Shareholder Activism, Engagement and Proxy Fights

The 35th Annual Federal Securities Institute Miami, Florida February 2017

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Today’s Discussion Participants

Cristiano Guerra Head of Special Situations Research and Executive

Director, ISS

Mark H. Harnett Managing Director, Strategic Governance Advisors

Robert B. Lamm

Of Counsel, Gunster

Tracy Stewart Senior Corporate Governance Analyst, State Board of

Administration of Florida

Moderator: Sabastian V. Niles

Partner, Wachtell, Lipton, Rosen & Katz

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Shareholder Activism and Proxy Fights

Governance Activism

Economic Activism

Engagement and Communications

Proxy Fights

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Overview of Governance Activism

Governance activism focuses primarily on governance issues and principles, while economic activism focuses primarily on steps seeking to increase share price

What’s active in governance activism New Frameworks for Governance: New Paradigm, WEF Compact, Investor

Stewardship Group, Commonsense Principles, Business Roundtable Proxy access: a majority of the S&P 500 now have proxy access and more

adoptions are expected; the first use of proxy access has also occurred Shareholder proposals continue to be submitted on issues such as:

separation of Chair and CEO; ability to call (and threshold for calling) a special meeting; and action by written consent

Governance activism has already been largely successful in dismantling poison pills and classified boards, and forcing widespread adoption of majority voting, in large-cap companies; attention now shifting to mid- and small-cap companies

Dismantling of Takeover Defenses and Shift in Governance: 2003 to 2016

Sources: SharkRepellent (Note: universe excludes foreign S&P 500 companies, except with respect to poison pills in force); Spencer Stuart 2016 Board Index.

% of S&P 500 Companies Takeover Defense/Governance Provisions 2003 Jan. 2017

“Poison Pill” In Effect 57% 3%

Classified Board 57% 11%

Majority Voting None 90%

Proxy Access None 52%

Supermajority Vote to Remove Directors 33% 20%

Shareholders Cannot Call Special Meetings 59% 37%

Shareholders Cannot Act by Written Consent 74% 71%

Independent Chair 9% 27%

CEO Is the Only Non-Independent Director 35% 60%

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The Rise and Rise of Institutional Ownership

Households/Retail Investors Institutions

Indexed Assets as a Percentage of All Mutual Fund Industry Assets

Share of Institutional Ownership of U.S. Common Stock

Source: Blume and Keim (2012), Wharton School Dept. of Finance, “Institutional Investors and Stock Market Liquidity: Trends and Relationships”; Strategic Insight 2010; Proxy Pulse (2015); Broadridge Financial Solutions, Inc. (2015); Bloomberg (2016); 2016 data for S&P 500 companies.

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The Rise and Rise of Index Funds Passive mutual funds are accumulating larger stakes in more big companies, often collectively exceeding the holdings of actively managed funds.

Number of S&P 500 companies in which Vanguard Group’s U.S.-based passive mutual funds

and exchange-traded funds owned 5% or more

Number of S&P 500 companies in which U.S.-based passive mutual funds and ETFs collectively own

more stock than active ones do

Note: Applies to total market value of share classes included in the S&P 500. All figures as of year-end except for 2016, which is as of June 30. Sources: Wall Street Journal analysis of data from Morningstar (funds and stock ownership); S&P Global Market Intelligence (S&P 500 constituents, share classes, share counts and market values).

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New Governance Frameworks

Strong statements from BlackRock, State Street and Vanguard supporting long-term investment, criticizing the short-termism afflicting corporate behavior and the economy and rejecting financial engineering to create short-term profits at the expense of sustainable value

The Launch of the U.S. Investor Stewardship Group (ISG) and the ISG Stewardship and Governance Framework (2017)

The New Paradigm: A Roadmap for an Implicit Corporate Governance Partnership Between Corporations and Investors to Achieve Sustainable Long-Term Investment and Growth and The Compact for Responsive and Responsible Leadership: A Roadmap for Sustainable Long-Term Growth and Opportunity (2016-2017)

The Commonsense Corporate Governance Principles (2016)

Business Roundtable Principles of Corporate Governance (2016)

FCLT Global / Focusing Capital on the Long Term (2015-2016)

