The Supreme Court — Social Battleground

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In the political, religious and cultural battles fought out before the United States Supreme Court these days, sometimes the cases that do not reach the court have the greatest impact. 

Steve Shapiro, Chief Counsel for the American Civil Liberties Union, noted in Boston remarks Tuesday that keeping certain cases off the Supreme Court docket, where the decisions below have struck a blow for civil liberties, is sometimes important.

Thus, working for the Supreme Court to deny cert for cases that strike down city ordinances preventing rental of apartments to undocumented aliens, striking down an Arizona statute that makes illegal any abortion after twenty weeks (clearly prior to the recognized point of fetus viability), preventing review of the 9th Circuit decision striking down a Florida executive order requiring executive employees of all agencies to undergo drug tests, keeping the Supreme Court away from revisiting a free speech case in which a Pennsylvania high school student was cleared of violating school rules by wearing the popular bracelet “I love boobies,” all represent a victory for civil liberties positions. 

Turning to cases the Supreme Court did hear this term: 

The Court has struck down race as one of the factors in admission to University of Michigan.  This case generated an impassioned dissent by Justice Sotomayor, suggesting that the Court majority was out of touch with the realities of discriminatory effects which need be addressed in an affirmative manner. 

The Court has also: supported the right of town councils to begin each meeting with a sectarian prayer; and, struck down a statutory cap on the aggregate of political donations given by an individual to all candidates during a given year.  These latter two decisions were by 5-4 vote. 

In the election donation decision, the government argued that a donor making contributions to numerous candidates of one party would thereby obtain tremendous power within the party and excessive access to the political process.  Chief Justice Roberts stated that the purpose of the donation laws was to prevent corruption by means of “bribery;” access to the political process is politics and not corruption, he maintained. 

At this dictation there are still pending for decision a variety of cases including two key ones: 

  • A Massachusetts case involving the 35’ buffer zone around abortion clinics, being challenged as an infringement on free speech;
  • A challenge to the Affordable Care Act (ObamaCare) by private company Hobby Lobby, wherein the owner of Hobby Lobby maintains that, when the Act requires him to provide health insurance for employees wherein contraceptive devices are included without a co-pay, this violates his personal religious rights. 

The latter case is interesting legally; the corporation is the employer and not the individual, and one of the questions is whether a corporation will be treated as a “person” for purposes of determining matters of religious freedom.  It is one thing, under the Citizens United Case, to say that corporations are persons for purposes of political donations; but religious freedom is a matter of conscience, and there is a real question as to whether a corporation has a “conscience” in a constitutional sense. 

In general discussion, it was noted that the Supreme Court itself has a great lack of diversity, divided among six Catholics and three Jews who have attended only two law schools, with only one Justice ever having tried a criminal case, only one Justice from West of the Appalachians, and with no Justice from the South.  Query whether such a demographic is conducive to the best delivery of “Justice.”

Accredited Investors Definition–SEC Changes under Consideration

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Yesterday I posted about remarks from Keith Higgins, head of CorpFin at the SEC, concerning general solicitation in securities placements for private companies.  Higgins also discussed SEC changes being considered in the definiton of Accredited Investor (that class of people who are favored in being able to invest in private placements under SEC Rules).

Today, for individuals, accredited status derives from net worth excluding primary residence of at least $1M per household, or annual earnings of $200,000 ($300,000 with spouse).  The Dodd Frank Act in 2010 required the SEC to revisit this definition in 2014, and the SEC is considering the following additional measures to achieve accredited status (no guarantee of what will be recommended ultimately):

First, possesson of a professional certification or degree such as CFA, CPA, a securities license (he pointedly did NOT mention attorneys– wonder if there is a message there?).

Second, ownership of other investment securities as an indication of an ability to exercise informed judgment (what if you hold a large portfolio and everything is down?).

Third, reliance on an intermediary such as a registered broker in making investment decisions (borrowing the sophistication of a third party to bolster one’s own sophistication).

