THE BLOG
02/11/2014 11:55 am ET Updated Apr 13, 2014

Large Shareholders Join Forces With Corporate Directors to Defeat Hedge Fund Locusts

Sam Levenson once observed, "The reason grandparents and grandchildren get along so well is that they have a common enemy."

The same could be said for a new alliance between groups who have often been at odds and more often had no communication at all: large institutional shareholders and corporate directors. A new initiative called SDX is prompted in part by a mutual interest in combating "activist shareholders" whose short-term pressure for performance is detrimental to both corporations and long-term investors. SDX founders include representatives from Vanguard, BlackRock and the Florida state pension fund as well as directors of JP Morgan Chase, Korn/Ferry and Six Flags. This is the kind of alliance that made it possible for Apple to resist Carl Icahn's six-month siege pushing the company to use their cash hoard for a $50 billion stock buy-back.

While their legal duty is to the shareholders, directors have a natural inclination to go along with management. While we use the term "election" to describe the mechanism for putting people on boards, in reality, the system is controlled by the insiders and most directors have had little contact with even the largest investors. Management selects the candidates, who run unopposed more than 99 percent of the time.

A provision in the post-financial meltdown Dodd-Frank legislation was supposed to make it possible for board candidates nominated by shareholders to be included on the company's proxy card sent to shareholders for voting. But the rule was struck down by a court following a challenge from trade groups that represent the people who run the largest corporations. So management still controls board composition and compensation. While legally directors owe their duties of care and loyalty to the shareholders -- since they are selected, paid and, most importantly, informed by the executives -- they tend to see things from the insiders' perspective.

On some matters, there can be a conflict of interest between executives and shareholders. For example, corporate officers like lower variability of CEO compensation to match pay to performance. Shareholders want to make sure that executives get paid only when they create value for shareholders. Better communication between shareholders and directors on issues like these can provide the essential oversight necessary to keep markets free and vibrant. And boards that earn the trust of their large institutional investors are in a strong position to fend off "activist" hedge funds looking for a quick boost in stock prices so they can sell out at a profit and go on to the next company.

Until the 1980's, the "Wall Street rule" was that shareholders who did not like what the directors and executives were doing should just sell their shares. But the rise of large institutional investors like pension funds, endowments and mutual funds and the widespread adoption of anti-shareholder provisions in the junk bond takeover era made it impossible to sell out every time shareholders disapproved of corporate decisions. Increasingly, shareholders wanted to engage with the directors and executives of portfolio companies on issues like executive compensation, capital allocation, CEO succession planning and director selection.

There have been some significant examples of constructive director/shareholder engagement, but most often after the company was already in crisis. The SDX Protocol focuses on real-time, two-way interactions between non-executive directors of public company issuers and representatives from long-term institutional investors such as asset managers and public pension funds. It is intended to supplement management's investment relations efforts by setting up a line of communications between the permanent shareholders and the directors who are fiduciaries for the capital they invest.

Corporate executives and board members who used to think that shareholders should shut up and cash their dividend checks are now discovering that they can be crucial allies in fighting off activist hedge funds who only want to extract money, sell out and find another victim. The SDX Protocol is an important step forward in reminding board members and long-term shareholders that they share more than a common enemy -- they share the same goals.