Increase in board spills predicted

Australian companies and directors have been warned to stay alert and vigilant for signs of shareholder activism.

Corrs Chambers Westgarth corporate partner Jonathan Farrer says Australian companies should be prepared for increased pressure from shareholders following a spike in shareholder activism globally, particularly in the US.

"There has been a very significant increase in shareholder activism recently, in particular board spill proposals, where an activist seeks to replace existing directors of a company with a new set of directors," says Farrer.

"We have seen this globally and in particular in the US there have been some very high-profile board spills, including one recently for Hess Corporation.

"We are also seeing globally the emergence of specialist funds in this area which are specifically looking for undervalued companies and targeting those companies through board spill proposals. There are a growing number of these activist funds in the US, including Elliott Management, Greenlight Capital, Icahn Associates, Jana Partners and Third Point.

"These activists have been relatively successful and in many cases, they have generated strong investment returns, leading to new entrants and additional capital flows into this area. Shareholder activists will often focus on underperforming companies which have lost market support, thereby enabling the activist to propose a turnaround plan which may involve changes to the board composition and new strategic directions (including divestments, restructurings and other forms of mergers and acquisitions activity)."

Farrer adds: "In Australia, we have seen a number of board spills, but they have tended to be at the smaller end of the listed market. We think there will be an increase in board spills ... both [for] small companies and large companies going forward.

"The experience from the US shows that companies which have performed poorly or have large cash holdings are particularly vulnerable."

Farrer notes three major drivers of an increase in board spills.

"Firstly, the legal framework is tilted toward shareholder activists rather than incumbent directors. In Australia, shareholders who own as little as five per cent of a company or who have the support of 100 or more shareholders can requisition a board spill," he says.

"The 'two strikes' rule has the potential to create more forced board spill situations for companies going forward and there are a number of other rules that help activists, including the ability to access the company's share register and send PR materials directly to shareholders."

"The second reason is around the cost of a proxy battle. The activists are generally companies or funds who are well funded, they have deep pockets and they are ready for a proxy fight. They are happy to have their names in the newspapers. On the other hand, you have directors who have limits around their ability to use the company's funds to defend themselves. They generally don't want their reputations and their names in the newspapers in relation to the proxy battle and in that situation.

"With that dynamic, you can see why in many cases an incumbent director forms a view fairly quickly that he or she would prefer just to step down gracefully rather than go through a difficult board fight."

"Finally, board spills can be used as an alternative path to traditional hostile takeover bids."

Farrer says companies exposed to the possibility of a board spill should take precautions, and that a strong share price is the best defence against any proposal to change composition of the board.

"Companies with poor corporate governance practices may also attract activists," he says.

"It is critical that companies know who their underlying shareholders are (by sending regular beneficial tracing notices) and have regular dialogue at the right level with key shareholders. Companies should also consider extending their takeover response plans to board spills – in both cases, the company can be caught off guard, there is a short response time and control of the company may be at stake.

"If a company receives a formal requisition notice which proposes to change the composition of the board, it needs to quickly assemble a team to determine the response strategy. It is also important to obtain legal advice on validity of requisition notice and other litigation options. Companies and their advisers should also undertake public due diligence on the requisitioners – who is behind them; do they own a stake; are they credible; what is motivating them; what have they done in the past; and are they aligned with other shareholders? Based on an assessment of all these factors, decisions can then be made about how to deal with the activist shareholder's proposal."