A Wake Up Call For Public Company Boards
Analysis of the Poor Performance of the Public Company Governance Model
Excerpted from the book Governance Arbitrage: Blowing Up the Public Company Governance Model to Maximize Long-Term Shareholder Value
In the late 1970s and into the 1980s “corporate raiders” such as T. Boone Pickens, Carl Icahn, Sir James Goldsmith and others became acutely aware that the assets on the books of many public companies in the United States were materially undervalued. This realization by these sophisticated outsiders led to the launch of an unprecedented wave of hostile takeovers and takeover attempts with the intent to realize the full value of these assets. What the raiders did and/or intended to do could have been done by the incumbent boards and management. But, as in so many cases where there is any kind of challenge to the “establishment,” the status quo was more powerful than the will to take action, with an unspoken message of “shareholders be damned.” And, of course, the raiders were made out to be villains in the press, were condemned by big corporate organizations such as the Business Roundtable and excoriated by politicians.
Roadblocks were thrown up to the raiders, including the advent of the poison pill, staggered boards, changes to bylaws, “crown jewel divestitures” and other actions to further entrench boards and managements. At the behest of CEOs, business lobbying organizations, including the aforementioned Business Roundtable, ran to Congress and state legislatures to enact measures to shut down the raiders. But none of this changes the fact that the raiders were right about the significant undervaluation and underperformance of corporate assets and the ensuing negative impact on public company values. Moira Johnston, in the book Takeover describes the realization of the undervaluation of corporate assets as the “Eureka Event” that set the takeover wars in motion. This “Eureka Event” for the raiders was an accurate one.
In regard to assets and their value in today’s business environment, rarely is the board of directors considered in these terms. Granted, the board is made up of people rather than plants, equipment, real estate or intangibles such as intellectual property that are normally considered to make up the asset base of a company. You will not find the board on the balance sheet. In fact, not only is the board not thought of as an asset, but when it is considered, more often than not it is because of something that has gone really wrong at a company, such as fraud or some other corporate scandal. At public companies, other than by certain activist investors and some other exceptions, the board is rarely, if ever, viewed as an asset that can be leveraged to improve performance, optimize capital allocation and increase shareholder value. At the very least, there has not been an intensive and large-scale focus on maximizing shareholder value by maximizing the potential of the board.
It is time for another “Eureka Event” regarding corporate assets, but this time with the board taking center stage. But let’s be clear, this “Eureka Event” is not about board improvement, refreshment or any of the other myriad governance topics. . Instead, it is about maximizing the value of the company via the maximization of the board’s potential — perceiving the board as an asset of the company and developing it as such. The thesis that underpins Governance Arbitrage is that an unprecedented radical change in the governance model of public companies (and others that do not have a robust, entrepreneurial, highly competent and engaged board) is required to unlock increased organizational performance and long-term value; and the private equity governance model offers an incredible template for a robust new governance paradigm. The key components of this thesis are as follows:
• While boards are obviously made up of individuals, the board as an entity should be viewed as an asset that can have a direct impact on capital allocation, company performance and shareholder value.
• The current public company governance model is flawed and, as such, the potential value of the board as an asset is not being realized (similar to the undervalued and underperforming assets identified by the raiders of the 1980s).
• The asset value of the board is not something that is commonly recognized at public companies but is an essential component of the private equity (PE) governance model and the overall PE value creation playbook.
• In regard to capital allocation, company performance and value creation, the PE governance model is superior to the public company model.
• Radically transforming the public company governance model to approximate that of the PE governance model will maximize the asset value of the board and have a direct, and highly beneficial, impact on the optimization of capital allocation and maximization of company performance and shareholder value, thus creating a “governance arbitrage,” a tangible gain realized by replacing the traditional board for another governance model that is fundamentally different in mindset, purpose, practice and composition.
Said another way, change the governing objective of the board (or define it for the first time), thereby creating a new (or first-time) clear context, and the other necessary changes will naturally align with this new guiding principle. And, in so doing, what should follow is improvement in capital allocation, operating performance and ultimately shareholder value of the company being governed. In other words, the board is an asset that does matter and is either maximized or not. Jeff Gramm, in his book Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism, states, “As Carl Icahn pointed out thirty-five years ago, an arbitrage exists when assets sitting in a public company are valued below what they would attract in an auction, or under different management.” (1) This thesis is that an arbitrage also exists under a different governance model (which in most cases would result in different board members).
Developing the full asset value of the board to maximize long-term company performance and shareholder value requires a radical shift in approach. Adopting a new governance model is like any other transformative organizational change — no matter where or why it originates (because investors push for it, a board here and there begins the shift or some combination of the two) it requires an entirely new way of thinking, and potentially disruptive changes. But the payoff — the arbitrage, as it were — can be enormous in the long term.
The remainder of this chapter will provide an analysis of the characteristics and underperformance of the public company governance model. We will look at some of the evidence that supports the underperformance argument, including several independent studies. Research conducted from different angles has shown, as I propose, that the asset value of public company boards (and other less rigorous boards) is not being realized due to the current governance model.
It is important to note that with all of the focus on corporate governance and different ways to improve it, there is no focus on the current model itself. All “fixes” and changes are advocated within the current model without ever considering that it is the model itself where the focus is needed.
