Introduction To The SDX Protocol

The Shareholder-Director Exchange (SDX") [1] is a working group of leading independent directors and representatives from some of the largest and most influential long-term institutional investors. [2] SDX participants came together to discuss shareholder-director engagement and to use their collective experience to develop the SDX Protocol, a set of guidelines to provide a framework for shareholder-director engagements. While the decision to engage directly with investors should be made in consultation with or at the request of management, the 10-point SDX Protocol offers guidance to US public company boards and shareholders on when such engagement is appropriate and how to make these engagements valuable and effective.

Changes to the corporate governance landscape, including an increasing focus on better and more effective governance practices, the frequency and scale of activist campaigns, the increased use of proxy advisory services, and an increased understanding of the potential benefits of direct engagement, have led institutional investors and public company boards to review their current approaches to shareholder-director engagement. More institutional investors are seeking meetings with the public company directors they elect, and more directors are accepting these requests. Some boards are proactively requesting meetings with significant shareholders.

In December 2013, Securities and Exchange Commission Chair Mary Jo White emphasized the importance of direct engagement by stating "the board of directors is—or ought to be—a central player in shareholder engagement." [3]

This post synthesizes the perspectives of participating directors, institutional investor representatives, and other thought leaders concerning four key reasons why the time is right for the SDX Protocol:

Shareholders are increasing their involvement with public companies and are often focused on corporate governance matters Directors are responding by engaging more frequently with the company's owners Both investors and directors are realizing significant value from direct engagement Perceived barriers to engagement can be avoided or addressed Shareholders are increasing their involvement with public companies and are often focused on corporate governance matters

One of the most significant developments in corporate affairs in recent years is the shift in the balance of power between shareholders and the management and boards of the companies in which they commit their capital. Passive shareholders whose portfolios are largely indexed have long seen engagement as an important tool; now, active shareholders are no longer content with exiting their investments when operating performance, investment returns, or corporate governance are unsatisfactory. With increasing frequency, more investors are attempting to influence the corporate governance and operations of companies through the proxy process or other forms of activism, and long-term investors are increasingly willing to consider and support these efforts. It is shortsighted for corporate boards to avoid engaging with their long-term investors when activists frequently meet with those same institutions to pursue corporate change.

Some directors involved with the SDX Protocol noted that companies on whose boards they sit have received engagement requests because performance, policies, or practices have triggered shareholder interest. This is more than just anecdotal, as traditional activism is clearly on the rise:

Activist shareholder interventions (e.g., seeking board representation, share buybacks, CEO removal) increased 88% between January 1, 2010 and September 20, 2013, with the majority of that growth in Europe and the United States. [4] Activist shareholders worldwide have stepped up their actions at companies with market capitalizations exceeding $2 billion by 129% since January 2010. [5] The average market value of companies targeted by activists increased to $8.2 billion in 2012, up from $3.9 billion in 2011. [6] The number of shareholders globally with a stated activist strategy has more than doubled over the last decade. [7] Activist funds are estimated to have over $100 billion in assets under management—three times the amount invested in 2008. [8] An important change from the past is that activists no longer need to take large stakes in their targets to gain leverage over companies, even those that were previously viewed as unapproachable because of their large size. Today, relatively small positions can provide a platform for disproportionate influence, as in the case of ValueAct's 0.8% position in Microsoft and Pershing Square's 1% position in Procter & Gamble. [9]

In addition, some institutional investors are pushing companies to change policies and practices, adopting tactics traditionally associated with activists. For example, the California State Teachers' Retirement System recently co-sponsored a proposal with activist fund Relational Investors in an effort to break up Timken Co. The two organizations objected to the Timken family holding three of 11 board seats while holding only 10% of the stock. [10]

The Shareholder Rights Project at Harvard Law School has targeted staggered boards of directors with remarkable success. In 2012 and 2013, 58 of the 61...