The Director’s Guide to Shareholder Activism

Maria Castañón Moats is Leader, Paul DeNicola is Principal, and Matt DiGuiseppe is Managing Director at the Governance Insights Center at PricewaterhouseCoopers LLP. This post is based on their PwC memorandum. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism (discussed on the Forum here) by Lucian Bebchuk, Alon Brav, and Wei Jiang; Dancing with Activists (discussed on the Forum here) by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch; and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System (discussed on the Forum here) by Leo E. Strine, Jr.

Preface

We take an expansive view of shareholder activism. For many people, the phrase may conjure images of hedge funds waging proxy battles as they try to win control of their target’s board. That’s a part of activism, to be sure. But, for the purposes of this document, the term refers to the efforts of any investor to leverage their rights and privileges as an owner to change a company’s practices or strategy.

In this sense, shareholder activism may include an institutional investor’s engagement with companies around governance matters or a retail investor’s shareholder proposal, as well as a hedge fund’s proxy fight.

Introduction: Shareholder activism today

The nature of shareholder activism, the key players, their preferred methods, and their typical targets all tend to shift along with investment and business trends. They are influenced by market pressures, stores of capital, and hot topics in governance. But during bull and bear markets, during recessions and times of growth, activists continue to look for opportunity, and companies continue to find themselves in the crosshairs.

The role of the board in an activist environment is an important one. Directors can help ensure the company anticipates which activists might target the company, and which issues they might raise. By being familiar with activism trends, they can encourage management to proactively address common issues that are attracting attention. In many cases, these issues deserve careful attention and should be reflected in company strategy. The board also plays a key role in shareholder engagement, and in responding to activist requests and demands. What do boards of directors need to know to navigate this environment? What can they learn from shareholders, and how can they leverage the benefits and insights activists can provide?

Activist campaigns

The number of activist campaigns reached a recent high in 2018, with shareholders launching 141 campaigns in the US. That figure fell significantly in 2020 as the COVID-19 pandemic took hold, but rebounded in 2021 with free-flowing capital. Activity in the first half of 2022 continued at a brisk pace, with a 20% jump in the number of campaigns over the same time period in 2021—although most of that activity was attributed to the first quarter of the year.

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SEC Adopts Amendments to Modernize Fund Shareholder Reports and Disclosures

Whitney Chatterjee, Donald Crawshaw, and William G. Farrar are Partners at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell memorandum by Ms. Chatterjee, Mr. Crawshaw, Mr. Farrar, Eric M. Diamond, Joseph A. Hearn, and Frederick Wertheim.

Amendments Modify the Disclosure Framework for Mutual Funds and Exchange-Traded Funds to Create a New Layered Disclosure Approach to Highlight Key Information for Retail Investors

SUMMARY

On October 26, 2022, the Securities and Exchange Commission (the “SEC”) adopted, by a unanimous vote, its previously proposed[1] amendments to the mutual fund and exchange-traded fund disclosure framework for annual and semi-annual shareholder reporting, with the goal of modernizing the disclosure framework for such funds and better tailoring fund disclosures to retail investors’ needs.[2] The final amendments modify the scope of rule 30e-3 to exclude open-end funds (as defined below) so that shareholders of such funds will directly receive in paper the new tailored annual and semi-annual reports. The final rules also amend investment company advertising rules with the stated goal of promoting more transparent and balanced statements concerning investment costs. The amendments to the disclosure framework and investment company advertising rules were adopted substantially as proposed with certain modifications.

Proposed amendments to funds’ prospectus disclosure of fund fees, expenses and principal risks and a new rule providing an alternative approach to satisfy prospectus delivery requirements for existing fund investors were not adopted. Among other things, the proposed amendments would have refined existing requirements for funds to disclose the acquired fund fees and expenses (“AFFE”) associated with investments in other funds by permitting open-end funds that invest 10% or less of their total assets in acquired funds to omit the AFFE line item in the fee table and instead disclose the amount of the fund’s AFFE in a footnote to the fee table and fee summary.[3] This change would have addressed, in part, concerns that current AFFE disclosure requirements overstate the costs of investing in business development companies (“BDCs”), and as a result, deter funds from investing in BDCs.[4] Commissioner Hester M. Peirce, in her statement supporting the rulemaking but noting that more can be done to improve mutual fund disclosure, emphasized that the final rules “jettison[ed]” the change to the AFFE disclosure, which she called a “small but important proposal” that could have facilitated investments in BDCs and the reintroduction of BDCs into indexes.[5]

The amendments will be effective 60 days after the date of publication in the Federal Register. However, as described below under “Compliance Dates,” extended transition periods will be available for compliance with certain amendments.

