trillion dollars is hard to miss, and with almost that much cash on the books, U.S. corporations have attracted the attention of hedge funds and other activist shareholders who want to know just how companies plan to put the money to work. According to Moody’s, U.S. nonfinancial companies had $943 billion in cash on their balance sheets at mid-year 2010, up from $775 billion at the end of 2008, and with interest rates at historic lows, that stockpile of dollars isn’t adding much value to the companies that hold it. Activist shareholders are pressing corporate management and boards to buy back shares, increase dividends, make acquisitions or otherwise deploy the cash in ways that explicitly benefit shareholders. But that pressure puts directors in an uncomfortable position.
Board members well remember the depths of the recent recession, when credit markets froze and liquidity was precious. They understand the need to invest in the business but want to be prudent and responsible, as global competition is fierce and the economy is susceptible to another decline. At the same time, trends in regulation and corporate governance, such as “say on pay” and proxy access, are giving shareholders more input into strategic and other corporate matters. If boards fail to heed the complaints of shareholders, activists could launch proxy fights or propose slates of directors who might disrupt corporate functions or result in the ouster of company officers. So as global economies improve and visibility into the future increases, how should boards respond to the tradeoff between preserving liquidity and pursuing investment during 2011? And beyond that, what should a board’s role be in setting strategy, working with management and monitoring performance? For insights, FTI Journal convened a roundtable of veteran board members.
Meeting in FTI Consulting’s Manhattan office, the panel included Robert Dinerstein, chairman of Crossbow Ventures and a former vicechairman of UBS Investment Bank; Rita Foley, director of Dresser-Rand and PetSmart; Stuart R. Levine, director of Broadridge Financial Solutions; and David Meachin, chairman and CEO of Cross Border Enterprises. Unable to attend but weighing in during separate interviews were Edward A. Kangas, chairman of the board of Tenet Healthcare; Philip R. Lochner, who serves on the boards of Clarcor, CMS Energy, Crane Co. and Gentiva Health Services; and Blythe McGarvie, CEO of consulting firm LIF Group and a board member for Accenture, The Travelers, Viacom and Wawa.
FTI Journal (FTIJ): In a recent survey of activist shareholders and corporate executives, the law firm Schulte Roth & Zabel found that both groups expect shareholder activism to increase during 2011, though they disagreed about what issues will provoke that activism. Activists said excessive cash holdings will be the primary catalyst, whereas executives thought financial performance would be the main catalyst. What is the sentiment of your boards? Are you concerned that activists will force you to change strategy and/or make premature decisions to commit capital?
David Meachin: If you sit on a big cash position for several years, you could have a huge political problem. But this is not a time to throw around a lot of cash just because activists tell you to spend. The economy still is deeply troubled, and it will be a long, slow process before the markets fully recover. And with the global marketplace becoming increasingly competitive, companies need to have a big cash war chest. There are any number of Western-educated Asian executives who now are running companies back home. They are very dedicated, and they have employees who will work hard for comparatively low pay. To meet that competition, many U.S. companies may have to spend money acquiring smaller businesses. Say you are a big pharmaceutical company. You could spend $1.8 billion developing a drug that may not succeed — or you could buy a small company that has strong research and development and a solid pipeline of new drugs.
Stuart R. Levine: Shareholders should give us advice, and we should listen. But at the end of the day, it is the responsibility of the chief executive and the board to make strategic decisions. Boards should develop long-term strategies that ensure shareholder value through R&D, M&A and organic growth.
FTIJ: In the wake of the financial crisis, how should boards look at the issue of holding cash vs. putting it to work?
Blythe McGarvie: Since the crisis began in 2008, corporate boards and managers have needed to answer three questions: Has the company restructured its debt to take advantage of some of the lowest interest rates in years? Have we reconsidered our discount rate when computing net present value analysis for potential investments? And what is a reasonable threshold, or “investment rate hurdle,” to use when comparing various potential investments? With interest rates so low, most companies can invest in their operations or in acquisitions for much higher returns than can be made in money markets. With returns on cash low, this is exactly the right time to invest in developing markets and in products to remain competitive and to capture market share. The rest of the world, particularly China, is not waiting to expand its reach into new markets. One of the best uses of cash now is to travel around the world looking for innovative products, services and processes that you can use in your own business.
