Attached is a new, much more fulsome compendium of useful checklists for M&A matters for 2019! Checklist M&A (2019)
Joint Article By: Ed Batts, Matthew Gemello and Mark Seneca
Originally publicly released on June 20, 2019
Earlier this week, Atlassian published its form acquisition letter of intent under the banner of The M&A Process is Broken: It’s outdated, inefficient and combative.
Atlassian developed and published the LOI in an effort to eliminate time-and-expense of negotiating issues that, based on its experience and research, rarely come into play following the deal closing. By reducing such adversarial positioning, Atlassian hopes to increase collective focus on realizing the larger commercial, product and/or talent synergies that underpin the basis for the deal in the first instance.
In our experience, the M&A market already has prescribed a fairly narrow range of key deal terms and arriving at a finalized term sheet is not often an agonizing process. Due diligence, on the other hand, can be particularly burdensome for founders, but the larger goals of the exercise typically extend to post-closing integration as well as risk mitigation. While streamlining the M&A process is a sound objective, we question whether the Atlassian term sheet will provide the necessary comfort to the average corporate buyer, particularly given facts and circumstances of individual companies which can vary significantly from deal-to-deal. Deal points of this nature and magnitude are judgment calls for buyers often driven by larger institutional perspectives on risk tolerance and compliance and a one-size-fits-all approach may not be practical given a particular buyer’s commercial realities. In particular we note:
- Reducing caps on sellers’ post-closing liability to 5% and making those caps more inclusive (i.e., eliminating special business representations and warranties relating to IP, privacy and other hot-button topics) may be challenging for many strategic buyers. For example, regulators are devoting extra scrutiny to data privacy, as evidenced by the General Data Protection Regulation (GDPR) in Europe, California’s Consumer Privacy Act (CCPA) which takes effect in January (see: https://ccpa.orrick.com/) and Nevada’s leaping to the front in the U.S. implement a similar opt-out construct on October 1, 2019. A 5% total recourse cap, particularly for target companies with large consumer facing activities or that transact in large amounts of consumer data, may not be sufficient.
- The Atlassian term sheet provides for representation and warranty insurance for any deal over $50 million in value – while remaining with an escrow construct for deals under that threshold. The proposed 5% escrow cap is roughly ½ of the 10% ‘market’ lower boundary; on the other hand, the model term sheet’s 15 month survival period for representations and warranties is longer than the 12 month ‘market’ lower boundary.
- While there is increased use of RWI by strategic buyers, RWI may not be the right remedy/protection for certain larger transactions for particular buyers. On one hand, RWI actually generally gives longer periods of protection than conventional holdback/escrow indemnification constructs; however on the other hand, it excludes from coverage any issue that is deemed ‘known’ by a buyer at the time of a deal. Moreover, given current premiums, many buyers are seeking coverage significantly in excess of 4% of the overall transaction value and either splitting the policy cost or absorbing it, rather than forcing the cost on seller to pay.
- The Atlassian term sheet appears to not contemplate crediting the target company for cash-on-hand at closing, but does deduct transaction expenses and any change of control payments – whether or not paid. These positions are not equitable for target companies, particularly those who generate cash or have contingent contractual obligations that may not actually become due and payable. Financial true-ups for cash, debt and/or working capital are useful for transactions with periods between signing and closing, such as those that exceed the applicable antitrust filing thresholds (for the U.S., any transaction worth over $90 million in 2019).
- Retention initiatives may be better addressed through broad-based approaches rather than selective hold-backs/rollovers for certain key executives.
As a result, we expect that the Atlassian model term sheet will serve as a useful basis for continued debate on the merits of various approaches, but that many of its principle tenets will continue to be the subject of case-by-case analysis. Strategic buyers in the current M&A market continue to appear to be willing to offer purchase prices that generally exceed that of more conservative financial buyers, but also expect risk protection for pre-closing issues.
In BlackRock CEO and Co-founder Larry Fink’s annual letter to companies on January 16, he issued a call to action for companies to have “a clear sense of purpose.” To BlackRock, having “a clear sense of purpose” means much more than simply delivering quarterly financial results—companies will be expected to have a strong commitment to evolving Environmental, Social and Governance (ESG) issues.
This letter matters both because BlackRock is an important large investor of actively managed assets and—more importantly—because we are living in a new world order of many fewer public companies with, at the same time, a continued crescendo of passive investment allocation. These changes in the U.S. equities markets have been underway for some time, but with the recent significant bull market run they are being magnified at an accelerated pace.
