Illustration by Justin Metz
The vote was still 13 days away, but Mick McGuire knew he was going to lose. McGuire, who got his start at Bill Ackman’s activist hedge fund Pershing Square Capital Management before launching his own firm in 2010, is one of the most aggressive shareholder activists to explode onto the scene during the post-financial-crisis bull market. In little more than seven years, he has taken activist stakes in 22 companies. Last year he waged proxy battles — heated contests over board seats that can change a company’s future — with two of them.
But on December 1 he got some horrible news: Institutional Shareholder Services, the privately owned proxy adviser whose recommendations can make or break a deal, released its much-anticipated report. Over 33 pages, ISS advised investors in Ugg boot-maker Deckers Outdoor Corp. — where McGuire had acquired an 8.4 percent stake — to vote for the board of directors recommended by the company’s management and not the hedge fund’s.
For months McGuire’s Marcato Capital Management had been waging a proxy war with the California company, even suing Deckers for postponing the shareholder meeting. Marcato initially put up a ten-person director slate hoping to topple Deckers’ entire board at the shareholder meeting scheduled for December 14. The plan was ambitious — even audacious.
For ISS, it wasn’t good enough. While endorsing three of Marcato’s proposed directors even as it recommended voting a management slate, ISS wrote that Marcato “could not meet the requirements of ISS’s framework . . . involving a possible change of boardroom control.”
“What happened with Marcato at Deckers — you could call it a ‘swing for the fences’ approach,” says Cristiano Guerra, the new head of special situations research at ISS, an earnest man heading an eight-analyst team whose tiny size belies the power its words wield over billion-dollar companies, as well as the hedge fund activists who often put billions of dollars on the line to change them.
And so, on December 4, McGuire took a highly unusual step. He reduced his slate to three nominees, just as ISS wanted. Two days later, in another rare move, ISS switched its recommendation to a vote for Marcato’s slate. But McGuire’s last-minute gambit was futile. With many votes already cast, he lost.
Mick McGuire’s defeat was the latest in an unusual year where ten proxy battles involved companies with market capitalizations greater than $1 billion tangling with powerful activists. These high-profile battles put a spotlight on the power ISS has over both corporate America and the activist shareholders out to change it, as McGuire’s willingness to publicly bow to ISS to try to salvage his proxy campaign indicates.
“You have these brand-name, blue-chip companies being targeted by activists,” explains Patrick McGurn, special counsel and head of strategic research and analysis at ISS. “The long-time rhetoric had been that a high market capitalization was either a deterrent or an outright defense to any sort of takeover or activism activity. That’s been proven untrue in recent years.”
The uptick in billion-dollar proxy battles in 2017 coincided with Guerra’s ascendancy within ISS — and according to one activist, he is “trying to find his sea legs” during a year of intense clashes. Guerra, who has worked as an analyst at ISS for nearly a decade, estimates that during the past two years, ISS has recommended the management slate 40 percent of the time — up from 33 percent in the past, a slight increase in favor of corporations. (Historically, ISS has tended to side with activists trying to boost share prices, which should come as no surprise since institutional investors are the bulk of its clients.)
Guerra says ISS looks for the “least invasive solution.” It may be too soon to call it a trend, but under his watch ISS three times has taken the unusual step of recommending management slates while suggesting investors withhold votes to allow a certain number of activist candidates to get a board seat. This is something of a departure from ISS’s past practice in which it typically recommended the activist slate on such split decisions, say several longtime investors and advisers. In the end, the ISS recommendation is a binary choice, and in these recent cases it has chosen management. “You think you’re splitting the baby, but what you’re really doing is supporting the company,” says one former ISS executive.
With higher stakes, corporations have become savvier in dealing with activists and are preparing for battle by hiring a slew of advisers who tell them to listen to their shareholders’ concerns instead of stonewalling or going to court — and prepping them for the ISS grilling they are going to get if a proxy contest gets underway. Maybe companies are learning, as the tide has been turning slightly in management’s favor. Investors had only won 50 percent of their battles by mid-2017, the latest numbers available, down from 67 percent in 2013-2014, according to ISS.
