Activist Shareholder Proxy Contests — Who Controls Long-Term Strategy?

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ACTIVIST SHAREHOLDER PROXY CONTESTS — WHO CONTROLS LONG-TERM STRATEGY?

By Gary D. Gilson*

INTRODUCTION Corporate strategy is set by senior management and boards of directors. Traditionally, shareholders chose to either accept or reject that strategy by buying or selling shares throughout the year. Historically, the greatest threat to a company’s existing strategy was a corporate raider that might offer a premium for all outstanding shares in order to take control and change the strategy. Now, the greatest threat to maintaining a corporate strategy is having an activist shareholder launch a proxy campaign to elect some or all of the target’s board. Compared to traditional takeover bids, these sophisticated campaigns require relatively modest investments to obtain substan- tial influence over the target. After buying as little as two or three percent of the target’s outstanding stock, activists seek to fuel the campaign with aggressive criticism of the board and its strategy to influence other investors. An activist shareholder whose nominees are elected to the board can strongly influence, or effectively control, the target company without purchasing any additional shares, without payment of a control premium to existing shareholders and, if the board seats are received in settlement of a proxy contest, without receiving a single vote in an election of directors. The board and management of the target corporation should under- stand that effective control of the corporation is as much at risk when facing an activist board campaign as when facing a traditional takeover bid. However, the ground rules and tactics for these proxy contests differ from those of traditional takeovers, making most typical takeover defenses of little value. To maintain control of long-term corporate strategy today, boards and senior management must revisit and revitalize corporate strategy, and effectively communicate it to the investment community in a manner that inspires a high level of confidence in their leadership. Determination and implementation of long-term strategy requires effective teamwork between outside directors and management. The presence of an activist shareholder places significant pressures on the working

* Gary D. Gilson is a senior partner with Husch Blackwell Sanders LLP and is the head of its Securities and Mergers and Acquisitions Department. He has 27 years of experience in mergers and acquisitions, including multi-billion dollar public company mergers and private equity consolidation programs; capital formation transactions, including public offerings and private placements of debt or equity; and counseling boards and senior management on fiduciary duties and governance issues, including complex matters such as going private transactions, recapitalizations, proxy contests and takeover strategies. He would like to acknowledge the assistance of Kirstin P. Salzman and Kate E. Milberger in the preparation of this article. He may be contacted at [email protected].

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620 BLOOMBERG CORPORATE LAW JOURNAL [Vol. 3:619 relationship between management and a board of directors. The focused public criticism of an activist board campaign can easily divide directors from management, leaving a leadership void for the activist to fill. The attention of an activist shareholder is best avoided through pre- emptive action. When performance lags, long-term strategy should be re- examined and, of course, steps should be taken to improve performance before an activist appears. Effectively communicating the steps taken to enhance shareholder value and the attributes of the current long-term strategy will help discourage activist involvement and maintain shareholder confidence. While corporate governance best practices frequently receive attention in this process, the overriding issue is shareholder value – how best to attain it and whether it is more likely to be delivered by the current board or by a reconstituted board led by the activist shareholder.

ACTIVIST SHAREHOLDERS The type of activist shareholder that is willing to wage a battle for control is most often a hedge fund seeking high returns on short-term investments, unlike the cause-focused activists who champion shareholder resolutions on particular issues such as executive compensation or trade with certain countries. Hedge funds are investment pools that are typically open only to institutional investors and high net worth individuals. Several current hedge fund founders, including Nelson Peltz and Carl Icahn, participated actively in traditional takeover battles before forming activist hedge funds. The universe of hedge fund types has increased in number and size in recent years. They represent a growing portion of the institutional investor universe. It is estimated that in September of 2007 there were over nine thousand hedge funds with over $1.8 trillion in net assets.1 Within the larger universe of hedge funds there exists a subset of hedge funds which have emerged as activist shareholders. These funds tend to seek higher short-term returns on a limited number of investments. Over seventy-five hedge funds can be characterized as activist funds and this group is estimated to hold around $50 billion in net assets in the United States alone.2 They take positions in public companies and strive to become change agents, seeking to force liquidity events. Although activist shareholders often advocate corporate governance best practices and shareholder rights, their real focus is short term returns from special dividends, large stock buyback programs and sales of entire companies. This differentiates them from other hedge funds and institutional shareholders. Delivering the types of corporate liquidity events necessary to achieve such returns requires a high degree of control or influence over a corporation’s board of directors.

1. Growth of Hedge Funds, 2007 Databook, PENSIONS & INVESTMENTS, December 24, 2007. 2. Damien Park, The Year of the Activist Hedge Fund, FINALTERNATIVES, March 11, 2008. \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 3 6-OCT-08 9:23

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Recently, another form of activist shareholder has emerged - a hy- brid between the cause-focused activist shareholder and the short-term return focused activist shareholder. This category of activist shareholder, the “social media activist,” focuses both on particular issues like a cause- focused activist and also drives for higher short-term returns. The social media activist utilizes media exposure to get other shareholders to support its campaign. An example of a social media activist shareholder is Eric Jackson, who used Internet, web-media tools and traditional media coverage to put pressure on CEOs at both Yahoo! and Motorola. Eventu- ally, both CEOs resigned. An activist shareholder has primarily two weapons to strengthen its campaign. The first is financial resources and the second is media exposure. The use of financial resources can be observed in the traditional Carl Icahn approach to launching an activist shareholder campaign. In this approach the activist shareholder uses its financial backing, or as some refer to it “war-chest,” to acquire equity in a company, yielding more voting power and a larger voice in the company’s decision-making process. The second weapon of media exposure has been recently broad- ened and developed by Eric Jackson. In this approach the activist shareholder uses forms of social media to “rally the shareholder troops” to adopt the same opinion and pledge to vote the same way on a company decision.