Below is a quick tour of how we got here. And then we discuss the take-away: For the foreseeable future, companies and their boards need to be in dialogue with passive investors’ governance departments. And they need to be prepared for a conversation in which ESG issues are squarely on the agenda.
Part I: The Revolution in U.S. Equity Markets
In the “old” days (think when EF Hutton was making those “people listen” commercials), a company’s stockholders were divided into:
- Active/Fundamental Mutual Funds (e.g. Fidelity, T. Rowe, Wellington)
- Hedge Funds (e.g. Tiger Management, Bridgewater Associates)
- Pension Funds (e.g. CalPERS/CalSTRS, Ontario Teachers’ Pension Plan)
- Labor Funds (a.k.a. Taft-Hartley multi-employer funds) (e.g. Service Employees International Union or the Sheet Metal Workers International Association)
- Activist Investors (essentially a subset of hedge) (e.g. Carl Icahn and Nelson Peltz)
- Retail Investors
The Ongoing Massive Shift in U.S. Equities Ownership
Two market phenomena have radically altered that landscape.
First, the number of actors/companies in which broad-market passive funds may invest has roughly halved, while average market capitalization has more than tripled.
- The total number of domestic public companies has shrunk from over 8,100 in 1996 to 4,300 today (World Bank/World Federation of Exchanges). That essentially eliminates half the domestic (non-foreign listing) investment targets in the U.S. And foreign companies listed in the U.S. add only 900.
- Total U.S. domestic equity market value in that same twenty-year period has doubled, from just over $12 trillion to $27 trillion (held constant in 2017 dollars) (Credit Suisse), going from 105 percent to 147 percent of annual U.S. GDP (World Bank/World Federation of Exchanges).
- Commensurately, to balance out fewer companies with greater total value, average domestic public market capitalization of a given public company has increased from $1.7 billion to over $6.9 billion in constant dollars (Credit Suisse). Median value is $832 million—and that median value is essentially what market observers would posit is the minimum value necessary for a public company to have scale and liquidity in its public float (E&Y).
- The top 1 percent of domestic public companies—roughly 30 companies—account for 29 percent of aggregate market value (E&Y).
- The top 4 percent of domestic public companies—roughly 130 companies, each of which is worth more than $50 billion—account for over 50 percent of aggregate market value (E&Y).
- To draw further conclusions: Roughly 1,650 domestic public companies are under $832 million in market capitalization. That leaves approximately 1,500 companies “in the middle”—a middle that ranges vastly from roughly $1 billion to $50 billion. And this is the concentrated set of companies on which the broad-based passive index funds by definition must be focused.
Second, as “the market” has decreased in number of actors/companies, it has been flooded with allocation to passive vehicles, whether Exchange Traded Funds (ETFs, whose prices fluctuate intra-day on a securities exchange) or mutual funds (whose prices are calculated once a day after market close):
- Total Market Value: More than 40 percent of U.S. equity assets under management (AUM) are in passive vehicles (Goldman Sachs) and, out of the entire U.S. equity market (professionally held plus individually invested), 30 percent are in passive vehicles (Morningstar).
- Concurrent Decline in Individual Ownership: Individual ownership has dropped precipitously from ½ of the market to 1/5 of the market—50 percent in 1976, 27 percent in 1996 and 21.5 percent in 2006 (Credit Suisse).
- Trend: In 2016, $506 billion flowed into passive funds, while $341 billion was hemorrhaged from active funds (Morningstar).
- Trading Volume: 25 percent of daily trading volume on U.S. exchanges is in ETFs—not actual stocks (Goldman Sachs). There were 2 ETFs in 1996. There were 658 as of 2016, and the number is growing (Credit Suisse).
The three largest passive investment management firms are (with numbers as of September 30, 2017—and no doubt increased since then):
- BlackRock, New York City: Out of almost $6 trillion AUM, $1.2 trillion is in the popular iShares equity-based ETFs (which tripled since BlackRock purchased the business from Barclays in 2009); another $1.6 trillion is in institutional passive equity funds. BlackRock, then, holds $2.8 trillion in passive equity strategy vehicles. While BlackRock does not report specific geographic investment mix, a rough approximation would be that some 70 percent of it is likely in U.S. markets (BlackRock 3Q18 Form 10-Q).
