Introduction to Corporate Governance

Transcription

1 Introduction to Corporate Governance Presented by the Corporate Governance Committee and the Young Lawyer Committee July 28, 2016 Bruce Dravis, Partner, Downey Brand LLP Ashley Gault, Associate, Roetzel & Andress, LPA 1

2 Corporate Governance in Context It wasn t always called corporate governance In 1985, we called it keeping the client out of trouble Governance became recognized as an inter-disciplinary practice area dealing with: Corporate law statutes, regs, and interpretations Securities law statutes, regs, and interpretations Case law Client articles and bylaws Contractual, exchange, and D&O obligations This section of webinar considers policy and practical issues affecting how governance rules developed and operate Example: Business Judgment Rule Board accountability is needed Directors should not be guarantor s for success of decisions

3 Corporate Governance in Context The central problem in any corporate governance system is how to make corporate executives accountable to the other contributors to the enterprise whose investments are at risk, while still giving those executives the freedom, the incentive, and the control over resources they need to create and seize investment opportunities and to be tough competitors. Margaret Blair, Ownership and Control (1995)

4 Corporate Governance in Context Governance is part of the infrastructure supporting capital markets Rules channel behavior of managers, investors, and directors in expected ways to support investment Investors rely on liquid market to store and invest wealth Under the securities laws, public companies internalize the cost of generating information used by capital market participants Company disclosure costs represent, collectively, maintenance costs for a viable securities market Capital market helps companies: Obtain capital for operations and expansion Provide liquidity for shareholders Use securities to compensate managers Use securities as currency for acquisitions Keep score

5 Corporate Governance in Context Good governance is not an end in itself Good governance alone does not save a weak competitor Bad governance alone does not doom a strong competitor Bad corporate adds risk to a company Investors can be devastated when governance fails Enron, WorldCom in early 2000s were examples, and led to adoption of SOX Governance rules require occasional change Rules evolve as business and social conditions change Changes are not an attack on capitalism Rules support trillions of dollars of investment, so change cannot be reckless

6 Corporate Governance in Context The basic structure Shareholders elect the Board The Board selects CEO and management Management operates business day-to-day, under supervision of the Board Management needs leeway to operate the company Monitoring and control cost to prevent all inefficiency would outweigh the benefit at some point Need to prevent management from operating corporate assets solely for its own benefit

7 Corporate Governance in Context Agency costs Shareholders cannot operate company directly Board and management direct operations, giving rise to inevitable costs Costs include Compensation; Preventing managers from taking or misusing the corporate assets they control; Preventing managers from adopting risky strategies that benefit managers rather than shareholders

8 Corporate Governance in Context Governance issues arise from many sources State and federal statutes and regulations Court decisions Exchange listing requirements D&O insurance policy requirements SEC enforcement programs Internal corporate policies, including codes of ethics and committee charters Investor policies Best practices recommendations

9 Governance s Many Sources State law Directors do not guarantee a successful outcome of their business decisions. Must make decisions with due care and without a conflict of interest Delaware case law fills in many details on duties Board oversees performance of management Also responsible for overseeing Strategy Risk Compliance with law

10 Governance s Many Sources Federal law Securities Act governs issuance of securities Exchange Act governs proxies, exchanges SOX federalized some governance elements Audit committee requirements Independence requirements Internal controls and certifications Dodd-Frank added governance elements Say on Pay Compensation committee independence Proxy access SOX and Dodd-Frank assume corporate managers require active oversight by individuals where are independent of management.

11 Governance s Many Sources Federal law Case law under SEC Rule 10b-5 affects: Corporate disclosures Broad SEC enforcement authority Administrative procedures: cease and desist orders Injunctive relief Lifetime bars from public company service

12 Governance s Many Sources Exchange listing requirements Some federal requirements are implemented via SEC oversight of exchange listing process Independence of directors Audit committee requirements Compensation committee independence Exchange rules are contractual between company and exchange NYSE and NASDAQ have similar rules, but differ in details Violations could lead to delisting or suspension.