TARGET COMPANIES Target companies are usually companies listed on a national securities exchange, although widely held unlisted companies are subject to similar attacks by anyone able to purchase a few shares of their stock. Vulnerable companies tend to fall into three categories: (1) well-run companies that have excess cash or debt capacity available for special dividends or large stock buy-back programs; (2) companies that perform below their peer group that might be easily sold or broken up so that shareholders receive sale proceeds, dividends or stock buybacks; and (3) companies that have announced friendly mergers or acquisitions, where the activist can criticize the sale price as inadequate and threaten to block the deal or start a bidding war. Forcing liquidity events produces the type of relatively quick returns on investment sought by hedge funds.

ACTIVIST SUCCESS RATE Activist shareholders have enjoyed a very high success rate because they select vulnerable targets and plan aggressive campaigns before purchasing equity positions and launching election bids. The Altman Group estimated that activists won fifty-seven percent of the 108 proxy contests tracked in 2007.3

3. Paul Schulman, Executive Managing Director, The Altman Group, Inc., Proxy Trends and Corporate Governance Updates (June 2, 2008). \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 4 6-OCT-08 9:23

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Proxy advisory firms and their institutional shareholder clients often feel activists bring a fresh perspective and new ideas to an incumbent board and generally expect their presence on the board to be a positive development. However, the appetite for change dissipates when the proxy battle is for control of the entire board. One study showed the activists were successful only about twenty percent of the time when at- tempting to elect the entire board, as contrasted with attempts to elect only one class of a staggered board, where they were successful seventy- seven percent of the time. Impending changes to the proxy rules may further improve the success rate of activist shareholders. Proposed changes to NYSE Rule 452 (ending broker discretionary votes for director elections),4 along with the majority voting movement, will make it more difficult to garner pro-management votes. Historically, proxy solicitor The Altman Group estimated that no more than one-third of the individual shareholders (who tend to favor existing company leadership) vote or grant proxies.5 According to Broadridge, the recently adopted notice and access proxy model has further decreased individual shareholder participation.6

SUCCESSFUL DEFENSES Despite the statistics, it is possible to defeat activist board election campaigns if a company focuses on explaining how their current strategy will maximize shareholder value and highlighting any deficiencies in the activist’s proposal. The following are some examples of how this strategy worked: • When a hedge fund activist nominated four candidates to the board of directors of Luby’s, Inc., the company re- sponded by clearly communicating the qualifications of the board’s nominees and the board’s long-term value orientation. Then, their platform and candidates were contrasted with the lack of relevant industry experience, potential con- flicts of interest, and short-term profit orientation of the activist slate. The activist slate was defeated. Yet on the day of the election, Luby’s announced it would declassify its board of directors, making it possible to replace the entire board at the next election if shareholders were not pleased with their strategy and performance during the next year.

4. NYSE Euronext, Proposal to Eliminate Discretionary Broker Voting for the Election of Directors – Rule 452 (October 24, 2006), available at http://apps.nyse.com/commdata/ pub19b4.nsf/docs/A2CC4C68070815068525721100589E90/$FILE/NYSE-2006-92.pdf; see also Report and Recommendations of the Proxy Working Group to the New York Stock Exchange (June 5, 2006), available at http://www.nyse.com/pdfs/REVISED_NYSE_Report _6_5_06.pdf. 5. A Perfect Proxy Storm, Corporate Secretary Guide, August 2007, at v. 6. Broadridge Financial Solutions, Inc., Notice & Access: Statistical Overview of Use with Beneficial Shareholders, June 30, 2008. \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 5 6-OCT-08 9:23

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• After taking a position in Biogen Idec in 2007 and criticizing attempts to sell the company, activist Carl Icahn offered to buy it and nominated a competing slate of director nominees. In June, 2008, Mr. Icahn’s nominees lost their bids and all company nominees were elected. The major proxy advisory firms PROXY Governance, RiskMetrics Group/ISS Gov- ernance Services and Glass, Lewis & Co. all endorsed the Bio- gen Idec nominees and recommended that clients not vote for Mr. Icahn’s nominees. PROXY Governance cited the five- year track record of management and the board, their commitment to certain performance targets and to delivering shareholder value. Biogen Idec posted on its website a video of their director nominees discussing their commitment to delivering shareholder value. The report from RiskMetrics stated that Mr. Icahn had not demonstrated that change was warranted. It went on to note that Biogen had outperformed its peers in terms of total shareholder return and that the industry analyst consensus was that Biogen had performed well strategically.

