The Law and Other Anomalies

Today the SEC announced final rules concerning compensation committees of public company boards of directors.  This action is a mere two years after being mandated by the Dodd Frank Act and demonstrates the struggles of the SEC in keeping up with its regulatory agenda.  That having been said, the content of the final rules is not startling.

Basically, securities exchanges now must establish listing rules that traded companies must comply with, requiring a wholly independent comp committee with the power to hire and totally control compensation consultants; companies must agree in advance to foot the bill.

Proxy disclosure amendments require indication of conflicts of interest between the consultant and the company and management, and how the conflict is being addressed; proxy disclosure already elicits details about the use of consultants, payment of fees, etc.

Many but not all public companies use consultants; while it is clear that using consultants is not sufficient alone to discharge fiduciary duty, the data provided by consultants and the discussion of variables is strong evidence of diligence and care.  Some large companies do not use consultants as a matter of practice, but the burden of going against a de facto best practice is heavy.

Those who decry creeping regulation through the securities laws as a drag on entrepreneurship and job creation, and who react negatively to the web of regulation contained in Dodd Frank, will have more evidence to point to.  But the new rules are not a significant added burden to the already existing practices of most companies.  The real game is the loss of the older practice of the board fixing compensation in its own judgment and not having to explain it to anyone.  And today, even with a comp committee and consultants, poor performance in stock price will foster resistance to the board from shareholders and problems with ISS.

The real problem of course is driven by human nature.  In fixing compensation of C level executives, what board member is content to say that his or her executive is just average in skills, or even below average (someone HAS TO BE below, mathematically)?  Does the disclosure say “Your board decided we have and want to keep an average CEO and pay him the market average, we think the board discharges its duty to you in this regard by providing mediocre pay to a mediocre president”?  Not hardly likely.  Boards want to think, and do think, they have gotten someone above average, at least.  Everyone ends up being perceived as above average.  The pay scale increases to make a new, higher average.

These are not human dynamics that can be cured by disclosures and by preventing conflicts of interest.  Unless the unthinkable is thought of (regulation by government or quasi-governmental institutions of actual executive pay), it will continue.  Again, a failure of regulation to rein in human nature.

It remains good to be king.  And to be a C level executive.

On a recent visit to Boston, Attorney Steve Shapiro (General Counsel to the American Civil Liberties Union) outlined matters before the Supreme Court today, or likely to arise in the coming 2012-2013 session.

I.    Obama – Care

The gorilla in the room is litigation concerning the healthcare law (designated derisively by some as “Obama Care” but we in Massachusetts really know it more by its original name: “Romney Care”).  In an unprecedented move, the Court extended its usual one hour argument time by a factor of six in order to hear arguments on specific issues posed by the Court itself:

• Is the case ripe to be decided today since most of the provisions, including the requirement to obtain health insurance (the so-called “individual mandate”), don’t take effect until 2014?
• Since the IRS can collect the penalty for violating the individual mandate only by offsetting tax refunds, and since there is an established rule of law that you can challenge a federal tax provision only after the tax is paid, will it ever be possible to challenge the law from the “tax” standpoint?
• Can a citizen be forced to buy a commercial product such as insurance?
• If the Supreme Court strikes the individual mandate, what other parts of the law if any are so inter-related that they must also be stricken?

Why is the Civil Liberties Union interested in the healthcare law, bearing in mind it is not overtly a civil liberties statute and the ACLU has taken no position as to whether the healthcare law is wise legislation?  The reason has to do with Commerce Clause of the Constitution; the ability of the Federal government to pass the healthcare law is dependent upon whether such legislation fits within the constitutional grant of authority to the Federal government to regulate interstate commerce, and a broad reading of the Commerce Clause of the Constitution is necessary in order to support a variety of civil rights legislation which is similarly premised.

Shapiro noted that there is political pressure on the Supreme Court to decide this issue now, regardless of the technicalities as to whether it is “ripe.”  As to the question of whether the case is appropriate for decision where the “tax” has yet to be collected, Shapiro points out that the Administration has firmly taken the position (requisite in the current economic climate) that the IRS-collected penalty is simplynot a tax.  Indeed, its collectability is only as an offset from otherwise government-owed refunds which may never arise.

