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.

Building an Effective Board of Directors

How do you build an effective board?  It depends on the stage of the company, as different board needs arise at different points in corporate growth, according to an expert panel convened in Boston on October 17 by the New England Chapter of the National Association of Corporate Directors.

Early-stage boards tend to be small, insiders only, and highly focused on getting the basic product or service correctly structured.

Boards of larger companies with greater internal resources are able to turn their attention to more mature subjects: risk evaluation, CEO succession, monitoring performance, and most importantly fixing corporate strategy.

There is thus a need for a dynamic board model, with membership updated over time, as companies mature. How do you achieve this transition? One method is through board self-assessment, leading to a candid evaluation of how well the board is functioning vis-à-vis company needs. Another method is through an independently director, or perhaps a CEO/Chair, having candid one on one conversations with individual directors about how they are functioning.

If a board is being changed to reflect the specific needs of a company as those needs evolve, how do you establish board cohesion? The panel noted that a careful interviewing process before onboarding a director can help focus on personality fit, and how well individuals will work within the group. One company generated a Handbook on how to onboard new directors, including designating a more senior director as a mentor. Others noted that joint education and orientation sessions for both old and new directors, together, can create the requisite bond. Retreats, social dinners prior to board meetings, and “unpacking” content from both retreats and regular board meetings so as to permit more personal interchange, also were mentioned as methods of building board cohesion.

[There will follow three more posts on separate subjects arising from discussions at the NACD meeting referenced in the above post.]

Simpler SEC Disclosure Rules?

Recently, the SEC voted to propose amendments to the regulation that defines the details of information required to be included in SEC filings by public companies, advisers and investment companies. Needless to say, Regulation SK has grown over time to be very granular, confusing to the uninitiated, and a perceived element of an over-extended regulatory scheme. As befits the arcane architecture of our government, this SEC initiative drives off provisions of the 2012 JOBs Act and of the 2015 Fixing America’s Surface Transportation (FAST) Act, and may be reflective of the thinking of the administration but (given the timing of these statutes) not directly attributable to the President’s pressures in this direction.

Final promulgation of amendments, which are now open to further public comment, follows several prior interim releases by the SEC which suggested many different approaches.

High points of the current proposal: expanding the definition of a “smaller reporting company” to afford lesser disclosure regimes to promote capital formation (floats below $250M or combination of zero float and revenues below $100M would qualify); relieving companies from description of realty if realty is not material to the business; reducing MD&A requirements; hyperlinking to other documents in lieu of long descriptions in text; shortening disclosures about executive officers in proxy statements; reducing SEC legend requirements on prospectuses for pending offerings; cleaning up text relating to underwriting arrangements; reducing requirements concerning disclosure of contracts.

This is progress although frankly not enough. But at least we have this effort, subject now to final public comment.

Corporate Deadlocks: Judicial Remedies

It is amazing how many corporations are set up “50-50,” which is to say two equal partners with equal ownership, and equal say on the board of directors. What happens when, over time, these shareholders come to violent disagreement?

The Massachusetts Supreme Judicial Court, in a September ruling (Indus Systems), applied the Massachusetts Corporate Statute to a tense shareholder dispute, declared the existence of a deadlock under the Statute, and sent the case back down to the Superior (Trial) Court to remedy the situation. The Massachusetts Statute provides that in the case of deadlock, the Courts have the power to dissolve a corporation.

Of course, in this case (a profitable going enterprise) it doesn’t make much sense to break up the company, wind down its contracts and lay off the workers. No problem for the Supreme Judicial Court: the Court declared that implicit in the power to dissolve is the power of the Court to take other action, including forcing a sale of the business to a third party or forcing a sale between the parties so that one shareholder remains standing.

Lawyers typically counsel at the formation of a company that some sort of an unwind procedure be built into the corporate documentation to meet the future contingency of deadlock. This is of course a negative message for a lawyer to deliver to two individuals who are anxious to get going with their business, and find it intrusive and unsettling to contemplate what might happen, years hence, when they violently disagree. Additionally, aside from this distraction, there is a cost to discussing and documenting an unwind procedure which sometimes can be as expensive as all the positive work of forming the company, issuing bylaws and issuing shares of stock. Along with addressing what happens in the event that one of the shareholders dies or becomes disabled, drafting provisions whereby, in the event of a deadlock, one shareholder might be forced to sell out to the other presents legal and interpersonal problems that are difficult to parse, particularly at the initial stages of forming a business.

But shareholders should not be relying wholly on statutory remedies because it is quite difficult to prove a “deadlock” within the meaning of the Massachusetts Corporate law. Suffice it to say that in the Indus case there were not only disagreements with respect to corporate policy, but also unilateral actions by one or the other of the shareholders, including the writing of a $690,000 personal check by one of the shareholders to his own order, against company funds.

The Future of US Business

What do Boston thought leaders believe are the keystones to future business growth? Long-term focus on education, shareholder relations, and application of disruptive sciences to their companies.

GE Director Dr. Susan Hockfield, Dr. Tom Kennedy (CEO of Raytheon), and Dick DeWolfe (Chairman of the parent of John Hancock) addressed major world and domestic trends at Tuesday morning’s breakfast meeting of the New England Chapter of the National Association of Corporate Directors.