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Weekly Roundup: November 25-December 1, 2022


More from:

This roundup contains a collection of the posts published on the Forum during the week of November 25-December 1, 2022

Lessons from the Chancery Court Decision in P3 Health Group


The PCAOB Is Missing In Action on Climate Risk



The corporate director’s guide to overseeing deals


The Unicorn Puzzle


Trends in E&S Proposals in the 2022 Proxy Season


The Rise of Rule 10b5-1 Enforcement and How Companies Can Mitigate Risk of DOJ and SEC Actions


The Attack on Share Buybacks



Communicating with the SEC When Your Organization Suffers a Cybersecurity Incident


Open Letter to Directors and Activists Regarding Amendments to Advance Notice Bylaws


Glass Lewis 2023 Policies Guidelines – ESG Initiatives


ESG Ratings: Considerations in Advance of Proxy Season


Cybersecurity for Investors: Why Digital Defenses Require Good Governance


Thoughts for Boards: Key Issues in Corporate Governance for 2023


Thoughts for Boards: Key Issues in Corporate Governance for 2023

Martin Lipton is a founding Partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, Steven A. Rosenblum, Karessa L. Cain, and Hannah Clark.

While the world recovers from the worst of the pandemic, the economic, political and social repercussions will continue to play out in ways that, while unpredictable, are in some respects characterized by observable patterns of cause-and-effect and cyclicality. The pendulum has been swinging back as, for example, the Federal Reserve has been ratcheting up interest rates and tightening liquidity, activist activity is once again on the rise, Republicans have taken control of the House, and back-to-office policies have been eased into effect. In this environment, stasis is the exception rather than the norm, and boards must continue to be nimble and open-minded in navigating the pitfalls and opportunities of this systemic recalibration.

Importantly, the infrastructure of corporate governance – namely, the structure and allocation of responsibilities and decision-making authority, and related principles, policies and information flows to facilitate such functioning – continues to serve as the anchoring framework for the board’s oversight of dynamic business conditions. Despite the complexity and range of issues that boards today must grapple with, the basic principles of governance continue to provide the best guideposts: engaged oversight, informed decision making, conflict-free business judgments, and balancing of competing interests to promote the overall best interests of the business and sustainable long-term growth in value.

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Cybersecurity for Investors: Why Digital Defenses Require Good Governance

Diana Lee is Director of Corporate Governance and an ESG Analyst for Responsible Investment team at AllianceBernstein. This post is based on her AllianceBernstein memorandum.

Hacker attacks and data breaches have pushed cyber and data security to the top of company agendas everywhere. Investors must get to grips with the governance issues and growing business risks as a digitally powered world grapples with the need for more secure defenses.

Cyber and data security is a hot topic across sectors. Ever-evolving threats are forcing companies to continuously evaluate their defenses and readiness—to help minimize the damage of a potential attack. Public statements of preparedness often overstate the actual level of defenses in place.

Despite company awareness, cybersecurity isn’t a high priority for many investors. We think that’s a mistake—especially since governance issues are an important component of an environmental, social and governance (ESG) focus. Unprepared companies risk financial losses, penalties and reputational damage that can undermine a business, brand and compromise a stock or bond’s return potential. We spoke with cybersecurity professionals across multiple fields and reviewed the regulatory landscape to provide guidelines for investors on assessing cyber-risk management.

Counting the Costs of Escalating Attacks

Cyberattacks are very costly. In the first half of 2022, at least 2.8 billion malware attacks were recorded globally, an increase of 11% over the previous 12 months, according to cybersecurity company SonicWall.

The cost of a data breach reached a record $4.4 million per breach on average globally in 2022, based on a study by the Ponemon Institute and IBM Security. Recovery costs vary depending on the sophistication of a firm’s systems, and whether remote work was a factor, which tends to increase the expense.

Some industries are more at risk than others (Display). Yet in today’s online world, no company is safe. Increased risk has prompted increased regulation. In the US alone, three new regulations were released in the past year: the SEC cybersecurity rule, the Cyber Incident Reporting for Critical Infrastructure Act, and the Ransomware and Financial Stability Act of 2021. Meanwhile, governments are on high alert as state-sponsored cyberattacks surged at the onset of the Russia-Ukraine war. In this evolving environment, companies can’t afford to ignore the problem.