Edward A. Kangas: If a company is generating strong cash flow and has more than adequate cash on hand, shareholders are going to want to know its plans for using that capital. One way to articulate that is to use return on invested capital to compare internal and external uses of cash. But if the ROIC on a stock buyback or dividend is much higher than you get from acquisitions or R&D, investors will question your priorities, and it will hurt the valuation of the company and its stock price. And though some companies want to keep “dry powder” for game-changing acquisitions, it’s generally better to arrange a large line of credit for that purpose rather than to keep a lot of cash.
FTIJ: By the time activist shareholders knock at your door, it may be too late to head off a confrontation. How can companies avoid becoming targets?
Rita Foley: By maintaining open communication with shareholders, who are less likely to side with activists if they understand your strategy. Some of that will come through individual meetings with investors, but companies also should hold strategy days that are open to all analysts. At these meetings, management can lay out a company’s five-year strategy and explain why it makes sense.
Levine: Some companies have effectively reviewed strategy through retreats. The sessions are designed to explore the future and are grounded in the reality of available capital and results. Reflecting on investor concerns helps enrich the discussion. This process helps the CEO continue to respond to these issues appropriately.
Kangas: It’s also important not to generalize about activist investors. They worry boards, which don’t appreciate the scrutiny. But some activists can add real value. And while they’re often seen as just wanting share buybacks, the really good activists can help companies improve their approaches to capital allocation.
FTIJ: Are there other effective forums for communicating with shareholders? And is it possible to communicate too much?
Levine: It’s important to talk with the general counsel about the best way to communicate so you don’t run into problems with fair disclosure regulations. I was a lead director at a company when a hedge fund took a substantial position in the stock. When a manager of the fund reached out to me, I listened for a reasonable amount of time while the investor shared his ideas about strategies on mergers and acquisitions. I thanked him for his ideas and assured him that I had heard his suggestions but explained that it would be inappropriate for me to get into a lengthy conversation. When people ask to talk with an independent board member at Broadridge, we refer the request to the CEO and determine which director would be the most appropriate person to respond, e.g., chairman of compensation, governance or audit.
Robert Dinerstein: There might not be much we can do to change the views of activist shareholders. But we need to find ways to reach retail investors. They have lost confidence in the market, and they are turning to brokers for advice. We need to provide focused communications for the brokers. It no longer is enough just to send out a press release.
Foley: You also can’t ignore Facebook, LinkedIn and Twitter. Someone has to be actively monitoring what is being said about a company in the new social media and respond accordingly.
FTIJ: One of the hottest topics for the next proxy season involves the “say on pay” provisions of the U.S. financial reform legislation passed last year. Under the rules, companies must give shareholders the right to provide advice on executive compensation. Some people see this as an intrusion on the rights of boards. But there has been an arms race to pay CEO s — if one CEO makes a certain amount, competitors feel they must match the figure. Could the new rule make boards more thoughtful about compensation policies?
Foley: Surveys of board members suggest that “say on pay” won’t have a great impact. Similar rules have existed in the United Kingdom for a long time, and there hasn’t been much fallout. Many boards already listen to shareholders and are transparent about compensation, so they will have little resistance to change. There will be more pressure to show how you measure executives relative to the business results. Activist shareholders often complain that companies spend too much to hire senior executives from outside, in part because you typically have to compensate people for stock options or other payments they give up when they leave their old jobs. Now there could be even more focus on such payouts, and to avoid controversies, companies may put a renewed emphasis on promoting from within. But that will require boards and management to spend more time grooming executives and having a robust succession plan. That could be a positive development.
Meachin: Whether or not say on pay has an impact, globalization could put pressure on salaries in the United States, which tend to be higher than those at competitors abroad. To compete internationally during the next 20 years, you’ll have to cut costs to the bone and adjust compensation.
