Meg Franklin, Associate Member, University of Cincinnati Law Review
Similar to a handyman homebuyer who purchases a house in order to make a profit on improvements made to the house, institutional activist funds “flip” a corporation in order to provide a profit to shareholders. These institutional activist investors use ownership of shares to affect change in management.[1] Once the corporation has increased in value, activist funds pressure a board into selling so that the owners can realize the profit. Opponents of institutional activist investors believe this short term strategy sacrifices long term corporate stability.[2] Yet, proponents believe institutions carry more knowledge than individual investors which enables them to steer corporations away from profit-reducing decisions.[3] Engaged Capital, an activist fund currently targeting SunOpta, provides an excellent example of strategic institutional activist investment and exemplifies the overall investment trend. .[4] While time will tell whether Engaged Capital will impact positive change in SunOpta, Engaged Capital holds itself out to be a fair investor looking to improve the business from within.
Pushing an Agenda through Ownership
Methods for corporate governance have adapted to changing laws. For example, securities law now requires investors to file a 13D statement of ownership with the Securities and Exchange Commission to disclose when they have acquired five percent or more interest in a publicly-traded company.[5] The purpose of this disclosure is both to inform investors about the ownership of a particular company and to notify management of a potential activist investor.[6] Activist investors use the ownership of stock to pressure management into adopting strategies they believe increase shareholder value.[7] In other words, “activist investors typically buy a minority stake in a targeted public company and agitate the board and management for changes they believe will boost shareholder returns.”[8] While activist investing is not a new form of corporate governance, activism by organized entities—hence “institutional investor”—is becoming more common. [9] To continue with the analogy, this distinction is the difference between an individual handyman flipping a house and a company that systematically flips houses.
As a form of management accountability, there are “increasing calls from both the public and private sectors for institutional investors to play a broad ‘stewardship’ role by ‘engaging’ with investee companies to ‘help achieve long-term sustainable value’ and to help curb excessive risk taking seen as a factor in the financial crisis.”[10] This is precisely the approach taken by Engaged Capital.[11]
Takeovers by institutional activist investors often have serious implications on corporate management’s job security. One study found that CEOs leave their position in greater numbers in response to activist investors.[12] This is especially curious since “activists generally don’t publicly target the CEO for replacement . . . [yet, e]ven in cases where activists do not gain board seats, CEOs leave their post 71 percent greater than the normal rate.”[13]
Recent News: Engaged Capital
One example of an institutional activist investor targeting a company to improve its management is Engaged Capital’s target of SunOpta, a “Canadian natural and organic food producer.”[14] A 13D filing on September 15, 2016, disclosed Engaged Capital’s 7.5 percent stake in SunOpta.[15] This ownership is valuable because it supplies Engaged Capital with voting rights and channels of communication with SunOpta’s management. Interestingly, “Engaged has entered into a non-disclosure agreement with SunOpta so the company can have the benefit of their advice on how to create shareholder value.”[16] Beginning the process with private talks then agitating for a sale is the typical process for Engaged Capital.[17] First, Engaged Capital “wants to improve the company’s board and management [due to] operational missteps including slow integration of acquisitions and lagging margins in consumer products.”[18] Then, once these improvements increase SunOpta’s value, Engaged Capital plans to use its voting rights to sell all or part of the company.[19]
According to its website, Engaged Capital exists to provide accountability through stewardship.[20] In other words, it “becomes the voice for the shareholders” to be a “catalyst for positive change.”[21] It claims to do so through: (1) “concentrated ownership (positions ranging from 1%-9.9% of portfolio companies)”; (2) “[a] long-term perspective (2-5 year holding periods)”; and (3) “[d]eep research and value-added insights for increasing the company’s worth.”[22] These characteristics of its philosophy attempt to solve some of the complaints of activist investors.[23] Moreover, Engaged Capital makes its motivations clear, stating on its website that it chooses to “invest for influence, not control.”[24]
Flipping SunOpta
By way of illustration, Engaged Capital’s investment in SunOpta is like an investment in a house one plans to flip. A few characteristics of desirable houses to flip include location and sound condition.[25] These are crucial if one plans to “find a cheap home for sale[, p]ut some money and sweat equity into fixing it up, and then resell the house for a huge profit.”[26] In real estate, location controls whether the house will sell once it has been flipped.[27] However, selling the house quickly is only one factor necessary to see a profit on the house.[28] The condition of the house should be sound.[29] Otherwise, one may spend more in repairs than one can recover on the resale value.[30]
If one pretends that the value of a house could be shared by many different people, then Engaged Capital would be the most influential owner who directs the improvements on the house. Here, the house is SunOpta, and the current inhabitant is the management of the company. In order for the shareholders to receive the best value on the improvements, the management often has to move out to make way for new inhabitants. These new inhabitants will pay for the value of the improvements. Then, the proceeds of the sale will be distributed to all the people co-owning the house. However, the shareholders are more likely to see a profit if SunOpta was a good investment. Like a house’s location, SunOpta’s location in the market may determine its desirability. Also, the current weaknesses in management need to be problems that Engaged Capital can realistically solve.
