The Law and Other Anomalies

The so-called SDX Protocol, a roadmap prepared by directors, advisors and institutional investors to establish a play book for interaction between the investment community and independent corporate directors, was analyzed at the January 13 meeting of the National Association of Corporate Directors/New England.

Historically, such communication has been anathema. Directors direct; member of management, the CEO or the director of investor relations, has laboring oar in communicating with the investment community.

There is a sense that this current practice has not worked well. It may create barriers between investors and directors, leading to misunderstandings which in turn lead to a poor and destructive level of shareholder-company relations.

The SDX Protocol may not be appropriate for all companies, but larger companies with institutional investors might consider adopting some or all of that proposal. In broad outline:

The company designates one or more independent directors, not management, to speak with institutional investors.

Institutional investors designate high level representatives (not just analysts) to engage with the independent directors.

Ground rules are established to set forth topics which cannot be discussed (the kinds of things that relate to earnings or operations, typically matters typically raised in an “earnings call,” should be avoided).

A list of appropriate areas of discussion should be generated (risk management, corporate philosophy on compensation, high level strategy).

Companies must be careful in selecting the board members to speak; not all board members are going to be adept. The Protocol also contemplates the director speaking without presence of either management or third party advisors, something which makes counsel nervous and raises the risk of violation of Regulation FD (impermissible selective disclosure of material inside information).

The SDX approach is radical, and contrary to historical corporate governance. It should be undertaken only very carefully and with consultation with outside advisors. It is unclear whether SDX represents an opportunity to cut into miscommunication, or a probing invasion by institutional investors into areas which should not be generally disclosed, nor indeed selectively disclosed, to anyone.

Proxy access, permitting shareholders to nominate directors and have that nomination included in the public company proxy statement itself, remains a volatile issue. You may recall that the SEC’s original regulation to provide shareholder access had two prongs: the first was a set formula by which corporations were required to afford proxy access for director election to shareholders holding 3% or more of the shares of a company, and a second procedure by which companies could themselves “privately order” (custom craft) a proxy access rule just for their own company. The Courts struck down the first part of the SEC regulation, leaving the field open only for private ordering.

Pursuant to private ordering, activist shareholders sometimes have proposed by-law amendments to permit shareholder nominations for directorships. However, a provision of the SEC regulation permits a company to exclude such shareholder proposals if the company itself has proposed a similar rule. As might be expected, company-proposed rules are less generous in affording shareholder access to the proxy mechanism.

In the recently rendered Whole Foods “no-action” letter, the SEC endorsed the company’s rejection of a shareholder proxy access proposal because the company itself had its own pending proposal, even though the company proposal was far more restrictive in allowing shareholder access (it required 9% of the shares held for at least three years, to put forward a proposal, and did not permit aggregation of shareholdings by different shareholders; the SEC required only a cut-back to a 5% threshold).

Although it was suggested that many other companies are flocking to this approach in order to deny the proxy mechanism to shareholders in most instances, discussion continues as to whether suggesting restrictive corporate initiatives, leading to rejection of more liberal shareholder initiatives, should be sustained where (allegedly) companies are pushing the envelope and consequently, de facto, are denying shareholder access to the proxy mechanism.

If ever there was a company which tracks the history of start-ups from the late ‘90s to date, it is Bullhorn. Their highs and lows (they are a software solution for recruiting employees) were traced by Art Papas, CEO and founder, at the December 11^th breakfast meeting of the Association for Corporate Growth held on the Boston Fish Pier.

In quick summary: Bullhorn was a dot-com start-up, which took $4,000,000 of venture capital in 2000, at the height of the market for dot-coms when the company had no customers, not to mention profits.

Along came the dot-com bust, and the company’s $235,000 a month burn rate, combined with inability to garner sale during the bust, became unsupportable. Raising additional capital to retool the company came at a huge price in terms of management dilution; the original investors had a full ratchet anti-dilution provision which almost wiped out the founder group’s equity position.

Rebuilding the company over time, in 2008 the original investors were taken out by Highland Capital and General Catalyst. Shortly thereafter, there came the 2008 crash — a bad time for a company whose sweet spot was facilitating the filling of job positions.

Sufficiently resilient to continue to grow at a reasonable pace throughout the “great recession,” in 2012 Bullhorn was acquired by a private equity firm which provided guidance for growth, supported another complete retooling of the software suite, and further encouraged growth through facilitating four acquisitions during the following twelve months.