- Vanguard, Valley Forge, Pennsylvania: $4.5 trillion AUM—the vast majority in U.S. index investing. Its founder, Jack Bogle—after having been fired from active manager Wellington—was the original primary advocate of indexing and created an index giant. In contrast, its large fundamental-based mutual fund competitor, Fidelity, has under $2 trillion AUM. Four of five of the largest U.S. mutual funds are index funds from Vanguard—the fifth is Fidelity’s money market fund—an investment in essentially cash, not portfolio management (Investopedia). In the past three years, Vanguard received about 85 percent of all new U.S. mutual fund investment money, while the remaining 15 percent went to all of Vanguard’s other 4,000 mutual fund competitors all combined (Morningstar/The New York Times).
- State Street Global Advisors (SSgA), Boston: $2.6 trillion AUM of which 70 percent is in North America, $1.5 trillion in passive equity. State Street, while separately a behemoth in third party securities custodianship, remains the smallest of the passive investment management shops—but has the well-known SPDR ETFs.
The result is that passive investment management firms now hold massive portions (closing in on 1/3) of U.S. equities. And because they are passive, they cannot summarily buy—or sell. Once a passive fund purchases an equity, it is there to stay … forever … unless the company runs into so much trouble as to fall off the particular index. A passive fund’s holdings may fluctuate with overall investment levels in U.S. equities; however, a passive fund’s ownership level relative to other investors is unlikely to materially change and, in fact, given the seeming march towards greater value, such fluctuations of late have meant only increased ownership levels as “dry powder” continues to aggressively enter the markets.
Part II: Three Ground Rules for Companies Living in a New World Order of Passive Investing
Ground Rule #1: Each of the “Big 3” Passive Shops Has an In-House Governance Function. Get to know them well in advance—to avoid barely getting a short, rushed meeting with them when it is crunch time.
As of January 2018, the heads of these departments (referred to as “Investment Stewardship”) were:
- BlackRock: Michelle Edkins, who Larry Fink announced in his message will be supplemented by BlackRock’s Vice Chairman and Co-founder, Barbara Novick. Ms. Edkins is a New Zealander who began in investment management in 1997 in the UK and joined BlackRock in 2009.
- Vanguard: Glenn Booream, who joined Vanguard directly from college in 1989.
- SSgA: Rakhi Kumar, a former chartered accountant in India who picked up an MBA from Yale and worked for Moody’s before spending the last seven years at SSgA.
Ground Rule #2: Passive Investors’ Influence Cannot Be Underestimated.
Take, for example, the heated October 2017 proxy contest between Proctor & Gamble and Nelson Peltz’s Trian Management. P&G’s share ownership falls out as (data from Proxy Insight; shares rounded to nearest million):
- Passives: Vanguard (187 million), BlackRock (159 million) and SSgA (113 million): They are #1-3 of the top stockholders—and the next largest holder is Bank of America at a distant 44 million.
- Major Actives (cross-section based on past importance/author experience): Capital, Dimensional, Fidelity, T.Rowe, TIAA-CREF and Wellington, all combined: 106 million.
- Teacher and state/municipal employee pension funds in California, Florida, New York, Ontario and Texas, all combined: 29 million.
- In other words, the most well-known active funds and major pension funds all combined hold 135 million shares in P&G—versus the smallest of the major 3 passive positions, SSgA, at 113 million shares.
All of the intensive proxy solicitation and lobbying effort invested into hitherto major (and still relatively large) funds spread throughout North America can be matched or dwarfed in a single vote from a passive investment management company.
Ground Rule #3: Passive Shops Are Independent Thinkers Who Do Not Necessarily Follow the Herd. Moreover, ISS and Glass Lewis No Longer Are the Undisputed Shepherds of the Herd.
Historically, fundamental/active fund portfolio managers focused almost exclusively on quantitative return of equity value. Beginning in the late 1980s, however, the U.S. Department of Labor’s Pension and Welfare Benefits Administration—exercising its jurisdiction for retirement plan investments through ERISA—issued advisory letters in Avon (1988) and Monks (1990) and then a 1994 Interpretive Bulletin, which cumulatively resulted as a practical matter in forcing investment advisers to vote. From Avon: “In general, the fiduciary act of managing plan assets which are shares of corporate stock would include the voting of proxies appurtenant to those shares of stock.” Rather than each investment adviser devoting the significant resources to establishing individual corporate governance departments to vote on thousands of annual proxies, most instead outsourced the substantive analysis to proxy advisory firms, first ISS and then its later arch rival, Glass Lewis. These outsourced proxy advisory firms for many years reigned supreme, particularly with ISS’s near-monolithic dominance of vote recommendations for funds.
