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May 24, 2018

How boards can face activists waving ESG flags

By joining the drumbeat of ESG proponents, activist investors could capitalize on popular sentiment

Corporate directors took note earlier this year when Jana Partners sent an open letter to Apple’s board in a case of Apple and the Activist, Round 2.

We already knew that no company, no matter how admired and profitable, is safe from large activist investors. After all, it had been almost five years since Carl Icahn announced his position in the company with two tweets. We also know that Icahn’s campaign ran an expected course: he demands a leveraged buyback, Apple resists, business and share performance continue to climb and Icahn sells with a self-estimated $2 billion gain.

But the January letter was different. Jana Partners was joined by the powerful CalSTRS, and the letter didn’t focus on financial engineering. Instead, it called on Apple to alter its iPhone technology to protect children from device overexposure. The unusual request implored Apple to continue its pioneering ways by doing what no other company has done.

The Jana/CalSTRS letter has been the most public example of activist investors adopting tools from the ESG movement. By using an ESG platform, activists not only gain additional avenues to launch attacks, but can also distinguish their fund-raising efforts with a message that appeals to many pension funds and other asset managers.

Jana isn’t alone. Last year activist fund Trian Partners emphasized the importance of ESG issues for a company’s long-term performance. ISS in February launched its Environmental & Social QualityScore, which measures the quality of corporate disclosures on these issues. Outside the activist arena, BlackRock CEO Larry Fink in January announced a ‘new model for corporate governance’ in which companies must show how they’re making a positive contribution to society.

Activist hedge fund assets under management showed very modest increases last year, growing at a meaningfully lower rate than hedge funds overall, and remaining slightly below the 2015 mid-year peak, according to Sullivan & Cromwell’s annual survey of this field.

The number of activist campaigns declined slightly last year, with only 233 announced. By joining the drumbeat of ESG proponents, activist investors could capitalize on a popular sentiment. It is no coincidence that, at the same time as Jana’s name was being discussed across boardrooms, the firm announced that it was raising a new sustainability fund.

The new message to corporate boards is that, under this evolving standard, no company – even the most financially successful – is insulated from an activist campaign. Directors must prepare for the possibility that activist investors will use ESG issues to try to gain influence. A board that ignores this movement, or hopes that it goes away, will be vulnerable. So what should a board do?

Start a healthy discussion
First, don’t view a meaningful discussion of ESG issues as an unwelcome chore. In the current environment, it will be a valuable exercise even if an activist doesn’t land at your door.

In the worst case, it builds goodwill with passive investors that represent about 30 percent of every large public company’s shareholder base. In the best case, looking at the company from a new perspective prompts changes that ultimately improve long-term value. A review of best practices is an easy, almost costless, first step in this area.

In any event, give careful consideration to assigning responsibility for ESG issues at the board level. Some companies might not want activist investors on their compensation committee or nominating/governance committee. If so, before you give these committees responsibility for ESG issues, consider what might happen if an activist investor gains a seat through an ESG platform. Instead, it may make sense to keep these issues for the entire board, or create a specific ESG committee.

Review and update public disclosures
Some companies created their disclosures on sustainability 10 years ago and haven’t revised them since. Make sure all your public disclosures, including SEC filings and website content, reflect the company’s efforts on ESG issues.

ISS, which often controls more than 20 percent of shareholder voting, is now grading companies on their disclosure of ESG issues. This makes a robust disclosure even more important, as ISS tends to side with activists. According to Sullivan & Cromwell’s survey of activist campaigns, last year ISS recommended in favor of the activist 45 percent of the time, and in support of issuers only 33 percent of the time. (It split its recommendation for the remaining vote.)

Strengthen relationships with institutional shareholders
The support of these investors will be crucial in any activist campaign. As the BlackRock letter highlights, institutional shareholders are increasingly focused on ESG issues. Both Vanguard and State Street have also announced they’re placing increased emphasis on ESG initiatives.

Unfortunately, most companies overestimate their relationships with institutional shareholders and many take their support for granted. Discussions and outreach need to continue year-round, not just during proxy season or in the middle of an activist campaign. Be thoroughly prepared and make sure your message is consistent with the company’s other public statements.

And be a good listener: these institutional investors might be the canary in the coal mine, alerting your representatives to issues the board hasn’t considered. Prominent activists have frequent conversations with large institutional investors, even if just as part of their other campaigns throughout the year. If your company does make changes as the result of engaging with these investors, give them some credit. This creates goodwill that can benefit your company later.

Examine diversity
Take a hard look at whether you have a sufficient range of perspectives on your board. A diverse board can bring valuable insight to ESG issues, while a board that isn’t diverse can become an Achilles heel.

In his January letter, BlackRock’s CEO stated that he intended to ask more than 300 companies about the diversity in their boardrooms and workforces. Although activist investors haven’t been known for promoting diverse boards, this has already changed.

Prepare to engage
None of these steps guarantees that a company will stay off the radar of an activist investor, as these investors may take aim at companies with good governance and strong shareholder outreach. Remember that a scorched-earth defense can backfire, particularly if an activist proposal resonates with institutional shareholders and the market. Increasingly, companies are quietly engaging with these investors and are able to avoid both a messy public fight and an activist on their board.

Melissa Sawyer and Marc Treviño are partners with Sullivan & Cromwell