ESG-Focused Hedge Fund Activism: 5 Best Practices for Succeeding Against Public Company BoardsPosted on Feb 10, 2022
Through August, the 2021 proxy season saw US public-company activism campaigns rise roughly 28% compared to 2020. For the first time, submissions on environmental and social, and political topics represented the majority of proposals submitted, with proposals focusing on social and political issues making up 40% of total submissions.
Out of the busy 2021 proxy season came a slam-dunk victory for ESG-minded asset managers and owners: Engine No. 1’s appointment of three directors to the board of ExxonMobil as part of an effort to push the “Big Oil” giant to reduce its carbon footprint and improve climate-related disclosures.
Indeed, there are headwinds providing momentum to activists focused on ESG-related issues. Major among those boons are two trends: (i) an unprecedented amount of ESG rulemaking within the current regulatory landscape, such as the SEC’s new rule on climate disclosure and recent approval of the Nasdaq proposal for board diversity;and (ii) the support of BlackRock, Vanguard, and State Street, which all issued new proxy voting guidelines, effective 2022, that included minimum requirements for gender, racial, and ethnic composition of the board.
With these factors contributing to growing momentum for ESG-minded institutional shareholders, now is a fitting time to review lessons learned from Engine No. 1’s success.
- Engine No. 1 and Exxon Mobil Corporation—2021
In the first half of 2021, a small hedge fund founded in December 2020 called Engine No. 1 won three seats on Exxon Mobil Corp’s board despite owning only .02% stake. The Exxon vulnerabilities highlighted by Engine No. 1 ultimately came down to: (i) inadequate focus on reducing carbon emissions and investment in renewable energy compared to peers; (ii) financial underperformance; (iii) and lack of board expertise on the energy industry.
In a full-blown proxy battle, both Exxon and Engine No. 1 had significant dialogue with major shareholders. Exxon attempted to persuade investors that it had viable plans to prepare for a lower carbon future, while also arguing that Engine No. 1’s plan was unworkable and that its nominees were unqualified. Key to Engine No. 1’s victory was engagement with and buy-in from the major asset managers and owners of Exxon’s shareholder base. With a combined 20% stake in Exxon, Vanguard, State Street, and BlackRock supported Engine No. 1’s nominees and plans. Additionally, Engine No. 1 was able to garner support from major asset owners, including, but not limited to, California’s pension fund for teachers and the endowment of the Church of England. Exxon has a relatively unique shareholder base for a “mega-cap” company—roughly 47% of the shares are held by individual investors. Despite investment from the usual institutional suspects, buy-in from the retail community was also crucial to Engine No. 1’s success. The victory was significant for Exxon shareholders that have been pushing back on the company’s climate-related plans and disclosures.
Engine No. 1’s win also hinged on the support of proxy advisors ISS and Glass Lewis. Glass Lewis recommended shareholders vote for two of Engine No. 1’s three nominees, while ISS supported the entire dissident slate. Both ISS and Glass Lewis gave the Exxon board credit for their solicitation of a consulting firm in appointing their three choices as part of a “refreshed board” but found that effort insufficient to adequately remedy the company’s operational shortcomings.
5 Best Practices for ESG-Focused Hedge Fund Activists
- Don’t allow nominee selections to hamstring the effort. Recruit candidates with executive leadership and relevant industry experience. Recruit such compelling talent that a board calling your nominees unqualified would be near-objectively absurd. Candidates with diverse skill sets that address several dimensions are hard to reject. The three dissident directors that won board seats for Engine No. 1 have experience in energy, technology, and biofuels.
- Communicate with and garner support of other relevant actors. This begins with institutional shareholders, asset managers and owners (public pension funds—especially those whose constituencies are impacted by the ESG-issue identified) alike. A successful campaign like Engine No. 1’s illustrates the importance of winning over the large institutional shareholder base—Engine No. 1 won three board seats with only .02% stake. Next is proxy advisory firms, which increasingly have more and more influence over shareholder voting decisions. Pitch the advisory firms just as you would the board and the shareholders—communicate with them early and often. Last, and especially in situations where the shareholder base is diffuse, make sure to find creative ways to convey the message to retail shareholders. Engine No. 1’s nominee Alexander Karsner won with only 1.7% between him and Exxon’s Douglas Oberhelman.
- Target companies with ESG-weaknesses and oversight or operational deficiencies. As a hedge fund with the ultimate goal of affecting ESG-related change, you are making the road to success a lot easier by also identifying oversight or operational deficiencies in the target company. It might even be smart to lead with these issues. Risk factors to identify might include companies with: low market value relative to book value; disappointing performance compared to peers; excessive cash on hand with a lack of direction; underperforming business lines; and inadequate board composition—long average board tenure, lack of independence, renewal, diversity, and/or industry experience.
- Create a productive dialogue with the board. Do not misunderstand—productive does not mean without oppositional tone. It is highly rare for a board to invite activism, even if the board is willing to listen and does not have entrenchment aspirations. Work to establish one-on-one relationships with the company’s management and open lines of communication. Attempt to build consensus around certain issues and try not to overclaim or make sweeping accusations—this only alienates your firm from the board.