Higgins promised a balancing between intelligent criteria and putting vulnerable investors at risk.  This focus on protecting invidual investors in placements is an interesting counterpoint to the front page of today’s WSJ:  seems that over the last 6 years as much as 60% of all stock trades were effected by “high frequency” trading firms.  While protecting individuals from fraud in private company placements is not ignoble, you have to wonder if there are not bigger regulatory fish to fry….

Angels and General Solicitation in “Private” Securities Offerings

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Keith Higgins, recently an SEC lawyer here in Boston, and now Director of the Corporate Finance Division of the SEC (“Corp Fin”), addressed the Angel Capital Association in Washington last week, touching upon several matters affecting angel investors.  Interestingly, he spent most of his time attempting to dispel misimpressions of the use of new SEC Rule 506(c), which Rule in some instances permits the use of general solicitation in the unregistered sale of company securities.

In spite of predictions that angels and other start-up investors would flock to the new exemption as a way to get broader participation in admittedly risky enterprises, the new Rule has been sparsely used.  Offerings under 506(c) since last September have numbered less than 900, raising $10B; the “old” 506(b) exemption, prohibiting solicitation, had 9,200 offerings raising over $233B.  Why?

Issuing companies must “verify” that investors are accredited, and self-declaration of accredited status is not enough.  BUT Higgins points out that companies can rely on alternate methods of verification without digging deep into investor finances, including: general information on hand; pre-secreening recommendation from a known reliable third party; investing a large amount (presumably, available only to wealthy and thus accredited investors). 

Some companies were unclear on what constituted “general solicitation,” a concern that Higgins found inexplicable given the plethora of historical interpretations of that phrase (in the context of the SEC declaring that companies could NOT undertake such actions under “old” Rule 506(b)).

Other companies feared that, since the rules for 506(c) offerings were experimental and that the SEC quite likely would amend them in the future, they might find themselves having violated a new SEC refinement.  Higgins assured that the SEC would not apply new regulatory requirements retroactively.

Seems like the SEC expected quite a flood of publicly solicited securities placements, particularly given the pressure for the new 506(c) format and the publicity surrounding its adoption, and is confused by experience to date.  To my mind, the state of the market simply reflects the caution applied to pushing new SEC initiatives which look and feel theoretically inconsistent with SEC history —  put another way, a fear you cannot teach that old SEC dog any new tricks.

The East is Green — Emerging Economies

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Harry Broadman, PWC’s Chief Economist and leader of its emerging markets practice, makes an overwhelming case that the economic future of the world lies in the Far East, including but not limited to China and India (which between them have 1/3 of the world’s population).

In remarks delivered this weekend in Philadelphia, Broadman demonstrated that emerging countries are the engines of global growth, and that the trend is increasing.  The growth of the economies of emerging countries is not cyclical; it is a long-term structural change driven by the world being flat, the speed of communication and change, and the rise of the middle class.  Indeed, emerging economies fared better than established economies in resisting the 2008 economic collapse. 

According to Broadman, we need a strategy which he calls “China 2.0.”  It is not just China; it is Vietnam, Myanmar, Philippines, South Korea, Indonesia. 

A related trend in emerging economies is more sophisticated buying.  Noting that equipment purchased at low cost often is of lower quality, buyers in emerging markets are moving toward buying the best possible equipment, as the amortized true cost over time is less. 

The key to marketing emerging economies is that you need a package; the country may need railroads, but it also needs banking, water management, IT and the like.  Larger companies servicing the emerging market must cobble together a package responsive to a broad spectrum of needs. 

Finally, we have to stop thinking about emerging economies as markets, or as labor pools.  To a growing extent, innovation itself is coming out of emerging markets, including out of Africa. 

So we used to say glibly that the “East is red” but, at least to PWC and Broadman, it looks more like greenbacks.  There are lessons for United States manufacturers, service firms and, indeed, mid-term and long-term investors in the equities markets.  Ladies and Gentlemen: replace your bets.

