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.

Directors can provide more insight on how they govern their companies, and investors can give more information on how they cast their votes, so that there is less mystery from both sides, stated Vanguard Chairman and CEO F. William McNabb in a recent speech at the University of Delaware’s Weinberg Center for Corporate Governance.

According to McNabb, Vanguard is the world’s largest mutual fund and owns about 5% of every U.S. public company, and the fact that they are “permanent shareholders” as an index fund is exactly the reason that they care about good governance.

Engagement was the primary focus of his discussion, and the impetus behind the more than 900 letters Vanguard sent to U.S. companies last year, with 358 of those requesting that companies make specific changes, which we previously discussed here in a conversation with Glenn Booraem of Vanguard. Over 80 companies have responded by making revisions.

In February 2014 a working group of some of the biggest long-term institutional investors – BlackRock, Hermes, Ontario Teachers’ Pension Plan, State Street and Vanguard – came together with leading independent directors from companies that included Home Depot and Hertz, as well as law firms and other corporate advisers like Cadwalader Wickersham & Taft and Teneo Holdings to form the Shareholder-Director Exchange (SDX). SDX offers, among many other things, a list of 20 red flags (see below) ‘that can draw the attention of activists and corporate governance experts and have led to engagement requests or activist campaigns’.

NEW YORK, Nov. 17, 2014 /PRNewswire/ — The Shareholder-Director Exchange (SDX) Working Group and Founders – Cadwalader, Wickersham & Taft LLP; Teneo; and Tapestry Networks – hosted the inaugural SDX Symposium at the Harvard Club in New York City on Friday, November 14, 2014. The event convened a group of leaders across various disciplines to engage in a candid discussion on the importance of shareholder-director engagement in corporate governance. Attendees included a distinguished group of CEOs, directors, and representatives from institutional investors and academic institutions.

Excerpt from report:

Shareholder Engagement: Emergence of Engagement Protocols

Shareholder engagement again took center stage in 2014. In April 2014, ISS published an update to its 2011 study, “Evolving Relationship Between Shareholders, Directors and Executives,” that suggests overall engagement levels are up — in terms of both the percentage of companies undertaking engagement and the frequency of their engagement. Study findings based on ISS’s survey conducted in late 2013 indicate that only 22% of issuers
and 19% of investors did not initiate any engagements that year. Both issuers and investors are paying greater attention and devoting increased resources to engagement, as regulatory and corporate governance trends have encouraged such dialogue. Evolving proxy advisory firms’ and institutional investors’ policy guidelines along with activists’ approaches have also placed greater emphasis on shareholder engagement.

Two new engagement protocols – Shareholder-Director Exchange (SDX) and The Conference Board Governance Center Task Force on Corporate/Investor Engagement – emerged in 2014. The SDX protocol provides a 10-point guide for public company boards and shareholders that determines when shareholder and director engagement is appropriate and how to make these engagements valuable and effective. Earlier this year, the SDX working group sent a letter to the lead directors and corporate secretaries of Russell 1000 companies, asking them to consider formally adopting a policy providing for shareholder-director engagement, whether pursuant to the SDX protocol or otherwise. The Conference Board Governance Center’s guidelines, released soon after the SDX protocol, similarly advocates for dialogue between boards and investors in special circumstances. But unlike the SDX protocol, the Conference Board guidelines do not regard it as a routine method of engagement for most companies and investors.

Following the London whale trading debacle at JPMorgan Chase & Co., which raised questions not only about the risk management practices at the country’s largest bank, but also how well the board of directors was overseeing management, the audit committee chairman of the $2.3-trillion asset bank went to several public meetings to explain what happened and what the board did to correct it.