A Baker’s Dozen of Blue Chip CEO’s and Leading Investors Speak Out on Corporate Governance: What Else Can be Offered to the Conversation?

A most curious press release sprouted up amidst summer’s hot growing season: 13 leaders of public companies and investing firms have put forth self-professed governance principles for public companies. (See www.governanceprinciples.org)  As can often happen with a group drawn from diverse constituencies, however, and no matter how laudable the goal, the message avoided controversy – and thus at times clarity. In many areas the principles simply restated what has become commonly accepted as the norm – and in other areas they merely described known facts without clearly adopting a position – thereby resulting in analytical hedging. While the governance principles are undeniably appropriate to initiate a dialogue, they beg the question of what raw issues lurk under the surface.

The leaders were drawn from the heads of:

  • Public companies: GM, JP Morgan Chase, GE and Verizon;
  • Actively managed funds: Capital Group, Berkshire Hathaway (yes, Mr. Buffett), JP Morgan Asset Management and T. Rowe Price;
  • Diversified asset managers (and indexers): Blackrock, State Street Global Advisors & Vanguard;
  • Public Investment Arms: Canadian Pension Plan (CPP) Investment Board; and
  • The Activists (or the “Constructivists”?): ValueAct Capital.

While the group took pains to note that their cadre was small out of practical necessity – not intent (the deliberations were conducted in secret) – notably absent from the cross-sample were:

  • Newer public companies: Google, Apple, Facebook (or even slightly older companies such as HP, Microsoft or Intel) – the issuers were drawn all from respectable and great companies – but ones who come from a very different cultural background than newer, but still large and well capitalized public companies – with many of them on the West Coast and many of them in technology.
  • Midcap public companies: Governance has cost. Hearing the duties of a lead director of a large company these days is akin in some respects to having a shadow CEO. Moreover, investment firms have limited resources devoted to governance and a smaller company may find it difficult to find receptive bandwith. Small and midcap companies out of necessity have different approaches and perspectives.
  • The largest US pension funds: Yes, the CPP manages $200 billion USD in assets. However, no CalPERS ($300 billion – dwarfing the CPP)? No CalSTRS ($189 billion)? No New York City pension funds (for a New York based group) ($163 billion in assets)?  And irrespective of size, each of CalPERS, CalSTRS and the New York City Comptroller have been extremely involved and vocal on governance.
  • The “activist” activists: ValueAct is known for pressing management in private and rarely going to a proxy contest – accordingly, their need for the levers of the shareholder franchise may be less pressing that those activists who threaten (to some, perhaps bully and to others, shake up underperforming) management: Carl Icahn (witness the eBay/PayPal split), Nelson Peltz (the subsequent merger of Dow Chemical) and Jeff Smith (the wholesale overthrow of the Darden board).
  • The advisors: At the risk of self-promotion, it is interesting that the group lacked any senior presence from those advisory constituencies who regularly must sort out these issues: whether from proxy advisory firms, investment banking or law firms.

This group of ultra-large asset managers and public companies  somewhat unsurprisingly focused on general contours of evolutionary governance – no matter that many, if not most, of those contours are widely accepted norms already, particularly by the primary proxy advisory firms (ISS and Glass Lewis).

The group’s overarching themes include:

Board Interaction

  • Executive sessions without the CEO and meeting management below the CEO level;
  • Benefits of board diversity;
  • Either an independent chairman or a strong lead independent director if the position of CEO/Chairman is combined;

The Stockholder Franchise

  • Majority voting: a majority of votes cast “for” a director must exceed the number of votes cast against, with broker non-votes and abstentions not counted;
  • Dual stock structures are not ‘best practice’ and should have sunset provisions ;
  • Written consents and special meetings “can be” important mechanisms;

Financial Reporting

  • Optionality of providing earnings guidance;
  • Including GAAP results prominently – and not excluding stock compensation expense for non-GAAP measures;

Stockholder Engagement

  • Access to institutional investor decision makers; and
  • Asset managers should devote appropriate time to analyzing votes.

The interesting and perhaps most controversial part of the group’s principles is within financial reporting. Providing guidance – particularly short term guidance on multiple variables – is increasingly being scaled back by companies – and large asset managers (as opposed to the ravenous appetites of the sell-side analyst community) may find such guidance not terribly useful for fundamental analysis. The role of non-GAAP reporting is also under scrutiny: The SEC has recently experienced renewed vigor in scrubbing non-GAAP financial provisions. It is interesting to note, however, that while the group clearly is advocating that stock expense cannot be part of a non-GAAP rubric, the group itself excludes companies (traditionally in the technology space) where equity customarily has been non-GAAP’d out.

