When Reader’s Digest Association Inc. recently reported a 21 percent drop in quarterly earnings and cut its fiscal year guidance due to weaker-than-expected results from its consumer business services division, the stock dropped more than 3.5 percent in one day, to below $14 a share.

The drop was a stark reminder that merely improving a company’s corporate governance policies doesn’t necessarily translate into a higher stock price.

Just ask the folks at the Boston-based activist hedge fund Highfields Capital.

The Cost Of Activism

A couple of years ago it engaged in a contentious battle with the media company in an attempt to merge its two classes of stock into one class, whereby all shareholders had the same voting rights. It eventually won that battle, but the investor lost the war — Reader’s Digest stock currently trades at less than half what Highfields had paid at the time.

Here’s how it played out.

Back in 2002, Highfields upped its stake in Reader’s Digest to 3.5 percent of the Class B voting shares and 9.6 percent of the Class A nonvoting shares, and offered to swap nonvoting shares plus another $3 a share for all of the voting stock held by Wallace-Reader's Digest Funds, the company’s largest shareholder.

Highfields’ goal: To create one class of stock and "cause the company to focus on existing businesses that should be grown, run for cash or sold," according to a government filing at the time.

"Highfields' interest is only in accelerating the turnaround of the issuer that Highfields and others have been demanding for some time," it added.

After the Wallace Funds rejected the offer, Highfields lifted its premium to $5 a share.

And in a letter fired off to M. Christine DeVita, President of Wallace-Reader's Digest Funds, Highfields wrote, “While the Company's Board may think it is acting in the shareholders' best interests, it is not accountable to all the shareholders. Only the Wallace Funds have the power to hire and fire directors to whom management reports. It is hard to imagine that the Company's protracted miserable performance and governance defects are coincidental.”

Corporate Side Shows

Reader’s Digest, though, had a different plan. In response to Highfields’ overtures, the company negotiated a recapitalization, sort of along the lines of what Highfields sought.

Under its own plan, Reader’s Digest would merge the two classes of stock into one class. And the Wallace-Reader's Digest Fund and DeWitt Wallace-Reader's Digest Fund — the two funds established by the company's founding families — agreed to cut their voting power from 50 percent to 14 percent.

So, Highfields’ activism paid off, right?

Yes and no.

The funds would also sell 3.6 million of their 6.2 million B shares to Reader's Digest for $27.50 a share in cash, or $100 million, a 24 percent premium to their closing price at the time. The rest of the shareholders would get a 24 percent premium in just stock.

However, other side shows were taking place. One month before the company proposed the recapitalization, it also agreed to pay $760 million in cash for Reiman Publications, a publisher of cooking, gardening, country lifestyle and nostalgia magazines and books.

Reader’s Digest also planned to borrow $950 million to pay for the acquisition and the $100 million to the foundations.

Highfields was very unhappy with these arrangements.

In a press release fired off after the publishing giant’s deal with the funds was announced, Highfields described the premium paid to the funds as "greenmail." It added: "For the company to pay and the funds to accept this payoff squanders any hope for change and seriously endangers the future of Reader's Digest. It is clear that there is a long way to go before there is a level playing field between the owners of corporations and boards of directors who desire to entrench themselves by interfering with shareholder franchise."

Reversal, And A New Plan

Stockholders were expected to approve these transactions at a special shareholders meeting scheduled for August 14, 2002. However, this meeting was postponed when the Delaware Supreme Court reversed the decision of the Delaware Chancery Court denying an injunction of the company's pending recapitalization. It also instructed the Chancery Court to preliminarily enjoin the recapitalization pending a trial on the merits of litigation brought by shareholders.

Then, on Oct. 16 Reader's Digest trotted out a new plan, replacing the one announced earlier in the year. Under this recapitalization plan, the funds' voting power would be reduced to 13 percent from 50 percent while holders of the nonvoting stock would wind up with 79 percent of the voting power.

Finally, in December of that year, shareholders approved the plan. That plan resulted in the combining of all shares of the company's class B voting common stock and class A nonvoting common stock into a single class of voting common stock. Holders of the new class of stock received one vote per share.

Under the recapitalization agreement between the company and the DeWitt Wallace-Reader's Digest Fund and the Lila Wallace-Reader's Digest Fund, the company repurchased about 4.6 million shares of class B stock held by the funds for $100 million, at $21.75 per share.

So, where is the stock today? At $14 a share, down one-third since late 2002. Meanwhile, Highfields had paid more than $28 apiece when it started this fight.

Like we said, it’s not always about good governance.

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