The Non-Executive Board – Praetorian Guard against Activist Shareholders

Activist Shareholders raise their voice over the legitimate interest, associated with their actual investment. This is competing with the economic interest of other shareholders. Activities of Activist Shareholders are also eligible to distract the management’s focus and attention. The role of the Board of Directors (BoD) includes to balance the different spheres of interest and make sure, shareholder rights are protected and management can perform its tasks without external interference. If alignment with Activist Shareholders cannot be achieved, to discipline Activist Shareholders can be challenging.

Activist shareholders can cause severe danger to a company

Activist Shareholders are known, to focus on short term gains, and to interact with the management of the firm, to influence the strategy, operations and also the decision-building processes of other investors, hence, bypassing the Non-Executive Board and its Directors (NEDs) or consuming time and attention often “above their fair equity share.”.  

The urge, to change the course of the firm, leads to raising their voice inside, but also outside of the general assembly. Among other shareholders, or even in public. Whereas the self-perception of Activist Shareholders is always “noble & integer”, they have earned the reputation of corporate raiders, forcing companies on their preferred course of strategy.

Regardless of the economic outcome, it is the duty of the board, to execute along the lines of the will of the majority of the shareholders and protect the management as well as the interest of the shareholder community as a whole from the illegitimate activities of minority shareholders.

Good Governance to discipline Activists

By definition, corporate governance is to balance the interests of the stakeholders of a firm. With regard to shareholder activism, this includes to retain the integrity of the sound operations of the company, focus, on the performance of the management and finally the collective interest of the shareholders. Whereas these elements might have opposing interests, at least partial alignment is crucial for success.

To foster success, two out of the three elements must be aligned.  

the non executive board - Infographic by Kolja Rafferty

Shareholder activism is creating uncertainty, doubt, and fear among the majority of shareholders and/or the management; hence is likely to disrupt alignment, and cause disequilibrium in the Corporate balance triangle.

By definition, protecting the balance of interests, is among the main objectives of corporate governance, hence a priority responsibility of the non-executive board.

Best practice in governance can be of help to balance the corporate triangle and to discipline Activist Shareholders.

Yet, tempting it is

For NEDs it is tempting, to take either side. Being in close contact and comradery with Activist Shareholders, as these are persuasive and reaching out to Non-Executives, but also hold a stick, to make NED-life more troubled. Whereas the alternative often means to disregard their advances and take a clear stand against proposals, initiatives, and even Activist individuals.

Just like the referee in a Rugy match, the NED has to put personal preferences, as well as the favoritism of the moment aside. Equal and fair treatment of all shareholders is imperative.

Who to owe duty to!?!

The core question the Board of Directors has to answer, is, to whom duty is owed? The correct answer is the cumulative community of shareholders. Hence, there must be no privileges for Activist or majority shareholders. In practice, this puts a high level of demand for moral integrity on the NEDs. Caught in a sandwich position between executives and investors, NEDs are the moderators of different interests.

Initially, the BoD is positioned as representatives of the shareholders, to oversee the activities of the Executive Board. Primarily assessing the status of a firm in its market positioning, and with regard to the Executives of the firm, differentiating hurdles from excuses. This is already a serious challenge. In addition, navigating competing interests in the shareholder community, where illegitimate interests may be combined with required (financial) support, is assigning a task, which is normally hard to include in the limited time contingent, of NEDs in mid-cap firms. Whereas NEDs may be charmed and threatened by Activist Shareholders, to disclose information or act in a certain way, this opens also legal claims against the NED by minority shareholders, to whom privileged access to information for Activist shareholders might turn out, to be costly.

Serving the shareholder community as a whole is synonymous with pursuing the best for the firm itself.

Being in close contact with relevant shareholders and having awareness of their needs and concerns is an example of best practice in corporate governance. Yet, access for the shareholders to the executive directors is to be controlled and limited. Also, it is imperative, to provide only equal access to data and information. The establishment of transparent and comprehensive processes of Investor Relations (IR) helps to excel in compliance. 

Strategies to deal with Activist Shareholders

The strict observation of good governance and the equal treatment of all shareholders in terms of access to information and influencing the strategy of the firm is the punchline of good governance in managing the shareholder community. If the going gets tough, options, how to deal with Activist Shareholders are limited.

