IT HAD ALL THE DRAMA of an Oliver Stone remake of his 1987 movie, Wall Street. The tall, prematurely white haired William A. Ackman, a billionaire hedge fund manager, bought 8.3 percent of the shares of ADP, a $50 billion payroll-processing company based in New Jersey, and launched a three-month-long public campaign to have two allies and himself elected to the company’s board. He demanded that CEO Carlos Rodriguez be fired because he was allegedly not embracing new technologies fast enough. The battle was engaged with large investors such as Vanguard and Fidelity to secure their votes because institutional investors now hold 70 percent of U.S. public company stock, according to accounting firm PwC. These investors tend to heed the recommendations of proxy advisory firms like Institutional Shareholder Services (ISS) and Glass Lewis, giving those firms big clout in some boardroom showdowns.

What made this fight somewhat different from other battles where CEOs have been shown the door is that ADP had an independent non-executive chairman, John Jones, who was the former CEO of Air Products. The board included at least three other former CEOs and a sitting CEO, giving it depth of experience and cohesiveness. Jones started meeting with big investors to defend the
company’s performance and came out swinging at Ackman in uncharacteristically candid prose: He noted that Ackman had been obliged to step down from the board of JCPenney because he had not respected confidentiality rules. He questioned whether Ackman had any experience of the type ADP needed. And he noted that Ackman’s fund, Pershing Square, had adopted “an aggressive incentive structure, even by hedge fund standards.” Jones, doubtlessly aided by a team of experts, skillfully made Ackman’s credibility the key issue, not ADP’s performance. In the final analysis, ISS recommended that shareholders vote for Ackman but not his two other candidates. At the same time, Vanguard decided to disregard the proxy advisers and vote with management. Ackman went down in
flames with less than 25 percent of the vote. Board cohesion was key. “They didn’t collapse like lawn furniture,” says Jeffrey Sonnenfeld, management guru at Yale University and Corporate Board Member’s “Before we Adjourn” columnist (see p. 48).

“Collective action and having backbone beats the activists.” CEO Rodriguez called the outcome “an ass-whooping” for Ackman. Ackman said he would remain invested in the company.

EMBATTLED BOARDS
The ADP fight shows that the battle over control of the American corporation, dating back a decade to the birth of the “shareholder democracy” movement, is entering a new, particularly intense stage. More companies and their boards are losing these fights than winning them. Nelson Peltz and his Trian Fund Management firm narrowly prevailed over Procter & Gamble to win a seat on that board, unseating a director. P&G was the largest company ever targeted, and defeated, by an activist. Others among America’s largest companies, including General Motors and General Electric,
have also been targeted.

These pressures are expected to intensify in 2018. “I absolutely don’t think the game is played out,” says Christopher Davis, who heads the investor activism group at Kleinberg Kaplan, a law firm, and has represented several hedge funds and other activist investors. The activists are becoming more sophisticated in analyzing the performance of directors using information in new databases from ISS, Glass Lewis, Bloomberg and S&P, according to a report from search firm Russell Reynolds. Activists can analyze whether a director has been on a board too long or sits on too many boards. They analyze whether a director has helped a company’s performance and has the right skills to assist in the future. And the activists retain public relations specialists to create narratives about targeted directors. “Activists generally will utilize against individual directors all current and historical negative press, statistics and data that is publicly available, whether or not it is accurate, comprehensive or fair,” the report states.

It is the sheer blaze of publicity that causes some boards to fold. “When activists run public hostile campaigns, it puts a lot of pressure on directors,” says Betsy Atkins. She currently serves on four public boards, has served on 27 during her career and is Corporate Board Member’s “Inside the Boardroom” columnist. “No one wants to be publicly attacked.” Adds Davis: “If the activists knock on the door and your first reaction is fear and terror, you’re already on the losing side of that fight.”

TOOLS OF THE TRADERS
Activists also use databases to identify a company’s largest shareholders and consider whether they have any worries or concerns about the company’s management and strategy that might lead them to support an activist agenda. “They pull the information up on Bloomberg and then they call the big shareholders—it’s easy,” says James Woolery, head of mergers and acquisitions and corporate governance at the law firm King & Spalding. Woolery helps companies defend against activists. “If you have your shareholder base in your camp, the activists won’t come because they do the due diligence on the shareholders, months and months of it,” he adds. Woolery argues that structural shifts in American financial markets are helping fuel the wave of activism.