Whether a citizen can be forced to buy insurance is fascinating.  It seems clear that State governments could in fact impose such a requirement, because it is an exercise of the general police powers.  But the Federal government only has those powers which are expressly afforded to it by enumeration in the Constitution.  All other powers are retained by the people and the States.  Thus for example, the similar Massachusetts Healthcare Law cannot be attacked on the ground of lack of government authority.

In a way it is therefore a shame for the Administration that it has claimed that the penalty is not a tax, since the Federal government clearly is entitled to levy tax pursuant to the Constitution.

Challengers to the law say that the Commerce Clause cannot support the legislation.  It may be true that if an individual chooses to buy health insurance he then participates in the interstate commerce business of the healthcare system.  But, say opponents, the statute is focused on individuals who do not buy health insurance and, consequently, uninsured individuals subject to this law are by definition notinvolved in interstate commerce relative to healthcare, as they do not participate.  The government counters by saying that in fact all Americans participate at some point in time, this is a matter not of “if” but simply “when.”  If someone who is not insured requires healthcare, and he does not have insurance, by law he cannot be denied medical care and ultimately that care is paid for by all Americans as part of the interstate commerce of healthcare.

Shapiro noted that two popular provisions of the healthcare law clearly are within the constitutional powers of the Federal government: that insurers cannot deny coverage for pre-existing conditions, and that insurers cannot increase charges for insurance based upon one individual’s health history.  Since the Constitution grants to the Federal government all other power necessary to effect otherwise constitutional actions, the individual mandate perhaps can be backed into a convenient parking space of constitutionality through this argument, without reference to the Commerce Clause.

Query: let us say it is true that the Federal government can require an individual to buy health insurance because the Federal government supports a national healthcare system which in turn is part of interstate commerce.  Does that also mean the government can require all citizens to buy a General Motors car because we bailed out GM?  Shapiro suggests that the issues are analytically the same but the political ramifications vastly different.

How will the case come out?  As in the past, Justice Kennedy is thought to be the key.  But the general thinking is that if the healthcare law is to be stricken, the vote will be five to four.  If, however, there are in fact five votes to retain all aspects of the law (that is, if Kennedy votes in favor of the law), then the vote is liable to be six to three.  Why is that?  Because at that point the Chief Justice is expected to vote to uphold the statute, because then the Chief Justice will be entitled to write the legal opinion, and he would want to write the legal opinion in the narrowest possible terms.

II.  Immigration

The second leading and as yet undecided case before the Supreme Court is the Arizona “show me your papers” law which requires the police, upon any otherwise permissible detaining of a person (including for example running a red light), if that officer also has a “reasonable suspicion to believe” that a person is in the country illegally, to ask the detainee to prove his legality (green card or some such).  If you cannot, you are to be taken into custody and a call placed to Immigration.

The key question here is the basis for “reason to suspect” that someone is in the U.S. illegally.  Shapiro’s position is that this is an open door in Arizona to racial profiling to accomplish Arizona’s overtly articulated goal: attrition through forced immigration of minorities out of the State.

The fight over the Arizona Immigration Law is the exact reverse of the fight over the healthcare law: the cases are mirror images.  Why is that?  It is again a question of who has authority to take action.  Under the healthcare law the question is whether the Federal government has authority to act under its constitutionally specified powers (the Commerce Clause).  In the Arizona “show me your papers” case, the question is whether the State has the authority to take any action with respect to immigration which is clearly a primary Federal function.

Opponents of the law say that immigration is a Federal matter and the States are preempted from acting upon it.  And here the issue is compounded by history.  Historically, immigration indeed was a Federal prerogative both in terms of articulating the law and enforcing it.  In the last Bush Administration, the President’s legal office stated that the Federal government could share enforcement of Federal policy with the States, and that the States therefore could have concurrent authority.  The Obama Administration, although urged to reverse this position, declined to do so.  Consequently the Obama Administration now cannot maintain that the States have no power whatsoever to enforce in the area of immigration.  Now the Obama Administration is therefore required to take the following position: States cannot enforce Federal immigration laws inconsistently.  The response of the State is obvious and based on the facts:  “we do in fact consistently enforce.”

