Corporate Governance: Business Judgment Rule Revisited

 

Corporate directors generally are aware of the fact that they are protected by the so-called “business judgment rule”: if a director of reasonable intelligence applies reasonable diligence and doesn’t make a personal profit out of any decisions, then courts will not hold the director liable because he made a mistake.

Corporate statutes, including Delaware and Massachusetts, have long codified this rule, although they do it in a particular way: they set forth an affirmative standard of conduct for directors and then say there will be no liability if this standard is met.

What about corporate officers? They have fiduciary duties to their corporations also. Do they have the benefit of the business judgment rule? Spoiler alert: sometimes.

There is Delaware judicial authority for the proposition of the business judgment rule also applies to officers. In Massachusetts there is a specific statute in the (fairly) new General Business Corporation Act which sets forth a standard of conduct for officers which is similar to (not quite as broad as) the protection from liability afforded by that statute to directors. The supposition that officers are covered in a manner similar to directors is contrary to traditional analysis, but seems to be the judicial trend in Delaware, and in Federal courts in Florida, New York, Illinois and Georgia.

However, recent litigation in various courts has perhaps set in motion a retreat back to the limitation of the business judgment rule as protecting only directors and not officers. Cases in California decided by state (as opposed to Federal) courts seemingly now have restricted the business judgment rule only to directors. And, now director protection is under assault.

Additionally, there is more than one way to skin the cat; persons who might otherwise be protected by the business judgment rule may lose that protection by reason of the nature of the company (bank directors should be held to a different standard given the impact of a bank failure on the economy), directors must be wholly disinterested (often not true in private corporations), directors may have close family ties or business relationships which taint their judgment and deny them use of the Rule, directors may become “interested” if they are intimidated by an interested director (this from Delaware). Further, directors have been held liable if they fail to inform themselves sufficiently of the facts of the case, and directors also are now being attacked by claims made under Federal Securities Laws (the business judgment rule relates to breach of fiduciary duty at common law and not statutory transgressions).

Given the current pressure to “make individuals liable” for corporate failures, particularly in derivative law suits, you rapidly reach the conclusion that the business judgment rule is under great pressure even in protecting directors, let alone applying it to the protection of corporate officers. (Indeed, there are strong arguments that the business judgment rule should not apply to officers, who generally are more involved in company affairs and thus might be chargeable with actually reaching the correct decision, not just trying hard.)

It may be that the Massachusetts statute, codifying a statement of officer conduct similar to the standard that satisfied the parameters of the court-invented business judgment rule, ultimately will prove among the more robust judicial protections afforded to corporate executives anywhere in the country.

SDX: Not a Railroad; an Investor Relations Proposal

The so-called SDX Protocol, a roadmap prepared by directors, advisors and institutional investors to establish a play book for interaction between the investment community and independent corporate directors, was analyzed at the January 13 meeting of the National Association of Corporate Directors/New England.

Historically, such communication has been anathema. Directors direct; member of management, the CEO or the director of investor relations, has laboring oar in communicating with the investment community.

There is a sense that this current practice has not worked well. It may create barriers between investors and directors, leading to misunderstandings which in turn lead to a poor and destructive level of shareholder-company relations.

The SDX Protocol may not be appropriate for all companies, but larger companies with institutional investors might consider adopting some or all of that proposal. In broad outline:

The company designates one or more independent directors, not management, to speak with institutional investors.

Institutional investors designate high level representatives (not just analysts) to engage with the independent directors.

Ground rules are established to set forth topics which cannot be discussed (the kinds of things that relate to earnings or operations, typically matters typically raised in an “earnings call,” should be avoided).

A list of appropriate areas of discussion should be generated (risk management, corporate philosophy on compensation, high level strategy).

Companies must be careful in selecting the board members to speak; not all board members are going to be adept. The Protocol also contemplates the director speaking without presence of either management or third party advisors, something which makes counsel nervous and raises the risk of violation of Regulation FD (impermissible selective disclosure of material inside information).

The SDX approach is radical, and contrary to historical corporate governance. It should be undertaken only very carefully and with consultation with outside advisors. It is unclear whether SDX represents an opportunity to cut into miscommunication, or a probing invasion by institutional investors into areas which should not be generally disclosed, nor indeed selectively disclosed, to anyone.

Drinking with Drizly– an Entrepreneur’s Story

Did you ever get a thirst for an adult beverage during a snow storm, only to find your larder bare? Along comes Drizly, an application that can get your alcohol delivered to you, at least if you are in a city, in twenty to forty minutes.

