SEC Activity

The SEC is active today on the regulatory side, although they still have not delivered some key items on their overdo agenda, notably Federal crowd funding.  The States are stealing their thunder on that front, although usually under the intra-state Federal exemption so mostly we are talking small local deals.

New today on executive claw-backs: proposed rules to direct the exchanges to establish a listing standard requiring claw-back of executive incentive pay erroneously granted.  Arises with a financial restatement and applies to current and former executives.  NOT related to any fault on the part of the executives.   Reaches back three years from restatement.  Open for two months comment.  This under Dodd Frank, a statute merely what–  three weeks shy of five years old?

New today on audit committee disclosures: SEC announces it will issue a “concept release” seeking comment on current audit disclosures, particularly oversight of independent auditors.  Would reach criteria used by committee to evaluate, and also to select auditors.  Also two month comment period after publication.  Hard to imagine this will help investors, more likely to result in expanded disclosure requirements eliciting platitudes.

Post M&A Integration

Diligence is complete and your acquisition deal has been signed and closed. Your company has acquired its target. What do you do next? This was the second topic discussed by the panel at the NACD/New England M&A program held June 9th in Boston.

Even if your plan is ultimately to fully integrate the target into the acquiror, it may make some sense to take some time, understand what makes the target tick from the inside, and evaluate the depth and quality of the management team. Sometimes an acquisition is designed to bring more energetic technology or operational approaches to a larger and more staid company. Letting the target run by itself may allow it to retain its entrepreneurial culture. You have acquired not only technology, contracts and physical assets; you have acquired the human beings who have built the target enterprise into the company you have identified as providing strategic strength to your own company. Don’t crush those strengths immediately in a rush to obtain financial efficiency.

Part of the post-acquisition integration process is to create a joint vision, between acquiror and target management, of what the consolidated company should look like. Target management, including several levels down depending upon size of the target, should be made to feel that after the acquisition they have a place to reside, and a better path to achieve their own goals. To fail in this regard drives target management to the placement counsellors. (One anecdotal tidbit: shortly after Procter and Gamble acquired Gillette, 80% of the senior management team of Gillette headed for the hills. Likely not the very best result….

The panel agreed that no acquisition, no matter the quality of the diligence, will work exactly as anticipated. Often the synergies are interpersonal and indirect, and the acquiror has to focus on team building (even if the acquisition is of a prior competitor where initial instincts are non-collaborative).

Since culture is so hard to identify, one of the panelist said he liked to take the inquiry down one step to look at the “values” which create the culture. Are the two companies agreed that they are structured for the long term to build shareholder value and to help the customer base? Or is the culture of one company that it is a vehicle for individual success? Are decisions typically reached in each organization through a small number or a very large number of decisional tiers? Diligence beforehand had better have gotten these factors correct, or any integration will be rocky road.

Board Strategic Role in M&A

How does a board of directors, faced with a pending acquisition which has management enthused, discharge its duties to shareholders? This discussion was one topic at the June 9th meeting of the New England Chapter of the National Association of Corporate Directors in Boston. An experienced panel of directors seemed to agree on a wide variety of approaches:

The board should first establish a strategic articulation of which kinds of acquisitions they believe will build value of the company. Proposed acquisitions should be tested back against this strategic approach, notwithstanding management impetus to the deal. Management can get very competitive, may be in love with the deal and may also want to “win” the fight to capture the target. The board must control that tendency.

But what about opportunistic acquisitions? They are the hardest to evaluate; they may indeed be valuable but if they don’t fit the prior strategic discussion, that means no preparatory work has been done. The board’s role: work really really hard because you have to drill down and do both the strategic work and the operational work to evaluate the deal. One director noted that sometimes the company will have one M&A advisor and the board will have its own separate advisor.

What is the board’s role in diligence? As with many things, the board should be performing the function of a monitor. Directors should identify the biggest issues, the biggest risks, and should ask questions that address those risk parameters. Also, questions should be asked concerning post-acquisition planning; is it in place? Has management evaluated the human talent being acquired, does management have the bandwidth to integrate the acquisition?

Finally, the board has a role in interrogating the post-acquisition financial model that is presented. That model must be based on a variety of assumptions. Those assumptions should be fully understood by the board.

