Preventing the Destruction of Shareholder Value in M&A Transactions

​​​​​Stephen L. Weiss is Chief Investment Officer and Managing Partner at Short Hills Capital Partners LLC. This post is based on his SHCP memorandum. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here) and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here).

The interests of shareholders are too often subjugated to those of interested parties. This circumstance has resulted in the transference of significant value from the rightful owners, the shareholders, to those unentitled. Institutional fund managers have undertaken commendable initiatives toward improving compliance with environmental, social and governance (“ESG”) principles at their investee companies but structural constraints have limited their actual impact on governance. The diversity of portfolios, coupled with broad ESG initiatives, may dilute these efforts since it is impractical and costly to directly engage with individual company managements on a broad and timely basis to proactively ensure that shareholder interests are being considered on critical events. Most often, by the time shareholders are informed of the corporate action, the damage has been done, leading to inefficient remedial measures such as litigation, an avenue that institutional managers rarely take. Preventative measures, on the other hand, would act as a significant deterrent as well as a solid defense to deleterious behavior ensuring that shareholders are not disadvantaged. Thus, while the impact on portfolios from driving awareness of environmental and social issues is real but somewhat difficult to define, the destruction of shareholder value from poor corporate governance is substantial, tangible and preventable.

The impact of poor governance, such as lax oversight by a Board of Directors or actions undertaken by self-interested managements, is particularly acute in corporate actions susceptible to conflicts of interest such as the sale of a company, significant acquisition or pursuit of strategic options leading to a material corporate event, particularly when not subject to a shareholder vote. Although these are company specific incidents, collectively within a portfolio their occurrence can meaningfully influence returns. While a Board of Directors owes a fiduciary responsibility to shareholders to ensure compliance with good governance, their efforts may fall short. For example, the inputs a Board relies upon are provided by management who may be a conflicted party, particularly in a going private transaction. In turn, investment bankers rely on management projections and shareholders, except in a negligible minority of instances, vote their proxy in reliance upon the Board’s recommendations and/or guidance from advisors that are conflicted or not fully informed which may or may not be their fault. Left unchecked, the compounding effects of poor governance will negatively impact the minority shareholder and the capital markets in a meaningful way.

Retaining an independent monitor on behalf of all shareholders to observe, assess and report on the steps taken by a Board of Directors that could reasonably lead to a change of control or other significant corporate event, will provide transparency into the process undertaken by corporate fiduciaries thereby enhancing adherence to guideline principles of strong corporate governance as well as providing a basis for executing a proxy ballot as a more informed shareholder. The monitor will be retained by the Board from a list pre-approved by a consortium of fund managers contemporaneous with the initiation of the process. Most importantly, the monitor will be the only advisor who is truly independent, a result of it being pre-selected directly by shareholders rather than management or the Board. Boards should embrace this measure both as a defense to potential litigation and in furtherance of their fiduciary responsibility.

Discussion

Passive investment funds have experienced exponential growth, with assets under management now representing 25% of all fund assets globally and 43% of equity fund assets in the U.S. Although the strategy has provided greater diversification, lower costs and superior performance over the last decade, the downside, according to one noted governance expert, is that passive investing may breed “harmful consequences for firm governance, shareholders and the economy.” Noting their deficiency in fundamental research, Professor Dorothy Lund characterizes passive managers as “uninformed” making a case for regulatory policy that would prevent these funds from voting at shareholder meetings. Although her concern is worth noting, Lund’s suggestion would not be a workable solution since it may create another, more problematic scenario by endowing a relatively small number of shareholders, perhaps those with a too short term time horizon, a disproportionate level of influence. Furthermore, bestowing the right to vote upon a specific population of shareholders infers a level of knowledge and diligence on proxy matters that may not be deserved. With a strong preference for every shareholder, regardless of investment style, maintaining their vote as a fundamental right of equity ownership, this paper provides a solution that will provide passive managers with the necessary information to responsibly execute a proxy ballot.

Concerns about the growing dominance of passive investing and the symmetry of its influence on governance is not limited to the grumblings of active managers who have experienced declining assets under management (“AUM”) and compressed profit margins. Nor is their only ally academics such as Professor Lund or Professor John C. Coates of Harvard Law School, the latter pointing out the multiplier effect of passive strategies wherein a large number of active investors are actually closet indexers, shadowing the holdings of passive portfolios. Recently, the father of passive investing, John C. Bogle, aired his concerns about further growth in indexed equities. He noted that three firms control 81% of passive assets, of which his firm, Vanguard, has a 51% share, followed by Blackrock at 21% and State Street with 9%. Mr. Bogle points out that on the current trajectory of growth, passive managers will eventually have de facto control over every publicly traded company, an outcome that he believes is problematic. He proposes multiple solutions of which the three most practical, by his account, are consistent with this paper. They include greater transparency into the proxy voting process and management engagement, appointment of an independent supervisor and a process to ensure the focus of the fund manager is on their fiduciary responsibilities to the investor. Despite the issues he noted, some present and others burgeoning, passive investment funds remain critically important to capital markets and incontrovertibly beneficial for the investor.

