PEs, Delaware Entities and Anomalies

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The formal title of this blog site is Law and Other Anomalies.  An anomaly is something that is incongruous and inconsistent.  Welcome to Delaware business law.

Let us say your are a fund investing in a Delaware corporation; you have preferences in the waterfall and the power to trigger a sale through board control or contract.  You trigger a sale and by definition you are getting a preference in the proceeds.  You run the risk of breaching your fiduciary duty to the minority, and deal terms likely are subject to fairness review under the “heightened fairness standard.”  Those of us in the business are aware of the complex charts that have been published trying to explain the various levels of review and approval that interested parties must go through to navigate safely the corporate fiduciary duties of the majority or the control parties or the favored parties, in order to avoid a claim of breach of duty.  And this is true even though Delaware, in closely held smaller enterprises, is less wedded to treating small companies as if the players owed each other the same high standard of loyalty as is owed in simple partnerships.

Same facts but let’s swing over to an LLC.  The standard paper for an LLC will have the same business terms but also will state that all fiduciary duties are waived and that the fund may well have discretion to call for a sale in its own judgment.  Such waivers of duties are not unusual in LLCs.

In claims brought against controlling investors in a Delaware LLC by junior investors, objecting to a sale that paid out the controlling interests but left virtually nothing for the junior tier, recognizing that the language of the Operating Agreement waived fiduciary arguments, the plaintiffs asserted a claim under the general contractual doctrine of breach of the obligation of good faith and fair dealing in the operation of any contract.

In a February decision (Miller v HCP), the Delaware Chancery Court threw out the claim.  Their decision basically was “can’t you plaintiffs read English?”  Fiduciary duties were waived.  It was clear on the face of the paper that the controlling parties could trigger a sale and be paid first.  And the argument that there is an obligation of good faith and fair dealing applies only if unexpected events arise which would work an unfairness.  Nothing unexpected here: it is all spelled out in the Operating Agreement you signed.

An argument can be made that the difference in result based on the choice of entity type is anomalous; the entity type should be driven by other business and tax considerations.  Further, in order to stimulate capital formation it is likely that the best rule is the LLC rule and that one ought to be able to draft effectively into corporate documents the same result you get with an LLC.  There are no doubt situations which create abuse and one would draft very carefully, but the ability of investment funds (for example) to obtain contractual leverage for their money should not depend on the type of entity — in a rational system.

As a side-note: I have written in the last year or so about the problems of the Delaware law in dealing with authorizing the sale of a corporate business, for which I respectfully direct you to my CV at my firm’s website;  at that point you can link to the relevant articles. http://www.duanemorris.com.

Forgive another side-note: when I first encountered the concept of an anomaly it was many years ago as an astronomy major in college; the concept if I recall correctly had to do with degrees of arc for the apogee or perigee of a body from its primary.  Understanding astronomy was difficult but at least there were logical answers — unlike Delaware business law on occasion.

Bankruptcy Waivers

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This last cold, gray drizzling day of April here in Boston might as well be the day on which we discuss bankruptcy, itself a gray subject.  I am sure all readers are fascinated by waivers in bankruptcy proceedings, so do read on.

When a company goes into bankruptcy, the law imposes an automatic “stay” on litigation against the bankrupt company which may be pending in another court.  The idea is that all claims should be brought before the same tribunal so that the relative rights of all aggrieved parties can be measured, and in light of the hopes in some cases of rehabilitating the bankrupt company.

A creditor can appear in bankruptcy court and argue that the stay be “lifted” so that litigation pending in another court can proceed, and the bankruptcy judges will apply principles of equity (fairness) to decide whether a stay should be lifted.  A secured creditor of a bankrupt, for example, having priority over other creditors by reason of its collateral, may successfully argue that it should be able to foreclose.

Prior to bankruptcy, clever creditors may seek a contract with a debtor which attempts to remove the risk of suffering a stay in event of default.  The creditor may obtain a pre-bankruptcy agreement from the debtor that the debtor will not file bankruptcy, or that the debtor will not object to the lifting of the stay in the event of a bankruptcy filing.  Federal bankruptcy courts historically have been loathe to enforce such private contract provisions which, after all, strip judicial power from the judge.

However, a new case in Boston’s bankruptcy court did in fact enforce a prior waiver of the stay to permit a creditor to proceed with collection during pendency of bankruptcy.  For us lawyers, this was sufficiently big news to find it reported on the front page of today’s issue of Massachusetts Lawyers Weekly.  All legal cases are of course fact-specific and there were many salient facts in this one (In Re: A. Hirsch Realty, LLC), but what interested me was the discussion that the pre-petition contractual waiver favoring the creditor was signed by a sophisticated debtor who had experienced counsel.  Judge Feeney distinguished this case as not involving a waiver which was contained in a loan agreement where an unsophisticated debtor just signed the form without really understanding the significant protection the debtor was surrendering.

