The SEC is Watching– for now

Each year, the SEC issues a Press Release signaling its enforcement agenda for the coming year.  Although this year’s Release, issued today, likely does not reflect an agenda specifically approved by the incoming administration, it no doubt reflects the intention of the Commission staff and is likely to be pursued in large measure in the upcoming months.

There will be continued effort to protect retail investors from advice provided to them through electronic mechanisms (“robo-advising”), and from overpriced services in the form of wrap fee programs covering both advisory and brokerage services.

There will be continued focus on the manner in which products such as variable insurance products and “target date” funds are offered to senior investors by advisers and brokers.  These same advisors and brokers will be subject also to review of cyber-security defenses to protect investor data.

The Commission will continue its oversight of money market fund compliance, and will also inspect the inspectors by assessing the quality of FINRA’s own examinations of broker dealer firms.

Of course, the press release ends with the usual admonition: the list is not exhaustive and may change.  Certainly the focus on plain fraud against investors, and the whistle-blower program, will continue to occupy the attention of the Enforcement side of the house in 2017.




New Years Board Topics

What should corporate directors be worried about as they prepare for the New Year and the upcoming proxy season?

First, a post-election revisiting to prior strategic planning based upon a reassessment of economic and political assumptions, including impact of trade and tariff issues. But, what else?

An expert panel at the January 10 breakfast meeting of the New England Chapter of the National Association of Corporate Directors also discussed an anticipated de-emphasis of business regulatory pressures. Not-yet-enacted SEC rule-making pursuant to Dodd Frank concerning ban on executive hedging, executive claw backs and “pay for performance” may well never get enacted. There also is speculation that the recently adopted SEC pay ratio proxy regulation, which applies for Fiscal Year 2017 and is reportable in 2018 proxy statements, also may well be sidelined by the SEC. There is no expectation that the existing say on pay rules will be rolled back.

There is growing pressure from shareholders, including institutional shareholders, on director compensation. Boards may consider putting aggregate director compensation to a shareholder vote in order to get protection from litigation and criticism.

The SEC is on the hunt for misuse of non-GAAP reporting measures, which in recent years have shown growing variance from GAAP; both the metrics going into the non-GAAP numbers and the prominence of presentation of the non-GAAP numbers should be looked at closely by the board itself.

New income recognition standards are effective for the 2018 calendar year, and SEC requirements include disclosing in this year’s 10K, if not the actual numerical impact, at least the anticipated general impact.

Finally, certain companies are inviting more constructive activist investors to make an investment, and perhaps join the Board, in an effort to head off a more adverse activist approach; the buzz word for this practice is “validation capital.” Since institutional investors also have moved, to some degree, away from supporting independent activists and have themselves become more direct in engaging their portfolio companies, it is clear that our standard governance model of board-centric corporate management is becoming a dual model, as shareholders are forcing themselves into the board room and will be heard more and more in the coming year.

SEC Pay Ratio Disclosure

The SEC Rule requiring disclosure of the ratio of the compensation of the CEO to the median salary paid the company’s other employees was slow in coming; the law demanding such a Rule was a Congressional response to public pressure about growing pay disparity. The SEC from the beginning questioned the value of such a disclosure and the adoption of the final rule was long delayed.

It looks like the CEO pay ratio disclosure is going to be eliminated by the Trump administration.

The panel at the NACD Boston breakfast forum in November, all members of compensation committees, joined in the criticism of the Rule as a meaningless and incendiary disclosure. I believe it is fair to say that the panel concluded that future deliberations of compensation committees, although complex, will remain “business as usual.” Compensation committees are going to continue to apply common sense, informed to some degree by metrics and approaches suggested by the proxy advisory companies, to fix compensation for CEOs (and executive management) which they deem appropriate in the discharge of their fiduciary duties.

A question from the floor raised one heck of an issue: how smart is that approach (it was of course phrased politely)? Various people agreed, after the meeting, that the press, and perhaps consumers buying products from companies which have enormous disparities between CEO pay and median pay, could generate substantial negative reputational impact. There seemed to be a lack of panel sensitivity to this issue; it was a matter of “how to present disparity so it doesn’t hurt us” combined with an acceptance of disparity.

