For good or ill, activists now are important players in the investor ecology, with increasingly successful records for changing a board’s makeup. At Egon Zehnder, we identified 58 incidents of investor activism against S&P 500 companies over the last two years. Of those, 16 contests involved changes to board composition, urging a “no” vote on the management’s slate of directors or proposing, or threatening to propose, an alternative slate. And of those, only six concluded in favor of management, resulting from the activist slate being withdrawn before a vote or management’s victory in a vote.
It is not surprising, then, that many boards are evaluating their plans for responding to an activist slate this proxy season. Broadly speaking, however, there are really only two possible courses of action a board can take. One path is to accept the reality of activist scrutiny and build it into the nominating committee’s ongoing work. The nominating committee needs to look at the board with an objective eye and identify how its composition might give an activist a foothold, such as directors with conspicuously long tenures or directors whose experience is unaligned with the company’s business and its strategic direction. The nominating committee must then design a director succession plan that identifies, cultivates, and elects candidates with the desired competencies. Doing so is not a guarantee against activist action, but having a carefully chosen board with relevant backgrounds and perspectives deprives activists of a clear weakness to exploit.
Because board seats turn over intermittently and because competition for directors is so high, fully executing this strategy can take several years. In the meantime, an activist investor may well decide to put forth its own slate. When that happens, the nominating committee must shift into high gear. In the 16 activist initiatives involving changes to board composition, the median campaign length was found to be only 77 days—just 11 weeks from the initial announcement to some sort of resolution. And six of those 16 initiatives concluded in less than one month.
Of course, the company could stick with its current slate and hope it receives the necessary votes. But once activists have sown the seeds of doubt in the minds of other investors, events have shown that change is more or less preordained. It is simply a matter of whose change will prevail.
Because time is of the essence when faced with an activist slate, it is incumbent upon boards to watch closely for tremors that might precede such an action. Besieged boards might feel blindsided, but successful activist attacks rarely come out of the blue. Seven of the companies that were subject to investor activism on board composition were the targets of initiatives from more than one group. For example, while Starboard’s Jeff Smith may be the one credited with replacing the Darden board, that upheaval only followed an initial salvo from Barrington Capital Group. Once the board gets the faintest sense that it is the object of activist interest, it needs to move quickly to examine its composition and reshape it as needed.
When the battle is joined, boards must ensure they do two things. First, they must reach beyond their usual networks in identifying new director candidates. Expanded networks are more likely to allow the board to draw upon candidates with a wider range of perspectives and experiences. Furthermore, the wider pool of candidates (and connections to candidates) is essential if a company can hope to quickly assemble a slate that doesn’t look quickly assembled.
Once the company has its nominees, it then must convince the investor community to give its support. Here it is particularly helpful to steal a page from the activist playbook. Activists know that no matter how good their slate may be, their real power lies in their ability to sway a majority of investors to their side. As a result, the best activists are also the best communicators. They make sure that the story they tell is clear and compelling and then tell that story relentlessly. If management has been less than successful, it is because they have been out-maneuvered in the court of investor opinion. Management must make sure that the story they tell about their slate is even more compelling than that put forth in support of the activist candidates, and it must be told with the same energy and clarity.
The bottom line is that nominating committees must build strong director succession plans that result in boards that are clearly relevant for the challenges and opportunities the business is facing. Their only choice is whether to do so preemptively and with the luxury of time or, instead, with their back to the wall and the clock ticking.
George L. Davis co-leads Egon Zehnder’s Global Board Practice and is a trusted advisor across a host of corporate governance matters, with particular focus on leadership succession planning and board effectiveness. Kim Van Der Zon leads the U.S. Board Practice of Egon Zehnder International and has expertise in CEO succession. She has successfully served Fortune 500 clients across a broad spectrum of global companies from financial services and consumer packaged goods to pharmaceuticals and technology.
Leading boards increasingly take an approach to board succession that goes beyond traditional placement and even planning. They don’t want to be caught flatfooted in the event of unexpected departures of directors, multiple retirements, strategic evolution that calls for new skills on the board, or the sudden appearance of an activist investor demanding seats at the table.
Bonnie W. Gwin
Theodore L. Dysart
At its most advanced, this approach includes establishing relationships with potential candidates even when foreseeable board vacancies lie far in the future. At a minimum, it involves identifying robust candidates across the various sets of competencies the board might need down the road, and then keeping tabs on them, looking for opportunities to get to know these individuals, and learning how they might one day fit into the company’s future. Boards that employ this approach:
Manage foreseeable vacancies and skill-sets as a portfolio. Through detailed assessment, boards can identify critical gaps in their committees or expertise, and zero in on the skills they will need. They can then develop a competency index that enables them to manage succession planning holistically, not as a series of one-offs.
Continually identify a broader range of potential candidates to address expected (and unexpected) vacancies. The board of a leading consumer company, for example, maintains what they call an “evergreen book” of 40–50 potential candidates they keep their eye on from year to year. Similarly, the board of a leading financial services company, facing four vacancies in the next five years, conducts periodic “lit searches” and at any one time is aware of a dozen or so potential candidates.
Engage potential candidates before they’re needed.Activist investors, for example, are well aware of annual meeting cycles, and they use this time pressure to push through their proposed director candidates. Boards must, therefore, either be able to conduct rapid searches for world-class alternative candidates or face the prospect of a proxy fight. Boards that have already engaged with candidates and gotten to know them will not only understand who would best fit the bill but also who has the stomach to enter the fray. Moreover, these candidates will better know the company. We find that this not only gives the company an edge in convincing widely sought executives to join the board, but also helps ensure a faster, more productive start when they do.
Anticipate cultural fit. Through proactive engagement, board members can get a sense of how potential candidates might improve upon (or poison) the atmosphere of candor and collegiality that effective boards require.
