The Law and Other Anomalies

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!)

It is always interesting to see the Pitchbook report on the M&A market.  Highlights from Q3 deals (which of course are pre-election):

Median deal value increased to 8.4 times EBITDA; been rising all year.  Median deal value as a multiple of target’s revenue was 1.5 times, but greatly skewed by deal size; strategic buyers picking up firms with an enterprise value of over $250M paid 3.2 times revenue; below $25M revenue the multiple was flat at roughly one times.

Private Equity buyers continued to use only about 50% leverage, down from prior years.

Finally, 36% of reported PE deals had seller financing or earn-outs, down slightly from Q2; this ratio historically has been somewhat volatile.

Wonder what happens when the Trump tax plan induces repatriation of offshore cash held by some strategics– 8.4X EBITDA is already pretty heady stuff.  As they say: time will tell.

You will read  that the United States Supreme Court unanimously re-established the “old rule” for liability for insider trading: if person A tips person B with material inside information, both parties will be liable for insider trading under the securities laws. This should not be analytically startlingly and, indeed, the Supreme Court had no trouble with it; how often do you see an unanimous decision? But the importance of this decision is that it overturns a cryptic 2014 case decided by the Federal Second Circuit (New York), which held that the government had to prove that the tipper and the tippee “needed to know that insiders . . . were improperly leaking confidential information in exchange for some personal benefit.” Justice Alito made analysis far simpler, removing the test of trying to measure the presence of personal benefit to the tipper: “[Tipper] would have breached his duty had he personally traded on the information here himself and then given the proceeds as a gift to[Tippee]. It is obvious that [Tipper] would personally benefit in that situation. But [Tipper] effectively achieved the same result by disclosing the information to [Tippee], and allowing him to trade on it.” The practical effect of this decision is significant, particularly as it comes from the Supreme Court so it is not likely to be messed with by a trial judge who is charging a jury. Practically speaking, if somebody has a relationship with another person which is sufficiently close as to induce the passing of inside information, both parties are going to have liability.

The NACD panel on executive compensation set forth its perceptions of tasks for the public compensation committee for 2017. Set forth below are some significant take-aways:

The first job of the compensation committee is to figure out how to motivate executives to do the right thing for the company. Don’t get distracted by changing policies of the proxy advisory community (see the November 11^th post to this site concerning changes in ISS parameters for measuring executive compensation).

What is the best way for the compensation committee to understand what motivates the CEO and executive team? The committee should stay very close to the CEO and include the CEO in its meetings. A suggestion to make sure that the committee also has its own time to separately consider compensation: an executive session held both before and after each committee meeting.

Executive compensation may be almost “out of control.” The audience was asked, “how many people here are in a company where the compensation committee target is to pay below the industry average?” There is a constant natural pressure, given human nature, to inflate CEO compensation. Coupled with research indicating that virtually every CEO views himself/herself as materially under-compensated, there is a problem which compensation committees may not be able to contain.

Although surveys may be valuable for lower echelon employees, compensation surveys for the C-suite should be looked at with great suspicion. Who did not participate? How accurate is the data? Most compensation committees do try to gauge compensation of chief executives of comparable companies.

There is growing pressure from the proxy regulatory companies on selecting the “correct” peer group for your company, as selecting an “aspirational” peer group will tend to drive up compensation.

See the following post re pay disparity.