The panel did suggest that for retail companies, sales on the internet will skew the nature of the work force and decrease disparity between sales people and the CEO. It was also suggested that low-paying jobs are disappearing anyway. Not mentioned is the fact that manufacturing flight from the United States may create unemployed workers but will make the pay ratio seem better as lower paid workers will disappear. The “new economy” compared with the old economy also will tend to decrease the ratio.

Not mentioned at all was to attack the problem directly: drive down pay at the top and raise the lower wage.

So if it is business as usual with well-meaning and well-advised compensation committees, what happens in the macro world in the future? If there is enough public outcry about the pay disparity (which was part of the anger driving the Trump triumph), and if our larger employing companies don’t do much to address that disparity, and if we come upon another election, what will the politics of that election look like?

This issue presents tremendous tension for the implicit social contract in the United States. There is risk here; the Trump revolution may in fact be only the first, and perhaps one of the mildest, of the working class political revolutions we will encounter if current pay disparity trends continue.

(I held off posting this, written about a month ago, to consider its content and to see if passage of a month’s time would bring greater clarity to the issue.  I post it today as part of a discussion which might take place at Compensation Committees as we move into year-end.)

VC on the Board–Can that Director be Independent?

On December 5, the Delaware Supreme Court decided that certain directors of successful on-line gaming company Zynga were not “independent” as a matter of Delaware law, and thus were not eligible to approve a transaction which benefited the majority stockholder and another director, while allegedly detrimental to the company itself.

Most interesting was the disqualification of two directors who were partners in the Kleiner Perkins venture firm which owned 9.2 % of the equity in Zynga.

The Court noted that the company itself, in its NASDAQ exchange listing, did not designate these disqualified directors as “independent.” However, independence in Delaware is not exactly congruent with NASDAQ listing standards. The Court seemed primarily to premise its holding on the fact that Kleiner Perkins’ equity stake evidenced a “mutually ongoing business relationship. . . which [might] have a material effect on the parties’ ability to act adversely toward each other.” Although acknowledging that a personal or business relationship with a major stockholder does not necessarily compromise director independence, Strine then claimed that venture firms compete with each other to finance talented entrepreneurs, and thus partners in the venture firm might not be willing to make decisions that might disadvantage the entrepreneur.

The result is analytically somewhat anomalous. One could equally argue that, holding a 9.2% stake, the VC would be economically motivated to vote against anything that might hurt the company or its stock price. Here, the directors sold stock immediately prior to a substantial dip in its price, a result which presumably might have been apparent to a VC. Would not the economic interest of the VC in fact be adverse to the interests of two directors (one a controlling stockholder) selling a large amount of stock and possibly leading to a drop in stock price, particularly when as it appears that the sold shares were released from “lock-up”?

The takeaways: independence is in the eye of the beholder, each case is fact-dependent, and the tendency of CEOs to name marginally independent buddies to the board, while attractive in a common sense way, is not necessarily a great idea.  Finally, the case should not be read as a categorical statement that directors representing capital investors can never be independent under Delaware law; there were numerous ancillary factoids that may have led Strine to this conclusion in this particular case.

NOTE: Only for the lawyers reading this, the context has been somewhat altered to focus clearly the point. This was an appeal from a holding that a demand on the board, prior to a derivative action, was necessary as there was an independent majority of directors; the Supreme Court here reversed, declaring demand prior to suit unnecessary, because there was not a majority of independent directors available, based on the findings set forth above.  (If you are not a lawyer and you read this note anyway, hopefully you were not confused– but I warned you!)

A break from the law

Today we take a break from legal and business posts to consider a riddle:

What comes from Spain, is all freshness and light, has gorgeous floral topnotes of orange blossom floating above a core of tangerine and guava, is nervy and bold, has a muscular texture, has pear and quince notes mingled with brioche, chamomile and dried pineapple details?