The guidance offered is a good beginning of what should be discussed. Yet, here is what is also needed:

  • Clarion positions that stake out firm ground in controversial areas: For example, take this less-than-fiery statement from the principles: “Directors should be business savvy, be shareholder oriented and have a genuine passion for their company.” Granted, board members draw from academia or government may not be as “business savvy” as one would hope – but generally such directors have unique depth in a given area and are balanced by other members.
    • Drilling down on the prior point, in a staid recitation of the past couple of years’ evolution on proxy access, the group dissected where proxy access has gone – but failed to endorse proxy access explicitly, any specific provisions or advocate for more or less access.
    • The group did a similar recitation that some companies have board age limits and some don’t.  And the group called for companies to articulate their positions and explain any exceptions. Communication. But is 70 the ‘new 68’ – or 72 the ‘new 70’ – What is the position of this country’s leading investment funds on age limits and whether or not they truly make sense?
  • Addressing “short termism”  vs. “entrenchment” and the right balance – or the risks of short-termism (such as leveraging up a balance sheet to return a special dividend potentially to the detriment of long term R&D and the business over decades, not a single one time hit of capital return). Or the role of sharply divergent viewpoints often presented by activists and how such viewpoints  actually may inject fresh intellectual capital onto boards – or whether classified boards impede short termism or merely are entrenchment mechanisms – and what the standard is for accepting or rejecting them.
  • The role of plaintiffs firms and litigation both good and bad – including the extent and wisdom of exclusive forum limits and even fee-shifting provisions.
  • Stark and raw self-inspection of the actual underpinnings of modern boards: The dean of the American corporate bar, Marty Lipton, has bemoaned the current paradigm of governance:  Boards composed of almost exclusively of outside directors, save for the CEO – it is increasingly rare for a board to have more than the CEO as an inside member.  Such (mostly retired) board members oftentimes spend no more than 8 (perhaps 10-12 at most) days per year in a regular rhythm: Ballooning stacks of virtual paper on electronic posting systems, parachuting in to convene for a day of committee meetings, followed by a board dinner and the following morning, a board meeting – and then a hasty collective scoot to the airport. Punctuated by the annual two day or so retreat.

Ironically, on the very same day that the principles were announced, CalSTRS disseminated a press release outlining their own changes to their governance principles (click here). One must wonder if the CalSTRS press timing was completely coincidental, particularly given dueling press releases on corporate governance principles are hardly an everyday event. Many of CalSTRS points mirrored the baker’s dozen group of CEO’s, specifically:

  • Increasing board diversity while also ensuring board competency;
  • Executive compensation, including peer group composition and enhanced scrutiny on equity grants – and particularly ones outside of established plans; and
  • Demanding one share, one vote capital structures.

In summary, the group of CEO’s message on corporate governance represents a baseline – something for which companies in the lowest decile of governance practice can aspire. But with a wider cross section of leaders, it possible to imagine the group driving harder to have positions on the tough issues facing boards today – and describing clearly areas where dissonance occurs while addressing the tension behind such obvious underlying disagreement.

SEC Approves NASDAQ Golden Leash Disclosure

In the past couple of years, a relatively hot area of the sometimes rather lackluster world of bylaws amendments has centered on requiring candidates for election to a board of directors to disclose any compensation arrangements with third parties that relate to such board service. In their most egregious form, issuers fear that such ‘golden leash’ arrangements incentivize board candidates – almost certainly those nominated by activist investor funds – to advocate positions that would otherwise not be in the long term interests of stockholders, instead focusing on short term increases in results.

When this issue first gained prominence in 2013-2014, some issuers attempted an outright ban on such third party arrangements. In the face of howling (though largely private) opposition from activists and, more importantly and publicly, proxy advisory firms, most companies fell back to a position of simply requiring disclosure rather than an outright ban. Accordingly, numerous bylaws have been amended to require disclosure of such arrangements. Disclosure (only) is increasingly viewed as the simple norm.

More recently, the NASDAQ – home to most technology companies, a sector which only in the past few years has firmly become a prime target of the activist community – proposed and, as of July, now has received SEC approval for, a listing rule that requires disclosure of all golden leash arrangements.