Deckers was at the low end of last year’s big deals, with a market value of $2.8 billion. In the biggest and most contentious proxy battle ever, an ISS recommendation for activist Nelson Peltz, a founding partner of Trian Partners, helped him win his brutal bid for a single board seat at Procter & Gamble, the consumer products company. With a $225 billion market cap, P&G is the biggest company to tangle with an activist. Peltz had another advantage: He hired Guerra’s former boss at ISS, Chris Cernich, the former head of its prestigious research unit, as an adviser, and after three recounts that went back and forth, lost by a tiny margin — but still nabbed a board seat.
That ISS has become the kingmaker in proxy contests between billionaire hedge fund activists and their multi-billion-dollar corporate prey is even more astonishing given that ISS itself is worth less than $1 billion and started out as a back-office support system, helping shareholders cast their ballots on what are typically mundane matters of corporate governance. Says one former ISS executive who now works at a hedge fund: “ISS sort of stumbled into this powerful role.”
Hints that the 33-year-old Rockville, Maryland, company would come to dominate contested situations were first dropped during the heated early-aught merger of Compaq and Hewlett-Packard. ISS came out in favor of the transaction, which passed by a slim margin. Several months later the head of the research division, Ram Kumar, who had written the recommendation, was forced to resign following revelations that he had lied about having a law degree.
“People pressing the button had no credibility to inform the marketplace,” says a former ISS executive. “It was a watershed moment.”
Or at least a wakeup call. “Going through the experience of HP-Compaq, our clients really were asking us to do more than we had before, to look at some of the strategic fit issues and doing a deep dive into the numbers, as far as valuation goes. It really drove us to come up with a separate stand-alone group that essentially did nothing but look at these highly contentious situations,” says McGurn, who has worked at ISS since 1996.
In 2004, ISS hired Christopher Young, a former mergers and acquisitions lawyer with Sullivan & Cromwell who had gone on to be a tech banker at Bear Stearns, to oversee the effort and add gravitas to its recommendations. “I had a blank slate,” recalls Young, who left in 2010 and now heads the takeover defense practice in the M&A group at Credit Suisse. He created a premium research product with a dedicated team, putting in place what ISS calls a “framework” to analyze any deal, and a system to interview both sides, with the goal of being a neutral arbiter. In a proxy contest, the activist — whom ISS calls the “dissident” — would go first, the corporation making its case thereafter. Each side would get about 90 minutes to make its case, and the activist then got a chance to rebut.
The timing of ISS’s new group, originally called M&A Edge, was fortuitous. Ackman had just launched Pershing Square, Carl Icahn had just rebranded as a shareholder activist, and Peltz had started Trian Partners. It was Peltz who would provide one of the first big tests of the new group: In 2006 he waged a proxy battle at H.J. Heinz and received the support of ISS. He ended up with two board seats.
Since then ISS has made about 250 recommendations on proxy battles. It is estimated to have a dominant market share — with 61 percent of the proxy business, according to a 2012 report by Proxy Monitor, though market participants judge it to be even higher. ISS’s main rival is Glass Lewis & Co., a portfolio company of the Ontario Teachers’ Pension Plan and Alberta Investment Management Corp., launched in 2003 in what was widely viewed as an effort to add competition to the field, countering the influence of ISS. Glass Lewis declined to comment.
Over the years ISS has passed through many hands. The company, an idea that came from the Investor Responsibility Research Center and pioneer corporate governance advocate Robert Monks, was launched in 1985. It has since been owned by Thomson Financial, followed by an investor group led by Warburg Pincus, then MSCI, which sold the unit to Vestar Capital Partners, a New York–based private-equity group, for $364 million in 2014. Last fall, Vestar sold ISS to Genstar Capital, a San Francisco–based private-equity group that focuses on middle-market companies, for $720 million. Genstar says the company’s management will remain the same and that ISS will continue to operate independently.
