The AI Role of Boards of Directors

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Last week, an expert panel under the auspices of the National Association of Corporate Directors–New England, presented on what a Board should know about use of AI within their own corporation.  To this observer, perhaps by reason of awaiting specific guidance to be passed on to Boards, the session was fascinating but somewhat frustrating.

Consultants and investors agreed that at this point most entities were at a very early stage, experimenting and not going “all-in” on any function wholly dependent on AI beyond very basic data analysis (for which the less sophisticated AI was wholly adequate)..  Many experiments were often “fails” on a learning curve.  It was estimated that no more than 5% of companies were deep into AI implementation for a variety of reasons, including fear of the biases or hallucinations  that might arise from AI relying on large language models, and fear that one’s own AI might find its way into the hands of competitors.

It also seems that the key at this stage is for a Board to identify “use cases” in which to experiment with an AI solution.  Little guidance was given as to how a Board is best able to identify its own optimal use cases.

While no one on the panel stated this, it seemed clear to me that a board member without specific application expertise would be at a loss to have an inkling as to initial direction.  This observation leads to the use of expert consultants, or larger enterprises hiring a group of AI experts; it was not clear where a group of AI experts might be found, given the lack of industry experience noted above indicating a good direction.  Indeed, the panel itself seemed to possess substantial insight into possible approaches, but the panel was culled from elite experts not likely to be found on the average (albeit highly competent) Board.

It should be noted that in the past couple of weeks Economist magazine also noted, in a major cover story, that actual business use of AI in almost all significant use  cases was quite unusual; there seemed in the coverage some ROI hesitancy in the level of investment capital today going into the AI side of the economy.

While I have generally not been a fan of adding a Board member for each vertical function, favoring general board experience or domain experience in the enterprise business space, I confess to having concluded that AI at this point may well be a spot for one AI-expert director given the risk and the size of the spend involved.   (Until now, I was of the view that skill-specialized directors beyond the specific business involved were highly desirable only for financial control/accounting functions in certain kinds of enterprises.)

One thing was quite clear: all on the NACD panel were quite sure that at some point AI would be integral in a major way in all business, with continuing  huge investments coming into the AI space.  In AI, the best is yet to come– with the caveat the worst to come may be the next step.

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Changes to Delaware Corporate Law Protect VCs, Fund Investors

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A new Delaware law effective August 1 but applying retrospectively, overturning a contrary court decision, makes it clear that when investors in a Delaware-formed company obtain contractual rights which limit what that corporation  can do, those “negative covenants” are in fact enforceable.

Professional investors typically want some sort of control over how a company will be operated, before they make a significant investment.  The practice has grown to include a set of so-called negative covenants, which specifically would prevent a board from taking actions without agreement of certain shareholders, or a certain percentage of shareholders, or of a director representing a particular class of shareholders.  The earlier, now-over-ruled Delaware court decision struck down an  agreement vesting stockholders with a veto right over taking certain corporate actions, since the Delaware corporate law specified that the business of a corporation was subject to the control of the directors unless set forth in the Certificate of Incorporation (charter).  Such agreements also may contain not a veto right but rather compel future action without board vote provided a certain trigger event occurs.

While there can be a wide variety of negative covenants on virtually any subject, and often reflects the maturity of the company involved, generally the list of prohibited transactions includes charter amendments affecting the voting or financial rights of shares, the incurrence of debt or guarantees, transactions that suggest self-dealing by management, changes in business conducted, and changes in key personnel.

This site, in a  July 3 post, noted the pendency of the above change in the Delaware corporation law, as it awaited signature by the Governor (now obtained).

Other, technical changes affecting M&A and investment practice also have been adopted, for which I respectfully refer you to the July 18 alert at https://duanemorris.com/alerts/2024

 

College Athletes Can Be Paid

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That college athletes can be paid has become common knowledge and widely reported.  What has escaped careful analysis is the May settlement by the NCAA of three antitrust law suits claiming damages for prior failure to compensate college athletes.

First, the lawsuit did not relate to nonpayment for playing. It related to: compensating college athletes when their name, image and likeness (in the trade, “NIL”) was used for commercial gain prior to 2021 (when NCAA first granted permission for such payments); and, income paid to NCAA for deals with TV markets (which practice also prevented athletes from profiting on their true market value).