THE PROXY BATTLE PROCESS Activist shareholders select target companies that appear susceptible to criticism, and use the element of surprise to their full advantage. Activ- ists have the added advantage of being able to criticize company performance without having had to operate the company profitably themselves. Instead, an activist is able to promise future rewards based on its track record of obtaining impressive returns for shareholders on unrelated investments. Struggling companies are often surprised and caught off guard when an activist emerges from among their shareholders. If the activist’s alternative strategy is not in the best interests of the company, an extraordinary effort will be required of management and the board to overcome the activist’s tactical advantage. Understanding the process and taking steps to guard against attempts to take control of the company are necessary if a board is to observe its fiduciary duties and protect shareholder interests. Vigilant examination of current strategy and an aggressive shareholder education campaign are essential to this effort. Target Selection. It is nearly impossible to detect that an activist is considering a target company and beginning to lay the groundwork for a proxy contest. The target company will be unaware that its financial fun- damentals, operating results and strategic plans are being analyzed. The activist will also examine stock analyst reports on the target and try to determine the level of shareholder satisfaction with the current management and board of directors. Becoming a Shareholder. Some activist shareholders use their financial strength to acquire significant equity in the target, increasing their voting power. The more equity an activist purchases, the larger the potential profit from any subsequent liquidity event. However, activist shareholders \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 6 6-OCT-08 9:23

624 BLOOMBERG CORPORATE LAW JOURNAL [Vol. 3:619 do not need to acquire any certain percentage of company stock. To give their campaign credibility, they only need to hold a number of shares that will be viewed as meaningful by other shareholders. If they are able to convince the target’s large shareholders to vote for their candidates, they needn’t invest any further. Various strategic considerations may also limit the size of the activist’s initial equity position. If the activist acquires more than five percent of the outstanding stock, or forms a “group” of investors who together own more than five percent, then Section 13(d) of the Securities Exchange Act of 1934 and Rule 13d-1 will require the activist to file a Schedule 13D within ten days of the purchase.7 In this filing the activist must disclose its stock position and intentions vis-a-vis` the company. This, of course, would alert the world to the activist’s plans, which would likely increase the market price of the stock, making accumulation of additional stock more expensive. It would also give the target more time to prepare a defense. Accordingly, it is not unusual for an activist to stop, or to pause, its stock accumulation at 4.9%. A recent example is Firebrand Partners, which halted its purchases at this level as it prepared to nominate four directors to the board of The New York Times. Occasionally, hedge funds work together in a parallel fashion. In these situations, one fund merely announces its ownership and intentions, and other funds simply follow without agreeing to act in concert with the activist fund. When this happens, the resulting de facto group is not required to file a Schedule 13D. These “wolf pack” tactics have been used successfully in some very high profile battles, resulting in, for example, the 2006 settlement between Time Warner and Carl Icahn. If, however, hedge funds agree to act in concert with regard to investment decisions and share ownership, they are required to file a Schedule 13D disclosing their holdings and that they are acting as a group. Recently, the penalty for failing to file a Schedule 13D was called into question when two hedge funds acted in concert to accumulate CSX Corp. stock and nominate a hostile slate for the CSX board. When CSX brought suit for violation of the Schedule 13D rules seeking to “sterilize” the voting rights of the stock and disqualify the proxies solicited by these funds, the District Court found that the funds had violated the Schedule 13D rules by not disclosing the formation of a group. The court issued a permanent injunction against further violations, but ruled that it did not have the authority to keep the shares from being voted, instead deferring to the SEC. This decision is on appeal; however, based upon preliminary voting results, representatives of the funds have been invited to join the board of CSX. Acquiring more than ten percent of the outstanding stock would require the activist to file a Form 3 under Section 16 of the Securities Ex- change Act of 1934 and become subject to its short swing profit recovery

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2008] ACTIVIST SHAREHOLDER PROXY CONTESTS 625 provisions.8 These provisions force disgorgement of any profit on shares held less than six months, and thus make it difficult for the activist to liquidate its position in the event its election bid is abandoned or defeated. Further acquisitions of stock may approach the trigger for any shareholder rights plan the target may have, or the thresholds for applicable state takeover statutes. Hart-Scott-Rodino Antitrust Improvements Act filing requirements will also become an issue if an activist’s stock position becomes large enough.9 Empty Voting. Notwithstanding the number of shares an activist may disclose that it owns, it is possible to cast more votes than shares held. The separation of stock voting rights from economic value, so called “empty voting,” has received increased attention in recent years. Empty voting may occur in a variety of circumstances, including through share lending and buying and selling stock after the record date. Because empty voting is difficult to track, it is impossible to determine how widespread the prac- tice is. Empty voting has received recent criticism because of its potential negative effects, including shareholder confusion, over-voting and the potential to influence voting in a manner inconsistent with shareholders’ long-term interests. In the recent CSX battle, voting rights were separated from beneficial ownership through the use of total return equity swaps, a cash settled derivative that gives one counterparty all the incidents of stock ownership except the right to vote the shares. The lack of voting rights was used as justification for not disclosing an ownership position. The other counterparty retains the right to vote the shares, but this party is often beholden to the counterparty, and inclined to vote as the counterparty would vote. In the CSX proxy battle, two hedge funds accumulated ownership of more than five percent of the outstanding stock (other than voting rights) using total return equity swaps, yet did not disclose their holdings. The SEC supported the approach taken by the hedge funds during litigation over their failure to disclose their holdings, although several in Congress have asked it to review its position on these instruments. Another prominent attempted use of empty voting occurred in the proposed acquisition of King Pharmaceuticals by Mylan Laboratories. Perry Corporation, a large hedge fund, held a significant stake in King and supported the consummation of the proposed acquisition. When Carl Icahn acquired 9.9% of Mylan stock and opposed the merger, Perry acquired an equivalent empty voting position in Mylan to offset Icahn’s interest. Thus, the Mylan votes cast by Perry were influenced by their stake in King and not by any economic interest in Mylan.

