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.”

Investing in the Future

The main thing to understand about the future is actually two things: the first is that it is here now, and the second is that the rest of it is going to arrive much faster than you think.

Putting flesh on these generalities, futurist and author Jack Uldrich outlined for a Boston lunch audience (convened by Atlantic Trust Company) some highlights of the rapid pace of change:

The rate of technological change is not linear but exponential. Very shortly companies operating in the “millions” will be operating in the “billions.”

There are numerous “new verticals” which will disrupt just about everything: manufacture by printing, nanotech, robotics, the internet of things, the genome, AI, Big Data.

You need only look back 10 or 20 years and see whether the shape of the current world could have been imagined at that time. The answer of course was “no.” You have to look ahead with humility, and not assume that the ideas fixed in your head are going to have anything to do with the shape of the future and, consequently, your investments in same. Even the organization of the distribution of “stuff” will be changed; think “Amazon Go” and the sharing economy.

Underlying theme? Be humble, be flexible, look around you: the future is already here and discernable if you pay attention.

Query: who fully believes this in making investment choices?  History and logic suggest such things as diversification; does anyone put 100% into the new economy?

Board Governance: ERM Trends

How do boards get a better handle on risk? Triggered in part by the Wells Fargo fiasco, which featured incentivizing sales goals that lead to fraudulent employee behavior, there has been in the governance literature a reexamination of enterprise risk management.

A couple of themes have developed. The first is that boards need to do more, which means requiring more detailed reports from management and greater involvement.

A second theme is establishing more aggressive claw-back clauses, which typically have economically penalized senior management if there are financial statement revisions based upon misconduct, or indeed based upon any reason; these agreements can be written to also penalize breaches of executive risk judgment as evidenced by economic performance in the future.

Discussion also has centered around establishing a well-managed, conservative and risk adverse “tone at the top,” a seemingly vague term which encompasses elements of conservative management and centralized control. One outgrowth of this latter focus, as noted in the always informative Ernst & Young “Board Matters Quarterly” (April 2017) is that ERM, traditionally the bailiwick of the audit committee or of a separate risk management committee, now in some companies is in part becoming the responsibility of the Nominating and Governance Committee, at least as to dictating the design and structure of the company’s ERM function.

Finally, recent literature suggests that, contrary to expectation, the presence of independent directors does not militate against fraud and high risk activity. Seemingly, independent directors are not only unsuccessful in a preventative role but, in some instances, have been participant in corporate fraud. Independence does not seem to be, necessarily, a guarantee of perspicacity, diligence or non-corruptibility.

Corporate Boards and Crisis Management

Does your company, whether public or private or nonprofit, have a crisis management plan? An expert panel convened by the National Association of Corporate Directors in Boston on May 9, 2017 all agree that a plan is necessary; they also agree that it is very hard to follow.

A written plan defines actions to be taken by lawyers, management, public relations, crisis management experts and the like. The first message from the company is very important as it sets the stage for a public understanding of the issues. This first statement must be immediate and is often at a time when all the facts are not known. The key things to remember in this first statement: a tone of concern, and a plan to mitigate or repair the damage.

If things are going well, the role of directors is to make sure that the crisis plan is in place and not to interface directly with implementation. If things are not going well, such as the recent United Airlines flap about injuring a removed passenger or the Wells Fargo flap about improper opening of customer accounts, boards have been known to make public statements.  Once you are in a crisis, boards should be busy monitoring. You can’t monitor a true crisis with weekly meetings; in the heat of things, daily attention is the order of the day.

One thing for boards to remember is that social media is very important for many companies, certainly those which are public-facing. It is important for someone understanding social media to advise the board in this regard, particularly because boards tend to be older and not skilled in this space.  It is also important to identify those constituencies most impacted so that your response addresses their concerns. Are you most interested in public consumers, employees, customers, or executives?

It was noted that many small tech companies, growing quickly, in fact do not have crisis management plans. Things are moving too fast and attention is diverted to growth. The obvious consensus: you nonetheless should have something in place.

One interesting omission in the discussion: when there is a crisis, lawyers often tell companies that the first people to contact are the lawyers, so that the lawyers can investigate, retain experts, and thereby maintain confidentiality of information based upon the lawyer-client privilege. This advice may be difficult to implement in the intense hours following the surfacing of a crisis.

Finally, a word about claims of sexual harassment from the top. There was unanimous sense that this must be, for all companies, a “zero tolerance moment” where the board must make sure that “the right thing” is done for the benefit of the company. Personal allegiances between senior management and the board may make difficult the enforcement of this fundamental position.

 

Trends in Wealth Management

What do the largest providers of financial investment products think are the economic trends which will drive the design of products in the near term? While there is mixed opinion as to the robustness of the United States capital markets, there seems to be uniform belief that great equity opportunities exist in Europe and in emerging foreign markets.

