Company Boards: Changed 2018 Focus

Everything from the new Tax Act to the”#Metoo” movement to changes in compensation for public companies to the rapidly developing focus on sustainability will create new and significant agenda items in 2018 for corporate boards and their committees.

An expert panel convened in Boston on January 9 by the New England Chapter of the National Association of Corporate Directors outlined anticipated areas of intensified board focus:

What does that Tax Act mean for your company?  What disclosures must you make if you are public?  What impact will the Tax Act have on your underlying business and profitability?  On your financial statements in terms of both content and format?  How will the Tax Act affect your earnings guidance, so as to avoid surprising the Market?

For public companies, the Tax Act repeals the Safe Harbor in Section 162(m) of the Code, which permits public companies to deduct senior executive compensation above one million dollars a year only if such compensation is “performance-based.”  (Private companies can continue to take such deductions without regard to whether or not compensation in excess of one million dollars is performance-based.)  This change for public companies will likely drive alterations in compensation schemes, but may also be liberating for compensation committees, which now can fix compensation based on changing company-specific metrics without suffering variances in tax treatment.  Attention must also be given to how the compensation changes are reported in the publicly filed CD&A.

Culture may be elusive to define.  Cultural tone may be set at the top.  “Culture” is a very broad concept, hard to understand and yet the Board is responsible for making sure that the “right culture” obtains.  Part of the “culture” issue has to do with sexual harassment.  But part of it has to do with sensitivity to sustainability (for more on sustainability, see below).  Corporate culture has ramifications not only in the price of your shares, but also resonates in the hiring (or non-hiring) of desired millennials, and may affect the acceptability of your products and services in the consumer marketplace.

Sustainability, part of the growingly popular acronym “ESG” (Environmental, Social and Governance factors), is of importance to a variety of constituencies.  It is of great interest to professional shareholders which are, more and more, studying sustainability in making investments.  (One audience member challenged this general comment by suggesting that private equity acquisition firms are at present not focused on sustainability).  One speaker suggested that companies should have a separate “sustainability committee.”  Such committee might focus on a variety of functions:  internal training (citing the Equifax hack), proxy transparency particularly with respect to climate matters, and (for private companies) addressing “sustainability” so that public companies to which they sell products and services can advise their own constituencies that their own sustainability programs apply not only to internal matters but also to their vendors and business partners.

A final word about environmental issues; there was tacit consensus that the environmental aspects of ESG will continue to be a major focus, and it “doesn’t depend on who is in the White House.”

 

Good Faith When Fiduciary Obligations are Waived by Contract?

This third and last post, based on noteworthy Delaware Court decisions during 2017 which I had not addressed in posts during the year, engages the seemingly technical question of what if any duties does a general partner owe to limited partners where the partnership agreement, not atypically, waives all fiduciary duties owed by the GP.

We are all aware of the waivers of duty obtained by sponsors of deals, allowing them to self-deal without running afoul of the fiduciary obligation owed by partners to each other under basic partnership law.  Recognizing that a GP cannot, however, contract with someone to permit that GP to steal from investors, often LLC and partnership agreements have mechanisms to protect the investors from what I will call in lay terms an “outrageous overreach,” typically drafted into sections that allow the controlling party to enter into transactions for his or her own account, or the account of his or her controlled entity, without facing some legal claim.

There is also in contract law (LLCs and partnerships are after all just contractual arrangements) an ill-defined but time-honored rule of construction that imposes on all parties an obligation to act with good faith and fair dealings with all other parties in the transaction.

In the January, 2017 Delaware Supreme Court Decision in  Dieckman v Regency, a GP undertook an interested party transaction and attempted to comply with both of the procedures set forth in that particular LP agreement.  He sought approval from a Conflicts Committee, which was allegedly tainted by self-interest.  He also sought a vote of the independent investors, but the complaint alleged that the materials given to the investors to induce approval for the transaction were false and misleading.

The Chancery Court below held that the complaint must be dismissed because all fiduciary obligations were waived in the contract and thus no argument could be made that misrepresentations violated such obligations.

The Supreme Court reversed and ruled that even where all fiduciary duties are waived, the implied covenant of good faith and fair dealing prevented the GP from misrepresenting to the investors to induce their approval.  In reaching this not-very-startling conclusion, the Court tripped over itself to explain that a waiver of fiduciary duty is not a license to lie and thus deprive the investors of their contractual right to approve or disapprove the transaction.  The covenant protects against action taken “arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected.”  What are these fruits of the bargain, as they are not expressly stated in the document; and indeed appear to have been waived?  Some “fruits” are so implicit that they need not be expressed, as their existence is “necessary to vindicate the apparent intentions and reasonable expectations of the parties.”  These fruits are “so obvious … that the drafter would not have need to include the conditions as express terms of the agreement.”

