CEOs and ISS’ Proxy Contest Framework

This post is based on a publication by Institutional Shareholder Services, Inc. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); and Dancing with the Activists by Lucian Bebchuk, Alon Brav, Wei Jiang and Thomas Keusch (discussed on the Forum here).

A pair of high-profile proxy contests currently underway—Trian’s campaign to add Nelson Peltz to Procter & Gamble’s board, and Pershing Square’s effort to replace three members of Automatic Data Processing’s board—reflect diverging paths in the ongoing evolution of activism. While the ADP contest may be seen, to some extent, as a continuation of this spring’s trend toward increasingly contentious fights, Trian seems to be deliberately distancing itself from such hostilities. The outcome of these two contests, at the ballot box as well as reconfiguring the income statements of these corporations over the next few years, will likely have a lasting impact on the overall strategy and tone of future activist campaigns.

Direct attacks against sitting CEOs were prominent features of this year’s proxy season, perhaps most notably because of Elliott’s campaign at Arconic, the primary focus of which was removal of CEO Klaus Kleinfeld. Land & Buildings also directly targeted Taubman Centers’ Chairman/CEO Robert Taubman for removal from the board; though Taubman was one of only two incumbent directors standing for reelection at the 2017 annual meeting due to the company’s classified board structure, the dissident was not shy about blaming him for the company’s governance missteps. In its contest at Buffalo Wild Wings, Marcato Capital did not directly target CEO Sally Smith for removal from the board, but the fund’s intention to replace management was abundantly clear in its investor presentations; Smith announced her retirement shortly after the dissident’s election victory. Trian was widely credited with prodding the GE board into pushing out Jeffrey Immelt out of the company’s corner office in July.

Though the aforementioned situations attracted more media attention, this year’s CEO-focused trend actually began earlier in proxy season, with the campaign by Alex Denner’s Sarissa Capital to replace three of seven directors at Innoviva, including the company’s CEO and its chairman. The trend even extended to smaller companies: At Rockwell Medical, dissident shareholder Richmond Group, which succeeded in replacing the only management nominee standing for election at the company’s June 2017 annual meeting, began calling for the removal of Chairman/CEO Rob Chioini in late August. (The company has since countered that Richmond Group and its nominee have demanded a payment of nearly $1 million to avoid another proxy contest.)

Interestingly, this Queen of Hearts (“off-with-their-heads”) strategy runs counter a slowdown in CEO exits across the broader economy. Outplacement specialist Challenger Gray & Christmas recently reported that 765 CEOs have announced their exits through the end of August, down 7.2 percent from the 825 CEOs who left their roles in the first eight months of 2016. Historically, dissidents have generally argued that providing them with board seats allows for a proper up-close assessment of whether CEO change is necessary, acknowledging that they “don’t know what they don’t know” from outside the board. The recent uptick in CEO attacks appears to dismiss any pretense that board change is a necessary precursor to CEO replacement.

That seismic shift has apparently been significant enough to prompt one leading law firm to suggest that ISS alter its analytical framework to “expressly account for whether a CEO is being targeted in a dissident’s minority slate.” While limiting ISS’ ability to recommend against CEO directors as a matter of policy might impose greater discipline on dissidents to present a more compelling case, the notion that ISS does not already view the targeting of a CEO as an unusual and significant factor—and thus worthy of careful consideration in a short-slate fight—would be a misrepresentation of our framework.

ISS’ proxy contest framework is broadly structured by design, reflecting our case-by-case approach to these analyses. Even when the CEO is not directly targeted for removal, ISS closely weighs the unintended consequences of any potential key-person change resulting from a contest. In the case of Cypress Semiconductors, for instance, ISS initially did not directly support the dissident slate—despite the fact that the dissident (founder and former CEO TJ Rodgers) had demonstrated a compelling case for change—given the downside risk related to the removal of the company’s executive chairman, who was seen as a significant contributor to the company’s strategic transition. ISS only reversed this recommendation in the face of material new information that, among other things, directly contradicted statements made by the executive chairman during his meeting with ISS.

The removal of a CEO from a board represents a vote of no-confidence that carries further-reaching consequences than the removal of most other directors. However, in instances of demonstrably poor execution, operational issues, or undue management influence over the board, such targeting may be appropriate—provided that the consequent risks have been properly assessed. Another consideration, as highlighted in the Taubman Centers contest, is whether a CEO, or any other director, should be insulated from accountability as a result of a staggered board structure.

At least at first glance, the path taken by Bill Ackman’s Pershing Square can be seen as a continuation of this spring’s trend. Though Pershing Square is not directly targeting ADP CEO Carlos Rodriguez for removal from the board, the fund’s initial presentation is far from complimentary of his tenure. Ackman has publicly stated that a CEO change might in fact be necessary to effect the strategic shift that Pershing believes is needed. Like all campaigns critical of a chief executive, the ADP contest has unsurprisingly taken on a more antagonistic tone, including some much-publicized personal attacks on Ackman by Rodriguez himself.

Trian, conversely, has opted for a less traveled path, avoiding not only threats to replace the CEO, but direct attacks on any of P&G’s current board members. In fact, Peltz has promised, if elected, to immediately propose the re-appointment of the displaced incumbent. Peltz’s lone nominee approach also represents a marked departure from the “at least two” strategy favored by activists, who have traditionally felt that a sole dissenting voice is too easily squelched, and that at least two dissident directors are needed to advance any ideas within a challenged board. Of course, this “softer” approach raises other questions: assuming Trian can prove that change is indeed necessary, is one additional director really enough to address the changes needed? Also, if Trian is right about P&G having an insular corporate culture, can a shift in culture at such a giant company really be effected without an eventual CEO change?

A dissident’s burden of proof is undoubtedly going to be lower when he seeks a single board seat than if he demands a complete boardroom makeover or a CEO change. It would probably be inaccurate, however, to characterize such a surgical strike contest as a cost-free, “what’s the harm?” option, at least in a rhetorical sense that implies a dismissive view of potential risks. As in any contest, a thorough assessment of the risks of granting (or perhaps not granting) a dissident any board representation is always a relevant consideration.

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