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First Contact. The requirements of a company’s bylaws often trigger the first notice that it is the target of an activist shareholder. Many companies have bylaw provisions requiring forty-five to sixty days advance notice prior to nomination of director candidates. Absent a notice provision in its bylaws, a target company might not learn about an activist’s nominations until proxy materials are filed four to six weeks prior to the annual meeting. That, of course, would leave company leadership scrambling to prepare responsive proxy filings and an effective informational campaign responding to the activist’s agenda. Advance notice bylaw provisions also preclude the activist from changing nominees after the notice deadline. In certain cases, an activist may choose to communicate with the target company before it is required to do so. Using a less aggressive strategy, the activist might arrange contact through an intermediary or send a private letter seeking some level of cooperation and settlement negotia- tions. A more aggressive strategy, one that puts the target immediately on the defensive, would involve sending a critical letter to company leadership and simultaneously publishing it in a press release. Campaign Platform. The activist usually emerges with a well-publi- cized campaign platform that both criticizes the past performance of the current board and management and suggests promising methods to increase shareholder returns. Leadership of underperforming companies should expect to be criticized for underutilization of significant assets, excessive expenses, ineffective deployment of capital, failure to sell un- needed assets and the like. For example, in its campaign for representa- tion on the board, K Capital criticized Sun-Times Media Group for lack of a detailed operating plan with clear targets, excessive executive cash compensation and failure to complete a share repurchase program. Activists employ additional criticisms, often based upon current corporate governance topics, such as compensation, majority voting, or a de- staggering of the board, designed to give their platform a tone of moral superiority. Media and stock analysts will be drawn to the contest by the activist’s promised changes. The activist platform will likely reflect criticisms of the company previously published by stock analysts. Often, analysts rapidly adopt and strongly advocate the activist’s platform, even if they have historically been very supportive of management. Web-Based Campaigns. Recently, activist shareholders have used the Internet as a medium for furthering their campaigns. These shareholders use websites, blogs, and internet social networks, such as Facebook, MySpace, and YouTube, to convey their message. Eric Jackson pioneered this use of the Internet when he started the first Internet-based activist shareholder campaign revolt against Yahoo! in January 2007. He launched his campaign on his blog, “Breakout Performance,” and later utilized YouTube videos, a Facebook group for Yahoo! shareholders, and \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 9 6-OCT-08 9:23

2008] ACTIVIST SHAREHOLDER PROXY CONTESTS 627 a website to further his agenda. Jackson later did the same thing in July of 2007 with a campaign targeting Motorola’s CEO. Shareholder Base. Once an activist’s presence is announced, the company’s shareholder base will begin to change. Even if they are not participants in a wolf pack, other hedge funds, arbitrageurs, and opportunist investors will be attracted by the possibility of a liquidity event and take positions in the stock. Attention in the marketplace and the change in strategy promised by the activist creates buying pressure and increases the price of target company stock. At the same time, activist criticism of leadership may decrease expectations for near-term performance. Either of these developments may encourage current shareholders to sell. As exiting shareholders are replaced with opportunity funds and arbitrageurs, the target’s shareholder base becomes less sympathetic to company leadership. Preserving the shareholder base against this erosion requires confir- mation or revision of the long-term strategy, and aggressive communication with shareholders to educate them about the strengths of the company strategy and the flaws in the activist strategy, as discussed below. Company Proxy Battle Strategy. The importance of the proxy contest should not be underestimated. Even if the election involves only one class of a classified board, effective control of the board is often at stake. If the activist’s slate is elected, it will likely take office with a shareholder man- date and the strategic ideas upon which they campaigned will assume le- gitimacy that commands support from incumbent directors. While the target company has no obligation to react to activist campaign statements, failing to address activist campaign issues is an ex- tremely risky strategy. Stonewalling creates suspicion in the investment community, and it allows activist allegations to fill the communication void, lending additional credibility to the activist’s allegations. To avoid losing effective control, company leadership must take decisive steps to respond to the activist’s challenge. A typical proxy defense is built of three components: (1) a candid assessment of the existing company strategy and the proposed activist strategy; (2) development of message from the company stating the advantages of the current strategy and the shortcomings of the proposed activist strategy; and (3) delivery of that message in the proxy battle. Candid Assessment of Strategies: The first step in proxy battle defense is to candidly assess the current company strategy. Which aspect of the strategy is being criticized? Is the criticism valid? What may have worked well about the strategy, and what has not worked well? Is the strategy still appropriate given the current environment or should it be modified? Are there better ways to deliver value to shareholders? Would it be appropriate to undertake a liquidity event at this time, such as a special dividend, the sale of a division, or a special share repurchase? Similarly, the strategy proposed by the activist must be thor- oughly and objectively assessed. Would it be a better way to de- \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 10 6-OCT-08 9:23