FTIJ: What role should a board play in developing strategy — what businesses and markets to be in, how cash is used, how executives are compensated and other important issues? Should the board actually formulate plans or simply oversee management as it develops ideas?
Meachin: It used to be that management would give a six-hour PowerPoint presentation to the board, which then would essentially give management the go-ahead to proceed with its plans. These days, the CEO and management are still responsible for making strategy, but to compete on a global stage, management has to harness the brainpower of everyone on the board, which needs to be involved in critiquing ideas and ensuring that plans make sense. Also, many board members serve for 10 years or more, while CEO s often are there for a much shorter time. So the board must take more responsibility for determining and implementing longterm strategy in case it needs to bridge a management transition.
FTIJ: We’ve talked about the important impact that globalization is having on business. Are boards doing enough to make sure that strategies are aligned with the demands of operating in a global environment?
Foley: Many people on the boards of U.S. companies have management experience only in the United States, and that really limits their ability to take a truly global perspective. It’s important to have people who have lived in different countries and have immersed themselves in those cultures. Some boards of multinationals are discussing where a company’s headquarters should be. Just because the company has always been run from the United States doesn’t mean it should stay there. If you have big operations overseas, it could make sense from a client standpoint to locate somewhere else. And you may be able to save on taxes.
Levine: If you are traveling and working abroad, it changes how you look at things. You look in the faces of people, and you can see how your product may not be suitable for particular markets.
FTIJ: The credit crisis and recession exposed the ignorance of many directors and boards about the companies they oversee. How can directors come to understand a business at a fundamental level? Do they need to go into the field and get their hands dirty?
Meachin Board members should visit plants and operations, and if plants and operations are overseas, that’s where board meetings should be. Procter & Gamble divides its board into groups and sends three board members to one country and three to another. You don’t have to travel 300 days year, but board members have to recognize that part of their job today is to travel to wherever major business is done. The point is to get a good understanding of the products and the customers.
Foley: Board members also need robust training. I serve on a board that includes several CEO s with experience in the industry. But everybody had to go through training, which consisted of getting tutorials and visiting clients as well as company facilities. It was helpful because some of those CEO s had come up through the financial ranks and were less familiar with the field and with manufacturing.
Levine: I have served on the board of a nonprofit hospital group for 25 years, and I find that field trips are always helpful. We recently toured a hospital and visited an emergency room and operating theaters. We talked with doctors and nurses. That provided important perspective about the reality of the organization and its operations.
FTIJ: Should board members seek to develop information sources that are independent of the CEO?
Philip R. Lochner: As long as a board has confidence in management’s willingness to report both good and bad news accurately and impartially, it’s entirely appropriate for boards to rely on management reporting. The CEO has access to performance measures and details the board couldn’t get from other sources. But intelligent boards supplement that information with industry analysts’ reports, SEC filings, trade publications and trade shows, other media coverage and so on. Boards need to have independent sources of information against which to test management assertions — not because anagements are dishonest but because, like all of us, they may have blind spots or get carried away with their own enthusiasm for the direction they’ve decided to take.
Foley: An outside perspective is important, and our board asks to see all of the analyst reports on the company. We also ask for an analysis of the competitive environment. That may come from someone in management, but it is helpful to look at reports from other sources as well.
Levine: Having access to independent analysts who follow your company is important. I was on a board that brought in one of our analysts. That direct conversation enhanced our board’s understanding of more indepth market realities that were contained in her report. Doing that, you find subtleties that aren’t in writing. In cases where I’ve been concerned about a particular issue, we have retained an independent counsel that reports to the board.
Another way to learn about a business is to get involved in succession planning. Board members should take the time to have a cup of coffee with candidates for CEO . That doesn’t mean just meeting with the top five candidates. You should consider talking with people in the top three tiers of management. By meeting with people at a variety of levels, you can learn a lot about the nuts and bolts of how the business works. Understanding how a consumer utilizes your product or service is huge. Understanding strategy requires you to view the service through the eyes of the end consumer of your product, with a global view of the future.