Sunday, December 12, 2010

Wachtell Lipton Highlights "Some Thoughts for Boards of Directors in 2011"

Esteemed corporate law firm Wachtell Lipton recently published "Some Thoughts for Boards of Directors in 2011" to highlight the key issues companies must address in the upcoming year. In 2011, companies will have greater difficulty in implementing corporate governance "best practices" that are geared toward building long-term shareholder value particularly due to, WLRK argues, "one-size-fits-all" regulation and increased shareholder activism. Among the latest concerns are: "pending rules regarding proxy access, say-on-pay, enhanced SEC disclosure requirements, compensation clawbacks, board structure", and so forth. WLRK addresses the following in the report:

Proxy Access

Although proxy access is currently stayed (with the case expected to be resolved by late spring 2011), companies are still vulnerable to activists "pursu[ing] shareholder proposals and bylaw amendments to impose proxy access on a company-by-company basis" regardless of the ruling.

WLRK provide a detailed approach to handling proxy access here. They recommend that companies engage discussions with major shareholders, particularly those who have owned 3% of the company continuously for at least 3 years and are now eligible to use proxy access. Firms should proactively monitor their shareholder bases well before any Schedule 14N filing. In addition, firms should take note of the fact that shareholders can "aggregate their holdings in order to meet the 3% minimum ownership threshold". At the same time, companies must be wary of that any communications concerning director nomination will result in the nomination not counting toward the 25% cap. Other considerations involve revising bylaws, director qualifications, board size and dynamics, etc.

In the event that a director is elected by a shareholder initiative under proxy access, "boards will need to work to minimize the potential for adverse effects on board stability, collegiality and effectiveness".

Executive Compensation

New SEC regulations and Dodd-Frank provisions have opened a floodgate of new executive compensation issues for companies.

- Companies holding a shareholder annual meeting on January 21, 2011 or later will need to have a "non-binding say-on-pay resolution seeking shareholder approval of named executive officer compensation", as well as a resolution on how often the say-on-pay vote will occur. WLRK argues that holding the say-on-pay vote once every three years more properly aligns the initiative with long-term goals. With that said,  many proxy advisory firms have recommended an annual say-on-pay vote. 

- Companies will need to disclose "golden parachute" plans via tender offer materials and merger proxy statements, in addition to seeking a non-binding vote on the matter.

- Companies will need to disclose information concerning executive compensation and its relationship to company performance in their proxy statements. Disclosure on stock hedging will be required, as well.

- Companies will need to disclose "the ratio of the median annual total compensation of the company's employees (excluding its CEO) to the annual total compensation of its CEO". This could entail "substantial administrative costs".

- Companies will need to disclose incentive-based compensation and follow newly expanded compensation clawback requirements.

In light of the regulatory and public focus on executive compensation, companies will need to focus on discouraging short-term risk-taking and be careful of allocating so-called "excessive" pay packages, while retaining talented long-term-minded executives.

Risk Management

Recent unfortunate events, like the Gulf of Mexico oil spill and Toyota product recalls, have revealed, and furthered, the importance of proper risk management. New regulation has also sought to establish greater transparency in companies risk management practices.

- "[B]ank holding companies with total assets of $10 billion or more, as well as certain other non-bank financial companies" will be required "to have a separate risk committee which includes at least on risk management expert with experience managing risk at large companies".

- The Federal Reserve Board might require smaller bank holding companies to take similar measures to the one described above.

- Required discussion of board risk oversight and leadership in proxy statements and annual reports.

- Companies must describe how compensation aligns with proper risk management.

Wachtell Lipton advises that directors not involve themselves in risk management on a day-to-day basis. Instead, directors should ensure "that the risk management policies and procedures… are consistent with the company's corporate strategy and risk appetite, that [they] are functioning as directed, and that necessary steps are taken to foster a culture of risk-aware and risk-adjusted decision-making throughout the organization". The CEO and senior executives should be the ones "fully engaged in risk management".

To read more, click here.

Board Composition and Director Qualifications

Wachtell Lipton recommends that companies find a "well-rounded board"--a task, the firm argues, that is being challenged by proxy advisor, regulator, and shareholder activist requests for independent directors. The law firm further states, "one of the 'lessons learned' from the financial crisis is that the tremendous complexity of the businesses and risks facing financial institutions warranted more industry expertise and insider knowledge in their boardrooms." Companies must seek to strike a happy medium between independence and insider knowledge in their boards. This is no easy task due to the nature of those with industry expertise having affiliations with other knowledgeable executives in the field. The NYSE's Commission on Corporate Governance only partially recognizes this when they state, "a properly functioning board can include one non-independent director". Wachtell Lipton argues that "there should be no complaint about adding additional inside directors to a board so long as a majority of the board consists of 'independent' directors".