What then can we deduce as the legal meaning of the implied covenant of good faith and fair dealing?  “You cannot lie, cheat or steal.”  Not radical concepts, and it would be amazing if a Court could not find its way to so holding.  As for how the Court explains and relies upon the implied covenant — well, it seems to me that my articulation is more direct and understandable than the lawyerly and extensive explanatory efforts of the Supreme Court.

And if a GP is tempted to seek a waiver, in the partnership agreement, of any claims based on an implied covenant of good faith and fair dealing, thus meeting the covenant head-on?  One might expect the Court to void that waiver as against public policy, putting aside that even the most jaded of investors might blink at such a startling provision.

Entrepreneurs Part Ways– Can One Pursue the Business?

We all are aware of the fragility of start-up enterprises.  What happens if a couple of people decide to give up their joint dream; can one of them take the opportunity for himself/herself?

This summer, a Delaware Chancery Court case engaged in analysis of this common question.  As in so many things corporate and fiduciary, the answer is, “it depends on the facts.”

The facts of McKenna v Singer (decided July 31, 2017) are too dense for meaningful summary and if you want a deep dive then read the forty page Court recitation, but the bottom line was that one of the former pair of entrepreneurs was allowed to take the deal for himself.  The fact that the plaintiff in this case misrepresented at the beginning and thus had “unclean hands” was a factor; it is unclear if the business logic of not letting an entrepreneurial idea get frozen to death, with no one able to pursue it, might have entered into it sub rosa.  Further, plaintiff was seeking part ownership of the new enterprise, and the Court might not have wanted to impose a shot-gun wedding on the two former partners who had themselves declared themselves divorced.

I will (almost) refrain from the typical lawyerly advice that at the start the entrepreneurs could have addressed this event by contract; entrepreneurs are short on time and money and often don’t want to spend either in addressing the ground-rules for their failure.

I also note that this is a Delaware decision, it has unique facts (don’t they all), and I am aware of some older Massachusetts authority that treated the business idea as a joint asset, of value to the abandoned enterprise, that could not be taken by only one player (and indeed suggesting that until the fight were resolved, neither party could act, a business result that is almost a death-knell in today’s speedy technology economy where getting to market fast is the difference between success and failure).

Particularly in start-ups set up as LLCs, which is the trend, writing something into the operating agreement about who owns the business idea in a divorce continues to look like an attractive idea; the only question is, what would it say?  Each equally?

Board Liability under Caremark

Caremark is a notable Delaware Court decision establishing the principle that, while corporate directors are protected from suit based on errors made in good faith and without self-interest, directors nonetheless can be liable if they simply ignore significant corporate matters which ultimately injure their company.  It has been difficult in fact to find successful assertion of a breach of this duty to diligently supervise, however.  Last month, the Delaware Supreme Court again highlighted that difficulty.

Duke Energy suffered liability for numerous environmental violations.  The board was sued for  breach of its duty properly to supervise the response to this liability; suit was brought without a prior demand on the board to cure its actions on the theory that such demand would be futile under the statute.  Noting that the majority of the board consisted of independent directors, the Court found that the plaintiffs indeed failed to make a required demand as such demand would not have been necessarily futile.

It was conceded that the board was indeed aware of the environmental liability, even based on criminal activity.  But knowledge did not mean that the board permitted illegal behavior through failure to maintain sufficient internal controls.  Plaintiffs failed to establish at the pleading stage that the board knew that the company was ignoring the violations, even though the board knew of these violations.

The Court decision is facially startling.  One might expect a vigorous response on the record from an independent board knowing of criminal environmental wrongdoing.  The decision emphasizes the hesitancy of the Delaware Courts to affix liability to directors, not involved in self-dealing, based on their exercise of their judgment about how to handle all manner of issues. A dissent from one justice hearing the case would have decided the case differently, but clearly the extent of breach of duty is a matter of judgment resting in the eyes of the beholder, and directors seemingly can be pretty far off-base without incurring legal liability for their actions absent self-interest.

Uber Alles?

