Minnesota-based companies have not been immune to attacks by activist investors. This article discusses what is driving the trends in investor activism, what companies are susceptible to activist investors, why activist investors are successful, strategies of activist investors, target defenses and responses and other recent developments.
Activist Investors in Minnesota
A number of activist investor campaigns have occurred in Minnesota, including:
- In 2004, Opportunity Partners announced it had taken a position in the stock of Hector Communications (Hector). In April 2005, it requested the Hector board consider a sale of the company. In September 2005, Opportunity Partners offered to purchase Hector. Hector responded in November 2005, asking why the purchase was not blocked because Opportunity Partners was an “interested shareholder” under the Minnesota Business Combinations Act and had not received the requisite board approval prior to becoming an interested shareholder.
- In March 2006, Pirate Capital filed a Schedule 13D announcing its intention to elect a majority slate to the board of PW Eagle. Caxton Associates filed a Schedule 13D shortly thereafter also announcing a position in PW Eagle. In April 2006, PW Eagle entered into agreements with Pirate Capital and Caxton Associates conferring control of the PW Eagle board. PW Eagle was subsequently sold.
- In July 2007, Pershing Square Capital Management acquired stock in Target Corporation and filed a Schedule 13D stating Target’s common stock was undervalued and it intended to explore ways in which that undervaluation could be corrected.
- According to press reports, an activist fund, the Clinton Group, announced a campaign in 2008 to unseat the CEO of Select Comfort Corp. The campaign initially began by seeking cost-cutting initiatives and other marketing improvements.
Driving Forces Behind Investor Activism
Perhaps the largest force behind investor activism is the large sums of money available to hedge funds. By some reports, hedge funds have more than $1.5 trillion to invest. The funds look for ways to earn high returns, and activist investing has been one way to do that. Activist investors who seek a sale of the company also have had the tailwinds of an active mergers and acquisitions market until recent times, and those tailwinds will return in the future. The Wall Street Journal (July 31, 2008) reports that some activists are currently focusing on operational initiatives given the inactive mergers and acquisitions market.
In addition, the rising power and influence of ISS Governance Services (ISS), a division of RiskMetrics Group, has contributed to the trend of investor activism.1 The rise of ISS can be attributed to a ruling by the U.S. Department of Labor that provided that pension funds have fiduciary obligations when voting proxies. The SEC also contributed, by adopting a rule requiring that registered investment advisers vote proxies in the best interest of clients. As a result, many of the affected participants determined the best way to comply was to outsource the analysis for shareholder voting, and that is the service ISS provides. In the opinion of some, ISS has a decidedly activist bent.
Over time, the SEC also has made it easier for activists to engage in hostile proxy solicitations through rule changes.2 In 1992, the SEC adopted rules allowing insurgents to solicit not more than ten shareholders (Rule 14a-2(b)(2)), to engage in free communications without SEC review in certain circumstances (Rule 14a-2(b)(1)), and to use a procedure when an activist seeks a minority of the board, the so-called short slate (Rule 14a-4(d)). In 1999, the SEC adopted Rule 14a-12, which permits unlimited communications before a proxy statement is filed without SEC clearance, provided that no proxy card is provided and the written materials are filed with the SEC. As a result, the proxy battle is usually won or lost before a proxy statement is filed.
Recently the SEC adopted Rule 14a-16, which permits insurgents to avoid the expense of printing paper proxies by making proxy statements available over the Internet. While not widely used to date, it provides a potent weapon to activist investors to engage in full-scale proxy battles at reduced cost.
Objectives of Activist Investors
Typical objectives of activist investors include:
- Gaining a minority or majority of board seats.
- Replacing the CEO or management team.
- Increased dividends or share buy-backs.
- Sale of the company.
- Sale or spin-off of selected assets.
- Business strategy initiatives, including cost-cutting initiatives.
- Preventing a pending acquisition.
- Elimination of take-over defenses.
- Implementation of perceived better governance practices.
- Realizing value on the balance sheet, such as “putting cash to work.”
What Companies Are Susceptible to Activist Investors?
Surprisingly, activist investors do not necessarily focus on poorly performing companies.3 The following have been identified as attributes of companies targeted by activist investors:4
- Low capitalization—it takes less cash to accumulate a significant stake in a company with lower capitalization.
- Perceived undervaluation—leading to ultimate gains when the activist strategy is executed.
- Ability to cut costs—taking costs out of the income statement can increase value and be a springboard for other activist tactics, such as a sale of the company.
- Excess cash—large cash balances can be used to finance buy-outs and share repurchases.
- Borrowing availability—the ability to leverage a balance sheet can be used to finance an acquisition or a share buy-back. In part, managing a business to maximize cash flow can therefore be an advantage to activist investors if unnecessary amounts of cash are retained.