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ESG Ratings: Considerations in Advance of Proxy Season

Michael Mencher is Special Counsel and Vince Flynn is an Associate at Cooley LLP. This post is based on their Cooley memorandum.

As companies prepare for the 2023 proxy season, their ESG performance, as evaluated and rated by various third-party ratings providers, is a key focus. With the growing importance of ESG to institutional investors, specialized funds and the general investing public, ESG ratings are an increasingly important investor relations concern. While such ratings may influence investor decision-making throughout the year, for many companies and boards, ESG matters take on heightened importance in advance of annual meetings and related shareholder engagement efforts. As a result, in the lead up to proxy season, many companies contemplate ratings improvement strategies, including proxy statement and other disclosure updates, policy adoptions and governance changes. With the ever-growing variety and complexity of ratings, however, developing effective strategies can be a challenge. Objectives and methodologies vary greatly among ratings providers, and there is often limited comparability (or even significant conflict) between different scores, leaving many companies confounded as to where to begin. Below, we’ve highlighted a few key considerations and action items to assist companies in taking steps toward improving their ESG ratings ahead of the upcoming proxy season.

Which ESG ratings apply to my company?

Whether your company is subject to a particular ESG rating is generally based on the company’s index, size and market. For US-based companies, for example, ISS’s Governance QualityScore applies to Russell 3000 and S&P 1500 issuers, and Sustainalytics’ ESG Risk Ratings apply to large- and medium-cap issuers. Some ratings providers, including Moody’s and Refinitiv, even provide ESG ratings for certain private companies.

To determine which ESG ratings apply to your company, we generally recommend reviewing your ISS and Glass Lewis proxy reports to determine which ESG ratings are included therein, engaging your investors to determine which ESG ratings they use that apply to your company, and reaching out to the ratings providers themselves. In many cases, particularly if your company is in the Russell 3000, ratings providers will proactively contact companies to verify the data underlying their ESG ratings, which often creates a meaningful opportunity to build a relationship upon which to facilitate timely and accurate updates to your rating.

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Glass Lewis 2023 Policies Guidelines – ESG Initiatives

Brianna Castro is Senior Director of North American Research; Courteney Keatinge is Senior Director of Environmental, Social & Governance Research; and Maria Vu is Senior Director of Compensation Research at Glass, Lewis & Co. This post is based on their Glass Lewis memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Does Enlightened Shareholder Value Add Value? (discussed on the Forum here) both by Lucian A. Bebchuk and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.; and Stakeholder Capitalism in the Time of Covid (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.

Guidelines Introduction

Shareholders are playing an increasingly important role at many companies by engaging in meetings and discussions with the board and management. When this engagement is unsuccessful, shareholders may submit their own proposals at the companies’ annual meetings. While shareholder resolutions are relatively common in some countries like the United States, Japan and Canada, in other markets shareholder proposals are rare. Additionally, securities regulations in nearly all countries define and limit the nature and type of allowable shareholder proposals including submission ownership thresholds. For example, in the United States, shareholders currently need only own 1% or $2,000 of a company’s shares to submit a proposal for inclusion on a company’s ballot. However, American issuers are able to exclude shareholder proposals for many defined reasons, such as when the proposal relates to a company’s ordinary business operations. In other countries such as Japan, however, shareholder proposals are not bound by such content restrictions. Additionally, whereas in the U.S. and Canada the vast majority of shareholder proposals are precatory (i.e. requesting an action), such proposals are binding in most other countries. Binding votes in the U.S. are most often presented in the form of a bylaw amendment, thereby incorporating the proponent’s “ask” in the company’s governing documents.

Glass Lewis believes binding proposals should be subject to heightened scrutiny since they do not allow the board latitude in implementation to ensure consistency with existing corporate governance provisions. Nonetheless, Glass Lewis will recommend supporting well-crafted, binding shareholder proposals that increase shareholder value or protect and enhance important shareholder rights.

We recognize that shareholder initiatives are not just limited to shareholder proposals. For example, in some markets, shareholders may submit countermotions (e.g., Germany) and/or may solicit votes against management proposals, most commonly the ratification of board acts.

