC released updated versions of the U.K. Corporate Governance Code and also introduced the U.K. Stewardship Code in 2010, which applies directly to institutional investors and essentially encourages them to engage more actively with boards of directors. In 2012, a “shareholder spring,” which saw a number of CEOs on U.K. public companies stand down in connection with excessive pay awards, led to the introduction of a binding vote for shareholders on executive directors’ pay every three years through the Enterprise and Regulatory Reform Act 2013. The focus on executive pay has continued and is expected to be in the spotlight again in the Spring 2017 AGM season, not least due to the outcome of the Brexit referendum and the feeling that companies now need to act responsibly on executive pay due to the perception noted by commentators that a significant part of society does not feel that it is sharing in the U.K.’s prosperity.
The more recent market development leading to increasingly active institutional investors has been the growth and increasing popularity of ETFs/passive index funds. These funds have achieved returns comparable to the institutional investors that typically charge significantly higher fees for the traditional benefits of a more active asset management strategy. The latter have therefore become increasingly activist. This has been seen most clearly in the U.S. where in some cases, institutional investors have encouraged hedge-fund activists to launch campaigns against a company, such as Ontario Teachers’ Pension Fund with Pershing Square in a campaign against Canadian Pacific, and CalSTRS with Relational in a campaign against Timken. The U.S. has also witnessed the establishment of several organizations established in the last 3 years to try and improve engagement between institutional investors and boards (partly inspired by what is seen as a traditionally more effective engagement structure in the U.K.), such as the Shareholder-Director Exchange in 2014 and more recently the Investor Coalition that recently published a U.S. Stewardship Code.
In both the U.K. and U.S., we have seen institutional investors becoming more willing to publicly disagree or even vote against the incumbent board on matters such as executive compensation. This increased institutional investor “soft activism” has meant that non-executive directors and management teams are having to commit an increasing amount of time and focus on shareholder engagement.
The second key development has been the dramatic rise of hedge fund activism. The status of hedge fund activism is well known with respect to the U.S., and for the last three years, there has been great expectation that U.S. hedge fund activism will spread to the U.K., not least due to the competition between numerous hedge funds for activist opportunities in the U.S., and the relatively investor-friendly legal framework in the U.K. providing opportunities for activists to apply pressure to boards.
The activist’s “toolkit” in the U.K. includes an ability to view the shareholder register, to requisition shareholder meetings and to propose resolutions where a shareholder holds at least 5% of the voting share capital of the company, and to effect board changes if the support of a simple majority of shareholders voting on the matter can be obtained. The expected wave of hedge fund activism has not materialized in the U.K. as quickly as expected, but an uptick is notable particularly in the last 12 months. Bullish U.K. M&A markets have allowed activists to play “bumpitrage” by seeking higher offers from previously announced deals.
After the Brexit referendum, various deals were exposed to calls for re-evaluations by activist hedge funds (notably Elliott), such as the AB-InBev/SABMiller and Steinhoff/Poundland transactions. We also saw Rolls-Royce Holdings become the first FTSE 100 company to cede a board seat to an activist (ValueAct Capital Partners) in 2016. We expect the number of campaigns by hedge fund activists in the U.K. to grow throughout 2017 and beyond, and companies should be reviewing their overall preparedness for such an attack, assessing potential vulnerabilities and remedying weaknesses to the extent possible.
Skroupa: How should boards prepare for an activist attack?
Dunbar: Preparation for an activist attack should be an ongoing process and consideration, in much the same way that a board should be well prepared in the event of a hostile takeover. The most important step is to build and maintain effective communication between the board, management and the company’s long-term investors. It is much better to focus on developing the support of long-term investors to the board’s strategy, before a board is in the midst of an activist campaign that may be criticizing that strategy. In addition, a board should be putting themselves in the mindset of an activist investor and considering what issues and strategies might an activist use to attack the board. The board should consider these vulnerabilities, anticipate likely lines of attack, and, to the extent possible, seek to remedy those weaknesses before a campaign starts.
Boards should also keep aware of the activist and takeover landscape in their sector, noting what activist funds are focusing on their industry. For example, activist funds, such as Guinness Oil and Gas Exploration Trust, have recently been established in the U.K. with an express focus on the oil and gas industry, and an increasing number of activist campaigns are being seen in this sector, such as the ongoing campaign by Crown Ocean Capital against the Edinburgh-based oil and gas exploration firm Bowleven. Boards should utilize advisors with a specific focus on activist situations and relevant sectors, to help them understand the tactics and approaches for dealing with activists, and the themes and issues being used by activists with respect to specific industries.
