This article first appeared in the fourth edition of The International Comparative Legal Guide to Cartels & Leniency; published by Global Legal Group Ltd, London.
We focus on key considerations of corporate counsel in assisting clients to navigate through the growing proliferation of governance-related rules and regulations.
Identification of the Client
As a threshold matter, counsel must identify, and remain clear as to, the identity of its client, which may be the company or a subsidiary, the Board or Board committee, or one or more executives. The identity of the client will inform the scope of counsel’s advice, the ranking by counsel of key considerations within the advice, and the scope of the attorney-client privilege. Our remarks rest on an assumption that the counsel’s client is the ultimate parent company and that such parent company is a public company, by which we mean a company with securities registered under Section 12 of the Securities Exchange Act of 1934.
Commonly counsel provides advice premised on counsel’s “working view” of a mutuality of interest among key constituencies of the company, including executives, the Board and Board committees. Counsel must anticipate circumstances that stress or sever the mutuality of interest among these constituencies. Through advance advice by counsel to key constituencies, counsel minimises both the likelihood that any such circumstances arise and the friction of resolving conflicts when such circumstances do arise. Components of this advance advice include communication to the Board and executives of:
- the mandate under federal securities laws (in particular under Section 307 of the Sarbanes-Oxley Act of 2002) that an attorney report evidence of a material violation of securities laws or breach of fiduciary duty by the company or any agent “up-the-ladder” (i.e., first to the chief legal officer or CEO and thereafter, if appropriate remedial measures are not taken, to the audit committee of the Board or other Board committee comprised solely of non-employee directors); and
- the absence of an attorney-client privilege that covers employee communication with corporate counsel, coupled with an explicit articulation of counsel’s obligations to the company and its constituencies.
Through this advice, the Board, Board committees and executives understand where counsel’s obligations and loyalties reside – an understanding that, among other things, enhances client confidence in counsel and reduces risks of disqualification of counsel on account of conflicts of interest that may arise.
Legal and Non-Legal Rules of Relevance
Until the close of the twentieth century, state law fiduciary duties of care and loyalty and Federal securities regulations of disclosures in connection with securities transactions were the main sources of what today we consider “corporate governance”. Since then, corporate governance has been populated from multiple legal and non-legal sources, and the population continues to grow and evolve. Today, counsel must integrate into its evaluation and advice:
- State Corporate Laws: State statutes, court decisions and the intertwined duty of care (i.e., the duty to be well informed) and duty of loyalty (i.e., the duty to make decisions free of conflicts of interest and undisclosed interests): these remain pillars of corporate governance. While doctrinal details evolve as subjects of controversies and arise with new twists and turns, the foundational principles persist. Apart from the inevitable judgment as to whether a given set of activities satisfies the intertwined fiduciary duties of care and loyalty, counsel must be clear on the constituency or constituencies entitled to compliance with the duties. State laws and company charters vary. In some instances, the duties run in favour of the company; in others, the duties run in favour of shareholders. At times, duties shift (such as when companies enter the zone of insolvency) to run in favour of creditors. Complicating matters, in some states, directors, in the discharge of their duties, may consider the impact of their decisions on employees, suppliers, customers, creditors and communities in which the company operates as well as on the short-term and long-term interests of the company. See, for example, Section 1715 of the Pennsylvania Business Corporation Law. Moreover, depending on circumstances, courts will evaluate director conduct under, potentially (i) the deferential “business judgment standard”, (ii) the stricter “enhanced scrutiny” standard for situations involving potential conflicts, or (iii) the “entire fairness” standard when known conflicts exist. See, for example, the recent opinion of the Delaware Court of Chancery in Chen, et al. v. Howard-Anderson, et al. (April 8, 2014).
- Federal Statutes and Regulations: Federal laws enacted since the turn of the century include mandates under Sarbanes-Oxley and Dodd-Frank. Day-to-day vigilance of corporate counsel must take into consideration: (i) transactions that could compromise a director’s independence and thereby disqualify the director from service on an audit, compensation or nominating committee; (ii) the vesting of exclusive jurisdiction of matters relating to audits and auditors, executive compensation and nomination procedures for director elections in committees comprised solely on independent directors; (iii) mandates on CEOs and CFOs to assure effective disclosure controls and internal controls over financial reporting, coupled with quarterly certifications of compliance; (iv) “real-time” public reporting on Form 8-K of company developments, such as entry into material transactions, incurrence of material liabilities and changes in directors or senior executives; (v) public posting of Board and Board committee charters and codes of conduct; (vi) Regulation FD restrictions on selective disclosure of material information; (vii) expansion of provisions for whistleblowers under Dodd-Frank; (viii) expanded disclosures of executive compensation and mandated claw-backs of executive compensation paid out on the basis of flawed financial reporting; and (ix) restrictions on the making and receiving of gifts (e.g., the Foreign Corrupt Practices Act). The foregoing list is not exhaustive; it highlights the range of issues addressed in recent and pending Federal laws and regulations.
- Stock Exchange Listing Standards: Largely reflecting Federal statutory directives, the rules governing companies with securities listed on stock exchanges have expanded to cover core areas of corporate governance, including: (i) mandated director qualifications to serve on Boards and Board committees; (ii) mandated meetings of non-employee directors; (iii) increased public disclosure requirements, including in annual proxy statements; and (iv) factors that Board committees must consider as a condition to engaging third party advisors. Because of the expansive (and expanding) coverage of stock exchange rules, counsel must remain vigilant as to whether any given corporate action or practice is either prohibited by the stock exchange or may be undertaken only in compliance with specified procedures (e.g., a shareholder vote). See, for example, Section 303A of the New York Stock Exchange Listed Company Manual.