Many loan documents contain pages of “boilerplate.”  Some of it (express here your shock) is highly technical and favors the creditor.  Debtors do not have much leverage in many of these situations.  And creditors extending credit in iffy situations are entitled to enhance their positions, where there is significant ongoing risk of non-payment.  But the law may be moving, ever so slightly, in favor of protecting your average debtor.  Institutional creditors with counsel may want to consider how much to rely on clauses that affect a future possible bankruptcy, such as the stay waiver, in evaluating their risk metrics.  They may for example provide specific disclosure of the meaning of the waiver, or insist that the waiving debtor have experienced counsel.

SEC Proposals for Investment Advisors

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The SEC yesterday proposed significant new regulations affecting the relationship between investment advisors and retail customers.  In substance, proposed Regulation Best Interest would establish a duty for registered advisors and retail brokers to act in the best interest of the customer in recommending securities or strategies, putting the economic interests of the customer first.  This reflects the SEC position that advisors and brokers function as fiduciaries, which in turn places a high burden on the advisor.

Additionally, the SEC proposed yet another form, CRS, a short-form disclosure describing the relationship in simple terms; registered advisors and brokers would both be required to comply.

In substance, major disclosures to be required: any conflicts of interest, an obligation to understand investment products proposed and that they are believed to be in the customer’s best interest.

Details abound.  There is a ninety day comment period after which the SEC may promulgate its new regulations, amend them, or withdraw them.

Who Owns Corporate Culture?

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It depends whom you ask.  The cultural values of a company are transmitted downstream by the CEO, but the Board of Directors names and monitors the CEO and is responsible for the culture evidenced at the Board level.

Since the Board is responsible for selecting the CEO, or replacing the CEO if either performance or cultural issues arise, the buck stops at the top.  But how does the Board, with limited time to spend on its tasks, gather insights sufficient to measure the cultural temperature of the entire organization?  This question occupied much of the attention of the panel convened today in Boston by the New England Chapter of the National Association of Corporate Directors.

Some tools: directors should talk to many executive and non-executive employees not in the CEO’s presence, asking open-ended questions to foster rambling information; directors should obtain detailed metrics on departures from the company by location and job description and sex and ethnicity; directors should ask the Compensation Committee to consider culture and talent, as well as statistical metrics, in awarding compensation; directors should put “culture” formally on their agenda, as ERM tends not to pick up this aspect of performance; as culture starts at the top, directors should establish and enforce a culture of the board room, bearing in mind that even one errant director, or CEO, can alter the content and enforcement of cultural values.

There was brief mention of, but seemingly implicit consensus for, the proposition that millennials are more overtly focused on good corporate culture.  I wonder if that is correct in the long run.  The purity of cultural values for younger generations tend, to my experience, to give way to an acceptance of compromise and expediency; and today there are many more companies founded, led and/or staffed with younger people in our tech economy, creating a sense that the younger players are better at establishing an open and honest cultural enterprise.  But observing the actions of young founders of major companies who are now “aging,” we may be looking at a passing  phase of millennial respect for culture, on the road to its deterioration.  We heard no discussion of whether the reputed millennial focus on good corporate culture is likely to be transitory.  I remain (perhaps predictably) convinced of the value of mature executives and directors applying experience to the task of enforcing cultural standards in the face of the push for rapid results.

The panel also noted that most acquisitions “fail,” largely due to differences in culture between acquirer and target.  It is time-consuming and difficult to change the culture of a target.  It was suggested that acquisitions by PE firms may be particularly culture-endangered; PEs are all about boosting sales and using leverage and exiting the enterprise in 3-5 years, and are often tone-deaf (it was alleged) to different values held by target management (and by, often, multiple successor CEOs who do not appreciate the PE approach).  It was suggested that M&A should stand for “Murders and Acquisitions” as PEs set goals inconsistent with ambient thinking.

The Color of Science

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FIRST runs robotics competitions for High School students.  The competition ends with a national championship round in Detroit.  But yesterday, the Greater Boston Regionals were held at Revere High School, outside of Boston.  It was an education.

There were about 64 teams competing; each team had at least a half-dozen members plus related parents and fans and coaches in the packed stands.  Some teams had upwards of twenty members.   There were many hundreds of people in attendance, I venture to say a couple of thousand although I have no reliable figures.

Where are all the high school students of color?  Yes, I admit it, I took an informal head-count.  There were many Asian students, a few I would guess to be from India or environs, and perhaps a dozen kids of African descent.  I know it is obnoxious to keep an unscientific count, as well as offensive in its own right; and I am sure my numbers are off, but — globally, I am correct, no doubt about it.

It was so skewed in favor of white faces that for a moment I thought I was in the stands at Fenway Park.