What do the leaders of the wealth management industry, broker-dealers and advisors, think are the major issues in providing wealth management services in the current environment? These include: overregulation and inordinate fines for minor infractions by the SEC and by FINRA; inability of the current wealth management model to provide cost-effective services to the middle class; difficulty in filling the pipeline with young advisors or diverse advisors interested in the profession; and, an accelerated swing in compensation away from charging fees based upon assets under management, moving toward “fee for service” in providing investment guidance.

These takeaways are from a program presented by Big Brothers/Big Sisters of Massachusetts Bay in conjunction with its annual “Big of the Year” fund-raising event. The program featured two industry-focused panels, comprised of presidents, CEOs and other senior executives from companies including Pershing, LPL, Voya, Hancock, PIMCO and Blackrock.

One panel discussed “robo advisors;” there was general consensus that such firms were not the platform for the future, but that their focus on greater efficiency and delivery of services online, combined with their utilization of big data, would drive modernization of what was described as a change-resistant industry.

Major overall risks? Aside (of course) from cyber security, there was substantial discussion concerning customer longevity. Mortality tables utilized by insurance companies vastly underestimate longevity, based upon advances in healthcare. “You can’t work 50 years and then live on your savings for the next 50 years” no matter how carefully you plan; this reality places substantial pressure on the advisory industry, not to mention the pressure it places upon the public.

(Interestingly and as an aside, the Boston Police Department was granted this year’s Big of the Year Award based upon its commitment to provide 25 “men in blue” to serve as big brothers or big sisters to the youth of Boston.)

Trends in Non-Profit Board Governance

The term “nonprofit organization” is a misnomer, agreed a panel convened Tuesday by the New England Chapter of the National Association of Corporate Directors. Organizations performing public service need profit in order to be sustainable in the long-term delivery of their missions.

And beware of establishing endowment funds. Some problems are not continuous, and people like to invest in solving problems and not perpetuating them. By way of example, if you have a problem that $1,000,000 might cure, why establish a $1,000,000 endowment where the annual income at a 5% yield is $50,000? The proliferation of endowments may be inhibiting the meeting of certain mission goals.

Other panel takeaways included:

Beware of the practice of establishing “consent agendas,” the practice of sending out detailed board agendas and committee reports for pre-meeting analysis, followed by a vote adopting all corporate action required by that agenda. The argument is that this saves time for more important discussions. However, major weakness were noted, including particularly that the practice encourages board members to not read the material carefully because there would be no discussion; and, the temptation for management to use the technique to hide exactly what is going on within the organization.

Beware also, in the face of the trend of nonprofit organizations to have larger and larger boards, often driven by donor participation, that you do not place too much power in an executive committee. With larger donor driven boards, there is a tendency to view deciding everything within an executive committee as being more efficient. However, ALL board members have fiduciary duties and an executive committee is a small group. You gain benefit from discussion within a larger group. Further, concentrating power in the executive committee tends to make your better board members less attentive, as they sense they are becoming “rubber stamps.”

 

M & A Trends in the Mid-Market

Last week, the Boston Chapter of the Association for Corporate Growth held an M&A Outlook Conference at the UMass Club. There was much discussion as to where the general economy fell on the timeline between boom and bust.

We are in a midst of a very long bull market; what was the consensus about the longevity of that market? There was general consensus that the bull market, which drives higher valuations of companies, including those on the block for acquisition, was not fully played out. Although some caution was expressed, including the thought that one should not assume that any future break in the market would be no worse than the 2008 recession, most commentators anticipated that there would be no major adjustment for nine to eighteen months, and one financial analysist thought that the current bull market might go as long as another four years.

The M&A folks noted that the first quarter of 2017 was very strong, with valuations as high as fourteen times EBITDA, perhaps reflecting the impact of the Trump Administration agenda. Particularly, it was noted that software tech deal valuations were very high.

It was also noted that there was great interest in funds resetting acquisition goals, looking to earlier stage companies; there are many funds with “too much money” chasing a finite number of deals, which tends to broaden the targets and maintain high EBITDA multiples.

Government policy is a confusion. The anti-international tone of some of the current US rhetoric likely is impacting certain deals. The promise of reduced government regulation might induce owners of smaller business to retain their businesses because the landscape would be more favorable.

There was some discussion as to whether the continued availability of “cheap money” was a current M&A driver. It was noted that cheap money generally doesn’t much affect the lower end of market deals. And indeed, the amount of leverage in the average deal is down somewhat from two years ago. Strategic deals don’t much rely on leverage either. It was also noted that many software companies have an economic model that will not sustain much leverage but, for those software and internet deals where the mathematics do work, such companies are using tremendous M&A leverage.

The median EBITDA multiples during the first quarter were a bit over seven times. Some concern was expressed that some deals were being done at 10 times EBITDA with leverage provided by “aggressive lenders” other than banks.

Bottom line predictions? In the tech sector, one panelist saw eighteen to twenty-four months of robust M&A with rising asset values, while another on the PE side saw two years of growth with particular focus on acquisition of companies with between $30 and $75 Million of EBITDA.