Click here, to read "Some Thoughts for Boards of Directors in 2011".

Posted by David Schatz

Conference Board Paper Argues for Corporations to Address Proxy Access Sooner than Later

Charles M. Nathan and Paul F. Kukish from the law firm Latham & Watkins recently authored a report for The Conference Board, titled "Private Ordering and Proxy Access Rules: The Case for Prompt Attention". Below is a review of some of the information covered in the report:

Despite the SEC stay of proxy access (see our Oct 4 blog post), the authors argue that it is an "almost-certain… shareholder right" that companies must address. Even regardless of proxy access implementation, corporate governance activism is expected to rise and, along with it, new vulnerabilities to boards. Companies should therefore seek to amend bylaws and governance policies "by summer 2011, well before the likely 120- to 150-day window for the 2012 proxy access nominations that would open in late fall 2011 for year-end reporting companies".

Furthermore, amending bylaws and governance policies is an issue that should be taken care of sooner rather than later. The authors, as stated in the report, believe that a prompt and proactive approach is necessary for the following reasons:

Adjusting takes time - Amending bylaw and governance policy requires thorough analysis. Senior management and the board should have time to adjust to the new rules.

Perception matters, especially in the Delaware courts - Revising bylaws during a proxy contest could backfire against the firm and be viewed as "defensive and unfair". Bylaw changes could be challenged in Delaware courts at an inconvenient time.

Rules or not, pressure from activists continue - There is an expectation for more directors being nominated and elected by shareholder initiatives. "Companies need to be prepared for the advent of a new regime for director selection and ensure that it does not threaten traditional board cohesion and collegial values".


Revise advance-notice bylaws, as well as board informational and governance policies 

Explicit Differentiation Option - This would entail companies making it "explicit that the advance-notice bylaw is not intended to apply to proxy access nominations". Such a drafting option would require two different regimes: "one for proxy access nominations and the other for conventional proxy contests". A drawback to this is that it can limit informational requests from nominees than what a unified advance-notice bylaw could otherwise provide. Creating a new advance-notice bylaw exclusive for proxy access purposes also could be criticized as "not reasonable or equitable as a matter of state law". Managing the bylaw could be further difficult if the company is engaged in several proxy contests, in which only some parties make use of Rule 14a-11. "This double-jeopardy-like situation could be avoided by postponing any decisions regarding the proxy access nominee until after the separate advance-notice deadline has passed for conventional election contest nominations" or by "requiring conventional election contest nominees to comply with the advance-notice requirements of the proxy access rule".

Integration Option - This would entail revising the original advance-notice bylaw altogether. According to the authors, of the two revisions, the integration option is "advantageous to most companies". Companies should consider getting more information out of proxy access nominees as a qualification for nomination than that which is required by the SEC under Rule 14a-11 (click here for specific stipulations). Informational requirements should not be an issue under new SEC proxy rules, but they must prove "reasonability and equitability as a matter of state law".

Revise director qualifications and conduct standards

More controversial qualifications that companies should consider establishing, include: (1) stringent independence standards, and (2) "[w]ritten agreement to comply with board governance and informational policies as a condition to nomination". Age, term limits, identity, and stock ownership standards are just some of the requirements that companies need to consider for proxy access nominees. The idea is to make director qualifications and conduct particularly explicit, especially in the context of representatives from special-interest groups.

Revise nominating committee charters and processes 

Firms need to adjust nominating committee charters to thoroughly consider the qualifications of both proxy access and company nominees. Corporations must investigate the qualifications of both respective nominees before recommending a vote. Establishing a nominating committee schedule is also advantageous in evaluating performance and creating a board slate, accordingly. "Among the reasons for such a time table is a provision in the proxy access rules that, if a company engages in a discussion with a nominating shareholder or group before it files its Schedule 14N and subsequently the company puts the proxy access candidate on the board slate, the candidate is not considered a proxy access director for purposes of the 25 percent cap on access nominees". Therefore, companies should create a bylaw stipulation that obliges them to not consider shareholder nominee candidacy proposals before the filing of the Schedule 14N. Doing so would allow companies to fairly decline discussions before the Schedule 14N filing, thus preventing the so-called "proxy access creep".

