Tony Featherstone examines an apparent trend in shareholder activism and provides some pointers on how boards can deal with it.
There are two opposing views on the rise of shareholder activism in Australia. First, that boards should embrace the benefits of an active, engaged shareholder base and accept that sophisticated, public and at times combative activism is here to stay.
The second view is that activism is emerging as an alternative asset class to exploit weaknesses in Australia’s regulatory regime: from the “two strikes” rule that arguably gives too much power to minority shareholders, to inadequate regulation of class actions, and an insufficient national “safe harbour” or business judgment rule for company directors.
Under this view, Australia will follow US trends and experience a sharp rise in shareholder activism against small and large ASX-listed companies in the next few years. More investment funds will be established with a mandate to engage in activism and boards and management will be mired in costly battles against protagonists with short-term motives. Law firms, such as Clayton Utz, have dubbed 2014 as potentially the “year of the shareholder activist”.
Activism is used by shareholders to influence a company’s behaviour by exercising their rights as owners. Tactics range from voicing concerns with management and the board in private, to public campaigns and pushing for proposals that are voted on by all shareholders.
Although shareholder activism has existed in Australia for decades, the big difference is that more institutional investors are becoming involved, working together on issues and targeting larger listed companies.
“The shareholder activism movement in Australia is just in it is infancy,” says Hugh McLernon MAICD, managing director of leading litigation funder Bentham IMF.
“There will be many other institutional investors focused on shareholder activism and others set up only for that purpose in the next few years.”
Arnold Bloch Leibler partner, Jeremy Leibler MAICD, says: “Through shareholder activism, we are starting to see a shift from director-centric governance to shareholder-centric governance. That is, shareholders are having a much more active say on strategic issues such as asset sales and takeovers.
“This is a dangerous trend for boards. They cannot allow activists to cause a shift in the board’s role from guiding and overseeing strategy to only ensuring compliance and governance.”
Dr Ulysses Chioatto MAICD, executive director of proxy adviser ISS Governance, says Australia could see a wave of shareholder activism.
“That is good news for investment banks seeking defence mandates and bad news for companies with lazy management or poor corporate governance.
“It will have mixed outcomes for shareholders, who will benefit if a company is forced to lift its game, but lose out if short-term activists wade in and undermine long-term strategic planning.”
ISS Governance identified a sharp rise in activist activity last year, with 230 “public actions” against listed companies. ISS says there were eight board spills announced in January 2014 — a record. Shareholder activism in the past five years in Qantas Airways, Fairfax Media, Brickworks, Intrepid Mines, Billabong International, Lynas Corporation, Australian Agricultural Company and Infigen Energy confirms the emerging trend.
A prominent campaign against retailer David Jones saw fund managers BT Investment Management, Perpetual and Allan Gray challenge the board over its retail experience, executive pay and corporate governance. The campaign led to former chairman Peter Mason AM FAICD and two directors stepping down in February.
The stoush between dissident shareholders Perpetual Investment Management and MH Carnegie & Co, and Washington H. Soul Pattinson and Brickworks is a closely watched current activist campaign.
Boards should keep a close eye on activists who use new tactics to exploit value. Some activists could maintain a small shareholding and use derivatives to maximise their leverage to corporate change and potentially a higher share price, in turn making it harder for boards to defend their advances. Instead of pushing for board seats, the activist fund could force change without director representation, to reduce personal legal risk by remaining free from director duties.
Other activists could adroitly use board spill powers, under the two strikes rule, to push for board change and install “friendly” directors, effectively taking control of the company without paying a premium to shareholders.
Another threat is local and foreign shareholders, private equity firms and fund managers joining forces to form a “wolf pack” around a takeover or asset sale, and to push for corporate change, under the guise of shareholder activism.
Wilson Asset Management chairman, Geoff Wilson FAICD, says investors are more likely to work together on activist campaigns.
“There are certainly more conversations between shareholders around this. That said, everybody forms an independent view and shareholders must disclose if they are working together. But it makes sense for funds with mutual interests on a governance issue to team up.”
Wilson has been involved in shareholder campaigns against the mortgage lender RHG, the former Australian Infrastructure Fund, Alesco Corporation during its takeover by DuluxGroup, and some listed investment companies, but does not describe his funds as “activist”.
“It’s only when we see something we do not like and aren’t being heard by a company or board that we make a noise about it,” he says.
“It costs funds a lot of time and money to run with an activist’s campaign, so it is not something you do lightly.”
Wilson says: “Ninety five per cent of companies and boards do the right thing. It’s really at the fringes where the funds are prepared to take on a company that is doing the wrong thing or not listening to shareholders.
