Corporate Directors: How to predict the future…

At this morning’s meeting of New England Chapter National Association of Corporate Directors, a panel of experts struggled to define issues that directors should be worrying about today – issues which might not arise until 2015 or thereafter.

The list of subjects was not surprising. 

In the technology sector, issues of cyber security and cyber crime, with particular focus on protecting customer data by reason of high economic and reputational risk, predominated.  In the patent area, company boards were admonished to establish a portfolio strategy and to pay attention  to whether their enterprise was indemnified against patent risk from third parties and whether they, in turn, were incurring potential liability by indemnifying their own customers.

In the health care sector, the restructuring of the delivery of medical care predominated.  Directors are responsible for establishing a health care strategy to be implemented by management.  There are three trends today:  (1) companies are getting more involved by driving employees to adopt healthy behaviors, to choose better providers, and to pick the right level of insurance; (2) other companies are stepping back, providing a “voucher” to employees and allowing the employees to decide their own level of care, generally by going to private exchanges and rolling their own; and (3) some companies are opting out, by reducing the amount of insurance, not offering insurance to family, and/or not providing insurance for part-time employees (Federal law requires insurance, generally, if you work 30 hours/week or more).  Boards must determine the level of obligation that their company adopts toward its own employees, bearing in mind that there is a tension between saving money by reducing benefits vs attracting better employees by providing benefits.

In the financial services sector, regulatory pressures dominated the discussion, particularly with respect to banks.  Boards must structure themselves to identify and adequately staff, with capable directors, all regulatory requirements, while at the same time fighting for enough agenda time for strategy in an increasingly competitive environment.

In response to a question concerning placing company data on the cloud, panelist Paul Sagan  (a partner at General Catalyst) noted that professional companies managing data in the cloud have much greater expertise than is likely to obtain for most companies protecting their own data and, therefore, placing data in the cloud (while not risk-free) is probably safer.

How accurate are these predictions of important future board focus?  Wendy Watson, chair of the Audit Committee at Citizens (among other Board memberships), noted that current bank regulatory reforms are designed, by necessity, to address failures leading to the 2008 meltdown.  Will they be effective in preventing future meltdowns?  Since risk may appear in situations we cannot even now imagine, no one can be sure that “it” won’t happen again. 

This admonishment, that the future is opaque, should be applied to all predictions.  Indeed, if we had a present and accurate understanding of the future, lives of companies would be more benign, and Board directorship a lot easier than it actually is.

Future Changes in US Corporate Taxation?

We are moving into yet another “Congressional year” where deadlock must remain the anticipated norm.  However, both the President’s budget and the Republican tax proposals contain corporate tax changes designed to drive different parts of the economy.  Below (with thanks to Paul Oliveira of KLR for his remarks on this subject at today’s Boston M&A Club) are some highlights: 

President Obama’s proposals tend to benefit multi-national corporations overall.  In order to reduce the US Federal tax rate, now very high on a comparative basis, the President is proposing a reduction of the C corporation rate from 35% to 28%, with a further drop to 25% for manufacturers.  The revenue loss is to be balanced by eliminating certain tax “loop holes” with which we have become quite comfortable, including notably: repeal of LIFO accounting; repeal of immediate tax deductions based on writing down inventory to lower of cost or market. 

Obama does suggest a minimum tax on certain foreign earnings, including where onshore-developed IP is transferred to a subsidiary in a low tax jurisdiction to be commercialized. 

A bundle of proposed tax relief for privately owned/smaller businesses includes increased expensing of certain equipment purchases, and extension of the zeroing out of capital gains on certain investments in small business stock. 

The Republican approach seems to focus more on private companies.  It also includes (more modest) enhanced expensing of equipment purchases, as well as simplification of the Code to allow companies with $10,000,000 or less of gross receipts to more easily avail themselves of cash basis accounting, and tweaks to the subchapter S rules which, inter alia, would permit non-resident aliens to invest (only individuals who are either American taxpayers or American residents presently can own subchapter S stock). 

The degree to which Congress finds time to address these issues, let alone reach consensus, is (to be charitable) unclear.  For the record, the Obama proposals reduce taxes in some areas and attempt to make up the revenue slippage in others; the Republican proposals seemingly all lead to corporate tax reductions only. 

[Note: any errors in this partial summary of Paul’s remarks are wholly the fault of this blogger.]

Venture Capital in Boston

Venture capital support for early stage businesses in Massachusetts, at least in the life sciences and in internet software, has not been this robust for many years.  Such was the consensus of a panel of three Boston-based early stage venture capital firms (Third Rock, Sigma Prime and Point Judith) at this morning’s breakfast meeting of ACG in Boston. 

