Directors in Private Companies: Best Practices

How do boards of directors function in larger, privately-held companies? The answer is: pretty much like boards of directors in publicly-held companies, according to a panel of directors convened February 9th in Boston by the National Association of Corporate Directors-New England Chapter.

Panelist came from a broad variety of companies: Mike Jeans sits on the board of the large Rhode Island insurer AMICA; Ralph Crowley is on the board (and is CEO) of Polar Beverages in Worcester; Ken Dreyer sits on the board of 225 year old King Arthur Flour in Vermont, a company owned by all its employees through an employee stock ownership plan (ESOP) and also organized as a “benefits corporation” with charter obligations to assist the community; Debra Jackson, President of Cambridge College, chairs the governance committee of 198 year old Eastern Bank.

Some commonalities: each company has a robust board of directors a majority of which are “from the outside;” each has a disciplined methodology for adding new directors, and each in a different way attempts to fill particular needs (rather than just hiring “cronies”); each emphasizes formal board procedures including robust “board books” in advance of meetings and reasonably formalized structure for the conduct of meetings; each has a relatively sophisticated system of committees in support of the board.

Notwithstanding somewhat differing fiduciary obligations (King Arthur Flour has strong fiduciary duties to its ESOP as well as to the community, Eastern Bank dedicates 10% of earnings to its foundation, AMICA is responsible as a mutual company to its policyholders, Polar Beverages is still a family owned enterprise), everyone identified their primary obligation in the first instance as flowing to “the company.” If a company is strong, then the rest of the mission can follow.

Other interesting takeaways:

Private boards, as public boards, see a primary function in fixing strategy (management presents strategy and “management comes to the board to have their answers questioned”); for full board meetings, no one goes on the telephone, some companies simply do not allow it (occasionally practice at the committee level may vary); boards are built not only to provide independent input and not only to provide diversity of race, geography, age and the like, but also with a strategic view toward retirements and ongoing need for continuity.

One over-riding theme: public company best practices have substantially infiltrated the operations of all these companies, including with respect to director independence, committee structure, often a designation of a lead director to provide guidance to the board and liaison to management, and in one instance the guidance of counsel to conform governance to listing standards of the New York Stock Exchange.

Clearly, larger private companies are being managed to a high level of professionalism, and directors in these companies attribute robust economic results to that practice.

Growth by Failed Acquisition

Citrix has grown to a $3 billion company driven by approximately fifty acquisitions over the past decade since it went public, enjoying a comfortable 14% CAGR. Why did their senior vice president tell the January 14th Boston breakfast meeting of the Association for Capital Growth that “a significant number of acquisitions have failed from a financial, strategic and talent prospective”?

The answer, according to Tony Gomes (who is also chief legal compliance officer and secretary of Citrix) is that only a few succeeded, but these few were critical. He also noted that, with some assistance from activist investors (with whom Citrix rapidly reached accommodation in order to improve company operations), Citrix is taking a “pause” to focus on its strategic core businesses and providing best service to its customers, while undertaking a couple of spin-offs of ancillary businesses.

What do you do if an acquisition does not live up to expectations? One approach is to use the acquired management and technology team to change direction. Another is to divest quickly, not deterred by loss of sunk costs; the strategic considerations for divestiture trump the pricing.

How does Citrix approach the integration of its numerous acquired companies, which by definition are smaller and perhaps more entrepreneurial? There are two possible approaches: first, you make sure the team stays together by insisting upon three year retention agreements bolstered by financial incentives. Second, for a while Citrix sometimes simply does not integrate the acquisition, leaving it as a free standing operation (particularly for a period necessary to refine a particular product).

Additional take-aways included: it takes five years of further investment in order to successfully build out an acquisition until it scales; as part of due diligence, an acquiror should determine if its own sales force believes that it can sell the “new thing,” the acid test for which is asking whether your sales team is willing to be subject to a “quota”; activist shareholding is the new normal, and SEC prohibitions limiting communications with shareholders get in the way of company’s being able effectively to deal with shareholders.

I asked Gomes whether “taking a pause” without acquisitions was a tolerable strategy for Citrix, which operates in a fast-moving tech market segment. The answer, with a smile, was: this is just a pause, we need a strategic approach to continued growth and that is likely going to lead ultimately to more acquisitions.