From ISS’s origins in a sleepy office park in the suburbs of Washington, D.C., across from a 7-Eleven convenience store, it now has 1,000 employees, 19 offices worldwide, and 1,700 institutional investor clients, and offers a wide range of corporate governance services in 117 markets. It also has an arm that offers advice to corporations that is separated from the prestigious proxy research unit by a Chinese wall. To avoid potential conflicts, ISS’s researchers are never told if a corporation they are analyzing is a corporate client, though an ISS investor client can find out by calling ISS.
Historically, “the business operations were really centered around our traditional proxy advisory services . . . sort of soup to nuts on any issues that come up on the agenda at public companies,” says McGurn. That could mean voting on everything from executive pay to bylaws. ISS estimates it executes about 8.5 million proxy ballots annually — the vast majority of them noncontroversial.
The back-office function of casting proxy ballots for its institutional investor clients became ISS’s bread and butter, dating from the days when votes were checked off on paper and mailed to ISS. “The biggest part of our operation back then was the mailroom. Believe it or not, we had our own ZIP code, with four extra digits there. And every day, literally carts of mail would be wheeled into the basement of our building. And we had a huge group of people that just sorted and went through that,” recalls McGurn.
The ISS role in weighing in on the outcome of corporate control battles, whether M&A deals or activist proxy contests for boardroom seats, is a small part of ISS — only eight out of 1,000 employees comprise the special situations research group. That’s no doubt because contested situations are rare — estimated at less than one half of a percent of total meetings. That group is, however, what one former ISS executive calls the “heartbeat” of the organization.
It is also the most controversial. For years, corporations have complained about ISS, believing that it typically sides with activists. “Every corporation in the U.S. hates ISS,” says one attorney who has been on both sides of activist battles.
It’s understandable that corporate chieftains don’t like the situation ISS puts them in. “You’re told that your future and your legacy depend on this tiny little office in Rockville, Maryland, and that you’ll sit there for 90 minutes while they pass judgment on you,” says one corporate adviser.
Cernich, who headed the ISS proxy research division for six years after Young left in 2010, recalls uneasy encounters with CEOs. “I used to strap on body armor before panels and public events . . . because the advisers spent so much effort telling their corporate clients how evil I was,” he jokes. “It’s not just ISS, though. A fellow panelist from a large institutional investor once told me at a director conference she wondered if she should be getting hazardous duty pay for what she was about to go through.”
For both Young and Cernich, running the proxy research division at ISS turned out to be a solid launching pad for a more lucrative career advising corporations — similar in many ways to former prosecutors becoming high-paid defense attorneys defending the very clients they once sent to jail.
Last year Cernich started his own corporate advisory firm, Strategic Governance Advisors, which is an affiliate of Sard Verbinnen & Co., the M&A public relations firm. Cernich was an adviser on two of 2017’s most high-profile contests. In addition to working for Peltz in his battle with P&G, he also counseled ADP, the human resources software company, as it fended off Ackman’s Pershing Square.
Cernich’s firm is part of a cottage industry of corporate advisers beyond the traditional investment-bank and law-firm defense practice. This new breed is geared, in large part, to dealing with investor concerns in general — and ISS specifically.
A more established player is CamberView Partners, whose CEO Abe Friedman was the global head of corporate governance and responsible investment at BlackRock before leaving to start CamberView in 2012.
Part of CamberView’s job is to prep clients for ISS. “Activists get more shots on goal than companies because they are involved in more campaigns. You have an hour or 90 minutes to make your case. It’s a tough environment, which is why it’s so important for companies to nail that meeting,” says Derek Zaba, a former activist who is now a partner at CamberView. “When we’re preparing clients to engage with ISS, we counsel them to speak with ISS after talking to investors.” That’s because one of the main questions from ISS is invariably, “‘What do your other shareholders think?’” he says.
