In the September-October issue of The Corporate Counsel – which was just mailed – the primary focus is on issues you need to consider for your upcoming Forms 10-Q and 10-K. It’s a great issue, which includes pieces on:
– Economic Crisis Impacts: Disclosure in 1934 Act Reports
– More Meltdown Fallout—Falling Share Prices Can Affect S-3 Eligibility, WKSI Status, Listing
– SEC Regulation of Investment Banking—R.I.P.
– Legal Opinions in Rule 14a-8 No-Action Letter Requests
– Rule 701 Heads-Ups—Measurement Date(s) for Restricted Stock/RSUs
– New 1934 Act CDIs—Staff Confirms 10-K Delinquency Date Where Issuer Doesn’t File Proxy Statement Within 120 Days After Yearend
– The Recent Short Sale Ban—Impact on Counterparty Transactions
– A Few More Meltdown Thoughts
– It’s Here! Lynn, Romanek & Borges’ Executive Compensation Treatise
If you aren’t a subscriber yet, take advantage of a “Rest of ’08 for Free” no-risk trial to have this issue sent to you immediately. Current subscribers will want to start renewing for ’09 since all subscriptions are on a calendar-year basis.
Trends: Retail Ownership Continues to Drop
Not a big surprise that the concentration of ownership of US companies among institutional investors continues to grow, but it’s nice to get confirmation of this trend via this Conference Board press release with plenty of statistics, including that retail ownership of US stocks has fallen to a record low of 34% of all shares and 24% for the top 1,000 companies at the end of 2006.
Fallout from the Market Dip: Preferred Shareholders Sue
In his “D&O Diary” Blog, Kevin LaCroix notes how preferred shareholders have begun securities class action lawsuits for the first time.
At our “3rd Annual Proxy Disclosure Conference” yesterday, Corp Fin Director John White delivered an important speech – entitled “Executive Compensation Disclosure: Observations on Year Two and a Look Forward to the Changing Landscape for 2009” – during which John talked briefly about how the TARP’s executive compensation provisions could potentially spill-over and impact the many companies not directly subject to TARP. Specifically, John addressed the TARP provision that requires participating financial institution’s compensation committees to meet with the senior risk officers of the institution to ensure that the incentive compensation arrangements do not encourage the senior executive officers to take “unnecessary and excessive risks that threaten the value of the financial institution.” Here is an excerpt from John’s remarks on this topic:
Most of you are not from financial institutions, so let’s talk for a moment about non-participating companies. This new Congressionally-mandated limitation on having compensation arrangements that could lead a financial institution’s senior executive officers to take unnecessary and excessive risks that could threaten the value of the financial institution obviously applies on its face only to participants in the TARP.
But, consider the broader implications and ask yourself this question: Would it be prudent for compensation committees, when establishing targets and creating incentives, not only to discuss how hard or how easy it is to meet the incentives, but also to consider the particular risks an executive might be incentivized to take to meet the target — with risk, in this case, being viewed in the context of the enterprise as a whole? I’ll let you think about what Congress might want. We know what our rules require. That is, to the extent that such considerations are or become a material part of a company’s compensation policies or decisions, a company would be required to discuss them as part of its CD&A. So please consider this carefully as you prepare your next CD&A.
Also, more broadly speaking, I expect that current market events are already affecting many companies’ compensation decisions and thus should be affecting the drafting of their upcoming CD&A’s. Regardless of whether your company participates in the TARP and consequently finds itself having to make new material disclosures, you should not merely be marking up last year’s disclosure. Instead, you should be carefully considering if and how recent economic and financial events affect your company’s compensation program.
For example, have you modified outstanding awards or plans, or implemented new ones? Have you reconsidered the structure of your program, or the relative weighting of various compensation elements? Have you waived any performance conditions, or set new ones using different standards? Have you changed your processes and procedures for determining executive and director pay, triggering disclosure under Item 407? These questions and more should be addressed as you consider disclosure for 2008.
Corp Fin’s ’09 Narrowly Selected Review of Executive Compensation Disclosures
Regarding Corp Fin’s review of compensation disclosures filed during the upcoming proxy season, John said this during his speech:
We also are looking at how we will shape our Corporation Finance review program for 2009 in light of recent market events, including the new executive compensation provisions in TARP and continued investor interest in executive compensation. As you know, our selective review program is guided by Section 408 of Sarbanes-Oxley, which requires that we review all public companies on a regular and systematic basis, but in no event less frequently than once every three years. The Act also sets out criteria for us to consider in scheduling these regular and systematic reviews, including considering companies that “experience significant volatility in their stock price,” companies “with the largest market capitalizations,” and companies “whose operations affect any material sector of the economy.” As you also will recall, in 2007 we did a targeted review of the executive compensation disclosure under our then-new rules for 350 companies of all sizes.
Our plan for 2009 will be responsive to current conditions. In 2009 we will select for review and review the annual reports of all of the very largest financial institutions in the U.S. that are public companies. This group will include the nine large financial institutions that have already agreed to participate in the Treasury’s capital purchase program. Our reviews will include both the financial statements and the executive compensation disclosures of these companies. We also intend to monitor the quarterly filings on Form 10-Q and current reports on Form 8-K of these companies.