Need more clues?  There is also a juicy acidity, light tannins, subtle hints of a lifted floral component, a voluptuous mouth-feel reminiscence of tropical fruit.  More?  How about grapefruit, a touch of white pepper (whatever that tastes like which is different from black pepper) and toast?

By now my astute followers will recognize it is a wine, on offer at a mere $195 for a whole case from my personal wine shopper.  Cheap stuff.

I am sure that the above list of attributes was composed by taking a large dictionary and stringing together every 14,237th word.

My understanding further is that if the wine were more expensive, they would take every 8,183rd word.

And by that standard– well, let me see. I once drank a magnum of 1929 Chateau Lafite.  It’s description from the wine merchant was indeed attached but I did not recognize it as that.  I recall, rather, asking my partner why an entire 20-volume set of the Oxford Dictionary of English Usage was delivered along with the decanter of wine.

I have just figured it out, and felt compelled to share with group.  Bottoms up.


M&A in Q3

It is always interesting to see the Pitchbook report on the M&A market.  Highlights from Q3 deals (which of course are pre-election):

Median deal value increased to 8.4 times EBITDA; been rising all year.  Median deal value as a multiple of target’s revenue was 1.5 times, but greatly skewed by deal size; strategic buyers picking up firms with an enterprise value of over $250M paid 3.2 times revenue; below $25M revenue the multiple was flat at roughly one times.

Private Equity buyers continued to use only about 50% leverage, down from prior years.

Finally, 36% of reported PE deals had seller financing or earn-outs, down slightly from Q2; this ratio historically has been somewhat volatile.

Wonder what happens when the Trump tax plan induces repatriation of offshore cash held by some strategics– 8.4X EBITDA is already pretty heady stuff.  As they say: time will tell.

About Repatriated Off-Shore Corporate Cash

The devil is always in the details when it comes to taxes, and the assumption that companies will just look at the cash that is sitting overseas, and may choose to repatriate it onshore and pay 10% (under the Trump plan) and pocket the other 90% or send it out to shareholders is, shall we say, a large cart before a questionable horse.

First, Trump’s plan is mandatory; whether you bring the money on-shore or leave it off-shore, you pay the tax.

Second this is a tax on past profits, not cash.  What if the company has spent a large part of past profits?  It will owe a tax and will have to fund it with on-shore cash. Or borrowing?

Third, there is a fear that companies will use the extra cash to intensify acquisitions, which may drive up target value and in any event may not increase jobs.

Fourth, there are other plans on the table for this; Speaker Ryan’s plan differs in material ways.  Whose plan, or what hybrid, gets adopted.

Finally, and this has long fascinated me: when the Republican Congress which is always budget-sensitive runs into a combination of proposed tax cuts and increased military and infra-structure spending, what happens?

Will Congress roll over and build deficit?  Will they reduce tax cuts?  Will they cut spending?  If they cut spending, where? Not military; not infrastructure….Cost to borrow will go up also.   How much can be cut from social programs before voters get disturbed?

It just may be that the repatriation of offshore profits will be viewed by the administration as a needed revenue pop and thus increase the likelihood of its adoption in some form.

As with much this coming business season, stay tuned.  But get it out of your head that all US companies with international operations are about to be awash in free cash; it depends.

Supreme Court Tips the law on Tipping: Insider Trading liability standard set

You will read  that the United States Supreme Court unanimously re-established the “old rule” for liability for insider trading: if person A tips person B with material inside information, both parties will be liable for insider trading under the securities laws. This should not be analytically startlingly and, indeed, the Supreme Court had no trouble with it; how often do you see an unanimous decision? But the importance of this decision is that it overturns a cryptic 2014 case decided by the Federal Second Circuit (New York), which held that the government had to prove that the tipper and the tippee “needed to know that insiders . . . were improperly leaking confidential information in exchange for some personal benefit.” Justice Alito made analysis far simpler, removing the test of trying to measure the presence of personal benefit to the tipper: “[Tipper] would have breached his duty had he personally traded on the information here himself and then given the proceeds as a gift to[Tippee]. It is obvious that [Tipper] would personally benefit in that situation. But [Tipper] effectively achieved the same result by disclosing the information to [Tippee], and allowing him to trade on it.” The practical effect of this decision is significant, particularly as it comes from the Supreme Court so it is not likely to be messed with by a trial judge who is charging a jury. Practically speaking, if somebody has a relationship with another person which is sufficiently close as to induce the passing of inside information, both parties are going to have liability.