Bullhorn now claims $67,000,000 in gross sales for the year 2013, a positive trending year for 2014, plans to greatly expand both the size of the enterprise and its top line, and an optimist future which includes going overseas to non-English speaking economies.

While not demonstrating the explosive growth shown by some of the social media or internet giants, the Bullhorn saga is a story of survival and success of a B-to-B enterprise spanning the highlights, and lowlights, of a turbulent economic period. It is stories like this which remind us of volatility over the last fifteen years.

If there is any takeaway, it is that flexibility and receptiveness to rapid change are the key elements for survival in the economic world into which we seem to be thrust.

Stock options are out, performance shares and restricted stock are in, equity may constitute 50% to 70% of the compensation of a public company CEO, and the ISS is on the move. Trends in CEO compensation for the coming year were examined at the November 11^th Breakfast meeting in Boston of the New England Chapter of the National Association of Corporate Directors.

Stock options used to be the standard equity play for CEOs. For companies undertaking substantial growth, they still can constitute a serviceable compensation tool for the equity side of the equation. However, performance shares and restricted stock seem to have taken over as the equity mechanisms of choice in most instances.

Other trends include establishing ownership guidelines for a CEO, and what is likely to come next is a mandatory holding period during which the CEO must retain shares after they have vested.

Golden parachutes are shrinking in importance, the multiple of annual salaries paid to CEOs in the event they are fired after a change of control is shrinking. Nobody is any longer granting a tax gross up to these CEOs to cover the taxes in the event they receive a parachute payment.

There was speculation that activist shareholders might be holding down run-away CEO pay, and there was debate over the efficacy or non-efficacy of the proposed SEC disclosure rule which will require information about the “all in” compensation of CEOs expressed as a multiple of the median employee salary. This metric, long overdue, creates problems for companies with international operations, where compensation of a US CEO will be perhaps thousands of times higher than median pay if most employees are located in places like India or China. It was suggested that alternate metrics could be provided, in addition to the required disclosure, perhaps also expressing CEO compensation as a multiple of median United States-only employees.

The influential Institutional Shareholder Services, which advises investors as to whether boards should be supported, is introducing a variety of changes to its outlook on CEO compensation for the 2015 proxy season. In terms of disclosure, credit will be given to companies for positive forward-looking compensation disclosures (historically disclosures have been more backward looking), and in evaluating plans for equity compensation the ISS will be more holistic, considering such matters as planned cost to shareholders (SVT or “shareholder value transfer”), grant practices (including historical plan grant burn-rate), and plan features (minimum vesting periods, minimum holding periods and clawbacks).

The ISS is also considering gender diversity, indicating that boards without women pose a higher government risk to investors based upon academic studies, and is also considering the number of financial experts on an audit committee (implying that having more than one such expert may result in less governance risk).

At the November 7^th MassMEDIC Boston conference on medical devices, a panel suggested that the medical device industry could learn a lot about how to finance early stage development by looking at the bio pharma model. It was posited that the bio tech model was better, in every year studied, in raising Series A funding and in reaching the IPO market. Why?

One reason: the potential rewards are higher. A single successful drug can sell billions of dollars per year. Further, some bio tech inventions create a platform which may provide the basis for a variety of drugs, or the application of the technology to a variety of diseases, thereby providing the potential of greater ultimate return. Another argument, somewhat circular, is that bio deals can exit at an earlier stage, so the investment is de-risked.

The panel then took a swipe at engineers who design medical devices. Engineers always seek perfection. In bio, once you have a molecule that is done, it is ready for the clinic and then to go to market. Engineers are always tinkering with machines. And, you also have to build machines, which is more complex then replicating a successfully designed molecule. (Whether these arguments are accurate or not I cannot say, but they were advanced by the panel.)

Another major problem is that you cannot easily do clinical trials in the United States on medical devices, which creates a problem for investors.

Then there is the issue of being able to scale in order to earn money. There is high capital expenditure, in order to reach scale and lower the cost of goods, when you are building a machine. This is not true, it was contended, with respect to chemicals.

Finally, it was speculated that the robust level of communication between investment bankers and the bio tech community is not echoed in the medical device field. Medical device companies, it was alleged, don’t really reach out to the investment bankers and tell their story.