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Proxy Access

Under proxy access, a company must include, in its proxy statement and on its proxy card, director nominees proposed by shareholders or groups of shareholders that meet specified share ownership and other criteria

As of early 2017, over 300 U.S. companies had adopted proxy access, with many more expected Most have implemented proxy access through amendment of their

bylaws and most have accepted the 3%/3 years eligibility formula Most have also capped the number of shareholders who may form a

group to meet the threshold, typically at 20 shareholders, and capped the number of nominees, typically at 20-25% of the board

Companies who have adopted proxy access now face “fix it / change it” shareholder proposals

In considering “substantial implementation” exclusion requests, the SEC Staff distinguishes between first-time adoptions and requests to amend existing proxy access bylaws

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The Proxy Access Proxy Contest

The first use of proxy access was attempted in late 2016 by Mario Gabelli’s GAMCO funds against an energy company The nominating shareholder reported its position on Schedule 13D, had

previously pursued a break-up of the company (including through a Rule 14a-8 shareholder proposal) and indicated it sought financial engineering

Company’s proxy access bylaw not available to those with “intent to change or influence control” (they have to use regular advance notice bylaws)

After Company determined that the shareholder did not qualify for proxy access, the nominating shareholder and proxy access nominee withdrew

Does the rapid end of the first proxy access campaign indicate that proxy access safeguards work? Does this first use signal that more proxy access proxy fights are to come? Who will use it?

How will institutional investors evaluate a proxy access candidate? Would company-side advisors view a proxy access contest as

different from a traditional proxy contest? How would ISS evaluate a proxy access candidate?

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ISS on Proxy Access Proxy Contests

• ISS general policy for assessing contested director nominations will apply, but ISS recognizes that “the circumstances and motivations of a proxy contest and a proxy access nomination may differ significantly”

• Cristiano Guerra, Head of ISS Special Situations: “We will carefully consider access nominees within the context of our existing framework for proxy contests. That framework, fundamentally, gauges whether there is a compelling case for change at the board level in order to arrive at a recommendation we deem in the best, long-term financial interests of our clients.”

• ISS has noted that in a proxy access nomination, while “the nominating shareholder’s views on the current leadership or company strategy may be opposed to the existing board’s views,” “a shareholder nominator may generally agree with the company’s strategy or have no specific critiques of incumbent directors, but wishes to propose an alternative candidate to address a specific concern, such as diversity, lack of refreshment or a perceived skills gap on the board.”

• ISS indicates it is possible that a proxy access election would occur when there are available seats on the board for all the nominees.

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Other Governance Proposals

Proposals to separate Chair and CEO remain common Companies have generally been able to defeat if company has a

strong lead or presiding director structure

Proposals also still common to permit shareholders to call a special meeting, to lower the threshold for calling a special meeting, or to act by written consent Some jurisdictions mandate right to call special meeting

May be disruptive to company and shareholders, but institutions support some form of ability to act between annual meetings

Activists continue to target governance in spinoffs Activist may seek to force parent company to limit takeover defenses

and other protections embedded in charter and bylaws of company to be spun off

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IPO / Spinoff Governance Restrictions

Greater focus by proxy advisory firms, activists and investors on IPO and spinoff governance structures ISS and Glass Lewis 2017 policy guidelines indicate negative voting

recommendations may be issued against directors at newly public companies if provisions “materially adverse to” (ISS) or “severely restrictive of” (Glass Lewis) shareholder rights are in place without mitigating factors (e.g., sunset provisions)

What kinds of NewCo provisions create “withhold” risks? Are ISS withhold recommendations justified? Will investors withhold?

Does ISS view IPOs differently from spin-offs for this purpose? Do investors?

How will the enhanced scrutiny affect NewCo structuring?

What is the future of multi-class capital structures?