Interestingly, the NYSE – at least publicly as of now – is not contemplating such a move, nor is the SEC pushing wider regulation. One could posit that the disclosure laws are already sufficiently broad to permit the SEC to require such disclosure through relatively simple rulemaking (or even just comment letters to strengthen interpretations). Such potential regulation would appear prudent, particularly for the ‘pink sheet’ OTC micro-cap stocks where this could also be an issue but such companies would not be subject to larger exchange regulation. However, the Staff – whether overburdened by thousands of pages of bureaucratic complexity stemming from initiatives such as Dodd Frank, or simply timid given their mixed success in regulation with respect to director elections (e.g. proxy access) – has declined to do so. Such declination arguably is an abdication of responsibility, though perhaps not a surprising one given the poisoned political atmosphere currently involved in merely having commissioners confirmed to serve.

Golden leash arrangements in and of themselves need not be  anathema to long term stockholder value. The pros and cons of the arguments are boiled down to:

Pro: To attract truly high quality board candidates – particularly to ‘normal’ activist situations which involve companies facing various challenge and usually whose stock as a result underperforms rather than outperforms – requires super-compensatory arrangements well beyond what has become the vanilla director benchmarked compensation rate for the standard 8 days a year (and a few teleconferences).

Pro: If tailored correctly, a separate compensation arrangement does not in and of itself need create disparate incentives on the board. Activists have begun arrangements that involve significant remuneration – but as a condition, such money must be invested exclusively in company stock, thereby aligning the particular board candidate with the stockholders as a whole.

Con: No matter how putatively aligned such compensatory arrangements may be, an arrangement may disproportionately affect a director when compared to holdings of a large institutional investor who may have more patience and fortitude to have a long term time horizon. Even if a director invests in company stock, he or she may still be looking for (or simply more susceptible to) the ‘quick pop’ from a year or two of board service and selling the company for a modest premium – even if the growth prospects for 5 or 10 years could be reasonably expected to eclipse the present value of a short term sale price.

Con: Disparate compensatory arrangements can create disparate power perceptions in the boardroom because of the different labor markets from which such director pools are drawn. This can create a situation where a new ‘superstar’ director is able to have outsized influence on management and de facto potentially intimidate other board members to be more susceptible to ‘short-termism.”

Obviously disclosure only requirements – including NASDAQ’s new rule – do not normatively weigh-in on the merits of the arguments listed above; that is left to the stockholders through the exercise of their franchise in director elections. The NASDAQ rule does, however, fortify the accepted norm of such disclosure.

Finally, NASDAQ’s rule also presents the odd optic that a self-regulator – who is in heated competition to retain listings against the NYSE – is unilaterally imposing the obligation as its own rule, inviting issuers to view this a stock exchange regulatory arbitrage. It remains entirely unclear whether this portends a future pattern of competition among exchanges based on perceived enhanced governance standards – ones that go beyond prior accepted norms such as director independence and delve into relatively technical and more disputed areas.

Yet Another Congressional Proposed Corporate Reform: Proxy Advisory Firms in the Crosshairs.

Over the past six months, U.S. legislators have engaged in an unusual burst of energy to introduce three separate bills regulating various areas affecting U.S. public company corporate governance:

  • The Cybersecurity Disclosure Act of 2015 would require disclosure of whether public company boards contained a cyber-security ‘expert’ or, if not, why not.  The bill, introduced by Senators Jack Reed (D-RI) and Susan Collins (R-ME), appears stranded in the Senate’s Banking, Housing and Urban Affairs Committee.
  • The Brokaw Act would shorten the trigger grace period for filing a Schedule 13D after acquiring 5% or more of an issuer’s stock from ten to two days.  It also would require disclosure of any party who ‘coordinated’ with the filer, targeting activist ‘wolf packs.’  This bill, sponsored by Senators Tammy Baldwin (D-WI) and Jeff Merkley (D-OR), is sitting with the same Senate committee and may become subject to political season vagaries, particularly as supporters including Senators Bernie Sanders and Elizabeth Warren.  However, ironically, it may find bipartisan support as the current ten day Schedule 13D filing period is viewed as archaic by many corporate issuers.  At the very least, this proposed legislation has worried activist investor firms enough to band together in an unprecedented lobbying effort.
  • Last – but certainly not least – Congressmen Sean Duffy (R-WI) and John Carney (D-DE) introduced in the House Financial Services Committee the Proxy Advisory Reform Act of 2016, which appears to have the most impetus for movement through the labyrinth of legislative crafting.

