Learning From This Year’s Proxy Season

This is not just another review of the recent proxy season for lessons learned. Instead, it’s a wake-up call for Corporate America that a new brand of activist investor has arrived on the scene that may well call for a change in how boards communicate with their major investors.

The “shareholder democracy” movement has been defined over the past two decades by public pension, social responsibility, and some mutual funds. Now certain hedge funds and professional investors like Carl Icahn are using the proxy to pursue a change in the company’s strategic direction that they believe will deliver greater share value to the company’s investors. This is an agenda largely driven by economics. That’s a big change from the past, where activists historically focused on governance, social responsibility, and executive compensation.

Meanwhile, companies that are waiting for the Securities and Exchange Commission to tell them what to do could well be left behind. For example, access to the proxy for director nominations has been a sore point with investors for more than five years. The SEC considered rulemaking last year but stalled instead, and allowed companies the discretion to reject non-binding director nominating resolutions for a proxy vote. Theoretically, the issue will be back on the SEC agenda now that it has five commissioners again—but nobody over there seems to be talking it up yet.

Instead of trying to throw out an entire board, the new brand of activist investor is having significant success in pursuing companies to allow a minority slate of directors of their liking—usually two or three— to be proposed for proxy vote. And they are amassing enough shares to force companies to accept their director nominees.

Not all of these efforts have succeeded. In June, Biogen Idec won a proxy fight with Carl Icahn, who held a 4.3 percent stake in the Boston biotech company. Icahn claimed Biogen would perform better as part of a large pharmaceutical company. He nominated three people for the 12-member board; all were defeated at Biogen’s annual shareholder meeting on June 20.

But as stated in the Wall Street Journal, in the high-profile contest between CSX Corp. and The Children’s Investment Fund Management, “an independent analyst’s preliminary results” show that TCI won four of five seats the company was seeking on the CSX board. And for the record, regardless of how TCI fared, a federal judge did find that the fund had violated SEC disclosure rules as it gathered support for its cause this spring.

Investors also prodded more than 90 companies for a say on CEO pay. According to RiskMetrics Group, shareholder backing for say-on-pay proposals was roughly the same this year as it was in 2007. These non-binding proposals received an average of 43 percent of the shareholder vote—not something boards can ignore. When four of ten investors call for something, it’s time for boards to pay attention. Then there is the approach that insurance company Aflac took this year by voluntarily giving its shareholders an advisory vote on CEO Dan Amos’ pay package in 2009. Verizon Communications will do the same in 2009, but only after shareholders passed a say-on-pay resolution last year.

What’s troubling is that some companies are ignoring the need for full executive compensation disclosure. In January, Watson Wyatt Worldwide released a study that found 31 percent of 135 large-cap companies surveyed had no plans to disclose the performance goals that boards use to determine the compensation for the top five executives. This is like sticking a finger in the eye of the SEC and investors by saying, in effect, “We’re not going to help you understand the principle basis for compensating our top executives.”

Pulling Things Together

The newer trends in shareholder activism raise the question of whether it would be better to bring boards and shareholders together to prevent friction, and nurture courses of action that could make the company a better long-term investment for the shareholders.

Why not try to enter a new world of boardroom-shareholder communication? One barrier often raised by legal counsel is concern over violating Regulation Fair Disclosure. Well, I’m not so sure that’s a legitimate worry. In March at a policy briefing hosted by the Millstein Center for Corporate Governance and Performance, the center circulated a whitepaper that stated: “There is no insurmountable legal obstacle to board-shareowner dialog on executive pay or governance.”

Ira Millstein himself, associate dean for the center, told the gathering, “The new capital markets virtually demand un-circling the wagons and opening up communications between boards and management with shareholders.” The policy paper went on to say that Reg FD was designed to prevent selective disclosure of information; it is not a barrier to communication between directors and investors. “Reg FD is a caution, not a barricade,” the paper said.

The solution to Reg FD concerns is to have legal counsel or the investor relations officer (both of whom should have full knowledge of the company’s disclosure record) attend board-shareholder meetings. Should a director make an inadvertent disclosure of material, non-public information, the company has 24 hours to issue a news release or file a Form 8K containing the newly disclosed information, thus avoiding any Reg FD trouble.

To embark on this new frontier of board-shareholder communications, boards should consider:

(1) Creating a shareholder relations committee of the board that would be in the forefront of meeting with major investors. This would make a substantial statement that the company is serious about communicating with its shareholders. But to work, it must be authentic. This committee could be comprised of the CEO, the non-executive chairman or lead director, and the chairs of the nominating and governance, compensation, and audit committees.

(2) Reaching out to major investors and inviting them to meet with the Shareholder Relations Committee. UnitedHealth Group’s board nominating and governance committee last year created a nominating advisory committee of major investors and health care professionals, which now meets with the board committee to discuss what criteria they would like to see in director nominees. The committee even asked the investors to submit names for consideration as director candidates.

(3) Knowing what the activist shareholders are trying to achieve. Is it an attempt to impose a particular agenda as represented by the fund itself? (An example would be the role the union funds played in the Safeway proxy fight several years ago.) Or is a hedge fund or professional investor trying to refocus the company’s strategic direction to achieve increased share value? The latter is particularly difficult for CEOs because “outsiders” are challenging his strategic plan for managing the company. As difficult as it may be, boards should consider meeting with these investors. It doesn’t hurt to listen, and they just might have a better idea of making the company a stronger entity over the long term.

Taking steps such as these won’t mean an end to confrontational situations between boards and major investors. But they could go a long way toward avoiding costly proxy contests. Instead of the board and activist investors immediately going to their respective corners when the company is challenged, the board can invite them in and listen to their concerns and recommendations. After all, they are owners of the company, and they may have some worthwhile ideas. Then directors can use their best business judgment in determining what’s best for the company and its shareholders.