The panel noted that the venture capital community has shrunk nationally and in Boston is now reasonably stable; they also acknowledged the debt which venture capital owes to angel investors for making high risk investments which sometimes bubble up into venture-financeable enterprises. Other significant points:

There are key elements that venture capital looks for in making an investment: an entrepreneur with deep domain experience and vision, a concept that has the potential of creating a truly large enterprise, a special technological edge, and a product or service which fills a fundamental need. 

The two VCs investing in life sciences had quite different appetites in terms of the size of an A round; one was looking for a range $2,000,000 to $6,000,000, another would go much higher (against milestones) in order to nurture the company to a point where professional management for ongoing operations could be brought in. 

When do you sell?  “Companies are bought, not sold.”  The venture capitalist knows when to sell when buyers are circling the company, and your professional management is listening to them. 

The IPO market is open for life sciences, and for larger internet/software based companies.  Will the IPO market open for the smaller SAAS companies?  The panel agreed that the prospect was dim; given needs for liquidity and the size of investment typically made by institutional investors, it doesn’t make sense to bring a software company public unless its market cap is in the range of $500,000,000 or more.  This size target in turn is only driven by sales of $50,000,000 to $100,000,000.  If you have a software company which has sales in the $30,000,000 to $50,000,000 range, it is too difficult to justify the requisite market cap so as to support an IPO.

Activist Shareholders: Care and Feeding

It is rare for a group of directors, such as the National Association of Corporate Directors/New England, to invite into its midst a so-called “activist shareholder.”  At the February 11th breakfast meeting, however, the group was addressed by Gregory Taxin, a co-founder and former CEO of the proxy advisory firm Glass Lewis and presently manager of an activist investment fund focused on small and mid-cap US public companies. 

Taxin pulled few punches.  He advised the directors that “you work for me, the shareholder.”  He reminded them that they are held to a fiduciary standard.  He stated that activism is a positive force in the capital markets and that activist shareholders should not be treated as an enemy, half-jokingly blaming Attorney Martin Lipton as the culprit. 

He noted that some shareholders have good ideas and do their homework and should not be met with immediate resistance.  Activists shareholders look for operational missteps without board reaction, and also for “stale boards” with historical hangers-on not providing added value. 

Directors should not feel that they have a “job” that is being threatened by shareholders, since they work for the shareholders and their duty is to maximize shareholder return.  He admonished directors to talk to all shareholders, not just activists, and find out what they really think. 

The biggest fireworks (to the extent fireworks ever break out at meetings of directors of public companies) arose when an audience member challenged the concept of activism, claiming that activist shareholders are short term investors who push hard for increased dividends, massive stock redemption plans and other actions that will bring immediate increase to the share price to the detriment of the interests of long term shareholders. 

Taxin fired back: there is no such thing as a long term investor;. everyone is economically rational or they are a bad fiduciary; the best way to create short term value is to make best long term decisions; best long term decisions increase projected future cash flow, which is discounted back to determine the present value of a share of stock.  The little old lady who invests and holds for the long haul does not even exist.  Everyone is a short term investor.

Hot Accounting Issues for Public Boards

What are the accounting issues most often being encountered by public companies filing annual reports with the SEC?  The following trends were noted at the February 11th meeting of the National Association of Corporate Directors/New England:

  • Request for detail as to effective tax rate as compared to the United States corporate rate of 35%, explaining variances above or below that rate. 
  • Discussion of the judgments applied to adjustment to valuations of balance sheet assets. 
  • Explanation of why a registrant believes that earnings held offshore are not subject to a balance sheet entry showing a deferred tax liability (why is the company saying that it does not intend to bring money held offshore into the United States?). 
  • More detailed segment reporting for different businesses. 
  • Discussion of assumed rate of return in funding retirement plans, measured against historical performance. 
  • Discussion of the judgment reached in not marking down goodwill (which must be reviewed annually for comparison of carrying value to fair value). 
  • Clearer labeling of non-GAAP financial reporting. 
  • Greater clarity in the accounting treatment of investments in China, Russia, India and other places where foreign direct ownership is limited and where companies enter into joint venture agreements. 
  • Increased focus on the robustness of internal financial controls, driven by PCAOB focus. 

A few years ago there was an effort to seek “convergence” of United States accounting principles (GAAP) with international accounting (IFRS).  Full convergence lacks steam; the different accounting systems have reached agreement on specific areas of reporting but full convergence is now viewed to be “a long way off.”