Today is the “5th Annual Executive Compensation Conference.” Note you can still register to watch online – and note that the archived video for yesterday’s “3rd Annual Proxy Disclosure Conference” is now available.
– How to Attend by Video Webcast: If you are registered to attend online, just log in to TheCorporateCounsel.net or CompensationStandards.com to watch it live or by archive (note that it will take about a day to post the video archives after it’s shown live). A prominent link called “Enter the Conference” on the home pages of those sites will take you directly to today’s Conference.
Remember to use the ID and password that you received for the Conferences (which may not be your normal ID/password for TheCorporateCounsel.net or CompensationStandards.com). If you are experiencing technical problems, follow these webcast troubleshooting tips. Here is the Conference Agenda; times are Central.
– How to Earn CLE Online: Please read these FAQs about Earning CLE carefully to see if that is possible for you to earn CLE for watching online – and if so, how to accomplish that. Remember you will first need to input your bar number(s) and that you will need to click on the periodic “prompts” all throughout each Conference to earn credit. Both Conferences will be available for CLE credit in all states except Pennsylvania (but hours for each state vary; see the list for each Conference in the FAQs).
Today is the “Tackling Your 2009 Compensation Disclosures: The 3rd Annual Proxy Disclosure Conference”; tomorrow is the “5th Annual Executive Compensation Conference.” Note you can still register to watch online by using your credit card and getting an ID/pw kicked out automatically to you without having to interface with our Staff (but you can still interface with them if you need to).
– How to Attend by Video Webcast: If you are registered to attend online, just log in to TheCorporateCounsel.net or CompensationStandards.com to watch it live or by archive (note that it will take about a day to post the video archives after it’s shown live). A prominent link called “Enter the Conference” on the home pages of those sites will take you directly to today’s Conference.
Remember to use the ID and password that you received for the Conferences (which may not be your normal ID/password for TheCorporateCounsel.net or CompensationStandards.com). If you are experiencing technical problems, follow these webcast troubleshooting tips. Here is the Conference Agenda; times are Central.
– How to Earn CLE Online: Please read these FAQs about Earning CLE carefully to see if that is possible for you to earn CLE for watching online – and if so, how to accomplish that. Remember you will first need to input your bar number(s) and that you will need to click on the periodic “prompts” all throughout each Conference to earn credit. Both Conferences will be available for CLE credit in all states except Pennsylvania (but hours for each state vary; see the list for each Conference in the FAQs).
– How Directors Can Earn ISS Credit: For those directors attending by video webcast, you should sign-up for ISS director education credit using this form. This is meant to facilitate providing information to ISS; they are the ones in charge of accreditation and any disputes will need to be taken up with them.
Soliciting Queries for Our “Compensation Consultants Speaks” Panel
Among the more popular panels during Wednesday’s “5th Annual Executive Compensation Conference” will be the panel entitled “The Consultants Speak: Straight Talk from the Top Experts.” I am soliciting issues or questions to be addressed by the panel if you want to shoot me an email beforehand (they will be posed anonymously).
Moral Hazard and Executive Compensation
Setting the tone for our big executive compensation conferences, we have posted an important new alert on CompensationStandards.com from Fred Cook, founder of Frederic W. Cook & Co. In his piece – “Moral Hazard and Executive Compensation” – Fred addresses what moral hazard means and lays out a number of steps that you can take to mitigate it. We strongly urge you to read this piece and show it to your CEO and directors.
In response to a no-action request, the SEC’s Corp Fin Staff recently decided that Hain Celestial could not exclude a shareholder proposal calling for the company to reincorporate to North Dakota from its proxy statement (the company had hoped to exclude the proposal on procedural grounds; there don’t appear to be substantive grounds to argue for exclusion). Hain Celestial is incorporated in Delaware; the other two companies with this proposal so far – Oshkosh and Whole Foods – are incorporated in Wisconsin and Texas, respectively. Here is a copy of the proposal.
More companies can expect this type of proposal this proxy season as proponents attempt to leverage the North Dakota Publicly Traded Corporations Act, enacted in mid-’07 to provide for a host of shareholder-friendly measures (as noted in this blog).
As noted in this Reuters article, hold-til-retirement and say-on-pay will be two popular shareholder proposals topics during this proxy season as investors turn their attention to pay practices that encourage excessive risk-taking.
An Opportunity to Comment on RiskMetric’s ’09 Proxy Policies
Last week, RiskMetrics’ ISS Division put up a “Request for Comment” for a number of potential modifications to its policies for 2009. Take advantage of this opportunity to influence these important proxy voting policies through an easy-to-use online form. This year, the topics include:
– Poor Accounting Practices (U.S.)
– Discharge of Directors (Europe)
– Independent Chair (U.S.)
– Names of Director Nominees Not Disclosed (Global)
– Net Operating Loss Poison Pills (U.S.)
