The Law and Other Anomalies

As a company progresses from early stage through growth to some sort of an exit (acquisition, IPO), the role of the Board must change so as to provide requisite skill sets to match the needs for these different company stages.

This was the primary take-away from the National Association of Corporate Directors-New England’s February 14 Boston Breakfast Meeting, which offered a panel of entrepreneurs who are leading growth companies (all of which had an IPO).

A typical trajectory for company expansion was identified:

First, a formative stage where the Board must lead the development of the technology and proving the business model.

Second, various stages of financing through growth mode and thereafter often an expansion through M&A.

Third, many companies themselves go public or are acquired.

Management must guide the evolution of the Board, identifying the particular needs at each stage, and easing people off and on the Board as appropriate.

Many emerging companies combine the chairmanship with the CEO role, which is not thought to be best practice. Indeed, in Europe, this is viewed as an inherent conflict of interest. Panelists noted that a strong, independent lead director is a counterbalance to the tensions created by the same person serving at the top of the company and of its supervising Board.

Aside from orchestrating the composition of the Board, CEOs must make sure that everyone is reasonably aligned; this means management and the Board but it also means dealing with the investors. There are particular tensions where early investors are looking for an exit while later investors tend to have a longer-term strategy. Does this mean the Board must always be thinking about exit, or sale? One panelist replied in the affirmative; you must look at the one, three and five year projections for your business, in terms of growth and business cycles; a sale, if not an overwhelming imperative, is always an option to be kept in mind.

A question from the floor asked whether Boards need to include someone adept at cyber security issues. While the panelists believed this was a growing trend and that cyber security was very important, growing companies have so many Board needs to fill and so few slots that, at least at an early stage, including someone with cyber capabilities is not the general practice. It was suggested that the company can have a series of advisory boards, one of which typically may be involved in the company’s science or business, but one could also be directed toward IT and cyber security issues.

Finally, what about founders? They generally were described as short on patience, and don’t want to stick around awaiting a liquidity event. There is sometimes tension as founders, moved aside into advisory or technical roles, may undermine the growth-oriented and exit-oriented management teams. How to you move a recalcitrant founder aside?

The consensus: very carefully.

Just over the internet, via SEC Release: Conservative SEC member Piwowar, acting chair, has solicited input on compliance problems being faced by reporting companies in meeting the disclosure requirement, starting with respect to this year, of the ratio between CEO pay and median pay of all company employees. A Congressional mandate designed to shame CEOs into moderating the rise in their average pay, and a stupid idea from the onset, the pay ratio rule was delayed by years within the Commission even when the liberal Democratic majority was in charge.  Interestingly, Piwowar as acting chair is adopting the “bleed them til they die” approach, not waiting around for Congress to outright kill this disclosure requirement (as I am sure they will).  He went out fishing, whoops I mean asking, for companies to send to the SEC enough industry-driven excuses to support what is no doubt his goal: to defer effective date, and let companies stop spending time and money in gathering data, until Congress itself kills this foolishness.  You cannot “disclose” CEOs into pay submission, and Congress should have been ashamed of itself to even try.  There may be a lot good in Dodd Frank that gets shot down, but the pay ratio rule deserves its own quick death.

It is common knowledge that in the delivery of healthcare most professionals believe that the trend will be away from “fee for service” and towards “fee for performance,” which means that providers will be paid to treat an entire population as opposed to being reimbursed for given visits or procedures. In practical terms, how will this trend play out?

James Agnew, Vice President of Corporate Development and Acquisitions for Tufts Health Plan and Tufts Health Ventures, an HMO unaffiliated with Tufts University but with an investment arm deploying capital into the marketplace, discussed some aspects of this trend at the Thursday morning breakfast meeting of the Boston Chapter, Association for Corporate Growth. Some high points are set forth below.

Big hospitals, providing healthcare in acute circumstances, are extremely expensive. One of the trends must be to bring healthcare out of the hospitals, to the extent possible, and provide healthcare through health systems, mobile medicine, in-home monitoring and similar solutions.

One overall consideration is how to deliver healthcare in the current regulatory environment. Cooperation between providers and payors (such as Tufts) will be essential. Tufts is active in all three healthcare delivery markets: commercial coverage, Medicare and Medicaid.

Electronic medical records is part of the solution, but extremely difficult to collect. Partners is paying about $1 billion dollars to install the EPIC software, after having spent hundreds of millions of dollars on a prior failed attempt. Agnew believes that ultimately electronic data will be aggregated and the companies which do the aggregation will be much like utilities; a provider or an insurer in search of data will buy the data from a central source the same way one buys electricity.