“Shareholder bases are way different than they used to be,” he explains. “They are wildly concentrated at the top. Eight shareholders may have 40 percent of a company’s stock.” The shift of tens of billions of investor dollars into Exchange Traded Funds (ETFs) means that money tracks a stock market index or other financial indicator; those funds, therefore, do not buy individual stocks as frequently as do actively managed funds. That leaves greater voting power in the hands of BlackRock, Vanguard, State Street and similar institutions. The emergence of a de facto, three-way alliance with the proxy advisory firms and many large investors is also empowering activists. “They (the activists) have been very effective—in some ways, too effective,” says Bill George, the former CEO of Medtronic, who now sits on the board of Goldman Sachs and teaches at Harvard Business School. “The reason is the institutional sellers are becoming ever more short term and many have voted with activists for short-term gains. I think boards are overreacting.”

PROXY PREFERENCES
In most cases, the big institutions listen to the proxy advisory firms. “The group that is the most difficult to handle is ISS and Glass Lewis,” George adds. “In reality, they are working for the hedge funds and activists—not for corporations. They will take a position against your compensation plans and anything you’re doing.” An ISS executive countered that his firm’s voting recommendations were based on publicly disclosed policies and that “any suggestion of bias toward one party or another is patently false.” Glass Lewis did not respond to a request for comment.

In response to these pressures, any remnants of the days when boards were considered an extension of golf course clubhouses are fast disappearing. In a kind of nuclear arms race, boards are hiring law firms or other outside specialists to analyze their company’s performance with the same financial tools that an activist would use, such as total shareholder return. Some are going through dry runs, acting out the scenario of what happens if “the black hats” arrive on their doorstep.

They are also devoting new energy to analyzing which directors might be vulnerable and adopting policies to rotate directors off on a regular basis. S&P 500 companies appointed 397 new independent directors in the 2017 proxy season, the highest number since 2004, according to executive search firm Spencer Stuart. Responding to the activists’ demands for greater diversity of all types, just over half, or 50.1 percent, of those new directors were women or minorities. The annual assessment of individual directors is also becoming more important. (See “How Should You Assess Your Board?” p. 39.)

To be sure, some activists make positive contributions to a company and its board. Value Act Capital Management, a San Francisco-based hedge fund, was credited with helping persuade
the board of Microsoft to dump CEO Steve Ballmer in 2014 and hire Satya Nadella, who has done a much better job rejuvenating Microsoft. Another company that saw value in what a hedge fund investor had to say was HD Supply, an independent supplier to Home Depot. When a position that JANA Partners took in HD Supply reached critical mass, the board invited JANA partner Scott D. Ostfeld to join them. “We invited him in because he had a big position, and he had been a five-year holder,” says Atkins, lead independent director at HD Supply. “We thought he would add value. He does high quality work. He’s analytic.” The board decision to invite him into the inner sanctum was unanimous.

Atkins says it is important for a board to understand an activist’s style and goals before deciding how to react. “Some are shorter-term holders and others are longer term,” she says. “Some run very public campaigns that can be bruising, and others negotiate behind the scenes. It’s important to identify the gradations of their strategy and the length of time they have held your stock because that drives your reaction.”

Clearly, there are cases where a company needs to be shaken up. Most outside analysts felt that GE’s board was right to oust CEO Jeffrey Immelt, who had failed over the course of 16 years to jump-start the company’s stock and to revive growth in its core industrial businesses. Under pressure from Peltz’s Trian Partners, the board ended up giving a seat to Ed Garden, Trian’s chief investment officer, after Immelt’s departure.

But most activists appear to be short-term operators—much like the “greenmailers” of an earlier era—who have wrapped themselves in the language of shareholder democracy. They take small positions in companies and agitate for change, then sell at great profit. George, the former Medtronic CEO, points to the case of E.I. du Pont de Nemours and Co., whose board retired Ellen Kullman in October 2015 after coming under pressure from Peltz. “Ellen had done a spectacular job,” George argues. “That was a huge mistake.” The company shut down its central research lab to cut costs in an effort to appease Peltz. But Peltz soon sold most of his shares.

THE LONG GAME
Sources familiar with Trian’s thinking dispute the accusation that he operates for short-term gains. “When Nelson is on a board, Trian typically holds a stock for seven years,” says one such source. “When someone else from Trian sits on a board,it is five to six years. That’s not a short-term strategy.”

The most common changes that activists ask for are an improvement in margins, profits or the sale of assets, which increase a company’s profitability—and share price—in the short term. But those steps may or may not be in the company’s best-long-term interests. “If you listen to what both sides are saying in one of these contests, they are saying the same things—‘We want to do what’s in the best long-term interests of shareholders,’” says activist lawyer Davis. “Yet they are diametrically opposed in some cases in terms of what they think that is.”

Davis expects that activists will continue to target companies of all sizes in 2018, but there will be a new emphasis on smaller and medium-sized companies. “Those companies don’t have the ability to attract the same quality of directors” as bigger companies do, he says. “They may not have access to a qualified but expensive group of advisers. And they may not have had as much training in dry runs, in playing the role of your own activist.”