As alluded to above, while the expectation may be different, some active managers similarly lack the resources or motivation to analyze the legitimacy of the process by which a company in which they own a position was merged into another entity. Moreover, even if a simple reading of a two hundred and fifty page proxy were achievable on a consistent basis, the information not included therein and not accessible, except through litigation, is often a more critical input. In effect, the choice facing a fund manager is between allocating analytical firepower to positions that will remain in the portfolio and finding new ideas or spending the time to understand the reason shareholders were effectively shortchanged on a specific situation even when the haircut is substantial. The former always seems to win and is actually a reasonable approach under current constructs given that any remedial action would likely involve litigation which often does not make sense when weighing the distraction of a legal proceeding against the limited impact a positive outcome would have on the average mutual fund with a portfolio of 90 positions and a more diverse fund of 388 stocks. Not addressing the underlying issues is also the path of least resistance but as is often true with taking such a route, there are consequences; tacitly rewarding negligent or bad actors through unjust enrichment may stimulate indifference to fiduciary duty well beyond a single corporate entity, the compounding of such incidents significantly detracting from performance and ultimately fraying confidence in the markets. For these reasons, preventative measures are required.

Statistically, there does not seem to be any perceptible difference between the voting patterns of active managers versus passive thus driving the conclusion that all asset managers should enhance their process for reviewing proxies. In support of this view note that, historically, shareholders have rarely disagreed with a Board’s recommendation for voting a proxy on critical events such as the sale of a company. To wit, of the 907 mergers submitted to a shareholder vote during the 10 year period from 2006-2015, only 5 were voted down. It defies logic that only 0.55% of all business combinations were not in the best interests of shareholders or did not leave relevant value for less entitled others to take. Perhaps this is one reason litigation is filed in ninety percent of all mergers although Delaware has attempted to mute some of the remedies available to shareholders.

It can be surmised that the almost perfect track record of shareholder proxies executed in favor of being acquired is not the byproduct of pristine governance practices or the result of a detailed analysis of merger price or process but is instead often a function of a portfolio manager’s desire to take advantage of a spike in share price resulting from an acquisition proposal. As fundamental investors cede ground to arbitrageurs, the shareholder vote in favor of the transaction is all but assured. However, shareholder ratification of a merger should not be confused with the company’s fiduciaries acting responsibly or the receipt of proper value for ownership interests. The purpose of retaining an independent monitor is not to squeeze the last dollar from an acquirer. Rather, the goal is to ensure that the company executed a proper process. If the tenets of good corporate governance were observed, such as a competitive auction process, then the value received by investors should generally be regarded as fair.

The mandate of passive managers to track performance of an index does not lend itself to performing fundamental analysis since the expense may cause tracking errors and, in any event, would not impact an investment decision. Passive funds are essentially captive investors, unable to exit a position regardless of the underlying fundamentals as long as it is an index component. Conversely, they cannot stay in a position after the close of a transaction for the purpose of challenging its legitimacy or valuation. But it is precisely for this reason that they should take a more aggressive, real-time preventative approach in order to ensure that shareholder value is realized and not destroyed. From a performance standpoint, markets will not always be so buoyant; there is no reason to transfer value to those unentitled to its receipt.

Conversely, active managers can register their dissatisfaction with value destroying corporate events by exiting a position as often happens when analysis is not supportive of a major acquisition. While this may limit their downside it does not prevent its occurrence nor does it act as a warning to other companies considering the same behavior. A prophylactic solution, such as real-time monitoring on behalf of all shareholders, is the only viable method; preventative steps are typically far less costly than remedial action. Greater transparency into a process undertaken by a Board and management will enhance accountability which research has shown leads to better performance.

