2012 NTU Conference on Finance1 Re-Jin Guo University of Illinois at Chicago Timothy Kruse Xavier University Tom Nohel Loyola University, Chicago.

2012 NTU Conference on Finance 1

ACTIVISM AND THE SHIFT TO ANNUAL DIRECTOR

ELECTIONS

Re-Jin GuoUniversity of Illinois at Chicago

Timothy KruseXavier University

Tom NohelLoyola University, Chicago

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Staggered Board in US Corporate Governance

The default law in all states requires that all directors stand for election at each annual shareholder meeting.

All states provide an exemption from this requirement if the board is staggered. Thirty-nine jurisdictions, including Delaware and California, permit a maximum of three classes. New York permits as many as four classes of directors, and Arizona allows three “or to the extent not inconsistent with cumulative voting rights.”

In all states: Installing/dismantling a staggered board through charter amendment requires both shareholder approval and board approval, while installing a staggered board in the bylaws requires either shareholder approval or board approval.

In a large sample of major U.S. public companies, 59% had a staggered board in 1998. Among firms going public in the 1990s, the incidence of staggered boards increased from 34% in 1990 to over 70% in 2001.

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ATA and Firm Valuation

Old literature: Antitakeover amendments (ATAs) protect entrenched

managers. ATAs enhance bargaining position of the incumbent board

with the potential bidders to extract higher premium (Comment and Schwert, 1995).

Recent research: Governance provisions weaken shareholder rights and are

associated with inferior subsequent stock returns (Gompers, Ishii, and Metrick, 2003).

Not every governance provision is created equal. BCF entrenchment index with 6 ATAs: staggered board; poison

pill; limits to shareholder bylaw amendments; supermajority requirement for mergers; supermajority requirement for charter amendments; and golden parachutes (Bebchuk et al., 2006).

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Staggered Board as most Powerful ATA

Staggered board impedes replacement of a majority of directors.

Staggered board with poison pill provides Impenetrable protection of incumbent managers.

Chancery Court (8/8/2010) and Supreme Court (11/23/2010) ruling on the takeover battle between Airgas and Air Products and Chemicals (Guo, Kruse, and Nohel, 2011; Bebchuk, Cohen, and Wang, 2012;).

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Takeover battle Airgas vs. Air Product

October 2009: Air products expressed interest in acquiring Airgas.

February 2010: Airgas rejected Air Product’s tender offer.

September 2010: Air Products launched a proxy fight. Air Products replaced 3 directors (Airgas has a staggered board).

September 2010: Air Product obtained a majority shareholder approval for a by-law provision that the next annual meeting will be held on January 18, 2011.

October 2010: Delaware Chancery Court issued an opinion sided with Air Product.

November 2010: Supreme Court of Delaware overturned the Chancery Court ruling.

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Divergent Views on Staggered Board

Total of 506 shareholder proposal to de-stagger the board in 1996-2010, 479 of which went to a vote.

Average percentage of votes cast in favor of proposal to dismantle staggered board exceeds 65% in 2006-2010.

Policies from institution investors (the Coucil of Institutional Investor, American Funds, BlackRock, CalPERS, Fidelity, TIAA-CREF and Vanguard) and leading proxy advisors (ISS and Glass Lewis) favors annual election of directors and proposal to declassify board.

Shareholder Bristol-Myers, Host

Marriott, Merck, and Proctor & Gamble received shareholder proposals to de-stagger their board for at least 16 consecutive years. The boards of those firms finally decided to de-stagger their boards in 2003-2004.

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Shareholder Proposal

The experience at Bausch & Lomb is typical. In 1997, shareholder activist William Steiner from the Investor Rights Association of America sponsored a proposal urging the board to de-stagger itself: [T]he Company’s classified Board of Directors maintains the incumbency of the current Board and therefore of current management, which in turn limits management’s accountability to stockholders. . . . I believe that [de-staggering the board] is one of the best methods available to the stockholder to insure that the Company will be managed in a manner that is in the best interests of the stockholders.

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Board Response The Steiner proposal received 62% approval

from Bausch & Lomb shareholders, yet the company continued to maintain a staggered board.

The Bausch & Lomb board of directors argued against the proposal: In the opinion of the Board, the above reasons continue to be valid and the staggered Board remains in the best interests of the shareholders. . . . The staggered board does not preclude unsolicited acquisition proposals but, by eliminating the threat of imminent removal, puts the incumbent Board in a position to act to maximize value to all shareholders. In addition, the Board does not believe that directors elected for staggered terms are any less accountable to shareholders than they would be if elected annually, since the same standards of performance apply regardless of the term of service.