- Be fundamentally sound. Simply put, do not make rookie mistakes. Activists should begin by exercising their inspection rights under DGCL 220 in order to credibly build their case. Exercising these rights should be relatively easy. Clearly articulate what issues you are raising and why you are raising them. Propose changes with sound, research-backed analyses – white papers and/or expert studies can be effective (see Jana/Apple). Lastly, frame issues in the language that all actors within the corporation’s apparatus can understand: value. Your pitch to the board, shareholders, proxy advisors, and other stakeholders will be more compelling if you can convert the impact of the ESG-issue into dollars. Engine No. 1 uses the “Total Value Framework,” which quantifies sustainability initiates in tangible dollars and long-term financial value.
Due primarily to three factors: (i) to the uptick in ESG-related law-making; (ii) the institutional investor community’s focus on climate sustainability, diversity, equity, and inclusion; (iii) and proven activist success despite equity stakes far less than the 5% trigger for Schedule 13(d), it is quite possible that ESG-activists will continue to feel inspired to launch ambitious board contests against vulnerable public company boards.
 See SC Publications, Review and Analysis of 2021 U.S. Shareholder Activism and Activist Settlement Agreements, Sullivan & Cromwell LLP (Dec. 20, 2021), https://www.sullcrom.com/files/upload/sc-publication-review-analysis-2021-US-shareholder-activism.pdf.
 See Matt Phillips, Exxon’s Board Defeat Signals the Rise of Social-Good Activists, N.Y. Times (Jun. 9, 2021), https://www.nytimes.com/2021/06/09/business/exxon-mobil-engine-no1-activist.html.
 See Cydney Posner, SEC Approves Nasdaq “Comply-or-Explain” Proposal for Board Diversity, Harvard Law School Forum on Corporate Governance (Aug. 26, 2021), https://corpgov.law.harvard.edu/2021/08/26/sec-approves-nasdaq-comply-or-explain-proposal-for-board-diversity/.
 See Vanguard funds, Proxy voting policy for U.S. portfolio companies, Vanguard, https://corporate.vanguard.com/content/dam/corp/advocate/investment-stewardship/pdf/policies-and-reports/US_Proxy_Voting.pdf. See also BlackRock Investment Stewardship, Proxy voting guidelines for U.S. securities, BlackRock, https://www.blackrock.com/corporate/literature/fact-sheet/blk-responsible-investment-guidelines-us.pdf. See also State Street Global Advisors, Proxy Voting and Engagement Guidelines, State Street Global Advisors, https://www.ssga.com/library-content/pdfs/ic/proxy-voting-and-engagement-guidelines-us-canada.pdf.
 See Scott Deveau, Shareholder Activism Campaigns Rebound Out of Pandemic, Bloomberg (Jun. 21, 2021), https://www.bloomberg.com/news/articles/2021-06-21/shareholder-activism-campaigns-rebound-out-of-pandemic.
 See Brian Valerio & James Miller, Was the Exxon Fight a Bellwether?, Harvard Law School Forum on Corporate Governance (Jul. 24, 2021),https://corpgov.law.harvard.edu/2021/07/24/was-the-exxon-fight-a-bellwether/.
 Deveau, supra note at 6.
 Valerio & Miller, supra note at 7.
 Valerio & Miller, supra note at 7.
 Deveau, supra note at 6.
 See Paul Rose, Proxy Advisors And Market Power: A Review of Institutional Investor Robovoting, Harvard Law School Forum on Corporate Governance (May 27, 2021), https://corpgov.law.harvard.edu/2021/05/27/proxy-advisors-and-market-power-a-review-of-institutional-investor-robovoting/.
 See Anna Dimitrijevic & Karessa Cain, Dealing with Activist Hedge Funds and Other Activist Investors, Harvard Law School Forum on Corporate Governance (May 27, 2021), https://corpgov.law.harvard.edu/2021/10/06/dealing-with-activist-hedge-funds-and-other-activist-investors-4/.
 Valerio & Miller, supra note at 7.
 See Catherine Bromilow & Leah Malone, The Changing Face of Shareholder Activism, Harvard Law School Forum on Corporate Governance(Feb. 1, 2018), https://corpgov.law.harvard.edu/2018/02/01/the-changing-face-of-shareholder-activism/.
 8 Del. C. 1953, § 220.
 See Gail Weinstein & Philip Richter, Where Things Stand at the End of 2020, Harvard Law School Forum on Corporate Governance (Jan. 10, 2021), https://corpgov.law.harvard.edu/2021/01/10/where-things-stand-at-the-end-of-2020/.
 See Witold Henisz, A New Way of Seeing Value, Harvard Law School Forum on Corporate Governance (Sep. 24, 2021), https://corpgov.law.harvard.edu/2021/09/24/a-new-way-of-seeing-value/#:~:text=the%20Forum%20here).-,Engine%20No.,to%20long%2Dterm%20value%20creation.
 17 C.F.R. § 240.13d-101.