Just as house flipping benefits the neighborhood, the economy benefits from institutional investors who increase shareholder value for one corporation. As long as this system has a balanced, fair motive, it is likely a method that will bring true value to the shareholders. From an outsider’s perspective, Engaged Capital holds itself to achieve fairness through its goal to “influence, not control.” It is also relatively transparent by engaging with the corporation early in the process through discussions with corporate management. This is beneficial because it is usually a smaller hurdle if an activist investor can convince management to cooperate in implementing improvements. Here, SunOpta has chosen not to actively resist and instead has engaged with Engaged Capital to implement improvements. Yet, with the high rate of CEO turnover that activist investors bring, it would not be surprising if management were tempted to resist the investor.
Conclusion
Utilizing institutions to “flip” corporations can increase value to shareholders and add a layer of accountability for boards and management. In a post-recession economy, accountability is an important goal for corporate governance. Therefore, when institutions truly have shareholders’ interests at heart, their expertise can lead a corporation into an economically strong future.
[1] Hedge Fund Activism In An Age Of Global Collaboration And Financial Innovation: The Need For A Regulatory Update Of United States Disclosure Rules, 35 Rev. Banking & Fin. L. 283.
[2] See, id. at 302.
[3] Id.
[4] See infra, note 12, page 2.
[5] 15 U.S.C.S. § 78m (LexisNexis, Lexis Advance through PL 114-244, approved 10/14/16).
[6] Thus, “the reporting requirement of the Securities Exchange Act was designed in part to empower company’s management to adopt defensive measures in response to perceived threats to corporate control.” Hedge Fund Activism In An Age Of Global Collaboration And Financial Innovation: The Need For A Regulatory Update Of United States Disclosure Rules, 35 Rev. Banking & Fin. L. 272.
[7] Bill George & Jay W. Lorsch, How to Outsmart Activist Investors, HARV. BUS. REV., May 2014, at 88, 90.
[8] Sonali Basak & Beth Jinks, Activist Investors Double Chance of CEO Exits, Study Shows: Bloomberg BNA, 2 CGR 187 (Dan Kraut, Issue No. 10, 2016).
[9]See, Ben W. Heineman, Jr. & Stephen Davis, Key Descriptive and Prescriptive Questions About Shareholders’ Role in U.S. Public Equity Markets, 1 (Oct. 2011).
[10] Id. at 4.
[11] See, Engaged Capital, http://www.engagedcapital.com/index.html.
[12] Supra note 7, page 2.
[13] Id.
[14] Beth Jinks, SunOpta Targeted by Activist Fund With New Stake, Bloomberg BNA, 2 CGR 187 (Elizabeth Fournier, Issue No. 10, 2016).
[15] Id.
[16] Id.
[17] Id.
[18] Id.
[19] Id.
[20] Engaged Capital, http://www.engagedcapital.com/index.html.
[21] Id.
[22] Id.
[23] Ben W. Heineman, Jr. & Stephen Davis, Key Descriptive and Prescriptive Questions About Shareholders’ Role in U.S. Public Equity Markets, 4 (Oct. 2011).
[24] Engaged Capital, http://www.engagedcapital.com/index.html.
[25] Heather Levin, Flipping Houses for Profit – Tips for How to Flip a House, Money Crashers, http://www.moneycrashers.com/five-tips-for-effectively-flipping-a-house/ (last accessed Nov. 20, 2016).
[26] Id.
[27] Id.
[28] Id.
[29] Id.
[30] Id.