– Peer Group Selection for Executive Compensation Comparisons (U.S.)
– Poor Pay Practices (U.S.) Pay for Performance (U.S.)
– Corporate Social Responsibility Compensation Related Proposals (U.S.)
– Share Buyback Proposals (Global)
This Gibson Dunn memo summarizes RiskMetrics’ proposed policy changes. In addition, RiskMetrics has made these survey results from institutional investors available.
Nasdaq has made a rule filing with the SEC seeking to temporarily suspend the exchange’s bid price and market value of publicly held securities continued listing requirements until January 16, 2009, given the current state of the market. The last time the Nasdaq imposed an across-the-board, three-month moratorium on the application of its minimum bid and public float requirements for continued listing was during the market turmoil following September 11, 2001.
In its filing, Nasdaq notes that, as of September 30, 2007, there were only 64 securities trading below $1 on Nasdaq, while by September 30, 2008 that number had jumped to 227, and by last Thursday, the number of securities trading below a $1 was 344. Nasdaq further notes that “during this time there was no fundamental change in the underlying business model or prospects for many of these companies, but the decline in general investor confidence has resulted in depressed pricing for companies that otherwise remain suitable for continued listing. These same conditions make it difficult for companies to successfully implement a plan to regain compliance with the price or market value of publicly held shares tests.”
Nasdaq is requesting that the SEC waive the 30-day operative delay period so that the rule change can be put in place immediately.
I think that this is a very positive step to help both issuers and investors at a time when neither can afford to experience unnecessary delistings.
Time to Choose Prime over LIBOR?
Earlier this year, I blogged about the troubles with LIBOR, that ubiquitous short-term rate used in so many lending arrangements. Now, with the extraordinary conditions in the credit markets (including a near collapse of inter-bank lending – yikes!), LIBOR has shot up, hitting new highs in recent weeks.
In an alert issued earlier this week, Foley Hoag LLP discussed the impact of the inversion of LIBOR relative to the US Prime Rate and the potential impact on credit agreements:
“U.S. Companies that borrow under bank credit facilities that provide for the borrower to elect payment of interest at either a LIBOR-based rate (sometimes called a “Eurodollar” loan) or a Prime Rate-based rate (sometimes called a “Base Rate” loan) need to be aware of a significant development resulting from the recent turmoil in the world’s credit markets.
Under normal market conditions, the Prime Rate generally exceeds LIBOR rates. Given this, borrowers generally elect to pay interest at a LIBOR-based rate on loans that will be outstanding for more than a short time.
However, in recent days, certain LIBOR rates have at times exceeded the Prime Rate quoted by most major U.S. banks. Because of this, chief financial officers and treasurers need to carefully monitor their LIBOR/Eurodollar interest periods and consider whether to elect the Prime Rate/Base Rate when those interest periods next roll over. Furthermore, borrowers may wish to consider whether to “break funding” on some or all of their existing LIBOR/Eurodollar contracts and convert their outstanding loans to Prime Rate/Base Rate loans – depending on how LIBOR rates have moved since the beginning of the current interest period for an outstanding LIBOR/Eurodollar loan, borrowers may have to pay minimal or no “breakage costs” for doing so. The ability to “break funds” on an outstanding LIBOR/Eurodollar loan and convert it to a Prime Rate-based loan will depend on, among other factors, the language of the relevant loan agreement and whether the relevant loan is a revolver loan or a term loan, and borrowers should discuss this option with their lender before doing so.
It’s impossible to predict how long this anomalous situation will last, but the savings to alert companies could be substantial. When and if this rate inversion is reversed and more normal conditions prevail, borrowers under typical loan agreements should again be able to elect LIBOR on short notice and resume their normal interest rate strategies.”
Walk-in Registration for New Orleans
For our big executive compensation conferences next week, online registration for New Orleans attendance closed last night. However, you can walk-in and register in New Orleans with a check or credit card. In light of current economic conditions, we are waiving the standard walk-in fee this year.
Note that you will still be able to register for the video webconference at any time as this deadline doesn’t apply to that method of attendance.
I look forward to seeing you either in New Orleans or on the web!
This week, the Treasury Department and the IRS rushed out guidance and rulemaking on the executive compensation provisions included in the Emergency Economic Stabilization Act. The guidance comes out as Treasury seeks to implement the $250 billion Capital Purchase Program (CPP), as well as other programs under the Troubled Asset Relief Program (TARP). The new rules and guidance are included in:
– An IRS notice regarding the Section 162(m) and 280G provisions of the EESA.
– A Treasury notice describing golden parachute restrictions applicable to institutions participating in the Troubled Asset Auction Program (TAAP).
– A Treasury notice describing (much tougher) golden parachute restrictions applicable to institutions participating in the Programs for Systematically Significant Failed Institutions (PSSFI).
For an excellent summary of the rulemaking and guidance, see Mark Borges’ Proxy Disclosure blog and Mike Melbinger’s Compensation blog, both on CompensationStandards.com.
