Assessing Management And Governance Quality In U.S.

Corporates When Activist Investors Engage

Primary Credit Analyst: Laurence P Hazell, New York (1) 212-438-1864; laurence.hazell@standardandpoors.com Secondary Credit Analyst: Joyce T Joseph, New York (1) 212-438-1217; joyce.joseph@standardandpoors.com

Table Of Contents
The Current State Of Activist Investor Influence Credit Analysis Is Affected, But Ratings May Not Change Related Criteria And Research

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(Editor's Note: The opinions stated herein are intended to represent Standard & Poor's Ratings Services' views on how activist investor initiatives affect our management and governance assessments. Our comments in this article do not affect our current rating criteria.) The analysis of management and governance is among the most qualitative elements of Standard & Poor's Ratings Services' ratings criteria. Nevertheless, the methodology is evidence-based (see "Methodology: Management And Governance Credit Factors For Corporate Entities and Insurers," published Nov. 13, 2012, on RatingsDirect). This evidence can come from many sources, ranging from our assessment of company executives and directors during management meetings, to the quality, timeliness, and transparency of corporate communications. Among these many sources, management and board responses to an activist investor provide crucial insight into management's flexibility in meeting new challenges, and the board of directors' responsiveness and engagement. In addition to our evaluation about the business or financial effect that activist proposals may have on creditworthiness, management and the board's responses to these investors create an opportunity to gather significant information about their qualities as leaders of the corporation. Their collective ability to communicate their vision and strategy for the company, their willingness to listen to and consider alternative perspectives, and ultimately, their ability either to constructively adopt a new direction or convincingly articulate why their own current plans are the right ones rank among the most fruitful sources for these qualitative assessments of corporate leadership.

The Current State Of Activist Investor Influence

The role of the activist investor has broadened considerably in recent years. Not so long ago, activists' demands mostly sought quick returns on shareholder investments through leverage. That type of demand, although still widespread, particularly at companies with speculative-grade ratings, now exists alongside activists' calls for strategic change, highlighting concerns about management's operational effectiveness or views about directors' oversight deficiencies. These changes in activist focus reflect many factors, among them enhanced proxy processes and the significant developments in electronic communication for companies and investors alike--along with the expectations that such communication enhancements generate. In addition, the proliferation and sophistication of hedge funds and the collaborations they sometimes forge with large, deep-pocketed investors like pension funds create a formidable voice that most corporations find hard to ignore. This activism also reflects a contemporary economic environment characterized by low interest rates and volatile investment returns, as well as investors' desires to take on debt to build improved businesses and boost those returns. Many activist proposals indicate that they are the product of substantial research about the company's business prospects and financial condition and often follow a period of engagement with the company prior to becoming publicly articulated "activism." Activists address these kinds of concerns most often

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with investment-grade-rated companies. Purchasing a block of shares exceeding 5% of the outstanding shares of a publicly listed company in the U.S. requires a Schedule 13 filing with the Securities and Exchange Commission. The higher market valuation of investment-grade companies generally makes acquiring such a significant stake unlikely and generally limits certain activists to companies in the 'BB' or 'B' categories. However, because many corporate ratings have migrated to this range, an activist's presence remains a significant rating consideration. Activism in this part of the ratings universe often resembles actions of the corporate raiders of the 1980s, wanting the company to pursue financial policies that, in our opinion, could significantly increase leverage and likely would hurt a company's financial risk profile. By contrast, activist involvement in investment-grade companies is more often associated with pursuing initiatives to change the corporate strategy or to highlight concerns about management's operational effectiveness or the quality of board oversight--matters that can modify our evaluation of a company's business risk profile. Of course, there are exceptions to these general examples, but they hold true broadly. Actually, there are few common characteristics among activist investors, apart from their willingness to engage--sometimes aggressively--with managements and boards. "Investment-grade activists" do not have to--and with the larger investment-grade companies, likely could not--amass a significant stake in a company, or even one that would require a securities filing, to be influential. A current example of this was the April 22, 2013, announcement that ValueAct Capital, which we regard as an activist investor, had made a $2 billion investment in Microsoft Corp. (AAA/Stable/--). Although this was a large investment by any standards, it represented less than 1% of Microsoft's market capitalization. And the size of that investment suggests that the activists' engagement with the company's management and board is likely under way. On June 6, 2013, the Federal Trade Commission announced that it had granted anti-trust clearance for ValueAct to pursue an as-yet unidentified transaction with the company. Therefore, it is the activists' ideas, not the size of their holdings, that present the challenge for managements and boards and why the latters' responses provide such good insight into their leadership capabilities and qualities. Even the decision not to engage with these investors provides an indication of management and governance characteristics that is illuminating for analytical purposes.

