ERM: Defining Risk

Directors sometimes don’t understand the meaning of risk.  Boards undertake ERM (enterprise risk management) as making sure there is regulatory compliance, sound accounting and reasonable cyber protection.  These are important to address but are NOT the key elements of risk that boards must engage, according to an expert panel convened today by National Association of Corporate Directors of New England.

Risk was defined as the occurrence of events that could deeply harm your organization and which you do not plan for.  Risk thus is mostly another word for how you manage your strategy, how you define and are guided by your risk appetite.  Sixty percent of failures are strategic in nature, thirty percent are operational and only ten percent are based in financial control failures.  As one panelists stated it: risk management is the same thing as running your business.

In for-profit business, one suggested risk definition is the avoidance of unexpected earnings volatility.  That informs us that you need not avoid risk, and indeed in a rapidly changing world it was emphasized that you must undertake risk to remain competitive.  ERM is not eliminating risk; it is balancing the hoped-for benefits against the negative impact of getting it wrong.

One panelist emphasized use of metrics; define your risk appetite in terms of what is an acceptable quantum of risk. Risk measurement must be quantitative (do not drive over 60 mph) and not qualitative (drive carefully).  That raises the issue of the quality of metrics, and whether the board is getting only internal metrics or market metrics.  Good checks on whether the board is getting the true picture: reviewing outside data, bringing on new directors, talking to junior employees, talking to customers, exit interviews, anonymous whistle-blower procedures.

Take-aways for directors: ask what is the risk of what you are not doing; approach risk on a portfolio basis, accepting different levels of risk for different products or services or initiatives; hire the right people to drive the strategy; make sure you are not getting a uniform response from everyone, as that is a sign of lack of healthy awareness; keep the pressure on management for being accountable for strategy that reflects risk management and mediation.

Most interesting perspectives (paraphrased): When I interview new board candidates I ask two gating questions: first, are you healthy enough to do this job; second, is your life style dependent on the income from this directorship (if the answer is “yes” to the latter, you will be too compliant with the common wisdom).  When I join a board I ask the following questions: do I want to fire the CEO; is there institutional buy-in on strategy; is that strategy fully funded.

Final key question to ask management: how do you know that your risk management program is working effectively?

Corporate Compliance Programs; What if you are Mid-Market or Privately Held?

So your company has been accused of committing a fraud, or of violating the Foreign Corrupt Practices Act.  You have attracted investigation by the US Department of Justice.  You are negotiating whether to enter a plea, or to try to head off charges. What will help you in these negotiations? Each case is different, but the DOJ’s recent “Evaluation of Corporate Compliance Programs” suggests courses of action in light of  DOJ’s typical inquiries:

Did the company have prior warnings which would allow it to detect misconduct?  Were  compliance procedures lacking?  If present, misapplied or  willfully ignored?

What specific changes did the company make to reduce risk?  Were senior leaders vocal in discouraging misconduct ?  Did the board hold private sessions with internal and external gate-keepers?

How important did the compliance program appear within the company as compared with “other strategic functions?”  Did the company fully staff, fund and give autonomy to internal compliance functions?

Were policies communicated below, and to third party vendors, and integrated into the risk management?  Did employees and customers have a reporting mechanism so that violations could be flagged?

Were people punished for infractions?  Did the company test its own programs by review of controls and by interviewing employees and others?

In acquisitions, did due diligence address risks in this area?

Many factors seem applicable to larger companies but fraud prosecution, and FCPA enforcement, occur even in smaller companies.  What should such companies do to protect themselves, where company structure is flat, and boards meet infrequently and are not in the habit of holding management accountable?

Every company needs a compliance policy. Distribute it.  Every company can have periodic meetings or programs to educate and remind sales people, inside people, all employees of their obligations.  A file can be kept of compliance inquiry made of third parties: outside vendors, contractors, sales channels.  A modicum of attention at the board level may go a long way here: calendar quarterly meetings and put compliance on the agenda a couple of times a year. Keep summary minutes.  Have zero tolerance for violations; take action to re-mediate and punish.  Ask your auditors or attorneys in writing to look in areas problematic in your industry, or where you had problems in the past, or where your scale does not provide layered controls.  No one will hold a small company to the standard applied to a multi-billion dollar company but, when under investigation, even the smaller company needs to show that it paid such attention as it size and financial resources permit.

Tax Trap for Purchasers of Partnership, LLC Interests from Current Holders

The new Tax Code contains many unclear or recently highlighted provisions, but here’s one that caught me by surprise: in an apparent effort to make sure that foreign partners in partnerships that do business in the US pay their US taxes when they sell their partnership interests, the new tax law requires the purchaser of partnership interests from existing foreign owners to withhold and send to the government 10% of the gross proceeds of any such sale.

As all know, this blog site does not give legal advice, and particularly here I repeat that admonition as I am not sure I am categorically correct in the matters described below; take your specific deal to your professional adviser.

This provision applies to all entities taxed as partnerships here in the US; it applies if a foreign entity is engaged directly or indirectly in a trade or business in the US; while withholding applies only to foreign sellers of interests in either of such entities, in order to avoid withholding each purchaser needs to obtain an affidavit from the seller that seller is NOT a foreign seller (until we see regulations, an affidavit should be obtained even if you believe you are 100% certain the seller is a US seller).  The affidavit needs to include a US tax number for the seller.

