Carly’s Creation: New Rules in M&A Proxy Battles

The 2002 combination of Hewlett-Packard Co. and Compaq Computer Corp., valued at $19 billion, ranks as the largest technology megamerger of all time. Arguably, however, it may be better remembered as a spark plug for an improvement in shareholder democracy and development of new methodologies for selling controversial deals to an increasingly choosey shareholder population. The deal has been called many things: a civil war in Palo Alto, the last gasp of the Bubble Economy, the triumph of a crass newcomer – H-P CEO Carly Fiorina – over the company’s traditional values as embodied by director Walter Hewlett. Hewlett, son of H-P co-founder Bill Hewlett, fought against the merger in a highly charged proxy contest that led to a potentially important court decision in Delaware. Ultimately, the deal closed in May 2002 after enough charges and countercharges to fill the plot line of a soap opera. Now that the smoke has cleared from the most expensive proxy battle ever, it’s a good time to assess the impact on proxy contests in general and voting battles specifically centering on m&a in a era of heightened shareholder vigilance. In one key phase of the dispute, Delaware Chancellor William B. Chandler rejected Hewlett’s complaint alleging that H-P improperly solicited votes from institutional holder Deutsche Bank but inserted a comment in the opinion that he didn’t like the way the contacts were handled. Many m&a lawyers held that the unsolicited comment should put companies on guard in talking with institutional shareholders that wore multiple hats, i.e., lender, finance consulting, pension management, etc. Merger pros, not surprisingly, had different assessments of the contested deal’s impact on subsequent m&a proxy contests. “H-P/Compaq will have a lasting impact on m&a,” says Patrick McGurn, a Senior Vice President at Institutional Shareholder Services (ISS), a shareholder advisory group. He says that one effect is that any deal will be more highly scrutinized by shareholders. H-P outside counsel, Lawrence Sonsini, a partner in the Palo Alto law firm of Wilson, Sonsini, Goodrich & Rosati, says that after H-P/Compaq a company has to be prepared to be open and candid during the proxy process. He notes that H-P made 300 separate regulatory filings in the course of the proxy fight. Sonsini adds that H-P/Compaq “raises the bar for getting complex deals sold.” In the new environment companies have to demonstrate what the cost savings are and what the synergies are, he states. McGurn says that a number of deals that were completed in the 1990s would have wilted under the pressures that H-P/Compaq has created. He cites the combination of First Union Corp. and Wachovia Corp., which was opposed by southeastern banking rival SunTrust Banks Inc., as a deal that wouldn’t have made it to the finish line had it come out of the gate after the epic H-P/Compaq struggle. Proxy expert Richard Grubaugh, a Senior Vice President at D.F. King & Co., says, “Walter Hewlett’s fight gave all large stockholders a precedent for second-guessing management.” And in an indication of the strong feelings generated by last year’s corporate battle, one expert on shareholder rights summed up its effect. “You can’t buy votes anymore,” says Charles Elson, Director of the University of Delaware’s Center for Corporate Governance. H-P did not respond to a request for comment. Another corporate governance expert, Paul Lapides, Director of the Center for Corporate Governance at Kenesaw State University in Georgia, says that the publicity around H-P/ Compaq has drawn increased attention to merger proxy battles from regulators. “Whether it takes the form of litigation or legislation, I think the government is going to be looking for any trading-votes-for-business conflicts that appear,” he remarks. H-P/Compaq Recap H-P’s bid for Compaq was launched in the summer of 2001 but Walter Hewlett objected to the proposed merger and launched a proxy battle against it. The election seemed to be decided in March 2002 with a pro-merger margin of victory of 45 million votes. But Hewlett contested the results in the Delaware Chancery Court, based on two complaints. He alleged that H-P had misled shareholders by presenting overly rosy forecasts for the deal. He also claimed that the company twisted arms, most notably of Deutsche Bank’s asset management unit, in order to get the German-based bank to put the shares it held behind the deal. Neither of these arguments prevailed. Chandler ruled in May 2002 that Hewlett hadn’t proved either of his contentions but included language that questioned the propriety of a conference call between H-P executives and Deutsche Bank asset management personnel. He says the events raise questions “about the integrity of the internal ethical wall that purportedly separates” Deutsche Bank’s asset management arm from its investment banking operations. The upshot was that people who didn’t like the deal in the first place had reason to feel that H-P cheated. For the merger’s supporters, H-P had won the vote fair and square. But for all the pubic acrimony, proxy expert John Wilcox, a director at proxy solicitation and advice firm Georgeson Shareholder, says that H-P/Compaq was one of the cleanest and most focused battles he has seen. “This was a fight about business strategy and strategic direction.” By contrast, he notes, most proxy battles are a fight between people who want to control the assets. Going Forward Whether or not they believe that Chinese walls were pierced and quid pro quos were employed in H-P’s successful campaign to win the proxy vote, dealmakers should be aware of the lessons of the H-P/Compaq proxy battle. McGurn says that Walter Hewlett’s battle to undo the merger has taken away the stigma from board members voting against management on mergers. “He (Hewlett) comes out of the fight beaten, but unbowed,” McGurn states. In the wake of Hewlett’s battle, dealmakers and their advisers noted a number of changes in how proxy battles in m&a situations will be conducted. But before delving into some of these specific changes, it must be acknowledged that the H-P/Compaq struggle did