Review voting standards and size of board 

Since the impending rule caps proxy access nominees to 25 percent and rounding down to the nearest whole number, companies should consider adjusting board size in accordance with their bylaws. The "rounding down" means that, effectively, proxy access nominees could represent at most 25% of a four-member board but only ~14% of a seven-member board, for example. Lastly, majority voting standards could present difficulties when there are several parties seeking board representations.

To see the report from The Conference Board, click here.

Posted by David Schatz

Wednesday, December 8, 2010

Examining Pershing's Activist Investment in J.C. Penney

(click to enlarge)
Following recent pressure by activist investor Pershing Square, Fortune Brands (Ticker: FO) confirmed this morning their plan to carve up the company into three separate operating businesses. The market's reaction has been positive.  As a result, Pershing has so far generated an unrealized return of over $300 million on their investment in the company in just a few short months. (Read the WSJ article for further details)

With this phenomenal investment return in mind, we decided to take a deeper look at Pershing's other major activist investment in J.C. Penney Company (Ticker: JCP) to better understand the activist's strategy and potential for share value improvement.

Since October 8, 2010, when Pershing Square and Vornado Reality Trust first disclosed their respective 16.5% and 9.9% beneficial ownership of JCPenney ("JCP"), there has been some speculation about how vulnerable the retailer might be to an activist campaign.  

Certainly, JCP is feeling the pressure, as evidenced by the fact that the company almost immediately employed a poison pill with a 10% trigger, in addition to hiring Goldman Sachs, Barclays Capital, and Skadden, Arps, Slate, Meagher & Flom LLP for financial and legal counsel.

Upon reviewing the company further, we found several areas of dormant value we believe Pershing Square will proactively pursue in an attempt to help "unlock" the company's true potential.  These include (i) realizing the full value attached to the company's real estate assets, (ii) reforming select corporate governance provisions such as director/executive compensation and low insider ownership, and (iii) addressing several operational inefficiencies that appear even more pronounced when comparing the company's recent results with other major department store chains.

Below is a quick look at each of these along with some thoughts about where Pershing Square might focus their efforts if an activist campaign escalates further.  

Extracted from Pershing Square's Q3 investment newsletter dated November 17, 2010

"We were attracted to JCP because of its inexpensive valuation, strong brand name and assets, and well-deserved reputation for overseas sourcing, high quality systems, and large in-house brands. We purchased our holding at an average price of $25.28 per share, an enterprise valuation of 4.1x 2010 EBITDA (adjusted for excess cash and other saleable non-core assets), a low multiple of what we believe to be trough or near-trough pre-tax earnings. At yesterday’s [November 16, 2010] closing share price of $30.80, JCP’s valuation has increased to 5.1 times EBITDA, a valuation that we continue to find attractive."


JCP may be vulnerable to a request to either lease out its real estate holdings or spin off the assets into a REIT operated by Vornado, which (unlike JCP's management) has significant ~28 years experience in the field.

According to the most recent 10-K statement, JCP (a company with a current market value around $8.0 Billion) owned $308 million worth of land and $4.3 billion in buildings. At January 30, 2010, JCP operated 1,108 department stores throughout the continental United States, Alaska, Puerto Rico, of which 416 were owned, including 119 stores located on ground leases.

Despite the attractive real estate, JCP appears to be struggling to effectively manage the optimal value associated with these asset. Todd Sullivan, a General Partner for value investor Rand Strategic Partners, argues that "JCP doesn't need to own its real estate. It makes them no money".

Oppositely, JCP has seemingly done well investing into REITs. While the retailer does not disclose which REITs it is investing in, as of January 30, 2010, the fair value of their investments in REITs was $178 million, experiencing a net unrealized gain of $63 million in 2009.


Implementation of anti-takeover provisions without shareholder approval
JCP recently enacted a poison pill with a 10% trigger without the approval of shareholders. The Shareholder Rights Plan expires on October 14, 2011. The retailer's stock price fell 3% upon the news when it first implemented the defense.

Low insider and board of director ownership
Additionally, as Todd Sullivan points out, "Abysmal. As a group".
According to the 2009 proxy statement, the company's directors at the time held a total of 1,176,095 shares, equaling less than 0.5% of the company's total shares outstanding.  Sullivan further commented, "I have not seen that during 2009 or 2010 management made ANY open market purchases of stock." 