 

Today’s news brings word of the filing yesterday of a Delaware class action brought by Uber shareholders against directors for approving the acquisition of a company formed by a defecting Google employee who is accused of downloading trade secrets of Waymo, the self-driving car company which is owned by Google.

Waymo sued Uber earlier this year, claiming the trade secret theft, which resulted in a criminal investigation and the allegation by Waymo that its damages were estimated at $2.6B.

The suit against the Uber directors claims lack of care and good faith, based on allegations that Uber knew that stolen intellectual property was involved. The speed with which the company (bought by Uber) was able to ramp up and hire former Google employees and then immediately sign a term sheet to sell to Uber was cited as a smoking gun.

While facially the complaint makes a coherent argument, which argument would be bolstered if the allegation of board knowledge is true, plaintiff Uber shareholders are going to have to overcome the business judgment rule to affix liability on Uber directors. That rule generally protects directors if they make business decisions, however badly they turn out, in instances where such directors do not have personal self-interest.

Unless the level of prior board knowledge made it clear that IP had in fact been wrongfully obtained, Uber directors may be found to be wrong in their judgment but not in violation of their fiduciary duties. Courts, particularly in Delaware, are uncomfortable in second-guessing business decisions of boards even if those decisions result in failure; the metric of risk and reward is the bailiwick of business people and not courts. Unless the board decision was so off-base that reasonable business people who were paying attention would never take the identified risk inherent in that decision, courts are likely to default in favor of giving the board the right to take its chances, even if the result is a disaster.

Plaintiffs also will mount claims based on the separate basis of director lack of care  (not paying attention and doing normal diligence).  Claims under this theory are difficult to establish, generally requiring a demonstrated laxity in practice that presents a high evidentiary bar.

This case is not likely the kind to make new law. The facts will drive the result based on established principles of liability and defense. But the case will be fascinating to watch; the Uber deal was high profile and raised eyebrows at the time it was announced; and, it involved lots of money in a hot business space. There is going to be a raft of expensive lawyering going on here; stay tuned.

Trends in Compensation Committees

An expert panel convened this week by the National Association of Corporate Directors – New England identified current issues occupying compensation committees as they begin to engage on policies for the coming fiscal year.

One surprise: tremendous attention to the much-maligned SEC Rule requiring that current proxies contain a disclosure of the earnings ratio comparing a company’s CEO to the earnings of a “mean” employee.

I recently posted that ISS, in survey, had discovered that this much-criticized and much-delayed disclosure had actually proven to be of interest to investors, notwithstanding the fact that analysis during the Rule’s adoption debate suggested that the data was superfluous. The panelists speculated that such disclosure will cause executives to question whether all management is being properly paid, and will trigger discussions about compensation strategy throughout the organization, and about the entire “employee value relationship.”

What is the value proposition for an employee, why should that employee want to work where now situated and at current compensation? Millennials might be more attuned to such issues; millennials do not anticipate permanent employment relationships and may be more interested in what a company offers by way of career development.

The panel also noted that much more attention was being paid to “fair compensation” of minorities and women. Since 55% to 60% of current college graduates are women, boards should ask for hiring metrics for women at all levels. The absence of women at senior levels, and sitting on boards, is “a problem” and comp committees should make sure that pay is monitored by gender and that accurate data is provided. It is necessary to specifically call out wage disparities, as the only way to eliminate them: “if it is measured, it gets done.”

The perennial issue of balancing compensation incentives between rewarding short-term goals and rewarding long-term strategic goals was discussed at length. It is necessary for the compensation committee to determine what results are most important, and to provide a compensation and bonus strategy that specifically rewards desired outcomes. There is a problem where strategic goals are long-term: how do you craft a bonus plan, for example, where somebody is working during the first year of a five year strategic program? The general approach for rewarding people working on long-term strategic issues is to provide individualized bonuses, and not to rely on the over-all comp/bonus program (which is generally driven by financial metrics).

Finally, the operational aspects of the compensation committee were discussed. Often there is not enough time to deal with matters which must be addressed as a matter of corporate governance, and then have time to discuss the philosophy of compensation. Ways around this include: an organized and strong chair; receiving the board package well in advance so that members of the comp committee can discuss by email or telephone some of the issues presented prior to the actual meeting; a dinner of the committee prior to its formal meeting, in order to provide soft exposure for ideas and to facilitate communication (a practice of many boards but not committees).

CEO Pay Ratios and the Investors

Confusion reigns.  And that is an optimistic summary.