This applies to LLCs taxed (as most are) as partnerships.  It does not apply to Sub-S corporations which by law cannot have foreign shareholders even if  C-corps are flow-through entities.

Absent regulations, the law seems to apply to redemption.  For PUBLIC investment partnerships such as funds making redemption, there is an IRS notice suspending the provision in SOME cases pending issuance of formal guidance.

If the individual buyer from a foreign seller does not withhold, the entity may be required to do so.

I do not yet understand what happens if an entity sells all its assets and later distributes proceeds.  I do not understand what you do if there is a merger or consolidation of an entity whereby all partners or LLC members receive cash, let alone if they receive stock or debt or property (no cash) or keep a carried forward interest in the emerging reconstituted entity.  Sounds like in all cases you should collect affidavits from everyone, but what happens if someone cannot give an affidavit because in fact they are a non-US person?  Talk to your tax adviser.


Coins Stocks and Blockchain

Okay, all the publicity is about crypto-currency, its volatility, its hack-ability ($530M lost yesterday), its potential for fraud (SEC action announced today against a so-called “bank” permitting trades in 700 crypto-coins, or so they said).  While all this is going on, among other wholly legitimate uses of blockchain is the maintenance of corporate stock records.

The dumbed-down description of blockchain is that it is just a set of bookkeeping entries, recorded electronically and accessible to anyone with a computer.  In my subsequent efforts to understand what it is, I did much more reading and discovered it is just a set of bookkeeping entries recorded in electron…. well, you get the idea.

It also seems perfect for keeping a stock ledger, recording holdings and transfers and stop-transfers and the like, replacing registrars and transfer agents and all sorts of intermediaries which have costs to incur.  As it turns out, the methods for doing all that by blockchain seem congruent with the laws that control stock transfers, probably without need to alter those laws.  While one alleged crypto-currency advantage of blockchain, total anonymity, is not possible with share ledgers (companies, brokers,  proxy solicitors, regulators need to know who’s who), there is no reason why names cannot be made accessible to appropriate, and only to appropriate, parties.

An interesting article in The Business Lawyer (vol 73, Winter 2017-18 at 85) describes the experience of one public company the shares of which are handled in this fashion.  The article is suitable for perusal by non-attorneys also as, unlike much legal writing, this piece appears to be written in English; and, the references to the statute (UCC Article 8) are easily skip-able.

I’ve Been Thinking

Did the Red Sox schedule a super-early opening day game in Boston because they believe that Global warming has already arrived?

Now that the iconic Sunday Times crossword puzzle is full of questions from television, modern pop music and rap, internet references and actors I never heard of, have I reached the age where I should invest in those large-format books that collect old puzzles and give up on the new stuff?

If the Federal government is out of money, how does the President still get to stay in the White House?  Is the electricity off?

If Tom Brady is truly immortal, why do the Patriots carry a back-up quarterback rather than apply that superfluous salary to reducing seat prices?

If IT, nanotech, robotics and gene therapy are the shape of the future, why are professionally managed investment portfolios usually structured for the old economy?

If the Congress really wants to cut domestic spending and shrink government, why don’t they eliminate Federal flood insurance programs that protect shore-front construction?

If our national immigration policy is really about inviting Nordic people to emigrate, why are we not advertising in Oslo and Copenhagen in search of immigrants who like to work in coal mines or wait tables in fast food restaurants?

Why do American private militia groups insist on arming themselves to protect themselves from the Federal government and then claim they are true American patriots?

Why is bitcoin a more volatile investment than orange juice futures?  Electronic currencies are not subject to freezes, floods, blight, consumer taste fluctuations and the vagaries of diet books.

Or more volatile than the currency of a country that collects trillions in taxes and is missing this week’s payroll?

Does SNL have any viewership West of Newark and East of Oakland?  Can anyone tell me how to get geographic information of SNL viewership?  I want to send it to the DNC so they can plan their 2018 campaign.

Final bonus question, after writing this post: Why do I feel like a victim of a victimless crime?


When an Executive Leaves the Job

When you leave your executive position, you are often asked to sign a “standard” severance document which reminds you of restrictions binding upon you, and addresses your entitlements upon leaving employ.  Sometimes, the form of this document is set forth as an attachment to your original employment agreement or is in a company handbook. These letters or formal agreements typically contain a release of all claims against your employer.

In a just-decided Massachusetts Appeals Court case, a departing executive signed such a general release and failed to except out his right (contained in his option grant agreement) to exercise his fully vested stock options for a period of time after employment terminated.  The court held that the executive forfeited his vested options and could not exercise them.  In Massachusetts, a general release will be literally enforced.  The former employee must expressly list those rights that survive.

While there is no standard check-list of surviving exceptions, and while companies present these agreements as boilerplate, the employee needs to record everything that is not being paid on the spot.  Clearly stock options and rights in other deferred comp plans need to be listed.  How about these: rights in all health, insurance, disability and like plans; rights to unpaid and accrued compensation and bonuses and expenses;  unpaid sick or vacation days; rights under any company-funded coverages; rights to exoneration, indemnity and defense under any charter, by-law, company policy or contractual provision that protects the executive from claims for breach of duty or wrong-doing; right to retrieve any personal property left on premises; rights under any out-placement program or understanding for maintenance of an office or support services; right to purchase a company vehicle.  This list is suggestive; departing employees need to think about what they are to retain, and employers typically will permit modification of the general release to reflect those things to which the executive is in fact entitled.

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.