Over the past decade, two seemingly disparate trends have been developing in the sometimes tempestuous relationship between shareholders and their Boards of Directors.
We have seen profound changes in the standards and expectations of corporate governance. Prompted by a series of business scandals including Enron and Bre-X, we have seen the introduction of Sarbanes-Oxley in the United States and comparable legislation in Canada designed to respond to specific investor concerns about the standards of corporate governance in North American public companies. These rules were intended to restore confidence in governance and disclosure practices. Ultimately they have fundamentally altered the landscape within which companies and their boards operate.
At the same time, we have witnessed an increasingly assertive culture of shareholder activism. This has grown rapidly in Canada partially as a result of the country’s capital markets attracting more United States hedge fund, private equity and other investors, who have traditionally been more vigorous in trying to influence boards than their Canadian counterparts.
These two trends have created an environment where activist share-holders have the opportunity and the inclination to engage on issues of governance and use it as leverage in strategic battles with corporate boards.
Increasingly, shareholders are pushing for changes in company direction, advancing particular interests and agendas and sometimes even challenging the composition of the board itself, creating an opportunity for dissident shareholders to influence corporate actions. Alleging breaches of corporate governance has become a key tactic for activist shareholders to apply pressure to a board. The new stringent standards of governance have created pitfalls for boards, and new opportunities for activist shareholders. Understanding corporate governance and securities law issues has become increasingly important.
The Pressure on Boards
One of the great challenges facing boards is how to reconcile competing interests within a company. Different shareholders may have different agendas, depending on their investment strategy. For example, a pension fund investor may have a very long-term perspective, while private equity investors typically have a shorter time horizon for their investment and may be looking for a large return in under three years. It is clear from recent history that the goals of activist shareholders can be complex. Sometimes they simply want to ensure that a company is meeting applicable governance standards that are the norm for the industry. At other times they may have more specific motives – such as the payout of existing cash resources through a special dividend, the sale of a division that may generate cash or stimulate a rise in the share price, or even a strategic review leading to the sale of the entire company.
In charting a course through these various interests, boards face a complicated task. They need to ensure they remain open and responsive to their shareholders, as well as satisfy different agendas. They also need to be vigilant to the possibility that activists may challenge their decisions and even become openly hostile to them.
The mechanisms shareholders use to express their views and try to influence boards will vary. In some cases, they may simply write a letter or meet with board members to remind the board of expected standards of what they consider to be appropriate conduct or to express their views about an issue the company faces. In other cases, however, they may attempt something much more aggressive such as an all-out dissident proxy battle.
While the methods and mechanics shareholders might employ will differ depending on their goals, a board’s fundamental approach should always be the same: ensure that it rigorously complies with the laws and standards in meeting its fiduciary duties. Doing so gives the board a specific defence under corporate law, insulates it from allegations of negligence and sends a message that it is not easily manipulated. Key to this is obtaining expert legal counsel, since the ever-changing legal framework requires a board to be advised by specialists who fully understand the law. Tactically, the very act of engaging a firm with recognized expertise in the area can deter – or at least dampen – the efforts of dissidents since they will understand that the board will not be pushed into strategic or technical errors that can be exploited.
Legal counsel also plays a critical role in policing dissident shareholders, to ensure that they comply with the rules governing their actions. These laws and regulations can be highly technical (such as those applicable to proxy solicitations or take-over bids), or cover more general issues outside of conventional corporate securities law, such as libel and slander. In all cases, the responsibility of a company’s lawyers is to ensure that the board is protected from unfair or illegal action, and to pursue remedies in the courts or before the securities commissions.
The Rules can Deter Activist Shareholders
While activist shareholders may benefit from the new governance landscape, they would be deluding themselves if they felt it was “open season” on boards.
Just as boards require legal counsel to protect them in the face of disagreements with shareholders, the shareholders also need experienced legal advice. For example, it is deceptively easy to launch a proxy battle in Canada – all that is required is support by as little as five percent of the shareholders to requisition a special meeting and any shareholder can solicit proxies in connection with a meeting that has already been called provided they comply with the solicitation rules. Conducting this process properly, however, is highly technical and the rules can seem arcane. Common pitfalls include inappropriately soliciting proxies without having issued a compliant proxy circular or not acting according to the law governing such solicitations. The result at minimum may be that proxies received under incorrect solicitations are rendered invalid and the votes are lost, but there is a possibility of the dissident and its officers being charged with an offence carrying a penalty of a fine and/or imprisonment.
The precarious nature of a proxy contest for dissident shareholders is all the more acute when the company is widely owned, since the board has the advantages of being funded by the corporation, having a pre-existing relationship with shareholders and better access to the shareholders, as well as the ability to communicate more quickly and effectively. While it is permissible to canvass shareholders for their views on a possible dissident battle, activist shareholders are not allowed to solicit votes unless certain legal requirements have been met. Common tactics such as issuing press releases, taking out newspaper advertisements, or setting up websites to gain support from the broad array of shareholders may end up violating the law if not done in strict compliance with the proxy rules.
Today both shareholders and boards face a changed environment, and more changes can be expected. The new relationship between them will continue to evolve but boards can expect more activist shareholder challenges up to, and including, full proxy contests with their full range of public attacks on the performance and integrity of the directors. Any failure to meet governance standards or technical requirements tilts the fight for control of the board towards the dissident shareholders.
Similarly, activist shareholders can expect boards to learn from the experience of all the preceding confrontations by other boards. As the body of experience grows, boards will develop new defensive strategies and roadblocks to resist being unduly influenced by activist shareholders. Any technical error by the activists will undermine their effort.
In this environment, both sides will continue to need expert counsel that understands both the technical and strategic aspects to avoid the tripwires standing between them and their objectives.