Boards differ in how they engage with potential candidates, but the process is usually jointly owned by the CEO and an independent director. In some cases, the CEO takes the initial meeting with potential candidates. In others, the lead director or a member of the nominating committee makes initial contact. In all cases, the encounters should be informal, get-acquainted sessions, not formal interviews. The subject of board membership should be brought up only as a casual point of conversation with no commitment to timing and with no certainty that things will move forward.
Why, then, should potential candidates agree to meet? Because the worst that can happen is that they have made contact with the CEO and board of a prominent company and established relationships that could lead in any number of directions.
By identifying and engaging with potential colleagues, boards can reap big dividends, enabling themselves to:
Respond faster, more flexibly, and more effectively to unforeseen events
Refuse to settle for less-than-ideal candidates
Evolve the board in step with the company’s long-term strategy
Strengthen the board’s culture, both through thoughtful appointments and the board’s better understanding of that culture
As we have found, once the process begins to pay off—in a faster search in an emergency, the successful recruitment of an accomplished leader, a rapid and smooth onboarding of a new director, or the fine-tuning of the board’s culture or mix of skills—board members get firmly behind it. Most importantly, they give themselves a perpetual head start on one of their most important responsibilities.
Bonnie W. Gwin is vice chair and managing partner of Heidrick & Struggle’s board practice in North America. Theodore L. Dysert is a vice chair in Heidrick & Struggles’ Chicago office, where he is a leader in the global board practice and an active member of the CEO practice.
Director compensation continues to gain attention in the corporate governance community. Once one of the most mundane topics of corporate compensation, director pay is becoming the topic du jour as governance experts and current board members alike debate the value of a strong, engaged board of directors, as evidenced by the fact that ISS now assesses director compensation levels on a relative basis using QuickScore, its analysis and rating system for corporate governance practices. All of this prompts the question: What is a quality board of directors really worth?
Total board cost (defined here as the sum of cash, equity, pension value changes, and all other compensation amounts as reported in the director compensation table of a company’s latest proxy statement) has emerged as another way for directors and other stakeholders to evaluate director compensation and to demonstrate the value of boards to shareholders.
Steven Hall and Partners studied the early proxy filings of 100 U.S.-based companies with revenues in excess of $1 billion. The study examined the aggregate amounts of cash, equity, and other compensation paid to directors, as disclosed in proxy tables. Among this year’s early proxy filers, the median increase of total board fees was 7 percent in 2014, bringing the median total cost to $2 million. The movement in pay was driven by a number of factors, including a median increase of 6 percent in equity awards granted, a 2 percent rise in the cash compensation, and an increase in the number of paid directors.
In addition, we found at median:
Total cash payments to directors increased 2 percent to $777,000
Total equity compensation rose 6 percent to $1.1 million
Total board fees grew 7 percent to $2.0 million
Boards were comprised of nine paid directors, up from eight in 2013
Average cost per director increased 5 percent, to $230,000
We also compared total board cost to revenue, net income, and market capitalization amounts to show the minimal financial impact of director fees. At median, total board cost equals 0.05 percent of revenue, 0.66 percent of net income and 0.03 percent of market capitalization. These figures reinforce the notion that the board continues to represent one of the wisest investments of capital, particularly in light of the experience and specific expertise that directors bring to the companies they serve.
Average Cost per Director
Among the companies studied, average cost per director ranged from $78,617 to $410,678 in 2014. Among the companies reviewed, the median increase over 2013 pay levels was 5 percent. The median average cost per director equaled $229,899 in 2014.
According to the study, the mix of pay delivered to directors remained virtually unchanged in 2014. Equity awards accounted for 55 percent of total board cost, up from 54 percent in 2013. Cash compensation decreased as a percent of total board cost to 42 percent, from 44 percent in 2013. Change in pension values increased to 1 percent of total board cost, from 0 percent in 2013, and all other compensation remained equal to 2 percent of total board cost. The increase in pension values is attributable to changes in actuarial assumptions used to value these programs, rather than a shift in approach; pension programs for directors are no longer a part of most pay programs.
Among the 100 companies studied:
Revenues ranged from $1 billion to $183 billion
Median equals $2.9 billion
Median one-year revenue growth equaled 7 percent
Net income ranged from negative $53 million to $40 billion
Median equals $269 million
Median one-year net income growth equaled 11 percent
One-year total shareholder return grew 10 percent
Action Items for Director Consideration
The recent focus on director pay by shareholders and members of the corporate governance community has prompted a number of important changes in the way directors consider and implement director pay programs. First, consider director pay issues on an annual, rather than a biennial or triennial basis. Staying abreast of market movements with small annual adjustments is generally preferable to larger, sporadic jumps in pay. While the ways of delivering pay (cash and equity retainers, meeting fees, and additional retainers for committee service) may vary depending upon the company, directors should focus on total pay per director as well as the total cost of the board. In addition, companies should remain mindful of how pay compares to that of their direct competitors as well as companies in their peer group, as defined by proxy advisory services like ISS.
As it comes time for your company to conduct its annual review of director compensation, we recommend that you consider the following questions:
Is your director compensation program fair and competitive?
Does the program allow you to attract and retain high quality director candidates?
Is the program justifiable to shareholders?
Are modifications to your director compensation program appropriate and reflective of projected market increases and company growth?
How does your director pay mix compare to the pay mix at companies of similar size and/or industry?
Is your program’s structure aligned with the current best practice of delivering at least half of total value to directors in the form of equity? If your program’s equity awards are denominated in shares, does your company account for the total potential volatility in grant value?
To what degree does your company consider total board cost when making modifications to your director compensation program?
For a more detailed analysis on director compensation, look for Steven Hall & Partners’ annual Director Compensation Study due out later this year.