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liver value to shareholders given the current position of the company, its competition and its operating environment? Does it emphasize a short-term return at the expense of long-term value? Is the strategy likely to be effective given the current circumstances of company? Development of the Company’s Message: The board of the company and management get little credit for the current long- term strategy if shareholders are not aware of the strategy and how it is designed to maximize shareholder value. The most important weapon available to leadership in the proxy battle is the substantive case supporting its long-term strategy and explaining company performance. This message is essential to any positive election outcome or settlement. Everyone on the proxy contest team—public relations advisors, investor relations advisors, financial advisors, proxy solicitors and legal advisors—should par- ticipate in development of the message. It should be drafted for a fairly broad audience, including institutional and retail shareholders, analysts, proxy advisory firms and the media. The message should convey the assessment and evaluation of strategies discussed above. It should explain the current long- term strategy, why performance has not met expectations, the changes considered or implemented in response to the lackluster performance, any anticipated changes to the long-term strategy and the reasons to question the activist’s strategy. The proxy battle will be determined by the confidence large shareholders have in the long-term strategy and vision of current leadership. A strong, effective articulation of a promising and realistic strategy will reassure shareholders. Without a compelling case, shareholders may be expected to vote against leadership either by selling shares before the election or by granting proxies for election of the activist candidates. Delivering the Message in the Proxy Battle: The delivery of the message must take into account the activist campaign platform, company operating results and current financial position, shareholder expectations and the voting guidelines of proxy advisory firms. Corporate governance campaign issues will likely receive considerable attention, but in the minds of activists and most shareholders these issues carry less weight than maximiza- tion of shareholder value. In some cases, the message will be delivered more effectively using a measured communication tone, while in others a more aggressive, critical posture will be most effective. It will be important to control the public campaign dialog to the greatest extent possible, noting that activist shareholders are generally viewed as being aggressive by nature. Each of the following elements is an important part of an effective defense strategy. • Investigation. Leadership will need as much information as possible regarding the activist slate of nominees, both for crafting a proxy battle strategy and to assess the nominees as potential board members. The board and management \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 11 6-OCT-08 9:23

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have a duty to examine new candidates and to provide shareholders with information relevant to their vote. In this regard, it may be appropriate to consider a private investigation report on the activist slate of nominees. The company might consider requesting a meeting with the activist at an early point in the process. Although a meeting is unlikely to defuse the activist’s proxy campaign, it may reveal information about the motivations be- hind the activist’s alternative strategy. The willingness of leadership to consider alternative strategies will be viewed positively by the investor community. Meetings with the activist raise the issue of confidentiality agreements. Without one, only publicly available information may be discussed. With a confidentiality agreement, an open and frank discussion of the company and its current prospects can take place. Unfortunately, activists seldom agree to execute confidentiality agreements because doing so hampers their ability to sell their stock. An activist in possession of material non-public information about the target company may not buy or sell company securities in the market until the marketplace has access to that information. If a confidentiality agreement prevents that disclosure, the activist is effectively forced to retain its stock position. • Communications. Public relations and investor relations advisors will suggest attempts to control the public dialog with the activist, and will normally discourage reactive responses to activist criticisms. However, the defense strategy usually includes one or more “fight letters” mailed to the shareholders, published in press releases and filed with the Securities and Exchange Commission. An ongoing series of company communications will be more effective than one comprehensive position statement. It is not unusual for a target company to issue a fight letter each week. In addition to fight letters, specific presentations will be prepared for proxy advisory firms and large shareholders. The communication strategy may also call for newspaper adver- tisements, blogs, or white papers on pertinent issues or suggested newspaper articles. Increasingly, the Internet is being used to disseminate information and facilitate discussion among shareholders of a company. Individual shareholders perceive electronic forums as a reliable means to educate and inform themselves and become more sophisticated investors. It would be wise for management and boards of companies to take heed of this trend and consider utilizing company spon- sored web tools as defensive tactics against activist shareholders. Electronic forums can be effective and are inex- pensive in communicating the board’s or management’s position on a company decision. Management and boards \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 12 6-OCT-08 9:23

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should, however, realize that the Internet and other electronic mediums of communication are an additional form of communication as opposed to a substitute means of communication. In addition, care must be taken to comply with any applicable filing requirements, as discussed below. The public relations advisor should monitor filings by and communications from the activist to allow any necessary adjustments in strategy. Depending upon the accuracy of statements made by the activist, a target company may consider sending a “bed bug” or “poison pen” letter to the staff of the Securities and Exchange Commission sug- gesting that the activist be required to correct or moderate incorrect or exaggerated statements. Meetings with large shareholders and proxy advisory firms to discuss the campaign issues are an important part of the information campaign for both company leadership and the activist. An experienced proxy solicitation firm can prove invaluable in identifying current shareholder ownership positions and in setting meetings with existing and new shareholders. These firms also are often able to gather information about how shareholders have voted in other recent proxy contests. • Proxy Advisors. A proxy solicitor can provide a useful indi- cation of how closely various institutional shareholders follow proxy advisory firm recommendations. RiskMetrics (formerly ISS) is said to have influenced as many as twenty to twenty-five percent of the votes cast in an election.10 Their process is to meet with both company leadership and the activist several weeks ahead of the shareholder meeting. The meetings provide each side with an opportunity to state their positions on the issues in question. Pres- entation materials for these meetings are filed as proxy solicitation materials and are available to the other side, so meetings with the two sides are often scheduled close in time to avoid giving one side a preparation advantage. RiskMetrics typically issues its recommendation approxi- mately two weeks before the vote. Some proxy advisory firms will not meet with either company leadership or activists in connection with their recommendation. • Board Participation. No matter how involved the target company board has been historically, a successful campaign requires the committed engagement of the target board. Ac- tivist campaigns frequently target past strategic decisions made by the board and the board must be involved in defending those decisions. Board members should partici- pate in development of the current long-term strategy, the proxy battle strategy, and the company’s message to share-

