For almost all U.S. public companies, COVID-19 has created unique and very profound challenges. For the board of directors, which is charged with overseeing the short-term and long-term health of the corporation and its business prospects, navigating the COVID-19 crisis requires careful consideration of a range of issues under these unprecedented circumstances. This Legal Update outlines several corporate governance issues for directors to consider as their companies respond to the challenges and risks posed by the COVID-19 pandemic.
Monitoring and Oversight Responsibilities of Directors
As a general matter, directors of a Delaware corporation have a responsibility to oversee the business and affairs of the corporation, which requires that directors make a good faith effort to put in place a reasonable board-level system of monitoring and reporting. The Delaware courts, in a line of cases beginning with In re Caremark Int’l Inc. Derivative Litig., have found that a failure of director oversight would occur (1) if directors failed to implement any corporate reporting or information systems or controls or (2) if such a system or controls were implemented, the directors consciously failed to monitor or oversee the company’s operations, thus removing themselves from being informed of material risks or problems requiring their attention.
In light of director oversight responsibilities and as a matter of good corporate governance, some specific active steps for boards to consider in response to COVID-19 include the following:
- Enhancing the company’s existing reporting and information systems that are used by the board to provide oversight. Such a system would help ensure that the board is able to receive relevant information in a timely manner to monitor COVID-19 issues and their potential risks to and effects on the company. Once a system is implemented, a board should be active in its monitoring of significant issues so that it stays informed of material business risks and red flags resulting from the COVID-19 pandemic.
- Forming a committee. A possible tool available to a board to address its monitoring and oversight responsibilities is to create a committee that could be tasked with evaluating and, if necessary, adopting any available preventative and ameliorative measures regarding the impact of COVID-19 on the company’s operations and affairs. Timely and sufficiently detailed minutes and resolutions should document the proceedings of the committee and provide evidence of the activities conducted, matters considered and decisions made by the committee. If, after due consideration, the committee declines to adopt any measure considered, clear, contemporaneous committee records would then be used to support a showing of good faith in the committee’s efforts to evaluate such measure.
- Enhancing communications with company management. A board should consider increased and sustained open dialogue with company management on both the business risks and the workplace health and safety issues posed by COVID-19. Boards and management should review legal and regulatory developments regarding COVID-19 at both the federal and state levels, review the company’s risk-mitigation policies and protocols and adjust such protocols as necessary to conform to developing regulatory circumstances (especially if a particular regulatory scheme relates to activities that are core to the company’s operations) and meet frequently to discuss the foregoing. Boards should be clear in their instructions to management as to the board’s expectations with respect to management’s responsibility to report to the board regarding COVID-19 matters.
- Confirming the feasibility of the company’s disaster plan. The disaster plan should address matters such as employee availability, functionality of IT systems, cybersecurity, communication protocols and legal/regulatory compliance. Due to the unique nature of COVID-19, the board, as part of its ongoing monitoring and oversight responsibilities, should continue discussing any implementation issues with management and evaluating whether any modifications to the disaster plan are necessary to deal with new issues as they arise.
- Evaluating potential disruptions to operations and business relationships. This evaluation may include ensuring that management is appropriately considering:
- The impact of COVID-19 on key customers, suppliers, financing sources and service providers and review of key contracts to identify any potential issues relating to force majeure, triggers for defaults and termination rights and related contract terms.
- The ability of the company to access any emergency government funds or other programs initiated in the wake of the COVID-19 crisis.
- The adequacy of the company’s insurance coverage and whether proper steps are being taken to preserve any potential claims.
- Assessing key areas where there is additional risk and probabilities for their occurrence. While the hope is that the COVID-19 crisis will become more manageable by the third quarter of 2020, consideration should be given to additional steps that might be required if the impact of COVID-19 is prolonged. The board should also consider the feasibility of implementing these steps under different scenarios given the possibility of fewer resources being available, increased health and safety regulations, supply chain issues, availability of financing sources and customer situations.