I omit here the likely reasoning behind NCAA’s decision to pay about $2.8 Billion (yes, BILLION) to settle cases brought under an 1890 Federal statute passed to break the 19th century Trusts over a century ago, a time when the NCAA and the idea that money could be made from college athletic contests was many decades in the future.

I note that the Federal court has yet to agree that such payment will be adequate in amount, nor as to the other terms of the settlement.

Payment will be effected by the NCAA in large measure, from its cash reserves and insurance payments (did you think the NCAA was a charitable institution?), while major schools each may be hit with as much as $30Million per year for the next ten years, which may well distort present athletic programs (and reduce direct scholarships or rosters sizes of major programs).  Feel free to think about your donation to your alma mater if it has a big-time athletic program, although it may be that your school will actually need your donation even more in the future….

It is unclear how proceeds will be split among athletes historically, how current payments will be made for future events, the split between male and female athletic programs– so no doubt more (confusing) developments will appear.  Newspaper reportage could be confused; not sure sports writers are best suited for this kind of stuff.  Forgive this shameless plug for my law firm, which  follows this matter closely, and which has a fuller report on the foregoing available now; http://www.duanemorris.com and go to “alerts.”

Major Change in Delaware Law?

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Delaware law is known to be friendly to management and to boards of directors.  Company founders and investors long have favored Delaware corporate law as being best for establishing good governance, predictability of result, and freedom from strike suits by disgruntled minorities.  Recent criticism of some seemingly contrary Delaware court cases, criticism by Elon Musk (whose ox was gored by a recent decision striking down his multi-billion dollar employment agreement) and the movement of some corporations out of Delaware, has for the first time created concern that pro-management corporate governance is under attack.

A couple of weeks ago Delaware’s legislature adopted a new statute, which the Governor has indicated he will sign, that further alleviates this concern that Delaware no longer will enforce board control with rigor.  Effective August 1, Delaware will make expressly legal a contract between investors and a company which will contractually compel boards of directors to undertake or refrain from specified corporate actions.  Last February, one such agreement was struck down by one Delaware Chancery Court member, although such contracts are not unusual as between corporations and major shareholders (typically PE or VC funds).  The new statute would make such typical agreements expressly permissible.

Frankly, the outcry against this new law, alleging that it restricts board action that should be absolute, while perhaps “correct’ in some abstract sense, seems foolish.  That horse ran out of the barn long ago.

First, general use of such agreements has long been an important element of capital formation and is reflective of established market logic, none of which previously  has in fact been judged to limit board primacy.  The new law merely reinstitutes the market status quo.  Second, it is clearly proper to place restrictions on what a corporation can do if contained within the charter (Certificate of Incorporation) of a Delaware corporation, and such charter provisions by their nature restrict  board action; thus, a contract is simply a different route to a fundamentally acceptable end.

The passage of this new statute is not bad news for Delaware governance, it is just a correction of a judicial blip.

 

 

Not Reporting the Law

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You may have noticed a paucity of recent posts of late, even though legal issues have dominated much of the news.  The Supreme Court has a near-monopoly on legal developments, but of course there are the legal battles of Donald Trump, the Boston drama of a weeks-long televised criminal trial, and numerous court determinations about abortion, curtailment of the powers of various Federal agencies such as the SEC and FTC, and restrictions on the President forgiving student debt, just to mention a few.

My view has been that  major themes are well-covered in the general or business press, and do not need my repetitive posts as an echo chamber; those people with an interest in such things will find sufficient information to satisfy their needs.  I try to post about important things that might not get either full coverage elsewhere or with respect to which the coverage is not crystal-clear as to major take-aways.

I did want to comment generally, however, about what is a clearly emerging legal trend in American case law, and its overall impact.  This impact is sometimes seen as a swing towards  conservative viewpoints, or as a swing to traditional law, or as a political or socio-political movement, and each such analysis bears consideration.  But from a technocratic standpoint, the trend is best seen, I suggest, as the dismantling of the liberal administrative state.

