The Law and Other Anomalies

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.

The Governor last week signed the long-awaited Massachusetts statute that deeply cuts back the enforceability of non-comp agreements for employees. The Act applies to all agreements made on or after October  1.   A detailed analysis will follow, but note that now:

*Maximum time is one year.

*To enforce the agreement, an employer must pay at least half base pay for the term of the restriction, unless employee breached a duty to employer (so called “garden leave” provisions).

*No noncomp will be enforced against employees let go without cause.  (This will put pressure on contractual definitions of “cause”).

*Employers can still prevent poaching of employees or pitching employer customers.

*Noncomps made in connection with the sale of a business will still be enforced.

Not quite California, where most noncomps are void, period; but a radical change in Mass business law.

Public corporate boards used to quake at the prospect of an attack by the “activists.” These corporate “raiders” force management to abandon long-term strategy, sell off parts of their business, reduce R&D, increase prices, pump the stock value in the near term, and then cash out their investment. This would leave the loyal long-term stockholder holding the bag, which was by then pretty much empty.

Enter today the new “activist” investor. These are large, long-term holders of your equity. Think State Street and BlackRock. Think the Investor Stewardship Group, a consortium of the world’s largest investors holding perhaps 20% of the value of U.S. equities. These major investors are seeking dialogue with boards, according to a panel convened today in Newton by the New England Chapter of the National Association of Corporate Directors.

And what do these newly active investors want to discuss?

They counsel good corporate governance. They counsel focusing on long-term strategy, as they are “value” investors. They counsel listening to the old-time activists, because they might have a good idea, but not caving in immediately in order to avoid a proxy fight. They look for engaged discussions with directors, touching on such matters as the strategic use of big data, diversity, overall strategy for employee compensation, and adequacy of climate change reporting (as it bears on long-term strategy).

When the panel members from Black Rock and State Street were asked directly by the moderator, “well then, aren’t YOU the activist investors now?” there followed an awkward silence. The audience laughed. The panel declined to admit to such a role until one finally said, “well, perhaps activists with a small a.” How do BlackRock and State Street Investments like to view themselves? Not activists certainly; just “not passive.”

So the corporate landscape today contains two kinds of constituencies pressing upon boards of directors: the more now polite, but still-lurking, old-school activist directors seeking perhaps a change in the long-term strategic goals of a company; and, the major institutional equity investor seeking good governance and an articulated long-term strategic plan.

Bottom line from the institutional investors: directors should be available to speak with their major shareholders, and not just to create a relationship but, rather, to also provide substantive dialogue around matters important to long-term strategic direction.

Golden Shares are equity interests with the power, within a corporate structure, to control a vote on some issue. Typically such shares are issued to creditors, who want to enforce superior rights in the event of a loan default, rather than being derailed by the equitable processes of Federal bankruptcy.  In such a case, a bankruptcy cannot be filed by a company unless the Golden Shares vote in favor.

Federal bankruptcy policy does not permit a creditor, before bankruptcy, to obtain a waiver of the company’s rights to file for bankruptcy.  If such waivers were permitted, every creditor would ask for one.  And the benefits of bankruptcy, including possible rehabilitation and fairness to creditors, would be thwarted.  Thus such agreements in all forms typically have been voided as against public policy.

But a bankruptcy court has no power to act upon any case unless, as a matter of proper corporate procedure, the bankruptcy case is duly authorized in the first instance.  If Golden Shares are properly included in the charter of a company, and thus corporate authority cannot be obtained to file the bankruptcy which thus gives the bankruptcy court any power, how can the bankruptcy court ever get so far as to over-rule the Golden Share’s power to ban bankruptcy?

The recent Federal District court case of In re Franchise Services permitted enforcement of Golden Share power, based on the following distinction: if the holder of Golden Shares got the shares for little or nominal consideration, then they really are not true corporate shares with enough economic interest within the debtor company to be given the vote, but rather they are just a gimmick to try to end-run public policy.  But in this case, the lender was a bona fide hard money equity investor, and as such could legally bargain for a control over bankruptcy to protect its investment.  The lender here only became a creditor after it was a material investor.  The Golden Shares were not a gimmick, but negotiated corporate rights afforded to a bona fide equity holder, and thus those shares could be properly voted as part of requisite corporate action and thus could be used to bar bankruptcy.

The case is on appeal to the Fifth Circuit, and there are prior cases on either side of this issue, so stay tuned.  And even if the decision in this case is upheld (that is, the Golden Shares of real equity investors can be sued to block company bankruptcy filing), there remain the following issues: Golden Shares obtained only to veto bankruptcy still will be ignored; it is not clear what metric should be used to measure the adequacy of the size of the equity interest needed to uphold the Golden Shares power; it is not clear as to the rights of an equity holder + lender if both the equity interest and the loan are made at the same time that the Golden Shares are issued (a not unusual business structure.)