Tall Pygmies and CEO Succession

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“Never measure the tallest of the pygmies.”

This advice comes from George Davis, Boston Managing Partner for the national search firm Egon Zehnder, commenting on the appropriate way to search for a CEO following a corporate merger.  Since CEOs should be selected based upon whether they fulfill future requirements for skill set and experience, it is possible that the existing CEOs and other C level executives of both constituent companies in a merger are not “tall enough”  to meet that standard; consideration should be given to looking to an outside player.   One must avoid the “brokered deal” where, for example, one senior position is given to the CEO of one constituent, another C level position to the CEO of the other constituent.

Davis spoke at the February 12th meeting of the National Association of Corporate Directors/New England, which meeting focused on the role of directors in CEO succession.  Other major takeaways:

  • It is appropriate for the board to ask of a CEO: “what do you want from your board of directors that you are not getting?”  (Pamela Godwin, President of Change Partners of Philadelphia and board member of Unum Group [NYSE]).

 

  • Boards should be  proactive in driving  CEO succession planning, and one device to consider is an educational/training session for the board, during a retreat, where lawyers or HR professionals discuss the fiduciary role of directors in planning succession.

 

  • The job description for a CEO should be updated annually to reflect strategic changes in a company’s business which may alter the criteria for the best choice of CEO (William Messenger, Director at ArQule, Inc.).

 

Since changing times may require changing strategy, to be implemented by a new CEO from outside the organization, it is essential prior to the arrival of that new CEO for the board to make sure that the executive ranks are educated as to these new challenges and the appropriateness of the changes that a new CEO may bring (Ellen Zane, CEO Emeritus of Tufts Medical Center).

Over the last five years, the average tenure of a CEO (based on a survey of many public and private companies) has shrunk from 7.3 years to 4.4 years.  Thus, focus on CEO succession is becoming more important.  Half the members of boards surveyed believe that their succession planning is inadequate; only 33% have a well-documented succession planning process.

The panel also agreed on the need to train internal people as possible CEO successors.  Although internal executives may not make it to CEO, a plan to rotate them through different functions and (if they are board members themselves) different committees should be presented to them  as building their own professional skills, and not as a step in a “horse race” to the top.  The panel also agreed that CEO selection is the task of the board, but that filling slots below the CEO level is the role of the CEO, with the board asking appropriate questions to make sure that the task is being handled properly.

Corporate Minutes as Trojan Horse

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If you are involved with corporate governance, if you sit on any board including a non-profit, if you are a fan of keeping complete minutes of meetings as an archival record of what was discussed and decided– I suggest you read my current article about how to properly record meeting minutes.  It ain’t so easy as you might think….  The article appears on page 14 of the current issue of Mass Lawyers Weekly and shortly will be linked to my bio on the firm website but if you are interested in an advance copy please just send me an email.

The answer to good corporate minutes, by the way, is brevity while describing the process of discussion, not recording the substance of that discussion.

Update on Foreign Corrupt Practices Act

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You might want to click to my recent article on the FCPA, which is rapidly becoming a huge problem for companies doing business overseas.  It is possible for a US company to get into deep financial trouble by reason of the actions of its sales reps and overseas partners; suggestions as to risk containment are included in text.  Enjoy.

New Rules for US Patents

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On March 16, the most important part of the 2011 America Invents Act takes effect, and conforms the US patent system with the rest of the world.  On that date, we switch to measuring patent priority based on the first company to file an application.  Our old system is based on priority of invention, which meant that you got the patent if you could prove by notebooks and the like that you had the patentable idea first.

Other aspects of the Act already have taken effect.  Third parties now can themselves in effect intervene by providing proof of prior art, thereby short-circuiting a given application as lacking in novelty.  We have also added a procedure by which, for nine months after a patent issues, anyone can challenge it post-issuance.