On the operational level, as relates to the conduct of American business, this is a process of substantial deregulation.  Until recently, government regulation was seen either as pro-active for the protection of people or, alternatively, as meddling with individual freedoms, with the pro-active viewpoint often reflected in growing governmental policy both at the federal and state levels.  However, many courts recently are consistently cutting back on the exercise of power by  governments to impede business practices.  The activism of the current federal administration is very robust, but against this back-drop the decisions of many courts stand highlighted in contrast.

While the upcoming election  season will define which approach will control the White House, the Congress and state governments, the composition of the courts (appointed at all levels and with an  increased  anti-regulatory streak in many cases) will remain relatively constant (most judges don’t get re-elected every few years), and those courts will continue to exercise power towards less governmental regulation.

Each side of the argument proceeds from a desire to provide the greatest good for the population at large.  But the manner of establishing that “greatest good” is radically different: government protection vs individual freedom to decide for oneself. The popular and business press is highly attuned to reporting this ongoing battle, and you will be spared much regurgitation of such matters   in this blog site.  But one last thought: you will see much impassioned rhetoric on both sides, a growing number of court cases trying  to negative governmental activism, and a set of business opportunities  which may well alter our understanding of  the social compact.

Stay tuned….

ESG vs WOKE: Politics vs Corporate Practice

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ESG is the buzz-acronym for investing based on equity, sustainability and governance practices of a company.  WOKE is the buzz-acronym for a political movement reflecting one side of a cultural war.  Anti-WOKE legislation of varied sorts has been adopted in nineteen States, and is heavily lobbied against by vocal groups including climate change deniers, fossil fuel groups and the Republican governments of several important and growing States (think Florida and Texas for starters).  ESG has become a toxic phrase in some parts of the marketplace.

What does all these mean for the conduct of corporations?  The Spring issue of Directorship, the official publication of the National Association of Corporate Directors, attempts to get underneath the rhetoric on both sides to measure the actual impact of the WOKE movement on the ESG agendas adopted by a large majority of America’s biggest corporations.

The conclusions need a caveat.  The NACD article relies on anecdotal input from admittedly senior people, but the interviewees are few in number, and the survey jointly conducted by NACD and Wall Street Pro was pretty limited in content.

The conclusions generally are: corporations are committed to ESG values; 75% of S&P 500 companies factor ESG into CEO compensation; companies may scale back the rhetoric and stop using ESG as a catch-all, but remain committed to its values and for the most part will not alter substance; over time, companies likely  will  break apart the elements of ESG  and start pursuing and reporting them as separate issues to avoid political pressure.

The corporate mind-set is reported as of the view that ESG attentiveness is related to better economic performance.  By adhering to this view, corporations can end-run most of the anti-WOKE legislation, which tries to tie permitted corporate policy to economic factors only.  People may stop trumpeting ESG efforts (Blackrock itself, an earlier investor supporter, is reputed to have already done so) but they will continue to pursue them.

Finally, seems to me that adherence to the substance of ESG as related to profit, putting aside positive social impact for purposes of this narrow analysis, needs to be founded on actual economic success for the bottom line which justifies ESG for the entity and its investors.  I have not seen recently any robust studies of the correlation of ESG focus to corporate profits, but a year or two ago I did see (and post about) the majority (albeit not 100%) view that such correlation existed.  It does seem, at this point, that ESG is here to stay as an operational element if not a PR focus; the substantial infrastructure supporting ESG in  many corporations will remain in place.  No doubt some smaller number of corporations will declare themselves ESG-free, but not with the present assent of the world of corporate advisors (including NACD).

[Disclosure: I am on the Emeritus Board of NACD-New England.]

 

 

 

 

Update on FTC Rule Banning Most Non-Competition Agreements

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First, there is no rush for employers or employees to react; the original FTC Rule was to take effect after 120 days of publication, but as anticipated litigation has been entered by several parties including the US Chamber of Commerce to void the proposed Rule as violative of the Constitution.  The crux of the claim is that a Federal agency (here, the FTC) does not have the constitutional power to in effect pass legislation which is not within the fair purview of the laws giving that agency its regulatory mandate.  Congress could, if it chose, address the matters addressed by the FTC–just not the agency absent Congressional mandate.

Interestingly and to me surprising: many recognized legal scholars agree that the Rule is an example of a Democrat-driven agency being overly aggressive in its regulatory posture.  And, I do not mean to engage that politically charged discussion which presents itself also and legitimately as a constitutional question.