Tufts seeks investments or acquisitions in hospitals, regional health plans and companies that provide coordination of medical services. They are also interested in companies that foster “consumer engagement,” as healthcare moves more to the home and away from the hospital. They have an interest in wearables and telemedicine, but are slow to embrace direct investments in medical devices. They avoid the complexities of the pharma space.

The landscape is chaotic for healthcare today. The myriad directions in which Tufts is looking to expand and invest echo the complications of this environment.

What should corporate directors be worried about as they prepare for the New Year and the upcoming proxy season?

First, a post-election revisiting to prior strategic planning based upon a reassessment of economic and political assumptions, including impact of trade and tariff issues. But, what else?

An expert panel at the January 10 breakfast meeting of the New England Chapter of the National Association of Corporate Directors also discussed an anticipated de-emphasis of business regulatory pressures. Not-yet-enacted SEC rule-making pursuant to Dodd Frank concerning ban on executive hedging, executive claw backs and “pay for performance” may well never get enacted. There also is speculation that the recently adopted SEC pay ratio proxy regulation, which applies for Fiscal Year 2017 and is reportable in 2018 proxy statements, also may well be sidelined by the SEC. There is no expectation that the existing say on pay rules will be rolled back.

There is growing pressure from shareholders, including institutional shareholders, on director compensation. Boards may consider putting aggregate director compensation to a shareholder vote in order to get protection from litigation and criticism.

The SEC is on the hunt for misuse of non-GAAP reporting measures, which in recent years have shown growing variance from GAAP; both the metrics going into the non-GAAP numbers and the prominence of presentation of the non-GAAP numbers should be looked at closely by the board itself.

New income recognition standards are effective for the 2018 calendar year, and SEC requirements include disclosing in this year’s 10K, if not the actual numerical impact, at least the anticipated general impact.

Finally, certain companies are inviting more constructive activist investors to make an investment, and perhaps join the Board, in an effort to head off a more adverse activist approach; the buzz word for this practice is “validation capital.” Since institutional investors also have moved, to some degree, away from supporting independent activists and have themselves become more direct in engaging their portfolio companies, it is clear that our standard governance model of board-centric corporate management is becoming a dual model, as shareholders are forcing themselves into the board room and will be heard more and more in the coming year.

On December 5, the Delaware Supreme Court decided that certain directors of successful on-line gaming company Zynga were not “independent” as a matter of Delaware law, and thus were not eligible to approve a transaction which benefited the majority stockholder and another director, while allegedly detrimental to the company itself.

Most interesting was the disqualification of two directors who were partners in the Kleiner Perkins venture firm which owned 9.2 % of the equity in Zynga.

The Court noted that the company itself, in its NASDAQ exchange listing, did not designate these disqualified directors as “independent.” However, independence in Delaware is not exactly congruent with NASDAQ listing standards. The Court seemed primarily to premise its holding on the fact that Kleiner Perkins’ equity stake evidenced a “mutually ongoing business relationship. . . which [might] have a material effect on the parties’ ability to act adversely toward each other.” Although acknowledging that a personal or business relationship with a major stockholder does not necessarily compromise director independence, Strine then claimed that venture firms compete with each other to finance talented entrepreneurs, and thus partners in the venture firm might not be willing to make decisions that might disadvantage the entrepreneur.

The result is analytically somewhat anomalous. One could equally argue that, holding a 9.2% stake, the VC would be economically motivated to vote against anything that might hurt the company or its stock price. Here, the directors sold stock immediately prior to a substantial dip in its price, a result which presumably might have been apparent to a VC. Would not the economic interest of the VC in fact be adverse to the interests of two directors (one a controlling stockholder) selling a large amount of stock and possibly leading to a drop in stock price, particularly when as it appears that the sold shares were released from “lock-up”?

The takeaways: independence is in the eye of the beholder, each case is fact-dependent, and the tendency of CEOs to name marginally independent buddies to the board, while attractive in a common sense way, is not necessarily a great idea.  Finally, the case should not be read as a categorical statement that directors representing capital investors can never be independent under Delaware law; there were numerous ancillary factoids that may have led Strine to this conclusion in this particular case.

NOTE: Only for the lawyers reading this, the context has been somewhat altered to focus clearly the point. This was an appeal from a holding that a demand on the board, prior to a derivative action, was necessary as there was an independent majority of directors; the Supreme Court here reversed, declaring demand prior to suit unnecessary, because there was not a majority of independent directors available, based on the findings set forth above.  (If you are not a lawyer and you read this note anyway, hopefully you were not confused– but I warned you!)