Nick Rellas, CEO and co-founder of four year old Drizly, explained how he applied technology to the historically staid liquor business. Drizly gives you an app for your phone or device. You use this app to order what you need. Drizly takes that order and sends it to a nearby liquor store under contract with Drizly. The liquor store delivers product, receives and keeps the entire payment.

How does Drizly make money? A monthly license fee from the liquor store. Drizly never touches the beverage, and never touches the money within the transaction. Now in fourteen markets including Boston and New York, Drizly is again raising capital and anticipates substantial expansion in the United States and Canada in the next twelve months.

An additional possible future revenue source could also be from manufacturers or importers, where advertisements could have a click-through button so that, if the consumer wants to buy the product, that information comes to Drizly and Drizly passes it to a retailer, thereby giving manufacturers or importers an immediate ability to themselves drive sales to consumers.

Drizly also has a compliance function wherein identification of persons authorized to place orders has been preprocessed, so as to avoid facilitating distribution to, for example, underage consumers.

Rellas provided his remarks to a breakfast meeting of the Association for Corporate Growth, held in Boston on January 15th. His description of his business model and its application to the consumer marketplace is suggestive of the disruptive impact of web-based services that are reshaping business: Uber and Amazon spring to mind immediately. The founder (who is in his 20s) worked in a liquor store, noted the absence of technology, and applied his generation’s technological skills to the normally conservative liquor business.

Trend in Access to Public Company Proxy Mechanisms

Proxy access, permitting shareholders to nominate directors and have that nomination included in the public company proxy statement itself, remains a volatile issue. You may recall that the SEC’s original regulation to provide shareholder access had two prongs: the first was a set formula by which corporations were required to afford proxy access for director election to shareholders holding 3% or more of the shares of a company, and a second procedure by which companies could themselves “privately order” (custom craft) a proxy access rule just for their own company. The Courts struck down the first part of the SEC regulation, leaving the field open only for private ordering.

Pursuant to private ordering, activist shareholders sometimes have proposed by-law amendments to permit shareholder nominations for directorships. However, a provision of the SEC regulation permits a company to exclude such shareholder proposals if the company itself has proposed a similar rule. As might be expected, company-proposed rules are less generous in affording shareholder access to the proxy mechanism.

In the recently rendered Whole Foods “no-action” letter, the SEC endorsed the company’s rejection of a shareholder proxy access proposal because the company itself had its own pending proposal, even though the company proposal was far more restrictive in allowing shareholder access (it required 9% of the shares held for at least three years, to put forward a proposal, and did not permit aggregation of shareholdings by different shareholders; the SEC required only a cut-back to a 5% threshold).

Although it was suggested that many other companies are flocking to this approach in order to deny the proxy mechanism to shareholders in most instances, discussion continues as to whether suggesting restrictive corporate initiatives, leading to rejection of more liberal shareholder initiatives, should be sustained where (allegedly) companies are pushing the envelope and consequently, de facto, are denying shareholder access to the proxy mechanism.

What your Public Board Should be Doing Now

During the time between year-end and the annual meeting, public boards are planning director elections, effecting audit review to conclude the annual financials, addressing 10K and proxy matters, evaluating shareholder proxy and other proposals from activists, and conducting intensified committee meetings which inevitably follow fiscal year-end. Key board issues for this period were highlighted at the January 13th breakfast meeting of the New England Chapter of the National Association of Corporate Directors, where a panel of financial, legal and shareholder relations experts summarized the current state of play.

From a shareholder communications standpoint, directors shall be focusing on an evaluation of board members standing for reelection. Broader disclosures should be considered, aside from simply reciting education and work background. Consider proactive disclosure with respect to the reason that each individual has been elected to your board: diversity, different skill sets, domain experience, etc.

Management should be prepared to engage activist or institutional shareholders which are likely to have questions after year-end. Have you reviewed your corporate strategy against performance last year? How do you answer questions about your plans for capital expenditure and, particularly, use of excess cash which many corporations have been collecting? Is a share repurchase program actually the best use of company money, given recent analyses that suggest that shareholder value is not thereby enhanced, or is it simply a sign of lack of imagination as to how else to apply the capital?

This is also a good time to review your crisis plan, including identification of inside and outside teams, coverage of social media, and review of “hidden website” content which has been prepared to meet various crisis scenarios.

From a financial control standpoint, boards sometimes find themselves on a somewhat different wavelength from internal audit, which may be directing its attention to operational efficiency. The board’s role is to assure robust financial reporting. Has your board reached out to the internal audit function to make clear that internal financial control is to be given high priority? Has the board engaged its audit committee, or its risk committee, for a year-end review and projection of risks in context?