Such hegemony has substantially eroded. Using the recent P&G context example, while both ISS and Glass Lewis recommended voting in favor of Mr. Peltz, P&G’s single largest shareholder, Vanguard, reportedly ignored those recommendations and voted with P&G management’s slate of directors. After a very, very close vote, Mr. Peltz ultimately was seated on the P&G board. This also shows that while the Big 3 passives matter, if they split—then every vote from non-passive stockholders suddenly becomes mathematically critical. Try hard to avoid ignoring or making an enemy of any institutional stockholder.
BlackRock’s 2018 Annual Letter to Companies
Index investing is an interesting commercial environment, since the primary historical factor for investing—seeking individual equity or fund return/Alpha—is stripped from consideration. Instead, fund expenses become key—but there are only so many fractions of a basis point to cut further before the expenses are very similar among competitors—and very, very cheap, at least in contrast to active trader funds or the steep carry and management fees of hedge funds. After two years of steep outflows and sub-market returns, hedge funds have stabilized of late—but even so, Boston Consulting Group is forecasting that a reasonable bad case—where hedge returns continue to suffer as they did in the past couple of years—could entail a further 30 percent shrinkage in hedge AUM by 2020. Conversely, keep in mind that, according to The New York Times, Vanguard has one employee (in any function … ) for every approximately $44 billion of AUM—and that Vanguard’s indices have significantly outperformed hedge fund median returns in this bull market.
In recent years, SSgA has increasingly differentiated itself from index fund purchasers by advocating for attention to Environmental, Social and Governance (ESG) issues. And while BlackRock certainly has not avoided the subject, it hitherto did not issue as clear a call to action. Indeed, while many similar themes were raised in last year’s annual letter, they were couched in more gentle coaxing, rather than this year’s direct call to action:
“Furthermore, the board is essential to helping a company articulate and pursue its purpose, as well as respond to the questions that are increasingly important to its investors, its consumers, and the communities in which it operates. In the current environment, these stakeholders are demanding that companies exercise leadership on a broader range of issues. And they are right to: a company’s ability to manage environmental, social, and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process.
“Companies must ask themselves: What role do we play in the community? How are we managing our impact on the environment? Are we working to create a diverse workforce? Are we adapting to technological change? Are we providing the retraining and opportunities that our employees and our business will need to adjust to an increasingly automated world? Are we using behavioral finance and other tools to prepare workers for retirement, so that they invest in a way that will help them achieve their goals?”
What Does This Mean in Practice?
There undoubtedly is a hypothetical saturation point at which macro-economic headwinds and increasing concentration of equity ownership in passive investment funds will collide—where too much investing dollars could be postulated to be “stranded” in rule-based investing at much more higher levels than indices are now in the aggregate. This potentially could create greater volatility since wholesale rotation out of equities entirely, rather than from one stock to another, seems more likely when dumping an index. Perhaps then, “seeking alpha” (and a bit more of Buffet’s value investing) may return with vengeance.
But don’t bet on it anytime soon. If anything, we appear headed for significant macro-economic tailwinds for the near future. As but one indicator, the new tax bill will likely significantly bolster equity prices, as both lower domestic effective tax rates and repatriation of foreign cash will likely be used to both repurchase stock and provide tidy sums for either dividends or fights over capital allocation strategies with activist investors—buckle up! A rising tide of equity prices raises all ships—and a continuing bull market is unlikely to shake investors’ seemingly unending appetite for smile-inducing returns from low cost, low hassle passive funds—further concentrating voting.
Companies need to expect:
- The continued need to engage in discussion routinely with governance departments. In fact,ask to do so.
- One or more independent directors to be part of those discussions. Depending on the circumstance, it may be necessary to give an investment steward the opportunity to talk without the CEO present for some part of the conversation—still a generally unpopular concept with management.
- Pointed questions on board diversity—gender and racial in particular—as well as pay equity.
- To substantively engage on environmental topics, such as climate change impact.