The Current Public Company Governance Model
Lack of Long-Term Shareholder Value Maximization Governing Objective:
Much of the focus remains on compliance, “oversight,” endless process and quarterly results (contrary to increasingly popular belief driven by denigrators of “shareholder value maximization,” emphasis only on quarterly earnings is not “shareholder value maximization.”). This model has been driven by a number of factors including pressure on institutional investors to outperform on a short-term basis, government regulation, stock exchange rules, Wall Street analysts and the failure of incumbent boards to understand their potential value and what should be their primary responsibilities.
To a significant degree, public company boards have viewed their role as “august deliberative bodies above the fray” as opposed to a robust team of highly competent individuals with a primary objective to drive maximum performance and value.
Central to the underperformance argument is this from Michael J. Mauboussin and Alfred Rappaport in their article entitled Reclaiming the Idea of Shareholder Value, “Corporate governance issues are constantly in the headlines. Activist investors challenge management strategies. Investors and others ask why companies binge on buybacks while skimping on value-creating opportunities. But discussions of corporate governance invariably miss the real problem: most companies have extensive governance procedures but no governing objective [emphasis added].” (2)
Poor Selection Criteria and Composition:
Director selection criteria and actual composition is not based on competence. Competence in this context is defined as “experience and track record of performance increases and value creation relative to the company’s industry, or its specific value drivers or value creation in general (the latter the type of skill is found in the best private equity firms for example) coupled with shareholder value maximization mindsets.
In the current model the core director selection criterion is independence, but some boards are still populated, at least in part, by CEO picks and cronies. The current focus on selecting independent directors may have come with good intentions, but has devolved into “independence for the sake of independence,” leaving boards without the specific competencies needed to extract maximum value. The late iconic venture capitalist Tom Perkins, in a Wall Street Journal article critical of the current public company governance model, bemoaned the fact that individuals with strategic knowledge of the company could not serve on the board if they had previously worked for the company since they were not “independent.” Perkins further said, “So where can good directors come from? Easy! A Compliance Board director can come from anywhere!” (3) That said, the current model creates the context and in that regard, independence has been an acceptable criterion.
Beyond independence, more recently there has been an aggressive push for diversity (mostly gender diversity). The primary argument made for this is that boards with gender diversity perform better with references to many consulting studies. Yet, as Wharton points out, the most in-depth peer reviewed research refutes this and found a neutral impact. (4) And, after ten years of gender quotas for Norway’s public company boards, the results show no performance improvement impact. (5)
And, as this is being written, the latest selection hot topic has surfaced: Age. According to current research there are not enough public company board members under the age of 50. (6)
The point here is not that women or those under 50 should not serve on boards. (The most recent board I was involved in developing, for an old-line company raising outside capital for the first time, had more women than men. And, other than me, all of the directors were all under 50. However, they were not selected for anything other than the competencies related to value maximization requirements for this company that had been identified) Instead, the point is, along with independence, the focus, which keeps expanding, is on everything but competence. If competence, as defined previously, is the primary selection criteria then the search for candidates can and should be wide open as to gender, age etc. Otherwise, how can it possibly be determined that the best candidates have been selected? This however, will not always result in gender balance, age balance or any other kind of balance. In fact, as noted in my example, it may sometimes result in reverse gender and age balance.
Further to the selection criteria/composition shortfall, outside or non-executive directors are frequently professional managers and in many cases, “Captains of Industry.” (From a performance standpoint, some of the worst offenders have been boards with high number of Captains of Industry, e.g. Canadian Pacific Railway pre Pershing Square investment and General Electric prior to Immelt’s departure). As such, they naturally lean toward and support management rather than shareholders. Undoubtedly, certain experience, track record and skills are needed from those with management backgrounds; however, without clearly defined responsibilities for the board around shareholder value maximization also known as a governing objective (and understanding of same) and without others with sophisticated investor mindsets on the board, their contributions in many cases fall short of optimal and in other cases result in disasters. A related point is that just because someone is a former or sitting CEO does not necessarily imply that they will be a great director.
Consider this: If you have a severe illness and the only chance of survival is to have a complicated surgery, what is going to be your selection criteria for the surgeon? Of course it would only be competence with competence meaning experience and excellent track record with the type of surgery required. Then, why should it be any different for investors, when electing directors, including pension fund investors who have the fiduciary responsibility to ensure that the funds are available for retirement for all those who depend upon them? Why would anyone settle for anything less than complete and relevant competence as the only criteria? Yet, in the current model settle they do and consistently.
Weak Criteria For The Non-Executive Chairman Role:
The core argument for the separation of the chairman and CEO roles is the need for the chairman to be independent. With very few exceptions, there is no in-depth understanding of what skills, experience and track record are required in a high-performing non-executive chairman nor what the specific responsibilities should be. But, again, as with other board members, independence is seen as sufficient within the current model and consensus building ranks at the top regarding skills. And then the governance community ponders why there is no discernable company performance improvement that results from having an independent non-executive chairman. Of course there is not because as with other directors, the right competencies and responsibilities have been left out of the equation.
Collegiality and Consensus Are Overblown:
Too much focus on consensus and not enough on in-depth analysis and hard questions. Public company boards have a bias toward collegiality that unfortunately precludes really tough questions, intense debate and dissent. But, without tough questions, intense debate and dissent, performance will rarely be maximized and the critical board function of holding management accountable will be anemic.
Sub-Optimal Information Flow:
The quantity and quality of the information provided to public company boards by management is dramatically lacking. It may in many cases be voluminous; but quantity, especially in the context of performance and value maximization, does not equate to quality. While there may be some exceptions, by and large boards acquiesce to management to determine what information should flow to the board and when rather than the board being the driving force. Shortfalls regarding information flow are one of the most common complaints when surveys of board members are conducted. Who is in charge — management or the board?