While the types and nature of shareholder initiatives vary significantly across markets, Glass Lewis approaches such initiatives in the same manner, regardless of a company’s domicile. Glass Lewis generally believes decisions regarding day-to-day management and policy decisions, including those related to social, environmental or political issues, are best left to management and the board as they in almost all cases have more and better information about company strategy and risk exposure. However, when there is a clear link between the subject of a shareholder proposal and value enhancement or risk mitigation, Glass Lewis will recommend in favor of such proposal where the company has inadequately addressed the issue. We strongly believe that shareholders should not attempt to micromanage a company, its businesses or its executives through the shareholder initiative process. Rather, we believe shareholders should use their influence to push for governance structures that protect shareholders and promote director accountability. Shareholders should then vote into place a trustworthy and qualified board of directors, who can make informed decisions that are in the best interests of the business and its owners. These directors can then be held accountable for management and policy decisions through board elections.

Glass Lewis evaluates all shareholder proposals on a case-by-case basis. However, we generally recommend shareholders support proposals on certain issues such as those calling for the elimination or prior shareholder approval of antitakeover devices such as poison pills and classified boards. Additionally, we generally recommend shareholders support proposals that are likely to increase or protect shareholder value, those that promote the furtherance of shareholder rights, those that promote director accountability and those that seek to improve compensation practices, especially those promoting a closer link between compensation and performance as well as those that promote more and better disclosure of relevant risk factors where such disclosure is lacking or inadequate.

Summary of Changes for 2023

Glass Lewis evaluates these guidelines on an ongoing basis and formally updates them on an annual basis. This year we’ve made noteworthy revisions in the following areas, which are summarized below but discussed in greater detail in the relevant sections of this document:

Board Accountability for Climate Related Issues

We have included a new discussion on director accountability for climate related issues. In particular, we believe that clear and comprehensive disclosure regarding climate risks, including how they are being mitigated and overseen, should be provided by those companies whose own GHG emissions represent a financially material risk, such as those companies identified by groups including Climate Action 100+.

Accordingly, for companies with material exposure to climate risk stemming from their own operations, we believe they should provide thorough climate-related disclosures in line with the recommendations of the Task Force on Climate-related Financial Disclosures (“TCFD”). We also believe the boards of these companies should have explicit and clearly defined oversight responsibilities for climate-related issues. As such, in instances where we find either of these disclosures to be absent or significantly lacking, we may recommend voting against responsible directors.

Disclosure of Shareholder Proponents

We have included a new discussion regarding our approach to disclosure of shareholder proponents at U.S. companies. Given the growing number of and focus on shareholder-submitted proposals, we believe that companies should provide clear disclosure in their proxy statements concerning the identity of the proponent (or lead proponent if multiple proponents have submitted a proposal) of any shareholder resolutions that may be going to a vote. If such disclosure is not provided, we will generally recommend voting against the governance committee chair.

Racial Equity Audits

We have codified our approach to proposals requesting that companies undertake racial equity or civil rights audits. When analyzing these resolutions, Glass Lewis will assess: (i) the nature of the company’s operations; (ii) the level of disclosure provided by the company and its peers on its internal and external stakeholder impacts and the steps it is taking to mitigate any attendant risks; and (iii) any relevant controversies, fines, or lawsuits. After taking into account these company-specific factors, we will generally recommend in favor of well-crafted proposals requesting that companies undertake a racial or civil rights-related audit when we believe that doing so could help the target company identify and mitigate potentially significant risks.

Retirement Benefits and Severance

We have updated our approach to proposals requesting that companies adopt a policy whereby shareholders must approve severance payments exceeding 2.99 times the amount of the executive’s base salary plus bonus. Although we are generally supportive of these policies, we have updated our guidelines to reflect that we may recommend shareholders vote against these proposals in instances where companies have adopted policies whereby they will seek shareholder approval for any cash severance payments exceeding 2.99 times the sum of an executives’ salary and bonus.

Link to the full report can be found here.

Open Letter to Directors and Activists Regarding Amendments to Advance Notice Bylaws

Andrew Freedman, and Ron Berenblat are Partners and Dorothy Sluszka is an Associate at Olshan Frome Wolosky LLP. This post is based on their Olshan memorandum.

We want to draw attention to a concerning corporate governance trend that directly impacts directors of public companies and shareholders with director representation on public company boards. As you are likely aware, the U.S. Securities and Exchange Commission adopted new rules regarding the use of “universal proxy cards” for contested director elections, which went into effect on August 31, 2022. In response to this, a large number of public companies have been amending the advance notice provisions under their bylaws to conform the timing and notification requirements of their shareholder nomination procedures to those of the new universal proxy card rules. Unfortunately, however, many of these bylaw amendments we are seeing go well beyond the provisions that would be needed to address the new universal proxy regime. Rather, company counsel have been using this opportunity to expand their advance notice bylaws with an array of so-called “disclosure enhancements” that make the process for a shareholder to nominate directors unnecessarily cumbersome and costly.