- Reviewing board and management succession plans. Key officers of both large and small companies have already fallen ill with COVID-19. Boards should consider implementing a detailed emergency succession plan that takes into account the unavailability of directors, officers and key managers of the company. The board should consider establishing a COVID-19 transition team that serves as the governing body to carry out necessary changes in company leadership. The transition team can help clearly define the responsibilities and roles for acting management and coordinate directors’ supervision and support of persons in acting management roles. In extreme circumstances, boards may consider adopting emergency bylaws that would become operative during an emergency (e.g., pursuant to Section 110 of the Delaware General Corporation Law). Such emergency bylaws can provide a list of officers or other persons designated on a list approved by the board who will be deemed directors for special meetings called pursuant to the emergency bylaws.
- Retaining additional advice where needed. Due to the rapidity of developments regarding unique COVID-19 issues and the limitation of internal resources, a board should consider if the company needs additional assistance and retain outside advisors where necessary. An effort to consult with outside advisors can help demonstrate a board’s good faith effort to be and stay informed throughout the COVID-19 crisis.
- Reassessing long-term corporate strategy. Undoubtedly, the COVID-19 pandemic has brought new and unique challenges to most businesses. Focusing on the critical functions of a company certainly takes priority for a board. However, once the critical areas of need are addressed, the board may want to consider the implications for longer-term corporate strategies in light of the changing environment caused by COVID-19. These may include cultivating new alliances, developing more innovation and technology, growing through acquisitions (or disposing of non-core assets or businesses), exploring lower cost financing structures, developing new employee benefit plans and evaluating real estate needs. Some of these issues are discussed in more detail below.
Liquidity and Capitalization Considerations
One key area of focus during the COVID-19 pandemic is liquidity. Given the unexpected, and extremely rapid, onset of the crisis, most companies did not foresee the dramatic slowdown of the global economy. Accordingly, as part of their general oversight duties during the pandemic, directors should receive periodic updates from management with respect to the company’s liquidity and capital considerations and ensure any issues in this regard are being addressed. This includes understanding the impact of the crisis on the company’s cash flow, whether there are upcoming maturities of outstanding indebtedness that need to be considered and the likelihood that financial covenants will be maintained.
One specific topic for directors to consider in this regard is whether to suspend the company’s ordinary dividend or pre-existing stock buyback program to preserve cash. This typically entails weighing a variety of factors, such as potential downward pressure on the company’s stock price that may result from suspending the dividend and the benefit to the company of buying back its shares when the price is relatively low. We do note that influential proxy advisor firm Institutional Shareholder Services (ISS) recently issued guidance in advance of the 2020 proxy season suggesting that boards may open themselves up to “intense criticism and reputational damage” if they undertake share repurchases under the current circumstances. ISS was less critical, however, about potential changes to a company’s approach to dividends saying that boards should have “broad discretion” in this regard.
If a decision is made to suspend an ordinary dividend, advice should be sought from counsel with respect to the timing of the announcement of that decision relative to the next dividend record date. Moreover, if a company wants to not pay a dividend that the board has already declared, further legal considerations are necessary.
Executive Compensation Matters
As the COVID-19 crisis emerged, many companies were either in the process of, or had just completed the process of, setting performance targets and metrics for the current performance period (both with respect to long-term and short-term arrangements, such as performance equity and annual bonuses). In addition, performance relating to awards granted in prior years can be seriously adversely affected by the ongoing pandemic and as a general matter, granting equity awards when a company’s stock price is suppressed (requiring more shares to provide the same value) could result in depletion of the share reserve under the company’s equity plan, thus reducing the ability to make future grants. Therefore, if the process is not yet complete, companies should consider waiting to finalize the targets and metrics until the market and other business conditions stabilize so that the targets that are set will more likely reflect the proper incentives and goals for executives in the new “post-pandemic” business climate. Most companies reserve the right to change targets and metrics. Thus, if the targets have been set, companies may want to exercise discretion to make changes but, as with situations where the targets have not yet been set, it may be appropriate to wait to decide what changes should be made until market and other business conditions stabilize.