FIRST stands for  For Inspiration and Recognition of Science and Technology.  It is a progressive organization dedicated to fostering science throughout local communities.  Teams from over much of Northern New England competed yesterday; an “alliance” led by the much-revered NUTRONs took first place (my son’s Newton-based Ligorbots were on the second place alliance and move onward in the competition).  FIRST’s publicity photos show racially diverse students, from the grade school program on upwards through high school.  Why then were there so few people of African descent in the competition?  And only one team with more than one African-American (as best I could tell).  Boston as a city is 45% white, although the affluent suburbs have a very different composition.  This competition was overwhelmingly white.

Is it the schools?  Is it money (the robots and related gear are expensive, complex, require money to support the team, not to mention that you need trucks or trailers or vans to transport robots the size of your desk to and from events)?  Are there coaches in the neighborhood with the skill sets to mentor, corporate sponsors, batteries, T-shirts, mascots, metal shops, computers galore, an educational milieu?  All the stuff that goes into a suburban childhood, with at least some access to capital, was on display on the part of the competing teams.

If a fine and properly aligned organization such as FIRST, running this competition for at least 21 years in Greater Boston, has yet to organize and advance students of color after all this time, we are living in a bad place as a society.  We all are certain that kids are kids, with the same innate skill sets across racial populations (indeed modern theory tells us there is only ONE racial population here on Earth).   When different groups, labelled as different racially, wind up at different end-points, we know there is a problem.

Time to retool approaches?  I am without insight here, but as a consumer of social reality I gotta tell ya– I left the High School yesterday elated for my son and depressed for my society.

 

Are You a Sub-Licensee of Technology?

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Recent cases both in the law reports and in my practice have emphasized the risks run by sub-licensees when the prime licensee lose the prime license.  Let’s assume University licenses technology to A and A sub-licenses (properly under the prime license) to B.

Then let us say A is a bad licensee and doesn’t pay royalties.  Or A has financial troubles and ends up in a bankruptcy liquidation.  In the first case University cancels the prime license.  In the second case, the chapter 7 bankruptcy trustee most typically has no money to spend messing with preserving contract rights and, failing to adopt the prime license, that prime license terminates as a matter of law.

Unless the University has agreed in advance (at the time of the sub-license) to recognize B as holder of the license in the event that A drops out of the picture, B may well lose its sub-license even though B has paid every royalty dime and complied with every covenant in the sub-license (including those provisions which fully protect the IP of the University).

Recent case law and an analogous case in my practice have emphasized the importance to the sub-licensee of getting this protection up front, lest being held hostage to the first licensor which realizes that its financial ship came in with flags flying.

Disclosing Climate Change

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The SEC requires reporting companies to report material risks and impacts of climate change on their businesses.  How are they doing?

Not so well, according the the Government Accountability Office report late last month.  The SEC does not get this information in an identifiable place within the disclosure regime, nor does all disclosure address similar factors, so that it is not easy to evaluate what disclosures are being made.  And it is wholly dependent on the subjective judgment of the companies as to what gets reported.

Climate disclosure shows up in descriptions of business, risk factors, MD&A and Legal Proceedings.  It may be considered in terms of physical risk or destruction, increased costs, interference of supply, loss of vital parts or components or agricultural products, loss of the entire subject of the business (growing grapefruits, for example), increased regulation and fines, long-term business trends, impact on customers or suppliers sensitive to environmental impact.

How important are such disclosures?  While many investors and investor groups cite increased focus on climate and the environment as important factors, the SEC’s own Advisory Committee reached no consensus and industry representatives said current disclosure standards are sufficient: a company knows when and if climate change presents a risk to its own business and if the risk is material, it must be disclosed.

It is not often that the increasingly complex web of SEC disclosure requirements is found wanting.  Since some senior SEC staff are in agreement with the GAO assessment, stay tuned for more disclosure regulation.  Will the tone in Washington hold off even more disclosure regs?  We shall see.

 

Killer Bees Return

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Okay, another baseball post.  Spent five hours yesterday in 39 degree weather at Fenway Park for Red Sox opening day.  Freezing cold, with a brisk wind.  Looked like a football crowd, but Thursday was clear and bright, a break between the cold rain of Wednesday and today’s forecast of afternoon snow.

The Sox were losing 2-0 and in the bottom of the ninth but tied the game with hits by Betts, Benintendi and Bogaerts.  They won in the 14th with a hit from Bradley.  Sure there were other contributors (Ramirez was outstanding), and I have long been a critic of Bradley (how can you win the Series with a streaky .240 center fielder no matter how good his glove?), but the Four Bs are in fact the young core of the team for the future.  It is a pleasure to see them field and hit and run.

The Sox know how to put on a show and opening day was no different, with four fighter jets ripping across the sky at the end of the National Anthem, and with Big Papi (standing on the mound with Aly Raisman to yell “play ball”) ripping off his Sox jersey to reveal a shirt the read in big letters “Woman Power.”  How much fun is that!

