It was the corporate version of Mayweather vs. Pacquiao—DuPont CEO Ellen Kullman battling activist investor Nelson Peltz in a high-profile proxy fight over whose slate of directors should be elected to DuPont’s board. And like the injured Pacquiao, it turned out that Peltz was going into the fight with a major handicap to which most of the public was oblivious.

While Kullman and Peltz spent months campaigning for their candidates, the real muscle in this recent bout belonged to three companies that the media largely ignored: BlackRock, Vanguard Group, and State Street, the asset-¬management firms that were DuPont’s largest shareholders by far. Though Peltz’s Trian Fund Management owned a substantial stake in DuPont—24 million shares—it was dwarfed by the three big institutions’ combined holdings: about 150 million shares owned on behalf of investors in their funds. On the morning of DuPont’s annual meeting in May, Kullman and Peltz got word that the giants were voting all their shares for Kullman’s slate, sealing the outcome of a closely fought contest. Kullman won, but BlackRock, Vanguard, and State Street provided the victory.

It’s a sign of changing times. High-profile activists like Peltz, Carl Icahn, David Einhorn, and Bill Ackman have shaken the giants of the Fortune 500 over the past 18 months. Icahn increased the market capitalization of the world’s most valuable company, Apple, just by sending two tweets. But such headline-grabbing successes may have marked the apogee of their influence. The new reality is that the activists are not today’s true power players in corporate America. The biggest companies are increasingly influenced by a new set of bosses—small in number, working mostly behind the scenes, and becoming more activist by the day. Together they’re creating a new order for large corporations and even changing the way the capitalist system operates. They’re the biggest of the big institutional investors, the largest asset managers.

One of 2014’s biggest corporate governance stories was the seemingly inexorable rise in board-shareholder engagement with real-time, two-way interaction between public company board members and institutional investor representatives.

This article examines that story and assesses the underlying drivers that suggest growth will continue over the next decade.

2014: the year of engagement

In 2014, a number of regulators, standards setters and private coalitions in major capital markets took action to support such engagement. In brief:

•United States: In February, the Shareholder-Director Exchange (SDX), a working group comprising leading independent directors and representatives from large and influential US public companies and institutional investors, released the SDX Protocol. This offered guidance to boards and shareholders of US public companies about when board-shareholder engagement is appropriate and how to make the interactions more effective. Later in the year, institutional investors in the SDX working group sent a letter to Russell 1000 companies in the United States, endorsing the SDX Protocol.

In March, as part of a project on investor engagement, the Conference Board Governance Center released its own recommendations regarding board-shareholder engagement. Polls from the second half of 2014 suggest that more board members are communicating directly with institutional investors. PwC reported that 66 per cent of boards of US public companies communicated directly with institutional investors, compared to 61 per cent the prior year.

While a number of community banks are preparing for lock horns with dissident shareholders, a bank in Indiana managed to work with an activist to avoid a nasty brouhaha.

Editor’s Note: The following post comes to us from Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication by Jay Clayton, Mitchell S. Eitel, Joseph B. Frumkin, and Glen T. Schleyer.

It is clear that shareholder activism continues to evolve, expand and increase in influence. There is a growing emphasis, in particular by large mutual funds and other institutional investors, on shareholder engagement and shareholder-friendly governance structures that, together with the increased activity of activist hedge funds and other “strategic” activist investors, make shareholder engagement and preparedness an essential focus for public companies and their boards.

Most recently, BlackRock Inc. and the Vanguard Group, the largest and third largest U.S. asset managers with more than $7 trillion in combined assets under management, have made public statements emphasizing that they are focused on corporate governance and board engagement. Vanguard recently sent a letter to many of its portfolio companies cautioning them not to confuse Vanguard’s “predominantly passive management style” with a “passive attitude toward corporate governance.” The letter goes on to emphasize numerous corporate governance principles and to highlight in detail (as discussed further below) the importance of direct shareholder-director interactions. BlackRock recently updated its voting policies to make clear that they are more than just guides to how BlackRock votes–they represent “our expectations of boards of directors.” The new policies continue an emphasis on direct interaction between investors and directors.