Four strategies are recognized, utilizing instruments of Corporate Finance:

  1. Creating alignment
    1. Finding alignment between the interests of the Activist Shareholders and the legitimate interests of the shareholder community is essential to unravel the different interests of various shareholder groups. This may require a great deal of diplomacy for the BoD or may result from a critical and immediate threat to the firm, hence, overpowering individual interests, as the cumulative interest is put at stake. Such threats can be external (e.g. disruptive competition, severe legal threats, attempts for a hostile take over, etc.) or internal (e.g. leaving management teams, the discovery of fraud, inaccuracies in accounting, etc.).
    2. A strong alignment of a majority of (minority) shareholders, to push back on Activist Shareholders can also serve this purpose. This approach is confrontative, whereas the alternative would be consensual. Sun Tzu reminded us in The Art of War: “Choose your battles wisely“. Intershareholder conflicts are likely to consume excess energy, dilute the focus of the NEDs, exhaust the management, diminish the commitment of the shareholder community, disrupt the course of the firm, and – if disclosed to the public, create uncertainties with customers and suppliers; hence, creating significant risks for the business and are very costly to the investors.
  2. Diluting to insignificance – with consensus among the shareholder community or interest to invest from outside investors, Activist shareholders can be diluted to insignificance through capital increases. However, applicable subscription rights must be observed,  this may lead to complex processes in the Corporate Finance of the firm.
  3. Buyback of shares – simply buying back shares, either with the help of “friendly shareholders” or through the company itself, and holding those as company stock, can help to resolve the dispute with Activist Shareholders. However, selling at a premium can be part of the strategy of the Activist Shareholder. The equal treatment of all shareholders is imperative, hence, transferring funds to the Activist Shareholder, beyond the fair value of the shares, can set precedent and also provide a basis for legal claims of other shareholders.
  4. Taking the Poison Pill – the economic poison pill is the ultimate ratio, dealing with Activist Shareholders. A Poison Pill is defined as a defense tactic against attempts of a hostile takeover. It is qualified, to create situations that make shares unfavorable for investors. Such disincentives can help to motivate Activist Shareholders to divest from the firm. Flip-In poison pills aim to dilute shares of the acquiring party, by offering shares at a discount to the existing shareholders. In cases of Activist Shareholders, subscription rights are to be observed, where Activist Shareholders have the right, to receive shares at the same conditions as other shareholders. Bypassing of equal subscription rights can be performed through special classes of shares. Providing Employee Share Option Programs (ESOP) to executives, or privileged subscription rights to founders can help to create a Flip-In poison pill. Flip-Over Poison Pills aim to acquire the shares of the acquiring company, preferably at a discount. Beyond the financial architecture, gaining control over, or at least a significant stake in the Activist Shareholder’s firm can help to change the course of the process. Whereas these are only two examples of how Poison Pills can be deployed, the basic idea is, to make the company less attractive for the Activist Shareholder. By definition, this is sensitive to the Activist’s strategy and true intentions. Further options for the BoD can include deploying challenging actions to the Activist’s strategy. This can include but is not limited to: divesting from assets, relevant to the Activist’s strategy, changing markets, creating corporate governance, unattractive to the Activist Shareholder et al.

Too much grey

Diversity of opinions and points of view is creating value and shareholders are free to express their thoughts. Also, legal means are available explicitly to equip shareholders with tools, to protect their investments. Yet, not all shareholder actions are legitimate.

For Activist Shareholders, there is a thin line, where shareholders, regardless of their relative size, investor sophistication, emotional commitment or legacy with the firm are entitled, to enforce shareholder interest. Challenging principal-agent conflicts, outlining areas of improvement, or pointing at inefficiencies and shortcomings among the NEDs, can always be seen as a legitimate act. Disagreeing with the majority or even all other shareholders does not qualify a shareholder as an Activist. Yet, an ineligible dispute between minority shareholders and the management of a company that misguides justified shareholder interests to renegade ideas about value creation and strategic leadership, ideological driven disputes about vision & mission of the firm or hidden agendas for creation of shareholder value and extraction, is likely to destroy value, if not for all, then for a group of shareholders. 

Take away:

Non-Executive Directors are to balance interests of different stakeholder groups. Being in a sandwich position between executives and investors, can already be challenging, navigating between different shareholder interests, is increasing the exposure of NEDs.

For NEDs it is imperative to position themselves, to entertain all legitimate shareholder interests. Observing shareholder rights, this must be non-discriminative to any shareholder group, hence, Activist Shareholders must not be privileged. 

Different strategies are known to discipline Activist Shareholders.

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