Activist-Driven Transactions Will Increase

Shareholder activism is not new to Canada, but Pershing Square's 2012 success with CP Rail sent a clear message to Canadian boards: no widely held public company – regardless of its size, the pedigree of its board or its iconic status – can ignore activists.

Shareholder activist campaigns have continued to make news. Some campaigns have involved governance issues alone, as was the case in the CP Rail battle, in which Pershing Square sought to add board members with a view to ultimately changing management and improving the company's performance, not selling the business. However, there have been many examples of the opposite extreme, including shareholder activists bringing pressure on a board to break up or spin off businesses. Often the pressure has been successful, signalling to activists that investing in these campaigns can reap significant rewards.

Whatever agenda is pursued by the activists, one thing is clear: boards will increasingly be forced to respond with initiatives that enhance shareholder value, including management change, recapitalizations, asset sales, spinoffs or even a sale of the business as a whole.

Institutional Investors Are Receptive to the Activist Message

Activism has entered the mainstream. Institutional shareholders are willing to lean openly on boards in situations where in the past they might have worked behind the scenes with management to deal with their concerns.

Several recent examples show this trend. Canada Pension Plan Investment Board (CPPIB) and Ontario Teachers' Pension Plan each supported the dissident slate during the CP Rail proxy battle. Ontario Teachers' also publicly opposed the Sprint Nextel CEO's re-election to the board in 2012, complaining that his compensation package was excessive relative to the company's performance. And Ontario Teachers' has not limited itself to commenting on board performance. In 2011, it took a joint stake with JANA Partners to push McGraw-Hill to split up its business, and it worked with CPPIB to challenge the terms on which Magna eliminated its dual class share structure, criticizing the board's actions before both the securities regulators and the courts. Other Canadian pension funds are also speaking up. AIMCo issued a news release in late 2011, stating that it was dissatisfied with Viterra's response to its previously expressed concerns regarding board renewal. And earlier in 2012, the Caisse de depot et placement du Quebec publicly questioned whether the board of SNC-Lavalin had acted decisively enough in its investigation of payments to agents in Africa. These recent public stands by several of Canada's pension funds send a strong signal to issuer boards that communicating with investors and responding to their concerns are critical.

Activists Can Surprise Issuers

Early warning requirements are intended to ensure that the market is notified when an investor accumulates a substantial position. For issuers that are publicly traded only in Canada, the relevant threshold is 10%. If that threshold is tripped, the Canadian rules require an immediate news release to be issued, but acquisitions of up to 9.9% of a public issuer listed only in Canada are possible without any notice. Although U.S. registrants and cross-listed issuers are subject to a lower – that is, 5% – threshold, the U.S. rules allow a 10-day window after tripping that threshold before any filing is required. These rules may allow an activist to accumulate a substantial position before filing the notice. Activists can also use derivative strategies to acquire effective control of positions that exceed the relevant threshold when the current disclosure rules may not require disclosure of those positions. Regulators on both sides of the border are reviewing their early warning regimes, including the requirements that should apply to reporting these arrangements; but new rules may be a long way off.

Management Must Respond

Although holders of as few as 5% of the shares can requisition a shareholders' meeting, management controls meeting mechanics, including timing and the company's proxy solicitation. Management can, within reason, determine the timing of a requisitioned meeting and can use corporate resources to wage a proxy battle. However, using these tactics will only delay – not stop – a determined activist. When the issues are brought before the shareholders, management will have to address the substance of the activist's complaints, and the most successful response will be performance-related.

Ignoring an activist's complaints regarding poor performance may simply push the debate into the public arena where the activist may have a compelling story to tell. A challenge for management is the practical reality that activist investors can tell their story more freely than management. Investors face little risk of liability for their public comments regarding management's performance or its ability to increase shareholder value. Issuers, by contrast, must meet strict disclosure requirements if they are making statements regarding the company's future prospects, and they face statutory and civil liability for any misrepresentation. 