Negatives: you need to be rich to see the Sox.  Parking in my lot is $45, in many places $60.  Beers $11 or more.  Clam chowder on a cold day, if you stand in line, is $8.75 (more in the stands) and not even a bag of Westminster soup crackers (watch them dump that soup into the cauldron from those pre-heated plastic bags; guess what it costs the concession stand to serve up a cupful [if it is one dollar including the container I would be shocked]).  Face price on a loge seat: $146 (I don’t know the price of a box seat as I only know millionaires and they cannot afford to sit there so I have no one to ask).

Hint to Sox management: don’t close all the food service places in the 8th inning, particularly when it is cold; an extra hour in April demands coffee, soup, hot chocolate, maybe chips or cookies.  People were leaving because between the cold and the lack of sustenance it just wasn’t such a great extra hour.

The inconvenient truth yesterday was not global warming but, rather, it’s late April arrival here in Boston.  But as the Manager pointed out to the press, playing baseball in cold weather is the team’s goal — it is chilly in October and November.

The Seven Percent Red Sox

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The recent projection by ESPN’s newsletter service gives the Red Sox, the team with baseball’s highest payroll (and likely second highest seat price) only a 7% chance of winning the World Series.  (Yankees 9%; Astros and Indians 14% each, Dodgers 12%.)  And tied with the Nats for sixth place in overall team rating.  Why?

First, the analysis comes out of 100,000 simulated game combinations so there is no weight whatsoever placed on just how badly the Red Sox need to have this, given the number of key players in their contract years.  Nor how pumped are the Red Sox fans, suffering yet another ticket price increase in honor of failing last year. Imagine basing a projection on silly things like hitting and pitching skills, age, fatigue during season travels, and difficulty of schedule!

Second, the system does not seem to have any respect for Sox hitting, even with Ramirez and Holt healthy and Martinez in the batting order.  The Sox projected annual run difference (scored vs allowed) is only + 93, which when you consider what must be viewed as a pretty good Sox pitching staff means the computer doesn’t think the team is going to hit.  (Of the top seven teams, only the Sox are below +118 and four are at least 50% better.)

Final indignity: of the top seven teams, the Sox are given the lowest likelihood (66%) of even making the play-offs.  Which Red Sox fan receiving this post can relate to that projection, we of the Nation believing that once we wipe up the AL we will give the Dodgers the contest of their lives in the Series?  Indeed, of those seven teams, we are projected with the fewest wins, 92!  Wait a minute here– that is one win LESS than last year, which by all accounts was terrible, with Price off the reservation, Petey injured, Betts and Benintendi and Bogaerts hitting lousy, no Martinez, Wright injured, Holt injured, our Cy Young winner leading the majors in losses, and Backey Jadley Ruin-ya in center field being his .240 self.

Can’t wait for opening day this Thursday.  Hope the snow melts by then….

Digital Revolution: Do or Die

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Digital data, its analysis and its use, is revolutionizing businesses of all types.  According to an expert panel convened today by the New England Chapter of National Association of Corporate Directors, either you digitize or die.

What is it?  It is the use of data to create competitive advantage by making internal operations efficient, by making sure you are producing the right kind of thing or service, and by removing the “friction” from the relationship between the company and its ultimate consumer/customer.  It is how you connect your operations internally.  It is how you figure out what the marketplace wants from you and tells you if you are in the wrong business or are not giving your buyer the optimal total service experience.  It is promptly applying newest technologies to your business strategy.  It is automating what you do.  It is protecting the security of your, and your customer’s, information.

Who is doing this? Apple Pay, Uber, Disney, Pinterest, Amazon.  Who has failed by not doing this?  Travel agents ceding market to on-line booking; box retailers; Blockbuster, Polaroid, Circuit City.  Data analysis needs to change two things to make your business survive: how you work inside to save cost and identify your deliverable, and how you present to your customers in a way that reduces friction by eliminating extra steps and to the greatest extent eliminates the entities that intermediate between company and customer.

What are the risks of implementation?  Abuse of data (current Facebook problems are only the most recent) may lead to curtailing use rather than protecting proper use (Congress wants to investigate, per today’s Boston Globe), lack of Board of Director understanding, fear of taking a short-term profits hit while you take the time to absorb the costs and failures of embracing the robust use of data.

Millennials may help us, says NACD’s Directorship Magazine.  They bring flexibility, embracing change, continuing training to bear.  They also bring necessary confusion, challenge of preconceptions, and changing work environments and hours and the “gig” economy;  all these things are part of redefining how work will be done in the future, something that boards of directors also must come to embrace.  Boards better make their matrix of needed skills and make sure the right mix of people is leading their business of the future.