- Diversification of asset base—value is sometimes perceived to be obtained through asset sales and spin-offs.
- Significant institutional ownership—concentration of holdings in institutions can be a perceived advantage for shareholders supporting an activist campaign.
- Poor disclosure and governance practices—pointing out poor practices may make it easier for activists to make their case.
One commentator has posited that certain industries may be more susceptible to activist investors. In particular, industries with valuable hard assets but sluggish returns may be targets.5
Success of Activist Investors
Activist investors are surprisingly successful in achieving change. Research indicates success rates of 66% to 84%, which includes any cognizable concession by management to an investor’s demands, no matter how immaterial.6 While these statistics may inflate the notion of success, there are indications that activist investors historically have achieved full success approximately 40% of the time.
The success rates can be attributed to the activist investors making credible demands, a track record of past success, and the ease with which the investors can go hostile as a result of relaxation of SEC rules. Success is also attributable to the so-called wolf pack phenomenon. When one activist investor announces a campaign, other activist investors, commonly referred to as the wolf pack, also take positions in the stock. At that point, long-term investors may sell into the increasing share price, resulting in large holdings by event-driven investors. Once the traditional long-term investors liquidate their positions, resisting demands of activist investors becomes more difficult.
Tactics of Activist Investors
Initial tactics of activist investors vary. Probably most often, they first seek an informal meeting with management. Sometimes, management first learns of a campaign by the filing of a Schedule 13D with the SEC, which the activist uses as a method to make a public announcement. Schedule 13D must be filed by persons or groups owning more than 5% of a company’s outstanding publicly traded equity securities. Other times, management first learns of an activist campaign when the activist seeks clearance to purchase shares under the Hart-Scott-Rodino Antitrust Improvements Act (HSR). The HSR filing is necessary for certain activist investors who wish to accumulate holdings in excess of certain thresholds (currently $63.1 million) under federal antitrust laws.
Activist investors are persistent and tend not to take no for an answer. If they have made a serious approach to the company, it is likely they have done their homework and have validated their investment strategy. The question, then, is what comes next. As already noted, activists may solicit proxies from 10 or fewer shareholders without complying with the proxy rules, and that alone may be outcome determinative, especially given the wolf pack phenomenon. However, there are other weapons in the activist’s arsenal.
“Just Vote No” Campaigns
One tactic an activist investor may use is a “just vote no” campaign.7 The technique involves reliance on exemptions put in place by the 1992 proxy amendments and is sometimes used where board representation is not necessary. The tactic works by encouraging stockholders to vote against a corporate proposal or withhold votes for an incumbent director that is proposed to be elected. A “just vote no” campaign does not require the insurgent to prepare, file and deliver a proxy statement and can therefore be highly cost-effective.
A “just vote no” campaign can rely solely on Rule 14a-1(l)(2)(iv). This rule provides that an insurgent is not soliciting proxies if the related communication merely states how the insurgent intends to vote and why, and is made by means of speeches in public forums, press releases, advertisements in public media and the like.
A “just vote no” campaign is often coupled with Rule 14a-2(b)(1). It provides an exemption from certain proxy rules if the investor does not seek the power to act as a proxy or furnish a form of proxy. To rely on the rule, the activist investor cannot have failed to file a Schedule 13D or, if the activist has filed a 13D, has not indicated it may engage in a control transaction or any contested solicitation for the election of directors. Rule 14a-6(g) also requires most Rule 14a-2(b)(1) written material to be filed with the SEC. However, the activist is not required to file a proxy statement and the communications are not subject to prior clearance by the SEC.
The “just vote no” campaign’s success typically hinges on public embarrassment of management and the board. A recent study indicates that “just vote no” campaigns result in a forced change of the CEO in the year following the campaign 25% of the time, and where there was no change in the CEO, the remaining 50% of the targets made other strategic changes.8 An example is Roy Disney’s campaign to oppose the reelection of certain of The Walt Disney Company’s directors. As a result, the board removed Michael Eisner as Chairman of the Board.
An activist investor may choose to elect a minority of the board, referred to as running a short slate, for a number of reasons.9 A target may have a staggered board, making a majority slate or full slate unobtainable. The perceived probability of success may be greater. A short slate may more readily receive the recommendation of ISS, and existing investors may perceive less risk with a majority of the incumbent board members remaining. Perhaps there are contracts or debt agreements that would have an adverse impact upon a change of control. Undoubtedly, the prospect of one or two of an insurgent’s nominees entering a board room may be enough to cause a company to seriously consider an activist’s demands.