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holders. The board must receive regular reports on proxy battle developments and should have opportunities to de- liberate as necessary to maintain unanimity on the proxy battle strategy (including any settlement discussions). Throughout the proxy battle, the board should re- main fully versed on the nuances of their fiduciary duties, as well as article and bylaw indemnification provisions and insurance coverage. Board members should expect and prepare for questions about whether their fiduciary duties have been observed. While election contests do not give rise to damage claims, as do traditional buy-out proposals, directors will rely upon indemnification and directors and officers insurance to cover attorney’s fees in the event of litigation. Directors will want to know that the company has a mandatory, rather than permissive, indemnification provision and that it must advance defense expenses as they are incurred rather than await the final outcome of the litigation. Directors will prefer to have indemnification agreements with the company to assure that indemnification provisions and insurance coverage are not terminated in the event control of the company changes. In some situations, independent directors may desire to have their own independent outside counsel. In that case, additional focus on communication and deliberation will be required to avoid divergent views on long-term strategy and the proxy contest strategy. Different perspec- tives on these strategies would work to the distinct advantage of the activist in the proxy battle or in any settlement. • Proxy Filings. Management and the board must carefully consider the proxy filing requirements when communicating with shareholders during a proxy battle. Because of the broad definition of “solicitation” under federal securities laws, any communication with shareholders should be analyzed to determine if securities laws are implicated. The term “solicitation” is broadly defined as any communication made under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy, which should not include general press releases and other communications relating to business and financial matters.11 But, it may include any communications made outside the ordinary course and thus management and the board should be cautious in all communications with shareholders during a proxy battle. Any “solicitation” made before shareholders have been sent a publicly-filed definitive proxy statement must: (1) not include a form of proxy card; (2) if written, con- tain legends with specified information about participants in the solicitation and the availability of a proxy statement;

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and (3) if written, be filed with the Securities and Ex- change Commission and the appropriate securities exchange no later than the date the material is first published, sent or given to shareholders.12 Oral communications need not be reduced to writing and filed. Solicitations made after the preliminary proxy statement is filed, but before the definitive proxy statement is dissemi- nated must also specify that a preliminary proxy statement is publicly available. After the dissemination of a definitive proxy statement, all written solicitation material must be filed with the Securities and Exchange Commission in definitive form on the date of first use.13 The Securities and Exchange Commission’s February 2008 announcement and proxy filing amendments have provided flexibility in electronic communications. Gener- ally, an electronic communication in an electronic forum would be a proxy solicitation, but the Securities and Ex- change Commission has declared that they are exempt from the proxy rules as long as the communication is made more than sixty days prior to the next meeting of shareholders.14 Further, those that operate electronic forums are not liable for other members’ statements.15 • Settlement. Throughout any proxy battle, the best interests of the shareholders must, of course, be paramount. At times, offering to settle the proxy battle by agreement prior to the election may be in the best interests of the shareholders. However, this idea can be difficult for the board and management to embrace, especially if the battle has become heated or somewhat personal in nature. Set- tlement avoids a great deal of expense for each side and provides a certain, if not totally favorable, outcome. Early in the contest, each side will place higher value on the cer- tainty afforded by settlement. Later in the process, either side may believe their prospects for a successful election are greater and therefore be unwilling to agree to any settlement. In settlement, the target company usually offers to ap- point or support the election of some number of candidates from the activist slate to the board and some of its key committees, and to reimburse a certain amount of the activist’s expenses. The company may also agree to take designated steps toward profitability, or to take certain actions to provide a return to shareholders, such as selling certain assets and distributing the proceeds to shareholders or conducting a self-tender. Additionally, it may agree to address certain governance related matters such as cre-

12. 17 C.F.R. § 240.14a-12. 13. 17 C.F.R. § 240.14a-6(b). 14. 17 C.F.R. § 240.14a-2(b)(6). 15. 17 C.F.R. § 240.14a-17(b). \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 15 6-OCT-08 9:23