Robust commentary in the last day or two has clarified certain elements of the proposed Rule, and those I address in part below.

First it is important to explore the different treatment between senior executives and “workers” who are not, as they are treated differently.  A senior executive is indeed a rare breed.  Not only must that person earn in excess of $151,000+ per year, but also must have authority to make policy.  Further, that policy-making power must be at a very senior level, it is not just making work rules or the like.  The power to make policy must have two attributes: the policy must be final and must be highly significant.  Sounds like CEOs and Presidents. These are the only people likely to be executives in this model; this category, which can be bound more profoundly to noncomps, is not a catch-all by which employers can just increase pay in order easily to bind high earners to noncomps.

If you are a worker and not an executive, you are not to be bound to any old noncomp nor to any noncomp imposed after the effective date of the Rule.

If you are an executive so defined, you can in many but not all circumstances be bound to noncomps you signed prior to the effective date; but even this group cannot be made party to a binding noncomp entered into after the effective date of the Rule.  The only difference is that executives prior to the effective date can be held after the effective date to those old noncomps.

This suggests employers today may be rushing to get noncomps from people who are executives under the Rule, if not already so bound.

Sales of businesses create one potential set of complexities.  It is often demanded by company purchasers that executives, founders and owners of corporations, or partners in a business being sold, enter into a new noncomp so that the business being purchased cannot be harmed by a person affiliated with the seller.  Here new noncomps can be obtained and enforced, in the future, against 25% shareholders (who presumably are being amply paid to stay away from competition).  Historically,  many lesser owners and employees were asked to sign non-comps in connection with an acquisition.

Impact on VC investments is interesting; VCs often seek noncomps from key workers and from defined executives before they invest.  Not getting such protection increases perceived risk to investors; will increased risk depress acquisition prices?

There may be issues for founders no longer employed.  Can an investor demand that a founder with <25% of the company who is not employed sign a noncomp?    Can an acquiror?  The Rule is supposed to protect only employees.

Seems in partnerships each partner may be deemed an employee?  What if a partner is a <25% owner (be careful how that is defined in the partnership documents) and is just an owner and not employed?

Impact on joint venture arrangements?  More an anti-trust issue?

Let us say someone is an executive as defined in the Rule, has an employment agreement with an embedded noncomp, the Rule becomes effective but the term of the employment agreement is running out–if the parties extend the term, is that deemed as to the noncomp an unenforceable new agreement?  What if the agreement self-renews every few years unless one party sends a notice of termination?

What about a separation agreement for any employee newly entered into that provides new compensation for a noncomp?  So-called garden party noncomps for which someone is paid?  They are being paid during the term of the arrangement, the person is “employed” and is not thereafter prohibited from competing. Seems okay?

Seems that normal accoutrements to basic noncomps will remain enforceable: protection of trade secrets and proprietary information, bans on hiring employees.  There is risk that some broader styles of articulating trade secret protection may constitute a de facto illegal noncomp, however:  what about a clause that says that trade secrets includes anything learned by the employee during the employment that could enhance a competitive effort?

There is a lot of law to be made if this Rule survives.  And if the Rule is killed now, and the Congress adopts anything like it (which may be unlikely), hopefully that law will address various scenarios with clarity or charge a committee to institute clear guidance in a wide variety of circumstances.

Sorry for reminder but it is super-important that readers understand this is NOT legal advice.  Take no action based on this post–see your friendly neighborhood lawyer.

FTC Rule Purports to Void Most Noncompetition Agreements for Individuals

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The adopted FTC Rule voids all present and future employee non-comps after a 120 day waiting period.  This Rule will surely be challenged in court and such a challenge likely will delay implementation.  It should be noted that the scope of the Rule is unclear as to which executives it applies to, how it functions in an M&A transaction, how it impacts such ancillary prohibitions such as inability to take employees or marketing to existing clients, etc.  There is also a date before which institution of litigation by employers based on old noncomps (which would otherwise be voided) may be valid.

This post, and my firm’s Client Alert (just google DuaneMorris.com and hit Alerts tab), are not legal advice.  Employees and employers are likely wise to review their particular situations and revert to their counsel with any questions. Much is unclear at this juncture but the driver of this action is to create competition in the marketplace and increase wage opportunities for the workforce.  No doubt future posts will seek clarity and will surely report on any delaying litigation.