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Spotlight on Charters and Bylaws

In re Vaalco Energy S’holder Litig., C.A. No. 11775-VCL (Del Ch. Dec. 21, 2015) and Frechter v. Zier, C.A. No. 12038-VCG (Del. Ch. Jan. 24, 2017)

Delaware Court of Chancery held that a Delaware corporation’s charter provision restricting stockholders’ ability to remove directors without cause was invalid where company did not have a classified board or cumulative voting and that a Delaware corporation’s bylaw (rather than charter provision) imposing a supermajority vote requirement on removing directors without cause was invalid

Continued controversy over use of bylaws to regulate corporate affairs, litigation conduct and shareholder action – proxy advisory firms and certain investors react negatively to “unilaterally adopted” bylaws that adversely affect shareholder rights

New ISS Focus on “Restricting Binding Shareholder Proposals”: ISS will issue withhold votes if shareholders face “undue restrictions” on their ability to amend the bylaws (e.g., an outright prohibition on the submission of binding shareholder proposals or share ownership requirements or time holding requirements in excess of SEC Rule 14a-8)

Is this an area of serious concern by investors? If a Company provides shareholders with the opportunity to propose binding bylaw amendments but includes a supermajority vote requirement, will directors still face withhold votes?

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Say on Pay (SOP) – 2016 Results

Proxy advisor policies and prospect of failed or low SOP vote significantly impacts disclosure practices and actual pay practices and design

Average vote in favor in 2016 – 97.7% ISS recommended “against” at 265 companies (12% of companies

reviewed by ISS)

Shareholder support of SOP proposals was 27.7% lower on average when ISS recommended against

In 2016, failed votes at 40 companies

Heightened “off-season” efforts to engage with investors regarding compensation in advance of say-on-pay vote

2017 will feature many “Say-When-On-Pay” frequency votes – will (can) non-annual say on pay receive investor support?

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Additional “Hot Button” Governance Topics

Director qualifications, evaluations and refreshment, including tenure, age and diversity Vast majority of shareholder proposals related to board-level gender

and diversity topics failed in 2016 – how will they fare in 2017?

Director “Over-Boarding” ISS and Glass Lewis 2017 policy guidelines recommend voting

against directors who sit on more than five public company boards, and some major institutional investors have more restrictive policies

Environmental and social proposals (e.g., sustainability, political contributions, etc.)

Shareholder proposals addressing economic matters

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Shareholder Activism and Proxy Fights

Governance Activism

Economic Activism

Engagement and Communications

Proxy Fights

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Economic Activism Environment

More than 100 hedge funds currently engage in frequent activism and over 300 others have launched activism campaigns recently

Activist hedge funds experienced significant volatility and a modest decline in AUM through 2016 – but still have more than $100 billion of assets under management

Mutual funds and other institutional investors who are not dedicated activist hedge funds are increasingly willing to deploy activist tactics

“Alumni” of activist hedge funds continue to start their own funds

While large companies continue to be targeted, activity against mid-cap and small-cap companies has significantly increased

Many campaigns focus on seeking to force sale, break-ups, spin-offs or distributions of cash (e.g., substantial share buybacks or special dividends), on cost-cutting, or on perceived operational deficiencies

While settlements continue to increase, companies have a higher rate of success (including with proxy advisory firms) when taking to a vote

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Activist Campaigns (2006 – 2016)

All Proxy Fights Proxy Fights for Board Control All Campaigns

____________________ Source: FactSet SharkRepellent (excludes activism against fund companies; includes governance-based campaigns and 13D filings).

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What Attracts an Economic Activist?

First and foremost, an economic opportunity or perceived economic opportunity Can the company absorb leverage and implement a large share

buyback or pay a large special dividend?

Does the company have a significant business that could be spun off or divested?

Is the company in a consolidating industry and a potential takeover target?

Can the company significantly reduce its cost structure?

Could a new CEO improve operations?

Although the economic activist looks for a specific economic opportunity, the activist may use a company’s perceived governance failings to seek support from institutions

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Perspectives on Economic Activism

What do investors think of economic activism?

Why do pension funds allocate capital to activist hedge funds? What does it mean for a company if a major pension fund is a shareholder and the company is approached by an activist in which the pension fund is an investor?

What kind of relationships are economic activists building with institutional investors and with proxy advisory services?

What do companies do that make an economic activist either more or less likely to support the company?

What do companies do that make a proxy advisory firm more or less likely to support the company against an economic activist?

What do companies do that make an institutional investor either more or less likely to support the company against an economic activist?

How do investors assess dissident director slates advanced by an activist?

