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".

POSSIBLE PRIVATE ORDERING INITIATIVES

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

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

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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.


Background:
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."

REAL ESTATE

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.

CORPORATE GOVERNANCE ISSUES

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.

OPERATIONAL PERFORMANCE

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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. 

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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%".

CONCLUSION

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.

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 www.savelionsgate.com

Harvard Report Finds Negative Impact of Classified Board Structure on Firm Value

Bebchuk, Cohen, and Wang of Harvard University just recently released a report examining the relationship between staggered boards and firm value. While numerous reports have found a negative correlation between classified boards and firm value, one must be cautious in determining causation. Are classified boards merely a product of low-valued firms or are they actually responsible for yielding a negative impact on firm value?

In determining causation, the researchers implemented a quasi-experiment that made use of an October 8, 2010 ruling by the "Delaware Court of Chancery… approv[ing] the legality of a shareholder-adopted bylaw that shortened the tenure of directors". The case concerned a takeover contest between Airgas, Inc. ("ARG") and Air Products and Chemicals, Inc. ("APD"), where the bylaw would move ARG's annual meeting earlier in the year to January (from August). The "January bylaw" would thus have the effect of limiting the extent to which ARG's staggered board could entrench incumbent directors.

As it turns out, following the ruling in favor of the "January bylaw", firms with staggered boards experienced positive abnormal stock returns, compared to those without staggered boards. Companies with late annual meetings, Delaware incorporation, non-supermajority voting requirements, below-industry return on assets, and small firm size, increased most notably in value. All told, five days following the ruling, firms with staggered boards increased 50 risk-adjusted basis points in value over those without staggered boards.

The study goes beyond the scope of prior research by indicating causation: staggered boards negatively impact firm value.

It is no surprise then that Georgeson reports an average of 65%+ shareholders voting in favor of the 187 shareholder proposals to de-stagger boards during the 2006 - 2010 proxy seasons. It should also be of no surprise that between 2000 and 2009, "the number of S&P 500 companies with classified boards declined from 300 to 164".  Download Georgeson's 2010 Annual Corporate Governance Review

With that said, about half of "the over 3,000 public companies whose takeover defenses are tracked by FactSet Research Systems still have staggered boards". That leaves quite a few firms vulnerable to some corporate governance criticism from their investor base.

No doubt the findings in this report will be used to help bolster support for many activist investors seeking to remove a company's classified board structure.  In our opinion, companies interested in taking a proactive approach to avoiding shareholder activism, de-staggering the board may present an attractive option and should be seriously studied in conjunction with the merits associated with the company's other defense mechanisms.  

The report can be found here.

***

IMPORTANT NOTE: On November 17, 2010, ARG appealed Chancellor Chandler's decision to the Delaware Supreme Court. Just yesterday, on November 23, 2010, the Delaware Supreme Court ruled in favor of ARG (overturning Chancellor Chandler's decision) determining the shareholder-approved bylaw to be illegal. ARG fell sharply 5.92% that day to $62. Thus, (assuming no other outside influence on ARG's stock) the report's findings not only remain consistent, but also are further validated.

Posted by David Schatz

Image extracted from (1).

Wachtell Lipton Issues Annual Client Memo: "Key Issues for Directors 2011"

In light of expectations that shareholder activism will rise over the next year, WLRK has issued to its clients a rather timely memo, titled "Key Issues for Directors 2011". The memo is written by the inventor of the "poison pill" and shareholder activist critic Marty Lipton. Given Lipton's track record as a skilled lawyer, the memo provides a helpful guideline for corporations looking for defense. In providing advice, Lipton considers the financial crisis, expectations for the upcoming takeover and shareholder activist environment, as well as new government rules and regulations in the era of Dodd-Frank. 

Excerpt from the memo:

Earlier this year, in The Spotlight on Boards, I published a list of the roles and responsibilities that boards today are expected to fulfill.  Looking forward to 2011, it is clear that in addition to satisfying these expectations, the key issues that boards will need to address include:

          ·         Organizing the business of the board so that each of the increasingly time-consuming matters that the board is expected to oversee receives the appropriate attention of the directors.

          ·         Retaining and recruiting sufficient directors to meet the requirements for experience, expertise, diversity, independence, leadership ability and character, and providing compensation for directors that fairly reflects the significantly increased time and energy that they will need to spend in serving as board members. 

          ·         Developing an understanding of shareholder perspectives on the company, as well as coping with the escalating requests of union and public pension funds and other activist shareholders for meetings with the independent members of the board to discuss performance, governance, compensation and director nominations matters.

          ·         Maintaining the collegiality of the board in light of the balkanization created by the mandatory independent committee structure, and maintaining a collegial relationship with senior management that allows the board to play the important role of a strategic partner in light of the constantly increasing focus on the monitoring function of the board. 

          ·         Developing an understanding how the company and the board will function in the event of a crisis.  Most crises are handled less than optimally because management and the board have not been proactive in discussing how they would function, and the board cedes control to outside counsel and consultants. 

          ·         Most importantly, working with management to encourage entrepreneurship, appropriate risk taking, and investment to promote the long-term success of the company, despite the unrelenting pressures for short-term performance. 

