The Law and Other Anomalies

We all are aware of the fragility of start-up enterprises.  What happens if a couple of people decide to give up their joint dream; can one of them take the opportunity for himself/herself?

This summer, a Delaware Chancery Court case engaged in analysis of this common question.  As in so many things corporate and fiduciary, the answer is, “it depends on the facts.”

The facts of McKenna v Singer (decided July 31, 2017) are too dense for meaningful summary and if you want a deep dive then read the forty page Court recitation, but the bottom line was that one of the former pair of entrepreneurs was allowed to take the deal for himself.  The fact that the plaintiff in this case misrepresented at the beginning and thus had “unclean hands” was a factor; it is unclear if the business logic of not letting an entrepreneurial idea get frozen to death, with no one able to pursue it, might have entered into it sub rosa.  Further, plaintiff was seeking part ownership of the new enterprise, and the Court might not have wanted to impose a shot-gun wedding on the two former partners who had themselves declared themselves divorced.

I will (almost) refrain from the typical lawyerly advice that at the start the entrepreneurs could have addressed this event by contract; entrepreneurs are short on time and money and often don’t want to spend either in addressing the ground-rules for their failure.

I also note that this is a Delaware decision, it has unique facts (don’t they all), and I am aware of some older Massachusetts authority that treated the business idea as a joint asset, of value to the abandoned enterprise, that could not be taken by only one player (and indeed suggesting that until the fight were resolved, neither party could act, a business result that is almost a death-knell in today’s speedy technology economy where getting to market fast is the difference between success and failure).

Particularly in start-ups set up as LLCs, which is the trend, writing something into the operating agreement about who owns the business idea in a divorce continues to look like an attractive idea; the only question is, what would it say?  Each equally?

Today’s news brings word of the filing yesterday of a Delaware class action brought by Uber shareholders against directors for approving the acquisition of a company formed by a defecting Google employee who is accused of downloading trade secrets of Waymo, the self-driving car company which is owned by Google.

Waymo sued Uber earlier this year, claiming the trade secret theft, which resulted in a criminal investigation and the allegation by Waymo that its damages were estimated at $2.6B.

The suit against the Uber directors claims lack of care and good faith, based on allegations that Uber knew that stolen intellectual property was involved. The speed with which the company (bought by Uber) was able to ramp up and hire former Google employees and then immediately sign a term sheet to sell to Uber was cited as a smoking gun.

While facially the complaint makes a coherent argument, which argument would be bolstered if the allegation of board knowledge is true, plaintiff Uber shareholders are going to have to overcome the business judgment rule to affix liability on Uber directors. That rule generally protects directors if they make business decisions, however badly they turn out, in instances where such directors do not have personal self-interest.

Unless the level of prior board knowledge made it clear that IP had in fact been wrongfully obtained, Uber directors may be found to be wrong in their judgment but not in violation of their fiduciary duties. Courts, particularly in Delaware, are uncomfortable in second-guessing business decisions of boards even if those decisions result in failure; the metric of risk and reward is the bailiwick of business people and not courts. Unless the board decision was so off-base that reasonable business people who were paying attention would never take the identified risk inherent in that decision, courts are likely to default in favor of giving the board the right to take its chances, even if the result is a disaster.

Plaintiffs also will mount claims based on the separate basis of director lack of care  (not paying attention and doing normal diligence).  Claims under this theory are difficult to establish, generally requiring a demonstrated laxity in practice that presents a high evidentiary bar.

This case is not likely the kind to make new law. The facts will drive the result based on established principles of liability and defense. But the case will be fascinating to watch; the Uber deal was high profile and raised eyebrows at the time it was announced; and, it involved lots of money in a hot business space. There is going to be a raft of expensive lawyering going on here; stay tuned.

Confusion reigns.  And that is an optimistic summary.

You will not doubt recall that no one except the US Congress wanted to impose a disclosure requirement that public companies calculate and report the ratio of CEO pay to median pay in their company.  Among the reasons: meaningless data;, some companies have low paid employees overseas (or even domestically) and the CEO pay will look absurdly high as a punishment for effectively keeping down costs; impossible to calculate for large companies; no one cares.

So the SEC dragged its feet and, several years late, promulgated the Congressionally mandated Rule of disclosure, but delayed its effect for a couple of years until the 2018 proxy season.  Many of us thought the new administration would kill the disclosure, so why worry?

Get worried. Look at the calendar.  Note that the SEC has announced they are not reconsidering their effective date.  Guess if the Congress is going to allocate band-width to this issue.

It gets worse.  ISS, the major proxy advisory firm, has advised it will not even consider the ratio this year in its proxy guidance.  And surveys of company management and boards indicated that they were sure that investors would not care.

BUT then, someone (ISS in fact) surveyed the investors and guess what: a clear majority of investors are interested to compare the ratios within industry sectors.  Surprise!

Now the SEC has issued a rash of recent rulings softening the permitted procedures for calculating the ratio, and promising not to prosecute erroneous reports provided the companies in effect “tried to do their best.”

But still…. There is one hope.  Perhaps the investors will be looking at the ratios not in an effort to cap CEO comp based on a great disparity (the Congressional intent).  Perhaps they will be looking, rather, for an INCREASE in the disparity of pay over time, as evidence that the good CEO will be dropping the cost of labor, and that the CEO should be rewarded for that by even-greater pay disparity.

Anyone out there willing to bet on that?

At the end of a lengthy discussion of key board practices at the NACD Boston conference, a panel of senior corporate directors was asked, “what is the single most important secret of an effective corporate Board?” You might expect a sophisticated set of responses. It turns out that what was deemed most important was basic blocking and tackling:

First, board members must show up at the board meetings fully prepared.

Second, cell phones off.

Third, diversity of all sorts on the board, including diversity in substance, diversity in race, diversity in gender, diversity in ethnicity and diversity in geography.

My personal response, based on decades of sitting on and advising boards, is “ability to be quiet and listen to the end when someone speaks.” At board meetings, egos sometime run rampant, everyone trying to prove how smart they are. Listening fosters respect and cooperation; if the right people are in the room, that cooperative dialog drives good decision-making.

How do you build an effective board?  It depends on the stage of the company, as different board needs arise at different points in corporate growth, according to an expert panel convened in Boston on October 17 by the New England Chapter of the National Association of Corporate Directors.

Early-stage boards tend to be small, insiders only, and highly focused on getting the basic product or service correctly structured.

Boards of larger companies with greater internal resources are able to turn their attention to more mature subjects: risk evaluation, CEO succession, monitoring performance, and most importantly fixing corporate strategy.

There is thus a need for a dynamic board model, with membership updated over time, as companies mature. How do you achieve this transition? One method is through board self-assessment, leading to a candid evaluation of how well the board is functioning vis-à-vis company needs. Another method is through an independently director, or perhaps a CEO/Chair, having candid one on one conversations with individual directors about how they are functioning.

If a board is being changed to reflect the specific needs of a company as those needs evolve, how do you establish board cohesion? The panel noted that a careful interviewing process before onboarding a director can help focus on personality fit, and how well individuals will work within the group. One company generated a Handbook on how to onboard new directors, including designating a more senior director as a mentor. Others noted that joint education and orientation sessions for both old and new directors, together, can create the requisite bond. Retreats, social dinners prior to board meetings, and “unpacking” content from both retreats and regular board meetings so as to permit more personal interchange, also were mentioned as methods of building board cohesion.

[There will follow three more posts on separate subjects arising from discussions at the NACD meeting referenced in the above post.]