“When you manage money on behalf of superannuants, you have a responsibility to do so.”
In a new scenario, activists could team up with litigation funders to better understand how the law can be used to force change and maximise shareholder value.
Company Director understands that Bentham IMF is reviewing how and if it can advise shareholder activists on such matters. There may be scope for Bentham to use its strategic litigation skills to help activists force change through the courts.
Although seemingly unrelated, shareholder activism and class actions could find common ground. The risk is that a successful class action eventually pushes for a financial remedy and governance change, such as the appointment of independent directors, as part of the overall settlement.
Compounding these challenges is the prospect that activism will find different targets. If Australia follows US trends, activists will increasingly target larger companies across a wider range of industries.
Up until now, activists have typically attacked smaller companies that are vulnerable to their advances.
US activists are not only zeroing in on underperforming corporate laggards with recalcitrant boards. High-performing companies, such as Apple Inc and PepsiCo Inc, have been targeted by activists over their balance sheet policies. Investment returns, it seems, is no longer the main determinant for activists.
Strong demand for dividend yield and franking credits in Australia, amid record-low interest rates, could encourage a different form of activism: shareholders protesting that a board should return more cash to shareholders in the form of special dividends or higher ordinary dividends, and seeking the support of other shareholders to force change if their demands are not met.
Activists are also likely to use new channels to promote their interests, particularly where they need support from retail investors. Wall Street titan Carl Icahn’s vigorous use of Twitter to state his case for change in Apple, eBay Inc and other companies in the past 12 months is another reason why Australian boards collectively need to lift their understanding of social media.
The big unknown is how far shareholder activists will take their campaigns. Although the ability of investors to direct how boards run companies is limited, the fear is that activism could be used in other ways to dictate corporate strategy to boards — in part, because activists are unhappy with how boards have engaged in strategy or held management accountable for performance.
Some activists clearly believe they can do a better job on strategy than boards.
Clearly, US developments on activism and class actions provide good reason for local regulators to ensure that our boards are not mired in mischievous actions, or that directors do not need to attend every board meeting and investor roadshow with lawyers at hand.
But that does not mean Australia will automatically mirror US trends.
Although shareholder activists attract headlines, Australia has had less exposure to the more aggressive US displays of activism.
Unlike in the US, Australian activists mostly pursue change by way of the board spill process through the two strikes rule. And this market has so far not had the depth of hedge funds or specialist investment funds to amplify the activist trend.
Also, many boards are acutely aware of these trends. Leibler has advised boards on defences against shareholder activists and has helped prepare others against the activism threat. His firm has also advised activists.
“Boards are increasingly looking at their organisation with an ‘activist hat’ on,” he says.
“They are seeking advice on where or how an activist could target the company and preparing for potential attack through mock scenarios.”
Leibler says Australian boards are more exposed to shareholder activism than their US peers.
“US directors have better protection from activists in terms of personal liability and US companies have greater takeover defences through ‘poison pill’ strategies and other takeover defence mechanisms. It is fair to say that activists could target Australia because they see boards here as more vulnerable.”
Leibler says shareholder activism has become so pronounced in the US that it is emerging as a new form of asset class as hedge funds, institutional investors and private equity firms use it as a tactic to enhance investment returns.
“We are seeing more activist funds formed in the US and activists generally becoming a lot more organised and structured, to create short-term value through their efforts. The jury is out as to whether these funds will create sustainable long-term value.”
No one doubts that the rise in US shareholder activism, and its likely rise here off a low base, is an important development for boards. Or that boards should prepare for activism, through ongoing shareholder engagement and as part of their normal risk-management activities.
Understanding how the board would meet its fiduciary duties through an activist campaign is critical.
But it would be dangerous for boards to over-react to this trend. Predictably, activist campaigns create a disproportionate amount of media coverage relative to their impact.
Professor Ian Ramsay, director of the Centre for Corporate Law and Securities Regulation at Melbourne Law School (Twitter @MelbLawSchool), says: “The increase in shareholder activism is more incremental, rather than a sharp, sudden change. In some instances, we have seen activists target larger companies and be more aggressive, but so far it has been the exception rather than rule.”
Several high-profile activist contests in the past five years have not materialised or the dissidents have lost their campaigns. Board change as a result of fierce shareholder activism, seen in David Jones and Echo Entertainment (where chairman John Story FAICD resigned in 2012), are notable exceptions.
Moreover, shareholder class actions that attract front-page headlines are small in the scheme of corporate Australia.