Credit Analysis Is Affected, But Ratings May Not Change

Below are five examples from our U.S.-based current, and in one case former, investment-grade universe that illustrate the type of shareholder actions activists take, along with corporate responses and their effect on our analysis of the company, together with any changes in the rating or outlook. Although our focus here is on the United States, we do review activist initiatives globally, taking into account the many variations that jurisdictions, laws of incorporation, and securities and disclosure rules impose on the actions of a company and its investors.

Timken Co. (BBB-/Stable/--)

Relational Investors LLC and the California State Teachers' Retirement System (CalSTERS) tabled a shareholder proposal to spin off Timken Co.'s steel operations from its bearings business into a separately traded public company.

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The 2013 proxy statement and subsequent filings by the three parties set out pros and cons of this initiative in great detail, alongside assertions that each of their respective analyses was flawed. The shareholder proposal received a majority of the votes cast at the company's recent annual meeting. However, Timken's management and board had earlier made clear that they did not intend to act on the proposal and recommended a vote against it at the company's annual meeting. Nevertheless, on June 10, the company said its board had formed a committee to evaluate the potential separation and retained Goldman Sachs & Co. to assist in that evaluation. We consider management and governance at Timken to be "satisfactory," as defined in our criteria. Our rating and outlook on Timken are currently unaffected by Relational and CalSTERS' actions. Standard & Poor's continues to monitor the situation to determine the credit effect of any corporate initiatives in response to the shareholder vote.

Hewlett-Packard Co. (BBB+/Stable/A-2)

Ralph Whitworth, the founder of Relational Investors, approached Hewlett-Packard Co. (H-P) about a board seat in November 2011, calling for a more careful approach to the company's capital spending as it began its turnaround effort after a period of turbulence and senior management turnover. Although Relational is capable of vigorously jousting with companies (as it did with Timken, above), Mr. Whitworth's engagement with H-P appears to be more closely aligned with the efforts of management and the other board members, as he was named interim chair of the board in April 2013. It is worth noting that the presence of one activist on a board of directors does not necessarily secure forbearance from other critics. Calls for certain H-P board members' resignations by, among others, New York City Comptroller John Liu resulted in significant votes against those individuals and their subsequent departures at this year's annual meeting. Our "fair" assessment of H-P's management and governance reflects turnover among senior management and the board in recent years, which, in our view, elevated the operational and execution risks in achieving management's strategy. However, the recent board departures have had no further effect on our rating or outlook on the company.

Dell Inc. (BBB/Watch Neg/A-2)

Dell Inc. may appear an odd candidate to include under an "activist" category because the company's founder, Michael Dell, and technology investor Silver Lake Partners are orchestrating a transaction to take the company private, announced on Feb. 5, 2013. However, subsequent developments, including alternative proposals suggested by veteran activist Carl Icahn and significant valuation questions raised by a number of investors, make Dell a good example of "activist" activity. Although rumors of a leveraged buyout surfaced at the beginning of the year, we took no action on the rating until the announcement of the $24.4 billion Dell and Silver Lake transaction, when we placed the 'A-/A-1' ratings on CreditWatch with negative implications. With all the investor engagement, management and the board have entered into a protracted process that has proven a significant challenge in terms of timely and adequate investor communications, providing insights into management and governance practices at the company, which we currently score as "satisfactory." On May 20, we lowered our long-term rating on Dell two notches, to 'BBB' (and the commercial paper rating one notch, to 'A-2'), based, among other things, on weak operating performance, including a 79% drop in net income from the previous year-end period. The ratings remain on CreditWatch negative.

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A shareholder vote on the Dell and Silver Lake initiative is now scheduled for July 18, 2013, after no better offer emerged during a "go shop period," during which the company sought competing offers even after it had received the firm purchase offer. However, the proposal is still the subject of significant opposition from Mr. Icahn and the company's largest shareholder, Southeastern Asset Management. The continuation of the CreditWatch after the May 20 downgrade reflects the possibility that we could downgrade the company out of investment grade following our analysis of the proposed capital structure, financial policy, and strategic direction under new ownership (see our full analysis on Dell Inc., published June 4, 2013, on RatingsDirect).

