In September 2022, Jana Partners made an investment in Freshpet after the company’s stock had dropped by approximately 74%.The firm liked the company and its business a lot, but thought that it was mismanaged and needed a reconstituted board to institute more focus and management accountability. Because Freshpet had a staggered board – one in which a portion of directors are up for election each year – Jana could only nominate four directors to the board last month to replace the four whose terms were expiring in 2023.
Jana made many good operational and capital allocation points in its case for change that alone justified adding one or two Jana representatives to the board. However, it is a big step from adding two new directors to four new directors. Replacing nearly 40% of the board is not something shareholders should do lightly, but it is necessary in situations where the bad performance is not just the problem but a symptom of poor governance, and that could not be clearer at Freshpet.
Forget about corporate governance infractions like a staggered board, which itself is a red flag. Freshpet had unique and somewhat unprecedented examples of at the very least, the board not holding management accountable, and at the worst, serious conflicts.
In 2020, Freshpet’s president and chief operating officer Scott Morris co-founded Hive Brands, a grocery and retail delivery service that focuses on the sustainability and environmental impact of the goods offered. Those goods include high-quality pet food and treats in direct competition with Freshpet. I almost hesitate to mention the “direct competition” point because it implies that this would be OK if Hive weren’t a competitor of Freshpet. Clearly, it wouldn’t be OK. Morris’s employment agreement states: “During the Employment Period, the Executive will devote the Executive’s full time and efforts to the business of the Company.” While it does also state that “The Executive may engage in non-competitive business or charitable activities for reasonable periods of time each month so long as such activities do not interfere with the Executive’s responsibilities under this Employment Agreement,” I do not think “activities” include participating in Hive’s launch, capital raises and management. Moreover, Hive is a competitor of the company by Freshpet’s own definition. The same employment agreement defines a competitor in part as “(i) engag[ing] in the manufacture, sale or distribution of either (A) fresh, refrigerated, frozen or raw pet food; or (B) dry pet food with more than 30% meat content.” But you do not need to be famed legal scholar Laurence Tribe to figure this out: It is highly inappropriate for a senior executive of a public company to work for another firm at the same time.
Additionally, many standard employment agreements include an inventions assignment provision in which the employee agrees to assign to the company any ownership or other rights he acquires through his work or services. Morris’s employment agreement does not have such a provision. But this does not appear to be an oversight as much as an omission through negotiation. Section 7 of his employment agreement governs non-competition and non-solicitation. Section 8 governs confidentiality, and section 9 is where you would normally see rights to inventions covered. However, there is no such section 9. Instead, that section is a standard publicity provision. Additionally, that is not how it seemed to be in the original draft of the agreement. Section 5(e) of the Morris employment agreement states: “The confidentiality and rights to inventions obligations established in Sections 8 and 9 of this Agreement will survive the termination of this Agreement pursuant to this section.” It seems that someone may have missed removing a cross reference in the document.
Ultimately, Morris acquired a valuable interest by founding Hive at a time when he was working as president and chief operating officer of Freshpet and being paid by Freshpet to be “involved in all aspects of Company development and day-to-day operations.” Between 2019 and 2021, Morris received $13.4 million in compensation from Freshpet while he was founding Hive. If the rights to inventions clause remained in the agreement, the company would have a very credible claim to his interest in Hive.
To exacerbate matters, Freshpet’s current vice chairman and former CFO Richard Kassar simultaneously served as Freshpet’s vice chairman and Hive’s CFO until August 2022. He later assumed the role of Freshpet’s interim CFO in September 2022, a post he held until December of that year. Additionally, directors J. David Basto and Olu Beck have served as a director and a formal advisor, respectively, at Hive, according to Jana. Basto resigned from Freshpet’s board, effective May 31, according to a filing with the Securities and Exchange Commission.
This situation seems to go against the company’s general ethics policy, which provides: “Team members are not to engage in outside work or conflicting outside activities that have, or could have, a material effect on the team member’s duties to the Company; imply sponsorship or support by the Company; adversely affect the reputation of the Company; or otherwise compete with the Company.”
Jana attempted to address this by talking to Freshpet about improving corporate governance and adding new directors identified by Jana to the board. The company could have walked away with Jana’s offer of (i) replacing two directors of Freshpet’s choosing with Jana directors, (ii) addressing ongoing conflict and governance issues (including the overlap of certain officers and directors with competitor Hive); and (iii) permitting Jana to provide input and feedback on any potential future board chair. Jana even agreed to defer (ii) above until after the Jana-appointed directors joined the board.
The Freshpet board should have looked at this as a gift from heaven. Instead, the board went in the opposite direction and seemingly attempted to set up obstacles to a fair election, including expediting the annual meeting by moving it to July from that fall. This could be interpreted as an attempt to partially disenfranchise Jana and entrench incumbent directors. Jana was forced to spend the time and money to file a lawsuit in the Delaware Chancery Court, a move it made on June 1. Less than a week later, Freshpet reverted the governance changes back to the way they were prior to Jana’s involvement, including postponing the annual meeting to a date in October.
These types of tactics by Freshpet accomplish three things: (i) it causes both Jana and the company to spend needless time and money; (ii) it creates self-inflicted distractions for management – the kind companies generally complain about any time an activist starts a proxy fight – and (iii) it harms the board’s credibility with other shareholders and Institutional Shareholder Services. Shakespeare referred to unleashing “the dogs of war” as creating a force that – once let loose – is very difficult to control. By making those ill-advised entrenchment governance changes, Freshpet has done just that, even though it has attempted to undo it. The damage has already been done.
If this were not a staggered board, I think Jana would have a good shot at getting a majority of board seats given the company’s behavior and performance. It is only because of Freshpet’s entrenchment device that Jana is restricted to four nominees. If the company can settle for less than that, it should count its lucky stars, take the best settlement it can get and start focusing on running Freshpet – and only Freshpet.
Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and he is the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Freshpet is a holding in the fund. Squire is also the creator of the AESG™ investment category, an activist investment style focused on improving ESG practices of portfolio companies.