See the next blog post to address questions of integration and focus on “the culture” of the two enterprises; whatever “culture” means. . . .”

SEC Rules on CEO Pay

You will recall that the Dodd Frank Act in 2010 charged the SEC with propounding a regulation requiring disclosure of the relative pay of reporting company CEOs to the median worker in his or her company.  This was part of the effort to shame CEOs into controlling their pay, and reflected Congressional concern about the growing wealth gap in the United States.  Observers were skeptical as to the efficacy of the requirement as a matter of policy, and most were quite sure that the value of disclosure to the investment community was nil.

So the SEC is years behind its timetable to promulgate this regulation and is still messing with it.  Just this week Senator Warren sent an open letter to SEC chair White, excoriating White for lax enforcement and citing among other things the SEC failure to complete this task.

Today the SEC, still trying to figure out what metrics make sense, posted a proposal for comment on the SEC Website; a portion of the SEC announcement is reprinted below:

“The analysis is posted on the SEC’s website as part of the comment file for rules proposed by the Commission in September 2013 that would require the disclosure of the median of the annual total compensation of all employees of the issuer; the annual total compensation of the chief executive officer of the issuer; and the ratio of the median of the annual total compensation of all employees of the issuer to the annual total compensation of the chief executive officer of the issuer. ”

The hearty among you may join the battle by repairing to the SEC site and engaging the merits….  The more cynical might come to the view that since the rule will have no effect and no value, the SEC should just adopt something/anything that doesn’t cost companies too much money for compliance, and then move on to useful tasks.

Non-Profit Director Liability

Directors of non-profit organizations generally take their responsibilities seriously. But directors of non-profits are motivated by fulfilling the mission, often while facing serious financial pressures.

All directors, including those of non-profits, are protected from lawsuits for breach of fiduciary duty in two ways. First, virtually all states have statutory limitations on the liability of non-profit directors, reflecting a policy of encouraging people to serve non-profit undertakings. Second, the so-called “business judgment rule” protects all directors (in both profit and non-profit companies) from liability for mismanagement provided the directors use reasonable judgment and do not self-deal.

Between these legal protections and contractual exonerations from liability typically \written into charter documents, directors rightfully have felt reasonably secure from litigation risk even as they guided their organizations along the narrow path of economic viability.

Enter the Third Federal Circuit Court of Appeals, reviewing the contentions of creditors claiming in two cases that the non-profit trustees/directors breached their duty by reason of imprudent management when on the verge of insolvency. (Creditors of bankrupt entities have the power to commence an adversary proceeding against the directors or trustees of any bankrupt company, including a non-profit, for breach of the fiduciary duty of care and loyalty, where the trustees/directors may have knowingly or carelessly expended monies and incurred indebtedness while the company was sinking financially.)

All such cases are highly fact-dependent. A company is insolvent when it is unable to pay its debts as due, or when its balance sheet is under water. In these recent cases, a 130 year old home for the elderly and a well-known women’s college each filed for bankruptcy, the trustees of each were sued, and the Circuit Court in each instance has allowed the cases to go forward (no final resolution as to liability yet).

Non-profit directors may be particularly susceptible to this kind of law suit; non-profits generally lack robust independent incomes streams. They are often dependent on donations and/or fundraising events (each of which may be quixotic given the general economy or other extrinsic factors).

No standard of how board members should act, beyond “prudently” and in the reasonable interest of creditors where insolvency seems imminent, can be generally stated, as facts and the alleged degree of grievous insensitivity to financial issues will vary wildly. We can say that boards should be particularly sensitive if endowment gives no adequate cushion, and if costs have run ahead of income over time. Attention to cash flow projections as well as the balance sheet is wise. Failure to collect receivables, undertaking major new products or services, granting high pay to management, and executive self-dealings could be significant indicators of liability where the non-profit has sunk into bankruptcy and the creditors are looking backwards in time to see “who is to blame.”

Yet another reason for non-profit boards to be formally educated in their technical fiduciary duties.

M&A Sensata Style

Sensata Technologies, a $3Billion New York Stock Exchange-listed manufacturer of sensors, grew last year through several acquisitions which added over $750,000,000 in revenue. Hans Lidforss, senior vice president of strategy and M&A, explained his approach at a May 21st Boston breakfast meeting sponsored by the Association for Corporate Growth.

