As shareholder activists continue to gain access to the boardroom with unprecedented frequency, it is more important than ever for executives and directors to be prepared for the possibility and have strategies in place to ensure the effective evaluation, selection and integration of activist directors.

Latham & Watkins partner Mark Gerstein, a Chair of the firm’s Mergers & Acquisitions Practice, was joined by Chris Ruggeri, a Principal at Deloitte Transitions and Business Analytics LLP, and Linda Morgan, a Director on the Board at Canadian Pacific Railway, for a recent 60-minute webcast focusing on how boards and executives can best prepare for an activist joining the boardroom.

In this Q&A interview, Gerstein, Ruggeri and Morgan offer highlights from the discussion. For more information, listen to a recording of the full webcast, Activists in Your Boardroom - Planning for and Managing the New Dynamic, which is available through May 20, 2016.

Why should the topic of activist investors be front of mind for executives and directors?

Gerstein: Activists are increasingly infiltrating the boardroom, whether by proxy fights or settlements. Their success rate has increased dramatically during the past several years, and that success has been evidenced both by fights won and by favorable settlements implementing board change. An average of two directors have come on board through a proxy fight or a settlement in 2013 and 2014, and, as far as we can see, that number is holding steady for 2015. It's a scenario for which every board should be preparing. While no company wishes to have activists forced onto its board, planning for that possibility in the longer run is useful both for the board and for the company’s shareholders.

What steps can boards take to proactively prepare for the inclusion of activist directors?

Gerstein: The important thing to bear in mind is that it is best to implement these measures on a clear day. In the context of a proxy fight, or even settlement discussions with an activist and a law firm, changes to bylaws, committee structure, board qualifications, confidentiality agreements and the like, while appropriate, may often garner more judicial or other attention. Instead, spending time at your next board meeting to both review these matters and make bylaws or other policy changes is appropriate and will generally serve a board well in its ability to maintain culture and effectiveness in the boardroom if activists do come on the board.

A few technical items generally involve the bylaws — most importantly, the number of directors required to call a board meeting. Many companies have one or two directors capable of calling a board meeting, and that is not necessarily ideal in the context of two activist directors coming on the board because it puts control of the agenda and timing in the hands of the activist directors, rather than in the hands of the board as a whole. We often suggest to boards that they move to three or more directors, or even possibly the majority of the board, having the ability to call those meetings, in addition to the chairman.

What are some of the best practices that apply to committee structure and leadership?

Gerstein: Board committees are another place to undertake a proactive review. Look at the membership of each of your committees. Are the board members well distributed? Is each committee on its own strong and led by a chair who has the ability to manage both the agenda and the strategies of that committee in the face of less than conciliatory relationships — perhaps in the case of an activist director who has come on the board? The delegation of authority to the committee should also be clear. Whether the committee has too broad or too narrow power should be assessed in the context of other directors coming on the board and joining these committees. Committee chair selection should be by the full board, rather than the committee itself. And again, a focus on having strong leadership in each of the committees is critical.

Board participation in meetings is also important. There are a number of companies that effectively invite all of the directors to attend committee meetings as observers. That practice can have benefits both from the use of time perspective as well as in terms of keeping all the directors well informed. But in the context of a boardroom that becomes perhaps less collegial or with a broader divergence of views, the ability to have committees function independently and on their own is generally preferable. It may be difficult to articulate a reason why the board is changing that practice after activist directors come on the board.

One should also review the authority of the chair and lead director. What is their role in shareholder communications? How do they manage communications between the board and management and employees? What kind of information requests can come to the management team from the board? This is a particular concern if principals of an activist fund join the board as directors. They tend to have a different view of information flow and access to employees. It can consume a lot of time, it can create disruption and uncertainty in the workforce and having a procedure in place where the chair has the ability to, not necessarily gate, but at least manage that process can be useful in the context of activists joining the boardroom.

What factors should boards consider when evaluating activist director nominees?

Ruggeri: The evaluation of nominees is a critical consideration. One of the areas that is always a challenge to assess is cultural fit. The decision style of the nominees will have a big impact on whether or not the board has a constructive style, so it is important to assess this. Are they likely to be analytical and thorough, or are they more intuitive and impatient in their style? Are they open to collaboration, or are they more closed in the way they process information and make decisions? You also want to be aware of their level of comfort with risk. Are they open to constructive debate around strategic considerations or transaction opportunities?

It is also important to take into account what we are seeing from the investors in terms of what they would like in the nominees who are being considered on the ballot. Proxy advisors, in particular, have favorably responded to candidates who tend to bring a fresh perspective. A fresh perspective can certainly be welcome on the board, but that fresh perspective really has to be aligned with the company’s long-term strategic direction.

How can nominating governance committees best begin to drill down the candidates?

Ruggeri: It is a combination of factors such as questionnaires, interviews, interactions and research that is done on the background of the nominee. If you think about a framework for assessing nominees, one of the things that is relevant is really looking at the skills matrix of the board in its entirety, and then what a specific nominee brings in particular and how that aligns with the company’s strategic direction and operating profile. So, making sure that a nominee is bringing something that is tangible and constructive.

Tenure has also become an issue. Certainly we have heard from a number of investors, and there are different views on this, but the proxy advisors have asserted that tenures that extend beyond a certain time frame suggest that there might be some degree of entrenchment and the board, or at least particular directors, may need some refreshment. Of course, there is a countervailing view that with experience comes wisdom. So, I think that the tenure issue needs to be considered on a case-by-case basis, but that it is certainly something that factors into it. You also want to consider the kind of fresh perspective the nominee will bring to the board discussion and what value it will add to shareholders in the long term as part of a cohesive whole.

Post-election, what advice do you have for boards as they integrate new members, especially with respect to committee assignments?

Morgan: At Canadian Pacific Railway, after the annual meeting that elected a board of seven new members and nine legacy members, that number of 16 was then pruned voluntarily. So, we ended up with a board that is now 10, of which one is legacy. So, that pruning process, in my view, was a natural progression and I think boards need to continually be in that process. They need to constantly be evaluating whether they are doing well on behalf of the shareholders, and ensuring that they have a board that represents all the necessary skillsets. I think the Canadian Pacific board is a good example of how you start with a difficult situation, but then, through natural evolution, you get to a place that is workable. We no longer talk about the new board members and the old board members. And that really happened fairly quickly.

When we were looking at committee assignments as a group, we were really more looking at the expertise among all of us and who could be most useful where. Now, one of the committees that was created post-election was the finance committee. We already had audit, compensation and operations committees, but we didn’t have a finance committee. And that, of course, was important to the new board members. So, I think that the addition of that committee represented a lot of the transition that occurred, but as far as the membership, I think from very early on it was about who is best equipped to serve on which committee, and it was not about legacy members versus new ones.

Activist directors tend to have a more hands-on approach in the boardroom. How can boards and management adapt to that?

Morgan: The issue of the relationship between boards and management is critical no matter who is on the board. There is a line that needs to be drawn because the board is not there to micromanage the company’s operation. I think it is very important to have a strong CEO, because a strong CEO will, from his or her perspective, manage the line crossing that can go on. I think our CEO has exercised appropriate restraint and emphasized the fact that the board is very important and very involved, but that at some point the management has to run the company. I think that is critically important, again, no matter who is on the board. Of course, the bigger the board the more this issue is going to come up. I have seen it and I am sure I will continue to see it, but I think a key element is the strength of the CEO and also the strength of the chairman of the board.