An independent monitor would be privy to non-public information while representing public shareholders. Although understandably a discussion point, this should not be a concern for a number of reasons. As with other advisors, a monitor would be bound by a non-disclosure agreement. There would be no communication between the monitor and shareholders until the privileged information is publicly disclosed in a filing with the SEC at which point the existence and identity of the monitor will be included. The monitor will be selected by the Board, or Special Committee to the Board, from a list pre-approved by a consortium of fund managers. The monitor will be free of any actual or perceived conflicts such as a prior fee based relationship. The monitor’s observations, limited to process and compliance of the Board with their fiduciary responsibilities, will be incorporated into the proxy in the same way a fairness opinion is included. It is not in the monitor’s purview to opine on valuation, the theory being that if a proper process was followed by the Board then fair value will be achieved. In other words, the means will define the end.

While this paper adds a new dimension to active engagement, outreach is not a radical concept. In 2006, the United Nations organized the Principles for Responsible Investment (PRI). With over 2,000 signatories, including virtually all brand name active and passive fund managers, it has become a leading organization promoting responsible investing. One of its six principles is to be an active owner, requiring increased engagement with portfolio companies. However “engagement” is undefined, thereby running the gamut from sending out a blast email disclosing the fund’s proxy voting guidelines to a meeting with management. Despite the efforts by the UN and so many other organizations and practitioners to increase awareness, engagement has stayed flat among the top twelve passive investors for at least three years. A shareholder advocate will directly increase engagement, without interfering in the operations of the Board, at one of the most critical points in a company’s existence and at a pivotal point for shareholder interests. In fairness, a number of asset managers have been particularly vocal about engagement, backing up their words with resources including staffing departments that target engagement.

In no way is it suggested that a shareholder advocate be engaged on every topic; certain matters in front of a Board may be fairly routine such as ratifying the selection of an outside auditor but others can destroy shareholder value immediately and permanently and enrich interested parties at the expense of shareholders. Additionally, certain corporate actions that can negatively impact shareholder value are not put to a shareholder vote such as a major acquisition or Board endorsement of a tender offer that does not require a proxy. “Acquisitions tend to highlight conflicts of interest between managers and shareholders in large public corporations, and provide an opportunity for managers to obtain personal gain at the expense of shareholders.” In other words, overbidding or ill-suited business combinations can be as, if not more, damaging to shareholders than selling a company for less than fair value. A shareholder appointed monitor would effectively limit value destroying actions undertaken by the Board by casting a light on the process.

Despite best intentions, the ability of fund managers to monitor or enforce governance principles is limited and often reactionary, not as a result of apathy but as a function of their large number of portfolio holdings and the cost of proactive one-on-one engagement. To deal with these issues, fund managers, some directly and others through proxy firms, have provided the companies in their portfolios with ESG guidelines listing the factors they will consider in executing their proxy ballot. Clearly, this is not a substitute for targeted engagement with investee companies on meaningful corporate events.

In formulating a decision on an acquisition or merger, the Board relies upon information provided by interested parties that will include management, self-interested shareholders and, on occasion, conflicted advisors. For example, management may deliberately tamp down financial results up to a year in advance of a sale in order to secure a lower acquisition price which then becomes a benchmark for their future wealth creation; the depressed operating metrics also the starting point for performance bonuses under the new ownership regime. As pointed out in multiple studies, suppressing earnings results and reducing projections is fairly common and surprisingly easy to accomplish yet is typically undetected and underappreciated in regard to diluting the value delivered to shareholders. “During the year prior to management buyout (MBOs) announcements, target firms exhibit abnormally high discretionary expenses in selling, general and administration, abnormally low discretionary accruals, and realize losses from asset sales.” A Board of Directors is not on even footing with a management desirous of participating in a low-ball buyout bid. “Put simply, arm’s-length bargaining is compromised in MBOs because managers can influence the terms on which a transaction takes place to their advantage even without serving on or dominating the board or special committee conducting the sale process.”

Management, as well as advisors to the Board, may also benefit by currying favor with the acquirer, delivering the company at a discounted merger price. Relying upon someone with whom there has been a close relationship as is often found between a Board and management is hardly unusual (particularly when the Chairman of the Board is also the CEO). This is not only a U.S. problem.

It may, in fact, be beneficial for a Board to retain a shareholder monitor on its own accord supplementing the team it employs for advice on transactions. The heightened focus by market participants on governance calls for specialized advice and deployment of appropriate safeguards to ensure that accepted protocols are met, particularly at the time of a seminal event a company’s evolution. Assuming the monitor is carefully chosen, this should instill confidence in shareholders that their interests were front of mind with the Board, giving pause to shareholders considering a challenge to price or process. While not a defense per se, it is evidence of the Board’s intent to execute their fiscal duties in a most responsible manner.