Procter & Gamble Co. (AA-/Stable/A-1+)

We monitor sudden or unexpected departures of key executives because they can be a harbinger of change that could have credit implications. In July 2012, activist hedge fund owner William Ackman, of Pershing Square Capital Management, announced that he had purchased $1.8 billion in Procter & Gamble Co. (P&G) stock (less than 1% of the stock outstanding) to push for changes in the company's top management and deeper cost cuts to improve profitability. We believe the abrupt departure of CEO Robert McDonald likely reflects, at least in part, the influence that Mr. Ackman has had on the company's board. However, we have taken no action on our rating or outlook because of P&G's "strong" management and governance profile, our favorable view of the company's strategic positioning, and management's track record of innovation, market leadership, and solid operating performance through economic cycles. (See our summary analysis on Procter & Gamble Co., published May 13, 2013.) In addition, Mr. McDonald's replacement with former CEO A.G. Lafley should result in a smooth transition, although we expect succession planning and compensation issues to remain a focus for investors. Of course, such influence is not always positive for a corporation or its credit quality, as Mr. Ackman's own experience with J.C. Penney Co. Inc. (CCC+/Negative/--) attests. Pershing, along with Vornado Realty Trust, pushed for a complete makeover of the retailer. The company implemented an initiative without trying it out on a limited basis to see how customers might respond, and they reacted negatively, as reduced sales have indicated.

CommonWealth REIT (BB+/Stable/--)

The credit measures of CommonWealth REIT, an office and industrial real estate investment trust, have weakened in the past few years, reflecting lackluster office market fundamentals, particularly in the trust's suburban markets. (See the research updated titled, "CommonWealth REIT Rating Is Lowered To BB+; Outlook Stable; 2 Recovery Rating Is Assigned To Senior Unsecured Debt," published June 10, 2013.) Responding to these performance declines, CommonWealth announced it would launch a $450 million public equity offering and related debt tender offer and pursue the sale of securities it holds in related entities. Shareholders, critical of the dilutive effect of the offering and with the share price below the trust's net asset value, raised concerns about the company's external management structure and governance profile generally. Two of the trust's investors, Corvex Management L.P. and Related Fund Management LLC, have been extremely active in challenging management and the trust's board, including attempting to remove all five members of the board. Because the board's members are elected to three-year staggered terms, Corvex and Related began a "written consent" process, which enables shareholders to act on a proposal through a written ballot in lieu of a shareholder meeting. CommonWealth has sought to block this initiative in a number of ways, including bylaw changes, and the matter is scheduled to be arbitrated in Maryland, where CommonWealth is

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incorporated. On June 21, Corvex and Related announced that they had delivered consents from holders of more than 70% of the shares outstanding approving the proposal to remove the entire board. In our opinion, this trust has a "weak" management and governance profile. Key attributes of this assessment are a staggered, small, and interrelated board that we believe lacks independence from management, and our corresponding negative assessment of the degree of control exercised by the trust's key executives, who also control the external management entity. These governance deficiencies have become apparent to us in various ways, including the failed election of a trustee at this year's annual shareholders' meeting, which resulted in the board's reinstating the trustee. That failed election reflects, in our view, the poorer alignment of interests between shareholders and management compared with internally managed REITs. More broadly, the actions and responses of CommonWealth's management and board demonstrate the potential for insufficient oversight and scrutiny of significant enterprise risks--key among them being future access to the institutional debt and equity markets--at least until the shareholders' issues have been resolved. On June 10, 2013, we lowered our long-term rating on CommonWealth to 'BB+' from 'BBB-' and removed all our ratings from CreditWatch with negative implications following an impairment charge the trust took related to poorly performing office properties. We could lower the rating again if portfolio trends worsen.

Related Criteria And Research

Standard & Poors Assigns Management & Governance Scores To More Than 2,000 North American Companies, May 13, 2013 JCP And Sears: Two Retailers At A Crossroad In Their Turnaround Plans, April 18, 2013 Methodology: Management And Governance Credit Factors For Corporate Entities and Insurers, Nov. 13, 2012 How We Use Management And Governance Credit Factors, Nov. 13, 2012

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