The fights with activists do, in fact, hinge on how much money either side is willing to invest. Peltz spent about $35 million to win a seat on P&G’s board, say sources familiar with his thinking, and the company reportedly spent $100 million in defense against him. The sheer cost of these fights is one reason defenders are trying to persuade companies to take the right steps before any activist challenge materializes.

“Rather than spending $100 million on a proxy fight and thousands of hours of management time, let’s take a small part of that money and that time and direct it to a proactive prevention or mitigation approach,” says King & Spalding’s Woolery. “Do it on a sunny day. Don’t wait for the rainy day.”

William J. Holstein is a business journalist and the author of “Has the American Media Misjudged China?”

HOW SHOULD YOU ASSESS YOUR BOARD?
What works—and what doesn’t.
It’s one of the thorniest problems facing any board—one or two directors are not doing their job well. According to a new survey of 886 directors by PwC, 46 percent of directors think that one or more of their fellow board members should be replaced. One-fifth say two or more should be replaced. “There are only a certain number of seats in the room,” says Paula Loop, leader of the Governance Insights Center at PWC. “So you want every seat filled with somebody who is adding value and helping oversee the company’s strategy. The bar has been raised on board performance.” Not to mention, boards increasingly want to get rid of directors who could be targeted by shareholder activists, making the entire board vulnerable.

Inevitably, this reality puts the spotlight on a seemingly ancient topic, but one that is increasingly urgent—the board assessment. Traditionally, corporate secretaries or general counsels distributed questionnaires to directors perhaps every other year to solicit their opinions about overall board performance, as well as other directors. Another approach was to ask an outside law firm to do the survey. Few directors, however, provided meaningful responses to this “check the box” approach. “Directors are hesitant to fill out a form criticizing other directors,” says Bill George, former lead director on Exxon’s board and currently on the Goldman Sachs board.

There’s also a debate about precisely what should be assessed. PWC’s Loop argues that boards should conduct three levels of assessment—the performance of the board as a whole, of individual committees and of individual directors. But most directors believe that formula is too complex and that the only type of assessment that matters is of individual directors. “Having the board evaluate itself or asking whether the audit committee performed—in my experience, those don’t produce anything,” says George. “It makes more sense to assess board members individually.”Inside or Out?

AN OUTSIDE PERSPECTIVE
Who then should do that, and what are the consequences? One school of thought is that the person doing the evaluation should be an outsider to avoid any recrimination among remaining directors. “If a board has identified Joe as the director who has to go, it’s a lot easier for me to do it,” says Roger Kenny of Kenny Boardroom Consulting, who has performed 70 board assessments. “They get me to take the first step of saying, ‘Joe, we need somebody with different skills in your chair. I recommend that you go to the chairman and tell him
you are not going to run for reelection.’” Outside law firms and other specialists also offer that service.

But increasingly, it seems directors are convinced that a lead director or non-executive chairman should assess every director every year. “I personally favor having the lead director speak with each member of the board and get their input on how the board could improve,” says Betsy Atkins, who is currently on four boards, including HD Supply, where she is the independent lead director. Atkins is also a columnist for this magazine. “You might have a questionnaire, but then you personally ask about other points. That’s when you get the juicy stuff. Those are the kinds of things that yield the best insights.” One positive benefit of a lead director having those conversations, Atkins says, is that it builds rapport and personal relationships at a time when the cohesiveness of boards is under attack from outsiders.

Ultimately, in this view, the lead director must be willing to deliver tough news to a fellow director. “Someone may need to step down, and that’s hard,” says George. “You have to say, ‘You’ve outlasted your time, and it’s time to give up the seat.’ That’s straight talk.” More boards these days, under pressure, are having that kind of straight talk. —WH

PREPARING FOR AN ACTIVIST KNOW YOUR VULNERABILITIES ASSESS ANNUALLY Be smart. Act before there’s a threat.

• Conduct the same type of financial analysis of your business as an activist would.
• Line up specialist law firms and public relations experts before any approach is made.
• Conduct annual assessments of board effectiveness. Look for obvious targets, such as directors who sit on too many boards. Seek to align the expertise of directors with the future of the business. Rotate as needed as part of a board development process.
• A non-executive chairman or lead director is increasingly necessary.
• Foster a cohesive board during executive sessions and informal dialogue.
• The non-executive chairman or the lead director should have regular contact with major investors in coordination with the CEO and investor relations representatives.
• When activists make an approach, listen and talk with them. Sometimes they have good ideas worth considering. A win-win outcome might be possible.
• If activists go hostile in public, give them a taste of their own medicine by pointing out their business failures and lack of the right type of expertise. Communicate aggressively.

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