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Economic Activist Strategies

Build stake May use derivatives to build larger stake before disclosure Timing for filing HSR, 13D Team with other activists

Engagement and application of pressure May include meetings with management and board members, private

or public letters, investor presentations, public relations / media campaigns, litigation, threatened proxy fight

Will try to drive wedge between board and management

Proxy fight or takeover bid May include shareholder proposals, short-slate or full slate election

contest, public bear hug or offer (rare for activist) Ability to call or threaten special meeting or action by written consent

may be even more powerful

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Disclosure of Activist Stake

13D filing required within 10 days once shareholder crosses 5% threshold, including disclosure of plans and proposals SEC has yet to make changes to reporting window or definition of

beneficial ownership Synthetic and derivatives arrangements have been used accumulate

significant stakes in target companies before disclosing their positions

13F quarterly reporting provides information about shareholders as of quarter-end 45 days after the quarter Activists may seek confidential treatment of holdings SEC has yet to make changes to 13F reporting deadlines

HSR requires prior notification to target of intent to cross threshold, but exceptions (e.g., passive investor exemption or partnership structures) may be used to circumvent – FTC has sanctioned hedge funds (ValueAct; Third Point; Biglari) for aggressive interpretations

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Company Preparedness for Activism

Assess and address vulnerabilities – how would an activist look at the company What proposals might an activist bring? Are there actions that the company should consider preemptively?

Have a robust shareholder engagement program Be able to explain business strategy and reasons for strategy clearly If company has had poor results, be transparent about how the

company is addressing the issues

Assess governance profile Board tenure and refreshment Other hot button issues

Establish core team – internal and external Review with board

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Company Response to an Activist

Meet with the activist Usually advisable to meet, but who will meet and timing of meeting

should be carefully considered

Careful preparation for any such meeting is important; generally first meeting should be a “listen-only” meeting

Consider the activist’s proposals Does the proposal make sense for the company?

It may be possible to reach a resolution with the activist that does not result in a public battle or any public disclosure at all

Make independent decision The board should consider the activist’s proposals, but it is the

board’s responsibility to make decisions it believes are in the best interests of the company and shareholders

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Settlements with Activists

Many companies are choosing to grant activists board seats, often as part of a standstill agreement, before letting the situation escalate to a proxy contest As of mid-December 2016, 71 non-proxy fight activist campaigns

resulted in at least one board seat, the second highest on record after 2015 when 87 such campaigns led to a board seat

Campaigns that evolve into proxy contests are likewise increasingly settled before reaching a shareholder vote Proxy fight settlements have risen every year since 2013

Settlements are coming quicker than they did in the past The time period between the beginning of an activist campaign and a

settlement has dropped form 146 days in 2013 to 60 days in 2016

What are the terms of a typical settlement?

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Institutional Investor Perspectives on Settlements with Activists

Given the uptick in quick settlements with potentially short-term oriented activists, institutional investors are increasingly calling on boards to protect long-term shareholder interests and sustainable value

In October 2016, State Street issued recommendations to boards when structuring settlements with activists: Extend duration of settlement agreements to foster long-term focus

for strategic action

Require activists to hold shares for long time periods from date of settlement to align them with long-term shareholders

Specify minimum ownership thresholds and director resignation requirements in exchange for board representation

Restrict pledging of activist shareholders to mitigate risk to share prices

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Institutional Investor Reactions to Settlements with Activists

State Street further noted it would scrutinize companies that pursue unplanned financial engineering strategies within a year of settling with an activist

Many institutional investors have voiced similar concerns that companies facing activist pressures settle without affording long-term investors an opportunity to express their views

What does this mean for companies?

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Activism Against M&A

Deal participants now regularly plan for the possibility that, after a deal is announced, activists may:

seek a higher price,

lobby ISS to recommend against an announced deal,

encourage a topping bid for all or part of the company,

dissent and seek appraisal,

try to influence the combined company and its integration or

try to scuttle a deal entirely, leveraging traditional disruptive activist campaign tactics in their efforts.

How does ISS think about deal activism? What kind of lobbying do hedge funds or arbitrageurs do? How does ISS’s approach to M&A-related votes differ from its approach to evaluating traditional activism? Can stock market volatility since the U.S. election results affect ISS or investor analyses of M&A?