VCs: Present Practices and the Election

At the Boston breakfast meeting this week of the Association for Corporate Growth, venture capital fund managers discussed how they do business, and the impact of the presidential election. The answer: there will be changes in the business environment, but it is necessary to continue to evaluate investments based on fundamentals, as usual.

Dana Callow of Millennia Partners and Deepak Sindwani of WaveCrest Growth Partners agreed on fundamentals in selecting companies: you need to take a macro view, look for markets which are growing, have a reasonably long time line, and do not get distracted by inevitable changes in the world as you move forward in building great companies. If you build great companies, the money will follow.

The speakers were primarily focused above the seed/A-round of investing. Deepak’s fund is for “growth capital” for firms with revenues and EBITDA. Callow, whose fund focuses on healthcare, will invest with companies with zero to five million dollars of EBITDA, tending toward the lower end of the range, but clearly above the seed/A-round level.

The impact of the election?

For Deepak, whose investments are primarily in the B to B software space, his companies are most affected by “high end” immigration, corporate tax and trade. He speculated that the first two issues would be resolved favorably but trade was a “wild card.” He did not think that companies of less than $50 million dollars of sales would be substantially affected by the election in any event.

Dana similarly seemed unconcerned by the election, noting that the Affordable Care Act was destined for substantial re-write even in a Democratic administration, and that simplification of the approval process in the FDA would be a benefit.

Other significant takeaways include the following:

The investment focus has to be in a robust and growing vertical; Dana for example wants a space to be highly competitive, and looks for “forty or fifty companies” or else he thinks it is likely the wrong vertical.

Best IRR has come from funds with $250 million to $350 million dollars to invest. First time funds tend to be the most successful.

While seed money has mushroomed in the Boston market, A-rounds have become difficult. Growth capital at the low end is also difficult, but easier at the high end. Capital is generally available in the buy-out space.

Family offices are a significant support for raising funds. Family offices tend to be long term investors, and co-investors, and are favored by fund managers.

Finally, there was substantial emphasis on the quality of the CEO. You need to be in a company for the long run. The world will change, and you need a quality CEO to respond; some investment funds have venture partners whom they place on company boards or as advisors to assist in these responses, and they may even share in the fund’s carried interest.

Advice for Compensation Committees of Boards

The NACD panel on executive compensation set forth its perceptions of tasks for the public compensation committee for 2017. Set forth below are some significant take-aways:

The first job of the compensation committee is to figure out how to motivate executives to do the right thing for the company. Don’t get distracted by changing policies of the proxy advisory community (see the November 11th post to this site concerning changes in ISS parameters for measuring executive compensation).

What is the best way for the compensation committee to understand what motivates the CEO and executive team? The committee should stay very close to the CEO and include the CEO in its meetings. A suggestion to make sure that the committee also has its own time to separately consider compensation: an executive session held both before and after each committee meeting.

Executive compensation may be almost “out of control.” The audience was asked, “how many people here are in a company where the compensation committee target is to pay below the industry average?” There is a constant natural pressure, given human nature, to inflate CEO compensation. Coupled with research indicating that virtually every CEO views himself/herself as materially under-compensated, there is a problem which compensation committees may not be able to contain.

Although surveys may be valuable for lower echelon employees, compensation surveys for the C-suite should be looked at with great suspicion. Who did not participate? How accurate is the data? Most compensation committees do try to gauge compensation of chief executives of comparable companies.

There is growing pressure from the proxy regulatory companies on selecting the “correct” peer group for your company, as selecting an “aspirational” peer group will tend to drive up compensation.

See the following post re pay disparity.