13 Governance s Many Sources Internal Corporate Policies Law requires companies to adopt certain policies, but these policies are not themselves laws. Whistleblower policies Code of ethics Legal compliance programs Trading policies Violation or waiver of the policies can have consequences Disclosure of waiver of ethics policy Caremark liability for legal compliance failure Committee charters Required by exchanges for audit, compensation and nominating committees Set out processes that committee will follow Breach could be evidence of bad faith or failure to use due care

14 Governance s Many Sources Best practices Beyond legal or exchange standards, investor and business organizations promote best practices recommendations. Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies (NACD).

15 Independence Independence is a proxy for what we really want: Decision makers who evaluate facts without bias and make judgments without favoritism

16 Independence Independence is tested at different times and for different purposes in corporate governance: For board, exchanges require independence of directors from management For transaction between company and insiders, consider lack of personal stake in the deal For audit committee, need independence from management, auditors and major shareholders For compensation committee, independence from management, but not necessarily major shareholders For special litigation committee, sufficient independence to act in company s best interest

17 Independence SOX created greater independence for boards and advisors Audit committee all independent controls audit relationship Public company auditors got new regulator Attorneys to report material violations to board, if needed Gatekeeper theory Institution or individual that puts its own credibility on the line on behalf of a company in reviewing or certifying corporate actions Motivated by professional self-interest, not fiduciary duty In theory, gatekeepers have less to gain, and more to lose, than a manager who wants to mislead the markets or improperly deal with the company

18 Independence Director independence comes primarily from NYSE and NASDAQ listing agreements Exchanges set definitions with SEC approval and statutory guidance Substantial similarities

19 Independence State law independence questions Disinterested director in conflict situation Independent from conflict in specific transaction or issue Independent director for exchange purposes might not be disinterested Management director could be disinterested Need can arise in transactions, investigations, litigation

20 Independence Related party transaction Interested director has duty to disclose material facts and existence of conflict Court may review entire fairness of deal if proper approvals not obtained Need approval of transaction terms by disinterested board members May need shareholder approval by majority of unaffiliated shareholders Proxy disclosures required for such transactions Transaction may get additional scrutiny from auditors

21 Independence Investigations Want to have supervision of investigation by individuals who are not beholden to management or other directors Not socially bound to others Want outcome not to be dictated by relationship of directors to one another

22 Director duties and liabilities The board of directors must act in good faith and in the reasonable belief that its actions are in the best interests of the corporation s shareholders. A director who violates those duties could be personally liable to the corporation or its shareholders. Directors could also be subject to SEC sanctions.

23 Director duties and liabilities All good corporate governance practices include compliance with statutory law and case law establishing fiduciary duties. But the law of corporate fiduciary duties and remedies for violation of those duties are distinct from the aspirational goals of ideal corporate governance practices.... Delaware law does not indeed, the common law cannot hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices. --In re Walt Disney Co. Derivative Litigation

24 Director duties and liabilities The basic fiduciary duties of directors are generally described as duties of loyalty and of due care. Subsets of these general include: Duty of disclosure when presenting information in a request for shareholder action. Revlon duty which is the legal obligation to seek the best sale terms for shareholders when the board of a public company has determined the company should be available for sale rather than continue as an independent organization.

25 Director duties and liabilities Duty of Loyalty is aimed at preventing inappropriate self-dealing. Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. Guth v. Loft, Inc.(Del. 1939). Examples: Conflict of interest Corporate opportunity Executive and Director Compensation Purchase of Control

26 Director duties and liabilities Duty of Care is the obligation of a director to be adequately informed and diligent when making corporate decisions and overseeing the management of the corporation. Time commitment Right to rely on others Disclosure among directors

27 Director duties and liabilities Business Judgment Rule Intended to prevent the court from second-guessing board decisions with the benefit of hindsight. Provides directors with legal presumption that they acted in the best interests of the corporation and its shareholders. If evidence by plaintiff overcomes presumption, burden of proof shifts to the company and the board to demonstrate that its action was entirely fair to the company and the shareholders, both as to the process used and the price obtained. In transactions involving a board with significant conflicts of interest, the board may use a special committee of disinterested directors as a procedural safeguard, in case the court reviews the transaction under the entire fairness standard.