Endemic to the issue of a management’s focus on self-enrichment at the expense of fulfilling their fiduciary duties are retention agreements which may serve as an inducement to favor one buyer over another. While companies are required to disclose agreed upon retention packages, disclosure is not required of the particulars of any discussions that occurred during the merger process that have not yet been memorialized in a contract regardless of a mutual expectation that those terms will control after the transaction closes. This information is critical in assessing conflicts of interest and should be an important data point for Boards, who may not be involved in these discussions, and for shareholders in voting their proxy. Typical language in the definitive proxy, Form DEFM14A, regarding retention agreements states: “…the Company [surviving entity] may grant special purpose awards to Management…” or “…the Company has engaged in discussions with Management regarding future compensation but nothing has yet been agreed to.” This carefully crafted phrasing violates the spirit of disclosure required by proxies.

Particularly in a going private transaction, often with no management team waiting in the wings to run the acquired company, it seems unlikely that discussions have not resulted in a compensation agreement being reached in principle, making the lack of disclosure troubling and in violation of good governance principles. This lack of disclosure on future compensation is arguably at odds with the requirement that public companies submit management compensation plans to shareholders via a proxy ballot, especially when it may be driving the ultimate decision a Board and management can make which is the sale of the company. An independent shareholder monitor would surely focus on management incentives as an input into their decision process.

In what is an exceedingly rare disclosure in a proxy, Lumos Networks provides a noteworthy example of what appears to be management enrichment at the expense of shareholders. From a reading of the proxy, it can be argued that the Board delayed executing the merger agreement until management received a retention package which ultimately included an award equal to 9% of the deal’s value, half of which vested immediately upon closing the transaction and was not tied to any performance metrics. The richness of this agreement is particularly confounding since the acquirer, EQT, specifically stated that retaining management was not a condition to closing the merger. Could it be that the Board, which included the CEO, put the interests of management over that of shareholders, the only party to whom they owed a fiduciary duty? This paper offers no conclusion but posits the question: if the value of the retention agreement was a function of what EQT had budgeted for the acquisition, under those circumstances was that sum rightly due shareholders? The proxy raises other issues that were equally troublesome. Despite these apparent conflicts and a merger price arguably well-below fair value, only 7,731 shares voted against the merger out of 19,497,770 proxies submitted.

While Lumos is but one example, many others exist. From 2015 through 2017, shareholders filed 204 appraisal petitions in Delaware challenging merger price in various public equity transactions. The discrepancy between merger price and fair value must be substantial—a spread of 20-25% is a reasonable hurdle—in order to justify the expense of litigation. Since appraisal is not a class action, only those that perfect their appraisal rights, averaging 4.6% of shares outstanding in challenged mergers, are entitled to any award by the court. The popularity of shortchanging an investor is supported by the math since the acquirer will only have to pay a premium to merger price, likely falling short of fair value since more than 80% of these cases settle, to less than 5% of shareholders thus acquiring the remaining 95.4% of the company at a material discount to fair value. Appraisal petitions result in a higher recovery to shareholders than any other form of litigation but I am not aware of any passive managers taking this course of action, in all likelihood because they are indifferent to the outcome since their objective is to match the index which is determined by the same merger price received by other passive investors. Active managers tend to stand down as well for the reasons noted earlier. This approach is shortsighted and ignores the cumulative impact from multiple occurrences as well as tacitly condones anti-shareholder behavior. The peril and impact can be averted by a shareholder monitor allowing the shareholder, both passive and active, to register their dissent or satisfaction via an informed vote.

Deficient value received in a merger may be the result of a flawed sales process. Although most advisors execute their mandate with integrity, understanding that achieving a high price for an asset may lead to engagement by other sellers as well as higher revenue since their fees are often based on a percentage of the acquisition price, that is not always the case. For example, in auctioning a company, an advisor may favor acquirers that offer future revenue opportunities whereas the target’s Board engaging the advisors will cease to exist once the merger closes. At the behest of management the number of potential acquirers contacted during an auction process may be intentionally limited in support of a particular acquirer(s) that will retain management. Or the merger agreement may contain clauses such as topping rights or a no shop provision that mitigate against a competing offer yet do not always serve the interests of shareholders. Even the most basic advice from investment banks, in the form of a fairness opinion can lull a Board into a mistaken belief that its actions were correct or provide cover for not exercising appropriate fiduciary responsibility. Fairness opinions are provided after a merger is agreed to as a check on the merger price of the acquired entity weighed against various methodologies, e.g., price/earnings, discounted cash flow, enterprise value/EBITDA, precedent transactions. The output of the exercise provides a wide range of fair value, perhaps one reason for their lack of probative value in appraisal proceedings. A fairness opinion concluding that a company was sold for less than fair value is excruciatingly uncommon.