As foreshadowed by its title, the Duffy/Carney draft legislation targets proxy advisory firms.  Decades ago, the dull duty of voting in favor of management proposals was viewed as so mundane that generally it was entrusted to an investment firm’s mailroom personnel.  A few corporate scandals created questions as to this automatic practice.   Equally importantly, the Department of Labor – as the U.S. primary regulator of retirement savings – chimed-in by declaring that investment funds owed a fiduciary duty to their investors when voting shares.

Since many funds lacked the scale to cost-effectively vet and decide positions on all the myriad companies in their portfolios, the concept of outsourcing those decisions to a group effort led to the creation of proxy advisory firms.   Today, that market is dominated by two providers:   Institutional Share Services (ISS), owned by a private equity firm, and Glass Lewis, owned by Canadian pension funds.  Clients (investment firms) pay ISS and Glass Lewis to read, evaluate and recommend voting on company annual meeting proposals    For many years, the weight of these firms was such that a recommendation ‘for’ or ‘against’ was extremely likely to sway the vote.

Increasingly over the past decade, however, as fund flows have both surged in overall volume and become more concentrated with the largest players – most notably burgeoning index funds – various investment shops have created and/or significantly reinforced their own in-house governance functions.   Investors are largely divided into:

  • Actively-Managed Funds, such as Fidelity Investments, Capital Research and T. Rowe Price;
  • Index Funds, such as Vanguard, BlackRock and State Street Global Advisors (SSGA);
  • Hedge Funds; and
  • Retail Investors.

Large investors with actively managed or index funds often use proxy advisory recommendations as a triage mechanism – the recommendations are useful but not dispositive of how a large investor may vote.   Nonetheless, many smaller investment funds appear to continue to defer entirely to whatever ISS and Glass Lewis may recommend.   And mid cap or small cap companies may not receive much independent scrutiny, even from investors with well-established internal voting departments.

Accordingly, ISS and Glass Lewis recommendations remain both important and, sometimes, controversial.  Public companies tend to have three primary complaints about proxy advisory firms:

  • Opaque Criteria:  Certain criteria used in evaluating proposals – particularly in the area of executive compensation and the refreshing of employee equity inventive plans, are perceived as ‘black boxes’, generally not easily understood and inflexible when applied to unusual or unique circumstances.
  • Inaccurate Analysis:  ISS and Glass Lewis are responsible for evaluating thousands of proxy statements – the majority of which still occur within the traditional compressed spring cycle of a couple of months for companies whose fiscal year end is December 31.  The advisory firms can be perceived as making mistakes in the analysis, for which they may or may not be open to conversation and correction.   The proxy firms would maintain that with sufficient advance planning, an issuer will have plenty of time to help correct mistakes – but issuers who are running businesses may not have that at the forefront of their list of priorities.
  • Apparent Conflicts of Interest:  ISS offers consulting services – fees to essentially explain their blackboxes.   They claim to ‘firewall’ the consulting segment of their business from the proxy advisory segment – going to the extent that the respective teams are housed in separate buildings.    In return for consulting fees, ISS will work with a company to model the company’s compensation policies and corporate governance policies.   Nonetheless, there is a perception of an apparent – or at worst actual – conflict in interest in offering companies services for which a company is then scored by ISS.

In response to these complaints, the Proxy Advisory Reform Act of 2015 proposes to force proxy advisory firms to:

  • SEC Registration:  Register as such with the SEC and certify that the firm has the requisite ‘financial and management’ resources to function.
  • Recommendation Pre-Review:  Give an issuer sufficient reasonable opportunity to review draft recommendations and to have an ombudsman office that assists issuers that purport to need corrections to such recommendations.
  • Business Model Disclosure:  Disclose a firm’s top twenty clients by revenue, any potential conflicts of interest and describe how clients do not have ‘undue influence.

Some industry observers – including the proxy advisory firms, to no surprise – view the issue of conflicts as a red herring – notwithstanding the appearance that may be given externally.   While theoretically such fees may create an appearance of impropriety, ISS’s response is that it goes to great lengths to ensure a division between consulting and scoring.

On a practical level, it is a complete unknown as to what reasonable standard the proxy advisory firms will be held in having discussions with thousands of issuers on recommendations – and what level of “financial and management’ resources would be required under SEC registration.  Proxy advising is not a particularly high margin field – and both of the dominant players remain modest in financial scope.   In addition, mandating public disclosure of the twenty largest clients by revenue would force revelation of what even the firms’ most antagonistic of opponents would admit seems to be highly confidential and proprietary information about the firms’ respective businesses.