28 Director duties and liabilities Public company officers and directors are required to make certain certifications under SOX when quarterly and annual reports are made to the SEC: CEO and CFO must certify that they have reviewed the report and that it is accurate. The signing officers must certify that the report fully complies with SEC s reporting requirements.

29 Director duties and liabilities Indemnity Agreements: Corporations generally are empowered to indemnify their directors for losses incurred if directors are found liable for breach of a fiduciary duty. D&O Insurance: Corporations often provide insurance coverage for directors and officers. Indemnification and insurance coverage typically will not be available if a director has not acted in good faith.

30 Director duties and liabilities Potential personal liability is a concern for every person who serves on a board of directors. Because independent directors are not involved in the day-to-day operations of the company, they must rely on information from managers. Ensuring the accuracy of this information is paramount to director s avoidance of personal liability.

31 Shareholders Shareholders, board and execs have separate roles in corporate governance Rules allocate risks and decision-making Rules strike economic, legal, and decision-making balances These balances change as business and society change Investors give execs operational control, overseen by board Investors share profits, with limited liability Managers get defined authority and a specific pool of assets to pursue business goals; investors take on limited risk with the expectation of financial gain

32 Shareholders In a small company, owner can be manager Owner/manager roles must split in a larger enterprise Rewards for shareholder-owners and managers also split Execs get cash compensation Set by the board Paid from company assets Execs may also get equity compensation Dilutes ownership percentage of other shareholders Not paid from company assets Converted to cash by sale to another party

33 Shareholders Shareholder financial rewards are sometimes paid directly from corporate assets as dividends Corporate assets pay for an indirect benefit to shareholders, via securities law compliance that gives shareholders access to stock market Most investors buy shares in the market, and gain by selling at a higher price Few investors infuse the company with capital by buying shares from the company itself Shareholders are paid if company is sold, merged or wound up

34 Shareholders Without direct control, investors rely on corporate and securities laws to protect money at risk from managers abusing corporate assets Companies must disclose material facts, facilitating informed stock trading SEC Rule 10b-5 promotes accuracy and completeness of disclosures, and provides legal remedies for fraud Standardized accounting rules mean financial statements are prepared using processes that promote confidence and comparability State case laws on fiduciary duties reinforce the requirement that managers act in the shareholders best interests Corporate governance developments mitigate risks that corporate managers might create

35 Shareholders Shareholder protective rights Right to sue directors on behalf of company For breach of fiduciary duty Section 16 for short swing profits Right to vote Board election; say-on-pay; some transactions Propose subjects for vote Propose director candidates Proxy access Proxy contests Right to sell

36 Shareholders When amount of shares or time of holding affects a shareholder s rights: Shareholder proposals allowed only if shareholder has held shares for at least one year in the amount of either $2,000 or 1% Must report under Williams Act if acquire 5% or more Subject to Section 16 short-swing profit rules if own 10% or more Holdings large enough to become an affiliate means shareholder is subject to Rule 144 sales restrictions under Rule 144 Large acquisition might trigger state law anti-takeover protections or company poison pill A controlling shareholder may sometimes owe fiduciary duties to other shareholders A shareholder holding $5 million worth of a public company s shares who solicits another investor s proxy in writing must file that material with SEC

37 Shareholders Voting power of shares is governed by state law and corporate charter Different classes of shares can have different voting powers Different series within a class can have different voting powers State law may affect use of voting agreements or written consent of a majority of shareholders Staggered board terms can limit shareholder ability to remove all directors Typically, elect one third of the board each year to 3-year terms Provides takeover protection because a would-be acquirer cannot replace the board in a single vote