not occur in a vacuum. The crisis at Enron Corp. had surfaced during the proxy battle, but the WorldCom Inc., Tyco International Ltd., Adelphia Communications Corp., Rite-Aid Corp., and other corporate scandals were not yet on the public’s radar screen. Since H-P/Compaq closed in May 2002, regulators have imposed a $1.4 billion settlement over analyst conflicts on 10 Wall Street investment firms and Congress passed the Sarbanes-Oxley governance and disclosure law to restore trust in Corporate America. All of these developments, combined with the lessons from H-P/Compaq, have created the current climate in which dealmakers face higher thresholds of persuasion to sell their deals to management and shareholders. Two common denominators among these events are that buying businesses has become frowned on and that Chinese walls have been patched or re-erected. Walter Hewlett’s lawsuit protesting the outcome of the proxy battle accused H-P of either causing or profiting from both of these activities. That said, the Delaware court ruled in H-P’s favor. So while a number of commentators agree that among the results of the H-P/Compaq proxy battle is increased suspicion of management, greater pressure to justify deals, and a higher standard of persuasion needed for any number of strategic moves, they caution that it is not H-P/Compaq alone that has rewritten the rules. But it is one major factor that has influenced a number of the changes and trends in m&a proxy battles going forward. A Rising Tide Lifts All Boats According to Nell Minow, Editor of The Corporate Library, an investment research firm specializing in corporate governance and board effectiveness, one effect of the H-P/Compaq merger battle is an unprecedented level of support for shareholder resolutions in general. “H-P/Compaq makes the world safe for directors and shareholders to question strategy. If it had occurred earlier, there might not have been an Enron,” she says. McGurn also connects the increased level of shareholder activism that he says he is seeing this year to the influence of H-P/Compaq. He says that Capital Research & Management Co. executive Gordon Crawford’s call for AOL Time Warner Inc. Chairman Steve Case’s resignation at the company’s shareholders’ meeting in August 2002 was partially a result of the changed climate created in part by the H-P/Compaq battle. The atmosphere in which a major institutional shareholder would speak out is a result of H-P/Compaq, he notes. “You haven’t seen mainstream investors go public with their dissatisfactions with management before,” he adds. While H-P set new standards for expense, publicity, and public relations battles in contested mergers, it also had a broader effect in the world of corporate governance. Now, issues such as staggered terms, poison pills, and executive pay in addition to change-of-control proposals have become easier to broach, if not win, in the wake of H-P/Compaq. Spencer Fleischer, a San Francisco-based investment banker, says that H-P/Compaq has increased pressure for more explicit disclosure of executive compensation. During the proxy battle, Fiorina said that Compaq CEO Michael Capellas would remain with the company as operations chief to make sure that the integration was successful. But his pay arrangements gave him $14.4 million if he left within a year. In November, six months after H-P/Compaq closed, Capellas accepted the chief executive job at MCI Communications Corp., as the re-launched WorldCom is now known. Minow says that a development that it is hard to pin directly to H-P/Compaq, but which she believes was strongly affected by the proxy battle, is the action taken by the SEC a few months after the big tech merger. The agency issued a proposal in September 2002 that will require mutual funds and other registered management investment companies to disclose their votes in proxy battles. “These proposals would give investors fundamental information about the practices of those who vote proxies on their behalf,” said then-SEC chairman Harvey Pitt. “They would also discourage or expose proxy voting conflicts of interests,” he said. This proposal became effective this month. “We had been fighting for this rule change for 14 years, but suddenly after H-P/Compaq, it was like a light bulb went on among the regulators,” Minow says. She says this ruling will have a huge impact on how investors allocate their funds. “People are going to take a critical look at whether they want to stay in a fund that supports management no matter what.” So Long, Unanimity Argument Another likely result of the Battle of Palo Alto will be a decreased use of the unanimity argument in deal negotiations. In H-P/Compaq, H-P management encouraged Hewlett to support the deal on the basis that the parties wanted to present the merger as being unanimously supported by both boards. Without such a consensus, there was concern that the deal would cost H-P more. “I think this negotiating strategy will be used less often,” says Fleischer, Vice Chairman of private equity firm Friedman Fleischer & Lowe, who was among Walter Hewlett’s principal advisers. Minow calls the unanimity argument “a recipe for disaster that undercuts the concept of director approval.” She agrees with Fleischer that post-H-P/Compaq, people won’t write a unanimity clause into a deal or use it as a negotiating tool. Proxy Pros Weigh In Wilcox says that H-P/Compaq shifts the balance somewhat in proxy fights toward shareholders. “Usually, in the proxy system, the deck is stacked in favor of management, but since H-P/Compaq, these contests are getting more winnable by dissidents,” he says. He attributes this change to the rise of better-educated shareholders. Another effect of H-P/Compaq, he adds, is the likelihood that companies will nail down all details of a deal or a proposal before presenting it to shareholders. Wilcox also says there will be an increased emphasis in dealing with any dissident positions early on. “You’re seeing more debate at earlier stages in the process to deal with peoples’ objections to deals or proposals.” Some examples of this trend can be seen in Haggar Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com