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They’re Backkkkk!

Backed by Dodd-Frank, activists are coming on stronger than ever. With the new Say-on-Pay stipulation, all shareholders will have a voice in the issue of executive compensation (even if they’re not binding). What other issues will you face and how should you deal with them?

Occidental Petroleum’s Ray Irani may have had a taste of the future facing American CEOs. His pay package of $31.4 million for 2009 sparked opposition from the California State Teachers’ Retirement System, as well as by Relational Investors, the San Diego asset management firm run by activist Ralph Whitworth. Between them, CalSTRS and Relational owned 10.1 million Occidental shares, representing 1.24 percent of the company’s total outstanding, and launched a non-binding “Say-on-Pay” vote in the 2010 proxy season. Occidental lost the vote, one of three companies, along with Keycorp and Motorola, to do so.

Result: The company announced in October 2010 that Irani, 75, will step down as CEO and become executive chairman of the company, handing the reins to his chosen successor, COO Steve Chazen. It also announced that it would cut executive salaries “substantially” to bring them more in line with those of peers.

Irani may have been ready for a reduced workload and a reduced salary as chairman won’t put a dent in his lifestyle, but CalSTRS and Relational also proclaimed that they expected one of their directors to be elected to the board by year’s end. With the two current directors who are retiring, that will significantly alter the board’s composition. Anne Sheehan, CalSTRS’s director of corporate governance, said the agreement was an “excellent example” of cooperation between shareholders and a board of directors.

Excellent or not, the Occidental fight suggests that the 2011 proxy season will be a particularly tough one for CEOs and boards targeted by a kaleidoscope of shareholder activist groups and the big investors who sometimes team up with them. The Securities and Exchange Commission’s ruling that shareholder groups can list their board candidates in the company’s own proxy materials will not be a factor in 2011, because the U.S. Chamber of Commerce and Business Roundtable have filed suit against the rule and seem prepared to fight it all the way to the Supreme Court.

Even in the absence of shareholder access, the Dodd-Frank financial reform law mandates that all publicly traded companies, large and small, must hold Say-on-Pay votes and also ask shareholders how often they want those votes, which are being called Say-on-When votes. Even though these votes are non-binding, they create openings for shareholder activists to bring pressure to bear in very public ways. Activists also will insist that directors should be elected by a majority of all shareholders voting, not just a plurality. Specific directors, particularly those on compensation committees, will be subjected to campaigns to withhold votes for their re-election. Fewer boards will have staggered membership, meaning that an entire slate of directors could be defeated. And brokerages, which ordinarily vote the shares they hold on behalf of individual investors in favor of management, can no longer vote the shares without specific instructions. Meaning: Large blocks of stock that once favored management may be absent, depriving CEOs and boards of crucial swing votes.

An Ounce of Prevention

With the battle lines shifting against CEOs and boards in proxy contests in 2011. The best solution will be to avoid becoming a target in the first place.

A GOOD FIRST PREVENTION STEP IS TO take a hard look at how big hedge fund investors such as Carl Icahn and Pershing Square’s Bill Ackman would analyze a company’s strengths and weaknesses, because they often form alliances with other activists. James C. Woolery, partner at Cravath, Swaine & Moore in New York, says CEOs should ask their chief financial officers and business development teams to study their own companies through the eyes of would-be attackers. “Very few companies do the rigorous internal analysis,” says Woolery. CEOs should say, “Do a Carl Icahn and Bill Ackman analysis and bring it back to me,” he argues.

Too many CEOs also do not personally learn about what religious, labor or environmental shareholders are seeking from their companies. “If the corporate secretary and investor relations staffs are doing their job, they are reaching out to their largest shareowners,” says Amy Borrus, deputy director of the Council of Institutional Investors in Washington, D.C., whose members manage more than $3 trillion “You’d be surprised by how many companies don’t do that.” Those insights, in turn, need to be reaching the corner office.

Each of these groups have clear agendas and it would behoove a CEO to understand what the United Brotherhood of Carpenters or the Sisters of Mercy are seeking to achieve by petitioning the company for a shareholder vote or contesting a director’s re-election. “This is a big mistake that some CEOs make,” Woolery adds. “They say, ‘Oh, Joe down in the legal department is worrying about that.’ They themselves are not fully briefed on the issue.”