Without regulatory relief, it would be difficult to run a short slate of directors. Rule 14a-4(d) requires a nominee’s consent to be named in a proxy statement. It can be taken for granted that an incumbent nominee will almost never consent to being named in an activist investor’s proxy statement. As a result, in 1992 the SEC adopted amendments to Rule 14a-4(d), which permits a proxy statement electing a short slate if:
- The activist’s nominees, if successful, would constitute only a minority of the Board members;
- The activist investor seeks authority to vote for the aggregate number of director positions then subject to election;
- The activist investor represents it will vote for all of the company’s nominees other than those specified;
- It provides the shareholder the opportunity to withhold authority for any other company nominee; and
- The proxy and proxy statement disclose there is no assurance the company’s nominees will serve if elected with any of the activist’s nominees.
In connection with a short slate solicitation, the activist investor can also use the proxy statement to make other shareholder proposals, such as shareholder friendly by-law proposals. For an example of a recent short slate proposal, see The Children’s Investment Fund and 3G Capital’s proxy statement in connection with the election of directors of CSX Corporation.
Majority Slates and Control Slates
An activist investor may determine that a majority slate or full slate is necessary to achieve its objectives despite perceived obstacles. Here, the 1999 amendments related to Rule 14a-12 permit the activist investor to launch its campaign and test the waters without filing a proxy statement or any SEC review. If the point is to win concessions and influence change, the difference between winning and losing may be a distinction without a difference. As a result, the threat of a campaign acts as a significant deterrent to incumbents engaging in a proxy battle.
Rule 14a-12 permits unlimited solicitations so long as no proxy card is furnished, the material is filed with the SEC on first use, and certain legends are included and disclosure of participants is made. While ultimately not wholly successful, Carl Icahn used this rule to engage in a six-month battle with Time Warner to elect a majority slate without ever filing a proxy statement. This rule can also be used in connection with a solicitation to elect a short slate of directors.
The Proxy Contest
Activist investors may use Rule 14a-12 to conduct a highly personal and intimidating campaign. For instance, in the recent Yahoo contest initiated by a group led by Carl Icahn, the Icahn group alleged the Yahoo board was irrational, irresponsible and unconscionable. In another filing the group stated they were amazed at the length that Jerry Yang and the Yahoo board had gone to entrench their position. In the CSX proxy contest initiated by The Children’s Investment Fund and 3G Capital, the insurgents accused CSX of deceiving shareholders and made statements such as “CSX lags behind its competitors,” “CSX lacks cost discipline,” and “CSX trains spend more time sitting around.”
A proxy contest can also be a very expensive proposition for an issuer. Yahoo disclosed that it spent $22 million in its second quarter of 2008 related to Microsoft’s proposed takeover, costs related to the Icahn proxy contest and related litigation defense costs. Others place the cost for a more typical proxy contest in the range of $1 million and under.
State Law Loopholes
State law may permit shareholders to call special meetings. This allows an insurgent to engage in a proxy contest at times other than the annual meeting. For instance, Section 302A.433 of the Minnesota Business Corporation Act permits shareholders or groups of shareholders who own 10% of the voting power to call special meetings. For actions intended to facilitate a business combination, including actions to effect the composition of the board, 25% of the voting power is required. States also have various anti-takeover laws. For instance, Minnesota has adopted a control share acquisitions statute. Embodied in Section 302A.671, the statute requires shareholder approval for an investor to vote shares in excess of a specified percentage of voting securities in certain circumstances. The lowest threshold specified is 20%. However, reliance on the statute could backfire, as the activist investor perhaps would welcome a special meeting to approve voting rights as a forum in which to present its agenda.
The old axiom “the best defense is a good offense” rings true for companies wanting to avoid becoming targets for activist investors in the first place. Commentators recommend a fairly uniform set of policies.10 Investor relations policies and programs will ideally include the following components:
- Have a clearly articulated business strategy that is communicated to investors. The more effectively a target has communicated the case for its business plan, the stronger the target’s position in negotiations with activist investors.
- Meet with investors and attend investor conferences and listen to what the investors have to say.
- Be prepared to justify capital availability and liquidity positions in relation to strategic goals.
- Be prepared to address any reasons for operational and financial performance shortfalls relative to comparable companies.
- Stay in contact with existing institutional investors as their decision to support activist investors may be determinative.
- Review the business plan in light of anticipated challenges regarding spin-offs, share buybacks, outright sale of the company and other matters and make appropriate adjustments.
- Maintain board consensus backing management’s strategy so that activists are not able to divide and conquer. Directors should encourage appropriate changes to avoid becoming a target. Management should articulate resistance to any changes to the satisfaction of the board.
