The Law and Other Anomalies

Last week SEC Chair Jay Clayton announced that the SEC has begun a study to completely revise the matrix of laws and rules that permit the sale of securities without filing a Federal prospectus.  Characterizing the current system as a patchwork and noting that it grew incrementally as the government increasingly liberalized or clarified the groundrules for private placements, Clayton promised a “concept release” that would reformat and rationalize the placement rules to make them more easily understood by business.

Followers of the SEC know that a concept release can take a long time to produce as it wends its way through the SEC, and then it is open to comment and public input which may lead to proposed legislation or regulation which, in turn, must move through the Congress or through the drafting and public comment process for new SEC regulations.  So don’t expect immediate clarifications.  But surely our current system could use rationalization.

A couple of recommendations from this quarter: why not preempt State regulation so we have a single Federal system?  Why not address the issue of deregulating people who act as agents in raising funds in private placements, rather than requiring that they hold a BD ticket (or violate the letter of the law, as is common in present practice)?  Why not either simplify or scrap crowdfunding, which is seldom used to date, is complex and labor-intensive, makes risky equity plays available to people who cannot afford it, and attracts dumb money to highly speculative ventures?  Why not establish a simple, lightly regulated trading market for shares of very large private companies which now function with very many shareholders but are privately held (think Uber for example)?

In the old days, before we had Regulation D and Rule 144, the common law established a level of practice that may not have been clearly articulated to the business community but nonetheless was simple to utilize.  Why not a regulatory scheme that includes a substantially unregulated private capital market for qualified investors, with no need for reporting anything to anyone and with an exemption from State interference (which always was, and remains, a major problem)?

The real issue is fraud and lying.  The real issue therefore is very difficult to regulate.  We know it is illegal to defraud and lie.  Now all we need is a system that prevents it.  I bet Clayton doesn’t try to tackle that one….   We rely primarily on back-end enforcement and if anyone out there has a better plan, please let us (and Clayton) know.

Will the twains ever meet in the board-room?  Sort of.

Recent statistics cited by the Korn Ferry placement firm looked at boards of the S&P companies.  Only twenty directors were in their thirties while a whopping 2,488 were in their 60s. In fact, there were 49 times as many directors in their 70s and 80s as there were millennial directors.

Several points:  First, smaller companies, particularly those not public, likely have different demographics, by reason of inclusion of family members and younger key operations people sitting on the board.  Second, of course time will cure this disparity by flipping it on its ear.  Third, many emerging companies are founded by millennials, who may blend in some grey hairs but do sit on their own boards.

What interests me is that one theory of board building (one of the best ones) is to add directors who cover gaps in crucial board skills.  Without suggesting that us older folks do not learn new tricks, I have seen seeming growing interest in boards adding younger members adept at cyber issues (uses and risks), blockchain, marijuana, mobile apps, changing consumer tastes — the new economy.  I would have suspected greater millennial representation on S&P boards.  Of course, companies large enough to make the S&P also are large enough to acquire requisite skills from staff hired below the board level, but that approach denies the board the direct guidance of millennial thinking in setting company strategy (the key board function, which would not be supported robustly by non-board staff).

On a different aspect, Korn Ferry statistics about the world-wide occurrence of millennials and boomers casts some focus on the oft-stated US plaint that we are inundated with too many boomers:  while the US ranks third (behind China and India) with the absolute number of boomers, we are not even in the top five worldwide (UN 2015 stats) by percentage; each of Japan, Bulgaria, Malta, Finland and Hungary top that list with 25-26%.

Are we awash in millennials, then?  Seems not, perhaps reflective in part of our birth rate in the US.  We do not make the top five list in either absolute number of millennials (of course we are blown away by China and India, but are also behind Indonesia, Brazil and Pakistan), nor with the highest percentage in the general population (stunningly at first blush, the top five are all Arab / Arab Gulf countries).

Then we get to Generation Z….

The PCAOB is the board supervising accounting services to public entities.  Its 2017 report on the quality of audits of 75 BDs is troubling.

I must add that it is not clear that any of the errors noted caused any material misstatements, and that much criticism about over-regulation continues to be leveled at the regulatory framework applied to US public companies.  However and with that overlay of caution, note:

8% of auditors even failed the initial test of their independence.  Some had performed non-audit work for the BD which they now were to audit; interestingly, one auditor was disqualified because its engagement letter indemnified the auditor from liability if management knowingly misrepresented (a seemingly logical protection but the idea is that the auditor is supposed to be able to uncover that misrepresentation).

