Major shareholders have long hoped for expanded communication with their portfolio companies. But now corporate directors are witnessing an intensification of that trend, with large institutions making waves that they want and even demand to be heard.

Large pension funds, such as the California Public Employees' Retirement System (CalPERS) and the California State Teachers' Retirement System (CalSTRS), are more actively calling for change, expecting not only to receive substantive and timely communications from companies, but also to have an open channel enabling them to speak directly with board members.

There's no doubt major shareholders are capable of shaking up a board room. Anne Simpson, director of corporate governance at CalPERS, cites examples of activism leading to the departure of directors at such companies as Hewlett-Packard, JPMorgan Chase, and Occidental Petroleum. ”Shareholder activism is evolving from barbarians at the gate to acting like owners.” As owners, however, institutional investors are no longer content to sit on the sidelines passively, but instead are teaming with activists to urge major changes at some companies.

Wait, what? Activist investors—once thought to be the scourge of the investment world—are teaming up with brand name mutual funds, hedge funds, and mammoth pension funds? The answer, quite simply, is “yes.” You know the names:  William Ackman, Carl Icahn, Daniel Loeb, and many others. But why would the likes of Vanguard and T. Rowe Price join forces with such individuals? Well, one reason is that they believe that cooperating with activists can effect positive change. More on that in a moment

While boards have historically viewed activists with concern, now that concern escalates to fear, as directors recognize that these activists together with their institutional backers could more readily take over the corporate ship. Boards can and do put up defenses, but the risks of losing control are all too real.

While boards have historically viewed activists with concern, now that concern escalates to fear, as directors recognize that these activists together with their institutional backers could more readily take over the corporate ship.

It's fascinating to see how far shareholder activists have come from the days of well-known corporate “gadflies” Evelyn Davis and the Gilbert Brothers. I remember seeing Ms. Davis jump up at shareholder meetings to ask a brash question, and the Gilbert brothers—John and Lewis—questioning CEOs on compensation, majority voting, and other issues. (John Gilbert was known to wear a red clown's nose to shareholder meetings, whereas Lewis was the more effective elder statesman). Shortly before they retired from the governance scene, they told me about their attendance at the first Exxon (then Esso) shareholder meeting, which took place in a garage in New Jersey with about 30 in attendance, and how badly they were treated. Back then they were seen as pests easily swatted away, but over time they helped shareholders win some basic rights, including the ability to submit proxy proposals.

How far have activists come? We need to look no further than instances where they've gained the support of institutional investors to effect major change, with examples such as T. Rowe Price's backing Icahn's opposition to the leveraged buyout of Dell. But recently there's been a major shift that can be viewed as no less than a sea change—not only are activists looking for support from major institutions, now institutions are seeking out and engaging the activists.

“Periodically, we are approached by large institutions who are disappointed with the performance of companies they are invested in to see if we would be interested in playing an active role in effectuating change,” Ackman recently told the New York Times. The shift is so prominent that institutional investors even have an acronym for what's happening—they refer to an R.F.A., or request for activist!

Intelligent Activism

There are at least two main reasons for the trend toward institutional investors teaming up with activist investors. First, major funds and other investors see value in cooperating with the activists, who know how to work the system and effect change, where there's money to be made by goosing the value of a lagging portfolio company. Second, many activists have cleaned up their act. One fund manager says activism “is becoming more and more intelligent.” Another says, “Activists have become more sophisticated in how they present their arguments.”

But not all shareholders think the forces at work are necessarily positive. There's pushback, for example, from none other than BlackRock CEO Laurence Fink, who recently wrote to the CEO of every S&P 500 company about the problem of “the short-term demands of the capital markets,” and he urged them to fight back.

The outspoken Leo Strine, who recently left the Delaware Chancery Court to become Chief Justice of the Delaware Supreme Court, says that constant pressure from some shareholders may distract executives and adversely affect returns. He advocates, “giving management some breathing space to do their primary job of developing and implementing profitable business plans.”

That this is more than just rumbling under the surface is clear. Indeed, Michael Carr, head of Goldman Sachs mergers and acquisitions Americas group, told the New York Times that at some point activists will not even be considered activists anymore; they will just be thought of as ordinary investors. Already, he said, “the boundary between long-only money managers and activists is starting to blur.”

Are boards getting the message? A recent PwC survey indicates that many are not. While the report says that nearly 30 percent of directors have increased communications with institutional investors during the last twelve months, the report also says there's a “substantial percentage of directors who do not believe it's ap­propriate to communicate about substantive issues directly with these stakehold­ers.” In fact, 39 percent of directors don't speak with institutional investors.  Some of those directors say they have concerns about Regulation Fair Disclosure, which restricts companies from providing material non-public information to select shareholders, and some say it's management's job to communicate with investors.

So, what's a board to do? My view is that it makes eminent sense to move down the path of not only communicating relevant information to shareholders, and being open to receiving their suggestions and recommendations, but also establishing a two-way channel with major investors. According to Martin Lipton, a corporate governance expert and partner at law firm Wachtell Lipton, “We advise our clients that it makes a great deal of sense for directors to meet with the major shareholders.” And Reg FD issues can be managed at such meetings with the general counsel or governance officer present to issue a relevant press release or SEC filing if the need should arise.

We're in unchartered waters, feeling seismic shifts that can cause great danger on the open seas—where the captains of the governance ships need to have sensors out and take action now to ensure all parties are in sync regarding the composition of the board room and how best to protect and grow shareholder value.