\\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 1 6-OCT-08 9:23 ACTIVIST SHAREHOLDER PROXY CONTESTS — WHO CONTROLS LONG-TERM STRATEGY? By Gary D. Gilson* INTRODUCTION Corporate strategy is set by senior management and boards of direc- tors. Traditionally, shareholders chose to either accept or reject that strat- egy 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 sophisti- cated 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 inves- tors. 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 de- fenses of little value. To maintain control of long-term corporate strategy today, boards and senior management must revisit and revitalize corpo- rate strategy, and effectively communicate it to the investment commu- nity in a manner that inspires a high level of confidence in their leadership. Determination and implementation of long-term strategy requires ef- fective teamwork between outside directors and management. The pres- ence 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]. 619 \\server05\productn\B\BLC\3-4\BLC410.txt unknown Seq: 2 6-OCT-08 9:23 620 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 share- holder 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 share- holder 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 individu- als. 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 in- vestor 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 invest- ments. 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 re- turns 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 2008] ACTIVIST SHAREHOLDER PROXY CONTESTS 621 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 sup- port 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 expo- sure. 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 share- holder 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 securi- ties 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 com- panies that have excess cash or debt capacity available for special divi- dends or large stock buy-back programs; (2) companies that perform be- low 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 9:23 622 BLOOMBERG CORPORATE LAW JOURNAL [Vol. 3:619 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