 

 

AI Burdens Patent Office

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Last week, the US Patent and Trademark Office issued guidance asking that lawyers submitting patent applications limit the number of references cited in the filing as constituting “prior art;” prior art refers to older inventions that should be considered in the patent review process.  Lawyers tend to cite all plausible prior art that could affect the novelty of the proposed patent, so that the subsequent grant of a patent after such disclosure is less subject to attack by a prior inventor claiming infringement.

AI is being used by attorneys filing patent applications to find and cite larger numbers of prior art; the theory is that such inclusion benefits client patent applicants and also meets the requirement that lawyers fully represent their client.  There therefore is a tension between applicants and PTO reviewers who seemingly are overworked or slowed down by so many references to prior art.

There is a tinge of “pot calling kettle black” on the part of the PTO, which itself is using AI to check prior art.  It takes a brave lawyer to omit a reference, although lawyers are required/expected to cull such references for applicability; and, applicants should be in favor of a maximal list (although they are harmed by processing delays).  Maybe more examiners?  Costs money–and although in fact the PTO also has increased filing fees based on number of references, the maximum fee of $800 per application remains seemingly modest.

Can we envision patent applications and patent review  being “assigned” to AI without human intervention?  I hope not to be practicing when two AI programs argue infringement in a proceeding being conducted by yet another AI-driven computer…..

The Boston Fed Discusses the Economy

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Susan Collins, CEO of the Boston Federal Reserve Bank, spoke yesterday about the prospects for the US economy, at a program sponsored by National Association of Corporate Directors – New England.  After an erudite and informative presentation, the audience learned much about how the Fed operates, and little new about where the economy was going nor how fast it was going there.

I hasten to add that this is no criticism; the Fed’s public announcements are pretty specific about what their public stance will  be, and it is foolish to expect the head of one of the constituent Fed banks to say, in effect, “well, no, let me give you the real scoop.”  Below for the record, is an anecdotal summary of certain of her remarks:

The Fed’s mandate here is to achieve price stability and robust employment.  Recent inflation was very rapid, unusually so.  It is unclear when it will show sufficient drop to trigger the anticipated but now seemingly delayed decline in interest rates.

The US economy was remarkably strong during the rate hikes.  The reasons were: supply chain was fixed; employment surged, in part due to immigration; employee productivity surged; consumers had a nest-egg from the pandemic to fund domestic spending, which is two-thirds of GDP; salary increases were just catch-up to prices and were confined mostly to lower wage-earners,.

Are we assured of a so-called “soft landing”?  Unclear.  Just now, core inflation ticked up slightly.  “There is so much we don’t know.”  (If the Fed doesn’t know, what are we to conclude?)  The economy will slow down–unclear what that means in detail. “We have been surprised so often.”

As to their mission to support labor: problems abound in affordable housing, child care costs, transportation.  Not a surprise that these issues are significant in New England.  Nationally, housing costs actually declined in 2023, but not the future near-term trend and was not even true in New England.  Low mortgage rates now in effect, vs high rates now offered, means that owners do not move or downsize (they are in “houselock”) and this reduces housing stock for sale which further drives up housing prices for both purchase and rental.

The pandemic clearly altered current patterns of work, which has impact on housing also.  What does the Fed think about whether work patterns we are seeing now reflects the future of work?  “Not settled.”

Questioners probed for clues about rate cuts and soft landings, without eliciting new insight, just recitation of factors.  It was also noted that inflation creates higher income for retirees, who are spenders in the economy and a growing population segment.

My conclusions:  the Fed is weighing many factors relative to rate cut timing and amounts, given the numerous above-cited unknowns and lack of certainty of a soft landing;  Ms. Collins never once said in substance that a “soft landing” was the Fed’s main goal, and I was afraid to ask “so the primary goal is to kill inflation and not to assure a soft landing, is that right?”; thus it is  unclear to me whether or not the audience just assumed that a soft landing was primary; this assumption of mine, with lack of audience probing, was the most fascinating part of the entire program for me.

I leave to my readers the impact of all this on your spending, investment and life planning.  We are promised, from high authority, lack of clarity, lack of settlement, and a history of surprises.