Shapiro suspects the Supreme Court may indeed uphold the “show me your papers” portion of the Arizona Immigration Law (other provisions clearly will fall), but will still leave open the issue of discriminatory application.  And in that regard, there ultimately may be a victory for the opponents of the law; business and agricultural interests in Arizona (and similar States that have adopted similar laws) have realized that clamping down on immigrants is bad for business, and the political will to enforce the law in a discriminatory manner may well have dissipated.

III.    Murderous Children

More consistent with the kinds of cases with which the ACLU generally deals are two pending cases involving whether imposing a criminal sanction of life in prison without parole, in cases of murder, can be applied to a minor.  The contrary argument is that it is cruel and unusual punishment violative of the Constitution’s Eighth Amendment.  The Supreme Court previously has held that a sentence of life without chance of parole constitutes cruel and unusual punishment for a minor in all non-homicide cases.

At this point two cases are pending under an Alabama law against two fourteen year olds (at the time of the crime), one of whom pulled the trigger in a murder and the other of whom was found guilty of murder under the time honored “felony murder rule” (any participant in a criminal act which is a felony, where that criminal act results in someone’s murder, is himself guilty of that murder).

Shapiro expects that the Alabama law will be determined to be unconstitutional because the Alabama lawrequires a life sentence without parole in such a case.  He expects that the Court will say that the judge must be left with some discretion with respect to sentencing.  Query whether the Court will go further?  Query whether the Court will establish an absolute minimum age with respect to which a life without parole sentence will always constitute cruel and unusual punishment.  Conveniently in the argument before the Supreme Court in the two Alabama cases, lawyers for the minors claimed that the appropriate absolute minimum age is fifteen while the State of Alabama claimed it was thirteen, artificial line drawing with respect to two defendants who happened to be fourteen years old.

IV.    Congressional Medal of Honor

Other interesting cases this term include:

United States v. Alverez (a pending case asking whether the statute which criminalizes lying about receiving a military honor such as the Congressional Medal of Honor violates the First Amendment right of free speech); and

Two decided Fourth Amendment search and seizure cases (United States v. Jones asked whether the police with no warrant can put a GPS tracking device on your automobile, answered in the negative by this Court in a rare nine to nothing decision; as compared to Florence v. Board of Freeholders, which asked whether a New Jersey jail can routinely strip search each person held in the jail, no matter how minor the offense and how short the incarceration, an exercise of police power upheld by a five to four vote).  Shapiro suggested that the difference between the decisions in the Jones and Florence cases is one of Court “empathy;” the Justices could imagine, and be shocked by, the government putting a GPS device on their own cars parked in the Supreme Court parking lot (they actually asked the government attorney during argument if the government felt it had the power to do so, and received an affirmative response!) while, it was suggested, the Justices simply could not imagine themselves in a position of being stripped and searched because they ran a red light).

V.  Coming Attractions

What is liable to come up in the next term?  (The Supreme Court operates on what is an academic year, the cases start getting heard in the Fall and all must be decided by the following June 30^th.)

There is likely to be another case on whether affirmative action is supportable in university admission settings, re-examining the acceptance of such a criterion in the University of Michigan case several years ago.

There may be a challenge to Section 5 of the 1965 Voting Rights Act, which requires States with a history of voting discrimination to obtain affirmative Department of Justice pre-approval of any change in their voting rules (Obama’s DOJ has struck down two such laws, while allowing a change in Wisconsin voting laws without DOJ review because Wisconsin had no history of voting discrimination).

It is likely that California Proposition 8 (defining legal marriage as only between a man and a woman) will come before the Court (the statute had been stuck down by three judge panel of the Ninth Circuit [California] Court of Appeals).