Other currently hot board topics include: should your CEO be your board chair or should the board chair position be independent (does your board want to undertake a renegotiation of the CEO contract which likely says that the CEO also is to serve as chair?); what is your board’s approach to term limits or “aging out” of directors (might your board be reviewing the European approach which views “independence” holistically, and suggest that ten years of service by definition renders any board member no longer “independent” in a meaningful way).

There will follow a post on the so-called SDX protocol, an organized effort to improve institutional investor access to independent board members.

Bullhorn: A History Lesson in Tech Funding

If ever there was a company which tracks the history of start-ups from the late ‘90s to date, it is Bullhorn. Their highs and lows (they are a software solution for recruiting employees) were traced by Art Papas, CEO and founder, at the December 11th breakfast meeting of the Association for Corporate Growth held on the Boston Fish Pier.

In quick summary: Bullhorn was a dot-com start-up, which took $4,000,000 of venture capital in 2000, at the height of the market for dot-coms when the company had no customers, not to mention profits.

Along came the dot-com bust, and the company’s $235,000 a month burn rate, combined with inability to garner sale during the bust, became unsupportable. Raising additional capital to retool the company came at a huge price in terms of management dilution; the original investors had a full ratchet anti-dilution provision which almost wiped out the founder group’s equity position.

Rebuilding the company over time, in 2008 the original investors were taken out by Highland Capital and General Catalyst. Shortly thereafter, there came the 2008 crash — a bad time for a company whose sweet spot was facilitating the filling of job positions.

Sufficiently resilient to continue to grow at a reasonable pace throughout the “great recession,” in 2012 Bullhorn was acquired by a private equity firm which provided guidance for growth, supported another complete retooling of the software suite, and further encouraged growth through facilitating four acquisitions during the following twelve months.

Bullhorn now claims $67,000,000 in gross sales for the year 2013, a positive trending year for 2014, plans to greatly expand both the size of the enterprise and its top line, and an optimist future which includes going overseas to non-English speaking economies.

While not demonstrating the explosive growth shown by some of the social media or internet giants, the Bullhorn saga is a story of survival and success of a B-to-B enterprise spanning the highlights, and lowlights, of a turbulent economic period. It is stories like this which remind us of volatility over the last fifteen years.

If there is any takeaway, it is that flexibility and receptiveness to rapid change are the key elements for survival in the economic world into which we seem to be thrust.

Life Science: Early Stage Funding Trends

What are the trends in funding early stage life science companies? A panel of seven investors speculated on the 2015 outlook, at a December 10th Venture Summit held in Dedham yesterday.

Riding an increasingly robust funding of transactions at the seed and A-round levels, the investors anticipate continued strong deal flow, driven by a reduction in the funding generally sought by start-ups. They speculated that this reduction was driven by more refined pitches and reliance on internet tools that make start-ups more flexible and efficient. Not mentioned, but perhaps another factor, is the sea change in the manner in which bio and bio-pharma companies are developing their products, in reaction to the massive capital requirements which caused negative investor reaction several years ago.

Hot areas anticipated are oncology, ocular disease, orphan diseases and, in the long run, genetic modification. One panelist, interestingly, suggested that capital is being scared off mass drug development because of the risks of liability arising from continued application of drugs to larger numbers of people over a multi-year period.

What company attributes are attracting capital these days? Robust teams. Proof of recurring revenue. A crisp story presentation. Avoidance of undue complexity (blamed on the lawyers, of course). And, although it can come in many forms, that elusive quality known as “traction.”

Trends in Public CEO Compensation

Stock options are out, performance shares and restricted stock are in, equity may constitute 50% to 70% of the compensation of a public company CEO, and the ISS is on the move. Trends in CEO compensation for the coming year were examined at the November 11th Breakfast meeting in Boston of the New England Chapter of the National Association of Corporate Directors.

Stock options used to be the standard equity play for CEOs. For companies undertaking substantial growth, they still can constitute a serviceable compensation tool for the equity side of the equation. However, performance shares and restricted stock seem to have taken over as the equity mechanisms of choice in most instances.

Other trends include establishing ownership guidelines for a CEO, and what is likely to come next is a mandatory holding period during which the CEO must retain shares after they have vested.

Golden parachutes are shrinking in importance, the multiple of annual salaries paid to CEOs in the event they are fired after a change of control is shrinking. Nobody is any longer granting a tax gross up to these CEOs to cover the taxes in the event they receive a parachute payment.