66% of audits failed properly to report revenue.  64% did not fully assess risk of misstatement due to fraud.  32% failed fully to report related party transactions.  59% failed properly to review the quality of their performance of the audit engagement.

Facially, one might conclude that BD audits are just plain unreliable, an unsettling thought about the industry that controls the care and investment of much of my, and I suspect your, personal wealth.  The PCAOB report does not necessarily mean that material error occurred, a helpful observation.  The report does suggest that material error has some palpable chance of occurring, a less sanguine thought.  The true import of this report (it is highlighted today in the leading securities lawyer blogsite “Jim Hamilton’s World of Securities Regulation”) is just obscure.

But food for thought: auditors who audit both reporting companies and broker dealers performed better than auditors who only worked on BDs.  Seems a broader world view may be better than a deep dive into only the BD universe.

Much of the US corporate governance scheme relies on the sagacity of independent directors, directors not beholden to management or major ownership’s interests and thus able to guide the company fairly on behalf of all shareholders.  Certainly for larger and public companies generally,  the need for independent directors is not only a mantra but also the law: public companies must have independent directors making up the comp and audit committees and a majority of independents overall; and under Delaware law, a vote of independent directors removes the stigma of self interest from many kinds of transactions wherein management and interested directors are dealing with the company and risk exists of unfairness to the minority.

Then you look at the defining corporate governance failure of our generation, the 2008 meltdown, and you see that independent boards were involved in some of the most spectacular failures of the era.  How can that be?

Recent research, building on seminal studies by Professor Jay Lorch at HBS, suggests that the failure was not the lack of independence in fact, but the lack of domain experience, that rendered independence irrelevant.

The board of Lehman Brothers, the bank which failed and triggered the collapse of financial markets, is a case in point.  The board was made up of smart accomplished independents, including ex-CEOs of IBM, SmithGlaxoKline, Haliburton, Telemundo and Sotheby’s.  But contemporary records confirm that none of them had domain experience in the financial markets in which Lehman played, let alone the sub-prime mortgage market.

The question arises, in a world of complex business, how DO you get directors who are independent of a company, not tied to a competitor, deeply knowledgeable in your business verticals (of which there may be several that are material), and not over the hill?  One suggestions is to get directors from industries that are at least analogous in terms of scale and business issues and target markets, if not spot on.

Another suggestion is to train directors to know what they need to know.  That would take a seismic shift in practice.  First, directors may be quite busy with their own companies or, alternately if retired, sitting on several boards.  Second, these senior people are not used to going to school, even if dedicated to doing a credible job as director.  Third, midst criticism of the high comp for public directors, one reply is that being a public director takes a huge amount of time if done correctly, and thus how do you increase the director work-load without increasing the compensation paid to the directors.

Every company and directorship experience is different.  Wise directors can find people inside or outside their companies upon whom to rely for risk-reward analysis.  But with directors of major corporations making hundreds of strategic decisions every month with potentially huge impact on companies or sectors or the whole economy, it doesn’t take more than a few failures of judgment  before you have the mini-depression of 2007-10 all over again.

My recent post flagged adoption of the new Mass law regulating noncomps by statute for the first time in the State, basically limiting noncomps to one year and requiring some payment during the restricted period.  Some important details to note:

*You cannot restrict non-exempt employees or interns at all.  This is for senior people only.

*If someone breaches a noncomp, the period can be extended to two years.

*There are mechanical steps and timing to get a valid noncomp from a new hire, including 10 day advance notice and flagging the right for the employee to have counsel.

*If an employer approaches a current employee for a noncomp, there must be a benefit to the employee, typically a raise or other “fair and reasonable consideration”; unlike some other states, notably NY, mere continued employment is not enough.  There is no definition of what kinds of benefit must be offered, and I smell litigation on the horizon.

*In a sale of a business where an employee gets a big payday, due to equity ownership or otherwise, a broader noncomp can be enforced provided the employee receives “significant consideration or benefit”– I smell further litigation on the horizon defining what is “significant.”

*Restrictions must be reasonable geographically and cover the specific services provided during the last two years (unless you can make a compelling argument for other services).

*If you fire an employee without cause or lay him/her off, your noncomp will not be enforced.

*The law covers people employed here and Mass residents employed elsewhere.

*Caveat: at the same time, Mass is enacting the Uniform Trade Secrets Act, which in some States has been interpreted as allowing the enjoining of competition, even without an agreement (!), if new employment would result in “inevitable disclosure” of trade secrets to a competitor, reports the Boston Business Journal (quoting an attorney in my firm, btw). Mass has never in the past entertained the “inevitable disclosure”doctrine under prior law, but then again they never had this new law on the books.  So stay tuned.