Lack of Knowledge and Understanding of Industry, Strategy and Value Creation Levers:
In addition to information flow, the actual knowledge of the industry in which the company being governed operates and the company’s levers for value creation is very weak as a study detailed in a later section reflects. Contrast this with the boards of the best private equity firms’ portfolio companies which have deep knowledge in these areas. The is clearly reflective of a governance model that is about everything but the performance of the company being governed.
Shareholder Orientation and Value Maximization Mindsets Absent:
The overall mindset prevalent in the current governance model is one of “oversight.” Mindset in any endeavor is typically either ignored or given short shrift. Yet, I will argue that it is ultimately the prime-mover, the guiding principle from which everything else follows. Said another way, how many individuals join public board with the passionate intent to take action to ensure that the full potential of the company is developed?
The Model is Too Complex and Complicated:
The model is too complex and too complicated. Between all of the compliance issues, other regulatory burdens and superfluous issues (not related directly to the company being governed), members of public company boards have a sense of overwhelm rather than the laser focus they should have. In the course of the continual expanding landscape of “governance issues”, many boards seem to forget that there is a business at the core of their responsibility.
In summary, the current governance model for public companies, at its best, is largely about preventing egregious mistakes and satisfying investment analysts. Primarily as a result of the pressure from activist investors over the last decade or so, there has been some positive movement with public company boards. For example, strategy and director selection have been pushed more to the forefront than in the pure compliance model. Yet, overall there is still a material shortfall in the current governance model, compared to the full potential that can be realized from a board of directors.
The Results
There have been numerous studies done on public company boards that reflect the “results” of the governance model described above. One conducted by McKinsey in 2013 found the following: (7)
• Only 34 percent of directors surveyed agreed that the boards on which they served fully comprehended their companies’ strategies.
• Only 22 percent said their boards were completely aware of how their firms created value.
• Only 16 percent claimed their boards had a strong understanding of the dynamics of their firms’ industries.
Now consider the following data from a Harvard Business Review article which references a McKinsey study that reveals the abysmal state of capital allocation in public companies. Optimizing capital allocation should be one the key components of the governing objective of the board but the results of this research reflect the significant underperformance resulting from the public company governance model.
This study showed that during a 20-year period, the majority of the 1,500-plus U.S. companies studied were content to maintain the status quo and dole out roughly the same amount of capital to business units as they did the previous year. These businesses moved forward in low gear as a result. By contrast, the most aggressive reallocators — companies that shifted more than 56 percent of their capital across business units over that period — delivered 30 percent higher total returns to shareholders. (8)
Researchers at Boston Consulting Group also noted the link between suboptimal capital allocation and overall underperformance:
• More than one-third of the $8 Trillion in invested capital in the S&P 1500 does not earn the cost of capital.
• Over a five-year period, half the companies saw a significant write-off, divested a major business or saw a decline of 50 percent or more in company value.(9)
If the poor record of capital allocation summarized above were the only issue related to the underperformance of the public company governance model, it alone would be enough to raise a massive red flag for investors.
The results of a later survey by McKinsey in 2015 reflected some progress as compared to the 2013 survey. For example, boards now spent an average of 8.91 days on strategy compared to 7.85 days in the 2013 analysis. The article summarizing this 2015 survey was entitled Toward A Value-Creating Board, but, the introduction to this piece noted that there was a long way to go to that end:
The amount of time board directors spend on their work and commit to strategy is rising. But in a new survey, few respondents rate their boards as effective [emphasis added] at most tasks or report good feedback or training practices. (10)
Also, just because boards are spending more time on strategy does not mean that they are taking action to ensure that performance and value are maximized. Typical strategy development is not the same, nor nearly as robust, as the value maximization plans that are developed by the portfolio companies of the best private equity firms. Nor is the progress toward plan milestones, targets and objectives, to the degree they exist and are reported to the board, monitored with the level of scrutiny, intense debate and holding management accountable as PE portfolio company boards. As another study described later in this chapter shows, public company boards pale in comparison regarding performance management when compared to the boards of private equity portfolio companies.
Another situation in which public company boards under-perform involves one of their most important responsibilities: Selection of the CEO. This is one more contributor to the widespread destruction of shareholder wealth resulting from an inadequate public company governance model — a travesty of immense proportions and driven by multiple components. Research from PwC shows that forced CEO turnover costs shareholders $112 Billion annually on a global basis.
The leadership advisory firm ghSmart conducted the CEO Genome Project , over ten years, building a database of over 17,000 in-depth assessments and logging over 13,000 hours of interviews. They determined that there is clearly a costly misalignment between what it takes to get hired into the CEO role and what it takes to perform well. These same researchers went on to say that even if the CEO is selected based on the right criteria, boards end up making decisions not objectively but through a distorted lens of power plays, group think and bias. But they also offered one example of when the selection process did work well:
When Steve Ballmer announced he was stepping down as CEO [of Microsoft] in 2014, a high-stakes beauty parade ensued. Over a dozen candidates were considered — often publicly thanks to leaked information. Fortune called the process “a circus,” and that this “isn’t how it’s supposed to work.”