38 Shareholders Shareholder voting may be enhanced by cumulative voting Permits a minority faction of shareholders to elect at least one director Public companies generally do not use cumulative voting Public companies with only common stock outstanding rarely have controlling shareholder Super-voting stock gives individual shareholders or groups control over elections Super-voting stock has more than one vote per share OK in public companies if issued before company went public Usually seen for family-owned company with public common shareholders, or where founders retain significant ownership and operating control

39 Shareholders Other than voting for directors, shareholders may vote on: Mergers Dissolution of the corporation or sale of substantially all of its assets Amendments to governing instruments of the corporation, including the corporate charter and certain corporate bylaws Certain compensatory stock plans or issuance of large amounts of stock Advisory or mandatory votes on corporate policies, such as say-onpay, say-when on-pay, or proposals advanced by the shareholders under SEC proxy rules

40 Shareholders Proxy rules establish specific and detailed disclosures to shareholders In addition to the specific elements proxy statements may not contain any materially misleading statements or omit material information Proxy statements are provided directly to shareholders Other reports are filed only with the SEC Delaware law has established a fiduciary duty of disclosure for directors regarding matters subject to a proxy vote The thrust of both the federal and state law is to prevent shareholders from approving or declining to approve a matter based on incorrect or inadequate facts

41 Shareholders Majority voting Most large public companies use majority voting for directors Important when director candidate is unopposed but does not get a majority vote Plurality voting: Most votes wins, even under 50% Majority voting is not an exchange listing standard NYSE in 2009 prohibited brokers from voting for director without owner instructions Prior to 2009, brokers reliably rubber-stamped management choices Under Dodd-Frank, brokers may not vote without shareholder instructions

42 Shareholders If nominating committee considers shareholder nominees, proxy statement must describe: How to submit a recommendation Any specific, minimum qualifications the nominating committee has set for board nominees or any specific qualities or skills that the nominating committee believes are necessary for one or more of the company s directors to possess How committee evaluates nominees for director Any differences in how committee evaluates nominees recommended by a shareholder The proxy statement must tell how shareholders may communicate directly to the board of directors If no direct communication process exists, the company needs to explain why not

43 Shareholders Adoption of Equity Compensation Plans If company offers incentive stock options, the tax code requires shareholder approval NYSE and NASDAQ require shareholder ratification for equity compensation plans prior to issuance of securities under the plans The SEC adopted a proxy statement rule that requires corporations to disclose the total number of compensatory shares that were available for issuance, specifying which share issuances had been approved by shareholders and which had not So long as a corporation has authorized shares available, the board is entitled as a matter of corporate law to issue additional shares for appropriate consideration. Accordingly, shareholders are always susceptible to having their percentage shareholdings diluted by additional issuances

44 Shareholders Say-on-Pay Shareholders get a nonbinding vote on executive compensation Most companies have an annual vote Institutions advocated for say on pay as a way to provide input on compensation practices Votes are advisory, so executive compensation is not revoked by negative vote Dodd-Frank expressly provides vote may not be construed as overruling a decision by such issuer or board of directors The say on pay votes must occur at least every three years. Shareholders must vote, at least every six years, on whether to conduct the say on pay vote annually, every two years, or every three years (a say-when-on-pay vote)

45 Shareholders Shareholder Proposals The SEC proxy rules in Rule 14a-8 provide that shareholders are entitled to propose matters to be included in the company proxy statement for a vote by shareholders. The proxy statement for the corporation s annual meeting will designate a date for submission of proposals for the following year s shareholder meeting. The corporation may exclude a shareholder proposal from the proxy statement if the proposal submission fails to meet the procedural requirements of SEC Rule 14a-8, or if the proposal falls into one of the categories of unacceptable proposals Frequently used to raise social or governance questions

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