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Shareholder Activism and Proxy Fights

Governance Activism

Economic Activism

Engagement and Communications

Proxy Fights

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Shareholder Engagement

Dramatic change in company-investor engagement in recent years Engagement no longer limited to “proxy season” – increasingly a

year-round effort More affirmative efforts by companies to garner support for business

strategies and directors More affirmative efforts by investors to express their views and

expectations on business and governance matters

Relationships with shareholders and role they play in facilitating long-term value creation is being re-thought

Ideal engagement differs by investor and by company, with no one-size-fits-all approach

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Shareholder Engagement (cont.)

How much engagement is enough and how much is too much? How effective is engagement in addressing activism?

With whom should the company meet? Portfolio managers v. governance professionals

Who should be involved on the company’s side? Should outside directors participate in meetings? Should companies engage with proxy advisory firms (how)? Indirect engagement through other opinion shapers

Analysts, media, political and regulatory bodies, governance “gurus” and other parties may help shape shareholders’ views

Company should monitor analyst commentary and address issues

What is the activist’s engagement strategy? Do mainstream institutions use activists to convey messages?

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Shareholder Engagement “Do’s” & “Don’t’s”

Do’s Plan ahead – don’t wait until you’ve got a problem or until proxy

season is upon you Prepare – know the investor’s voting and other policies and prep

company spokespersons (especially directors) Prepare – know what your own documents say and be prepared

to answer questions and proactively discuss problem areas Prepare – develop an agenda and send it to the investor in

advance Take “no” for an answer – if an investor says it’s not necessary to

talk, don’t force the issue Disclose your process, particularly how you convey feedback to

your board and how your board responds, especially if you anticipate say on pay issues

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Shareholder Engagement “Do’s” & “Don’t’s” (cont.)

Don’t’s Talk about how awful ISS is (or Glass Lewis or other advisors

or investors) (are there ever exceptions to this?) Assume that all investors think alike (hint: they don’t) Be defensive Expect your investors to agree with everything you do Treat engagement as a one-off / check the box task Have management representatives address subjects that

management should not discuss – e.g., criticisms of your executive compensation program (this is one of the topics where independent director engagement can be critical)

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Practical Engagement Implications of the New Paradigm

What to communicate • Lead with the strategy • Confirm board involvement • Make the case for long-term

investments, R&D and innovation • Describe capital allocation

priorities • Right directors are in the

boardroom • Sustainability and ESG/CSR • Articulate the link between

compensation and strategy • Board practices and culture

support independent oversight

How to communicate • Letters to investors from

Board and/or management • Investor days • Quarterly communications • Proxy statements • Annual reports • SEC filings • Voluntary disclosures • Online presence • Guidelines and policies • Investor engagement • Investor perception studies

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Communications with Activists

What is the activist’s goal in seeking a meeting To gather information? Communicate ideas? Seek quotes to use in

a proxy fight?

Preparing for a meeting with an activist Gather as much information as possible, including prior history and

results, contentiousness, willingness to negotiate, etc.

Listen Activists may have ideas worth considering; keep open mind

Don’t need to respond on the spot; can take ideas under advisement

Create record of engagement with activist If there is ultimately a fight, other shareholders will want to see that

the company tried to engage constructively with the activist

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Media Communications

Keep media relationships fresh Develop relationships prior to being targeted

Conduct interviews around planned corporate events (e.g., earnings) or other “easy wins” (e.g., project announcements)

Identify spokespeople and conduct training as appropriate Media training can help executives feel comfortable in interview

setting and avoid mistakes

Consider social media strategy

What are the activists’ media strategies Do they develop the same kinds of relationships with the media?

How can company counteract?

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Board Communications

Board communications with respect to activism should start before any activism situation arises Periodic review of governance, shareholder activism and M&A activity

Review of company’s assessment of how an activist might attack and what the company’s response would be

Activists try to divide the board and management; periodic reviews can help maintain board cohesiveness

After an activist surfaces, consider whether to agree to any activist requests for meeting with independent directors In some circumstances, agreeing to a meeting with independent

directors may be warranted and/or create a favorable record

However, any such meeting requires careful advance preparation

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Shareholder Activism and Proxy Fights

Governance Activism

Economic Activism

Engagement and Communications

Proxy Fights

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Responding to a Proxy Fight

If an activist threatens or launches a proxy fight, the company should be realistic about chances of success How receptive are shareholders likely to be to dissident platform? Will proxy advisory services likely recommend in favor of dissidents?