Baseball been berry berry good to me…

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I hesitate to again post on baseball, as my view of the game seems skewed towards the sensibilities of people who can recognize the source of the quote which entitles this post.  But much of the snow in my yard has melted, players are playing games in the South, the Red Sox have again augmented their roster with people we do not know (worked last year, ya know!), the Evil Empire has taken yet another Sox Center Fielder and to put a point on it also spent a gazillion dollars to land yet another Japanese pitching ace, and newspapers are telling us to watch out for the Orioles, the As, KC, just about anyone (except for the Mets; no one is worried about the Mets).

The Sox are dependent on a whole bunch of people who are unproven here.  Now last year we had a roster of new people unproven here but many were proven elsewhere.  This time around, we have a center fielder who hasn’t played in a couple of years (while on Sabbatical having a half-dozen operations, no less), another center fielder who went zero-for-two million at bats in the post-season for Boston, a catcher rumored to be toxic (just when our last catcher was learning how to play well), another catcher who is now being trained to play first base (after spending 6 years teaching him to catch, during which time he forgot how to hit), a short-stop who is supposed to be a superstar even though he can’t turn the double play as well as the old man we threw out (maybe not a bad idea, though, since Drew still doesn’t have a job; good move, Boros), a totally inconsistent third baseman (was never a fan of Middlemarch), and the ever-inscrutible aged tyro Daniel Nava (if he is as good as his numbers, why was he platooned?).

We do have pitching, including some new guys.  Maybe enough, but pitching is supposed to go hand in glove with defense particularly up the middle, and we ain’t got that defense no more up the middle.  And it is time to give up on Workman, so we can trade him to some other club where he will win 15 games just to show us a thing or two.

Even now, no doubt, the Fenway crew is repainting my seats and installing cushions and one more cup holder so the number of cup holders matches the number of seats in the row.  Perhaps they will put flooring on the metal mesh booth directly over my head so that when the occupants spill their beer it does not drip into my beer cup; I hate mixing brewskies, don’t you?  I do want my increased price of $5 per game ticket (a mere $405 annual increase per seat, who am I to complain, we won didn’t we?) to be reflected in better service, in order to balance the worser team….

Baseball quiz: in what month do the Sox play the most home games?  Answer: last year it was April– cold rainy New England April.  Good news this year though: only 15 games in April at Fenway.  More that in the summer months it is true, but still, an improvement.  What foresight, to load those games into April and not play them in Atlanta, in California, in Texas, in Florida….  Who wants to have the team play in warm summer weather here in Boston when we can be given the chance to prove that baseball fans are just as ardent and dedicated as the Patriot Posse? 

Yeah yeah yeah, I am looking forward to the season.  My father ruined me the first time he walked me up the ramp at Ebbetts Field to see our new second baseman, and (like a grade B movie, I know) burned the first glimpse of intense green into the back of my skull.  Sitting on my knees to see over the hats of the men, ducking their cigar smoke, trying to see the game, going to the park and cutting school (eat your heart out, PS 189), I was hooked.  It has only been about a 64 year addiction since I first went to my first Big League game, so I hope to grow out of it soon.  It would be good to grow out of it.  I always feel the fool when I think about the Sox ownership getting fat on my nickel.

I would even write this post and send it for publication in the Boston Globe but, wouldn’t you know it, John Henry bought the newspaper also.  I think he did it to keep my sedition from public view.

Corporate Directors: How to predict the future…

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At this morning’s meeting of New England Chapter National Association of Corporate Directors, a panel of experts struggled to define issues that directors should be worrying about today – issues which might not arise until 2015 or thereafter.

The list of subjects was not surprising. 

In the technology sector, issues of cyber security and cyber crime, with particular focus on protecting customer data by reason of high economic and reputational risk, predominated.  In the patent area, company boards were admonished to establish a portfolio strategy and to pay attention  to whether their enterprise was indemnified against patent risk from third parties and whether they, in turn, were incurring potential liability by indemnifying their own customers.