- Shareholder Activism and the Shifting of Balance of Authority: The rise in shareholder activism has led to, and in turn been reinforced by, practices that become trends and trends that become expectations and expectations that penalise non-conformity. Prominent examples of these practices through which counsel must navigate its client include: (i) the rise in majority voting in direction elections; (ii) the decline of classified Boards; (iii) the separation of the Chairman and CEO positions; (iv) the hostility of shareholders to poison pills and other mechanisms once characterised as shareholder protections and more recently characterised as management entrenchment devices; (v) the emergence of “proxy access” provisions in company charters to facilitate inclusion of shareholder nominees in company proxy statements (and thereby to obviate or reduce costs incurred in proxy contests for Board representation); and (vi) the Federal mandate for shareholder “say-on-pay” votes (and the consequences for directors at companies that fail to garner a favourable vote). In rendering advice to clients to assist their evaluation as to whether to accommodate or resist pressures exerted by shareholder activists, counsel must remain vigilant as to how any one accommodation impacts (or potentially impacts) the effects of any other accommodation. Take for example a company that opted several years ago to amend its charter to provide for continuation of a director only if the director receives, annually, a vote by an absolute majority of outstanding shares. Whether or not this amendment is viewed as desirable, the increase in shareholder influence entailed by this amendment has been amplified by the elimination of New York Stock Exchange rules that historically gave brokers discretion to vote shares held in “street name” in director elections. Put another way, the coupling of (i) the expansion of subjects now submitted routinely to a shareholder vote (including recurring “say-on-pay” proposals), (ii) the elimination of broker discretionary voting on (most) proposals submitted for a shareholder vote, (iii) majority-voting in director elections, and (iv) de-classified Boards increases the impact of each of the foregoing on the others, thereby further increasing the influence of shareholders over the company.
- The Rise of Advisory Firms: The past decade has witnessed a rise in non-governmental, largely unregulated firms (most notably ISS) that provide proxy voting advice to their shareholder-clients and promulgate rules the departure from which may result in recommendations to clients to vote against management/company proposals or the re-election of directors. Much has been written about conflicts embedded with the business models of these firms, but the reality is that the influence of these firms on governance practices (including those relating to Board and Board committee functions and composition; executive compensation; company charters; and key company transactions and initiatives) cannot be overlooked by counsel in advising its client on the myriad of subjects considered by these firms. The fact that these firms regularly change and expand the criteria by which they judge companies and formulate their recommendations makes counseling particularly challenging in regards to practices that may be viewed as acceptable when implemented but that become problematic when the firms change their criteria. Examples include tax gross-up and severance features in executive employment agreements; accelerated vesting of restricted equity tied solely to a change of control transaction without also being tied to an adverse change in the executive’s employment position; and payment levels that do not fall within quantitative standards of acceptability (such as the advisory firm’s methodology for determining a pay-for-performance disconnect).
- Formalisation of Corporate Policies: Responding to the mandates of Federal laws and stock exchange listing standards, companies have adopted and posted on their websites charters of key Board committees, primarily the audit, compensation and nominating committees. Going beyond these charters, and highlighting other governance initiative and mandates, companies also have adopted, and posted to their websites, policies designed to assure alignment of management and shareholder interests, including policies on executive stock ownership (and stock holding) requirements; anti-hedging policies; anti-pledging policies; and compensation claw-back policies. These policies add to or supplement codes of conduct; omnibus corporate governance policies; and policies that reflect company goals, values and commitments.
Shareholder Litigation as a Shaper and Monitor of Corporate Governance
Private class action securities fraud lawsuits continue to proliferate. A recent article indicates that more than 3,200 such lawsuits have been filed between 1997 and 2013, and further states that settlements in these lawsuits totaled more than $73 billion. See “Damages and Reliance under Section 10(b) of the Exchange Act” by Joseph A. Grundfest in The Business Lawyer (February 2014, volume 69, issue 2). Whether or not one views the litigation as a net positive or negative, the litigation, as Professor Grundfest observes in the foregoing article, is viewed by some as a necessary supplement to SEC enforcement activities. In our view, any quantification of the benefits and costs of such litigation would need to account for the inherently unmeasurable and nonquantifiable impact that the risk of such litigation has on shaping corporate practice precisely to avoid any such litigation.
Changes that Drive Changes
Obviously, technology has changed virtually “everything” and many of these changed “things” present counsel with novel legal questions. Relatively straightforward examples include: (i) electronic voting by shareholders and, more broadly, rules that have enabled and encouraged a shift from paper to electronic communication; and (ii) required website postings of charter documents, insider trading reports (i.e., Forms 3, 4 and 5) and waivers of codes of conduct. More challenging examples include disclosures of company information through social media outlets and the impact on company compliance with securities laws. In April 2014, the SEC updated its Compliance and Disclosure Interpretations (CD&Is) to address company use of technologies (such as social media) to communicate to shareholders and to potential investors, including implications of technology constraints on communications. See, for example, Question 110.04 of the CD&I on Securities Act Rules (as updated April 21, 2014). See also Question 110.02 addressing re-transmissions (re-tweets) of company communications by third parties.
Given the multiplying sources of influence on company activities, and the continuing proliferation of rules and regulations, counsel must assist the Board and management in establishing a framework to assure a match of company goals with these rules and regulations. Essential to this framework is a clear recognition of the allocation of rights and responsibilities among shareholders, the Board, Board committees and management. Within this framework are components that articulate broad corporate goals and values; and “sub-components”, formulated with increasing specificity, that position the company to achieve its goals and withstand challenges from behaviours antithetical to these goals.