The road shows of yesteryear meant relatively narrow lanes of traipsing up and down the Northeastern Corridor—from Baltimore to New York and then Philly to Boston—to perform a pilgrimage to a few portfolio active fund managers and review a financial model. Now management—and importantly, board members—get to add passive shops to their tours. The sooner that boards and, of course, management accept a new reality driven by enormous underlying market dynamics, the sooner they will adapt to a new power structure that increasingly looks far beyond EPS guidance.
- Recent developments demonstrate that the SEC Staff is taking to heart the “Open for Business” mantra propagated by political appointees from the recent change in administrations.
- The most significant development is the dramatic shift in receptiveness for waivers for audited financial statements where the production may be burdensome but not clearly material to investors. Such waivers are being granted specifically with respect to financial statements in cases of marginal significance tests or where fully audited financials would involve significant cost but not necessarily provide substantial incremental useful information.
- In addition, the Staff continue to emphasize eligibility for all filers (and not just “emerging growth companies” under the JOBS Act) to take advantage of confidential preliminary registration statements for IPOs as well as follow-on offerings occurring within one year of IPO.
- The number of Staff comments issued upon review of registration statements have declined significantly, in an effort toward a speedier path to encourage use of public markets.
- In a relative revolution in customer service, registrants are encouraged to call the Staff early in a process to potentially be granted relief without a labored, sclerotic timeline.
New Administration, New Focus
A change in administration has brought with it a new focus by the SEC to lessen regulatory burden on public companies. This comes as large private companies in recent years have increasingly eschewed the public markets. Such avoidance may have been for various reasons wholly unrelated to SEC regulation, and also may have been transient, given the advent of late of unicorns such as Uber that are openly espousing the benefits of public ownership. However, the SEC, to its credit, appears committed to ensuring that the Commission is not considered part of the problem – and “Open for Business” has become an overarching mantra at all levels.
Pain Relief for Accounting Waivers on Both M&A and Equity Markets
Accounting treatment can send chills through transaction participants. Two circumstances in particular have historically required fully audited financial statements – including potentially the painful need to recast prior year financials – even though their substantive worth was arguable. In recent public remarks, senior SEC accounting staff have highlighted two specific areas that in particular are the beneficiaries of increased relief in the form of accounting waivers, referred to as Section 313 waivers.
The first situation surrounds significance testing, which focuses on three tests: income, balance sheet and earnings. If any of these tests breaches the relevant significance threshold (beginning at 20% – a summary is available on our M&A checklist here), then various periods of audited financials are required. The tests are more complex than they necessarily appear on their face, involving look-back periods and twists and turns if a filer has been loss-making instead of income-recognizing. A common “foot fault” in significance testing is when a Buyer has marginal earnings per share (either negative or positive). In the situation where significance testing is not triggered with respect to the balance sheet or income tests, a relatively small and arguably immaterial transaction may trigger the earnings-per-share significance test due to rounding error. For example, if a Buyer with $0.01 EPS acquires a Target and rounding error pushes the Buyer to break-even (0) EPS, then even though the Buyer may have income and a strong balance sheet that dwarfs that of the target company, the Buyer could be required to file full financials, as the change in the EPS number on a relative basis is quantitatively material. The Staff have been explicit that in this situation they are open to discussions on the actual qualitative materiality and facts and circumstances of the transaction, and have been granting waivers for precisely this situation.
The second scenario involves where a Buyer may purchase a carved-out business from a Target, but the business was not previously held separate by the Target and thus fully audited carve-out financials are burdensome in cost and time. While the Staff may still (reasonably) request a high-level summary of the financial impact of the transaction, such as aggregate assets purchased and liabilities assumed, they may waive requiring fully broken-out financial statements with various sub-categories that would entail substantial upfront accounting judgments and work, but would thus conform completely with GAAP.
Equity Registration – Greater Availability, Easing of Comments
Further, the Staff has reinforced its relatively recently changed rule that confidential preliminary filings are available to all IPO candidates, as well as for follow-on offerings that occur within one year of IPO. While “emerging growth companies” under the JOBS Act were already eligible for this, expanding it to large enterprises means that the large unicorns that may be considering going public will also be able to avail themselves of starting the process in private.
Moreover, practice in the past year has indicated a substantial reduction in the sheer volume of Staff comments on registration statements relative to historical norms. During the technology IPO boom of the late 1990s, it was not unusual to receive a first Staff review comment letter with well over 100 comments. In recent months, that number may have fallen dramatically in a given offering – to the magnitude of 25 or so.
