Insights & Reports > Kroll Global Fraud Report

Fallout from the financial crisis may create a tense battle between shareholder activists and corporate boards in the spring 2009 proxy season.

In one corner, public companies in the United States are responding to severe stock price declines by erecting classic defenses against unwanted takeovers: in 2008 (through October), some 50 adopted poison pills, versus 42 for all of 2007. A poison pill makes hostile bids more expensive by allowing existing shareholders – except the acquirer – to buy more shares at a discount. In addition, in 2008 more than 20 public companies re-priced options or exchanged underwater options for new option grants. Both moves are typically seen as benefiting management at the expense of shareholders.

In the other corner, activists are gaining new weapons to attack under-performing companies. Now that Congress has mandated limits on executive compensation for banks participating in the Wall Street bailout, in the upcoming proxy season every company should prepare for “say on pay” proposals. These give shareholders a non-binding vote on executive compensation at annual meetings, a litmus test of management performance.

During his campaign, President-elect Barack Obama endorsed legislation requiring such votes and co-sponsored a similar bill in the Senate.

Historically, “say on pay” proposals have passed at only a handful of troubled companies. Now, public concern over executive compensation will make them another weapon in the activists’ arsenal. Other important shifts include:

• The Obama administration is likely to address the issue of “proxy access”, making it easier for corporate governance activists to put their director nominees on company proxy ballots.
• The Securities and Exchange Commission is considering the New York Stock Exchange’s wish to abolish broker votes. Critics call the practice legalized ballot stuffing because stockbrokers, representing clients, traditionally favor existing boards in direct elections. Abolishing the practice means that more shareholders will vote directly.
• Since 2006, about two-thirds of S&P 500 companies have adopted some form of majority, rather than plurality, voting. This gives shareholders muscle to oust existing board members.

For activists, these developments come not a moment too soon. A number of institutions invest in corporate governance funds, which seek to gain above-average performance through changing company leadership – via taking board seats or ousting management – in order to unlock shareholder value through the sale of assets, stock buybacks, or increased dividends. The California Public Employees Retirement System, the nation’s largest public sector pension fund, is one such investor. It reported that in 2007, before the crisis set in, many of these funds posted among the worst returns since the movement was born, and many lagged in the first half of 2008 too. For example:

• Relational Investors – an activist at companies including industrial manufacturer SPX (2004), and retailer Home Depot (2007) – lost 10 percent in 2007 while the S&P 500 grew at 5.5 percent, an underperformance against the market of 15.5 percent.
• In Britain, the Hermes U.K. Focus Fund lost 9.4 percent in 2007, underperforming the FTSE index by nearly 15 percent.
• A major Japanese corporate governance fund trailed the Japanese market by almost 11 percent in 2007.

Corporate governance activists working with funds have plenty of motivation to increase their attacks. They need to raise their currently dismal relative returns in order to keep their institutional investors happy – and fees coming in. Armed with new ammunition, like “say on pay” proposals, they will find new targets. In this environment, however, activists have a limited window to turn around their funds. If they do not, their corporate targets will rightly start asking, “If the activists can’t profitably run their own businesses, why should they try to run anyone else’s?”

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Marcia Berss is an associate managing director in Kroll’s Chicago office specializing in public securities filings, corporate finance and corporate governance issues. She began her career as a corporate finance associate with Warburg Paribas Becker and was vice president in M&A for Dean Witter Reynolds. Before joining Kroll, she served as the European bureau chief and then senior editor for Forbes Magazine.

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