ISS’s historic support for activists could be one reason why corporations are trying to convince Washington to rein it in. Last year, new legislation to regulate proxy advisers was introduced in the House by Representative Sean Patrick Duffy, a Republican from Wisconsin.
The legislation “would grant ‘companies,’ apparently meaning corporate management, the right to review the proxy advisory firms’ research reports before the paying customers — investors — receive the reports,” the Council of Institutional Investors said in a letter to House Speaker Paul Ryan and House Minority Leader Nancy Pelosi opposing the legislation. Proxy advisers would also be forced to hire an ombudsman to resolve a corporation’s complaints, and publish company management’s dissenting statements. In part because of the tight timeline during proxy season for many of the contested cases, it wrote, “the provisions are not practical.”
Companies may complain about the power of ISS. But it is the activists, not the companies they target, who are most dependent on its recommendations — and, not surprisingly, some are upset about perceived changes in ISS policy and past patterns that work to their detriment.
A recommendation from ISS does not guarantee an activist win, but it’s virtually impossible for an activist to win without the recommendation of ISS, say former and current ISS executives, activists, and other market participants. That said, many institutional investors like to say that the power of ISS is overstated, that it is merely reflecting the desires of its biggest clients — like BlackRock, Vanguard Group, State Street Corp., and others — who control the biggest stakes in most large corporations.
“If ISS has tended to side with activists, there’s a good reason,” says one former ISS executive. “ISS is not a public institution. It is a private, for-profit company, and they are trying to please their clients. They are issuing recommendations they wish to be well received by their clients. They are not writing this report for the good of society. They’re writing for clients who pay them money.”
One activist attorney goes so far as to say that ISS has solved the “shareholder collective-action problem.” By letting ISS be the quasi-judge, “it avoids shareholders being a group and busting a poison pill or having to file a 13D,” he says.
As Anne Sheehan, head of corporate governance for the California State Teachers’ Retirement System, puts it, “When people rail against ISS, they’re actually railing against me.” Even so, she adds, “We frequently do not vote with them. We vote our own policy.” But for a big institutional investor like CalSTRS, with 8,000 companies in its portfolio, ISS provides a valuable research tool. “Very rarely are they factually wrong,” she says. If there is disagreement, “usually it’s a matter of interpretation.”
Others say ISS actually acts as a shield for institutional investors, who as long-term investors might not want to tell the company directly what they would say privately to ISS. Those clients aren’t shy about telling ISS what they think of an activist campaign or a corporation under siege, and neither are hedge funds. Guerra says ISS is also open to hearing from those who aren’t its clients, especially if they are big investors in a company involved in a proxy battle.
The big institutional investors like CalSTRS, BlackRock, and Vanguard have developed their own research capabilities in recent years and say they don’t automatically vote the ISS recommendation. But some smaller funds do rely on ISS.
In addition, at least some retail investors with accounts at the big brokers like Merrill Lynch and Morgan Stanley Wealth Management are automatically voting the ISS recommendation.
These retail investors have become important in many recent elections, including Paul Singer’s battle with aluminum manufacturer Arconic, Peltz’s tussle with P&G, and Ackman’s fight with ADP. As Ackman acknowledged during that campaign, “A meaningful percentage of ADP shares are voted automatically according to the ISS recommendation.”
Given the importance of ISS to activists, it’s no surprise that they are viewing the change of guard there closely. Guerra, who has seven men working under him, gets high marks from former colleagues. “The fact he’s hard to read professionally is intentional, and part of what makes him good in that role,” says Cernich. He adds that Guerra’s years of working as an analyst and an operating executive before he joined ISS are added benefits. “He’s not negotiating with anyone in those meetings. He’s trying to get to answers that his clients can rely on.”