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Communicating with the SEC When Your Organization Suffers a Cybersecurity Incident

Haimavathi Marlier and Michael Birnbaum are Partners at Morrison & Foerster LLP. This post is based on their Morrison & Foerster memorandum.

If there was ever doubt before, the Securities and Exchange Commission (SEC) has made clear—through two proposed rules related to cybersecurity, enforcement actions, public statements, and a beefed up “Crypto Assets and Cyber Unit” within the Division of Enforcement—that it expects public companies and registered entities to promptly assess the materiality of cybersecurity incidents and make swift disclosures of material incidents. In particular, if adopted, the SEC’s proposed cybersecurity disclosure rule for public companies states that issuers will have to disclose, via Form 8-K, material cybersecurity incidents, including any impact on business operations, within four business days of their determination that the incident is material.[1] And, if adopted, the SEC’s proposed cybersecurity risk management rules for registered investment advisers (RIAs), registered funds, and closed-end companies state that these registrants must report “significant cybersecurity incidents” to the SEC within 48 hours of discovery.[2] Final action on these rules is expected in April 2023.[3]

As it determines the materiality of a cybersecurity incident, an organization must also decide whether to report the incident to the SEC in advance of any public disclosure and whether to cooperate with any ensuing SEC inquiry or investigation. On the one hand, proactive reporting of likely material cybersecurity incidents can build goodwill with the SEC and make clear from the outset that the organization is thoroughly investigating the incident. On the other hand, informing of the SEC of immaterial incidents could expose the organization to expense, business disruption, and unwanted SEC scrutiny, particularly into the organization’s cybersecurity-related internal controls.

Here are four considerations in-house counsel should keep in mind in determining whether to proactively inform the SEC about a cybersecurity incident before making a formal public disclosure.

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Understanding the Role of ESG and Stakeholder Governance Within the Framework of Fiduciary Duties

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, Adam O. EmmerichKevin S. SchwartzSabastian V. Niles and Anna M. D’Ginto. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders? (discussed on the Forum here), both by Lucian A. Bebchuk and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr; and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.

Over the past decade, investors, companies, and commentators have increasingly accepted and adopted stakeholder governance as the way to pursue the proper purpose of the corporation and have embraced consideration of environmental, social and governance (ESG) issues in corporate decision-making toward that end. But an emerging movement opposed to any consideration, at all, of ESG factors threatens to erase the gains that have been made over the past ten years and revert to the outdated view that the purpose of a company is solely to maximize short-term shareholder profits.

This debate is playing out very publicly, with politicians at the highest levels of state and federal government publicly staking out positions on ESG and the extent to which it should (or should not) be considered by asset managers; through regulation and law; and in boardrooms across the country and around the world. At one extreme, critics of ESG are dismissing any consideration of the long-term impact of environmental or social risk on a company as “woke” capitalism, to be condemned, if not outlawed. (See Bloomberg, Populist House Republicans Picking a Fight With US Business Over ‘Woke Capitalism’ (Nov. 27, 2022).) At the same time, attacks from the other end of the spectrum condemn board consideration of ESG in a stakeholder governance model as insufficiently prescriptive. Yet neither view, attempting to politicize the role of companies and their boards, grapples adequately with the real meaning of ESG and stakeholder governance and the role of these concepts in the decision-making process of corporate boards and management.

ESG, properly understood, is not a monolithic concept, but rather refers to the panoply of risks and policies that a company must carefully balance in seeking to achieve long-term, sustainable value. To be sure, political action may be necessary to meaningfully confront climate change and other environmental and social challenges to the long-term success of the U.S. economy and global prosperity. But separate and apart from that political will — and all the debate that should properly surround it — it remains incumbent upon and entirely within the purview of each board of directors to look beyond short-term shareholder profits and seek sustainable long-term value creation, taking into account all stakeholders, including those implicated by ESG matters. With this in mind, we write to correct recent misinformation about stakeholder governance and ESG, and to explain how the consideration of ESG, properly understood, as well as other stakeholder factors, is entirely consistent with the fiduciary duties owed by the board and management to the company and to shareholders, and indeed required if board and management are to act prudently.

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