On the acquisition side, little was startling; they evaluate the usual parameters of risk and reward, price the target, look for interpersonal fit and possible synergistic savings. What was interesting, however, was the early focus on integrating the target into the acquiror.

The approach to integration begins prior to the time a deal is struck, let alone prior to the closing. An integration team is identified, and discusses the manner in which integration can proceed. Lindforss noted the commonly stated, but perhaps little-appreciated, fact that integrating a company is a lot harder than acquiring it.

Upon acquisition, Sensata designates both an operations chief and an integration chief, who must coordinate so that integration does not stifle operations, and vice-versa.

Notwithstanding the common wisdom that integration should proceed as quickly as possible, Lindforss spoke in favor of a more deliberate and deal-sensitive process. For the initial period, they look to get a better understanding of their acquired target, lest they inadvertently destroy some value they have just purchased. His full integration timeline runs not less than a year and, depending on circumstance, may run longer.

It was unusual to hear an M&A chief, applying the usual granular checklists for vetting a deal, contemporaneously applying the same kind of process rigor to understanding integration.

Perhaps failure to be as rigorous on integration as on the M&A side is why there is so much acquiror disappointment in the cold dawn after the closing dinner. . . .

Trends in Business Contracting

Last week, I was speaker at a program at Massachusetts Continuing Legal Education, a Boston-based non-profit bringing new developments and best practices to members of the Bar. The discussion among panelists and attendees bubbled up a few interesting observations:

First, there are just a lot of bad contract forms out there. Companies use older forms of contracts, often prepared in-house by lay people and pasted together from a variety of sources. These agreements contain self-contradictory provisions, often make no sense, and may not represent the state of the “market.”

“Closings” of business transactions often no longer occur in person. Electronic closings using the internet have become standard even for complex deals. Gone are the days of everyone gathering in large conference rooms, fidgeting and waiting their turn to sign documents. And indeed, sometimes closings occur not only without the physical presence of the signatories but also even without their actual signatures, as electronic signature execution has become wide-spread. This may be an economically efficient trend, but it avoids people talking with each other and building trust for addressing post-closing issues.

Other developments were noted in drafting for: venture capital investment (growing use of complex documentation for early stage deals); licensing of technologies from universities (solving the problem where licensor wants a solvent licensee and licensee needs the license grant to raise any money); dispute resolution (the choice of arbitration on the sometimes faulty assumption it is faster and less expensive); warranties and representations about cyber security in M&A transactions (a strong trend); and how “earn-outs” in acquisition transactions seem to attract litigation about both the terms of the agreement and the claim of acquiror’s breach of implied covenants of good faith and fair dealing.

Our conclusions: writing almost any contract that is clear and easily enforced is becoming more complicated as the world becomes more complicated; don’t expect a decline in contract litigation any time soon.

Delaware Protects Independent Directors

The Delaware Supreme Court on May 14th held that independent directors, who approved a going private transaction by which a controlling shareholder freezes out the minority, must be dismissed from shareholder litigation claiming inadequate price unless the complaint alleges specific wrong-doing on the part of those independent directors.

Followers of Delaware corporate law know that in any liquidity event wherein a controlling insider is a principal, directors are not protected by the broad business judgment rule but, rather, the transaction must pass the more rigorous “entire fairness” test. In other words, it must be demonstrated that the transaction, substantively, is entirely fair to the minority shareholders. (There is an exception for merger transactions which are conditioned from the very beginning upon approval by a special board committee and the affirmative vote of the majority of the minority shareholders.)

In these two cases before the Supreme Court, shareholders sued all the directors for breach of fiduciary duty in a freeze-out merger, claiming inadequate price, even though the transaction was a negotiated by a special committee of independent directors, was approved by a majority of the minority shareholders, and was effected at a substantial premium above the pre-announcement market price of the company stock.

The question before the Court was not whether the interested directors could be sued; the law is clearly affirmative in that regard.

The question here was whether the independent directors, constituting the special committee, were entitled to be dismissed from the litigation pursuant to an exculpatory charter provision, where no specific improper act was alleged against them. The only thing pleaded was that the independent directors voted in favor of the transaction, and that the price was inadequate.