Only one thing. It worked out well for Microsoft shareholders. The board ultimately selected Satya Nadella, who is widely considered a success and continues to hold the job. Activist shareholder ValueAct was instrumental to the process, pushing for a clear set of selection criteria and introducing external data into candidate evaluation. That ensured the board didn’t get overly swayed by glossy resumes and marquee pedigree and instead prioritized factors connected to shareholder value. ValueAct dissected performance and strategies of businesses run by candidates under consideration to inject hard facts into evaluation. (11)
Think for a moment about the implications of the above. At a company as large as Microsoft, it took the investor sophistication and value maximization understanding and lens of activist investor ValueAct to design and execute the CEO search and selection process in a manner structured around finding the best candidate to maximize value for shareholders.
For an indirect or implicit look at the failings of public company boards vis à vis performance and value creation, consider the findings of Chicago Booth’s Elisabeth Kempf, Bocconi University’s Alberto Manconi and Tilburg University’s Oliver G. Spalt, who studied the impact of “distracted shareholders.” Their research shows that in this environment, where investors cannot monitor all of the companies in which they have invested, management is more likely to resort to actions that destroy value rather than create it. The following key findings from this research were summarized in a Chicago Booth Review article by Alex Verkhiver: (12)
· “The researchers find that when shareholders are ‘distracted,’ executives have greater leeway to maximize private gains, to the detriment of shareholder value.”
· “The researchers analyze corporate takeovers because those involve executive decisions to make large discretionary investments. Their results suggest that the likelihood of a company announcing a merger is higher when shareholders are distracted and that acquisitions that diversify a company’s business are nearly twice as likely to happen as compared with general deals. A diversifying acquisition, expanding the products and services of the merged company, is considered to disproportionately benefit management ‘for reasons of empire building or job security through more stable cash flows,’ according to the researchers. When investors are distracted, managers tend to tilt their budgets toward diversifying acquisitions, which turn out to be value destroying. Kempf, Manconi and Spalt find that ‘bidders with distracted shareholders experience substantially negative abnormal returns over the 36 months following the deal.’”
· “The underperformance of firms with distracted shareholders relative to firms with less distracted shareholders isn’t confined to M&A announcements. They find significant underperformance in companies with distracted shareholders but no abnormal performance for companies whose shareholders are less distracted. This relative underperformance amounts to 15 basis points per month, suggesting that managers engage in value reducing actions, beyond M&A, on an economically significant scale when their investors aren’t paying attention.”
· “Unmonitored managers are more likely to cut dividends and design merger financing so that a shareholder vote isn’t required, and they are less likely to be fired during periods when the firm’s shareholders are distracted by outside events.
The researchers further state, “Understanding managers’ behavior where shareholder attention is limited could ‘significantly improve our understanding of value creation in firms.’”
There is no mention of the board in the article referenced above. However, what is glaringly implicit is that the entity that should be functioning on the shareholders’ behalf, that is, the board, is not doing its job and that management only avoids these value-destroying decisions and actions when the shareholders are looking. This is a different view but still a clear indictment of the current public company governance model.
In alignment with the Tom Perkins quote on page seven regarding “compliance board directors,” still another body of research and analysis conducted by Olubunmi Faleye, a professor of finance and the Mark L. and Karen D. Vachon Faculty Fellow at Northeastern University’s D’Amore McKim School of Business, and published in the MIT Sloan Management Review, provides a look at public company board performance from the angle of independent directors. (13) The following provides a synopsis of Faleye’s research:
• Study of the effect of fully “independent” boards on operating profits and corporate value.
• Sample consisted of 20,000 annual observations of 2,900 S&P 1500 companies from 1998–2011.
• Fifty-four percent of these observations belonged to years when a company’s board was fully independent; rest occurred when the company had more than one employee director.
• Controlled for factors such as company size, use of debt, growth opportunities, managerial equity ownership and other board factors.
• Companies with fully independent boards earned significantly lower operating profits, up to 8.2 percent lower.
• These companies also deviated more from value maximization and attracted lower market values.
Finally, and incredibly eye-opening, is a McKinsey study done with 20 chairmen or CEOs who had served on the boards of both public and private equity companies, “Advocates of the private equity model have long argued that the better PE firms perform better than public companies do. The advantage, these advocates say, stems not only from financial engineering but also from stronger operational performance. Directors who have served on the boards of both public and private equity companies agree — and add that the behavior of the board is one key element in driving superior operational performance. Among the 20 chairmen or CEOs we recently interviewed as a part of a study in the United Kingdom, most said that PE boards were significantly more effective than those of their public counterparts [emphasis added].” (14)
More specifically, the results of this study showed:
• Most of those surveyed said that PE boards were significantly more effective than public boards.
• Fifteen of the 20 said that PE boards added more value; none said that the public counterparts were better.
• On a five-point scale (where 1 was poor and 5 was world class), PE boards averaged 4.6, public boards 3.5.
• The intensity of the performance-management culture of PE boards was the single largest variance between the two types of boards.
• Public boards focus much less on fundamental value creation levers and more on quarterly profit targets and market expectations.
• Public boards seek to follow precedent and avoid conflict rather than exploring what could maximize value; that is, they are more focused on risk avoidance than value creation.
While certainly short of exhaustive, this study clearly demonstrates, based on the experience of 20 top business leaders, that the PE governance model is superior to the public company model in regard to company performance and value creation.
When considered in the context of optimizing capital allocation and maximizing company performance and shareholder value, the various studies presented offer a scathing indictment of the overall performance of public company boards which, at its essence, is really an indictment of the governance model.
Wake-up Calls (Challenges to the Model) and Tepid Responses
There have been four periods in recent history when the public company governance model has been challenged either explicitly or implicitly. The first commenced in the late 1970s and continued into the 1980s. As mentioned at the beginning of this chapter, at numerous companies, the appraised asset values were greater than the company’s market capitalization, reflecting significant opportunities. Into this situation came the corporate raiders, the best of whom were extremely smart and highly skilled at identifying undervalued assets and developing and executing plans to liberate these values.