Director and executive compensation
Despite their lack of substantial ownership, directors receive an annual stock grant that has a market value of ~$120,000.

The activists may also take issue with the amount of compensation paid to top executives.  From 2007 through 2009 JCP paid their top four executives (Ullman, Cavanaugh, Theilmann and Hicks) close to $70 million during a period when shareholder value eroded by about $6 billion.  Below is a breakdown of JCP's top executives' compensation for the past three years, extracted from its 2009 Proxy Statement:

The activists may also highlight JCP's generous golden parachute plans for their top executives. CEO Myron Ullman's plan, for example, is set at 2.99 times his target bonus and annual salary. In the event that Ullman's job is terminated without a change in control, he would receive ~$12 million if he resigns or retires. However, in the event that there  is a change in control, Ullman receives ~$20.3 million if he resigns or retires.


(click to enlarge)

JCP has been facing stiff competition against Kohl's, Macy's, Sears, and other top department chain stores. Arguably, the company's most significant vulnerability to an activist attack is the fact that, from a competitive standpoint, the company has struggled to perform.

Much of the company's loss in share value is, understandably, attributable to the recession, which depressed consumer spending, especially amongst JCP's market. With a consumer market of limited discretionary income JCP - more so than other department stores, slashed prices in an effort to maintain (and hopefully gain) consumers.

In order to determine why Pershing Square and Vornado found the retailer "undervalued" from a comparable market value perspective, we examined the company's change in stock price over the past three years compared to that of its competitors immediately preceding the activists' announcement on August 17, 2010. As illustrated below, just before the activist intervention, JCP had lost in excess of half of its value over three years, reducing total shareholder value by approximately $6 billion during the period. 

(click to enlarge)
The company has also struggled in terms of earnings and margins. On November 12, 2010, the company released disappointing third quarter results. Net sales rose a dismal 0.2% from last year's 3Q results, which totaled $4.19 billion in 2010--below analyst expectations of $4.25 billion. Shares fell 3% on the news. Net income was up 63% from last year at $44 million in 3Q.

The retailer was able to fuel sales growth by discounting its products. However, by doing so, JCP cut into profits. Gross margins were down 3.6% from last year at $1.6 billion, or 39% as a percentage of sales, in 3Q. Profit margins were further limited by JCP's lack of layoffs relative to its competitors during the recession--a point which Pershing Square has notably mentioned in the past.

Pershing Square further commented in their 3Q10 letter to investors:

"[T]here is significant potential for operational improvements at JCP which has underperformed its competitors including Kohl's and other retailers. Trailing earnings are at cyclically depressed levels; margins have been squeezed and sales productivity is low, with sales per square foot now at 2002 levels. 2010 adjusted EBITDA is approximately 30% below its 2007 peak and EBIT margins have deteriorated by about 45%".


As the economy further improves and consumer spending recovers, JCP seems to be in a good position to recover much of its lost wealth even without activist intervention. Attractive new brands, like Liz Claiborne and Sephora, have already aided sales growth--and likely will continue to do so. However, it is likely the activists' involvement will help unlock even more value associated with real estate, corporate governance, and operational improvements.

Going Forward:  Important Dates to Keep in Mind:
Expected date of 2011 Annual Meeting: Mid-May 2011
Deadline to Nominate Director Candidates: Mid-February 2011

Posted by David Schatz

Stock Images extracted from Google Finance with comments added by the author.

Monday, December 6, 2010

Icahn Launches Website to Help Elect 5 Directors to Lions Gate Board

On December 6 Icahn launched a website Save Lions Gate in an effort to help elect 5 new directors to Lions Gate's 12-member board.  The annual meeting is scheduled for December 14.

The site contains Icahn's December 3 presentation to ISS titled "Why Change is Needed at Lions Gate" along with a presentation to ISS from the investment bank Salem Partners (prepared at the request of Icahn).  The site also compares Lions Gate's board nominees to Icahn's board nominees.

Lions Gate also presented to ISS.  The Company's presentation is available here.

To read a summary of events going back to February 2009 download a recent December 3, 2010 Catalyst Investment Research Report from Hedge Fund Solutions.

Other relevant information worth examining:
Icahn Definitive proxy materials
Lions Gate Definitive proxy materials

Extracted from