Preparing the Defense
Companies should consider taking the following steps to be in a position to rapidly respond to an approach by an activist investor:
- Form a response team comprising key executive officers, investor relations, inside and outside counsel, an investment banker, a public relations firm with experience dealing with shareholder activists and a proxy soliciting firm. The team should keep abreast of current trends and strategies used by activist investors.
- Monitor trading and publicly reported shareholdings for accumulation by activist investors, including Schedules 13F and 13D. Consider engaging a stock watch or surveillance firm. Advise the response team and convene a meeting if there are any early warning signs of an activist investor.
A key component of a defense is an advance notice by-law. These by-laws prevent shareholder sponsored proposals at a shareholders meeting unless the company has been notified in advance of the shareholder meeting. Two recent cases (Jana Master Fund v. CNET and Levitt Corp. v. Office Depot) drew into question the validity of certain advance notice by-laws. Advance notice by-laws should therefore be reviewed and modified as required in light of the cases. In particular, advance notice by-laws with the following provisions should be examined:
- A by-law that suggests compliance is permissive instead of mandatory.
- A by-law that sets the deadline for a shareholder notice that is tied to the mailing of the prior year’s proxy statement.
- A by-law that requires shareholders to submit materials equivalent to Rule 14a-8.
- A by-law that does not explicitly state it applies to the nomination of directors.
Note also that one drawback to an advance notice by-law is that it requires an activist investor to announce its campaign at an early date to comply with the by-law. Most companies conclude that this is an acceptable trade-off to being taken by surprise shortly before a meeting.
Responding to an Approach
The most fundamental question to consider in the event of a non-public approach is whether to engage in discussions with an activist investor. While there is no duty to negotiate or, in most circumstances, to publicly disclose the approach, the question to consider is what will be gained by meeting with the activist. The following are relevant considerations:11
- A meeting will allow the company to correct any short-term views or any misinformation the activist believes is reliable.
- The company can seek to persuade the activist to moderate the related demands.
- A refusal to meet will likely be highlighted in any public demand to the detriment of the company.
- Stalling is not likely to cause the activist to abandon the pursuit of its agenda and runs the risk of making the ultimate negotiation more confrontational.
- The company will be able to gather intelligence if the activist engages in a public campaign.
If the decision is made to meet with the activist investor, legal questions surrounding compliance with Regulation FD and insider trading laws must be considered if non-public information is to be disclosed. Consideration should be given to obtaining a confidentiality agreement from the activist investor, but it is likely the investor will not agree to any provision that restricts its ability to trade in the stock.
In the event of a public approach, an immediate dismissal of the demand should be avoided. A board meeting should be called to consider the communication. As with a private approach, the company should seek to learn as much as possible about the activist investor’s agenda. Many of the same considerations for meeting with an insurgent after a non-public demand are applicable. However, in a study conducted by one commentator, it was noted that no activist abandoned a public agenda after meeting with the company.
If the company decides to resist the activist’s demands, it should deliver a compelling message as to why the demands are inappropriate and contrary to its previously stated long-term objectives. Plans should be implemented to prepare for a proxy contest and continuing communications with other investors to assess the likelihood of success. If the company decides to accept the demands or a negotiated settlement, the rational for acceptance or settlement should be clearly stated.
Other Recent Developments
In CA, Inc. v. AFSCME Employees Pension Plan, the Delaware Supreme Court held that a shareholder proposed by-law that would require reimbursement of costs for a successful campaign to elect a short slate of directors was invalid. The court noted that the by-law was a proper subject for shareholder action because it addressed the process for electing directors, a subject in which the shareholders have a legitimate interest. However, the court declared the by-law invalid because the by-law mandated reimbursement of election expenses in circumstances that a proper application of fiduciary principles could preclude. Such circumstances could include situations where the proxy contest is motivated by personal or petty concerns or to promote interests that do not further, or are adverse to, the corporation.
In CSX Corp. v. The Children’s Investment Fund Management (UK) LLP, the U.S. District Court for the Southern District of New York considered whether The Children’s Investment Fund (Children’s) violated Section 13(d) of the Securities Exchange Act of 1934 by failing to file a Schedule 13D and to disclose total return swaps on Schedule 13D. Children’s used the total return swap in connection with transactions that led to a proxy fight to elect a short slate to the CSX board. The court did not rule on the question of whether a total return swap confers beneficial ownership for the purpose of Rule 13d-3(a). The court did, however, find that Children’s violated Rule 13d-3(b) because the total return swaps had the purpose or effect of preventing the vesting of beneficial ownership as part of a plan or scheme to evade the reporting requirements of Section 13(d), and a Schedule 13D should have been filed at an earlier date. While the court enjoined Children’s from future securities law violations, it declined to enjoin Children’s from voting the shares because the information was subsequently disclosed. The case is currently the subject of an appeal.