DeWolfe noted that today’s boards are not nearly active enough in reaching out to institutional shareholders and explaining the long-term best interests of the company. Activist shareholders, even those with a “long” window, have short-term goals that are not necessarily in the best interests of companies.

The panel generally agreed that “education is the road to the future” and criticized education in Massachusetts, even at the elementary school level, as “broken.” One suggestion was to provide significant tax cuts in order to induce talented people to go into teaching for some part of their own lives. There was general recognition that online learning could be significant but that there was a continuing problem in how to motivate people to complete online programs absent “human contact.” The group decried the decline of vocational high school education, caused by the misconception that everyone had to go to a college.

There was general agreement that current technology was at an inflection point. The assumption that technology would grow in a straight line was fallacious, and there was agreement that artificial intelligence, genetics and nanotechnology were poised for “exponential takeoff” that will remake business within a decade.

There was overall caution about the general world stage: the world is a more dangerous place with increased pressure from Russia resulting in a return of the Western theory of deterrence, pressure from terrorists, and full-blown wars in the Middle East including the not-fully-appreciated full-blown conflict in Yemen against the Saudis. With North Korea on the horizon and China making claim to the nearby island chains, and with Japan likely moving from a passive to a more active military posture, there are significant international risks.

However, the panel then put these geopolitical risks aside, focusing rather on issues of education, science and poor corporate governance. Perhaps, because there is not much that the people assembled in the room can do in addressing the international sphere?

Report: Activist Shareholders

2017 has been a banner year for activist shareholders approaching public companies. Major activists continue to target large companies, but the average market cap of targets is approximately $260,000,000. How should boards approach the discharge of their obligations, when an activist comes knocking?

An expert panel convened by the New England Chapter of the National Association of Corporate Directors on June 13 suggested that the first step is to be prepared. This involves identifying what the 72 hours following an initial approach by an activist shareholder should look like: who speaks for the company, how are legal and public relations and SEC inputs triggered, what is the general nature of the response? Of course, proper preparation also steps back further in time: since activists often are questioning fundamental corporate strategy, a board should oversee making corporate strategy generally known, on a continual basis, through SEC filings and shareholder conferences.

Old school was to “circle the wagons” and not listen to activists, many of whom were viewed as simply attempting to force a company sale in order to achieve short-term gain.

But this instinctive response may not be the wisest. Activists typically have carefully analyzed the company, and indeed may have identified other shareholders friendly to their position. The proper response is to engage, listen and evaluate. Many boards have “learned things” of value from activists.

It is appropriate for the board to make an independent judgement as to whether activist proposals make sense for the long term (not the short term) health of the corporation and its owner-shareholders. Boards, and management, ultimately are responsible to these owners, and sometimes violent resistance to activists serves the purpose of offending other shareholders and strengthening the hand of the activist.

Statistically, in the past year only about 20% of activists’ approaches to companies resulted in a formal shareholder proposal, and of these more than half ultimately were withdrawn based upon discussion with a target. Even if a company is not in agreement with what is being proposed, open discussion with activists seeking agreement on strategic changes (and possibly an addition to the board) is the preferred initial approach.

Who should speak for the board? Activists often want to speak to individual directors. This may be a growing trend but it is dangerous; a given director may not be the best-informed emissary, and may well not be prepared about compliance with Regulation FD, the SEC regulation requiring public disclosure to all parties if material confidential information is released to any party.

Civil Liberties Union Report

Each June, the sitting national Legal Director of the Civil Liberties Union comes to Boston to address the Boston legal community, and interested citizens, concerning the work of the ACLU nationally; on June 6 the new Director, Professor David Cole, spoke of the expansion of the ACLU base and the role of the Union under the present administration.

For reasons which at least within the liberal Massachusetts environment need not be restated, ACLU has been growing since the last election, with membership increasing from 425,000 to 1,600,000 nationally.  Locally, Massachusetts chapter has increased from 16,000 to 73,000.  The ACLU national staff of 100 lawyers in New York and about 200 in other states are handling about 1400 pending cases.

Hallmark cases, well known to all, include efforts to block the immigration ban; and, likely upcoming cases may involve contraception coverage under proposed revised national health care, voter suppression and banning overseas recipients of US health assistance (a massive program) from advising concerning abortion even from separate funds.

Cole believes that support for the ACLU is simply one aspect of a wide spectrum of reactions by citizenry to the Trump agenda relative to the above matters, as well as to economic penalties to sanctuary cities (Cole says such action is unconstitutional), efforts to roll back Roe v Wade, and AG Sessions’ efforts to roll back gender and voting rights protections and to re-instate draconian sentencing regimes for all drug crimes even not involving violence.  He points to protests at airports, the women’s marches, resistance mounted by Silicon Valley CEOs and University presidents, and suits instituted by state AGs as consistent with growth in ACLU support.

Interesting side-light: Cole identified the NRA as one of the groups defending civil liberties that interest them, noting that the NRA is highly effective.  Why effective?  According to the NRA, because their civil rights are being threatened – an analogy to the reaction of ACLU in rising to protect their favorite civil rights.

Emphasizing the political neutrality of the ACLU, Cole did note his belief that the biggest issue was not any particular policy proposal but rather the attack on democratic checks on power by reason of demeaning courts and the press, characterizing Trump as “dismissive of basic constitutional principles.”