You will not doubt recall that no one except the US Congress wanted to impose a disclosure requirement that public companies calculate and report the ratio of CEO pay to median pay in their company.  Among the reasons: meaningless data;, some companies have low paid employees overseas (or even domestically) and the CEO pay will look absurdly high as a punishment for effectively keeping down costs; impossible to calculate for large companies; no one cares.

So the SEC dragged its feet and, several years late, promulgated the Congressionally mandated Rule of disclosure, but delayed its effect for a couple of years until the 2018 proxy season.  Many of us thought the new administration would kill the disclosure, so why worry?

Get worried. Look at the calendar.  Note that the SEC has announced they are not reconsidering their effective date.  Guess if the Congress is going to allocate band-width to this issue.

It gets worse.  ISS, the major proxy advisory firm, has advised it will not even consider the ratio this year in its proxy guidance.  And surveys of company management and boards indicated that they were sure that investors would not care.

BUT then, someone (ISS in fact) surveyed the investors and guess what: a clear majority of investors are interested to compare the ratios within industry sectors.  Surprise!

Now the SEC has issued a rash of recent rulings softening the permitted procedures for calculating the ratio, and promising not to prosecute erroneous reports provided the companies in effect “tried to do their best.”

But still…. There is one hope.  Perhaps the investors will be looking at the ratios not in an effort to cap CEO comp based on a great disparity (the Congressional intent).  Perhaps they will be looking, rather, for an INCREASE in the disparity of pay over time, as evidence that the good CEO will be dropping the cost of labor, and that the CEO should be rewarded for that by even-greater pay disparity.

Anyone out there willing to bet on that?

When the “Money” is on the Board

What are the ramifications for a corporate board when investor activists or investor-designating directors join?

Todd Kraznow, a member of several boards including Carbonite, noted (at the NACD conference last week in Boston) that whether or not you accept an activist on your board involves an evaluation by the directors as to whether that activist is bringing a different corporate direction which is fairly judged to be worthy of exploration. With an activist on the board, the acid test is whether that new board member actually is able to “perform” and not just ending up “yapping.” If the latter, that new director can be isolated, can be a problem and will not contribute.

Kraznow suggests that rather than seeing activists as the enemy, they should be treated and evaluated as shareholders with just another particular set of investment goals, like all other shareholder cohorts.

I am not convinced that most boards share this view; lawyers often are called upon to thwart the activist, not evaluate the activist’s ideas. And as for directors sitting by designation by investors or PE or VC firms, companies may know that this comes with the territory but are wary of disparate goals down the line and struggle to counter-balance and out-vote these directors to the extent the company has the leverage to negotiate the investment deal.

 

Three Most Important Attributes of a Good Corporate Board

At the end of a lengthy discussion of key board practices at the NACD Boston conference, a panel of senior corporate directors was asked, “what is the single most important secret of an effective corporate Board?” You might expect a sophisticated set of responses. It turns out that what was deemed most important was basic blocking and tackling:

First, board members must show up at the board meetings fully prepared.

Second, cell phones off.

Third, diversity of all sorts on the board, including diversity in substance, diversity in race, diversity in gender, diversity in ethnicity and diversity in geography.

My personal response, based on decades of sitting on and advising boards, is “ability to be quiet and listen to the end when someone speaks.” At board meetings, egos sometime run rampant, everyone trying to prove how smart they are. Listening fosters respect and cooperation; if the right people are in the room, that cooperative dialog drives good decision-making.

 

Board Term Limits and Age Caps

What is the current thinking on whether corporate boards should impose director term limits, or a maximum age for service?

According to the National Association of Corporate Directors/New England panel, there is a risk, with either term limits or maximum age limits, that valuable institutional knowledge can be lost. However, at least with public company boards, maximum age and term limits are often imposed.

Nelda Connors, Director of several public companies including locally based Boston Scientific, noted that her experience in the United Kingdom was that term limits were capped at three elections each for three years, a total of nine years. After that much exposure to the company, the director was no longer considered to be “independent.”

At Eastern Bank, after extensive consideration the maximum age limit for directors was recently amended from age 70 to age 72, with a maximum service of 20 years in the aggregate.

Based on experience, a corporation can bridge the experience gap and still term out directors by placing vibrant ex-board members onto an active advisory board or “promoting” them to “emeritus” status; these solutions often obtain in non-profit settings. For business corporations this is not a common practice and, for public companies, virtually nonexistent.