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ating a non-executive chairman or lead director, removing supermajority voting provisions, increasing or decreasing the size of the board or eliminating staggered board provisions. Activists, on the other hand, typically agree to with- draw their director nominations and to drop their proxy solicitation. Additionally, they often agree to confidentiality and non-disparagement provisions and a standstill prohibiting further stock accumulation or transactions with the target. Both parties also agree to dismiss any pending litigation against the other relating to the proxy battle. Examples of prominent settlements in recent years include the 2006 settlement between Time Warner and Carl Icahn and other activist investors in which Time Warner agreed to a $20 billion stock buyback, cost cutting and the nomination and election of two new independent directors; and the 2007 settlement between Home Depot and Relational Investors in which David H. Batchelder, a Rela- tional Investors principal, was given board and committee seats and four directors agreed to leave in 2008. As discussed in the next section, when considering whether to offer board seats in a settlement proposal, the board must candidly consider the impact of the individuals involved upon the working dynamic of the board and its subsequent effectiveness. A voluntary settlement with an activist can result in the loss of control over long-term strategy and disruption of the working dynamic among the board and management, presenting risks to shareholder value. • Timeline and Meeting Mechanics. After a proxy battle is announced, the upcoming shareholder meeting timeline will need to be re-examined. Additional time will be required for such steps as reviewing long-term strategy, responding to the activist campaign, preparing the contested proxy statement and its review by staff of the Securities and Ex- change Commission, and developing responses to staff comments. The framework of the meeting timeline is dic- tated by state corporate law, which controls such matters as the setting of meeting dates and record dates, the ability to adjourn or postpone the meeting and the selection of election inspectors. One benchmark on the timeline that is of particular strategic concern is the record date for determination of shareholders entitled to vote at the meeting. Only those shareholders who own stock on the record date are entitled to vote at the subsequent meeting, whether or not they continue to own that stock at the time of the meeting. The record date for a shareholder meeting normally oc- curs forty-five to sixty days before the meeting. After the initial meeting date and record date have been set, the \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 16 6-OCT-08 9:23

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board may reschedule them, but doing so may work to the advantage of the activist. From the time the proxy battle is announced, the percentage of target company shareholders who are sympathetic to the activist will likely grow. Re- setting the record date to a later date would increase the number of shareholders who will vote against current leadership. As the shareholder meeting nears, the level of activity will increase significantly. The last fight letters will be re- leased, proxy solicitors will canvas shareholders, and final meeting arrangements will be made under the watchful eye of the activist. Even determination of shareholder meeting logistics will become competitive in nature. Most institutional investors will grant proxies in the last twenty- four to forty-eight hours before the shareholder meeting. Both sides will focus intently upon the granting and exer- cise of proxies. Election Results. If possible, preliminary election results will be announced at the shareholder meeting, subject to final certification by the election inspectors, a process that may take several weeks. If the activist slate is not elected, the activist still retains its stock position and may either sell it or hold it and return for another proxy battle the next year. If elected, the activist slate of directors will take office promptly after election results are certified. An unintended victim of proxy battles can be effective board dynamics. Institutional investors and proxy advisory firms are willing to elect one or two activist nominees to a board in order to “shake things up.” At first glance, shareholders might not see a problem with voting to install one or two antagonist, dissenting directors to serve along with the incumbent majority. They may expect a wider array of ideas and more robust debate to result. Such an analysis overlooks the crucial, and often delicate, internal working dynamic of an effective board of directors. The practical impact of inserting adversarial board members goes far beyond vote counting. The interaction of personalities and communication styles of all directors must be assessed. Some boards may regroup and perform efficiently with antagonist members, others may experience disruptive tension and gridlock. Still others may cede control to the new appointees. No matter which long-term strategy is to be pursued, a board must be able to work together effectively, and to work well with management. Shareholder value can suffer when board effectiveness declines. The effectiveness of the reconstituted board and the results of any revised long-term strategy will determine the ultimate success of the election process.

PLANNING POINTS Advance Preparation. It is important to have a proxy contest team identified before they are needed. The internal members of the team \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 17 6-OCT-08 9:23

2008] ACTIVIST SHAREHOLDER PROXY CONTESTS 635 should include the CEO, CFO, general counsel, investor relations officer and public relations officer. External members should include financial advisors, outside counsel, proxy solicitors and a public relations firm. This team should meet periodically by conference call. Customary steps should be taken to maintain confidentiality of the information they receive. Once an activist has surfaced, confirm responsibilities for receiving and initiating activist communications, press and shareholder inquiries, press releases, and proxy filings. Insist upon a single point of communication with the activist and discourage approaches through directors, other officers, and advisors. The team should assess existing takeover defenses to make sure they are appropriate and can be justified if called into question. The most important of these is an advance notice bylaw provision. A notice period that is too long appears to undermine shareholder suffrage, while a notice period that is too short provides little protection for the company. The team should be familiar with the company’s governance provisions and know the corporate law ground rules relating to the upcoming meeting (quorum, vote, notice, record date, postponement, adjournment requirements, etc.). Governance Issues and Takeover Defenses. Some question the link between best governance practices and strong stock performance. Others question the actual weight given to best governance practices in shareholder voting decisions. Traditional takeover defenses such as advance notice bylaw provisions, prohibitions on shareholder written consents and calling special meetings, a shareholder rights plan, a classified board, and supermajority vote provisions typically don’t impact long-term strategy or company performance. To support their objectives, activists and media may attempt to portray these defenses as indicia of poor management or entrenched management. They are not. They can serve valuable purposes and may be needed in order to properly pursue a well chosen long-term strategy or to deliver a liquidity event. Consider them carefully before eliminating any of these tools. Shareholders are not likely to re- ward management for dropping takeover defenses in the name of better governance unless it is part of a revised strategy to enhance shareholder value. Integrate the Board. Strengthen relationships with board members. Surviving a proxy contest requires each director to fully support the company strategy. A proxy contest puts enormous pressure on the board/ management relationship. Boards receive criticism for strategies and op- erations that often have been left, to some degree, to management. Threats of litigation and allegations of breached fiduciary duties are not uncommon and can be very unsettling. Directors, particularly outside directors, will be assured by knowing that appropriate indemnification provisions, indemnification agreements and insurance coverage are in place, and that appropriate access to independent counsel is available. It can be advantageous to have identified advisors for independent directors ahead \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 18 6-OCT-08 9:23

