Memo co-author Martin Lipton. Photo by Hugh Williams.
A Wachtell Memo by Martin Lipton, Steven A. Rosenblum and Karessa L. Cain
Some Thoughts for Boards of Directors in 2015
The challenges that directors of public companies face in carrying out their duties continue to grow. The end goal remains the same, to oversee the successful, profitable and sustainable operations of their companies. But the pressures that confront directors, from activism and short-termism, to ongoing shifts in governance, to global risks and competition, are many. A few weeks ago we issued an updated list of key issues that boards will be expected to deal with in the coming year (accessible at this link: The Spotlight on Boards). Highlighted below are a few of the more significant issues and trends that we believe directors should bear in mind as they consider their companies’ priorities and objectives and seek to meet their companies’ goals.
Section 1 - Activism.
Companies today are more vulnerable to activist attacks than ever before. Over the past decade or so, several trends have converged to foster an environment that is rife with opportunities for activists to extract value. These include the steady erosion of takeover defenses, the expansion of the ability of shareholders to pressure directors, the increasingly impatient and short-termist mindset of Wall Street, and a regulatory disclosure regime that is badly in need of modernization to reflect the current realities of rapid stock accumulations by activists, derivative securities and behind-the-scenes coordination among activist hedge-funds and investment-manager members of “wolf packs.”
The number of activist attacks has surged from 27 in 2000 to nearly 250 year-to-date in 2014, in addition to numerous undisclosed behind-the-scenes situations. Activist funds have become an “asset class” in their own right and have amassed an estimated $200 billion of assets under management. In this environment, boards and management teams have been spending a significant amount of time preparing for and responding to activist attacks, and proactively considering whether adjustments to their companies’ business strategies are warranted in order to avoid becoming a target.
Three decades of campaigns by public and union pension funds, Institutional Shareholder Services (ISS) and Council of Institutional Investors (CII), and their academic and corporate raider supporters, have served to promote majority voting standards, eliminate rights plans, declassify boards and otherwise shift power to shareholders.
This, in turn, has precipitated important changes to the governance landscape and played a key role in laying the groundwork for today’s activism. Yesterday’s corporate governance crusades have turned an evolutionary corner in the last few years, to morph into the heavyweight attacks of today where entire boards of directors are ousted in proxy fights and a 3% shareholder can compel a $100+ billion company to accommodate its demands for spin-offs, buybacks and other major changes.
The proliferation of activism has prompted much reflection and revisiting of the basic purpose and role of corporations. As recently stated by the Financial Times’ chief economics commentator Martin Wolf, “Almost nothing in economics is more important than thinking through how companies should be managed and for what ends.” Activist attacks vividly illustrate what is truly at stake in corporate governance debates—such as how to balance demands for stock prices that are robust in the short term without sacrificing long-term value creation, and whether maximization of stockholder value should be the exclusive aim of the corporate enterprise. The special agendas, white papers and “fight letters” of activists are anything but subtle in framing these issues and have direct, real-world implications for the future paths of the corporations they target as well as the futures of employees, local communities and other stakeholders.
In short, the rapid rise in the number of activist attacks, the impact they are having on U.S. companies and the slowing of GDP growth, have added a new spark and sense of urgency to the classic debate about board- versus shareholder-centric models of corporate governance: who is best positioned to determine what will best serve the interests of the corporation and its stakeholders?
In this regard, a key question is whether activists actually create value. It is clear that many activists have produced alpha returns for themselves and their investors. Pershing Square, for example, realized an estimated $1 billion gain on its investment in Allergan on the day that Valeant announced its takeover offer for Allergan, and will reap an estimated $2.6 billion profit as a result of Actavis’s pending acquisition of Allergan. However, it is far from clear that activists have more insight and experience in suggesting value-enhancing strategies than the management teams that actually run the businesses, or are more incentivized than boards and management teams (whose reputations, livelihoods and/or considerable portions of personal wealth tend to be tied to the success of the company) to drive such strategies. By way of comparison, the management and operational changes that Pershing Square advocated for J.C. Penney had disastrous results for the company and Pershing Square realized steep losses on that investment.
Moreover, to the extent that activists do precipitate stock price increases, a further question is whether such gains come at the expense of long-term sustainability and value-creation. To be sure, some activists tend to engage in a more constructive form of advocacy characterized by a genuine desire to create medium- to long-term value. However, the far more prevalent form of “scorched-earth” activism features a fairly predictable playbook of advocating a sale of the company, increased debt or asset divestitures to fund extraordinary dividends or share buybacks, employee headcount reductions, reduced capital expenditures and R&D and other drastic cost cuts that go well beyond the scope of prudent cost discipline.
The experience of the overwhelming majority of corporate managers and their advisors is that attacks by activist hedge funds are followed by declines in long-term future performance, and that such attacks (as well as proactive efforts to avoid becoming the target of an attack) result in increased leverage, decreased investment in capital expenditures and R&D, employee layoffs and poor employee morale. A number of academic studies confirm this view and rebut the contrary position espoused by shareholder rights activists who believe that activist attacks are beneficial to the targeted companies and should be encouraged. For example, a recent report by the Institute for Governance of Private and Public Organizations concludes: “[T]he most generous conclusion one may reach from these empirical studies has to be that ‘activist’ hedge funds create some short-term wealth for some shareholders as a result of investors who believe hedge fund propaganda (and some academic studies), jumping in the stock of targeted companies. In a minority of cases, activist hedge funds may bring some lasting value for shareholders but largely at the expense of workers and bond holders; thus, the impact of activist hedge funds seems to take the form of wealth transfer rather than wealth creation.”
The debate about whether activists create value underscores one of most critical factors in determining the outcome of activist attacks and the future direction of this trend: credibility. Starting with the Enron debacle and culminating in the financial crisis, the public confidence level in boards was impaired and shareholders became generally more skeptical of their oversight effectiveness. Activists, in espousing the virtues of good corporate governance and shareholder rights, gradually rebranded and cleansed themselves of the raider stigma of the 1980s and gained mainstream credibility with shareholder rights proponents, the media, institutional investors and academia.
And some activists clearly have more reputational capital than others. As hedge funds of varying degrees of firepower and sophistication have sought to claim the activist label, it is clear that not all activists have the same playbook, track record or approach to dealing with companies. These macro trends boil down to specifics in each proxy fight, with the key questions being whether management and the board can articulate a credible and convincing case for the company’s business plan and demonstrate the results of that plan, and whether institutional investors will support a long-term growth strategy despite the allure of more immediate results.
Against this backdrop, it is essential that boards not be unduly distracted from their core mission of overseeing the strategic direction and management of the business. Directors should develop an understanding of shareholder perspectives on the company and foster long-term relationships with shareholders, as well as deal with the requests of shareholders for meetings to discuss governance, the business portfolio and operating strategy. Directors should also work with management and advisors to review the company’s business and strategy with a view toward minimizing vulnerability to attacks by activist hedge funds.