There's a new wrinkle to contend with during the coming proxy season next year: Previously docile public pension funds are becoming activist investors and may be the new “barbarians at the gate.” Their tactic is to target individual directors of companies they consider to have poor board governance.

Ira Millstein, who specializes in corporate governance at law firm Weil Gotshal & Manges, says it's significant that large public pension funds are pushing for companies to make changes. “The biggest pension fund, California Public Employees' Retirement System (CalPERS), is taking an activist role, going to companies and saying, ‘You really ought to change,'” he says. The second largest, California State Teachers' Retirement System (CalSTRS), went so far as to co-sponsor a proposal with activist fund Relational Investors in an effort to break up Timken Co., a maker of steel and bearings in Ohio. The two organizations objected to the Timken family holding 3 of 11 board sets while holding only 10 percent of the stock.

“There's a shift in tactics” where big activist investors are moving from shareholder proposals to greater engagement with companies with the aim of replacing directors, says Nell Minow, co-founder of Governance Metrics International. Other examples include votes by CalPERS for a board changes at Hewlett-Packard and JPMorgan Chase. CalPERS targeted the chairman of the audit committee, Kennedy Thompson, and the chairman of the finance and investment committee, John Hammergren, after the company took a $19 billion write-down on three major acquisitions. At JPMorgan, CalPERS and a large labor group, Change to Win, called for three directors on the board's risk committee to step down after the bank suffered billions in losses from the “London Whale” trades.

“There's a shift in tactics where big activist investors are moving from shareholder proposals to greater engagement with companies with the aim of replacing directors.”

—Nell Minow,

Co-founder,

Governance Metrics International.

For two decades CalpPERS had tried to shame poorly governed companies into changing by publishing an annual list of companies it said had poor governance. It is no longer doing that and, instead, has adopted a strategy that CalPERS' Director of Corporate Governance Anne Simpson calls “walk softly and carry a big stick.” The pension fund has signaled it will use that stick sparingly, mostly in those cases where there's a clear failure of board oversight. At JPMorgan, for example, CalPERS called for separation of Jamie Dimon's role as chairman and CEO.

So, what are companies to do when faced with demands from these new activist investors? Martin Lipton, who represents corporate boards at Wachtel Liptom Rosen & Katz, says, “We advise our clients that it makes a great deal of sense for directors to meet with major shareholders.” This may pose a problem for companies that resist having directors meet face-to-face with investors out of fear that they may unintentionally provide material non-public information and violate Regulation Fair Disclosure. However, Reg FD provides a remedy should this occur. For this reason it's a good idea to have someone who is very familiar with the company's disclosure record, such as a compliance officer, an investor relations officer, or corporate counsel, monitor these meetings so they can immediately issue a market-wide news release or a Form S-K with the Securities and Exchange Commission.

Activist public pension funds are generally not interested in speaking with company officials on governance topics. They want to send their message directly to board members. So, avoiding these meetings is not advisable. But compliance officers and other executives need to make sure directors are well coached before holding direct meetings with major investors so there are no unintentional disclosures.

Follow the Money

The positions taken by long-time activist investors like Carl Ican and Ralph Whitworth of Relational Investors have made major profits this year—26 percent and 34 percent respectively. It's likely, that CalPERS, indexes its stock investments and owns about 0.5 percent or more of most public companies, and other large pension funds have noticed these outsized returns. Moreover, CalPERS has its own priorities and doesn't follow lock-step with the proxy advisory services. Other investors have noticed, too. They placed a net $7.2 billion into activist funds in 2013 through September, greater than twice the amount in 2012.

Although the adoption of the strategy by large pension funds is relatively new, activist investing has been around for a long time. In the 1970s corporate gadflies Evelyn Y. Davis and the Gilbert brothers came to corporate annual meetings to pester CEOs with their sometimes harsh questions and comments about corporate performance. In those days, individual investors dominated the market but their power to initiate change was limited because of their diverse interests.

A History of Activism

The era of activism took a turn in the early 1980s when some institutional funds and a few pension funds entered the scene challenging companies over their corporate social policies. In the early days, these funds used a strategy of divestment, rather than the more overt activism that have turned to more recently in an effort to change corporate behavior.

In 1983, for example, the Harvard Pension Fund divested its holdings in IBM as a protest over the company's operations in apartheid-controlled South Africa. While the funds' holdings in IBM were substantial, it didn't cause IBM's management to change its practices. Still, it was clearly the camel's nose under the tent, because other funds followed suit using divestment as a means for protesting corporate social policies. Some called it “taking the Wall Street walk.”

CalPERS, then as it is today, the largest pension fund in the United States, followed the Harvard fund's lead and instituted a divestment strategy for companies that did business in South Africa and Northern Ireland, where human and labor rights were an issue. These funds used the Sullivan Principles, a body of codes of conduct for transnational corporations involved in human and labor rights as the focus of their investment policies. It was not until late 1987 that institutional investors held a majority of shares in corporate America.

In 1989, then-CalPERS president Dale Hanson told the Council of Institutional investors that the fund's board had decided that divesting its holdings in major companies was depriving their participants of the value of their investments and it was going to change its strategy to one of using the proxy to register their protests and attempt to change corporate behavior. To that end, he addressed a letter to the SEC's director of the Division of Corporation Finance, Linda Quinn, proposing 48 amendments to the proxy rules to allow shareholders to communicate among each other without having to go through the slow and costly proxy solicitation process.

In 1991, the SEC proposed changes to the proxy process that drew a record 1,700 comment letters, and by 1992, SEC Chairman Richard Breeden announced the Commission had adopted the final proxy amendments. So, CalPERS, CalSTRS, and other major public pension funds were off to the races. In 1990, Harvard University professor John Pound, with the help of Ira Millstein, convened the New Foundations Working Group, of which I was a member, advocating ways to improve communications between institutional investors and corporate boards and senior management. As we entered the 21st century, the focus on corporate governance and board accountability rose to a new level when Wall Street darling Enron declared bankruptcy. Enron's demise was followed closely by WorldCom, Adelphia, and many others, raising the question—“where was the board?” In July 2002, Congress passed the Sarbanes-Oxley Act. And that was to be followed in 2010 by the Dodd-Frank Act, with its focus on greater transparency in the proxy about the board of directors among many other ramifications.

So, the issue of shareholder activism is not going away. If anything it is increasing, and this demands that companies step up to the plate with their best offense by instituting the needed changes in compliance with what the SEC rules require, giving investors confidence that the company has instituted best practices, and demonstrating more than adequate board oversight of corporate management and involvement in executive compensation matters, along with a willingness to meet directly with major investors who request it.