Think Twice Before Settling With An Activist

Posted by Kai Haakon E. Liekefett, Vinson & Elkins LLP, on Thursday, December 22, 2016

The vast majority of activist situations result in a negotiated settlement between the activist and the target company. The problem is that—more often than not—settlements fail to secure long-lasting peace between the parties. This post examines why many companies have “buyer’s remorse” post-settlement and why a proxy fight is not the only alternative to settling with an activist.

The tide of shareholder activism keeps rising in the U.S. and elsewhere around the world. At the beginning of this era of shareholder activism, target companies fought back. For example, 15 years ago in 2001, more than 60% of the proxy contests in the U.S. went to a shareholder vote and only 20% settled prior to the shareholder meeting. Times have changed dramatically. In 2016 to date, only approximately 30% of the proxy fights in corporate America went the distance while 47% of them ended in settlements. And these numbers understate the prevalence of settlements because the vast majority of activist situations never reach the proxy contest phase. Many activist situations settle in private, confidential negotiations before any public agitation by the activist begins and long before the shareholder meeting.

Moreover, not only do parties settle more often than they did 15 years ago, they also settle much faster. The time period between the beginning of an activist campaign and a settlement has contracted significantly—from 146 days in 2013 to 60 days in 2016. Corporate America is capitulating. At times, it appears that corporate boards cannot wait to hoist the white flag and invite activists into the boardroom.

Needless to say, there are often good reasons for boards to settle. Frequently, boards and activists find sufficient common ground during private negotiations. Proxy contests are time-consuming, distracting and costly, which motivates many boards to avoid them. However, in recent years, it has become clear that many settlements did not yield the desired results. This post examines why boards should think twice before they rush into a settlement with an activist.

A Changing Investor Sentiment on Settlements

In the past, institutional investors favored settlements with activists due to the cost and distraction of proxy contests, but this sentiment has started to change. The rush to settlement in recent years has “unsettled” many institutional investors. They are now troubled that companies may settle with activists without seeking the input of other shareholders. Long-term focused institutional investors have come to realize that the short-term strategies of many activists are frequently at odds with their own investment horizon. The problem is that most activist hedge funds have relatively short lock-up periods, which is why these funds focus on short-term, event-driven strategies.

In response, several institutional investors have privately and publicly called on companies to engage with long-term investors prior to entering into a settlement agreement with an activist. For example, State Street issued a press release in October 2016 in which it called on companies to better protect long-term shareholder interests in settlements with activists. Over the past two years, other large institutional investors such as BlackRock and Vanguard have been pushing back against short-termism and hasty settlements with activists that could jeopardize long-term strategy.

Many institutional investors object to settlements that are reached outside the public eye. They would like companies to delay settlement and instead initially proceed toward a proxy fight to provide long-term investors with an opportunity to express their views. They criticize the fact that many companies treat the director nomination deadline as a “point of no return” that forces the parties into a rushed, private settlement. Many institutional investors would like companies to force activists to publicly disclose their opposing director slate and strategy. A private settlement without input from institutional investors may create more new issues than it solves.

The Inherent Conflicts of Activist Directors

Most activists demand a “shareholder representative” on the board and thus settlement agreements typically give activists the right to designate board members. At first sight, it makes perfect sense to give a significant shareholder a seat on the board. Upon deeper reflection, however, the concept of activist representatives as board members is fraught with potential for conflict. Like every other board member, activist directors owe fiduciary duties to the company on whose board they sit. Simultaneously, these individuals also most often owe a duty of loyalty to their funds and their own investors. Frequently, conflicts arise for these representatives in their role as dual fiduciaries as a result of different investment time horizons. As explained, activist hedge funds are frequently short-term investors by design. By contrast, Delaware law requires that directors maximize the value of the corporation over the long-term for the benefit of all shareholders. Under Delaware law, a director’s fiduciary duties require that the director act in the best interest of all the corporation’s shareholders as a collective. This “single owner standard” creates a dilemma for board members who are also principals or employees of the activist hedge fund that designated them to the board. A common retort of activist directors is that if they were placed on the board by a particular constituency, they must represent the interests of that constituency. However, Delaware courts have consistently rejected the concept of “constituency directors.” Therefore, activist directors are breaching their fiduciary duty of loyalty if they act to benefit their fund to the exclusion or detriment of the corporation and its shareholders. Consequently, in theory, activist directors are required by law to put the interest of the company above the interests of the activist hedge fund.

Unfortunately, the reality in corporate America does not always meet this legal standard. While there are instances of activist directors who act in the best long-term interest of all shareholders, there are countless examples of activists who solely promote their own short-term interests in the boardroom. Common examples are activist directors who advocate for an immediate sale of the company even if there is reason to believe that a higher price could be obtained a few years later. Activists also frequently push for an immediate “return of capital” to shareholders in the form of share buybacks or special dividends, and it is almost unheard of for activist directors to promote a long-term investment in a plant or R&D. That should not surprise anyone, especially because there are not always legal repercussions when activist directors promote their short-term agendas. For a variety of reasons, boards are extraordinarily reluctant to sue fellow activist directors for breach of fiduciary duty. Activist directors face potential liability mostly as a result shareholder lawsuits in connection with the sale of a company. For example, last year, a Delaware court found an entire board potentially liable for breach of fiduciary duty after the incumbent directors allegedly acquiesced after being badgered into a sale by activist directors.