That said, such is the ire that has provoked the bill, that an indirect consequence may be the bolstering of an appeals/consultation process with issuers and more transparent engagement from proxy advisory firms overall.  Even if the draft legislation were to languish as other bills appear to be doing, the mere introduction has forced a focused, substantive discussion on the role and financial wherewithal of proxy advisory firms – topics which have been the subject of strong opinion for some time but hitherto not under the bright lights of legislative hearing rooms.

Cybersecurity, Boards and Cyber-Board “Experts”: Caution Should Rule

A continuing frequent question from public companies is how a board should be constituted to oversee cybersecurity.  Many public companies foist this additional burden on the audit committee.   Those large enough to have a risk committee frequently allocate it there.  A corollary question then becomes what qualifications do one or more directors need to have to oversee such risk.

Much of this analysis would seem apt for individual state law which, for the majority of corporations, means fiduciary duties in Delaware.   The business judgment rule requires an absence of conflicts (presumably not really applicable in this context) and due care by a board.   Plaintiffs firms—ever eager to seize upon a new potential litigation entry point—have been relatively unsuccessful in asserting breach of fiduciary duty claims against boards.  The seminal case to date, against Wyndham Hotels, was unsuccessful.   Despite multiple separate data breaches, the district court in the case found that Wyndham’s directors had been regularly briefed on cyber-risk and had exercised their fiduciary responsibilities.

Not one to let a good opportunity to muddle an issue pass it by, Congress waded into this debate in late 2015 with the introduction of a bill from Senators Jack Reed and Susan Collins titled the “Cybersecurity Disclosure Act of 2015.”   If enacted the bill would, within 360 days of becoming law, require public companies to:

  • Disclose whether any of their directors had cybersecurity “expertise or experience”; and
  • If no such directors qualified, what efforts the Nominating Committee had undertaken to remedy such absence.

The definition of “expertise or experience” would be designated by the SEC in consultation with the bureaucracy at the National Institute for Standards and Technology (NIST), which promulgates the U.S. Government’s protocols on cybersecurity.

Like many government interventions, the bill is well-intentioned but misplaced as follows:

  • The bill references NIST relying on, “…professional qualifications to administer information security program functions or experience detecting, preventing, mitigating, or addressing cybersecurity threats…”  A few directors—particularly of technology companies—who are professors or computer scientists or the like may qualify based on their profession.  However, many competent directors who are astute business managers may lack such obvious credentials.   The bill threatens to force boards to dilute business expertise of a board with members who either have gone through bureaucratic hoops—or force members to be washed quickly through a cottage industry in purported cyber-programs.
  • While bill proponents may note that it is a “disclosure only” requirement, the onus of additional government regulation is clear.  And while proponents may also draw an analogy to the financial expert requirement under Sarbanes-Oxley—the analogy is flawed.  GAAP is the language of any corporation—a complex body of specific rules where interpretation is the key.   Cyber-security is highly evolving, fluid and differs vastly from one company to another.  While the NIST protocols are rough guidelines, they are simply not a technical body of regulation or operational language as is the case with GAAP.   Further, risk profiles and substance differs drastically:  A consumer payments company has very different risk issues from a business-to-business equipment supplier.  Mandating some government-blessed background offers the precision of a butter knife approach—not a scalpel.
  • Private rights of action, and thus plaintiffs’ law firms are an excellent counterbalance and arguably more effective than any government decree.   Corporations face massive liability, whether in direct damages or derivative actions, if they get it wrong.

A few salient points of best practice:

  • Time is the number one factor in assessing any strategic implication of a company.   In a world when directors average eight (or so) days a year at in-person meetings—notwithstanding telephonic committee meetings—carving out sufficient calm, thorough time to actually delve substantively on a continuing basis into an issue is difficult but necessary.
  • A best functioning board is an inquisitive, active board.   Relying on a management dog-and-pony show schedule of any presentation is unlikely to yield best results.  Board members should not hesitate to immediately and frequently interject with tactful questions.  That does not mean the board has to contentiously cross-examine presenters—but savvy board members will intuitively nudge rather than excoriate management.   A highly intelligent board member with specific relevant industry expertise is worth more than a government-mandated security course.
  • Balancing workload.   It is not clear that the Audit Committee is the best place for cyber-risk.  Those companies that have risk committees would seem to devote additional time to other risks as well—without impinging on the important work of the audit committee.
  • Policies and architecture.  A board need not be nuanced in highly technical issues to understand the importance of organizational roles.  Does the company have an independent voice, such as a Chief Information Security Officer (CISO) who can dissent from I.T. and report directly to the head of a committee (or at least a CFO or CEO)?    Does the company have an incident response plan tailored to the company—and has it been through table-top simulated exercises with after-action reports?
  • Rely on your inside and external teams.   In any technical subject, it matters to have both the right teams and the right structural checks-and-balances.  Competition both internally and with more than one external advisory firm is wonderful at motivating behavior.  At the risk of self-interest, boards should not hesitate to independently engage outside experts, both at a technical and governance level.  Even if these teams are sporadically consulted, retention also assures familiarity and response time if a crisis breaks out.

Schedule 13D: Congressional Move May Significantly Affect Activist Strategies

In March, a group of Democratic senators introduced legislation, currently sitting with the Committee on Banking, Housing and Urban Affairs, to tame the purported disclosure skullduggery of activist investors through:

  • Shortening the Schedule 13D disclosure trigger period to 2 (from 10) calendar days;
  • Expanding the definition of a “group” to include any person who is “otherwise coordinating the actions of the persons…” – which as a practical matter will force significant introspection by activists who frequently share ideas and strategies on whether they would constitute a wider group subject to Schedule 13D obligations; and
  • Requiring 2 day disclosure of short derivative positions affecting 5% or more of a company’s stock.

The legislation’s authors dubbed it the Brokaw Act for the small Wisconsin town that was home to paper mill operated by Wassau Paper, which endured a four year tussle with activist of Jeff Smith of Starboard Value LP.  Smith recently settled a threatened full-slate director proxy contest with Yahoo! and has been active in numerous Silicon Valley public companies.   Wassau ended up being sold and Brokaw’s paper mill was shutdown, resulting in the loss of 90%+ of the town’s jobs.  However, Wassau was subject to an intense corporate policy debate – sheet paper vs. tissue paper.   And Smith committed capital for four years in that debate until an exit was arrived – hardly the form of balance sheet activist short termism (often in the form of massive debt issuances followed by stock buybacks or special dividends) that seems most corrosive to long term business success.

Activists are loathe to accept a shortened Schedule 13D disclosure period:  They often argue that when their interest in a given company becomes public, it immediate pushes the  stock price higher – and so shortening the period in which they can amass a block of stock robs them of an ability to buy stock without tipping their hand to the wider market and disrupting prices.   This timing challenge also has interplay for HSR anti-trust clearance for acquiring material positions (i.e. more than $78.3 million in 2016).   Activists in the past have used a combination of derivatives and open market purchases to accumulate significant stakes within the 10 day current Schedule 13D window – shortening it to 2 days will materially impact that ability.

Activists also will be reluctant to become part of groups that are very loosely ‘coordinating’.  If one activist calls up another and suggest embarking on a campaign – where each pick up 3% of stock – that would presumably then force a Schedule 13D obligation – significantly curtailing the period of time in which activists could wait for their investment to become public.  The word “coordinating” surely will quickly become subject to judicial scrutiny and interpretation.

What the three prongs of the Brokaw Act do provide are clear direction on items that either have been hotly debated already – or are have been tightened by various courts but not uniformly and explicitly tackled by the SEC.   For a few years now, companies have routinely adopted bylaws provisions that require a stockholder who nominates directors or makes a proposal to disclose derivative positions (which would include shorts).  In addition, various federal courts have staked positions on whether derivatives constitute reportable positions under Schedule 13D (they increasingly do), as well as what affiliates constitute a “group.”

The Brokaw Act is authored by two Democratic senators from Wisconsin and Oregon – and co-sponsored by Sen. Bernie Sanders and Sen. Elizabeth Warren.  However, the shortening of the Schedule 13D timeframe has been a favorite topic for the traditional business establishment – and it is far from clear that the central tenets of the Brokaw Act will provoke partisan vitriol.  The progress of the legislation undoubted will be subject to activist lobbying and the gyrations of a wildly unusual election cycle.  It would not be crazy, however, that a rare coalition of liberal and conservative Congress members could push the bill through.  At the very least, it should make the SEC pay attention and move forward with this topic, as it was encouraged to do under Dodd-Frank but thus far for which it has been either unwilling or unable to definitively act.

