Current trends in shareholder activism in Canada

May 2014 | SPOTLIGHT | BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

The origins of contemporary shareholder activism lie in the bursting of the ‘tech bubble’ in 2001. The vast over-investment in public companies whose only assets were ideas with potential, generated investor concerns about the prudence of corporate management and the quality of public disclosure. This resulted in legislation that mandated director independence, tightened public disclosure requirements and imposed personal liability on officers and directors for inadequate disclosure. These developments were part of a corporate governance culture that promoted greater investor scrutiny of managerial behaviour and emphasised the rights of shareholders to change corporate management. The impetus for shareholder-induced board change was heightened significantly after the 2008 crash, even though that crash was precipitated more by inadequate regulation of financial markets and products than poor corporate management.

Another post-2008 phenomenon was the emergence of ‘activist’ hedge funds whose business model was the provision to investors of higher returns than the post-2008 market could generate. The outsized expectations of hedge fund investors, combined with the fact that their investments in the funds could be redeemed quarterly, led the funds to use shareholder activism to induce their investee companies to deliver higher immediate returns through strategies such as business spin-offs and increased return of capital to shareholders.

In the last two years, the Canadian market experienced two significant proxy battles, both driven by US activist hedge funds. In 2012, Bill Ackman’s Pershing Square Capital Management initiated a proxy challenge that successfully replaced the CEO and changed the board composition of Canadian Pacific Railway Limited, one of Canada’s great historic companies. The second, in 2013, was the attempt by JANA Partners, another US activist hedge fund, to elect five of its nominees to the 12-person board of the Canadian potash giant, Agrium Inc. (Agrium), in order to influence Agrium’s corporate strategy. In both cases, the activists complained of underperformance blaming poor leadership in CP and a suboptimal corporate strategy in Agrium. While CP’s shareholders elected Pershing’s slate to the CP board, none of JANA’s nominees were elected to Agrium’s board.

The JANA battle did, however, surface two controversial issues that attracted significant investor and public attention: JANA’s compensation arrangements for its director nominees and Agrium’s agreement to pay brokers to solicit favourable votes.

Compensation of director nominees

JANA had argued that Agrium’s combination of its retail and wholesale potash distribution businesses under one umbrella resulted in Agrium’s share price not adequately reflecting the value of the retail business. JANA urged Agrium to divest the retail operations. JANA was concerned that no Agrium board member had the necessary retail expertise to assess Agrium’s retail operations or JANA’s spin-off proposal. To address these issues, JANA recruited three nominees with high profile retail experience, together with two other illustrious candidates, including Canada’s former Minister of Agriculture. To induce these nominees to subject themselves to the ordeal of a public and hostile battle, JANA offered compensation comprised of a typical up-front cash payment to cover the time and effort associated with serving as a member of the slate, together with a novel form of cash compensation based on a percentage of the net profits that JANA might earn on its sale of its Agrium holdings. If JANA did not sell all of its Agrium shares before the third anniversary of the date on which the nominee was retained, the nominee would be paid its agreed percentage of JANA’s net profits as if JANA had sold its shares at the market price on that anniversary date.

Agrium vigorously objected to this payment arrangement, labelling it a ‘golden leash’ for JANA’s nominees. Agrium asserted that JANA’s nominees could not be considered independent “given their effective employ with JANA”, and that, given the three-year term of the arrangement, JANA’s nominees were incentivised to take short-term actions without regard to the long-term interests of Agrium. While the better view was that the payments did not affect the “independence of the nominees” as a legal matter, the issue that resonated with the investment and corporate governance communities was the perceived conflict between the short-term incentive nature of the compensation and the perspective that directors must take a long-term view of corporate strategy. Had JANA’s nominees become entitled to receive shares, instead of cash, the perception of conflicting considerations might have been mitigated.

The shareholder advisory firms Glass Lewis and ISS had differing perspectives on the compensation arrangements. Glass Lewis saw the arrangements as compromising the nominees’ independence and creating the possibility of a conflict given the short-term of the arrangement. ISS concluded that while such compensation arrangements were uncommon in Canada, they had no “adverse impact on the dissident nominees’ independence”. It remained silent on the conflict issue and endorsed two of JANA’s nominees for election to the Agrium board.

