Taking a shareholder onboard

Tony Featherstone examines the pros and cons of giving a shareholder a seat around the boardroom table.

There is only one way to describe Gina Rinehart’s push for Fairfax Media board seats: brutal. Since March, Rinehart has emerged as Fairfax’s largest shareholder, demanded three board seats, savaged the company’s performance and its board and rejected Fairfax’s editorial independence charter. Fairfax shares tumbled 30 per cent during the stoush.

Echo Entertainment Group’s battle has been just as ferocious. Chairman John Story resigned in June after an attack from James Packer’s Crown Group that culminated in newspaper ads criticising Story’s record at other companies. Crown, a 10 per cent shareholder, wanted board representation and Echo resisted on competition grounds. Now, Australian Rugby Union boss John O’Neill chairs Echo.

Rarely have pushes for board representation been so aggressive, had so much personal venom directed towards boards that resist such requests, or attracted so many media headlines over so many months. The Fairfax and Echo boardroom fights might suggest battles are commonplace and that many boards reject requests from substantial shareholders for board representation. But that is not the case.

"In my experience, the majority of boards tend to accommodate a request from a shareholder who owns around 20 per cent of the company for a board seat," says Rick Allert AO FAICD, former chairman of Coles Myer, Southcorp and AXA Asia Pacific Holdings, current non-executive director of AMP and chairman of Western Desert Resources.

"Boards need to consider requests from shareholders for board representation on a case-by-case basis and the circumstances surrounding the request. Certainly, if the board is unclear of the shareholder’s intentions – for example, it believes the intention is to gather information and make a hostile bid for the company or sees potential competitive risks from having the shareholder representative on the board – it should reject the request."

Allert adds: "Most of all, companies must be very clear what the shareholder would add if given board representation. The chairman must carefully consider the skills of the shareholder representative and how his or her appointment would affect board dynamics and unity. At a minimum, the chairman should interview the prospective director before granting the request."

It is hard to imagine Fairfax chairman Roger Corbett interviewing Rinehart, the world’s richest woman, about the skills she or her nominee directors would add to Fairfax’s board. Like others in her position, Rinehart has no legal claim for a Fairfax board seat, but with a 15 per cent stake in Fairfax she is well within her rights to request seats. There is an unwritten rule in corporate Australia that 15 to 20 per cent ownership typically gets a board seat.

Both sides have a case. Rinehart can point to Fairfax shares falling from more than $5 in 2007 to 45 cents in August 2012, the company’s previously ineffective strategy to transition to a digital future and the support of influential fund manager Allan Gray, a key Fairfax shareholder, in her board push. Long-suffering Fairfax shareholders might believe a potential Rinehart takeover of Fairfax is sorely needed.

Corbett could argue Rinehart does not have Fairfax’s long-term interests at heart; wants board representation to facilitate a takeover for Fairfax without paying a significant on-market premium; would add little to the board and upset board dynamics; and by refusing to sign the company’s editorial independence charter, a requirement for all directors, misunderstands or disregards Fairfax’s culture and product integrity.

Rejecting a major shareholder’s request for board representation can place boards in an incredibly delicate position. Directors must weigh up the shareholder’s motives for board representation, the potential benefit the shareholder’s representative could offer the board and company, and the possible damage if a hostile shareholder uses board representation for personal gain, rather than to govern for all shareholders.

There are many risks. A substantial shareholder could push for board seats to gain information about the company to help a potential takeover bid or use board representation to try to control the company. He or she could leak board information to the media and destabilise the company, or provide information to a competitor. And his or her presence on the board could damage director collegiality, create a dysfunctional board and lead to some directors resigning. But in doing so, the hostile shareholder who gains a board seat would breach his or her director’s duties.

Quentin Digby, a Freehills partner, says shareholders who push for a board seat can overestimate the benefits. "Quite often, gaining a board seat provides the shareholder with relatively limited power and influence, and certainly less than anticipated," says Digby.

"A board seat is not the golden prize some substantial shareholders seem to think it is. The reality is, management runs the business, not the board. For example, if a cornerstone shareholder wants to influence and control the company’s direction, it can’t really do that just through one or two directors on the board. In practice, his or her influence is more effective where it involves direct two-way engagement and support at the management level. A management (of the shareholder) to management (of the company) relationship has many advantages because often key issues are best ‘influenced’ well before they reach the board level. And unlike directors, a shareholder does not owe a fiduciary duty to put the company’s interest first."

Digby adds: "In some situations, gaining a board seat can also be counter-productive. The shareholder’s nominated director is bound by director’s duties and must prefer the company’s interests over the shareholder’s. Any information received as a director will be confidential to the company and cannot be used for the shareholder’s benefit. If the director is an executive of the shareholder and receives price-sensitive confidential information, that then may preclude the shareholder from being able to buy or sell any shares in the company."