These provisions are only applicable to a relatively narrow group of financial institutions. While this NY Times article notes some doubt about the real impact of the provisions on executive pay at financial institutions – much less on other companies – I think that it is starting to feel like we are at a broader tipping point with the recognition of some pay excesses in this federal legislation. Now it is up to all boards to take the public and shareholder anger to heart when making compensation decisions. This will certainly be a topic that we will discuss in more detail at next week’s “3rd Annual Proxy Disclosure Conference” & “5th Annual Executive Compensation Conference.” Don’t miss them!
Accounting Guidance: It Keeps on Flowing
The accounting guidance for fair value and other financial meltdown issues continues to flow at a rapid pace:
1. Last Friday, the FASB issued FASB Staff Position No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. This FSP amends FAS 157 by incorporating “an example to illustrate key considerations in determining the fair value of a financial asset” in an inactive market. FSP No. 157-3 is effective upon issuance, and should be applied to prior periods for which financial statements have not been issued – including in upcoming third quarter 10-Qs. The FSP notes that the guidance included in the Statement is consistent with the guidance provided by the SEC’s Office of Chief Accountant and the FASB Staff in last month’s press release. The FSP’s example illustrates how a company can determine the fair value of an investment in a collateralized debt obligation security that is no longer quoted in an active market, emphasizing that approaches other than the market value may be appropriate for determining fair value.
2. On Tuesday, under intense political pressure, the IASB amended IAS 39, Financial Instruments: Recognition and Measurement. The amendment, which is effective immediately and to be applied retrospectively to July 1, 2008, will permit financial instruments that had been measured at fair value through profit or loss to be reclassified to a different accounting basis (to, i.e., held-to-maturity). The restrictions on reclassification had been in place to stop companies from gaming the system by, e.g., marking to market in the good times and then ceasing to mark to market in the bad times. The IASB shift may tilt the playing field in favor of international standards, because, under US GAAP, reclassifications among trading, available for sale and held-to-maturity are only permitted (under FAS 115) in rare circumstances. So much for “convergence” when the going gets tough.
3. Also on Tuesday, SEC Chief Accountant Conrad Hewitt sent a letter to FASB Chairman Robert Herz on interpretive issues arising in how to assess declines in fair value for perpetual preferred securities under the existing other-than-temporary impairment model in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. In the letter, Hewitt states that for perpetual preferred securities, which are treated like equity securities under FAS 115, the Staff (in consultation with the FASB Staff), “would not object to an issuer, for impairment tests in filings subsequent to the date of this letter, applying an impairment model (including an anticipated recovery period) similar to a debt security. OCA would not object to this treatment provided there has been no evidence of a deterioration in credit of the issuer (for example, a decline in the cash flows from holding the investment or a downgrade of the rating of the security below investment grade) until this matter can be addressed further by the FASB.” The Staff expects sufficient disclosure about the impairment analysis, so that investors can understand all of the information considered in determining that the impairment is other than temporary and what was considered in determining that there was no evidence of credit deterioration in the perpetual preferred securities.
Short Sale Disclosure (Only to the SEC) Now In Place
Yesterday the SEC adopted an interim final temporary rule requiring specified institutional investment managers to file information on Form SH concerning their short sales and positions of Section 13(f) securities, other than options. The rule is effective on October 18 and will continue in place until August 1, 2009.
The disclosures about short positions will not be available to the public, only to the SEC. The SEC stated that Form SH “will provide useful information to the staff to analyze the effects of our rulemakings relating to short sales and in evaluating whether our current rules are working as intended, particularly in times of financial stress in our markets. The reports will supply the Commission with important information about the size and changes in short sales of particular issuers by particular investors. That information will be available to the Commission to consider when questions about the propriety of certain short selling occur.”
Note that you will need your Conference ID and password to access the course materials (if you’ll be in New Orleans, a set will be handed out to you). It’s not too late to register!
Instructions for Those Watching Online Next Week: Come to the home page on the day of the Conference and click the prominent link that will be posted that day. Watch the Conference live by clicking a video link that will be on the Conference page that matches the type of player installed on your computer (ie. Windows Media Player or Flash) and the speed of the connection that you have. Panels will be archived a day after they are shown live.
Short Sale Tuesday
Yesterday, the SEC issued three separate releases taking action on short sale rules. All of these rule changes are effective this Friday, October 17. The changes include:
1. In Release 34-58773, the SEC adopted Rule 204T of Regulation SHO as an “interim final temporary rule” (I think that is a whole new flavor of rule). Rule 204T was first adopted in a September 17 Emergency Order and was set to expire on Friday, October 17. Now, a revised version Rule 204T will be effective until July 31, 2009, and the SEC will consider comments on the rule and respond to those comments “in a subsequent release.” The new version of Rule 204T includes some tweaks from the version adopted in the September 17 Emergency Order to address operational and technical concerns. The rule generally requires that securities be purchased or borrowed to close out any fail to deliver position in an equity security by no later than the beginning of regular trading hours on the settlement day following the date on which the fail to deliver position occurred, as a means for discouraging potentially abusive “naked” short selling.