Simultaneous with their pursuit of value, takeover entrepreneurs such as T. Boone Pickens, Carl Icahn and Sir James Goldsmith shook up the establishment and brought to light the complacency of public company boards and the imperial nature of CEOs. As is typical, especially when in the wrong, the establishment demonized the outsiders, who in effect were saying “the emperor has no clothes.” However, instead of taking responsibility, looking honestly in the mirror and admitting the poor job they were doing for shareholders, these boards and managements ran to their lawyers, the media and to the government for protection. This entrenchment response led to the advent of the poison pill and staggered boards as tools to stave off the raiders and maintain the status quo. Further, as a result of intense lobbying by corporations and their support groups, numerous state legislatures enacted new laws that restricted hostile takeovers. Even the Federal Reserve got in on the action by restricting the use of high-yield bonds in takeovers. Thus, what could have been the catalyst for a new model of corporate governance focused primarily on the maximization of shareholder value came to an abrupt halt.
The second “turning up of the pressure” came, at least from an historical perspective, from an unlikely source: institutional investors. Although they controlled an increasing percentage of the stock holdings of public companies, beginning in the 1950s, this potentially powerful group of investors had remained passive. The trigger point came as the result of a buyout in 1986 by General Motors of Ross Perot’s huge stake in the company, his removal from the board of GM and subsequent public airing by Perot of the complacency and incompetence of GM’s board and management. Further, investors liked having Perot, one of America’s most successful businessmen in history, on the GM board. His resignation from the GM board and the awareness that came of the board/management incompetence was unnerving and pushed some institutional investors over the edge from passive to active investors. Jeff Gramm, in his highly informative book entitled Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism, eloquently tells the story:
Before Ross Perot pushed them to a breaking point, these kinds of investors [institutional investors] were highly unlikely to intervene in the oversight of powerful companies like General Motors.
Just as institutional investors were promoting revolutionary change at General Motors, they were flexing their muscles at other large public companies. The year after Ross Perot’s buyout, four pension funds (including CalPERS and SWIB) submitted forty-seven shareholder resolutions on corporate governance-related issues. These were the first resolutions on governance matters ever filed by public pension funds….CalPERS CEO Doug Hanson, who battled with GM over its succession plans, stated, “as much care and attention goes to the owning of stock as to the selection of stock . . . as owners for the last 30 or 40 years, we’ve been asleep at the switch.” (15)
The shedding, at least to some degree, of passiveness on the part of institutional investors was a definite and continuing step in the right direction for public company governance. But, as with other governance wake-up calls, it was (and continues to be) only a single step forward — a small incremental improvement rather than the radical change that is really needed to transform the public company governance model to one that allows for the maximum development of the board’s value — as the asset it can and should be.
The third challenge was different; it was in response to the scandals at Enron, WorldCom, Tyco, Adelphia and a few others. Of the approximately 6,700 U.S. publicly traded companies in 2000, the unethical and/or illegal behavior of only a few companies prompted the government and, subsequently, major stock exchanges, to do a pendulum swing toward heightened regulation. This kind of over-reaction to a very small percentage of the total has become all too common in the U.S. on myriad issues.
The reaction to this tiny number of rogue companies led to the Sarbanes-Oxley Act and new rules set out by the major stock exchanges. In short, the result was the creation of the “Compliance Board” described in the previous Tom Perkins’ quote and further defined in the opening section of this chapter. Hallmarks of this governance model include: director independence over director competence, ticking of boxes/process over results, protecting assets rather than maximizing performance and value. It is as if new rules were developed for world-class rugby teams that focused coaches only on player safety and the processes required to achieve this (and filling out a blizzard of forms proving that this was being done) rather than on developing the players’ and teams potential and winning matches. (For those who are rugby fans, can you imagine a Compliance Model of the New Zealand All Blacks?).
The “Compliance Board” has been the predominant model since shortly after the turn of the century, but it has been far from a panacea for positive change on boards. The flaws inherent in other governance models from earlier times continue to hold on even in the wake of the sweeping changes made in reaction to the aforementioned scandals. Despite the unrelenting focus on oversight and director independence in the compliance model, boards are still afflicted with directors who are CEO cronies, directors selected more for their “prestige” than for what they can bring to the value creation equation, many selected for reasons that remain a mystery and a continued sense of collegiality resulting in a lack of toughness on the part of the board. Commencing in the late 1990s and accelerating around 2003, activist investors waded into this situation, creating what is, and will continue to be, the fourth and biggest challenge to date for corporate boards and management of the companies they serve.
Activist investors are similar in their mindset to the raiders in that they invest in situations in which there is perceived underperformance. However, they differ from the raiders in that they do not seek to take over the companies in which they invest. Instead, activist investors build up a minority position in a company and then become active to seek the changes needed for a company to maximize value. This level of activity may range from quiet, behind the scenes engagement with the board and management to full blown proxy fights to add new board members or replace the entire board.
In the earlier years, many activist investors focused on balance sheet changes such as stock buybacks, changes to capital structures and increased dividends, or on the sale of the target company. However, while these approaches are still operative, the current trend is moving more toward a focus on needed changes in strategy and/or operations. As such, the approach of the best activists in not dissimilar to that of private equity firms, with the exception that the activist is not acquiring the entire company. And, in the same vein as private equity firms, activist investors conduct incredibly deep research into, and analysis of, the companies in which they invest. This research and analysis results in concrete initiatives to move a company to its full potential. In fact, in most cases, the activist investor will know more about the company than its incumbent board. This increased focus on strategy and operations has led to growing support from institutional investors of the plans developed by activist investors.