The Court cleaned up some prior and cryptic decisions by making it clear that, if you do not allege that the independent directors acted in bad faith, or had their own self-interest, or had an interest in advancing the self-interest of an insider, then those independent directors were entitled to be dismissed from the case even though the standard of review to be applied to the transaction by the Court, “entire fairness,” would be applied to the insiders.

A principal driver of the decision was to encourage independent directors to serve on fiduciary committees for the benefit of minority shareholders. The Court observed, not surprisingly, that if an independent director exercised best judgment and had done nothing wrong, and still was subject to suit, no independent director would be willing to serve and thus there would be no one to protect the minority.

Hospitals: New Economic Reality

A few years ago, virtually all hospital patients in the United States were billed on a fee-for-service basis. Today at Beth Israel Deaconess Medical Center in Boston (a two billion dollar operation), only about one-third of patients are charged on that basis.

Dr. Kevin Tabb, President and CEO of BI Deaconess, discussed the revolution in delivery of hospital care, and its implications for patient care generally, this morning at the Duane Morris law firm office in Boston (which was hosting an investor presentation by emerging life science/health care companies). The new hospital model establishes payment for treatments across the board, and it is up to the hospital to manage its business so that costs are contained and charges for non-essential tests and procedures are dis-incentivized.

Dr. Tabb noted that Boston is far ahead of the rest of the country in coming to terms with the new economics. Recently visiting California, where for example at Stanford the operational model is still fee-for-service, Dr. Tabb warned that this new reality was coming, and that it meant there would be less dollars; thus, delivery models would have to change in order to both maintain quality of service and solvency.

In his words, the “heads in beds” business model was obsolete. There likely would be: fewer hospitals; fewer beds; reorientation on the care delivery front in favor of fewer specialists and more general practitioners; and, greater reliance on mid-level service providers (such as nurse practitioners).

I’ve Been Thinking….

At business breakfasts, why do hotels put out huge bread baskets of rolls and buns when no one in a suit will touch them at that hour in the morning?

What do they do with the untouched food, I wonder.

How does the German government get away with holding onto art stolen by Nazis by saying that all the heirs of the original owners were killed? Sounds like the old joke about the kid who killed his parents and then pleads for mercy as an orphan.

And lawyers know that there are almost always heirs at law; there are companies whose business it is to track them down. Why doesn’t Germany hire search firms and turn over every stone in a bona fide search? And if they cannot find heirs, turn the art over to anyone other than a German institution?

Do you share the secret and embarrassing rush of pride when you see Secretary of State John Kerry, who is well over six feet tall, looking down to shake hands with every uniformly shorter diplomat from another country with whom he is meeting?

Even if we cannot get our foreign policy right, at least we can slam dunk better than those other guys.

Do you find it troubling that a major argument to absolve the Patriots and Tom Brady from guilt is that everyone in the NFL cheats? Did you mother ever tell you that two wrongs don’t make a right? Or thirty-two wrongs?

And if everyone cheats, why is the NFL such an American icon making incredible sums of money? Where is A-Rod when truth needs a champion….

Speaking of sports, I want my $99 back, the fee for watching the non-fight between Mayweather and that short guy whose last name I refuse to try to spell. That Manny guy lied to us, and thinks he is walking away with more money for that evening than I will make in my lifetime.

Ever notice that, in our society, if you do something bad (even a wilful and venal wrong), and then cover it up (a normal human reaction), you get punished more for the cover-up than the thing? Think Martha Stewart, the SEC, the DOJ enforcing the Foreign Corrupt Practices Act, and the comments from the NFL that Brady didn’t produce his emails.

If not producing emails helps get you a four game suspension as a Pats quarterback, what do you do with Hillary Clinton?

Of course, she is running for a job with a good deal less power than quarterback as things sit on the Hill, so perhaps she should get a skate….

And speaking of the Foreign Corrupt Practices Act, did you see the recent Economist screed claiming that huge fines are absurd in most cases because companies must spend such enormously high amounts just investigating their own wrongdoing in numerous foreign lands that piling on more expense is unfair?

Of course, all those expenses fall on the company anyway and thus upon the shareholders, and not on the executives who committed the wrongs or failed to supervise and prevent them. THAT’S unfair.

Do you still wonder why the official title of this blog site is “Law and Other Anomalies”?