Skroupa: When responding to an activist, what is the downside of settling?
Dunbar: In the early years of shareholder activism in the U.S., boards were very defensive in responding to shareholder activism, often refusing to engage with activist investors and viewing them as aggressive short-term investors that were out to make a quick return. In many respects a target company might respond and seek to use tactics to wrong-foot an activist in the way target companies in the 1980s and 90s had responded to corporate raiders and hostile takeover situations. Institutional investors probably shared a similar view and this resulted in the majority of early activist campaigns and proxy contests being settled only at a shareholder vote. In recent years, the market perception of hedge fund activism has improved, with institutional investors occasionally working with activists as we noted above or at the very least publicly supporting issues raised by activists where they share a concern for example around executive compensation, corporate governance or strategy.
Boards have learned that you can’t just ignore activists and hope they will go away. As a result, the number of settlements with activists prior to a shareholder meeting has increased dramatically. For example in 2001, only 20% of proxy contests in the U.S. settled prior to the shareholder meeting. In 2016, 47% of proxy contests in the U.S. ended in settlements before the shareholder meeting. There are frequently good reasons for boards to settle, as long-running activist campaigns can be costly, time-consuming and distracting to the day-to-day operation of the business. However, we are now seeing increasing concern and skepticism from a significant number of institutional investors that companies are settling with activist investors too quickly and are not taking into account the views of their long-term investors to the same extent as the activist investor.
Institutional investors are increasingly concerned with companies that are too focused on settling with an activist hedge fund as quickly as possible. They realize that the short-term strategies of many activist investors are typically at odds with their own investment timelines and priorities. This is because the strategies of activist hedge funds are essentially “event driven” and are seeking to help bring about an event that will generate a high return for them as quickly as possible, such as a sale of the company, buy-back, split-off and/or return of capital. This focus on bringing about an event to generate a return in the short-term is likely to be at odds with the focus of long-term investors. As Laurence Fink, Chairman and CEO of BlackRock recently noted, “BlackRock engages with companies from the perspective of a long-term shareholder… advocacy and engagement have become even more important for protecting the long-term interests of investors.” A board that settles too soon risks alienating long-term investors.
A settlement with an activist typically includes an ability for the activist to nominate an individual to the board of the target. Particularly where such a person is an executive of the activist fund, this raises conflict of interest issues and potentially weakens the long-term position of the company due to the failure of many settlements to last beyond an initial standstill period. A year or so from the settlement when the standstill included in the settlement expires, the board will be in an even weaker position to respond to an activist where they have a nominee director involved in board meetings. Directors should not believe that simply having an activist on the board means that they will suddenly become more reasonable, can be persuaded of the strategy of management or will not become aggressively activist again in the future.
In the U.K., the example of Elliott and Alliance Trust is instructive. Elliott had recently renewed its activist stance, reportedly intending to oppose the appointment, recently announced by Alliance, of Willis Towers Watson as investment manager, even though Alliance had previously settled with Elliott and allowed executives from Elliott onto the board of Alliance. It is only with the proposed buy-back of Elliott’s shares that Alliance now hopes to move on from this episode.
Skroupa: So how should a board react beyond settlement?
Dunbar: Quick settlements are unlikely to be the right answer. A board should ensure that they remove any obvious weaknesses, such as corporate governance failings, that can be attacked by an activist and in respect of which institutional investors will not be able to defend the board. Directors should ensure that they engage regularly with their long-term investors and should not be afraid to debate the merits of their long-term strategy for the business. Long-term investors will be ready to support well-run companies, that meet corporate governance and executive compensation best practice, that engage well with all shareholders, and have a positive and convincing long-term business strategy.
Boards should still be willing to listen and meet with activist investors, and where suggestions are sensible, should be willing to implement them having obtained the views of long-term investors. Where common ground can be reached with an activist and it is decided to bring new experience onto the board, the focus should be on finding a truly independent non-executive director with relevant sector experience who can add a fresh perspective and experience to the board for the benefit of all shareholders in the company, and to avoid allowing executives of the relevant fund to be appointed but, if necessary, a company should be prepared to engage in a public proxy fight, having courage of their convictions, while ensuring the management remains focused on the day-to-day performance of the business. It will be very difficult for an activist to succeed against a well-run company that is supported by its long-term investors.