Meanwhile, going from less than $10 million of revenue at IPO to over $3 billion of annual revenue based upon a less-than-perfect acquisition strategy doesn’t seem like bad historical performance.

Trending Board Governance Topics

Moving into the proxy season, what are the hottest board topics this year? Disclosure of corporate political contributions, the impact of enhanced SEC disclosure requirements on executive compensation, heightened audit committee responsibility, and board responsiveness to socially motivated activist shareholders, according to an expert panel convened January 12th  by the National Association of Corporate Directors-New England Chapter.

Additional discussion included speculation as to the impact on board governance of the growing number of foreign shareholders (about 15% of all United States equities are now held overseas), and foreign countries have different ideas, including about proxy access [it is normal and why is there resistance?], boardroom diversity [many foreign countries have statutes fixing quotas for female board members], and a greater focus on macro societal issues [impact of overseas reincorporation, breaking up big banks, political contributions].

The panel was critical of proposed SEC regulations attempting to prescribe disclosure of the relationship between corporate performance and executive compensation. The SEC proposals rest on total shareholder return as the metric against which performance pay should be evaluated, and TSR is not appropriate for all companies.

Audit committees will be under increasing pressure to supervise auditors to ensure “audit quality.” This involves making sure that the team of accountants has the requisite time, experience and industry knowledge. There will be increased pressure also on the quality of critical accounting estimates such as fair value, pension liability, loss contingencies and asset impairment. Further down the road, in 2019, revised treatment of long-term leasehold obligations will have substantial impact on balance sheet presentation.

Socially active shareholders last year created pressure on disclosure of corporate political spending, environmental and climate change matters, deforestation, renewable energy, board gender diversity, and perhaps most importantly opening proxy access (minority shareholders having access to the corporate proxy mechanisms for soliciting board vote proxies). These pressures will continue.

Long-term trend? A changing view of the role of the corporation in society, driven by data (for example, data demonstrates higher profitability for gender diverse boards), and demographics, as women and millennial investors seem more interested in corporate social responsibility than traditional investors.

2016: Year of Anomalies?

I generally avoid politics; people have their own views and do not need mine.  I try to stick to things I know a little about: law and occasionally the Boston Red Sox.  (I do better on predicting the former.)

But the name of this site is “Law and Other Anomalies” and the way 2016 is starting out, I cannot resist pointing out a few things that are, well, strange; and we are only five days into the new year.

Do you not find it anomalous that:

One of our staunchest allies in the Mid East, Saudi Arabia, executed 47 people at one time?

When Iranians protested against the execution of a Shiite cleric among the 47, the picture of the protest appearing on the front page of the Wall Street Journal showed the crowd burning the flags of the United States and of Israel, not Saudi Arabia?

When incredibly heightened tensions in the Mid-East must suggest a risk to the supply of crude, the barrel price of oil responded by falling?

Bill Clinton in yesterday’s stump speech in New Hampshire emphasized his support for Hillary by constant reference to his intimate knowledge of Hillary based on his 40 year marriage and their close relationship?

That Democratic Representative Richard Neal, from the Massachusetts Congressional district which houses his largest campaign donor Mass Mutual, would claim that his sponsorship of a bill to lighten regulation on that company’s business (in opposition to the position of his own party’s administration) was merely coincidental?

That Paul Ryan is leading the House, as it reconvenes, to again vote to terminate Obamacare in order to live up to his party’s pledge to its base?

And finally, per headline on page A8 of today’s Boston Globe, “GOP Presidential Hopefuls Poised to Get More Combative”?  (I always love speculation about some development that appears logically impossible.)

Happy New Year to all…..

Accredited Investor: New SEC standard coming?

Last week the SEC issued a staff report seeking reaction to proposed amendments to the definition of an “accredited investor.”

Regulation D is the most relied-upon exemption from SEC (and typically State) registration requirements for the sale of securities, and Reg D relies primarily upon one definition: that of “accredited investor.”  For individuals that means you and spouse have a net worth of $1M or earn $200K (combined $300K)/year.

