What the Allergan/Valeant Story Teaches About Staggered Boards 

Arnold Pinkston is former General Counsel at Allergan, Inc. and Beckman Coulter, Inc. This post comments on the work of institutional investors working with the Shareholder Rights Project, (discussed on the Forum here, here, and here) which successfully advocated for board declassification in about 100 S&P 500 and Fortune 500 companies.

Until March 2015, I was the Executive Vice President and General Counsel of Allergan, Inc. For much of 2014 my job was to address the hostile bid launched by Valeant and Pershing Square to acquire Allergan.

With that perspective, I followed with interest the debate surrounding staggered boards, and in particular the success of institutional investors working with the Shareholder Rights Project in bringing about board declassification in over 100 S&P 500 and Fortune 500 companies. From my perspective, the debate did not seem to fully reflect the complexity of the relationship between a company and its shareholders—i) that each company and each set of shareholders is unique; ii) that destaggering a board can affect the value of companies positively, negatively or hardly at all; and iii) that shareholders, each from their own unique perspective, will be searching for factors that will determine whether annual elections are in their own best interests—not the company’s. For that reason, I respectfully offer my thoughts regarding the campaign to destagger boards.

My bottom-line view

As a corporate insider, I see the debate over staggered boards as fundamentally a battle between directors and shareholders for power over the company. With a destaggered board, shareholders can more quickly impose their will on the company by threatening all of the directors with removal at annual meetings. For shareholders, this provides a powerful tool to force their agenda in the short term. Directors must respond to shareholders’ demands and deliver more of the company’s value to shareholders in the short term and away from the company’s long-term opportunities, and its customers, employees, vendors and communities.

Annual elections aren’t per se good or bad. They can be used, however, in ways that destroy considerable company value. To fully inform shareholders, declassification proposals and company responses to such proposals should indicate that annual elections provide further leverage to shareholder interests. They should acknowledge that shareholders have wholly separate interests that can conflict with the company’s interests and the interests of other shareholders. They should disclose that in situations such as Valeant’s pursuit of Allergan, shareholder demands can be hugely destructive of corporate and shareholder value; and that independent directors, with governance structures that allow them time to resist shareholder pressure can deliver billions of dollars of value to the company and its shareholders.

Destaggering a Board involves a shift in power from the Board to shareholders who seek to exercise further control over the company.

Annual elections can change how the company is managed. They give shareholders a tool to more quickly threaten directors with removal if they don’t act as shareholders demand. What would have taken two or three years, shareholders can now accomplish in one or less. In fact, with a staggered board, a disappointed shareholder might simply sell their shares rather than wage a long-term battle with a board. With annual elections, shareholders who want to influence the company in the short-term, can credibly threaten directors who resist.

Fully informed and engaged directors are required by law to act in the company’s best interests and typically are best situated to maximize the company’s value.

I would not expect that shifting power from directors to shareholders would improve corporate performance. Directors are legally bound to act in the best interests of the corporation. They are subject to liability if they don’t. Moreover, they have access to all of the company’s confidential information and can use that information to build their strategy. Shareholders have fairly full information about a corporation, but that information is qualitatively inferior to the information available to a board. Full transparency between a company and its shareholders or any of its constituencies is simply not possible given the company’s need to protect its confidential information, trade secrets and other intellectual property from competition. It would be very difficult for the shareholders to formulate a better strategic plan than the board given this information disadvantage.

In contrast to directors, shareholders are free to act in their own best interests as opposed to the best interests of the company. Shareholders can’t be held liable for their proposals or how they vote. While the corporation exists theoretically forever, shareholders can sell their shares at any time. They can be opportunistic with their investment; pressing for short-term gains, and then selling their shares before any problems arise due to lack of long-term investment. Importantly, each shareholder has many interests beyond his shares in the company. Those other interests differ from the interests of the other shareholders, let alone the company’s interests. Shareholders are free to prioritize their other interests over their investment in the company or the company’s wellbeing.