There was speculation that activist shareholders might be holding down run-away CEO pay, and there was debate over the efficacy or non-efficacy of the proposed SEC disclosure rule which will require information about the “all in” compensation of CEOs expressed as a multiple of the median employee salary. This metric, long overdue, creates problems for companies with international operations, where compensation of a US CEO will be perhaps thousands of times higher than median pay if most employees are located in places like India or China. It was suggested that alternate metrics could be provided, in addition to the required disclosure, perhaps also expressing CEO compensation as a multiple of median United States-only employees.

The influential Institutional Shareholder Services, which advises investors as to whether boards should be supported, is introducing a variety of changes to its outlook on CEO compensation for the 2015 proxy season. In terms of disclosure, credit will be given to companies for positive forward-looking compensation disclosures (historically disclosures have been more backward looking), and in evaluating plans for equity compensation the ISS will be more holistic, considering such matters as planned cost to shareholders (SVT or “shareholder value transfer”), grant practices (including historical plan grant burn-rate), and plan features (minimum vesting periods, minimum holding periods and clawbacks).

The ISS is also considering gender diversity, indicating that boards without women pose a higher government risk to investors based upon academic studies, and is also considering the number of financial experts on an audit committee (implying that having more than one such expert may result in less governance risk).

Getting Reimbursement Codes for Med Devices

Over the last few years, medical device companies have learned that in order to get financing at any level it is not only necessary to establish efficacy and potential economic benefits, but also necessary to understand a strategy for obtaining reimbursement for these benefits. A medical device company, to obtain financing, must show value to the party making the payment, not to another party in the use of the technology.

At MassMEDIC’s November 7th conference discussing markets for medical devices, it was suggested that one way to prove efficacy might be to target a smaller cohort notwithstanding the fact that one’s device might have general applicability. Proof of efficacy in the smaller cohort, and obtaining a reimbursement code, may be easier if focus is narrowed.

Noting that the United States is an outlier in the world’s healthcare universe, spending a disproportionate amount per person on healthcare, it was also noted that the value of a medical device in the United States market is higher by definition. Spending one day in a Unites States hospital is three or four times more expensive than one day in a European hospital. The United States also has an unusual model in that doctors are paid separately, which increases the likelihood that individual doctors will support new devices.

Some key take-aways with respect to the reimbursement system in the United States:

Reimbursement depends upon the setting, with different codes and different rates for the same procedure dependent upon whether that procedure is performed in a doctor’s office, a hospital ambulatory setting, or a hospital inpatient setting.

In the coming year, new ICD-10 codes, with far greater granularity, will be introduced in the United States, with mandatory usage beginning October 1, 2015. This will have huge impact on hospitals. (Coding for doctor offices and for outpatient treatment will continue to be under the CPT system.)

For a variety of reasons, many medical devices these days are first introduced in Europe, in the UK or Germany or Nordic countries. Most of Europe is on a single payer system. We thus have an anomaly: the value of medical devices is highest in the United States but the preferred path of introduction nonetheless is moving toward Europe in any event, by reason of ease of regulatory clearance and obtaining payment.

Why cannot a Med Device be more like a Molecule?

At the November 7th MassMEDIC Boston conference on medical devices, a panel suggested that the medical device industry could learn a lot about how to finance early stage development by looking at the bio pharma model. It was posited that the bio tech model was better, in every year studied, in raising Series A funding and in reaching the IPO market. Why?

One reason: the potential rewards are higher. A single successful drug can sell billions of dollars per year. Further, some bio tech inventions create a platform which may provide the basis for a variety of drugs, or the application of the technology to a variety of diseases, thereby providing the potential of greater ultimate return. Another argument, somewhat circular, is that bio deals can exit at an earlier stage, so the investment is de-risked.

The panel then took a swipe at engineers who design medical devices. Engineers always seek perfection. In bio, once you have a molecule that is done, it is ready for the clinic and then to go to market. Engineers are always tinkering with machines. And, you also have to build machines, which is more complex then replicating a successfully designed molecule. (Whether these arguments are accurate or not I cannot say, but they were advanced by the panel.)

Another major problem is that you cannot easily do clinical trials in the United States on medical devices, which creates a problem for investors.

Then there is the issue of being able to scale in order to earn money. There is high capital expenditure, in order to reach scale and lower the cost of goods, when you are building a machine. This is not true, it was contended, with respect to chemicals.

Finally, it was speculated that the robust level of communication between investment bankers and the bio tech community is not echoed in the medical device field. Medical device companies, it was alleged, don’t really reach out to the investment bankers and tell their story.