New Pubcos Should Consider Defensive Health in Light of ISS/GL Recommendations

Cooley M&A Blog

ISS and Glass Lewis are continuing to apply special scrutiny to certain corporate governance provisions of "newly public" companies (generally, companies that have gone public in 2014 or later). See our December 2016 client alert. In short, the latest policies (which have evolved over the last few years) provide that the proxy advisory firms will recommend voting against the re-election of newly public directors who, prior to or in connection with their company IPOs, adopted bylaw or charter provisions that the proxy advisory firms believe are generally adverse to stockholder rights, such as supermajority vote requirements to amend the company's charter or bylaws, a classified board structure or a multi-class capital structure.1 While the proxy advisory firms generally disfavor these provisions, these protective measures also serve to protect public companies from unsolicited takeover attempts and can deter other forms of activism. Therefore, companies that receive negative recommendations based on these policies should consider the factors discussed below before making any changes, including the company's general defensive health in light of the current activist environment.

So far in the 2017 proxy season, ISS is almost universally recommending against all director elections at companies with a supermajority vote requirement to amend the company's bylaws or charter, a classified board structure or a multi-class capital structure. There is still a lack of uniformity in the GL recommendations for similarly situated companies, but GL most often recommends only against nominating and governance committee members and gives some new directors and companies who have been public for less than one year a "pass." Absent a few limited situations involving IPO spinouts from public companies, we have not seen any companies adopt the so-called "sunset" clauses that would cause a disfavored provision to lapse after a reasonable time if stockholder approval is not obtained, which ISS and GL have cited as a mitigating feature. We also have not seen IPO companies committing in advance to submit these provisions for stockholder approval (although ISS has noted that committing to submit the problematic provision within three years of IPO is not enough and that a sunset clause is also required) or changing their practices of adopting these provisions before or at their IPOs.

It is too soon to assess the impact that negative recommendations this proxy season may have on director elections. According to a recent ISS publication, median stockholder opposition to director elections at Russell 3000 companies who have been public for less than three years has increased from 4.4% in 2015 to 7.2% thus far in 2017 and a few directors (four in 2016) failed to earn majority support. However, because the vast majority of recently public companies have a plurality vote standard in place for director elections, we expect that directors of these new public companies will still be elected despite negative recommendations from proxy advisory firms, although companies with institutional stockholder bases who are influenced by the proxy advisory firms will have lower levels of support.

Although ISS and GL have a strong following of institutional stockholders, issuers that receive negative recommendations should consider, as a threshold matter, the composition of their particular stockholder bases, the extent to which those stockholders look to ISS or GL in determining whether to support a proxy proposal, and the areas with which their stockholders appear to be most concerned. Some institutional stockholders still follow ISS or GL recommendations without exception, some consider the ISS or GL recommendations as a factor, but not necessarily a determinative factor, in their voting decisions, and others are guided by their own policies, which may or may not overlap with ISS and GL policies. Even if ISS and GL do not have a consequential influence on an issuer's particular stockholders, they are often viewed as standard-setters for best practices in corporate governance, and changes in policies often reflect investors' changing expectations. For this reason, ISS and GL policies are often starting points for board, governance committee and compensation committee discussions on corporate governance.

For most newly public companies, the recommendations of ISS and GL do not have a decisive influence on their stockholders and, accordingly, we expect that a negative recommendation by itself is unlikely to lead most IPO companies to place sunset provisions on their stockholder protective provisions. As a company matures and its stockholder base evolves, the board should carefully monitor the company's stockholder base, engage in dialogue with stockholders regarding governance matters and regularly assess its governance practices, including weighing the potential advantages and disadvantages of retaining each stockholder protective provision. In our experience, such provisions have proven to be helpful in giving the boards of young public companies the time and leverage to consider the company's various alternatives in the interests of the company's stockholders for the long-term, in the face of an activist threat.

As noted above, the governing documents of most newly public companies contain many (and often all) of the stockholder protective provisions considered problematic by ISS and GL. For example, according to data available on Sharkrepellent.net, of the Delaware companies that have gone public in 2014 or later, about 80% have a classified board, 71% have a supermajority vote requirement to amend a charter provision, 74% have provisions restricting stockholders from acting by written consent and 80% prohibit stockholders from calling special meetings. Companies generally adopt these provisions prior to or in connection with their IPOs as "stockholder protection measures" or provisions that give the board the flexibility to protect the stockholders from takeover attempts that it has not negotiated or approved. For example, a company with a classified board is less susceptible to a proxy fight to unseat a board majority because in a classified board structure, only a minority of the board is up for re-election in any given year so it will usually take at least two years for the activist or unsolicited bidder to unseat enough directors to obtain a board majority. Companies whose stockholders cannot act by written consent (except by unanimous written consent) or call a special meeting may have greater difficulty proposing corporate governance changes outside of the company's annual meeting regime and procedures, which provides additional timing and procedural advantages. Supermajority voting requirements will require a greater number of stockholders to vote in favor of a proposal to amend a company's governing documents and a multi-class capital structure is designed to concentrate voting power in a particular class of stockholders.

Unsolicited takeover attempts are often viewed as serious disruptions to the business and management of the company that could result in less favorable terms to the stockholders in the long-term than would be available in a board-approved transaction. Therefore, these protective provisions can provide boards with meaningful flexibility to consider takeover and other activist threats. However, ISS, GL and, on varying levels, institutional stockholders, generally disfavor these measures because they can also restrict the ability of stockholders to effect changes.

What should you do if you receive a negative recommendation for a board member for this reason?

  • Assess the impact of the negative recommendation on your stockholder base; if stockholders are heavily influenced by proxy advisory firms, consider possible outreach to stockholders before annual meeting (if appropriate)
  • Educate the board (if not previously done) on the issue and evaluate the appropriateness of the stockholder protective measures (e.g., peer company practices); consider any action items following the annual meeting
  • Consider various courses of action and pros/cons: changes to protective provisions, stockholder engagement, disclosure in next year's proxy statement regarding outreach/rationale for maintaining the provisions
  • Regularly assess and monitor your governance practices as the company matures and your stockholder base evolves

According to data available on Sharkrepellent.net, at least 9% of newly public Delaware companies have experienced some form of activism, including campaigns to maximize stockholder value, campaigns to obtain board representation or board control and proposals to make changes to a company's charter. A discussion of a board's considerations in the context of a particular activist campaign is highly fact-specific and outside the scope of this post. However, issuers that receive a negative recommendation from ISS or GL should factor in these defensive considerations before making a requested governance change. Even if your company has not received a negative recommendation or is not currently subject to an activist threat, it is still helpful to consider these issues prophylactically and always a good idea to do a regular check-up of your company's general defensive health.

Please contact any of us for further information.

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Notes
  1. Other stockholder protective provisions disfavored by ISS and/or GL include restrictions on stockholders' ability to call special meetings or act by written consent and, in some cases, director qualification bylaws that disqualify nominees who could receive third-party compensation, poison pills, advance notice bylaws, exclusive venue/forum provisions, fee-shifting provisions and the inability for stockholders to remove directors other than for cause.
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