More than $1 billion was paid out in shareholder class sectors over 20 years to 2012, according to law firm King and Wood Mallesons research. Although settlements are rising, the overall amount compares to an Australian sharemarket capitalised at $1.56 trillion in April 2014.
“Fears of a sharp rise in shareholder class actions in Australia are also overstated in my view,” says Ramsay.
Also, talk of sharply higher activism overlooks the work of Australian boards to lift shareholder engagement.
Even proxy advisers say governance standards in S&P/ASX 200 companies, especially around executive pay, have improved in the past few years, and that many listed companies have noticeably lifted their shareholder engagement.
“In the past, we only spoke to management,” says Wilson. “But now we get a lot of calls from chairmen wanting to meet with us, usually when the board has had a first strike, to explain their position.
“I was against the two strikes rule when it first came in, but now I support it because has clearly forced boards to listen to and communicate more with shareholders.”
Another issue that could limit growth in shareholder activism is the composition of investment funds in Australia. The self-managed super fund sector is incredibly diverse. Industry super funds have shown greater interest in broader governance issues, such as executive pay, diversity and corporate social responsibility, rather than aggressive activism. And the ability of retail super funds to engage in combative activism could be limited by the small size of this market — for example, consider the issues if a prominent fund manager from an investment bank began attacking a company when other parts of that bank advise it on capital raisings.
Moreover, shareholder activism, and class actions for that matter, can damage the interests of long-term shareholders, such as super funds.
Activists often have short-term incentives, and class actions involve a redistribution of wealth from the company to shareholders who seek remedy (and law firms and litigation funders involved in the action), or from the insurance firm that ultimately pays out the settlement.
Either way, it is not clear that aggressive activism will be supported by the shareholders who matter most — superannuation funds.
Technically, Australian activists are limited in their ability to influence strategic change in companies, thanks to the long-held NRMA principle. Born out of the lengthy campaign for control of the then NRMA’s board, it means investors in Australia cannot call a general meeting to direct strategic change, as US investors can do through shareholder resolutions. Australian activists have to use board spill motions to call for board change — or to send a message to the company.
The NRMA principle “makes US-style activism more challenging in Australia,” ISS Governance notes in its insightful April 2014 Shareholder Activism in Australia report.
Another issue is the definition of “activism”. The fund manager Allan Gray, for example, has been involved in several campaigns, most recently Roc Oil’s proposed merger with Horizon Oil, but does not see itself as an activist investor. It believes it is simply doing what all funds should do — fighting on behalf of their investors for better governance that leads to higher shareholder returns.
“Activism is the wrong term,” says Allan Gray Australia (Twitter @AllanGrayAus) managing director, Dr Simon Marais.
“We see it as our responsibility to challenge companies and boards that have poor governance and are not performing. Surely it’s our duty, on behalf of our investors, to hold these companies accountable? If regulation is not holding companies accountable, then it’s up to the shareholders.”
Marais says: “We generally don’t take a position in a company with the express idea of changing it through shareholder activism. And we are long-term investors.
“But if the company does something that is not in the best interests of shareholders, or is taking too long to change, then of course we will say something.
“As custodians of other people’s superannuation, we have to do this.”
Marais believes more investment funds have become engaged in activism for two reasons.
“First, there are lot of independent fund managers who are coming through the system, who are not in the game like some big fund managers in terms of their corporate relationships.
“Second, industry super funds are taking a lot more interest in governance and having a much bigger say in issues such as pay-for-performance.”
Could it be that funds, such as Allan Gray, are doing what many boards have called for in recent years — institutional investors having greater input into governance rather than outsourcing this function to proxy advisory firms? And is there a benefit in having long-term shareholders who are more active and engaged, and only combative and publicly activist as a last resort?
“Boards should take advantage of a more active and engaged shareholder base,” says property group Stockland Corporation’s chairman, Graham Bradley AM FAICD.
“Shareholders own the company and the fact that they are much more interested in talking to the board and management is, on balance, a very good thing.
“Higher levels of shareholder activism is inevitable and where the world is heading for boards.”
Bradley also chairs HSBC Bank Australia, metallurgical coal business Anglo American Australia, Virgin Australia International Holdings and Po Valley Energy.
He says: “There will always be shareholders who are interested in a quick turn on their investment and who will use whatever pressure is available to them, which may be at the expense of long-term value creations. Boards have to weigh up the interests of short-term and long-term investors in activist campaigns.”
The evidence suggests shareholder activism in Australia, while increasing, is not yet a significant problem for the majority of ASX 300 boards, most of which are more than capable of staring down activists who have opportunistic, low-merit campaigns.
But there is a risk that Australia’s regulatory settings could open the door for higher shareholder activism in coming years.