Can steps be taken to improve chances of success? Disclose or accelerate new business initiatives Add or replace directors Proactively engage with shareholders before proxy fight begins

Should company fight or try to settle? Factors include likelihood of success in a fight; time and distraction of

a fight; willingness of activist to settle on reasonable terms Settlements can occur at any time in process, all the way up to the

eve of the shareholders meeting, but negotiating leverage may shift in one direction or another depending on developments in the fight

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Proxy Fight Tactics

Activist typically engages in public criticism of company, board and management, sometimes with very aggressive tone

Company typically defends track record and/or embraces new strategies and change Can also counterattack against dissident track record, perceived

conflicts and any other area of vulnerability

Company often held to higher standard Dissidents may use caustic language, but company usually well

advised to take high road and not respond in kind Can sometimes use dissident’s egregious rhetoric against them

Both sides typically send “bed bug” letters to SEC; seldom results in meaningful remedies but may temper behavior and compel additional disclosures

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Proxy Fight Tactics (cont.)

One-on-one meetings with major investors are generally the most effective method of soliciting votes Need to consider optimal timing and attendees, as well as the voting

structure and policies of each institution What is the impact of an adverse proxy advisory recommendation

and how can it be countered

Be wary of risks of large format or group meetings, which afford less control and may favor dissident attack strategies

Gaining recommendation of ISS and other proxy advisory services is often key to a successful fight for both sides Should understand analytic framework that ISS and other advisory

services use in making recommendation But adverse proxy advisory firm recommendations can be overcome,

particularly as more institutions develop internal teams

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Proxy Fight Tactics (cont.)

Any potential statement or action should be viewed through the lens of whether it will win votes or lose votes Reacting emotionally may feel good, but may lose votes Company litigation may also alienate other shareholders and lose

votes – assess whether any remedy will be meaningful or timely

Advance notice bylaws and policies can provide companies with more time to prepare and elicit more fulsome disclosure from the activist (but will activists seek to circumvent requirements with “placeholder” nominations?)

Carefully tailored rights plans can address threats and prevent an activist from “buying” votes above threshold But need to consider potential reaction from other shareholders

In October 2016, the SEC proposed requiring universal ballots in proxy fights – TBD as to the new SEC’s stance

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Role of Shareholder Advisory Services

How does ISS determine its recommendation? Meets with both sides in a proxy contest

Test of whether dissident has made the case for change and whether the dissident nominees are the right candidates to effect that change

From company perspective, ISS often seems to have a dissident bias

How can a company, or a dissident, improve its chances of a favorable recommendation?

How does Glass Lewis’ approach differ from ISS? Other advisory services?

Has SEC review of, and institutional reliance on, proxy advisors had any impact on procedures, practices or recommendations?

How do investors select and use proxy advisory services?

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Role of Board

Important to keep board informed and prepared for likely tactics from the dissident Maintain cohesion and avoid splintering the board and management Company should speak with a single voice externally Directors should not comment separately or allow themselves to get

drawn into conversations with third party; should have phone screeners to avoid unprepared communications

Independent directors will need to participate in meetings with major shareholders and with ISS Should consider which directors are best suited for these roles Advance preparation for these meetings is essential

Board is ultimately the decision maker with respect to the conduct of the proxy fight and any potential settlement

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After the Proxy Fight

If dissidents win or are placed on the board through a settlement Welcome the new directors and try to integrate them into the board

Dissident nominees can become constructive directors if they are embraced and respected

If dissident nominees are, and continue to be, disruptive, will need to work out procedures to allow the board to continue to function

If company wins Remember that dissident may remain a significant investor

Continue to try to maintain as constructive a relationship as possible with the dissident; seek to avoid a renewed battle at the next meeting

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Where Are We Going From Here?

How will the Trump administration approach shareholder activism? What will Icahn’s influence be?

Some larger institutional shareholders are starting to express concerns over the excesses of shareholder activism

The political environment has been – and is likely to continue to be – supportive of activists, despite some questions about “quarterly capitalism” and “short-termism”

Congress and SEC reviewing role of proxy advisory services and the shareholder proposal process, though there is no indication of any imminent action

The effect of proxy access on proxy fights is not yet clear

For now, companies continue to feel pressure to show immediate results, but signs continue to indicate that pendulum may be shifting towards a longer-term perspective