2. In Release 34-58774, the SEC adopted Exchange Act Rule 10b-21, the naked short selling antifraud rule. This rule is actually being adopted in the “normal” way – it was proposed back in March and comment was solicited on the rule. In the September 17 Emergency Order, the SEC had adopted Rule 10b-21, but only through this Friday. New Rule 10b-21 is aimed specifically at short sellers (including broker-dealers acting for their own accounts) “who deceive specified persons, such as a broker or dealer, about their intention or ability to deliver securities in time for settlement and that fail to deliver securities by settlement date.” Such deception could include lying to a broker about the source of the borrowable securities under the locate requirement of Regulation SHO, or lying about whether the short seller owns the securities to be sold short.
3. In Release 34-58775, the SEC adopted previously proposed changes that eliminate the options market maker exception to the close-out requirement of Regulation SHO. With these amendments, fails to deliver in threshold securities resulting from hedging activities by options market makers will no longer be excepted from Regulation SHO’s close-out requirement. In the September 17 Emergency Order, the SEC had adopted and made immediately effective the elimination of the options market maker exception to Regulation SHO’s close-out requirement, which was also set to expire this Friday. The Release also provides some interpretive guidance on activities that constitute bona fide market making activities.
These rule changes are by and large targeted at naked short selling, and may finally go a long way toward stamping out the shady side of the short sale business. However, these changes may not be the last word on short selling regulation – calls for reviving the uptick rule will continue, as will perhaps the overall mistrust of short selling that the SEC has contributed to with its emergency short sale ban. Also, the SEC should be publishing interim final rules in the next day or so to implement the new Form SH filing requirement (for the SEC’s eyes only) on a permanent basis.
What’s Next for the SEC’s Emergency Actions?
With the markets’ big comeback on Monday and the rally cries of “capitulation” emerging, is the SEC going to ban long purchases next? I think not, but that would make about as much sense as banning short sales, in my opinion. What the SEC could do now is adopt some interim final temporary rule changes to continue the relaxation of the Rule 10b-18 volume and timing conditions to facilitate long purchasers by issuers. The timing of the SEC’s Emergency Order relaxing the 10b-18 requirements was not particularly good, since many issuers were in possession of material nonpublic information as a result of being so close to the end of the quarter, and thus had concerns about implementing any new repurchase plans or doing any sort of one-off repurchases. The potential benefits of encouraging issuers into the market to support their shares could actually be realized soon, as earnings get announced and issuers get back into windows where they could be in a position to repurchase their own securities.
The recent market crash has knocked quite a few companies out of WKSI status and some might not recognize the implications. In this podcast, Stephen Quinlivan of Leonard, Street and Deinard discusses the impact of the market drop on WKSI issuers, including:
– How has the recent market drop impacted some WKSI issuers?
– What are the implications of no longer being classified as a WKSI?
– Is there anything an issuer can do about it?
– What is the effect on registration statements of other issuers?
– Any other effects of the market drop?
CII’s New Policies: Gross-Ups, Severance Pay and More
During last week’s Council of Institutional Investors meeting, seven new corporate governance policies were adopted, including these four:
– Gross-ups: “Senior executives should not receive gross-ups beyond those provided to all the company’s employees.”
– Severance Pay: “Executives should not be entitled to severance payments in the event of termination for poor performance, resignation under pressure, or failure to renew an employment contract. Company payments awarded upon death or disability should be limited to compensation already earned or vested.”
– Proxy Solicitation: “Advance notice bylaws, holding requirements, disclosure rules, and any other company imposed regulations on the ability of shareowners to solicit proxies beyond those required by law should not be so onerous as to deny sufficient time or otherwise make it impractical for shareowners to submit nominations or proposals and distribute supporting proxy materials.”
– Executive Stock Sales: “Executive should be required to sell stock through pre-announced 10b5-1 program sales or by providing a minimum 30-da7 advance notice of any stock sales. 10b5-1 program adoptions, amendments, terminations and transactions should be disclosed immediately, and boards of companies using 10b5-1 plans should: (1) adopt policies covering plan practices; (2) periodically monitor plan transactions; and (3) ensure that company policies discuss plan use in the context of guidelines or requirements on equity hedging, holding and ownership.”
The other three polices relate to timely disclosure of voting results, shareholder rights to call special meetings and independence of accounting/auditing standard setters.
Delaware Court of Chancery Directs Hexion/Huntsman Merger To Go Forward
From Travis Laster, as posted on the DealLawyers.com Blog recently (here are the firm memos on the opinion): A few weeks ago, Delaware Vice Chancellor Lamb issued his much anticipated post-trial decision on the Hexion/Huntsman deal. In the opinion and implementing order, Vice Chancellor Lamb holds that (i) Huntsman had not suffered an MAE, (ii) Hexion “knowingly and intentionally” breached its obligations under the merger agreement such that potential damages are not limited to the $325 million termination fee, (iii) whether or not the combined entity would be insolvent is an issue that is not yet ripe, and (iv) Hexion must specifically perform its obligations under the merger agreement (which does not include an obligation to close). This decision is a blockbuster that will occupy center stage for a while. Here are some highlights from this major ruling.