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For/Against Staggered Board Considerations

Favoring a Classified Board: Classification of the Board tends

to balance experience, continuity and stability with the regular opportunity to add valuable, fresh perspectives.

It takes several years for a new director to become fully conversant in the complexities of the utility business model.

Classification makes it more difficult and time consuming to change majority control of the Board which reduces the vulnerability of the Company to an unsolicited takeover proposal. Thus, classification may encourage persons attempting certain types of transactions that involve an actual or threatened change of control of the Company to first seek to negotiate with the Company and may discourage pursuit of such transactions on a non-negotiated basis.

Considerations Against a Classified Board:

Classification of the Board could make more difficult or discourage the removal of incumbent directors, through a proxy contest or otherwise, and the assumption of control by a holder of a substantial block of the Company’s common stock, and could thus have the effect of entrenching incumbent management.

Classification could have the effect of discouraging a third party from making a tender offer or otherwise attempting to obtain control of the Company, even though such an attempt might be beneficial to the Company and its shareholders.

Some institutional shareholders and commentators argue that classification reduces director’s accountability to shareholders, since such a structure does not enable shareholders to express a view on each director’s performance by means of an annual vote. The Board does not agree with this argument.

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Staggered Board and Firm Valuation

Staggered (classified) board is associated with lower firm valuation (Bebchuk and Cohen, 2005; Bebchuck, Cohen, and Ferrell, 2009).

Positive market reaction to board declassification announcement (Guo, Kruse, and Nohel, 2008, 2012).

Staggered board decreases firm value (Bebchuk, Cohen, and Wang, 2012).

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Summary Findings:

Guo, Kruse, and Nohel (2008): Using a sample of firms declassifying their boards in 1987-2004, we report that: Firms with better corporate index scores, with

more independent boards, without poison pill, receiving shareholder proposals, are more likely to declassify their boards.

CARs are higher for firms with immediate board declassification, and for firms with high industry M&A volume pre-SARBOX.

Much variation among de-staggering firms before and after SARBOX.

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Our Sample

467 announcement of board declassification between 2003 and 2010, after passage of the Sarbanes-Oxley act of 2002.

Data sources: Investor Responsibility Research Center (IRRC), Riskmetrics, and searches from Factiva/Lexis-Nexis, and proxy statements.

Shareholder activism: Shareholder proposals in prior 3 years. Hedge fund activism from 13D filings (required for

investors acquiring 5% or greater equity stake). Plans or proposals that could relate to or result in a significant change at the company disclosed in the “purpose of transaction section” of 13D filings.

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Shareholder Activism

Activist as “an investor who tries to change the status quo through ‘voice’, without a change in control of the firm” (Gillan and Starks, 1998).

Target firms with hedge fund activism experience increases in payout, operating performance, and CEO turnover after the activism (Brav, Jiang, Partnoy, and Thomas, 2008).

Returns for firms with hedge fund activism are high for targets that are subsequently acquired, but not different from zero for those which remain independent (Greenwood and Schor, 2009).

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Time Trend of Board Declassification

1987

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Wealth Effect

Mean/ Median CAR of 0.42%/0.17% (significant). Mean/ Median CAR of 1.08%/0.90% (significant) with

hedge fund activism. Mean CAR of 0.60% (significant) prior 13D filings. Mean/ Median CAR insignificant for other sample firms.

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Implementation of Annual Elections

2003 2004 2005 2006 2007 2008 2009 20100

0.1

0.2

0.3

0.4

0.5

0.6

0.7

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0.5

1

1.5

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Year 1

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Average years to elect entire board

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Implementation DecisionYear of first opportunity to elect entire board Test statistic

Year 0 Year +1 Year +2 Year +3 0 v 3 0 or 1 v 2 or 3Panel A: activismShareholder proposal 0.156 0.301 0.438 0.646 50.08*** 51.06***

Activist event 0.231 0.170 0.184 0.124 4.46** 1.89Boilerplate 13D 0.143 0.102 0.092 0.068 3.45* 2.15Any 13D filing 0.372 0.272 0.289 0.180 10.50*** 5.02**

Panel B: ownership and defensesProportion CEO ownership 0.067 0.029 0.032 0.016 2.87*** 2.60***