Still, ISS, while a registered investment adviser, is largely self-regulated. It talks about operating under a framework, but that is defined primarily as following two central questions: “Have the dissidents made a compelling case that change is warranted? If so, which nominees are most likely to drive that change?” There are few rules, except that ISS doesn’t let participants review its decisions ahead of time and will only consider public information in making them. That’s not insignificant during heated proxy battles where a lot of personal invective and misinformation gets thrown around. In its reports, ISS often says it is ignoring all that and focusing on the facts. But since it is making a judgment call that can have significant consequences, financially and otherwise, it remains open to criticism from everyone. One of the biggest: People want more time to make their case.
“ISS should be more open to follow-up discussions before they issue their report. We wish we’d had a chance to talk with them again,” says one activist who ended up settling with the company instead of going to a full vote.
Most won’t speak publicly for fear of angering ISS, given their dependence on its goodwill. But that didn’t stop Ackman from writing a letter to ISS after it failed to endorse his three-director slate in his battle with ADP.
Less than a month before the Marcato-Deckers fight, Ackman’s proxy contest at ADP had received a similar — and uncommon — split recommendation for investors to vote management’s slate, while suggesting Ackman could get a board seat by withholding a vote for a management candidate. It didn’t work, and Ackman lost.
Ackman was baffled when ISS did not give Pershing Square a chance to counter management’s claims — as he says was ISS’s “customary practice.” In a letter to ISS, he wrote: “In the course of all of our activist engagements over more than a decade, ISS has always offered us an opportunity to participate in an extensive and productive dialogue. This is the first time in our experience that ISS’s approach has varied from its established precedent and rules of engagement where we were not offered the opportunity to address new facts or issues raised by the subject company subsequent to our meeting with ISS in the midst of a proxy contest.”
ISS claims it has always reserved the right to contact both parties in a proxy contest if it deems it necessary, but has made no promise to that effect. Yet others agree with Ackman that more limited engagements appear to be a change in practice. When Young and Cernich were in charge, says one activist attorney, “there was a constant flow of information back and forth. They were the only people besides the chief justice of the Delaware Supreme Court [where many shareholder disputes are adjudicated] who had my direct line.”
More seriously, Ackman also claimed that, based on the comments made in its report, ISS relied on “nonpublic, inaccurate, and misleading information, claims, and arguments” to make its decision not to endorse his director slate.
Both ADP and ISS vehemently deny Ackman’s accusation. “We only use publicly available information, full stop,” says Guerra. “Every time we have a meeting or a phone call with companies and with activists, the very first thing we say after we say, ‘Thank you for getting on the phone,’ is, ‘Do not give us any material nonpublic information.’” That doesn’t mean the participants comply, of course.
Guerra isn’t holding Ackman’s complaints against him. “I still believe adding Bill Ackman to the board was the right answer,” he says. Yet the winner-take-all nature of proxy contests and the ISS recommendation for management’s slate, with a simple “withhold” on one candidate, meant it was virtually impossible Ackman would get one.
That’s one reason why Guerra wants investors to look beyond the ISS recommendations. “It’s important for our clients to read the report and understand how we got to where we got, as opposed to just saying, ‘Well, it’s just a one-liner for or against,’ because these are never black-and-white situations,” he says. “You’re talking about much bigger companies, much more high-profile contests. You’re dealing with issues that are perhaps more nuanced. A lot of these [recent cases] were operational contests where it’s not just, ‘Hey, put the company up for sale.’ It’s not a simplified argument.”
Such complex fights among antagonists with billions of dollars on the line are likely to continue to test Guerra and ISS. “Our primary focus is maintaining a neutral and independent voice in the process,” he says.
Few doubt his sincerity — but that is not enough. The battles may not be black and white, but the nature of proxy voting means the outcome remains a binary one. As they continue to rage — with activists ponying up more money and corporations becoming slicker at defense — a small group of men sitting in an office park in a leafy Maryland suburb will continue to hold sway over the fate of these corporate clashes. As Guerra himself puts it, “You have to think about the unintended consequences.”
Photo Credit: Image 1: Illustration by Justin Metz; Image 2: ISS offices in Rockville, Maryland. Photograph by Ed Johnson; Image 3: Bill Ackman lost his proxy battle with ADP after ISS backed management.