In sum, there are myriad complexities that arise when appointing an activist director to the board. These issues are at least mitigated, however, if the activist fund designates an independent director as board member. In this context, it is important to unearth any “golden leash” arrangements, pursuant to which activists provide additional, special compensation to their directors designees. In several proxy fights, companies successfully argued that “golden leashes” create incentives for activist directors to put the interests of the activist above their fiduciary duties as directors of the company. As a consequence, nowadays activists are exceedingly reluctant to employ golden leashes.

Failed Settlements and Subsequent Proxy Fights

In light of the aforementioned divergence of interests, it should not come as a surprise that many settlements fail to secure lasting peace. Numerous activist situations that were resolved with a rushed settlement subsequently escalated into a full blown public fight after the standstill period expired. In other words, many settlements ultimately fail to achieve the board’s primary objective: avoiding a fight.

The problem is that many boards agree to settlements even though they disagree with the core strategies advocated by the activist. Boards often hope to convince activists of the wisdom of their vision for the company once the activists are inside the boardroom. The reality, however, is that activists often will not come around to the board’s views, in part due to different investment horizons. In these cases, settlements only “kick the can down the road.” In other cases, in particular where the activist’s goal is a sale of the company, activist directors intentionally make the board dysfunctional in order to incentivize the other directors to sell.

Another factor is that standstill periods in most settlement agreements are relatively short. In recent years, most settlements provided for a one-year standstill, where the activist sits out only one proxy season and reserves the right to launch another proxy contest the following year. Depending on the nomination deadline for the next annual meeting, some standstills last even only six to nine months. This is not a lot of time for a board to implement changes with lasting effects and makes it difficult for the board to focus on long-term strategies. In practice, the looming specter of a proxy fight in the near future often stands in the way of constructive cooperation between an activist and a board.

Fighting a proxy contest against activists becomes harder after they have been inside the boardroom. Delaware courts have indicated that, when a director serves on the board as the designee of a shareholder, the director is permitted to share confidential board information with the designating shareholder. Many practitioners believe that the courts established only a default rule that can be contracted away by virtue of a bylaw, a confidentiality agreement or a board policy. Generally, however, activist directors are free to share confidential company information with their fund, provided that the fund does not trade on the information or misuse it in other ways. Activists often expressly negotiate for this right in a settlement agreement.

This issue becomes even more problematic if the settlement agreement permits activist directors to serve out their terms after the standstill expires. In that framework, the activist is free to launch a proxy contest against the board from within the boardroom, which creates complicated legal issues. Under Delaware law, a director has generally “unfettered access” to all company information. However, this situation may make it desirable or even necessary to shield the deliberations of the remaining directors from the activist representatives on the board. Delaware courts have allowed boards to form special committees and withhold privileged information once sufficient adversity exists between the company and the activist directors. Still, numerous practical issues persist.

Alternatives to Settlements: Looking for the “Third Way”

The risks and issues described above should make it plain that settlements are often not the right answer. Boards should be reluctant to enter into settlement agreements if there is not sufficient common ground with the activist. Still, even boards that realize this point are often hesitant to show the courage of their conviction because of a desire to steer clear of proxy contests.

In practice, the fear of proxy fights is largely overblown because these contests are not remotely as sordid as political campaigns. Institutional investors and proxy advisory firms such as ISS and Glass Lewis insist on civilized, merit-based campaigns. The Securities and Exchange Commission (SEC) is closely watching proxy contests and expressly prohibits activists to impugn the character, integrity or personal reputation of a company’s directors without factual foundation. And, while the media is fascinated with activist campaigns against mega cap companies, proxy contests at smaller companies are rarely picked up by The Wall Street Journal, Bloomberg or CNBC. Lastly, unlike in previous years, this year boards have fared pretty well in proxy contests that went all the way to a shareholder vote. In 2016 to date, boards prevailed in almost 70% of the proxy contests. This shows that directors who have the courage of their conviction do not need to be afraid of a proxy contest.

That said, the better approach is to not view activism as a binary decision between settlement and proxy fight. Rather, boards should work with their activism advisors to look for a “third way” to resolve an activist situation. For instance, in practice, it is uncommon for activists to be wrong on all counts. Sometimes it makes sense to implement a few of the activist’s suggestions unilaterally. There are also many other creative tactics that can be used to take the wind out of an activist’s sails. Typically activists have numerous companies in their portfolio; however, they do not have the bandwidth to pursue more than two or three full-blown campaigns simultaneously. If a board is nimble early in the engagement, many activists can be convinced to move on to another, easier target without a settlement.