0.010 0.007 0.008 0.006 3.20*** 2.09**

Proportion O&D ownership 0.154 0.095 0.097 0.056 4.08*** 3.44***

0.072 0.040 0.047 0.026 4.91*** 3.80***

Firm E-index 2.913 3.365 3.446 3.938 5.28*** 4.41***

3.000 3.000 3.000 4.000 4.79*** 4.20***

Adjusted E-index 0.233 0.425*** 0.500*** 0.624*** 2.20** 1.87*

0.000 0.000 0.000 1.000*** 2.16** 2.10**

Panel C: financial dataAdjusted EBITDA to TA -0.015 0.019 0.021 0.057*** 2.97*** 2.71***

-0.011 0.010*** 0.009* 0.018*** 3.23*** 2.41**

Adjusted Leverage 0.080*** 0.056*** 0.094*** 0.086*** 0.25 1.560.020*** 0.028*** 0.066*** 0.067*** 1.43 2.36**

Adjusted Market to book 0.195* 0.056 0.163* 0.050 1.19 0.250.027 -0.013 0.000 -0.031 0.33 0.48

Total assets 21.378 26.534 14.150 21.625 0.02 0.661.350 3.940 2.911 5.974 5.42*** 3.64***

Market capitalization 7.594 11.785 8.013 11.010 1.22 0.130.771 1.575 1.470 3.852 4.64*** 3.32***

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Time to Complete Board Declassification

(1) (2) (3) (4) (5) (6)Intercept 0.976*** 0.747*** 0.989*** 1.001*** 0.764*** 1.008***

(0.286) (0.235) (0.182) (1.48) (0.235) (0.182)Active investor -0.326** -0.295* -0.292*

(0.136) (0.167) (0.167)Investment only 13D -0.049 -0.187 -0.200

(0.186) (0.230) (0.230)Any 13D filing -0.275** -0.293** -0.296**

(0.119) (0.145) (0.145)Shareholder proposal 0.753*** 0.669*** 0.680*** 0.722*** 0.660*** 0.671***

(0.105) (0.114) (0.114) (0.105) (0.114) (0.114)CEO shares -0.812 -0.746 -0.817 -1.019* -0.745 -0.819

(0.602) (00.638) (0.637) (0.587) (0.636) (0.635)Median industry E-index 0.011 0.016

(0.091) (0.091)Firm E-index 0.093* 0.094*

(0.050) (0.049)Adjusted E-index 0.078* 0.081*

(0.047) (0.047)Total assets ($ millions) -0.153 -0.144 -0.239 -0.256 -0.177

-0.273(0.823) (0.835) (0.833) (0.824) (0.824) (0.831)

Adj EBITDA/TA 0.745** 0.276* 0.916** 0.708* 0.855** 0.912**

(0.363) (0.437) (0.438) (0.362) (0.434) (0.435)Adj Leverage 0.039 0.276 0.230 0.102 0.287 0.241

(0.303) (0.364) (0.363) (0.301) (0.362) (0.361)Adj Market to book -0.058 -0.084 -0.094 -0.053 -0.087 -0.097

(0.065) (0.071) (0.071) (0.065) (0.071) (0.071)R2 0.285 0.297 0.295 0.283 0.298 0.297Adj-R2 0.285 0.261 0.259 0.255 0.264 0.263F-statistic 9.510 8.160 8.090 10.100 8.790 8.730

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Announcement Returns

(1) (2)Intercept 0.003 0.003

(0.003) (0.003)Active investor 0.016*** 0.020***

(0.006) (0.007)Crisis -0.011** -0.007

(0.005) (0.005)Adjusted EBITDA/TA 0.021 0.012

(0.005) (0.017)Adjusted Leverage 0.022 0.009

(0.014) (0.011)Adjusted Capex -0.118 -0.011

(0.083) (0.009)Adjusted E-Index 0.001

(0.002)R2 0.049 0.036Adj-R2 0.035 0.015F-statistic 3.550 1.760

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Subsequent Event of Acquisition(Logit Regression Analysis)

(1) (2) (3)

Intercept 0.097*** 0.081*** 0.115***

(0.016) (0.017) (0.019)Active investor 0.135***

(0.050)Active investor*crisis -0.172**

(0.071)Any 13D filing 0.140***

(0.039)Any 13D filing*crisis -0.107*

(0.058)Shareholder proposal -0.012

(0.034)Shareholder proposal*crisis

-0.020(0.046)

R2 0.018 0.028 0.001Adj-R2 0.014 0.024 0.000F-statistic 4.130 6.570 0.330

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Conclusion

Significant and positive market response to board declassification announcement. The positive event returns come from those preceded by hedge fund activism.

Speed of conversion to annual director elections is higher when declassification is triggered by hedge fund activism.

Sample firms subject to hedge fund activism are more likely to be acquired within two years.

Overall, our results are consistent with that board declassification increases firm value, and hedge fund activism adds value.