The Law and Other Anomalies

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.]

It is amazing how many corporations are set up “50-50,” which is to say two equal partners with equal ownership, and equal say on the board of directors. What happens when, over time, these shareholders come to violent disagreement?

The Massachusetts Supreme Judicial Court, in a September ruling (Indus Systems), applied the Massachusetts Corporate Statute to a tense shareholder dispute, declared the existence of a deadlock under the Statute, and sent the case back down to the Superior (Trial) Court to remedy the situation. The Massachusetts Statute provides that in the case of deadlock, the Courts have the power to dissolve a corporation.

Of course, in this case (a profitable going enterprise) it doesn’t make much sense to break up the company, wind down its contracts and lay off the workers. No problem for the Supreme Judicial Court: the Court declared that implicit in the power to dissolve is the power of the Court to take other action, including forcing a sale of the business to a third party or forcing a sale between the parties so that one shareholder remains standing.

Lawyers typically counsel at the formation of a company that some sort of an unwind procedure be built into the corporate documentation to meet the future contingency of deadlock. This is of course a negative message for a lawyer to deliver to two individuals who are anxious to get going with their business, and find it intrusive and unsettling to contemplate what might happen, years hence, when they violently disagree. Additionally, aside from this distraction, there is a cost to discussing and documenting an unwind procedure which sometimes can be as expensive as all the positive work of forming the company, issuing bylaws and issuing shares of stock. Along with addressing what happens in the event that one of the shareholders dies or becomes disabled, drafting provisions whereby, in the event of a deadlock, one shareholder might be forced to sell out to the other presents legal and interpersonal problems that are difficult to parse, particularly at the initial stages of forming a business.

But shareholders should not be relying wholly on statutory remedies because it is quite difficult to prove a “deadlock” within the meaning of the Massachusetts Corporate law. Suffice it to say that in the Indus case there were not only disagreements with respect to corporate policy, but also unilateral actions by one or the other of the shareholders, including the writing of a $690,000 personal check by one of the shareholders to his own order, against company funds.

2017 has been a banner year for activist shareholders approaching public companies. Major activists continue to target large companies, but the average market cap of targets is approximately $260,000,000. How should boards approach the discharge of their obligations, when an activist comes knocking?

An expert panel convened by the New England Chapter of the National Association of Corporate Directors on June 13 suggested that the first step is to be prepared. This involves identifying what the 72 hours following an initial approach by an activist shareholder should look like: who speaks for the company, how are legal and public relations and SEC inputs triggered, what is the general nature of the response? Of course, proper preparation also steps back further in time: since activists often are questioning fundamental corporate strategy, a board should oversee making corporate strategy generally known, on a continual basis, through SEC filings and shareholder conferences.

Old school was to “circle the wagons” and not listen to activists, many of whom were viewed as simply attempting to force a company sale in order to achieve short-term gain.

But this instinctive response may not be the wisest. Activists typically have carefully analyzed the company, and indeed may have identified other shareholders friendly to their position. The proper response is to engage, listen and evaluate. Many boards have “learned things” of value from activists.

It is appropriate for the board to make an independent judgement as to whether activist proposals make sense for the long term (not the short term) health of the corporation and its owner-shareholders. Boards, and management, ultimately are responsible to these owners, and sometimes violent resistance to activists serves the purpose of offending other shareholders and strengthening the hand of the activist.

Statistically, in the past year only about 20% of activists’ approaches to companies resulted in a formal shareholder proposal, and of these more than half ultimately were withdrawn based upon discussion with a target. Even if a company is not in agreement with what is being proposed, open discussion with activists seeking agreement on strategic changes (and possibly an addition to the board) is the preferred initial approach.

Who should speak for the board? Activists often want to speak to individual directors. This may be a growing trend but it is dangerous; a given director may not be the best-informed emissary, and may well not be prepared about compliance with Regulation FD, the SEC regulation requiring public disclosure to all parties if material confidential information is released to any party.