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Oct 31, 2008

The outsiders

Stunning Napster, three small retail shareholders launch a big proxy fight

The world of shareholder activism has seen a number of significant shake-ups in the past few years. Once the sole purview of large pension funds and the occasional governance gadfly, the activist ring has seen hedge funds throw their hats firmly into it, followed by a handful of ultra-wealthy, self-declared investing gurus.

Now the world of activism may be about to witness another sea change triggered by a group of previously unknown retail investors. It is perhaps appropriate that a former darling of the internet boom plays a central role in this new drama. Napster’s rise and fall and the subsequent legal challenges to its file sharing platform made headlines during the early part of this century but little has been seen of the California company in recent years. That was until September, when Best Buy announced it would acquire Napster.

While the buyout attracted some attention, the real story is the aggressive proxy fight that was taking place behind the scenes.

The three investors


Like many proxy fights, on the face of it, this is a simple story. Yet beneath that façade lies a complicated and far-from-average dissident action. What makes this situation startlingly unique is the demographic of the dissident group: the action was begun by a young investor with a very small holding in the company who was joined by two other small retail holders, none of whom had any prior history with leading a shareholder fight against a company.

So who are these three investors? Perry Rod, a 29 year-old professional investor, Kavan Singh, an entrepreneur who operates ice cream franchises, and Thomas Sailors, an investment manager. For more on the dissidents, see ‘Not so usual suspects’.

How did these individuals get together and decide to work together to launch a campaign? Rod, who got the ball rolling, describes how it happened: ‘I had a contact who was also a Napster shareholder and he was always on the message boards talking about Napster and the management. He helped me to start sending out letters to other people on the message boards and we all came in contact. This was January 2008.

‘I felt the need to do something because of the poor performance of the stock. I had no confidence in the management of the company and felt that something needed to be done. During 2007, I had sold my Napster holdings for a small loss. After that the share price fell around 50 percent and I felt the price was right to buy back into the stock, but I did so with the intention of doing something about the management – namely, getting a seat on the board.’

This was the first time Rod had been involved in a situation like this. ‘I had never filed a shareholder resolution before,’ he explains.

Everyone involved in the case admits that this was not your everyday proxy fight. Bruce Goldfarb, president and CEO of Okapi Partners, who acted for the first-time activists, says, ‘These were not hedge funds, institutional investors or pension funds with a political or social agenda. They were merely three individuals with a sound knowledge of the company and the industry and they had a good understanding of the power of the internet.’

Goldfarb continues: ‘These were three small investors who had invested in a product they knew and loved, not unlike a lot of other retail investors. The three individuals were not happy with the way the company was being managed so they put together the notion of running for board seats.’

Tom Cronin, partner at Laurel Hill Advisory Group, which acted for Napster, says, ‘I think it is fair to say that this deal is a sign of the times in terms of it being a potential indicator of a changing face of shareholder activism.’ He does point out, however, that this was a unique situation in that Napster was a relatively small company with a small group of investors. ‘It is unlikely that the same situation could occur at a larger public company,’ Cronin suggests.

It could certainly be argued that this deal might signal the start of a revolution in shareholder resolutions and proxy fights. While the situation may be specific, it could embolden individual shareholders and highlight the power of modern communication tools in conducting successful proxy fights.

A seat at the emperor’s table


Once Rod and his co-dissidents came together through online chat rooms, they decided to challenge Napster’s board. Launching a number of proposals, the most ambitious was for each of them to gain a board seat. Goldfarb explains: ‘Although they pooled their resources and coordinated communications, they all ran as individuals.’

Rod and the other dissidents credit the work of Okapi for their level of success. It should be noted that the shareholder proposals did not actually come to a vote; the company agreed to sell itself to Best Buy prior to the annual meeting when proposals would have been voted on.

‘What they did for us is one of the most incredible stories. We were three random guys with no experience in the field who came together and we were going to win. That is amazing. They were relentless and as a result we were winning overwhelmingly. At the outset I thought maybe we had a 15 to 20 percent chance of winning but as the process went on we got great support. Overall the three of us held around 1.5 percent of the stock but we were going to get way over 50 percent of the votes,’ Rod enthuses.