Thankfully, the situation of investors launching all-out media assaults on directors who reject their request for board seats or board changes is the exception. The involvement of high-profile billionaires, such as Rinehart and Packer, has elevated the situation of shareholders demanding board seats, and, perhaps, given the issue more attention than it deserves. Rinehart’s rejection of Fairfax’s editorial charter, and a view in some sections of the media that she wants editorial control over the company’s content to gain public influence, amplified the stoush.

Digby says a shareholder who owns 15 to 20 per cent or more of a listed company and who seeks representation on the board, usually approaches the chairman for board representation. Such discussions are typically behind closed doors and the board considers the shareholder’s intentions and what he or she offers the company and board. If convinced the shareholder’s long-term interests are aligned with other shareholders and that the candidate is suitable, the board will appoint the proposed director and endorse his or her election to shareholders at the next annual general meeting.

Should that not occur, any shareholder who owns more than five per cent of a public company has the right to requisition the directors to call an extraordinary general meeting (EGM) to consider a resolution appointing a new director to the board (and can also propose a resolution to remove one or more of the existing directors). What follows is a "proxy battle" with the outcome being determined either way by a majority vote (more than 50 per cent) at the EGM.

Digby says it is rare for an activist shareholder to requisition an EGM to put a resolution to appoint a new director and remove another. "This tactic is not widely used. First, the board will typically know if the activist investor has the numbers to get a board seat and will head things off before the EGM is called or held. Second, forcing the company to hold an EGM will be viewed in the media as a hostile act. It can destabilise the share price and damage the shareholder’s investment and will obviously affect the shareholder’s reputation as well."

The experiences of Fairfax and Echo suggest boards have much to lose when activist shareholders push for board seats. The truth is, many more companies and boards benefit when substantial shareholders are granted board seats. The new shareholder may bring different skills and expertise to the board, new connections and perhaps a new profile and access to capital.

There are many examples of small and mid-size ASX-listed companies that give board seats to cornerstone investors. For example, an exploration company might secure funding from a Chinese state-owned corporation to develop a mine and an off-take agreement for part of the mineral products. Once approved by the Foreign Investment Review Board, the foreign investors would typically request, and be granted, one or two seats on the mining company’s board. In this case, the investor brings precious capital to the company, potential access to more capital, extra board skills through expertise of Asian markets and added profile to the company. Certainly, many junior miners eagerly promote their ability to attract a cornerstone investor and their representation on the board.

Another listed company might give a substantial shareholder board seats because this will add to the board’s expertise and stabilise its share register. Or because the board appointment of a well-known investor, or his or her nominee, brings added profile to a small company and gives other investors more confidence in its continuing governance structure.

An unlisted company might welcome a private equity (PE) firm on its board. A buy-out PE firm will typically be granted at least one or two seats on a private company’s board and may even drive the formation of its board. PE firms are less likely to seek board representation when investing in public companies, but their involvement can still add great value.

A much smaller private company might benefit from its "angel" investor joining its advisory or formal board to provide expertise.

In these examples, the shareholder, by gaining a board seat, brings much more than money to the company. Even so, all boards need a process to decide if a shareholder’s request for a seat should be granted.

Allens partner Mark Malinas says the starting point is deciding whether a shareholder is active or passive. An active shareholder, such as a hedge fund, might seek short-term share price gains, while a passive shareholder, such as a traditional fund manager, might prefer medium to long-term gain and not seek board representation. "The board must think carefully about the activist shareholder’s motives and how they align with the interest of all shareholders," says Malinas. "Ideally, what a board wants is a shareholder who is there for the long term and thus has the right incentives to govern the company for all shareholders. What it doesn’t want is a shareholder who seeks short-term personal gain through a board seat and who might gain at the expense of other shareholders."

The motives of activist shareholders can present a dilemma for the board when deciding whether to grant board seats, says Malinas. The risk is that they could use the board appointment to "game" the share price by implying an imminent takeover bid or that bigger company changes are likely. The shareholder then sells its stock, makes a short-term profit and damages the company’s long-term prospects. Or the shareholder gains control of the company by stealth without paying any takeover premium.

Malinas says the growing presence of hedge funds and other investors with a shorter investment horizon has compounded the problem for boards. Traditional fund managers typically have a longer-term investment mandate and often do not support activist shareholders. Hedge funds and other speculators may side with activist shareholders if their presence on the board means a quick share price boost.

Malinas says the next step is to assess what the shareholder’s nominee director offers the board. "The board should determine whether that director brings additional skills and access to resources the board does not already have, and how he or she will fit in with other directors. There are lots of examples you don’t read about in the press where shareholders get a board seat and add real value, even in circumstances where the shareholder had pushed aggressively for a board seat," he says. "For PE investors looking to hold for the longer term, the shareholder’s nominee may bring financial and structuring expertise and specific industry or sector knowledge. This can be of real value."