In the health care sector, the restructuring of the delivery of medical care predominated.  Directors are responsible for establishing a health care strategy to be implemented by management.  There are three trends today:  (1) companies are getting more involved by driving employees to adopt healthy behaviors, to choose better providers, and to pick the right level of insurance; (2) other companies are stepping back, providing a “voucher” to employees and allowing the employees to decide their own level of care, generally by going to private exchanges and rolling their own; and (3) some companies are opting out, by reducing the amount of insurance, not offering insurance to family, and/or not providing insurance for part-time employees (Federal law requires insurance, generally, if you work 30 hours/week or more).  Boards must determine the level of obligation that their company adopts toward its own employees, bearing in mind that there is a tension between saving money by reducing benefits vs attracting better employees by providing benefits.

In the financial services sector, regulatory pressures dominated the discussion, particularly with respect to banks.  Boards must structure themselves to identify and adequately staff, with capable directors, all regulatory requirements, while at the same time fighting for enough agenda time for strategy in an increasingly competitive environment.

In response to a question concerning placing company data on the cloud, panelist Paul Sagan  (a partner at General Catalyst) noted that professional companies managing data in the cloud have much greater expertise than is likely to obtain for most companies protecting their own data and, therefore, placing data in the cloud (while not risk-free) is probably safer.

How accurate are these predictions of important future board focus?  Wendy Watson, chair of the Audit Committee at Citizens (among other Board memberships), noted that current bank regulatory reforms are designed, by necessity, to address failures leading to the 2008 meltdown.  Will they be effective in preventing future meltdowns?  Since risk may appear in situations we cannot even now imagine, no one can be sure that “it” won’t happen again. 

This admonishment, that the future is opaque, should be applied to all predictions.  Indeed, if we had a present and accurate understanding of the future, lives of companies would be more benign, and Board directorship a lot easier than it actually is.

Future Changes in US Corporate Taxation?

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We are moving into yet another “Congressional year” where deadlock must remain the anticipated norm.  However, both the President’s budget and the Republican tax proposals contain corporate tax changes designed to drive different parts of the economy.  Below (with thanks to Paul Oliveira of KLR for his remarks on this subject at today’s Boston M&A Club) are some highlights: 

President Obama’s proposals tend to benefit multi-national corporations overall.  In order to reduce the US Federal tax rate, now very high on a comparative basis, the President is proposing a reduction of the C corporation rate from 35% to 28%, with a further drop to 25% for manufacturers.  The revenue loss is to be balanced by eliminating certain tax “loop holes” with which we have become quite comfortable, including notably: repeal of LIFO accounting; repeal of immediate tax deductions based on writing down inventory to lower of cost or market. 

Obama does suggest a minimum tax on certain foreign earnings, including where onshore-developed IP is transferred to a subsidiary in a low tax jurisdiction to be commercialized. 

A bundle of proposed tax relief for privately owned/smaller businesses includes increased expensing of certain equipment purchases, and extension of the zeroing out of capital gains on certain investments in small business stock. 

The Republican approach seems to focus more on private companies.  It also includes (more modest) enhanced expensing of equipment purchases, as well as simplification of the Code to allow companies with $10,000,000 or less of gross receipts to more easily avail themselves of cash basis accounting, and tweaks to the subchapter S rules which, inter alia, would permit non-resident aliens to invest (only individuals who are either American taxpayers or American residents presently can own subchapter S stock). 

The degree to which Congress finds time to address these issues, let alone reach consensus, is (to be charitable) unclear.  For the record, the Obama proposals reduce taxes in some areas and attempt to make up the revenue slippage in others; the Republican proposals seemingly all lead to corporate tax reductions only. 

[Note: any errors in this partial summary of Paul’s remarks are wholly the fault of this blogger.]

Venture Capital in Boston

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Venture capital support for early stage businesses in Massachusetts, at least in the life sciences and in internet software, has not been this robust for many years.  Such was the consensus of a panel of three Boston-based early stage venture capital firms (Third Rock, Sigma Prime and Point Judith) at this morning’s breakfast meeting of ACG in Boston. 

The panel noted that the venture capital community has shrunk nationally and in Boston is now reasonably stable; they also acknowledged the debt which venture capital owes to angel investors for making high risk investments which sometimes bubble up into venture-financeable enterprises. Other significant points:

There are key elements that venture capital looks for in making an investment: an entrepreneur with deep domain experience and vision, a concept that has the potential of creating a truly large enterprise, a special technological edge, and a product or service which fills a fundamental need. 