‘Napster and the board fought pretty hard against the proposals but we gained a lot of traction,’ he goes on. ‘Our message was very strong and Okapi helped us focus and deliver that message. At the beginning we had a lot of different messages and although they were filled with good content, we did not have a good solid message that would get us elected. Okapi really helped us get focused.’

One of the most significant steps in this challenge was the support the dissident proposals gained from the leading proxy advisory firms. In a statement to Napster shareholders, RiskMetrics declared: ‘Based on our discussions with the dissidents and the company, we believe that the incumbent board may have failed to provide the necessary management oversight to stem the decline in shareholder value and competitive position. As such, we believe that the dissident nominees could provide additional management oversight and perspectives as Napster implements its current strategy or explores strategic alternatives for the company.’

The other proxy advisors recommended support of the raft of governance proposals, although only one supported the election of any of the dissidents to the board. In this case only Sailors gained specific support for election to the board.

Rod explains that a large part of the reason they were able to gain some support from RiskMetrics was because of the extensive interview preparation their proxy solicitor put them through.

Forcing Napster’s hand


The shareholder action has been credited in some circles as being the catalyst for the sale of Napster to Best Buy. Some people even go so far as to suggest the proxy fight forced Napster’s management to sell the company. ‘I do not believe that this was the case at all. There is no doubt that the dissident group was looking to take profit out through the sale of the company but the management at Napster were already looking at a number of options well before the proxy proposal first came to light,’ explains Cronin.

He continues: ‘When we were brought in there were already a number of offers on the table. With pressure coming from dissidents and other market forces at play, there was a renewed focus, but the proxy action was by no means the driver of the sale. We believe the management did a good job in finding a fit for the company and achieving a strong purchase price.’

The dissidents do not agree. In fact, Rod says they were not seeking the sale of the business. He is dissatisfied with the eventual outcome. ‘We believe that the company was not seriously engaged in trying to sell itself in 2006, or in recent times when it claims to have been talking to potential bidders. We also believe it is worth a lot more money than what it is being sold for now.

‘They have agreed to a sale very quickly and are getting a very good deal for themselves (the CEO and board). They had a disgustingly high CEO pay structure and [the CEO] is doing very well out of this change of control. We do not believe that the board had the best interests of shareholder in mind and were working hard to benefit themselves. They didn’t really view us (the shareholders) as people but more as an abstract concept.’

New-wave communication


Another interesting element of the proxy campaign was the use of innovative new technologies in the communications process.

Cronin says, ‘We examined the shareholder demographics carefully and were preparing to use a technology for shareholder communications that as far as we know would be a first. Had the proxy action actually run its course (obviously it did not because Napster sold before the annual meeting), we were ready to send materials via SMS (text) message. This is a very new technology and there may be other circumstances where this would work extremely well. This is just another part of the way our proxy firm can ensure the best coverage and would be done in conjunction with email, phone calls and paper mailing.’

Indeed, that style of communicating with Napster investors dominated the dissidents’ own dialogue. ‘One of the strange things is that for all the communication we had, the three of us have never actually met. All our interaction has been over the phone or via email,’ says Rod.

In some fights money is no option. Large hedge funds and pension funds have vast resources to run campaigns and distribute materials. In this case neither the dissidents nor the company had a bottomless pit of money so carefully managing the process was very important. This was a very tech-savvy group of investors and that made it a lot easier to rely on non-traditional distribution methods, thus making the whole campaign cheaper for both sides.

Despite the level of support gained for the dissidents, Rod is unsure if he would start something like this again. ‘I have to say that after everything is done, I feel far more cynical about the entire process of corporate governance. The more you learn about governance, the more you find out that being a shareholder is not all it is made out to be. When you look at what it really takes for a shareholder to take action, it is quite intimidating. As far as shareholder democracy and the ability to have your voice heard, a person who holds 1,000 shares might as well have none.

‘It is very frustrating to have to spend so much on a monopolized system of voting. There are so many impediments to the process and so many tricks that a CEO and management can pull to make it almost impossible to win a vote. It is almost not worth going through with it unless you are a real crusader.’

Yet, after the success of this deal, it is clear we are going to see more small hedge funds or individuals take ownership positions in smaller companies and then press for change.

Brendan Sheehan

Brendan Sheehan is the former Executive Editor at Corporate Secretary magazine, and is a leading expert in public company governance and compliance. He regularly lectures on cutting edge governance, risk and compliance issues and is a regular...