Stockholder activism disclosure tips: deciphering increasingly complicated timing and ownership positions

Batts SmallPeeling away the various arguments of stockholder activists and their often larger-than-life personas − and occasional multi-hour conference calls − lays bare the gritty details of the ways stockholder activists actually take positions in their companies and what, if any, notice a company may have of such a position. Activists have applied increasingly complex methodologies to their ownership positions. Discerning where they may pop up next requires nuance and sophistication.

OBJECTIVE:  Activists generally have two goals:

Skin in the game:  Accumulate a sufficient position so that they carry credibility, or “skin in the game,” with larger institutional investors upon which activists rely for votes – usually 5-10 percent of a company’s equity position and increasingly, whatever it may take to have to a impactful-sounding $1 billion of at-risk capital, and

Buy low; sell high:  Accumulate that position with a minimum of fuss – so that their basis is as low as possible.  This entails avoiding public disclosure of their position until the very last possible juncture.

Most activists who become significantly involved with a given company will accumulate a position of between 5-10 percent of the company – whether through direct equity ownership or other positions discussed below.   Some activists will do less, particularly the embryonic activists who are seemingly emerging from anywhere  these days as the area is flush with assets under management.  And while some activists may go further in on a percentage basis, they uniformly will rely on large institutions – whether actively managed funds or index funds – to find an activist’s arguments appealing at a stockholder vote.

INSTRUMENTS:  To accomplish these goals – and do so deploying the carefully choreographed timing tactics set forth below – activists long ago abandoned the plain vanilla approach of mere equity ownership in favor of a combination of the following:

Common stock.   The cornerstone of an activist position remains owning a company’s common stock, accumulated through open market purchases or privately arranged trades.  For reasons discussed below, such positions may be spread across a variety of funds controlled by a particular activist.

Options.  Activists increasingly use options – to avoid market-moving accumulation of an underlying security, to give optionality to capital at-risk and to maximize an activist’s firepower in its portfolio.  For the latter, if an activist spends a relatively modest amount up front on options, it can take a larger potential position and then subsequently decide which position merits actual equity ownership and thus increased deployment of capital.

Derivatives.  Activists may engage in “synthetic” equity positions – cash-settled equity swaps – that are private contractual obligations.  The interesting downside of such instruments is that every such contract by its nature involves a counter-party.  For a material position, such counterparty may suddenly have a very distinct interest in blunting the impact of an activist – particularly where an activist is agitating for short term change that could immediately adversely impact the counterparty’s risk – whether by demanding the company be sold in whole or in parts or that it leverage itself for a special dividend.

TIMING STRATEGY:  Three disclosure regimes impact activist positions:

Schedule 13D:  An activist has 10 calendar days after tripping the 5 percent beneficial ownership mark to file a Schedule 13D.  In an effort to avoid a full listing of an activist’s position (or at least delay the timing of the 13D), in the past some activists asserted that derivative instruments were not captured under the Schedule 13D requirements.  Court cases subsequently established that derivatives are disclosable instruments – and the addition of bylaw provisions for many companies that require eventual disclosure make the point largely moot as well.

Hart-Scott-Rodino (HSR):  The US antitrust pre-transaction notification filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1974 is generally associated with pre-merger anti-trust clearance.  However, it actually applies to any acquisition of “voting securities.”  Accordingly, any single entity proposing to acquire in excess of the applicable threshold (in 2015, $76.3 million) must file for HSR antitrust review and clearance prior to acquiring the voting securities. This leads to a few areas of interest:

  • Avoiding a filing.  An activist may spread its investment over a few different funds to putatively avoid HSR review – while perhaps technically legal, one has to imagine that if used prolifically, the FTC and DoJ will find sufficient means to close that strategy.
  • Regulators talking.  The regulators from the FTC and DoJ are allowed to speak to economic participants to gauge any level of economic concern from a proposed transaction.  For a relatively small purchase in a company where the activist does not have another position in the same industry, it would seem unlikely that regulators would call a competitor to the company and thus start a potential trail of leaks.  But if the activist is active in a given sector or there are significant concerns of market concentration or the like, such calls could happen.
  • To early terminate or not.  The HSR clock runs 30 calendar days from submission of the filing.  A filer may request “early termination” of this 30-day period, assuming that the relevant agency (FTC or DoJ) concurs.  In doing so, the FTC (as the coordinator of HSR filings) will post the occurrence of the granting of early termination to its website. An activist must weigh the benefits of early termination under HSR, and thus public disclosure, against letting the clock run out.  Even if selecting early termination, an activist must lie in wait and hope that news of the filing does not leak before being notified of early termination and pulling the trigger on the equity purchase shortly before website publication.  In companies with a market capitalization of over approximately $1.5 billion (derived from 5 percent and the $76.3 million filing threshold in 2015), this means that HSR early termination potentially will be an earlier indicator of a position than a Schedule 13D, which again is due 10 days after the position is acquired.