Again, similar to private equity, the best activist investors bring a sophisticated investor mindset and an intense drive for value maximization to the companies they target and the boards they join, or to which their director candidates are nominated. This sophisticated investor mindset and drive for value maximization are typically lacking on the part of the directors in the current governance model.
As activist investment activity has accelerated in recent years, both in the number of campaigns and the size of target companies, the drum beats of corporate anxiety have also accelerated. There was (and is) mounting concern that no company is “safe” from a possible activist campaign. As with the raiders of the 1980s, once again the corporate establishment is under “attack.”
In response to the rise of activist investors, the reactions by boards, management, advisors (legal, investment banking and consulting) and, to some extent, the government have varied. The following is a look at some of the reactions to activist investors, which reveal, at best, incomplete steps toward governance improvement and, at worst, opposition to a more robust governance model.
Defense:
Google the phrase “defending against activist investors” and you will find piece after piece on this subject from major consulting firms, law firms, business publications, and others. Google “activist investor defense services” and there will be more of the same, including services provided by major investment banks such as Goldman Sachs. And, right in the middle of it all or, perhaps better said, leading the pack, is the law firm of Wachtell Lipton Rosen & Katz and its senior partner Marty Lipton. Mr. Lipton was also the leading enabler of entrenched boards and management during the 1980s and the creator of the “Shareholder Rights Plan,” better known as the Poison Pill. Much of the focus around the defensive approach to activist investors has been similar in its underlying intent to the 1980s-era defense against corporate raiders: To provide an entrenching mechanism for incumbent boards and managements that maintains the status quo in the governance of public companies and resists any attempts to change this model to one that is more effective.
An interesting look at how specialized this “defense industry” has become was revealed in Bloomberg Markets in a piece entitled “It’s Getting Harder to Keep the Barbarians at the Gate — and It’s This Guy’s Job,” written by Sonali Basak and Beth Jinks. (16) This article describes the corporate preparedness group at investment banking firm Lazard, which expanded to more than a dozen activist-defense bankers. One focus of this group is a study of every investor reporting holdings in any of 1,000 companies. They are looking at the percentage of the stock in each company held by different types of investors, including exchange-traded funds, mutual funds, hedge funds and other types of asset managers. With this information, they can start to predict how influential an activist investor may be.
Additional defensive mechanisms are highlighted by Frank Portnoy and Steven Davidoff Solomon in a 2017 article in The Atlantic: “Some companies have adopted notice provisions in their bylaws, which force activists to give the board advance warning before they try to replace directors or propose new strategies. These and other measures add cost and red tape to activists’ efforts, and give management time to wage a public-relations war against them. Companies have also become more proactive with shareholders generally, blasting them information and conveying the idea that they are transparent and open to dialogue. The main goal of all this defense is to rally the shareholder base to management’s side. Painting activists as money-grubbing short-timers who will harm the company’s long-term prospects — and who care nothing for the broader social goals the company’s management has always cherished — is a favored strategy.” (17)
These kinds of anti-activist defense strategies are, at minimum, a knee-jerk reaction to change and, at worst, an organized attempt to retain the faulty power structure in the company. Either way, anti-activist defenses compromise the effectiveness of the board, limiting not only its potential to add value, but also the potential value of the company itself. Rather than spending the shareholders money and valuable time on pre-determining how an activist might be repelled in the future, it seems common sense that the focus should be on developing the company’s full potential. The only reason that activist exist in the first place is because boards are not doing their job.
Legislation:
On March 17, 2016, two U.S. Senators, Tammy Baldwin (D-WI) and Jeff Merkley (D-OR), introduced legislation to curb the activity of activist hedge funds. The sponsors called their proposed legislation the Brokaw Act and it was heartily endorsed and co-sponsored by Senators Bernie Sanders (I-VT) and Elizabeth Warren (D-MA). The bill’s sponsors said that the bill was named after a small Wisconsin town that went bankrupt after an out-of-state hedge fund bought up the legendary Wausau Paper Company, forced out the executives and demanded short-term returns like buybacks at the expense of the company’s long-term future. The Brokaw Act seeks to do the following:
1. Reduce the timeframe in which investors are required to file SEC Form 13D after building a 5 percent stake.
2. Undercut so-called “wolfpack” groups of investors who individually hold less than 5 percent of the stock but collectively exceed the 5 percent threshold.
3. Cause hedge funds to disclose their net short positions.
In essence, this proposed legislation would create a material shift in advantage to incumbent boards and management.
But, what is bizarre about the Brokaw Act is that none of the issues that it seeks to resolve seems to apply in the Wausau Paper situation. Yes, Starboard Value, an activist fund led by Jeff Smith, did have a position in Wausau. But was Starboard singlehandedly responsible for the company’s demise? Not according to Alon Brav, the Robert L. Dickens Professor of Finance at Duke University’s Fuqua School of Business and co-author of a paper on the Brokaw Act:
But did “an out-of-state hedge fund close a paper mill that had provided good jobs to the town for over 100 years” after “forcing out its executives?” A look at the timeline and the public announcements shows the answer to be no. Though engaged in some discussion with a hedge fund activist at the time of the Brokaw mill closure, Wausau’s existing board of directors and executives remained in full control of the company before and during the decision to close the Brokaw mill in December 2011 and had been considering closure of the Brokaw mill for months and possibly years. (18)
Another assessment was offered by Antoine Gara in Forbes:
Rhetoric aside, none of the three pillars of the Brokaw Act seem pertinent to Smith’s [Starboard’s Jeff Smith] campaign against Wausau Paper. Smith wasn’t betting against the paper company and he wasn’t part of a “wolfpack” of investors that quickly grouped together.