Board Issues: M& Litigation; Confidentiality

What are the legal trends affecting board governance of public companies?  This question was explored at the February 11th meeting of the National Association of Corporate Directors/New England. 

The biggest story by far: in M&A transactions exceeding $100,000,000 in value, based upon the last available statistics (2012), litigation occurred 93% of the time and the average number of cases filed was about five.  Almost all these cases settled, generally based upon increased disclosure and payment of legal fees, and generally without increased dollar remuneration to the shareholders.  There is a serious question as to whether this practice is in fact value added, or simply a money machine for plaintiff law firms. 

One defensive approach is for corporations to require that shareholder suits and derivative suits be brought in a single court, generally designating Delaware Chancery.  The Delaware courts have upheld the enforceability of these provisions.  Many companies going public now include such a provision in bylaws.  If the Delaware Chancery is without jurisdiction, litigants must use another appropriate Delaware court or the Federal court sitting in Delaware.  Placing all litigation in one court facilitates settlements; Delaware also is thought to be increasingly unfriendly to this kind of litigation.

There was a discussion of board confidentiality.  This generally is reflected in: establishing insider trading prohibitions; enforcement of SEC Regulation FD, requiring simultaneous disclosure of material corporate facts to all, rather than selectively.  However there is growing focus on more sensitive kinds of information: the texture of board discussions, especially what positions were taken by specific directors. 

The question of director positioning also arose in the context of directors who are designated to represent particular investor constituencies.  Although there is a general rule of confidentiality at the board level, a designated director is expected in fact to report back to the shareholders designating that director.  Many companies have adopted a practice of seeking confidentiality agreements with designated directors, restricting the kinds of information that may be disclosed, and sometimes requiring the sponsoring shareholders to sign similar confidentiality agreements.  There are difficult issues of enforcement in the case of violation. 

Lastly, it was noted that the New York Stock Exchange, has abandoned its 50% quorum requirement, now simply requiring that a “significant level” of shareholder participation (at least one-third) is required.

Developments Affecting Public Company Boards

This is the first of a series of four blogs reporting on corporate board developments.  These posts are based upon remarks at the February 11th breakfast meeting of the National Association of Corporate Directors/New England.  This first post relates to developments in the operation of boards of public companies. 

Gender diversity.  Although boards of all Standard & Poor’s Index Companies over the last five years increased from 12% to 17% female, the gap is obvious notwithstanding compelling documentation that diverse boards simply perform better.  In Europe, where gender diversity is sometimes mandated, companies are beginning to recruit qualified United States women for service overseas. 

Age, Term Limits.  There is an increasing trend to impose age limits on boards, although few boards have instituted term limits.  Most boards in larger public companies have enacted declassification and imposed majority voting, developments which favor shareholder activism and which are now cascading into mid-tier and lower-tier public companies. 

Risk.  The perennial major issue for boards: risk oversight.  Much of this effort is confined to committees, and the question therefore is: does the whole board get a complete understanding of its risk profile?  The boards tend to get into risk only through discussions of strategy. 

Proxies.  For the next proxy season, can we be informed by the past?  Last year, proposals for dividing CEO and chair functions passed 30% of the time; proposals affecting executive compensation (such as changes in option policy and holding periods) passed 23% of the time; majority voting proposals 60% of the time; declassification 80% of the time; private ordering of inclusion of shareholder-proposed candidates for directorships passed one-third of the time. 

Social Media.  Many boards these days are seeking experts in the use of “social media.”  This is liable to drive a younger cohort of directors.  The question was asked: will this effect built-in long term board members, who have a lot of ramp time before retirement?  One comment was in the negative; this type of person will not become entrenched.  To my mind, an optimistic view of human nature.

How to Price a Stock

Most of us invest.  We read the business news, we read the national and international political news, we rely on research and analysts and our personal observation of trends, products and the like.  It seems we are missing important data, however.

We should be reading the gossip columns.

Astute readers of the Wall Street Journal may have seen an article which convincingly ties the divorce status of CEOs to stock price.  (Thanks to Frank, one of my co-members of the National Association of Corporate Directors, for pointing this out to me, as I seemingly was not astute enough to notice it myself.)

Divorce that create the risk that a CEO must split his/her stock with the divorcing spouse can be a negative, as it suggests an overhang of shares for sale in the market.  Is there a pre-nup?  What is the law of the State applicable to the divorce, does it create community property?