These sorts of statements by large institutions are becoming more common—TIAA-CREF has sent letters to many issuers advocating the adoption of proxy access provisions, and a number of the largest institutions last year signed a letter sent to numerous companies in support of the shareholder engagement principles embodied in the Shareholder-Director Exchange (SDX) Protocol. These statements and advocacy efforts come amid continuing high level of shareholder activism at a wide range of large and small companies.

Chair Mary Jo White gave a speech at the Tulane University Law School 27th Annual Corporate Law Institute in New Orleans, Louisiana on March 19, 2015. Chair White’s speech on cutting-edge issues in M&A included a few observations on three specific areas: the current state of shareholder activism; the shareholder proposal process; and fee-shifting bylaws. The Shareholder-Director Exchange was referenced in the speech footnotes as an example of “efforts to provide services to assist in this engagement and to establish procedures and protocols for what some think engagement should look like.”

On The Current Activism Landscape:

“Activism is used to achieve a variety of outcomes: board seats or control of the board; an acquisition or spin-off of a non-core or unprofitable line of business; or a share buyback. Negotiations between an activist and a target company may take place privately, or an activist may choose to go public. An activist may also begin a campaign behind the scenes, but go public if it believes it is not being heard or making enough progress. Any of these approaches, if used in the right circumstances, can be compatible with the kind of engagement that I hope companies and shareholders can foster.

Increasingly, companies are talking to their shareholders, including so-called activist ones.[1] That, in my view, is generally a very good thing. Increased engagement is important and a growing necessity for many companies today.”

Concluding Remarks:

“Let me stop here. What I have been advocating a bit today is a more open, constructive and balanced approach between companies and their shareholders. Companies should continue toward greater engagement with their owners, and carefully listen to their views. Activists should act responsibly and according to the rules. The strategic creativity of lawyers on either side may not always best serve the public interest. Upending the traditional roles of management, boards, and shareholders should not be the objective. Companies need their management and boards focused on their “jobs” so they can deliver shareholder value and contribute to the economic growth and innovation on which our country has always depended. But resisting all change, stonewalling every overture or ignoring the views of shareholders is also not acceptable or productive. Constructive engagement should be everyone’s goal.”

Don’t be dissuaded by common concerns
As with any change in behavior, there may be questions or objections from those who have yet to fully embrace
more significant engagement. That said, we do not believe these should be insurmountable barriers to progress.
Among the perspectives we’ve heard in this regard are the following:
• “Strong shareholder-director engagement will disintermediate management.” This is not what large shareholders seek in an engagement program. Boards often choose to include management for legal support and to discuss operational issues. There are also matters that are the exclusive province of the board (e.g., CEO compensation), which we believe are appropriate for discussion with the board alone.
• “We’ll get tripped up on Reg FD issues.” To be clear, we are not seeking inside information on strategy or future expectations. Rather, we are seeking to provide the perspective of a long-term investor. Individual firms should decide how to manage this risk. You may choose to train directors, include your legal counsel in shareholder conversations, and/or set clear boundaries for discussions.
• “There is no time in our agenda.” Individual boards can decide how much time to allot to engagement. Respectfully, we’d submit that time for engagement with significant shareholders deserves consideration on a board’s agenda. After all, investors are an important constituency whom boards represent.
• “This would be too difficult to implement.” Many companies already have substantive engagement programs in place. The Shareholder-Director Exchange (SDX) Protocol, available at sdxprotocol.com, offers guidance for such programs. This protocol also provides specific considerations for companies that may be concerned about Regulation FD.

With more than two centuries of making everything from gunpowder to nylon and Tyvek, Dupont Co. has renewed its product lines many times. Now it is being pressed to renew its governing board as well. Its directors have turned over many times, of course, but Trian Fund Management, led by activist Nelson Peltz, is pressing for far more than a routine remake, demanding four seats of its own choosing at the table. This despite Dupont’s strong results over the past two years, its stock outperforming the S&P 500 index by 47 percent. Dupont did not give in to Nelson Pelz’s demands, but it did make big changes in its board.