It seems that Starboard wanted Wausau Paper to focus on its tissue paper business and sell or wind down shrinking operations in free sheet paper. That strategy made sense. Today, the free sheet focused Verso Paper is re-entering bankruptcy, but tissue focused Kimberly Clark is thriving.
Wausau appears to be have been a good faith debate, with CEO Newell favoring maintaining some operations to the protest of his largest shareholder. This wasn’t wolfpack activism or quick-buck artistry. Smith held onto his Wausau stake right up until the company’s sale to SCA this January, putting his holding period at over four years. (19)
Similar to the legislation that was proposed and enacted in the 1980s to counteract the takeover attempts of corporate raiders, the upshot of legislation such as the Brokaw Act is to curtail activity that in many cases upsets the status quo of boards and company management.
New Corporate Governance Codes:
Writing in The Financial Times, Stephen Foley states, “US corporate governance codes are like London buses. You wait ages for one, and then two come along at once.” (20) Mr. Foley’s reference is to “Commonsense Principles of Corporate Governance” and “Corporate Governance Principles for US Listed Companies.” The former was developed by a group that includes institutional investors, the CEOs of several large and prominent companies, a large Canadian pension plan manager and one activist investor. The latter is the product of Investor Stewardship Group (ISG). ISG includes some of the largest institutional investors and asset managers in the U.S. and internationally. The two codes were launched about six months apart and have a number of overlapping signatories among institutional investors. Mr. Foley continues, “What is going on? There is broad consensus among investors that US boards are more entrenched and less attuned to shareholders than those in Europe, where countries such as the UK have had powerful codes of conduct since the 1990s. But getting companies to accept higher standards is proving tricky.”
The creation of these codes is at least a tacit admission by some companies and institutional investors that something is not right with the current governance model. As Mr. Foley writes, there are some common themes embodied in the two codes, “Both codes demand a diverse mix of skills from directors, delegation of work to specifically qualified board committees and processes [more process! — Wolfe’s comment] to evaluate and refresh boards.” And, there is some reference to shareholder accountability. But nowhere in either “code” is there any reference to the board’s primary responsibility — their role in maximizing the potential of the company. Although well intentioned, the prescriptions in these two codes are simply “safe” extensions of the current governance model. They don’t go far enough toward significant and meaningful reform and, therefore, fall short of maximizing board effectiveness and, by extension, company value.
Governance Associations:
The most prominent corporate governance association in the United States is the National Association of Corporate Directors (NACD). NACD is famous for its Blue Ribbon Commissions, organized to study various issues. With the pressure from activist directors rising (and their focus on strategy and value maximization), NACD has created the following: Blue Ribbon Commission on Strategy Development, Blue Ribbon Commission on the Role of the Board on Strategy, and the Blue Ribbon Commission on the Board and Long-Term Value Creation. All well and good, but think for a minute about the implications: Strategy and value creation should be Governance 101. But if the leading governance association in the country has to put together Blue Ribbon Commissions to study these issues, what does that say about the current governance model?
Think Like an Activist:
Some corporate advisors are attempting to work with boards and company management to help them think about their businesses more like activist investors do (that is, thinking in terms of maximizing the potential and value of the business). There have also been numerous articles written on this subject. One of the best was by Susan Decker, former president and chief financial officer at Yahoo and a member of the boards of Berkshire Hathaway, Cisco and Intel. In a piece entitled, “Outthinking Activist Investors: 3 Rules for Corporate Boards,” (21) she writes:
Directors must insist on asking management to analyze strategic choices as an activist would: by looking at alternatives to the strategies the CEO is recommending. This is not typical. The more common pattern is for the CEO to consider options and present only the chosen one to the board.
The road not taken is the one the activist will surface so the board must have analyzed these alternatives. This means understanding what it would mean to get out of underperforming operations, split up the company and evaluate varying alternatives for measuring and handling excess cash versus the ones being recommended. If these choices are not discussed, the board will be poorly prepared to articulate and defend its alternate message.
As noted, of the myriad “prescriptions” offered to boards to deal with activist investors, Ms. Decker’s is one of the best. This does not imply that it is a great “prescription,” however. While absolutely pointed in the right direction, this approach is not nearly comprehensive enough and still places strategy formulation solely in the hands of management. Additionally, the mindset needed to optimize capital allocation and maximize performance and value is not addressed in this prescription, nor are other aspects of what is required to develop a value maximization board. With the exception of the best activist investors who function much like private equity, all who are proposing changes and improvements are not grasping that the underlying model is the issue.
The conclusions from this analysis are straightforward: In general, the public company governance model is not designed to maximize the full potential of the companies being governed. While there is some improvement taking place, primarily as a result of pressure from activist investors, most of this reform involves only incremental changes within the context of the current model. As such, there is solid substantiation of one part of the thesis: “The current public company model of governance is flawed and as such, the potential value of the board as an asset is not being realized (similar to the undervalued and underperforming assets identified by the raiders of the 1980s).”