Like many leading directors, Bradley has been concerned about the potential for the two strikes rule to give too much power to minority shareholders.
“There’s no doubt that the two strikes rule has been misused in some cases by shareholders intent on destabilising the company for personal purposes,” says Bradley.
“With a large section of shareholders often not voting on resolutions, activists can get a strike against a company with a low proportion of the vote, which is a real problem with the way the legislation was drafted.
“The executive pay issue has become a lightning rod for shareholders to express other dissatisfactions with the board.”
Bradley says the lack of a new and improved national business judgment rule for company directors is another shortcoming. Such a rule could provide a much stronger, clearer defence for directors who act to the best of their judgement at the time, but are later seen to have made poor decisions in good faith.
“Australia absolutely needs a ‘safe harbour’ rule to better protect directors. I don’t know why this is taking so long,” says Bradley.
“Americans have a very sensible rule that says if directors rely on credible advice from management, and act in their best judgement, they will not personally be liable if something goes wrong.”
Ramsay is also concerned by the way in which the two strikes rule can be used by shareholders to pursue agendas not relating to remuneration and laws that impose liability on directors without any fault on their part.
He welcomes the move of state governments to wind back some of these laws.
“These laws impose liability in unfair ways,” he says.
The Australian Institute of Company Directors has long called for a stronger, clearer statutory business judgment rule to better protect directors and ensure a fairer balance between the risks and rewards of directorship. The lack of such a rule arguably plays into the hands of opportunistic shareholder activists.
Regulation of class actions is another missing piece of the regulatory framework.
“There is no doubt that litigation funders in Australia need to be regulated,” says Professor Michael Legg FAICD (Twitter @LitigatorLegg), a prominent legal expert on class actions, from the University of New South Wales Faculty of Law.
“I am not saying we should regulate litigation funders out of existence, but rather ensure that funders who back litigation can live up to their obligations.”
Legg proposes a licensing regime for litigation funders and a capital-adequacy test to ensure that only credible, solvent funders are able to back time-consuming class actions.
“The likely result of more litigation funders entering this market is higher-risk cases being pursued, to elicit quick settlements from companies to make the cases go away,” he says.
Governance observers might suggest there is, at best, an indirect link between shareholder activism and class actions.
The former involves current shareholders who agitate for change through market and governance mechanisms.
The latter involves shareholders at the time of the alleged breach — often several years prior because of the lag in class actions — who seek remedy through the courts.
But Legg says there are two linkages. The first is that the rise of class actions is creating a culture of blame among shareholders who, on the one hand, have to take risks, and on the other, expect somebody to pay a price if something goes wrong.
“Growth in class actions may have emboldened shareholder activists to pursue more aggressive strategies against boards,” says Legg.
The second linkage is the type of settlement. Legg says it is possible that some class actions could seek corporate governance reforms from a company as part of relief sought.
“Instead of simply receiving a monetary payment, the settlement could also require that the company improves its continuous disclosure policies, has adequately trained compliance staff, or agrees to change the composition of the board by removing some directors and appointing others,” he says.
McLernon believes the problem of “free riders” in class actions also affects shareholder activists. That is, the main protagonists in a class action, or activist campaign, do the hard work and take the risks, which, if successful, benefits other shareholders who are not involved.
An activist, for example, who holds 15 per cent of the company’s shares, and who successfully pushed for change, only gets a proportionate amount of the reward — a higher share price. The other 85 per cent of shareholders who contributed nothing to the campaign also benefit.
McLernon expects activists to increasingly use derivatives, such as options or contracts-for-difference, to increase their leverage to the benefits of any campaign, while maintaining a small holding in the company’s ordinary shares.
“A better strategy is trying to get control of the company with, say, 25 per cent of the votes, thanks to the indifference of other shareholders who do not vote,” he says.
“Then use derivatives to build a much bigger interest in the outcome, and not push for board seats, which means you are not taking on all the responsibilities of a director.”
This is potentially a nightmare scenario for boards, which suddenly find an activist with a few per cent of the company’s shares and a derivatives position that provides a powerful position for their campaign.
It is not entirely clear how, when or if boards should inform the market, under continuous disclosure obligations, about derivative-based tactics from activists.
It does show that boards need to be aware that activists could emerge from beyond the company’s substantial shareholders.
Ultimately, the best defence against activism is ensuring that the company has strong governance systems, that the board and executive team are accountable for performance and that there is regular, open-minded dialogue with key shareholders.
It is also vital that a strong board has the fortitude to stare down activists who purse short-term gains at the expense of other shareholders.
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