Activist investors waged a record number of campaigns against U.S. companies in 2014 and show no signs of letting up in 2015. Among their trophies in 2014 was a complete housecleaning at Darden Restaurants, the largest operator of full-service restaurants in the U.S. When Darden directors backed a spin-off that many owners opposed, Starboard Capital—with the support of many institutional investors—led the ouster of the entire board. Much the same occurred at Canadian Pacific Railway in 2012, when Pershing Square Capital Management acquired control of its board.

This is a good time to renew your board before an outside activist tries to change it. Here’s why. The backing of the traditionalists like Vanguard Group is often giving activists like Trian — the latter with just 2.7% of DuPont’s shares — the extra clout they need. Vanguard holds more than $3 trillion in assets, making it the equivalent of the world’s fifth largest country in GDP, ahead of France. Along with its heavyweight brethren like Fidelity and Blackrock, it packs enormous punch. Vanguard owns some 5% of most publicly-traded companies in the U.S., and with half of its fund assets indexed, it is not going anywhere if it does not like its portfolios’ strategies or results. But that does mean indexed investors will remain passive if a company’s strategy could be strengthened or its results could be better.

As the 2015 proxy season approaches, the dominant theme appears to be the interaction between directors and investors. Though, traditionally, there was little to no direct engagement, recent experience indicates that communication between these two groups is now on the rise, in some cases resulting in collaboration. This is potentially a beneficial development, particularly insofar as it may help companies and long-term investors work together to resist pressure from activist shareholders seeking short-term profits. In the current environment where activists and hedge funds appear to wield unprecedented financial and political leverage, and the influence of proxy advisors is as significant as it is controversial, the predominant trend seems to be “toward diplomacy rather than war.”1 Organizations such as the Shareholder-Director Exchange, which began last year to offer guidance to shareholders and boards on direct engagement, are promoting policies that may reduce the incidence, duration, and severity of contentious public disagreements.

Shareholder-Director Engagement

Earlier this year, we identified shareholder engagement as one of the five developments to follow in 2014. This year’s proxy season showed that shareholder engagement with directors is undoubtedly becoming a staple of the governance landscape. Last spring, the Shareholder-Director Exchange (SDX) working group was formed by advisers to corporations to regroup leading independent directors and representatives from some of the largest and most influential long-term institutional investors. To provide a framework for shareholder-director engagements, the SDX working group created the Shareholder-Director Exchange Protocol (SDX Protocol). In July 2014, a letter written by investor members of the working group was sent to Chair, Lead Directors and Corporate Secretaries of every Russell 1000 corporations. The letter suggest to these corporations that they consider formally adopting a policy on shareholder-director engagement by adopting or endorsing the SDX Protocol or otherwise.

In Canada, the demand for engagement between boards and shareholders is also a reality of this new era of governance marked by greater activism. And demand for engagement on the part of investors appears to be growing. In fact, since 2010, the Canadian Coalition for Good Governance has recommended that boards adopt its model policy on engagement with shareholders and disclose it to shareholders. The recent SDX initiative suggests that boards would be well advised to discuss the format for shareholder dialogue, including the adoption of a policy.

Boards aren’t working. It’s been more than a decade since the first wave of post-Enron regulatory reforms, and despite a host of guidelines from independent watchdogs such as the International Corporate Governance Network, most boards aren’t delivering on their core mission: providing strong oversight and strategic support for management’s efforts to create long-term value. This isn’t just our opinion. Directors also believe boards are falling short, our research suggests.

A mere 34% of the 772 directors surveyed by McKinsey in 2013 agreed that the boards on which they served fully comprehended their companies’ strategies. Only 22% said their boards were completely aware of how their firms created value, and just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries.

More recently, in March 2014, McKinsey and the Canada Pension Plan Investment Board (CPPIB) asked 604 C-suite executives and directors around the world which source of pressure was most responsible for their organizations’ overemphasis on short-term financial results and underemphasis on long-term value creation. The most frequent response, cited by 47% of those surveyed, was the company’s board. An even higher percentage (74%) of the 47 respondents who identified themselves as sitting directors on public company boards pointed the finger at themselves.