NEW YORK (Reuters) - Yahoo Inc will appoint activist investor Carl Icahn and two of his nominees to its board, defusing a proxy battle showdown and making an immediate deal with Microsoft Corp less likely.

The settlement with Icahn, announced on Monday, came just 11 days before Yahoo’s August 1 annual shareholders meeting. Icahn had originally sought to replace the entire board with his own nominees and oust Yahoo Chief Executive Jerry Yang.

But Icahn’s campaign appeared to have failed to win backing from key shareholders such as Legg Mason fund manager Bill Miller, who said on Friday that he would support Yahoo’s board. Legg owned 4.4 percent of Yahoo, according to recent filings.

Icahn failed to convince many investors that if he had won control of Yahoo at the upcoming annual meeting, that he had any alternative for turning the business around, other than to sell it in part or in whole to Microsoft.

“It may be possible it does generate some positive change. Perhaps Icahn can drive some more staff reductions, persuade it to divest its Asia investments,” Jeffrey Lindsay, an analyst at Sanford C. Bernstein, said of the settlement.

“Overall it seems much less likely that there will be a transaction with Microsoft. The market is already reading it that way,” he added. “This looks like a compromise and in general most of these compromises, certainly with ones with Icahn in the past, have reinforced the status quo.”

Yahoo has said Microsoft’s various deal proposals have undervalued its business and instead reached a search advertising partnership with arch rival Google to boost its performance.

Yahoo shares fell 69 cents, or 3 percent, to $21.76 in afternoon trading. The stock is far below Microsoft’s last offer price of $33 per share, a bid that was withdrawn in May. Microsoft shares fell lost 20 cents to $25.66.

A REPRIEVE FOR MANAGEMENT

After six months of on-again, off-again talks with Microsoft that have undermined Yang and his management team’s credibility with Wall Street, the settlement with Icahn could shore up Yahoo’s position in the near term.

“Yahoo’s current management is much better suited for Yahoo shareholders throughout this transition period. It’s not like a vote of confidence, it’s just they’re the right people to get us through the disaster that we’re in,” said RBC Capital Markets analyst Ross Sandler.

“They’ve done a poor job, but unfortunately there isn’t a whole lineup of really good Internet executives who are pounding down the door to take on this challenge.”

Yahoo reports quarterly results on Tuesday and some analysts said the Icahn settlement could help allay pressure over what is expected to be a weak second-quarter performance.

Investor Carl Icahn speaks at the Wall Street Journal Deals & Deal Makers conference in New York, June 27, 2007. REUTERS/Chip East

“They may be able to find a few extra pennies this quarter via cost controls just to show the market that they are making improvements,” Canaccord Adams analyst Colin Gillis said.

But Gillis added it would be difficult for Yahoo to show momentum when it gives forecasts for the current quarter, given economic weakness and competitive pressures hurting online advertising, which could still come back to haunt its leaders.

“The key thing is, is Jerry inspiring people, and if he’s not, then there’s a good chance Carl Icahn will agitate him out of that position,” Gillis said.

YAHOO TO EXPAND BOARD

Icahn, who owned 4.98 percent of Yahoo, called the settlement a “good outcome” and said he continues to believe a transaction to sell Yahoo or its search business should be given full consideration, according to a company statement.

Yahoo said it will expand its board to 11 members from nine, with eight of its existing directors standing for re-election. Icahn will be appointed and the remaining two board seats will be chosen from a list that includes Icahn’s original slate of candidates and Jonathan Miller, former chairman and CEO of Time Warner Inc’s AOL, Yahoo said.

Yahoo said Roy Bostock, Ronald Burkle, Eric Hippeau, Vyomesh Joshi, Arthur Kern, Mary Agnes Wilderotter, Gary Wilson and Jerry Yang would stand for re-election. Activision Blizzard CEO Robert Kotick will not.