Once a CEO does know what the different classes of shareholder activists are thinking, he or she should meet with them. “If they get a petition, it’s important to find out what their concerns are and whether there are grounds for a common understanding,” Borrus argues. “Investors don’t really want a proposal to come to a vote. They’d prefer to see movement from the company. If it comes to a vote, that means talks with management failed.” Of course, a CEO must keep the board of directors in the loop on key shareholder concerns so that directors are not surprised.

Once a CEO has a clear understanding of what the hot button issues are, he or she can compromise with the activists, even if it might mean sacrificing some personal compensation, which once again will be a lightning rod issue in 2011.

And the second half of the year is the best time to defuse potential shareholder concerns. “It’s best to have a free-flowing dialogue off season when you’re not up against the proxy season,” says Anne Sheehan, director of corporate governance at the California State Teachers’ Retirement System in West Sacramento. “Don’t wait until the annual meeting and find that directors get a large ‘withhold’ vote.”

In short, in the new era, CEOs need to be monitoring big shareholder groups and meeting with them year round—at the same time they run their businesses.

Add it all up and it appears that the forces of “shareholder democracy,” which have been gathering strength for years, will be cresting in 2011 and forcing the fundamental question about who controls American corporations. CEOs who can’t increase their companies’ share price or find ways to create top-line growth in an anemic economy will find themselves marginalized in boardroom fights. CEOs’ ability to receive large pay packages or to create compensation packages for their top performers also will be sharply circumscribed as compensation committees hire their own compensation advisers and lawyers. As boardrooms become increasingly politicized, some CEOs may even be toppled amid populist anger of the sort that turned the tables on President Obama’s Democrats in the mid-term elections in November. “It all fits together in a new environment in which shareholders, with the means, can exert a lot of influence over corporations,” says Robert S. Reder, partner at Milbank, Tweed, Hadley & McCloy, which typically defends boards.

Two companies that face potential challenges are Keycorp and Motorola, because they lost Say-on-Pay votes in 2010. “If they don’t take steps, they could find themselves in the headlines again,” warns Amy Borrus, deputy director of the Council of Institutional Investors in Washington, D.C., which represents large union and public pension funds. The Change to Win Investment Group, representing union pension funds, is targeting Massey Energy on environmental and safety grounds after the explosion at its West Virginia mine, and environmental issues will once again loom large.

Smaller companies are going to face shareholder pressure. In previous years, activists have targeted mostly the Standard & Poor’s 500, but CalSTRS’s Sheehan and others are signaling that this season, they are going to expand their efforts to the Russell 2000.

The range of issues also seems to be expanding: Executive compensation will remain a hardy perennial, but shareholder groups also want boards to disclose a company’s political contributions, rein in relocation packages for executives and promise greater diversity on boards.

Say-on-Pay votes will be the most powerful weapon, partly because they attract the attention of the proxy advisory firms, particularly the 800-pound gorilla, Institutional Shareholder Services (ISS), a unit of Risk Metrics. Even a 30 to 40 percent vote to reject a company’s compensation plan, short of a majority, could set the stage for trouble down the road. “ISS will use those votes,” says Milbank’s Reder. “If you get a negative vote and you do nothing, that will have an impact on future elections.”

If a board gets a “no” vote and does not take corrective action, it is required to explain why it chose not to respond in the Compensation Discussion and Analysis portion of the proxy statement. These torturous CD&A statements have grown in length and contain an avalanche of detailed information, so it isn’t always clear why shareholders are voting against a compensation package. Is it the CEO’s restricted stock grants or the CFO’s relocation bonus? “It’s one vote on a massive disclosure,” Reder says. If a company does poorly on a Say-on-Pay vote, management will be best advised to begin talking to shareholder groups to find out why.

The vision that some activists are pursuing might seem radical to CEOs and directors. CalSTRS, with assets of $141 billion, has invested in about 4,000 U.S. companies of all sizes. Aside from Say-on-Pay votes, it is pushing the concept of majority votes for directors. Some two-thirds of S&P 500 companies have adopted that method, which is why Cal- STRS and others also will be pushing smaller companies to adopt it. In addition, CalSTRS wants more declassified boards, meaning all members are elected in one vote. “The whole board should be up for a majority vote every year,” says Sheehan. “That’s fundamental shareholder democracy 101.”