Possible amendments: limit investments per issuer to a percentage of income or net worth (borrowed concept from new crowd funding rule?); adjusting thresholds for inflation, once or ongoing by indexing; expanding the spousal pooling to cover all marriage/civil union arrangements; grandfathering existing investors who today qualify; setting an additional standard for experienced investors or certain professionals.

The financial standards now in effect date to the Reg’s adoption (although a few years back an amendment excluded primary residence equity as part of the net worth calculation), so marking the financial triggers to market makes some sense; we have not been subject to great inflation of late, but it has been many years and with the Fed now advancing interest rates some greater inflation is reasonable to anticipate.  Capping investment per issuer is more problematical; is it prudence (albeit externally enforced), or meddling in personal decisions (someone is rich enough to invest in speculation but the government will tell you just how much).

Most intriguing is establishing an alternate approach: you may not be rich, but you are pretty smart based on experience or professional credentials so, go for it!  This is a faint echo of the law prior to Reg D, when the registration exemption under Section 4(2) of the ’33 Act was defined under common law and where courts would sometimes consider both how rich and how smart an investor was in order to avoid declaring an offering as needing registration.  Problem in those days was: we never knew how rich OR how smart you had to be, and whether being sophisticated trumped near-poverty.

Corporate Political Spending and the SEC

The SEC has been entertaining, for several years, a rule requiring reporting companies to disclose political contributions.  Yesterday, a compromise budget bill was announced by Speaker Ryan which includes a rider barring the SEC from finalizing, issuing or implementing any action regarding political contribution disclosure.

The general understanding of the proposed SEC action (a rule was first proposed in 2011) was that it was in response to the Supreme Court decision in 2010 (Citizens United) which removed any cap on corporate campaign spending.  That removal is credited with giving rise to Super-PACs.  The proposed SEC Rule, which would be nixed by the budget rider if finally enacted by Congress and signed by the President, drew wide support, including 1.2 million letters from the public, but was staunchly opposed by many Republican lawmakers and by the Chamber of Commerce.

Often overlooked in public discussion is the appropriate SEC role in disclosure.  Corporate management, with and sometimes without specific Board oversight, is spending other people’s money when making a political contribution.  The extent to which that expenditure is sufficiently linked to appropriate corporate purpose is difficult to assess, of course, but it can be argued logically that contributions (at least above a modest trigger amount) are appropriate for disclosure to shareholders.

The House yesterday passed the bill.  Our country’s money runs out December 22; during the next five days, the future of corporate campaign disclosure requirements will be resolved one way or the other.

FDA and Med Devices Today

Dealing with the FDA today is getting slightly easier, but it is nothing to write home about. Agency plans will attempt to improve the regulatory experience; success remains to be demonstrated. Presentations by a research firm and by the Regional FDA office explored the situation at the December 9 MassMEDIC symposium referenced in the last two blog posts here.

For the first half of 2015, FDA approvals have increased markedly as compared to 2014, although the time to PMA approval remained roughly constant which suggests not so much increased speed as existence of backlog. De novo device approvals for the first six months did somewhat better; ten were granted with an average processing time of 12 months. Cardiology approvals seemed to be faster tracked for both PMAs and HDEs (humanitarian device exemption requests). 510(k) approvals for 2014 and 2015, geographically, both showed California as having the highest number, followed by Massachusetts; in 2015 so far, Florida was third, Minnesota fourth.

A rough survey of the activity of the New England FDA District (covering all six states) revealed robust investigative activity, with nine warnings issued for medical devices. Imports are growing “expotentially” with the three primary importers being (in order) Germany, Switzerland and Ireland.

Tentative FDA plans for 2016: increased training for each District office to meet growing device sophistication, and a reorganized focus on assigning reviews based on specialized substantive knowledge as opposed to assigning work merely based on geography.. This latter target is disquieting only in the sense that, presumably, the best people seemingly have not been deployed up to now where their expertise might have been best applied.

Whither US Healthcare?

Where is health care going in the United States? Well, no big surprises: it is costing more, is on an upwards cost trend given demographics (e.g. we are getting older as a population), and it is harder to get reimbursement.