What I would expect is that shareholders would use their annual voting power to improve shareholder returns and that it would often come at the expense of the company’s long-term opportunities and its other stakeholders. Because annual elections allow shareholders to have more of an impact in the near term, the tool is ready made for shareholders who want to improve near term performance and move on.

Companies that have been managed to perform well in the mid- to long-term become easy targets for shareholder activists. Any action that reduces the company’s longer-term resource investments will allow the company to deliver higher returns in the short term for its shareholders. By having fewer employees with less training, a company can return more value to shareholders in the next few quarters. The same is true if the company provides less customer support, or uses low cost suppliers and vendors from less regulated markets. Rather than investing in a promising project that would deliver profits a decade from now, a company can invest in marketing programs that will deliver sales over the next few quarters. Even without an express demand from shareholders, the directors will feel additional pressure to perform in the short term when there are annual elections.

Certainly these comments are generalizations. Each situation, board, company and shareholder, is unique. We should expect a wide variation in how annual elections affect companies. In some circumstances, annual elections can be very helpful. When directors are ignoring shareholders’ proposals that are in the company’s best interests, providing shareholders with powerful tools to effect change can lead to improved value for the corporation. However, I don’t believe that this is common. More commonly, when the shareholders and the directors disagree, it is the directors who have the agenda and strategic plan that is in the best interests of the company. In these circumstances, additional shareholder voting power can be problematic. This is the Allergan story.

Shareholders are free to act selfishly and against the best interests of the corporation and other shareholders.

My experience at Allergan tells me that permitting shareholders the right to remove directors quickly can be misused to undermine a corporation’s value. In 2014, Pershing Square and other Allergan shareholders sought to force Allergan directors to accept a hostile bid for the company from Valeant that the Allergan board believed was grossly inadequate. When the directors refused, Pershing Square called for a special meeting to remove the directors—not an annual meeting, but the leverage had the same effect. Shareholders threatened the directors with removal if they would not follow the shareholders’ direction.

Here we don’t need an academic study to decide whether the shareholders’ proposal would have been best for Allergan shareholders. The directors had it right all along. Allergan was worth much more than what the shareholders wanted to accept, as evidenced by the sale to Actavis for $72B—about $22B more than the original hostile bid. A sale to the hostile acquirer would have been a massive transfer of value from Allergan and its shareholders to Valeant and its shareholders.

Allergan had an excellent Board, with talented directors who worked well together. They had access to any and all information about the corporation, its strategy, its business development opportunities, and were fully engaged in understanding that information. Moreover, they had access to world-class advisors and were fully committed to acting in the company’s and it’s shareholders’ best interests. Even further, the board and the company had performed extraordinarily well for more than a decade, and the company’s five-year strategic plan forecast continued strong growth. None of that mattered. Those directors were threatened with removal for rejecting a hostile bid that undervalued the company.

Why? To be fair, many shareholders may have simply doubted the board’s view that the bid undervalued Allergan. They did not have access to the information available to the Board. But also, many shareholders were much more interested in their own performance in the short-term than the long-term wellbeing of Allergan.

Many large shareholders of Allergan had larger holdings in Valeant. They would have benefitted from a transfer of value from Allergan to Valeant. Other Allergan shareholders had large holdings in other companies and urged Allergan to consider strategic alternatives with those other companies. Still other Allergan shareholders were not interested in waiting and taking the risks necessary to capture long-term value; especially when they could take a sizable gain in the near-term. This effect was compounded because the money managers who make decisions for these funds receive bonuses based on the annual performance of their funds. And the effect was further compounded because event-driven hedge funds and arbitrage firms entered the Allergan shareholder base. The common thread is that shareholders and those who managed their money were focused on matters other than maximizing the value of Allergan.

Providing time for directors to implement their plans can be extraordinarily valuable!