In addition, as a result of the pandemic, some companies have considered (or implemented) pay reductions either on a case by case basis or across the executive ranks. Consideration should be given to the effect of such reductions on various executive arrangements. For example, certain arrangements, such as employment agreements and severance arrangements may have “good reason” provisions that are triggered by reductions in base pay. This could provide an executive with the ability to terminate service and receive a generous severance package. In addition, a salary reduction could have a negative effect on an executive’s golden parachute tax calculations in the event of a future change in control, as golden parachute taxes are based on an average of five years of compensation such that a salary reduction will reduce the average and increase the amounts that may be subject to golden parachute taxes.
Finally, some companies that previously granted stock options or stock appreciation rights (SARs) have considered repricing those awards in light of market performance. Repricing stock options or SARS includes either lowering the exercise or base price, substituting the award with a new award with a lower exercise or base price and/or cancelling the award for another type of award or cash. Almost all equity plans of public companies have prohibitions on repricing of stock options or SARs without stockholder approval. In addition, repricing of an underwater stock option or SAR would most likely be treated as an extension of the award and would have serious negative implications under Section 409A of the Internal Revenue Code.
Takeover Defenses and Preparedness
Many public companies are experiencing a dramatic fall in their stock price in light of the global financial turmoil that has become an unwelcome byproduct of the COVID-19 crisis. It is prudent for boards of companies experiencing a significant decline in stock price to consider the company’s takeover preparedness and whether any steps should be taken in response to the vulnerability to hostile activity resulting from a depressed stock price.
If a board typically considers takeover preparedness on an annual basis, that board should consider whether it makes sense to accelerate that analysis this year given the changes in circumstances due to COVID-19. If a board does not consider takeover preparedness on a regular basis, that board should consider adding this topic to an upcoming agenda.
In the context of reviewing the company’s takeover defenses and preparedness, a board should consider whether to enlist the assistance of outside advisors. For one, an investment bank may be able to provide the board with useful market intelligence, views on the likelihood that the company would be a takeover target and particular insight into market changes happening in real time due to the effects of the COVID-19 pandemic. Similarly, outside counsel could provide a summary of current structural defenses that are in place and whether adding additional defenses at this time may be prudent and feasible.
One specific takeover defense that a board may consider under these circumstances is a shareholders rights plan, also known as a “poison pill.” While many public companies have a “pill on the shelf” so that they are prepared to quickly implement a rights plan if the situation warrants, the COVID-19 crisis has resulted in a recent uptick in public companies putting shareholder rights plans in place both to protect against hostile activity as well as to, in certain cases, protect tax assets that could be impacted by shifts in ownership resulting from volatility in the companies’ stock. As there are various issues for a board to consider in determining whether to put a shareholder rights plan on place (and if so, the terms of such plan), a board would typically enlist the assistance of an investment bank and outside counsel to assist with this analysis. One particular issue for a board to consider is the duration of the rights plan, with shorter duration plans (e.g., one year) designed to address only the current crisis likely to draw less scrutiny from shareholders and proxy advisors than longer duration plans. In this regard, we note that the recent ISS guidance contained a softening of ISS’ traditional position on pills, suggesting that the “COVID-19 pandemic is likely to be considered valid justification in most cases for adopting a pill of less than one year in duration.”
Even if the board does not expect the company to be the target of hostile activity under the current circumstances, it still may make sense for the board to take the time to ensure that the board has procedures in place for responding to a friendly takeover approach. These procedures typically include having clear instructions in place among the directors in terms of who communicates with the potential acquirer (typically, but not always, the CEO), and having outside advisors lined up who are familiar with the company and can help the board analyze and respond to a takeover approach very quickly.