Among the many benefits of living in a democracy is the right to participate in electing our representatives. This applies not only to our political process, but also to our corporate governance system. As shareholders, we expect and are afforded the right to vote for those who will represent our and our company’s best interests: the members of the board of directors. We wouldn’t have it any other way.

We’ve seen shareholder activists become increasingly active in recent years, looking to put themselves or their surrogates into board seats. Their agendas range from increasing dividends and share buybacks to spinning off business segments to changing business strategies or reducing executive pay. Often the focus is on ousting current directors and installing those who will push for the activists’ own desired goals.

And activists have had significant success: One report notes, according to FactSet, that last year activists had a 73 percent success rate in electing directors. Some boards find it better to acquiesce to certain demands than fight, especially when a leading activist is joined by other institutional investors. Other boards dig in and push back—and indications are that this year more companies are indeed fighting back.

Regardless, corporate boards have to put up with the reality of the current activist environment and be prepared for more that might be just over the horizon, if not already upon them.

Is Activism Good for Shareholders?

The answer to this question, not surprisingly, is that “it depends.” Certainly circumstances arise where a current board is tired, lazy or just inept, and change is necessary to protect and grow share value. In such circumstances, an overhaul of those sitting in board seats is useful and beneficial to all shareholders.

That, however, is not always the case; in fact in my experience, it usually is not. The reality is that far too often activists have an agenda that is short-term and self-serving: to juice up the stock price and get out with a handsome gain. For example, take the idea of transferring massive amounts of corporate funds to shareholders, either directly in the form of increased dividends or indirectly through share buy-backs. A legitimate question is whether such distributions of corporate assets will enable a company to be innovative and grow corporate wealth organically or by strategic acquisitions or partnerships—or create a lack of such ability going forward.

Related is whether a shareholder would be able to use such funds more profitably on an individual basis rather than through the company. This issue was recently addressed by the chief executive of BlackRock, Lawrence Fink. As head of the world’s largest asset manager, Fink issued a letter to corporate CEOs outlining why such proposed increased dividends and buybacks focus too much on the short term and usually make little sense.

Other highly respected governance gurus have weighed in. Martin Lipton, a founding partner of the Wachtell Lipton law firm, several years ago said long-term shareholders in public companies are being undermined “by a gaggle of activist hedge funds who troll through [Securities and Exchange Commission] filings looking for opportunities to demand a change in a company’s strategy or portfolio that will create a short-term profit without regard to the impact on the company’s long-term prospects.”

Shareholders—whether activists, other institutional investors, or individual owners—would be well-advised to look to the long-term success of their company. Those voting their shares should carefully consider whether an alternative slate will indeed promote the company’s future success, or rather reduce its likelihood.

And Leo Strine Jr., while Chancellor of the Delaware Chancery Court (he is now chief justice of the Delaware Supreme Court), said, “Many activist investors hold their stock for a very short period of time and may have the potential to reap profits based on short-term trading strategies that arbitrage corporate policies … Why should we expect corporations to chart a sound long-term course of economic growth, if the so-called investors who determine the fate of their managers do not themselves act or think with the long term in mind?”

The core issue is who sits in a company’s board seats. Related to activists’ threats or warlike actions is the issue of proxy access. The Dodd-Frank Act gave the SEC authority to promote proxy access by adopting rules allowing shareholders to include nominees in a company’s proxy materials without having to incur the significant costs of a proxy fight. The SEC proposed allowing what’s known as “3 and 3:” Shareholders with at least 3 percent of voting power who have had continuous ownership of at least three years would be entitled to submit nominations for at least one and up to 25 percent of board seats. That proposal never became final, but was replaced by what’s known as “private ordering,” where a company’s shareholders can put forth a resolution to win the right to nominate their own director candidates in the proxy. Such proposals use the 3 and 3 approach or something similar. Some have been successful. And some companies, such as General Electric and Citigroup, have gotten ahead of the curve with their own such initiatives.

Among those arguing against the SEC’s initial proposal—and who moved forward with a lawsuit—were the U.S. Chamber of Commerce and the Business Roundtable. The latter said: “Far from effective reform, this ruling will allow special-interest groups to pursue narrow agendas and exacerbate the market’s short-term focus … Rather than encouraging the creation of long-term shareholder value, this new federal right will handcuff boards and directors and stifle American companies’ ability to focus on long-term growth.” An SEC commissioner at the time said the proposed rule “threatens destabilizing effects on corporate governance, adverse impacts that may far outweigh any possible benefits to capital formation and investor protection,” noting also that the newly elected directors may owe their allegiance to the nominating shareholder rather than to the corporation.

What to Watch Out For

That last point is absolutely critical. Directors pushed onto a board by an activist shareholder can cause great harm for several reasons:

Such directors can, and do, focus like a laser on the agenda of the activist organization. You may have seen this, and I certainly have. I’ve worked with several organizations whose board is comprised of directors appointed or elected by constituent groups, where these directors seek to achieve goals of the constituent groups rather than the organization as a whole. In many states this may be deemed illegal, but occurs nonetheless.

These directors often are disruptive and detrimental to a board’s effectiveness. Rather than being able to focus on company strategy, emerging risk issues, operational performance, compliance, new opportunities, and other critical issues, boardroom discussion centers on the newly installed directors’ agenda.

Similarly, the cohesiveness of a board and its ability to address relevant issues intelligently and thoroughly is damaged by one or more activist-sponsored directors who shift the discussion and focus to their agenda matters. Constructive debate and discussion is replaced by narrowly focused diatribes.

Directors replaced by those newly installed in board seats can represent a loss of skills and attributes necessary to a well-balanced board capable of carrying out its fiduciary responsibilities. Large company boards usually carefully balance the knowledge and experience of directors to ensure board composition is well constructed, to deal with today’s issues and where the company is headed tomorrow. Skill sets might include expertise not only in the company’s industry, but also marketing, cyber-risk, technology, mergers and acquisitions, social networking, finance, financial reporting, international business, consumerism, and the like—usually crafted to deal with the company’s business(es).

Some argue “refreshing” a board is important, where “entrenched” directors are “male, stale, and pale” or otherwise out of touch with current company needs. And yes, refreshment is important as corporate circumstances and needs evolve. But experience shows that the board itself typically is in the best position to make those changes. With an effective board and director evaluation process, and a cognizant and forward-looking nominating committee—with a clear and thoughtful succession plan and identification of future candidates that will complement the board’s existing composition—a board will ensure the right individuals are at the table, that high-performing and needed directors remain, and the composition of the board as a whole is right for the company.

Be Careful What You Ask For

Shareholders—whether activists, other institutional investors, or individual owners—would be well-advised to look to the long-term success of their company. Those voting their shares should carefully consider whether an alternative slate will indeed promote the company’s future success, or rather reduce its likelihood.

The democratic process is a cornerstone of our political and governance processes, and it’s critically important that voters think carefully before casting their ballot. In the case of boards of directors, one should keep in mind that allowing one shareholder to create upheaval on a board of directors might not be in the company’s and shareholders’ long-term best interests.

Topics