What is the effect of the new system?.  We likely will see applications filed early, of course.  We will see larger companies monitoring filings so as to promptly provide proof of prior art and thus try to head off patent issuances.  We may see it become more difficult to obtain patents and that may further impact a difficult venture finance market.  We likely will see companies avail themselves of accelerated processing which will be available upon payment of an additional fee. And hopefully we will see the PTO eating into its substantial backlog of applications as it opens more offices and hires more staff with its increasing fee schedule.

Meanwhile the life science community has gotten in the habit of closely watching the US Supreme Court, which about a year ago (in the Prometheus case) put in doubt some patents covering methods and diagnostics.  A larger shoe may drop by this summer when the Court decides the Myriad Genetics case and addresses the patentability of genes and isolated DNA.

Financing Life Science Start-Ups

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Those who despair of our ability to inspire or fund start-ups could take a lesson from Israel’s Chief Scientist Office.  Here is how the CSO does it:

* Pre-seed, the CSO may fund 100% of costs.

*Promising ideas are funded for two or three years at 85%;  these companies are placed in incubators.  The CSO takes no equity and is repaid, if at all, from a royalty on sales.

*The incubators are for-profit private companies that fund the other 15%, so they have skin in the game.  The incubators get between 30% and 50% of the equity.

*The founders are not expected to invest their own monies.  They get 50% to 70% of the initial equity.

What kinds of life science companies are incubated?  About 55% are med device companies, and 30% are biopharmas.  About 200 companies now are resident in 25 or so government supported incubator facilities.  Recent experience is that about 90% of recently incubated companies have been successful in obtaining additional outside financing, reflecting an improving quality of enterprise being accepted into the program.

More mature companies may continue to get CSO funds, ranging from 30% to 75% of needs.  Additionally, the incubators themselves are free to participate in later equity rounds to increase or protect their stakes.

Israel invests about 4.5% of its GDP in life science, by far the highest percentage of any country, and about double the US percentage.  48% of incubated life science companies (all incubated over the last six years or so) have reached the revenue stage; 60 life science companies are listed on the Tel Aviv stock exchange (where, I am told [having no direct experience] that listing of very small companies is typical).

(Thanks to David Barone of Boston MedTech Advisors for some of the information and all of the statistics cited above.  David was addressing a presentation by emerging Israeli med device companies held January 29 at Newton Wellelsey Hospital.)

SEC Meeting on Fostering Emerging Companies

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The SEC may be behind schedule in promulgating regulations mandated by Federal Law, most notably relative to crowd funding under the JOBS Act, but it continues to discuss other possible initiatives to loosen regulation in an effort to spur the economy.

This Friday, February 1, the SEC will hold a public meeting of its Advisory Committee on Small and Emerging Companies to consider several possible stimuli: increasing the “tick size” in trading shares of emerging companies (brokers claim they cannot sustain a trading market and make a proper profit unless the pricing moves in larger increments, creating a profit potential; recall that until fairly recently the minimum tick was 1/8th); encouraging  a new stock exchange for small companies; revisiting the scope of required disclosure.

There is no mention of “Broker-dealer Lite,” a registration scheme for intermediaries who raise capital (and perform M&A) for smaller companies; these intermediaries typically are not registered as broker dealers, an expensive and time-consuming process, and thus operate outside of the stated law regulating such functions. Emerging companies have argued that some sort of modest registration for such “finders” would spur business development, particularly at the pre-IPO stage, without imperiling the public.

If you want to observe the meeting on-line, or submit comments on-line to the meeting, go to the SEC home page; reference is file # 265-27.

Private Equity Prognosis for 2013

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According to Kevin Callahan, Managing Director of Berkshire Partners (which has a $4,500,000,000 Fund 8), the year 2013 will be complicated, but with many PE opportunities for the careful investor.

Speaking before a Boston meeting of the Association for Corporate Growth on January 17th, Callahan started with a summary of 2012, which he characterized as a “rough year”: the whole industry took heat through criticism of Bain during the election, the recognition of income inequality as a social problem made it a difficult year to do PE, LBO and other acquisition activities fell off somewhat from 2011 (and remain massively below peak years 2006 and 2007), and price multiples and leverage increased across both large and small transactions.

What about 2013?