What led to a positive result in the Allergan situation—the sale to Actavis—was that Allergan and its board had sufficient time i) to demonstrate the full value of its business and the credibility to execute its five-year strategic plan, and ii) to explore strategic alternatives to combining with Valeant. Allergan’s by-laws provided for annual elections of all directors, and allowed shareholders to present proposals at an annual meeting with just 60 days’ notice. Thus, Valeant and Pershing Square might have launched their bid just in advance of the notice period for Allergan’s May annual meeting. If it had done so, the Allergan Board would have had little more than two months to respond to the hostile bid or risk replacement. Valeant and Pershing Square may well have been able to force a sale at prices that dramatically undervalued Allergan—both in comparison to management’s strategic plan and the eventual price paid by Actavis.

Instead, Valeant launched their bid after the deadline to raise their proposal at the annual meeting, and then took time to try more informal methods to press their bid. Valeant eventually launched a tender offer and Pershing Square called for a special meeting of shareholders to remove the directors. Allergan’s by-laws permitted Allergan’s board 120 days to call that meeting, and Allergan’s directors wisely chose to use essentially the entire 120 days. The directors were roundly criticized for doing so, but during the eight months between when Valeant and Pershing Square and Valeant launched their bid (April 22) and the date set for the special meeting to remove the directors (December 17), the Board had time to shift spending/investments to raise Allergan’s earnings (and thus its stock price) in the near term, and negotiate strategic alternatives with other companies besides the hostile bidder. Had Valeant and Pershing Square pressed their hostile bid in advance of Allergan’s 2014 annual meeting in May, this would not have been possible.

Each situation is going to be different. One can’t guess whether a board might need 2, 6, 12 or more months to demonstrate the full value of their plan to create value versus an alternative proposal by shareholders. Yet the Allergan story demonstrates that giving a Board additional time can be extraordinarily valuable.

Given the 22 Billion dollars of additional value the Allergan board was able to capture, one would think that shareholders might want to consider re-staggering boards or adopting other by-law provisions such that their board would have time to fully explore potentially valuable alternatives to activist shareholder proposals. At the very least, it must be acknowledged that charter and by-law provisions that constrain short-term shareholder actions can be very positive for a corporation and its shareholders. Shareholders with a long-term bias might prefer such charter and by-law provisions to constrain over-aggressive short-term oriented or conflicted shareholders.

Declassification proposals and company responses should inform shareholders about the true nature of the staggered board debate.

To fully inform shareholders, proponents of declassification proposals and issuers bringing such proposals to a vote should inform voting shareholders that destaggering a board shifts power to shareholders, and particularly short-term oriented shareholders, from directors. They should note that shareholders who either have conflicts of interest or who have mostly or only a short-term interest in the company, could use that new found voting authority in ways that are contrary to the interests of the company, as well as the interests of other shareholders. The disclosure should note that directors, in contrast to shareholders, must disclose their conflicts and are bound by their legal duties to act in the best interest of the company and its shareholders. The disclosure should also note that directors given additional time to consider strategic alternatives have been able to generate considerable value for the company and its shareholders.

The proxy advisory firms should be similarly advising shareholders. Moreover, investors and those who advise them should fully consider that the proxy advisory firms can be utterly wrong in their positions, as they were in characterizing Valeant’s bid for Allergan as a fair, even a premium offer and suggesting that Allergan’s Board was entrenched. The proxy advisory firms should describe their potential conflicts in significant detail and, when relevant, highlight that they have less information than is available to a board. Allergan teaches that blindly following the advice of the proxy advisory firms such as ISS is not warranted; and fiduciaries must scrutinize ISS positions to meet their duties to their investors.

Conclusion

I don’t expect that additional disclosures will sway shareholders to decline the additional voting power associated with annual elections. Shareholders will continue to grab as much structural power over the corporation as they can get. But, they should remember that their interests don’t always align with their fellow shareholders. Directors, on the other hand, are positioned to act in the best interests of the corporation and all of its shareholders. Engaged directors can help to focus and nurture the long-term interests that the shareholders have in common—the value and health of the company in which they have all invested.

Hopefully, fully informed investors will have more faith in boards and companies that are performing well, and be more skeptical of shareholders advocating for agendas in which they have a selfish interest. Directors can help to create the cooperation between a company and its shareholders by spending considerable time with shareholders; listening to and addressing shareholder ideas and concerns; and advocating the board’s vision for creating value for all.

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