Practitioners should start with the implementing order. It is a partial final order that Vice Chancellor Lamb certified as final pursuant to Court of Chancery Rule 54(b), thereby setting up an appeal as of right for Hexion.
Several paragraphs leap out of the order. In paragraphs 3-7, Vice Chancellor Lamb orders Hexion to move forward with the actions necessary to complete the merger. This is the type of open-ended, affirmative relief that Delaware courts often resist giving. Even more strikingly, in paragraph 8, Vice Chancellor Lamb prohibits Hexion from terminating the merger, and in paragraph 11, Vice Chancellor Lamb orders that “If the Closing has not occurred by October 1, 2008, the Termination Date under the Merger shall be and is hereby extended until five (5) business days following such date that this Court determines that Hexion has fully complied with the terms of this Order.” This language would appear to eliminate the drop dead date and make the Merger Agreement effectively open-ended, requiring Huntsman consent or court approval to terminate the deal. To my knowledge, this is unprecedented relief.
Turning to the opinion, VC Lamb first holds that there was no MAE. This is largely a fact-driven application of IBP and Frontier Oil; however, three points are particularly noteworthy. First, the Huntsman MAE contained a carveout for industry-wide effects, with an exception for effects with a disproportionate effect on HUN. Hexion argued that this required comparing Huntsman’s performance against the chemical industry’s performance to determine whether an MAE had occurred. VC Lamb rejects this reading and holds squarely that the initial inquiry is whether the target suffered an MAE at all. “If a catastrophe were to befall the chemical industry and cause a material adverse effect in Huntsman’s business, the carve-outs would prevent this from qualifying as an MAE under the Agreement. But the converse is not true–Huntsman’s performance being disproportionately worse than the chemical industry in general does not, in itself, constitute an MAE.” (37-38). This interpretive approach should apply to MAE carveouts generally and will affect how they are read and the leverage respective parties have.
Second, addressing the expected future performance of Huntsman, VC Lamb holds that whether Huntsman suffered an MAE is NOT measured by how it performed versus its projections. This is principally because in the merger agreement, Hexion disclaimed reliance on any Huntsman projections. “Hexion agreed that the contract contained no representation or warranty with respect to Huntsman’s forecasts. To now allow the MAE analysis to hinge on Huntsman’s failure to hit its forecast targets during the period leading up to closing would eviscerate, if not render altogether void, the meaning of [that section].” (46).
Third, in assessing the past performance aspect of the claimed MAE, VC Lamb concurred with Huntsman’s expert that the terms “‘financial condition, business or results of operations’ are terms of art, to be understood within reference to their meaning in Reg S-X and Item 7, the ‘Management’s Discussion and Analysis of Financial Conditions and Results of Operation’ section” of SEC filings. That section requires companies to disclose their results for the reporting period as well as their results for the same time period in each of the previous two years. Therefore, VC Lamb, holds that the proper benchmark for assessing whether changes in a company’s performance amount to an MAE is an examination of “each year and quarter and compare it to the prior year’s equivalent period.” (47-48) Though it addresses only one aspect of the MAE analysis-i.e. past performance not expected future performance-this is the clearest guidance the Court of Chancery has yet provided on the appropriate metrics for evaluating an MAE.
As in IBP and Frontier, burden of proof appears to have played a significant role in the ruling, and VC Lamb suggests in a footnote that parties to a merger agreement contractually allocate the burden of proof for establishing an MAE. (41 n.60).
In the next major ruling in the opinion, VC Lamb holds that Hexion committed a “knowing and intentional breach” of its obligations under the merger agreement. Hexion argued that the phrase “knowing and intentional” requires that a party (i) know of its actions, (ii) know that they breached the contract, and (iii) intend for them to breach of contract. (57). VC Lamb rejects this view as “simply wrong.” (57). He rather holds that a “knowing and intentional” breach is “a deliberate one — a breach that is a direct consequence of a deliberate act undertaken by the breaching party, rather than one which results indirectly, or as a result of the breaching party’s negligence or unforeseeable misadventure.” (59). It thus simply requires “a deliberate act, which act constitutes in and of itself a breach of the merger agreement, even if breaching was not the conscious object of the act.” (60).
Having interpreted “knowing and intentional breach” in this fashion, VC Lamb turns to Hexion’s actions over the past few months, during which Hexion identified a concern about the combined entity’s solvency, retained Duff & Phelps to analyze the issue, obtained an “insolvency” opinion, and then went public with its insolvency contentions and filed a lawsuit in Delaware. VC Lamb holds that this course of conduct breached (i) Hexion’s covenant to use its reasonable best efforts to consummate the financing and (ii) Hexion’s obligation to keep Huntsman informed about the status of the financing and to notify Huntsman if Hexion believed the financing was no longer available.