There is a “bear” case for 2013: Europe is in a mess, U.S. economy is not clarified, unemployment is high, prices and leverage remain high.

But there is also a “bull” case for 2013: Berkshire believes that the micro opportunities in particular industries such as consumer goods, technology and healthcare will trump macro negatives; interest rates remain low; certain US market segments such as manufacturing and construction are on recovery cycles.

Callahan then launched into a defense of the role of private equity: it fills a void in the capital markets, it is a proven asset class through three cycles, at least the top half of the funds out-perform public securities markets, PE is a constant performer during recession.  He does not see the number of private equity funds falling substantially; unlike hedge funds which operate on “one bad year and you are out,” hedge funds have a longer horizon and structurally are not built to disappear rapidly given the provisions of their partnership agreements.

Finally and most controversially, Callahan gave up the ghost on tax treatment of carried interests; as a logical matter, he suggested, they really are ordinary income, and are not entitled to favored capital gains treatments.  He does not see this as the slightest impediment to the growth of private equity; to paraphrase, he observed that “no one entered this business because of the tax breaks.”

The Petting Zoo

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During the week of January 7th, I attended what one client has described, with only slight hyperbole, as a vast “petting zoo.”  This would be the JP Morgan Life Science Conference held early in January each year in San Francisco, California.

Although our firm maintains both a robust life science and healthcare practice (note the plug), and although various of my partners from the East Coast and West Coast have attended JPM in the past, this was my first foray.  For those of you acquainted with the event, you may choose to cease reading.  However, for those of you have never attended, you may find the conference interesting.

First of all, most people who come to the conference do not attend the conference.  You can be credentialed to attend the formal sessions; I cannot say what percentage of people show up in San Francisco and do not get credentialed, but clearly it is a very large number and indeed, anecdotally, I would say more than half.

Second, there are two other conferences surrounding the official conference.  The first is a series of events and receptions run by venture firms, PEs, investment bankers and service providers which are open, in varying degrees, to people who sign up or are invited.  These are networking events with a flurry of business cards exchanged.

Then there are private meetings and receptions, attendance at which is policed.  “Crashing” these receptions is usually not possible.  Among other things, investment banks and capital sources also hold office hours in suites in nearby hotels to evaluate deals.

A wide spectrum of healthcare and life science companies attend, from the most sophisticated biopharmas to companies in more mundane spaces.  The conference enjoys a reputation as being “the” place to be for life science networking.

One final and perhaps interesting thought: amidst all the lunches, dinners and receptions with passed hors d’oeuvres, and amidst all the open bars, it is quite possible to starve to death.  The pace of meetings, and the geographic spread of meeting places, is such that the idea of getting three regular square meals a day, at anywhere near regular eating times, is impossible.  Hence, those of you who see me may notice a slightly added stomach bulge; those are the Danish pastries eaten on the run, between meetings.

Losing Face? The Facebook Litigation

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Lost in the economic turmoil concerning the fiscal cliff and the initial stock market rally occasioned by the compromise (notwithstanding prior assertions that this was “priced into the market already”), is the ongoing substantial litigation concerning Facebook’s May IPO.

The United States District Court (Southern District NY) finally has appointed lead counsel in the various class actions.  One measure of the complexity and magnitude of the allegations: two law firms have been named lead counsel for actions under the ’33 Act and the ’34 Act, a third firm as lead counsel for securities actions against NASDAQ, and a fourth and fifth firm were approved as co-lead counsel for allegations against NASDAQ based in negligence.

The NASDAQ actions lack the juiciness of the SEC-based claims against Facebook.  They are fundamentally technical, alleging improper execution and confirmation of transactions on the IPO date by reason of failed NASDAQ systems.  Interestingly, some claimants had sued NASDAQ based upon traditional state law negligence, while others alleged material misrepresentations and omissions.

The sexier claims are against Facebook, based upon facts that have been generally reported.  Did Facebook alter its earnings guidance at the road show and yet fail improperly to amend its SEC offering materials?  Did major investment banks reduce their earnings forecast but then keep that reduction  secret from all but a limited number of preferred clients?