A more subtle risk inheres in the perceived attitude of the divorced CEO whose personal wealth typically has been clipped.  The fear is that that CEO becomes more risk-adverse.  Some evidence is noted to the effect that cash bonuses and stock grants increase following a divorce, reflecting board perception that incentives for risk-taking must be increased following “a loss of wealth.”

Should we expect a new disclosure section mandated by the SEC?

Relief for (some) Finders

For decades, the SEC  (and state securities regulators) have interpreted the broker/dealer registration requirements to cover “finders,” who were deemed to be broker/dealers (in the business of selling the securities of others) and who thus had to be registered as such.  The registration was tedious, expensive, opened the finder to continuous disclosure, and most importantly was irrelevant to the functions the finders were performing. 

Finders generally operated in two spheres: raising capital for companies by the sale of securities, and engaging in the sale of businesses. 

The SEC on January 31st issued a so-called “no action letter” materially impacting the analysis relating to finders working on the sale of a company.  (The SEC action does not address the continuing interpretation of the law where finders retained to sell company stock  are classified as brokers.) 

Simply put, the SEC letter says that the SEC staff will not take enforcement action against finders in the sale of a business for failure to register as broker/dealers, in the following circumstances:

  • The general business of the finder is to arrange acquisition transactions, whether structured for the sale of assets or for a stock transaction, between privately-held companies. 
  • The buyer must “actively operate” the target after the transaction. 
  • The standard for “actively operate” is very broad; the buyer must end up with 25% of the vote or equity, and the finder itself cannot put together a group of buyers in order to reach that threshold. 

The theory is that if a finder is brokering the sale of a business,  such transaction can be structured either as an asset sale or a sale of securities, depending upon the negotiations between the parties (which depend on business or tax considerations); it seems anomalous to not require a finder to be registered if the parties elect to structure the transaction as an asset sale, but to require registration if the parties elect to utilize securities in the deal. 

There are many subtleties in the SEC’s letter not covered here; the area still remains sensitive.  The SEC letter is strictly limited to specific facts contained in it.  Assertions that I have seen on the internet, that now all business finders are not classified as broker/dealers according to the SEC, are inaccurate;  the SEC specifically says only that the staff will not undertake enforcement action in the limited cases described, but that the SEC is not conceding the legal principle.  Finders need to carefully structure transactions to conform to the SEC letter and, further, there is no assurance that state regulators will see matters the same way (although surely this SEC action will take some wind out of the States’ sails).

The Age of Snowden

Edward Snowden, the person who leaked the National Security Administration documents, has set off a public dialogue of sweeping proportion,  bringing substantial changes to the way in which the American press operates, and raising questions as to whether laws should be changed with respect to gathering data. 

Addressing a February 3 Boston meeting of the Amicus Club of the Civil Liberties Union of Massachusetts, New York Times writer and Yale Law School lecturer Emily Bazelon exhorted civil libertarians to sometimes embrace the actions of “rabble-rousers” as a counter-balance to excessive exercise of governmental power. 

High points:

In the  FISA courts that pass upon use of this collected data, there is no presentation of an opposing view (the view in favor of privacy), the proceedings are not public and the opinions are not published.  Snowden has allowed us to obtain some of the FISA opinions, which in turn has led to some suggestions, including one on the part of the President, that some sort of representation for the privacy position ought to be integral to the actions of this “court.”

There is pending legislation to affect the powers of NSA, but the future of that legislation is unclear.  Judge Leon, of the Federal District Court in Washington, has opined that the present method of collecting data is probably unconstitutional, noting that the government has never shown that it’s data collection program has actually prevented any particular event.  NSA’s  power was established to gather information in the fight against terrorism, and not for other purposes.

Glenn Greenwald of the Guardian,  the journalist who has been championing Snowden’s position and who first published the NSA information, has challenged the general assumption that a good reporter needs to avoid becoming an advocate for any particular cause, but should maintain a “critical distance.” 

In response to a question concerning unregulated data collection by commercial US enterprises, Bazelon agreed that there was substantial risk that the government would gain access.  The Europeans have a different tradition: skeptical of commercial enterprises generally, they thus are skeptical about their collection of “commercial” data.  She is not optimistic  that there will be a change of United States law with regard to private data collection, although some larger American companies now are pushing for limitations lest the lack of protection impact their international business. 

An informal inspection of the audience for this program indicated that more than 60% of attendees sported “gray hair.”  The attendees, at a lunch-time program in downtown Boston, did not reflect the demographics of the vicinity (not to mention the demographics of Boston at large).  Civil liberties issues, even those in the forefront such as NSA data programs, do not seem to light a fire under “younger generations.”