Martin Lipton

Links to some previous thoughts…

Some Thoughts for Board of Directors 2010

Some Thoughts for Board of Directors 2009

Some Thoughts for Board of Directors 2008

Posted by David Schatz

Report by Schulte Roth & Zabel and Mergermarket Sheds Light on the Outlook of Shareholder Activism

Corporate law firm Schulte Roth & Zabel (SRZ), along with Mergermarket, recently released the findings of their annual survey Shareholder Activism Insight at SRZ's inaugural Shareholder Activism Conference in New York City this past week.

Here are a few survey results…

Not surprisingly, both activist and corporate respondents see a rise in shareholder activism over the upcoming 12 months.  60% of activists see a rise in shareholder activism versus 64% for corporate respondents.

This latter number is up from 39% in 2008. Only 4% of executives (and 0% of investors) actually see a decrease in shareholder activism over the upcoming 12 months.

While both activists (88%) and corporates (56%) are in agreement that the most  notable increases in shareholder activism in the next year will come from hedge funds, they disagree on the specifics. In terms of activism, excluding hedge funds, corporate respondents are most bullish on union funds; activist respondents, pension funds. All told, activists see a greater use of activism across all investor groups, except union funds, than corporate respondents do. While 46% of corporate respondents see an increased use of activism for union funds, only 35% of activists agree. Conversely, 40% of activists see a rise in activism amongst sovereign wealth funds, but only 4% of corporates expect an increase.

Perhaps most notably, respondents disagree as to which sectors will experience the greatest rise in shareholder activism over the next year and what catalysts will be responsible for this trend. Although a plurality of corporates (44%) and activists (26%) see shareholder activism rising most in the financial services industry, the latter class evidently has their eyes set on a more diversified portfolio. 22% of activists expect the greatest amount of activism to occur in the energy/utilities and technology/media/telecom industries each. 33% of corporates, not expecting a rise in technology/media/telecom targets, believe the greatest use of shareholder activism will take place in the energy/utilities industry, followed by 11% for chemicals/industrials (which activists, conversely don't expect any rise to take place in.) However, the most significant disagreements between corporates and activists arise when polled about catalysts. While 68% of activists see excessive cash on balance sheets (versus 15% for corporates) as the main driver of shareholder activism, 54% of executives see financial performance (versus 40% for activists) as the main driver. Activists see greater rises in activist investing due to every catalyst than corporates do (and quite significantly, at that), except for financial performance. Lastly, despite 50% of executives viewing activists as short-term market opportunists, nearly a majority (48%) of activists polled stated that their average holding period is in excess of a year.

With that said, there still is significant agreement between executive and activist respondents. For example, the two believe, by a substantial majority, that dialogue/negotiations is both the best strategy for activists, as well as for companies, to take in addressing shareholder activism. A plurality of activists (44%) and a majority of corporate respondents (57%) believe that investors and corporations work constructively on these negotiations most of the time, free from the limelight--which contrasts with media portrayals. Executives' views of activists have also improved over the last year, with 46% of executives viewing them as value driven co-owners and 74% of executives believing that shareholder board representation is important. Additionally, a majority of both parties believe "say on pay" rules will have the greatest impact on the extent of shareholder activism over the upcoming 12 months. 80% of activists and 72% of executives also expect investors to take advantage of proxy access, although technically in the long-term only executives (by a majority) expect this to be a long-term trend.

Despite the perceived impact of new regulations, only approximately 10% of corporates will respond by changing their composition of boards/senior management, their executive compensation structure, or their public relations strategies. Says David Rosewater, Partner at Schulte Roth & Zabel, "It is interesting to note that although more than half of the corporate executives responding state that the Dodd-Frank Act provisions will make them more responsive, very few believe it will change their behavior on relevant issues."

The report, which can be found here, is fascinating in the context of the major proxy campaigns taking place currently, the financial crisis, and the ruling going on over proxy access. Hedge Fund Solutions, LLC., as well as other consultants, have been counseling companies and investors in preparation for this increased and distinctive rise in shareholder activism.

Marc Weingarten and David Rosewater lead SRZ's shareholder activism practice.  

Marc Weingarten

David Rosewater

SRZ has a preeminent practice specialty in activist matters, with an unparalleled expertise in the applicable securities laws, proxy rules and the current state of market practice. SRZ has been counsel in many of the highest-profile activist matters in recent years. Serving both issuers and activists, the firm advises on federal securities law, state corporate law, Hart-Scott-Rodino, proxy rules and related matters, as well as handling investigations and litigations arising out of activist activity.

Charts extracted from Shareholder Activism Insight


Posted by David Schatz

HBS Research Finds Positive Market Value of Proxy Access

In a recently released study titled "Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable Challenge", the authors--Becker, Bergstresser, and Subramanian of Harvard Business School--argue "that financial markets place a positive value on shareholder access".

As published earlier, on October 4, the SEC granted a Stay of proxy access following litigation by the Business Roundtable and the US Chamber of Commerce. Consequentially, there has been some ongoing debate as to whether or not proxy access will go into effect. Should it not get into effect, and the paper's conclusions are accurate, firms will miss out in a potential source of value creation.

According to the research, as manifested in the SEC's final Rule 14a-11, shareholder access improves overall shareholder value.

"We find that firms that would have been most affected by proxy access, as measured by overall institutional ownership, lost 17 basis points of value for each standard deviation of ownership.  For firms that were owned more by historically activist institutions, the value lost was nearly four times as large." [emphasis added]

The paper can be found here.

Posted by David Schatz