The public company board as a fully developed and high performance asset is not complicated. At the risk of oversimplification, it consists of a team of heavily engaged, deeply informed, highly and specifically competent individuals pursuing a governing objective to optimize capital allocation and maximize company performance and shareholder value. Or, in other words, to develop the full potential of the company.
I propose that radical change is required to fix what is broken in the current public company governance model — an entirely new paradigm that can unlock the potential value of the board as an asset and improve the performance and value of the company as a whole.
Notes
(1) Jeff Gramm, Dear Chairman: Boardroom Battles and the Rise of Shareholder Activist, HarperCollins, 2016
(2) Michael J. Mauboussin and Alfred Rappaport, Reclaiming the Idea of Shareholder Value, Harvard Business Review — Economics & Society, July 1, 2016
https://hbr.org/2016/07/reclaiming-the-idea-of-shareholder-value
(3) Tom Perkins, The Compliance Board, Commentary, The Wall Street Journal, March 2, 2007 https://www.wsj.com/articles/SB117280725006124469
(4) Katherine Klein, Does Gender Diversity on Boards Really Boost Company Performance? Knowledge @Wharton May 18, 2017 http://knowledge.wharton.upenn.edu/article/will-gender-diversity-boards-really-boost-company-performance/
(5) The Old Girls Network: Ten Years on From Norway’s Quota for Women on Corporate Boards, The Economist February 17, 2018 https://www.economist.com/news/business/21737079-gender-quotas-board-level-europe-have-done-little-boost-corporate-performance-or
(6) Olivia Berkman, Wanted: Younger Directors: A Q&A With PwC’s Paula Loop, FEI Daily, May 3, 2018 https://www.financialexecutives.org/FEI-Daily/May-2018/Wanted-Younger-Directors-A-Q-A-With-PwC%E2%80%99s-Paula.aspx
(7) McKinsey & Company, Improving Board Governance August 2013 Global Survey http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our- insights/improving-board-governance-mckinsey-global-survey-results
(8) Dominic Barton and Mark Wiseman, Where Boards Fall Short, Harvard Business Review, January –February 2015 https://hbr.org/2015/01/where-boards-fall-short
(9) Gerry Hansell and Dieter Hueskel, The CEO as Investor. Boston Consulting Group, April 14, 2012 https://www.bcg.com/publications/2012/value-creation-strategy-corporate-strategy-portfolio-management-ceo-as-investor.aspx
(10) McKinsey & Company, Toward A Value Creating Board, February 2016 https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/toward-a-value-creating-board
(11) Elena Lytkina Botelho, Kim Rosenkoetter Powell and Benjamin J.D. Wright, The Cost to Shareholders of Picking the Wrong CEOs is a Stunning $112 Billion a Year, MarketWatch, March 7, 2018 https://www.marketwatch.com/story/the-cost-to-shareholders-of-picking-the-wrong-ceos-is-a-stunning-112-billion-a-each-year-2018-03-06?mod=mw_share_twitter
(12) Alex Verkhivker, When Shareholders Aren’t Watching, Managers Misbehave, Chicago Booth Reviews, Finance Section, January 23, 2017 http://review.chicagobooth.edu/finance/2017/article/when-shareholders-aren%E2%80%99t-watching-managers-misbehave
(13) Olubunmi Faleye, The Downside To Full Board Independence, MIT Sloan Management Review, Winter 2017 http://sloanreview.mit.edu/article/the-downside-to-full-board-independence/
(14) Viral Acharya, Conor Kehoe and Michael Reyner, The Voice of Experience: Public Versus Private Equity, McKinsey & Company Insights & Publications, December 2008 http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-voice-of-experience-public-versus-private-equity
(15) Jeff Gramm, Dear Chairman: Boardroom Battles and the Rise of Shareholder Activist, HarperCollins, 2016
(16) Sonali Basak & Beth Jinks, It’s Getting Harder to Keep the Barbarians at the Gate — — -and It’s This Guy’s Job, Bloomberg Markets, February 1, 2017 https://www.bloomberg.com/news/articles/2017-02-01/lazard-s-jim-rossman-studies-shareholding-to-help-fight-activists
(17) Frank Portnoy & Steven Davidoff Solomon, Frank and Steven’s Excellent Corporate Raiding Adventure, The Atlantic, May 2017 https://www.theatlantic.com/magazine/archive/2017/05/frank-and-stevens-excellent- corporate-raiding-adventure/521436/
(18) Alon Brav, Anti-Activist Legislation: The Curious Case of the Brokaw Act, Harvard Law School Forum on Corporate Governance and Financial Regulation, November 15, 2016 https://corpgov.law.harvard.edu/2016/11/15/anti-activist-legislation-the-curious-case-of-the- brokaw-act/
(19) Antoine Gara, Bernie Sanders and Elizabeth Warren Back Useless Bill To Regulate Hedge Fund Activism, FORBES, March 17, 2016 https://www.forbes.com/sites/antoinegara/2016/03/17/bernie-sanders-and-elizabeth-warren- back-useless-bill-to-regulate-hedge-fund-activism/#7b785d88d5a1
(20) Stephen Foley, The Battle of the US Corporate Governance Codes, The Financial Times, February 4, 2017 https://www.ft.com/content/e52f6f22-e93c-11e6-893c-082c54a7f539
(21) Susan Decker, Outthinking Activist Investors: 3 Rules for Corporate Boards, FORTUNE, January 29, 2017 http://fortune.com/2017/01/29/outthinking-activist-investors-3-rules-for-corporate-boards/