ACLU hopes to bring up the case of Clapper v. Amnesty International, where ACLU raises the Fourth Amendment protection against unlawful search and seizure in a wire-tapping for national security purposes without judicial oversight.  This case presents an anomalous twist: generally you can only challenge United States Federal surveillance powers if you have standing because you have been under surveillance, but under the national securities regime you may well not know that you are under surveillance, and if you ask you will not be told because it is of course a secret national security matter.  This surveillance right was struck down by a three-judge panel of the Second Circuit [New York] Court of Appeals), but the en banc Second Circuit (a conclave of all the judges who sit on the Circuit) was divided six to six.

Finally, it was asked whether any more litigation was liable to reach the Supreme Court out of the Gitmo detentions.  While there is of course no definitive answer, Shapiro noted that at present all detainee cases go to the Federal District Court for the District of Columbia, which has granted the government broad license to detain a wide variety of suspects, and has determined that although a given detention may in fact be unlawful there is no ready remedy because the detained individuals cannot be set free in the United States and the courts cannot compel deportation.

The other day at UMass Boston, MassMEDIC (the trade organization of Massachusetts medical device companies) held its 16^th Annual Conference.  It was well attended, and my prior blog post reported Covidien CEO Jose Almeida’s comments for the advancement of the United States medical device industry.

Another speaker, Yair Holtzman, is a director at WTP Advisers of White Plains, New York, where he focuses on business advisory services to the life science industry.  A CPA and MBA, Yair ambitiously traced the current and future states of R&D in device development.  Let me take a stab at summarizing the high points.

In the past, the United States has been dominant in the medical device market through a combination of its head start with a large number people working within the field, deep expertise, entrepreneurial investment, a robust middle class that drove medical device advances, and a group of patients who could afford to be price-insensitive when it came to buying medical services.  A large number of hospitals, and the leadership of the FDA in device safety, didn’t hurt.

International R&D, as many have noted, is greatly increasing.  Reimbursement has become an issue in the United States, creating concern for ROI that can be derived from R&D efforts.  Added pressure was placed on U.S. ROI for many other reasons, as outlined by Covidien’s Almeida (see the May 1^st post).  China and India have growing middle classes and growing expertise; they may well develop medical device products and not even bother to have them cleared in the United States.  Approval of devices in Europe takes half the time of FDA review; Brazil, India and China are becoming very entrepreneurial and are attracting substantial investment.  Germany and Israel have substantial medical device expertise.

For these reasons the United States, historically a leader in the production and consumption of medical device advances, may find itself left behind the rest of the world.

Joining the cacophony in criticizing the Affordable Care Act, which in 2013 will assess a 2.3% excise on the gross income of medical device companies regardless of whether or not a profit has been made, Holtzman anticipated that the effect would be “devastating” and urged that the excise be repealed.  Also in order is a reinstatement of the R&D tax credit, which expired at the end of 2011.

What else must be done in the future?  First, greater speed and predictability must become part of the FDA approval process.  Second, a continuation in the trend to reduce R&D costs through joint ventures and through “farming out” R&D functions must continue.  Third, the industry must recognize certain trends in healthcare: mobile health, personalized medicine, economic efficiency demanded by patients and their reimbursers, and the need for disruptive technologies which will create a paradigm shift in costs and outcomes.  Analytics to demonstrate both health and financial outcomes must become part of device development.

Holtzman observed a trend in the United States to develop incremental products, as opposed to developing disruptive technologies through R&D expenditure, with the “disruptive” perhaps more likely to be generated offshore.  This development is not beneficial to U.S. industry, to say the least.

Holtzman also noted that many VCs are establishing offshore presences, including in Israel and Singapore.  Hopefully some of his recommended changes (at the FDA and in tax policy) will again make domestic United States venture investment in medical device companies attractive, but Holtzman added that his firm has success in identifying grants, state credits and local incentives, as well as joint venturing approaches, in order to drive down R&D costs, speed development and thereby improve ROI.

Interestingly, Holtzman’s remarks also reflected an anomaly which was apparent upon analysis of several recent life science conferences (not just medical devices).  On the one hand, the FDA is praised as setting the standard for review of medical technology which is emulated around the world, and which is one basis for historical American primacy in these markets; on the other hand, the FDA now also is criticized as one of the primary causes of the United States slipping behind the rest of the world.