Call Them Early
As part of an overall initiative to encourage interaction with the regulator, the SEC is explicitly inviting early discussion of waiver requests or other areas of particular concern. SEC officials have noted that in more than one case, a Buyer could have avoided the cost and time delay of a lengthy treatise letter from outside counsel by simply calling the Staff first. Moreover, the Staff publishing the telephone numbers for key waiver request areas in the Commission’s Financial Reporting Manual.
These tweaks are cumulatively important – and at the same time, the Staff appears to continue with its statutory duties to protect investors, lately and most notably including its growing levels of concern on the increasingly frothy and grey-operating world of initial coin offerings. With respect to bread and butter regulation of equity offerings, clearly the Commission is focused on tweaking the regulatory formula to grease the wheels of offerings, with the intended effect of stimulating what has been a relatively lackluster crop of offerings in recent years.
|Effective January 1, 2018, California Labor Code Section 432.3 was amended to, among other things, prohibit any employer – public or private – from “seek[ing]” salary and compensation history from applicants for employment. Moreover, California’s new law introduces a further requirement that employers provide applicants with “the pay scale for [the] position” for which she or he is applying. For more information, check out Orrick’s Employment Law and Litigation blog post on the topic: https://blogs.orrick.com/employment/2017/10/20/california-waves-goodbye-to-salary-history/
Buyers and sellers alike will need to think carefully about the potential application of these new requirements within the M&A context – where oftentimes employees of the target company may continue their positions, but as new employees of the buyer. In particular, buyers should consider evaluating their current approach to HR diligence. If a buyer intends to inherit all employees of the seller, it may posit that none of these employees are “applicants” covered by the new statute. However, in almost all acquisitions, there is an element of uncertainty with respect to at least some positions. Accordingly, buyers should be mindful of the overall structure of the acquisition, particularly in situations where acquired employees may be regarded as job applicants.
In addition, buyers also should keep in mind that:
While the law and guidance develops in this rapidly changing area, buyers and sellers alike should consult counsel to ensure they are up to date on the latest activity.
To Access the Corporate Governance Report Referenced Below, Use the Following Link
The Morning Risk Report: Exclusive Forums, Proxy Access Are Hot Governance Issues
By Ben DiPietro
The Wall Street Journal
Mar 28, 2017 7:12 am ET
An increasing number of publicly traded companies in the San Francisco Bay area are moving to limit the jurisdiction where a stockholder derivative class-action lawsuit can be filed. Some of these companies, as well as other companies from the region, are adopting some form of proxy access–and some are requiring board members to win a majority of votes before they can gain or retain their seat, according to a report from law firm Orrick released on Monday. The report looked at 153 Bay Area companies that are publicly traded and have market capitalizations of $750 million or more, said Ed Batts, global leader of Orrick’s M&A and private equity practice.
With regard to the so-called “exclusive forum” provisions that allow a company to decide in which jurisdiction a shareholder can file a lawsuit—it’s usually Delaware—Mr. Batts said more companies are changing their incorporation bylaws or other rules to stipulate where such lawsuits can be litigated. “In 2011-2012 nobody had it. Now 50% of companies have it” and more are likely to follow suit, said Mr. Batts. With proxy access—a provision allowing group of up to 20 stockholders who own collectively 3% of the company’s stock for at least three years to be able to nominate up to 20% of the board of directors–the report found fewer than 20% of the companies permit it. Mr. Betts said he expects that number to increase. “My guess is it will jump from 20% to 50% next year, and to 75% not too long after,” he said. “Companies are beginning to proactively adopt it.” Of the Bay Area companies that don’t have dual-class shares of common stock that allow founders to retain super-voting rights, 70% have some rule requiring a board nominee to get a majority of votes in support to win the seat in an uncontested election.
What does all this mean for companies outside of the Bay Area? Mr. Batts said they need to start to pay attention to some of these governance issues—and ought to do so before an activist investor comes knocking at the door. “They ought to get a check-up of their corporate governance health profile,” he said, adding the time to make changes is before an outside group starts to put pressure on the company, at which point making changes will look bad. “Be proactive in how you attack the corporate governance assessment and ask, ‘What do we have, what should we have?’”
Compensation committees composed of independent outside directors were created as the check-and-balance guardians against management compensation engorgement. But as the Roman philosopher Cicero famously posed, “Who guards the guards?”