As stated, the sentiment put forth herein is not that all advisors operate out of self-interest, but rather that it is incumbent upon fund managers, as fiduciaries, to exercise all possible efforts to protect the interests of investors in their funds, augmenting the insufficient safeguards of the proxy process, deficiencies in fundamental research and a paucity of active engagement.
Thus the seminal question as to who can effectively assume the responsibility of ensuring that companies operate within the guidelines of good corporate governance to the benefit of investors?

Conclusion

An independent shareholder advocate should be engaged to monitor corporate events that are susceptible to directly and negatively impacting shareholder value, often enriching certain interested parties at the expense of investors. The advocate has only one ambition: ensure that the minority shareholder is treated fairly as dictated by the appropriate principles of good corporate governance. This is a preventive measure with the monitor’s engagement occurring at the initiation of any process that may reasonably lead to a major strategic event. Realistically, once a decision has been made by a Board to pursue a specific course of action, it is rarely repudiated by shareholders in the proxy vote thereby allowing value destroying events to unfold to the detriment of investors. Preventive measures are a far superior alternative to pursuit of after-the-fact remedies such as an appraisal rights petition or class action lawsuit; litigation is always an imperfect solution since it is time consuming, has an uncertain outcome regardless of the fact pattern, results in fractional compensation to the shareholder and only serves those that are parties to the lawsuit. Institutional fund managers typically have an understandable aversion to shareholder litigation allowing harmful behavior to go unchecked.

The monitor’s real-time observations will be an important input for the fund manager, on behalf of its investors, and the proxy firm, on behalf of its clients, in determining how to vote the proxy for the shares they represent. Importantly, the shareholder advocate would only have observer status and not be a participant in any discussions regarding business matters that are in front of the Board. Fund managers, despite their ownership interests, understandably avoid any incidence of control such as a Board seat; the benign presence of an independent monitor serving all shareholders maintains this separation. However, the monitor’s presence will motivate proper governance behavior as well as increase transparency into the decision process of the investee company regarding major decisions. Analogous to the simplistic example of the SEC monitoring trading activity, there is no assumption that untoward activity is occurring but the awareness by the Board and management that their actions are being marked to adherence of good governance standards should act as a deterrent to deficient exercise of fiduciary responsibility. This level of transparency is common in regulated industries such as fund management. Should any untoward activity occur, it will be noted to fund managers who will determine its impact on their proxy vote.

The presence of a shareholder advocate should reasonably result in greater value realized by the shareholder. As with others involved in the process, such as investment banks or legal counsel, working on behalf of all shareholders, the advocate’s fee should be assumed by the company. This would further mollify any concerns regarding exercise of control by any specific fund manager. The monitor will be compensated on an hourly basis, similar to outside counsel, or on a set retainer. The expense will be immaterial relative to the transaction size and substantially lower than fees paid to other advisors given the narrow scope of the engagement.

Among the many situations that call for an independent shareholder advocate, two in particular stand out: (1) change of corporate control, whether in response to an unsolicited offer or a proactive effort by the Board to sell the company; and (2) the Board embarking upon a key initiative such as a major acquisition or other strategic alternatives that may result in a sale or significant corporate action.

  1. From a list pre-approved by a consortium of institutional shareholders, the monitor will be retained by the Board of Directors at the commencement of a process that may reasonably lead to a significant corporate event.
  2. Notification of the engagement will be furnished to the relevant shareholders upon public disclosure of the corporate action.
  3. The requirement to engage a shareholder advocate/monitor is to be included in proxy guidelines issued by investment managers, proxy firms and organizations focused on governance.
  4. The absence of a shareholder monitor will be deemed a negative input in weighing the benefits of the proxy proposal submitted to shareholders.
  5. The monitor’s observations will first be included in the preliminary proxy, Form PREM 14A, and also filed with the SEC on Form 8-K providing an input for shareholders to consider in executing their proxy ballot.
  6. The advocate is unequivocally independent and owes a duty only to shareholders.
  7. The advocate will not opine on the merits of any transaction, concerned only with adherence to guideline governance protocols.
  8. The shareholder monitor is an observer and not a participant in any discussions, deliberations or negotiations.
  9. The monitor will not usurp nor intrude on the Board’s relationship with its advisors. Advice on ESG issues is most properly given by legal counsel or others retained to advise the Board. (Worth noting is that these advisors do not have a fiduciary obligation to shareholders.)
  10. The monitor shall serve all shareholders equally.

The complete publication, including footnotes, is available here.

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