That would mean that CEOs could be facing board shakeups every year. Ultimately, if shareholder access to the proxy is approved, CEOs could be facing more single-cause directors on those boards who have been nominated by shareholder activists. “Any given year, a CEO may have to accept a short slate of directors who are put up and have a good chance of success,” says James C. Woolery, a partner at Cravath, Swaine & Moore, which typically represents boards. The reason they will be only short slates is that shareholder coalitions will be able to include only a handful of directors on a company’s proxy because they will be barred from seeking a change in control.

What’s a CEO to do? Whether a CEO is subject to activism depends at least in part on how well the company and its stock are performing. That may set the stage for a supremely difficult balancing act for many CEOs. “The real issue for CEOs as it relates to this season is how to stay ahead of the curve,” Woolery says. “CEOs will be thinking, ‘I have to move forward from a growth point of view. If not, I’m going to be much more vulnerable to activism and my fate could be taken out of my hands.'”

So CEOs will have to give some carefully selected ground to the activists on certain issues while taking greater risks to achieve organic growth or to launch acquisitions to keep the company’s top line growing. “Stay conservative and prudent on the governance side and take the risk on the business side,” Woolery advises. “That’s the tradeoff.”

The bottom line? The CEO’s job, never easy, is getting harder even still.

Fighting Back

Reform Could Tip the Balance

ONE REASON THAT CEOS AND THEIR BOARDS AREhaving an increasingly difficult time winning proxy fights is that the systemitself is broken, in the view of would-be reformers.

A coalition of business groups, called the Shareholder CommunicationsCoalition (www.shareholdercoalition.com), based in Washington, is tryingto persuade the Securities and Exchange Commission to issue new rulesthat would improve the ability of companies to communicate with theirshareholders—and hopefully persuade them to support management.”We’re focused on the proxy infrastructure, all the rules by which you castyour ballot and vote,” explains Niels C. Holch, executive director of thecoalition, which includes the Business Roundtable, the NationalAssociation of Corporate Directors and similar groups. “Our complicated,cumbersome and expensive system has evolved over 20 or 25 years andhasn’t taken advantage of the Internet and newer shareholder communicationtechnologies.”

One frustration some CEOs face during a proxy fight is reaching retailshareholders, who may represent 30 percent of the total outstandingstock of a large company. In the past, these retail shareholders allowedtheir brokerage, say Merrill Lynch, to vote their proxies under Merrill’sstreet name. Brokers typically supported management. But that system ischanging because brokerage houses will no longer be able to automaticallyvote on behalf of their customers.

That leaves CEOs unable to communicate with a large block of individualshareholders with unknown names and addresses, and thus with no personalway to persuade them to support management, rather than to backthe hugely influential proxy advisory firms, such as Institutional ShareholderServices, which are often critical of the way a company is being run.

Another flaw of the current system is that brokers lend shares, often tohedge funds seeking to short a company’s stock. If the hedge funds controlthe shares when the date is set for a company’s annual meeting, they maybe able to vote, even though the owner of the shares also wants to vote.This can result in more votes being cast than the total number of shares outstanding,greatly complicating a CEO’s efforts to win a proxy fight.

To address these and other issues, the SEC issued a concept releasein July 2010 with its recommendations on how to fix the system. It won’tbe until 2011 that the SEC actually starts issuing rules, meaning theywon’t take effect until the 2012 proxy season. “We would have companiesknow who individual investors are and be able to communicatedirectly with them, and make sure that the votes work in ways that everyoneexpects,” Holch says. All of which might tilt the balance of power inproxy fights back toward management and boards.

William J. Holstein is the author of the forthcoming book, The Next American Economy: Blueprint for a Real Recovery.

About William J. Holstein

William J. Holstein
William J. Holstein is a journalist, consultant and speaker. He is the author of, "The Next American Economy: Blueprint For A Sustainable Recovery." For more of his work, visit www.williamjholstein.com.