King & Wood Mallesons partner David Friedlander says "short-termism" is the biggest risk when boards grant a seat to an activist shareholder. "Time and again you see the share price get a short-term bump when the activist shareholder pushes for a board seat and it lasts a quarter or long enough for shareholders to sell out. All it does is damage the stability of the share register and encourages a more transient shareholder base."

Friedlander says competitive risks are another key consideration when activist shareholders have cross-shareholdings in different companies. "The company can be vulnerable if the activist shareholder has a stake in a key competitor or is on the board of a competitor," he says. "The activist shareholder can use the board seat to gain information that helps a competitor or a particular investor."

Friedlander says another vital consideration is board dynamics. "The board dynamic can quickly become terrible when you have a hostile shareholder on the board whom nobody wants there. Suddenly the board has to write down every single thing said at board meetings because directors are having missiles thrown at them. And the board is worried the activist shareholder will leak information to the media, which tends to give the activist’s position a good hearing."

Friedlander adds: "Proxy advisers can sometimes give activist shareholders more credence than they deserve when pushing for board representation. Smart activist shareholders will attack a company over an issue they know resonates with proxy advisers to gain support in any public battle."

Therein lies the biggest problem for boards. The real damage is often done when the activist shareholder airs his or her request for a board seat in the media, or threatens to call an EGM. Fairfax is a case in point. Fairfax’s detractors might argue the board has handled Rinehart’s attack poorly and amplified another problem for the embattled media company. But as always, so much information is not known, and one should never judge boards on who wins the public relations war.

The only certainty is that the biggest losers in battles for board representation are usually passive small shareholders caught in the crossfire.

Ten tips for boards in dealing with shareholder requests for board seats

1. Process: Understand the types of issues the board should consider when determining whether a shareholder or its representative is suitable for a board position and should be granted a directorship. Ensure the board has good access to specialist legal and governance advice in this area.
2. Share registry dynamics: Smart listed companies pay considerable attention to their share registers. An activist shareholder with 15 per cent might hold less sway in a company with a larger base of long-term institutional shareholders, or where another shareholder holds 40 per cent.
3. Shareholder style: Does the shareholder have a more active, short-term focus, or is he or she a passive, long-term investor who is less likely to seek board representation? Speculators and short-term traders can pose problems for boards when they seek directorships.
4. Shareholder intentions: Why does the shareholder seek a position on the board? Is it to help grow the company’s long-term wealth through good governance and to benefit all shareholders; or is it to safeguard his or her investment or create other personal financial gain? Directors must serve in the interests of all shareholders, never just their own. No director should be appointed to safeguard his or her investment.
5. Competition issues: Could appointing a shareholder to the board provide an advantage to a rival company? Shareholders with investments in competing companies can pose big problems when granted board seats. Competitive risk is a genuine reason for boards to reject such approaches.
6. Takeovers: Is the activist shareholder’s request for a seat simply part of an agenda to gain control, by using "creep" provisions in takeover laws, where a bidder can buy a three per cent stake in a company every six months after hitting the 19.9 per cent takeover threshold? Good boards ensure suitors pay a reasonable on-market premium to acquire companies, which benefits all shareholders, rather than allowing suitors to control companies cheaply by stealth, through board seats and antiquated creep provisions.
7. Other shareholders: A board is well within its rights to canvass the views of other shareholders when deciding whether to grant a seat to an activist shareholder. It should not base its decision only on the view of a single shareholder, but consider the interests of all shareholders.
8. Board skills: Chairmen should interview the activist shareholders and/or their representatives to determine what skills they offer the board and company, and whether they add additional skills to the board. The chairman should also consider how a director’s appointment would affect board dynamics, and whether it would cause director resignations. He or she should canvass the issue with all directors. Also, he or she should ensure the new director understands how the board functions and its expectations.
9. Rejecting the activist: Shareholders will expect the board to state why it did not support a resolution from an activist shareholder to be granted a board seat. However, there is a fine line between boards stating an opinion and lobbying shareholders to reject an appointment. Directors should be conscious of their legal risks if they are seen to prejudice shareholders against an appointment, and always seek legal advice. They should present factual reasons to shareholders for their decision not to endorse a director’s appointment, and keep emotions and politics out of the equation.
10. Treat each case on its own merit: Do not subscribe to the unwritten rule that shareholders should get a board seat on owning 15 to 20 per cent of the company. There may be good reasons why such shareholders should not get a board seat. The most important consideration is whether the board can govern in the long-term interests of all shareholders and, through good governance, help the company sustainably grow shareholder wealth. That is surely the ultimate consideration when deciding if an activist shareholder deserves a board seat.