The two VCs investing in life sciences had quite different appetites in terms of the size of an A round; one was looking for a range $2,000,000 to $6,000,000, another would go much higher (against milestones) in order to nurture the company to a point where professional management for ongoing operations could be brought in. 

When do you sell?  “Companies are bought, not sold.”  The venture capitalist knows when to sell when buyers are circling the company, and your professional management is listening to them. 

The IPO market is open for life sciences, and for larger internet/software based companies.  Will the IPO market open for the smaller SAAS companies?  The panel agreed that the prospect was dim; given needs for liquidity and the size of investment typically made by institutional investors, it doesn’t make sense to bring a software company public unless its market cap is in the range of $500,000,000 or more.  This size target in turn is only driven by sales of $50,000,000 to $100,000,000.  If you have a software company which has sales in the $30,000,000 to $50,000,000 range, it is too difficult to justify the requisite market cap so as to support an IPO.

Activist Shareholders: Care and Feeding

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It is rare for a group of directors, such as the National Association of Corporate Directors/New England, to invite into its midst a so-called “activist shareholder.”  At the February 11th breakfast meeting, however, the group was addressed by Gregory Taxin, a co-founder and former CEO of the proxy advisory firm Glass Lewis and presently manager of an activist investment fund focused on small and mid-cap US public companies. 

Taxin pulled few punches.  He advised the directors that “you work for me, the shareholder.”  He reminded them that they are held to a fiduciary standard.  He stated that activism is a positive force in the capital markets and that activist shareholders should not be treated as an enemy, half-jokingly blaming Attorney Martin Lipton as the culprit. 

He noted that some shareholders have good ideas and do their homework and should not be met with immediate resistance.  Activists shareholders look for operational missteps without board reaction, and also for “stale boards” with historical hangers-on not providing added value. 

Directors should not feel that they have a “job” that is being threatened by shareholders, since they work for the shareholders and their duty is to maximize shareholder return.  He admonished directors to talk to all shareholders, not just activists, and find out what they really think. 

The biggest fireworks (to the extent fireworks ever break out at meetings of directors of public companies) arose when an audience member challenged the concept of activism, claiming that activist shareholders are short term investors who push hard for increased dividends, massive stock redemption plans and other actions that will bring immediate increase to the share price to the detriment of the interests of long term shareholders. 

Taxin fired back: there is no such thing as a long term investor;. everyone is economically rational or they are a bad fiduciary; the best way to create short term value is to make best long term decisions; best long term decisions increase projected future cash flow, which is discounted back to determine the present value of a share of stock.  The little old lady who invests and holds for the long haul does not even exist.  Everyone is a short term investor.

Hot Accounting Issues for Public Boards

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What are the accounting issues most often being encountered by public companies filing annual reports with the SEC?  The following trends were noted at the February 11th meeting of the National Association of Corporate Directors/New England:

  • Request for detail as to effective tax rate as compared to the United States corporate rate of 35%, explaining variances above or below that rate. 
  • Discussion of the judgments applied to adjustment to valuations of balance sheet assets. 
  • Explanation of why a registrant believes that earnings held offshore are not subject to a balance sheet entry showing a deferred tax liability (why is the company saying that it does not intend to bring money held offshore into the United States?). 
  • More detailed segment reporting for different businesses. 
  • Discussion of assumed rate of return in funding retirement plans, measured against historical performance. 
  • Discussion of the judgment reached in not marking down goodwill (which must be reviewed annually for comparison of carrying value to fair value). 
  • Clearer labeling of non-GAAP financial reporting. 
  • Greater clarity in the accounting treatment of investments in China, Russia, India and other places where foreign direct ownership is limited and where companies enter into joint venture agreements. 
  • Increased focus on the robustness of internal financial controls, driven by PCAOB focus. 

A few years ago there was an effort to seek “convergence” of United States accounting principles (GAAP) with international accounting (IFRS).  Full convergence lacks steam; the different accounting systems have reached agreement on specific areas of reporting but full convergence is now viewed to be “a long way off.”