VC Lamb notes that “[s]ometime in May, Hexion apparently became concerned that the combined entity … would be insolvent.” (62). He remarks that a “reasonable response” at that time would have been to contact Huntsman and discuss the issue. But rather than doing that, Hexion hired counsel and began analyzing alternatives. At this stage, however, he observes that was not Hexion “definitively” in breach of its obligations. (63). But Hexion and its counsel then hired Duff & Phelps, which developed an insolvency analysis. At that point, “Hexion was … clearly obligated to approach Huntsman management to discuss the appropriate course to take to mitigate these concerns.” (63). Hexion’s failure to do so “alone would be sufficient to find that Hexion had knowingly and intentionally breached.” (64). Rather than doing so, Hexion obtained an insolvency opinion from Duff & Phelps and delivered it to the banks, which VC Lamb regarded as a clear, knowing and intentional breach. (67-68).
Vice Chancellor Lamb then wraps up by writing that “In the face of this overwhelming evidence, it is the court’s firm conclusion that by June 19, 2008 Hexion had knowingly and intentionally breached its covenants and obligations under the merger agreement.” (77). He holds that if it is later necessary to determine damages, “any damages which were proximately caused by that knowing and intentional breach will be uncapped and determined on the basis of standard contract damages or any special provision in the merger agreement.” (77). The merger agreement in fact contains a provision contemplating damages based on the lost value of the merger for stockholders. VC Lamb also rules that Hexion will have the burden to prove that any damages were not caused by its knowing and intentional breach.
After addressing two major issues, VC Lamb declines to make any ruling on the solvency of the combined entity, which was the issue that consumed the bulk of the parties’ litigation efforts at trial. VC Lamb holds that the question of the solvency of the combined company is not ripe “because that issue will not arise unless and until a solvency opinion is delivered to the lending banks and those banks either fund or refuse to fund the transaction.” (78). He notes that solvency of the combined entity “is not a condition precedent to Hexion’s obligations under the merger agreement,” and the lack of a solvency opinion “does not negate [Hexion’s] obligation to close.” (79). The issue is only relevant to the obligation of the lending banks. (79). He therefore leaves it for another day.
Finally, VC Lamb holds that Hexion must specifically perform its obligations under the merger agreement, while noting that the merger agreement specifically exempts Hexion from having the obligated to close. He finds the specific performance provision of the merger agreement to be “virtually impenetrable” and ambiguous, and he therefore resorts to extrinsic evidence, including the testimony of Hexion’s counsel, to interpret its meaning. He concludes that the Court can require Hexion to comply with all of its obligations short of consummation, but cannot order Hexion to consummate. “[I]f all other conditions precedent to closing are met, Hexion will remain free to choose to refuse to close. Of course, if Hexion’s refusal to close results in a breach of contract, it will remain liable to Huntsman in damages.” (87).
The Hexion decision joins IBP and Frontier as the major guideposts for MAE analysis. Hexion applies and elaborates on IBP and Frontier; it does not appear to open up any inconsistencies in Delaware’s approach. The opinion rather tends towards greater clarity in MAE application by establishing a rubric for interpreting carveouts, putting projections off limits when reliance on them has been disclaimed, and establishing a securities law-based standard for evaluating past performance. It is not readily apparent to me what the long-term impact of this greater clarity will be. Some MAE threats will likely not be made and others may be more readily rejected. But since part of the leverage to recut deals and resolve MAE issues flows from uncertainty over how the MAE issues will play out, the existence of more defined judicial standards could result in parties being more aggressive in their MAE positions and less willing to compromise. This ironically could lead to more MAE litigation.
The Hexion opinion is also a reminder of the importance Delaware places on contracts and contractual obligations. Both the URI decision from December 2007 and the Hexion ruling provide examples of Delaware courts enforcing bargained-for contractual provisions. In URI, those provisions favored the acquiror. In Hexion, they favored the target.
Last week, the SEC Staff posted a 129-page Enforcement Manual. I believe that this document is new and not something the Staff has been sitting on behind closed door – although I don’t think the content itself is anything new. It’s a great idea since it seems to pull together all of the key Enforcement positions and policies in one place. I’m not sure why the SEC made it public, but I’m glad they did.
Gibson Dunn has written this memo summarizing some of the key areas of the SEC’s Enforcement Manual, including waiver of privilege, document production and the process by which the Staff may contact employees of a company under investigation.
The RiskMetrics’ 2008 Postseason Report
RiskMetrics Group has released its 2008 Postseason Report (and a series of unique industry sector reports). We have posted an executive summary of the Postseason Report in our “Proxy Season” Practice Area. Some key takeaways from the report include:
-Board declassification proposals received the greatest backing this year, averaging 67% support at 76 firms, up from 64% in 2007.
-Proposals calling for an independent board chair saw average support climb by more than 5% to nearly 30% of votes cast “for” and “against.”
-While the global credit crisis resulted in fewer transactions this year, hedge funds and other activists continue to target underperforming companies, leading to another record year for U.S. proxy contests.