The compensation arrangements fed into the raging debate in the US between the eminent American M&A lawyer, Martin Lipton, and Harvard law professor and shareholder rights advocate, Lucian Bebchuk. Mr Lipton has long argued that corporate directors, as the stewards of a corporation, must take a long view of the corporation’s interests, particularly in the face of shareholders wanting to tender their shares to opportunistic unsolicited bids or shareholder-induced initiatives to change corporate strategy to increase short term returns.

To that end, he has accused shareholder activists as being ‘short-termists’ who advance an agenda that adversely affects the prudent management of corporations. Lipton argues that the activist perspective causes boards to forego long-term value maximisation for short-term results to the detriment of the long-term viability of American business and the American economy.

The Bebchuk perspective, on the other hand, emphasises the legal right of shareholders to deal freely with their shares and the need to prevent incumbent boards from encumbering those rights by invoking their fiduciary duties in the name of good corporate governance. Bebchuk argues that Lipton’s views on the adverse effects of unsolicited bids and shareholder activism are based on anecdote and personal experience, rather than empirical data. In cooperation with other academics, Bebchuk has produced empirical studies that aim to refute Lipton’s arguments as to the adverse long-term economic effects of unsolicited bids.

JANA’s ‘golden leash’ arrangements led Wachtell Lipton, the firm founded by Lipton, to circulate a memorandum which described the practice as “egregious” together with a form of Delaware corporate by-law aimed at disqualifying director nominees who were party to such arrangements from serving as directors. A number of American companies adopted the Lipton by-law and, in November 2013, when one company asked its shareholders to approve the Lipton by-law, ISS recommended that shareholders withhold votes from the directors who had approved the adoption of that by-law.

The Lipton by-law may have gone too far. Most criticism of ‘golden leash’ arrangements focused on the terms of the compensation, not the principle of compensating shareholder nominees.

Compensation for proxy solicitation

In recent years, it has been the practice in Canadian takeover bids and change-of-control corporate combinations for bidders or parties to the combination to compensate retail brokers for soliciting their clients to tender their shares to the bid or vote in favour of the combination. In 2012, for the first time on record, a Canadian public company confronting a proxy challenge to its board, paid brokers for soliciting favourable votes in the face of dissident shareholders’ objections.

In the Agrium case, Agrium disclosed in its proxy circular that it “May cause a soliciting dealer agreement to be formed and take customary fees for such services”. JANA provided similar disclosure in its circular. Shortly after Agrium issued its circular, it entered into an undisclosed agreement with its lead soliciting dealer under which it agreed that, if Agrium’s’ full slate was elected, it would pay each soliciting broker a per share fee up to a maximum fee of C$1500 per shareholder, for each shareholder that broker solicited who voted for all of Agrium’s nominees. That arrangement was discovered by JANA almost three weeks after it was entered and just a week before the shareholders meeting. JANA immediately issued a press release disclosing and fiercely criticising the arrangement, noting the conflict of interest that such fees created for brokers.

Public reaction to JANA’s revelation of this scheme was immediate and intense, with the financial community and the press being highly critical of Agrium. In a lead editorial, the Globe and Mail called for a regulatory ban of that practice. Another op-ed piece described Agrium’s solicitation fee as failing to “pass the smell test”. The Canadian Coalition for Good Governance publicly condemned the practice, referring to it as “vote buying” and inconsistent with the basic tenets of shareholder democracy and the fiduciary duties of directors.

While the Canadian proxy season is off to a quiet start this year, the heat of the battle in hard-fought proxy fights will inevitably continue to generate new challenges for shareholders, boards and their advisers.

I. Berl Nadler is a partner at Davies Ward Philips & Vineberg LLP. He can be contacted on +1 (416) 863 5512 or by email: bnadler@dwpv.com.

I. Berl Nadler

Davies Ward Philips & Vineberg LLP