The issues presented in the securities claims against Facebook are in many ways fundamentally directed at the efficacy of our regulatory scheme.  A company involved in a huge IPO, working with major underwriting firms, and everyone represented by top-notch legal counsel, is alleged to have violated a pretty simple and fundamental rule: on the date that you go public, information about the IPO company must be both accurate and broadly disseminated.

How could these major players fail to adhere to this non-too-subtle basic rule?  We are talking SEC 101 here, involving none of the subtleties that haunt asset backed securities or auction rate securities, nor involving fine line-distinctions of whether overseas payments to murky people in murky circumstances were permissible “facilitating” payments or ran afoul of the Draconian provisions of the Foreign Corrupt Practices Act.

A review of Facebook’s SEC filings reveals that the Company considers all this litigation to be without merit, and intends to vigorously defend the suits.  The Company also notes pending governmental investigations concerning the IPO, and pledges cooperation with such investigations.

Allegations, no matter how widely reported or pleaded, are not proof.  We do not really “know” what happened.  It is unprofessional to conclude there is fire behind the smoke, although one can be tantalized by the huge quantity of that smoke.  I suspect these cases will be negotiated and not tried.  In a way it is a shame; one might have a voyeur’s fascination with a granular recitation of what actually happened.

Accounting for Public Companies

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The drive to create a unified world-wide system for corporate accounting has stalled, perhaps permanently.

In March, 2009, my article in New England In-House noted the SECs then-proposed road map leading to mandatory adoption of International Financial Reporting Standards (“IFRS”) for all reporting United States issuers (’34 Act public companies).  At the time, there was talk of a several year timetable, and resolution of what was then perceived to be the knotty questions: would IFRS integrate with the SECs mandated XBRL language (requiring financial statements to format  consistently so that computerized comparisons could be achieved); resolving the tension created by United States regulatory  requirements for “GAAP” accounting; how to deal with LIFO accounting, which was not  permitted under IFRS; resolving differences in accounting for P&L, recognition of litigation liability, and the equity method of valuing investments.

Where are we today?  Bogged down.

Neither the United States Financial Accounting Standards Board (“FASB”) nor the board administering the international standards (“IASB”) is making much headway, nor are they talking about a program to resolve all inconsistencies between the systems.  IASB has stated that seeking “convergence” with US GAAP is no longer a priority.  Rather, the two organizations presently seem focused on resolving specific differences concerning income recognition, and  accounting for financial instruments and leaseholds; a joint standard on revenue recognition may well issue, according to Compliance Week, in early 2013.

In the meantime:

* FASB is moving forward at its own deliberate pace in an effort to address, without adopting international standards, some of the basic issues presented by the emerging world economy.

*The Committee of Sponsoring Organizations (“COSO”) has published an update to its long standing “framework” which establishes the methodology for companies creating internal controls over their financial reporting.  You may recall that the original COSO framework was in existence at the times Sarbanes-Oxley was adopted in 2002, SOX required reporting on the efficacy of internal financial controls by SEC-registered companies, and use of the COSO framework became normative.  The old COSO framework was a decade old at that time and is now, of course, 20 years old.  The revised COSO version is directed at solving issues that were difficult to resolve under the old framework, and is replete with illustrative tools to facilitate compliance.

*The Public Company Accounting Oversight Board (“PCAOB”), which controls the auditing of SEC registered companies, has announced that PCAOB and Chinese authorities will begin observing the audit oversight activities of each other, better to understand quality control; granular reviews of specific audits are not presently contemplated.  As more and more companies from China are coming onshore into the United States, some by generally disfavored “reverse mergers” into shells that are already publicly held, getting a better understanding of the accounting history of Chinese companies makes a lot of sense.

And as for convergence of GAAP and IFRS?  It always struck me that the commentators and magazine writers were more excited by the prospect of accounting convergence than were CFOs and CPAs.  In any event, at least for now American standards for accounting seem to be intact and without immediate prospect of substantial revision.