-While most directors were elected with broad support, investors have become increasingly willing to withhold support from board members in uncontested elections, even in the absence of a high-profile “vote no” campaign. In fact, directors at 82 S&P 500 companies received more than 10% opposition this year, up from 64 firms in 2007 and 57 in 2006.
How to Change Your Advance Notice Bylaws
We have posted the transcript from the popular webcast: “How to Change Your Advance Notice Bylaws.”
It looks like the folks at AIG have taken “tone at the top” to heart. Unfortunately, their tone isn’t of the type that is good news for taxpayers, who now own 80% of AIG. As this Washington Post article describes, two former AIG CEOs were grilled during a House Committee on Oversight and Government Reform hearing this week (one of whom received a $5 million performance bonus just before he left – in addition to a $15 million golden parachute – and another AIG executive was fired who still receives $1 million per month for consulting services). The former CEOs expressed no remorse for their actions that drove AIG into the arms of the government and didn’t acknowledge making any mistakes. Rather, they blamed the accounting. The House committee members were visibly disturbed by the sheer audacity of these so-called corporate leaders. Given the long list of troubling practices at AIG described in this front-page WSJ article, we may well see these two in pinstripes someday.
The topper is the fact that AIG is now getting an additional $37.8 billion loan from the taxpayers, which is lumped on top of the $80 billion load the government provided last month. This came a day after it was revealed that the company held a junket for sales reps at a resort, spending unbelievable amounts of the taxpayer’s money. How exactly does one spend $23,000 on spa treatments or $5,000 at the bar? The story is outrageous and listening to the radio, it’s fair to say that AIG already has become the posterchild of all that is broken in Corporate America. If this doesn’t get you mad, nothing will.
Reflecting on a True Corporate Leader
Kevin LaCroix does a masterful job reviewing the new uncensored – and authorized – biography of Warren Buffett in his “The D&O Diary Blog. In my opinion, Warren is one of the few leaders in Corporate America deserving of the title “leader.” Reading Kevin’s description, you can see that Warren values his reputation more than money. How many CEOs can you say that about?
It’s worth noting that Warren’s annual letter to shareholders is one of the only “straight talk” pieces out there when it comes to disclosure documents for shareholders. I’ve never understood why other CEOs haven’t followed his lead. Just like few have followed his lead in the face of today’s crisis to speak up, take actions to show they are accountable and try to produce calm.
So What Now? Does Board-Centric Oversight Really Work?
Given the events leading up to this crisis (and continuing today, see the AIG story above), there certainly will be a rash of regulatory reforms. It’s clear that there are numerous practices that need fixing and right now, Corporate America doesn’t seem capable of doing it on its own.
Exhibit A is excessive executive compensation. As I often state when debating defenders of today’s pay packages, would you be motivated to work to 100% of your abilities if you made $10 million per year? If the answer is “yes,” what purpose does paying you $20 million serve?
Apologists then trot out the argument that another company may pay you that $20 million – thus, your current employer should pony up. That may well be true in relatively rare circumstances – but the reality is that there are very few CEO superstars that could easily move from one company to another (just like there are few superstars in sports that could command top dollar from another team).
Boards continue the status quo of handing out oversized pay packages because it’s the easy thing to do. Having that hard negotiation with a sitting CEO is tough to do – most directors have day jobs where they face tough situations every day and I imagine that it would be rough to go to a board meeting and continue fighting the good fight. But that is their job and they need to do it – or they need to drop off the board. As I blogged recently, I hear that the few companies that really make responsible changes are the ones where the CEO speaks up and voluntarily asks for the change. Sadly, boards and compensation committees are not the ones driving responsible change.
In the wake of the ongoing crisis, there may well be a push to dramatically alter the board-centric oversight model that exists today. In his most recent column, Jim Kristie of “Directors and Boards” looks at this topic, first noting Marty Lipton’s speech defending the board-centric model from a few months ago, then pointing out that growing evidence of a lack of confidence in the board-centric model today and ending with the thought that “shareholder-centric governance may be one of the ways out of this financial crisis, widely thought to be the worst since the Great Depression.”
Powerful food for thought. Are boards listening – and acting – to stave off this possibility? Like most others, I’m cynical at this point. My guess is that most would rather blame the accounting or short sellers than take responsiblity for their own oversight failures. True leadership is a rare commodity these days.
The Bottom Line: We Need Trust
I believe the reason that the government’s daily solutions to the credit crunch are not working is because the trust within our system has evaporated. It is widely reported that banks refuse to lend to each other. The approval rating of our politicians are at historical lows.
And I wouldn’t be surprised if many of the retail investors now leaving the stock market never return, particularly the older baby boomers who don’t have the time to wait this out. And even though our markets are now dominated by institutional investors, their size often is attributable to participation by the masses. Look for their sizes to shrink as coffee cans are buried in the backyard. Without true leadership – setting the proper tone at the top and taking responsibility – I don’t think this market will turn around. To start down the path to true leadership, CEOs can start by voluntarily reining in their excessive pay packages.