A few, relatively recent cases stemming from director compensation – most prominently involving outside directors at Citrix and Facebook – have opened up a new front for the Delaware plaintiff’s bar to seek fees in return for easily-implemented and relatively small governance changes.
When there is no inherent conflict of interest in a given corporate decision, directors are afforded the business judgment rule – or essentially wide ranging latitude to direct the business as they see fit. However, Delaware courts have held it is an inherent conflict to have independent outside directors approve their own compensation. This throws such determinations under the scrutiny of the harsh light of the entire fairness rule – where directors (and not plaintiff stockholders) bear the burden of proving that their compensation is fair in terms of both price and process.
As a practical matter, the shifting of the burden of proof makes it much more difficult for a corporate defendant and board to succeed in throwing out a suit on a motion to dismiss early on, prior to discovery or trial. This thereby leads to the specter of litigation cost both in terms of opportunity cost, through time and distraction, and out of pocket costs, through outside defense counsel, discovery and the bells and whistles of full blown litigation. The potential for a lengthy and costly battle thus encourages public companies to hash out a quick-and-easy settlement that makes changes that may have little practical difference to the company or its stockholders, but nonetheless close an optics-based loophole while flicking some gold coins in the pockets of the plaintiff’s firms.
Public companies have been quick to point out that director compensation – particularly equity compensation – is fully disclosed in proxy statements annually and has customarily been awarded under plans that are subject to stockholder approval. Moreover, proxy advisory firms were entirely free to (and do) take director compensation amounts into consideration when making recommendations as whether to re-elect directors. The Delaware judiciary has retorted, however, that because omnibus plans historically were effectively free from limits, any stockholder approval was essentially illusory. Never mind that directors are subject usually to annual election. Never mind that shareholders are in fact free to reject adoption of omnibus stock plans.
Accordingly, public company boards should now consider:
- Setting realistic, benchmarked limits on director compensation, whether in cash or equity – and preferably submit these limits to affirmative stockholder approval at an annual meeting of stockholders.
- Being extra proactive in disclosures surrounding director compensation, including benchmarking procedures, whether outside compensation consultants were engaged and general director compensation philosophies. In other words, create a “mini-CD&A” (Compensation Disclosure & Analysis) section in the proxy statement for outside directors that in many respects mirrors disclosure for management.
The upside of these changes is likely to be modest, at most. For example, in the Facebook case, the Delaware court ruled that Mark Zuckerberg’s relatively informal endorsement of the compensation policy after the fact was insufficient – and that a formal consent or meeting was required. While the overlooking of corporate formalities may allow for a plaintiff firm to greenmail a juicy settlement from an issuer – it is a fleeting opportunity as the simple adoption of such formalities stymies a case when a controlling stockholder resoundingly sides with directors. Nothing substantively changes. And, in the more customary context of shares that are widely held, public companies generally were already attuned to director compensation issues given scrutiny from proxy advisory firms and activist investors who may seek to highlight any corporate warts.
Indeed, this genre of lawsuit is almost certainly a ‘business line’ for the Delaware plaintiff firms that will inevitably fade out quickly over time. For the next couple of proxy seasons, it would be unsurprising if such plaintiff’s firms scour the proxy statements and equity plans of issuer after issuer, and upon striking “Eureka!” with a non-compliant issuer, filing a formulaic suit. But as issuers are sure to heed the alarmist cries of their outside advisors (yours truly included) and adopt such explicit limits over time while enhancing proxy statement disclosure, the vulnerability will become closed and such plaintiff’s firms will be forced to search out more meaty issues. No doubt, given the dramatic judicially-driven and long overdue curtailment of M&A disclosure-only litigation in the past year through the rejection of generous settlement fees to plaintiff’s counsel, more than one plaintiff’s firm will be eager to find similar new lines of argument and business.
More broadly, these cases and the underlying issues illustrate the ongoing tension between the level of direct democracy, versus representative democracy, that stockholders are afforded. With the advent of the federally-mandated ‘advisory’ vote on executive compensation (“say-on-pay”) and now continued ratcheting down on areas such as director compensation where there are still checks and balances (before these cases, there was already plenty of required disclosure– and an option to simply throw the directors out of office), will we continue to see either federal government or state judiciary mandated direct approval of specific business items by stockholders? And, if so, does the investment of time and energy in such individualized direct-democracy pursuits truly benefit the corporation and its stockholders in efficiently maximizing stockholder return?