In Canada, Shareholders Have Final Say

Boards in Canada can be replaced by a simple shareholder vote. Staggered board structures that are possible in the United States do not work in Canada, where a majority vote at a shareholders' meeting is sufficient to replace the entire board at any time.

However, a growing number of issuers in Canada are following the established U.S. practice of adopting advance notice policies to prevent unexpected motions to nominate directors from the floor of a shareholders' meeting. These policies require advance notice to the company of any proposal to nominate a director at an upcoming meeting, together with specified information concerning the nominee. Failure to give the issuer suitable notice within the prescribed period will prevent the proposed director from being eligible for election.

An issuer's legal defences are otherwise limited. Although an issuer may introduce a "poison pill," or shareholder rights plan, to help it deal with an unwanted takeover bid (a rights plan is not an effective defence to a proxy contest), Canadian securities regulators will generally permit the pill to remain in place only for a limited time (typically 45 to 60 days) to allow the board to seek alternatives - not to reject a transaction outright. This has been the regulatory policy in this area for over 15 years, even though during that period significant developments have taken place in the environment in which these battles for control play out; these developments include boards' paying greater attention to good corporate governance practices and the hedge fund industry's growth and increased sophistication. As discussed in trend 2, Hostile Bids, the regulators are considering a new approach to pills, but their overall philosophy in favour of allowing shareholders to decide is unlikely to change. Therefore, what might begin as a debate with management over the right vision for the company can quickly become a debate in which the shareholders will have the final say. And experience demonstrates that shareholders will generally support a transaction that increases the current market value of their shares - unless they are presented with a better short-term alternative.

The regulators are also aware that the current mergers and acquisitions defence regime in Canada focuses on takeovers. They have identified the need to reorientate their policies to take into account the increasing number of proxy fights outside the bid context; in some cases, these proxy fights are being used to advocate a transformational change within an issuer. The regulators are considering changes to reduce the toehold disclosure threshold to 5%, from 10%; widen the scope of the early warning regime to catch certain derivatives; and place greater focus on disclosure issues in management and dissidents' circulars.

In the current legal environment, absent the support of a large or controlling shareholder or regulatory impediments that protect incumbent management, no board can be confident of its ability to execute a long-term corporate strategy in the face of an activist shareholder who presents the promise of short-term share price gains.

How Should Boards Deal with This Reality?

What is most important is that issuers should avoid becoming complacent and should focus on the business case. They should listen carefully to shareholders and respond to shareholders' valid concerns before they air them publicly. Obtaining solid financial, legal, government-relations and investor-relations advice will be critical. Issuers should be in a position, on short notice, to thoughtfully defend their strategy and explain how it compares, from a financial perspective, with alternatives that could be suggested by an activist. Issuers should also ensure that their key stakeholders understand their strategy – stakeholders who include not only securityholders but also regulators and politicians who may be able to influence the outcome.

Good preparation is also key. Issuers should consider either implementing a shareholder rights plan to prevent creeping share accumulations above 20% or adopting an advance notice policy to prevent unexpected motions from the floor of a shareholders' meeting. They should also review their corporate governance practices to ensure that these meet current norms or that the differences can be justified, because these practices often provide an avenue for the initial attack. Issuers may also want to consider board renewal at their own initiative, especially when specific directors come under attack by a proxy advisory service or an institutional shareholder.

Moreover, issuers should be prepared to undertake value-enhancing steps themselves, rather than waiting for an activist to seize control of the agenda. When shareholders began to put pressure on McGraw-Hill to lift its share price, the company announced that it would break itself up, spinning off its education division. Spinoffs can be an effective way to bridge perceived valuation discounts or to separate and increase the value that the market ascribes to businesses with different growth prospects or income-generating potential. By undertaking a spinoff, boards can increase shareholder value while maintaining control of the process. More of this activity is likely, whether at the instigation of an activist or as a defensive measure.

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This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

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