This bleak prognosis came out of Mass Medic’s December 9 symposium (see immediately prior post). Some grim highlights (lowlights?):

Health care costs in the US are 18% of gross domestic product. Pretty high. Increase in chronic diseases is one driver, headed by diabetes explosion. Our population over age 65, now just over 10%, will be 25% by 2050. Between 2007 and 2012, obtaining approval for reimbursement codes for new innovations became (statistically) twenty times more difficult, applying an “effectiveness vs value” standard.

Med device margins, being lower than in pharma, may not permit as robust an innovation culture within established manufacturers as for drugs; the percentage of gross being plowed back into innovation in devices is much lower than for pharma, even after the sea change in the approach of big pharma to drug development (e.g., let’s buy it from someone, not invent it ourselves). A contrary push, however, is coming from the public, now much more savvy about possible benefits which could be delivered. And, non-traditional companies are beginning to invade the healthcare space (think Google Health).

Possible Beneficial FDA Legislation?

At the December 9 symposium on FDA issues for medical device companies sponsored in Waltham by MassMEDIC (the association of device manufacturers), legislation passed by the House of Representatives that would greatly assist the industry was outlined, for the benefit of more than one hundred attending industry representatives and consultants.

The House bill enhances NIH support for innovation, alters FDA criteria for med device trials by incorporating public comment, eases regulatory pathways for anti-microbiotics, grants enhanced exclusivity for new orphan drug indications for existing approved pharmaceuticals, grants priority review by senior staff for “breakthrough devices” where there is no approved alternative, expands scope of data admissible to evaluate device improvements by acceptance of peer-reviewed articles and off-shore trials, and provides a road-map for expedited exemption from need to prove efficacy for “humanitarian devices.” These changes are a useful effort to cut into the regulatory delays which the industry has suffered. (A subsequent blog will outline the current situation in dealing with the FDA.)

Specific NIH highlights: an added $1.86B innovation fund, on top of existing grant programs, for young emerging scientists and high risk research, and changes in HIPAA regulations to make health data more available for innovation.

There is a parallel Senate version that has not been voted upon and which would have to be conformed to the House bill prior to Congressional passage. Can the Congress achieve this, given its divisiveness and other agenda items, particularly in 2016, with a legislative year shortened by the presidential election?

Corporate Noncompliance and Director Liability

Current literature is full of warnings about individual liability of directors when corporations violate governmental laws or regulations. I suggest that the practical risk for directors is minimal.

The United States Attorney General’s Office is out to emphasize that individuals can be criminally liable, not just corporations. Sharper focus results from a September 9th memorandum sent by Deputy Attorney General Sally Yates to all US attorneys, outlining key steps to “strengthen our pursuit of individual corporate wrong doing.” Among other things, prosecutors will no longer soften corporate punishment unless disclosed information concerning the wrong doing includes names of individuals involved. The corporate governance community is just waking up to the facial import of this memorandum.

It is easy to see how active management, failing to follow compliance programs or willfully violating them, can incur criminal prosecution. It is much harder to picture a director, serving only a director’s function, incurring individual liability. The role of the board is to establish a robust compliance program. There is a lot of guidance for how to do that: from counsel, from the government, and indeed from the National Association of Corporate Directors (which has robust materials in this regard). But once the directors adopt a compliance program, and then periodically ask for management to report on violations and efficacy, the directors step back and do not have an active role.

Commentators also now are making reference to the Delaware Chancery Court decision in the Caremark case, which broadly charges directors with a duty to attempt in good faith to assure corporate compliance, and suggests that “in theory at least, [failure could] render a director liable for losses caused by non-compliance with applicable legal standards.”

It is interesting to observe that numerous cases litigated in reliance on the Caremark decision have, to date, not resulted in a single determination of director liability even on a civil level. Further, since criminal prosecution requires intent, or such gross disregard and recklessness as to constitute intent, it is difficult to imagine that a director could be found guilty even under the expanded ambit of the Department of Justice pronouncements. Rather, I would anticipate greater liability on the part of management.

Nonetheless, it is conceivable that the Department of Justice or the SEC will pursue cases against directors in order to force greater attention and, the weight of Federal government prosecution being what it is, it may be that some director someday is going to have to take a plea. But under current law, notwithstanding the mild hysteria today prevalent, I think it most unlikely that individual directors can end up with enough culpability to be found criminally liable.