636 BLOOMBERG CORPORATE LAW JOURNAL [Vol. 3:619 of time and to have familiarized them with the board, its decision process and the long-term strategy. Work to maintain consensus on the company’s message regarding its strategy. Look in the Mirror. Periodically examine your company from the perspective of a potential activist. Do you have excess cash, marketable securities or borrowing capacity that can be used to return value to shareholders? How does your stock performance compare to industry peers? Do you hold undervalued assets? Has your operating strategy been ques- tioned by analysts or large shareholders? Have you had temporary hard- ships (in particular, restatements of financials)? Are there better alternative uses for your capital? Have you informed your shareholders that everything which reasonably can be done to enhance shareholder value is being done? If so, the chances of being singled out by an activist shareholder diminish. Activists don’t target the strongest performers in an industry. Lackluster performance may not be a problem if industry peers are also performing poorly. Consider your corporate governance ratings. Good governance ratings are by no means protection from activists, but poor governance ratings can used to imply poor leadership and provide fodder for an activist campaign. Know Your Shareholders. It has never been more important to know as much as possible about your shareholders, and to anticipate their expectations for your stock. Consider implementing a shareholder identifica- tion program to regularly collect information about stock ownership. Your investor relations officer should consider employing the stock watch services of a proxy solicitor. Maintain your contacts with trading special- ists. Monitor Securities and Exchange Commission reports (even though the information may be somewhat dated). Constantly tend to shareholder relationships. Examine your non-objecting beneficial owner list. See how many significant beneficial owners can be identified. Assess the extent of your retail shareholder base; it tends to be more loyal to incumbent leadership. Find out which of your institutional shareholders automatically follow RiskMetrics, Glass Lewis and other proxy advisory firms. Be alert to any relationships that may exist among shareholders or signs of parallel trading activity. Be Flexible and Do It to Yourself First. Don’t lock in to a long-term strategy that isn’t working. The best way to avoid attracting the attention of an activist is to eliminate the reason the activists might want to get involved. One way to do this is to put your company through the analysis and strategic changes that an activist would pursue – before the activist shows up and makes demands. Consider increasing debt or selling assets to fund an extraordinary dividend, redeployment of assets, etc. Communicate Your Case Effectively. Regularly communicate with large shareholders and analysts in a proactive dialogue, not a monologue. Clearly and consistently share your strategic plan, its implementation, any shortcomings, and remedies for those shortcomings. Work to avoid performance surprises, manage expectations, develop credibility and win the \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 19 6-OCT-08 9:23

2008] ACTIVIST SHAREHOLDER PROXY CONTESTS 637 trust of institutional shareholders and analysts. Proactively monitor the level of investor and analyst dissatisfaction. Effective communication demonstrates to shareholders and analysts that their concerns have been heard. Remember that the shareholders on the record date, and primarily those that are large institutional shareholders, not the media, determine the outcome of the proxy battle. Shareholders needn’t wait for the election to register displeasure. If the company message is not clear and compelling, shareholders can begin to vote with their feet by selling company stock after an activist surfaces. The investment management professionals at these institutional investors have their own performance expectations to meet. They need to achieve a certain level of return, whether from the ongoing performance of portfolio companies or from liquidity events. Even extraordinary past company performance won’t help them satisfy their current personal performance expectations – so they can be expected to align themselves with the entity who has the most compelling strategy to deliver the most shareholder value. Without a clear and compelling case that justifies supporting the target company board and management, an activist can put great pressure on directors, other shareholders and analysts who have in the past supported company leadership. In this context, it is not difficult to allege that committees and individual directors have breached fiduciary duties. Even the most engaged and loyal directors may waver when confronted by the prospect of defending their actions in litigation. Mutual funds, as institutional shareholders, previously had some degree of voting anonymity. Now, Rule 30b1-4 under the Investment Com- pany Act of 1940 requires them to disclose how they vote in a proxy contest. Their voting records are now available to the press, proxy advisory firms and proxy solicitors. Company communications must provide am- ple reason to maintain support of current leadership.

CONCLUSION

If your company profile might attract attention from an activist hedge fund, a proactive and decisive revision of your long-term strategy and an aggressive communication campaign can reduce the probability that an activist will seek effective control in a proxy contest over board seats. If an activist hedge fund takes a position in your stock, statistics indicate a change in board composition is likely and, typically, changes in senior management will follow. The impact of such a change poses a risk of diminishing board effectiveness. However, proxy battles can be won, and effective control of the board and long-term strategy retained, but that takes a vigorous re-examination of current strategy, an aggressive shareholder communication program and commitment from all members of the board and senior management to persevere through a difficult and potentially divisive proxy contest.