Charter documentsIn response to the advent of more sophisticated derivative positions by activists, many companies have adopted bylaws provisions that require a proponent of a stockholder proposal for an annual or special meeting to disclose not simply equity ownership, or shares held, but any economic position that has the effect of mimicking equity ownership.  Companies should carefully evaluate their bylaws for the existence of such provisions and the details required to be disclosed.

MARKET SURVEILLANCE:   Besides passively awaiting the filing of a Schedule 13D or scouring the FTC HSR early termination website, most companies will engage in some degree of market surveillance, though the quality and insight of such services varies widely.  Companies may receive, for free, reports of large movements in volume or stock trades.  Such reports are opaque as to the actual purchaser or seller, which may be behind a financial institution custodian of shares held in street name.  However, the value add of a tailored, and correspondingly more costly, surveillance service is to look behind the numbers.  Most proxy solicitation firms will offer such services, which harness their insight into which particular activists – or, of equal insight, non-activists, such as fast-moving hedge funds or longer-term fund portfolio managers – use which particular custodians.

The Menace of the Mini-Tender

EdBattsPostImageA perfectly legal, but on its face very predatory, practice is increasingly hitting major public companies and likely confusing and taking advantage of their small individual investors: the “mini” tender offer. Thus far, the practice has hit Silicon Valley household names, particularly in the past year, such as Gilead (2011), Intel (2013), PayPal (2015), Yahoo! (2015) and AT&T (2015), all of which issued press releases recommending against these dubious tenders. READ MORE

Delaware’s One-Two Punch to M&A Litigation Disrupts The Cozy Status Quo of M&A Deal Settlements

EdBattsPostImageOver the summer, Delaware in two separate and impactful decisions hit out at many, if not most, shareholder litigation suits challenging public company M&A suits. The result: uncertainty ahead.

The customary rhythm in an M&A deal historically went something like this: two parties entered into an acquisition contract and filed pertinent disclosure documents with the SEC. Plaintiffs law firms would jockey furiously for position as lead counsel in a class action under state law challenging the sufficiency of the disclosure documents, if not the underlying substantive fairness of the transaction. READ MORE

Posted in M&A

Delaware Hammers The Last Nail Into the Coffin of Fee-Shifting Bylaws

EdBattsPostImageDelaware Governor Jack Markell has signed into law Senate Bill No. 75, which prohibits fee-shifting (or “loser pays”) bylaws for stock corporations.  Much to the chagrin of the US Chamber of Commerce, the legislation sped through the Delaware legislature on its way to killing the purported opening created when the Delaware Supreme Court permitted fee-shifting for non-stock corporations in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014).

Of note:

•  The ban does not apply to non-stock corporations, although the intellectual reasoning for not extending it to non-stock corporations is unclear – it is convenient, however, that by carving out non-stock corporations, the Delaware legislature and executive are not put in the position of having to overturn the holding of ATP which thus continues to permit fee-shifting for non-stock corporations.

• The ban is precisely that – an outright ban. Despite a few lonely cries from a couple of Delaware practitioners, there does not appear to be any impetus to explore more pragmatic compromise positions, such as limiting loser pays liability at a reasonable pre-set amount (perhaps US$250,000 or US$500,000 or the like).

• The ban is to be accompanied by a ban on adopting exclusive forum bylaws that put exclusivity in a state other than Delaware – hence, a Delaware corporation may only centralize its litigation in Delaware, but not elsewhere.

• There has been no outwardly observable chatter regarding the inherent and glaring contradiction in this situation: why many a Delaware jurist will often emphasize the sacrosanct nature of contract on one hand, but conversely, plaintiff lawyers could not rely on the private markets (as opposed to government regulation) to regulate risks arising from filing lawsuits. Presumably an insurance market, or pooling of risks by plaintiffs in broader collaborative groupings, could have mitigated the worst fears propagated by the plaintiffs’ bar. READ MORE