We previously blogged about the Chancery Court’s decision in Kellner v. AIM Immunotech, (Del. Ch.; 12/23), in which Vice Chancellor Will invalidated certain amendments to a company’s advance notice bylaw adopted during a proxy contest, but ultimately concluded that the board acted reasonably in rejecting the investors’ notice of nominations for noncompliance with the advance notice bylaw. Last week, the Delaware Supreme Court issued an opinion affirming that decision in part and reversing it in part.
The plaintiffs challenged six bylaw provisions, which are detailed in our earlier blog on the case. The Chancery Court invalidated four of the challenged bylaw provisions but upheld two others. The Supreme Court held that, under the circumstances of this case, all of the bylaws had to go. This excerpt from a recent blog by Prof. Ann Lipton summarizes the Court’s reasoning:
First, the Delaware Supreme Court held (and we should all take note of this for future cases) that advance notice bylaws may be evaluated for invalidity, and separately for inequity. A validity challenge is a facial challenge, and relatively narrow: quoting ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), the Court held “A facially valid bylaw is one that is authorized by the Delaware General Corporation Law (DGCL), consistent with the corporation’s certificate of incorporation, and not otherwise prohibited.” The fact that it might operate inequitably or unlawfully in some circumstances is not sufficient to render the bylaw invalid.
On that analysis, the Court found that one amended AIM bylaw was invalid, because it was unintelligible: “The bylaw, with its thirteen discrete parts, is excessively long, contains vague terms, and imposes virtually endless requirements on a stockholder seeking to nominate directors….An unintelligible bylaw is invalid under ‘any circumstances.’”
The other bylaws, however, were found to be facially valid. But, they still had to be “twice-tested” in equity. And that test is the enhanced scrutiny test, as articulated in Coster v. UIP Companies, 300 A.3d 656 (Del. 2023). First, the board must identify a threat and act in good faith; second, the board’s response must be proportional.
In this case, the Court found that the totality of the amended bylaws – which were exceptionally broad, required information potentially unknown to the nominee, were ambiguous, unreasonable, and ultimately at odds with the board’s stated purpose of information-collection – suggested that the board did not, in fact, act with a proper purpose when amending them. Instead, the purpose was to block the dissident entirely. When it comes to proxy contests, boards may try to inform stockholders, but they can’t substitute their own judgment for the stockholder vote; therefore, all of the bylaws (including the two that Will did not find to be unreasonable) had to be stricken.
I think the Court’s reminder that “when corporate action is challenged, it must be twice-tested – first for legal authorization, and second by equity” is important to keep in mind, and not just for advance notice bylaw challenges. My guess is that the “twice-tested in equity” concept will feature prominently in the parade of case law that’s likely to result from the adoption of new Section 122(18) of the DGCL.
This week, I am taking a walk down memory lane and offering up some of the key lessons that I have learned over the course of my career. Today, I turn our attention to the mid-2000s options backdating fiasco, which I witnessed from my perch as Chief Counsel of the Division of Corporation Finance at the SEC.
For those who did not experience the events first-hand, the options backdating fiasco was a sprawling scandal that affected many public companies at a time when we were just trying to get past the crisis in confidence brought about by the major corporate scandals that I talked about yesterday. The conduct underlying the fiasco was simple enough – executives falsified corporate documents by selecting an option grant date when the stock price was at its lowest, locking in an immediate boost in value and achieving favorable tax outcomes. In addition to straight-up options backdating, there were other nefarious practices prevalent at the time, including “bullet dodging” and “spring loading” by timing option grants relative to the release of material nonpublic information, which remains a topic of great interest to the SEC even to this day.
What was particularly notable about this fiasco was the extraordinary impact on companies and shareholders of this seemingly innocuous act of selecting favorable grant dates. Many companies were forced to restate several years of their financial statements, and those restatements took extended periods of time as the investigations unfolded. Many talented executives from very high profile companies lost their jobs and were implicated personally in SEC actions. I gleaned some valuable lessons for the options backdating fiasco, including:
1. If it Sounds Too Good to Be True, It Probably Is: The fact that so many companies and executives were implicated in options backdating cases demonstrates how a practice can become endemic when no one steps up and says: “Isn’t this too good to be true?” Some healthy skepticism about conduct that did not even seem to pass the smell test might have gone a long way to avoid a situation where a great deal of shareholder value was destroyed and careers were ruined.
2. The Little Things Matter: While board and committee minutes, resolutions and consents are admittedly one of the more boring things that we do, it is critically important that they accurately reflect the proceedings and not be subject to manipulation. Whenever someone wants to “fudge” a date in a resolution, I always think back to the parade of horribles that emerged from the options backdating fiasco.
3. Creativity is Not Always Good: Lawyers and other professionals are always seeking to come up with creative solutions to the problems that clients face, which I think is generally a good thing, but those professionals need to always think about how a proposed “creative” approach to a problem could ultimately be viewed by regulators, criminal authorities, auditors, plaintiffs’ lawyers, academia and the media before advising companies to go down that creative path. In other words, there can sometimes be a fine line between being creative and committing fraud.
4. A Protracted Restatement is a Very Rough Ride: The sheer scope of options backdating issues meant that the internal investigations and restatement efforts at affected companies were very complicated and protracted, meaning that companies were slogging through the restatement process for many months before they could file restated financial statements. This often meant that companies could not hold their annual meeting (because they could not provided the financial information for the annual report that accompanies the proxy statement), could not raise capital in public markets (because they had to shut their registration statements down) and could not even offer equity compensation to employees in some circumstances (because their Form S-8 registration statement was no longer available). These were very difficult waters to navigate, and not any place that a company wants to find itself.
I am grateful to have had the opportunity to share my lessons learned with you this week!
As this Reuters article notes, the SEC suffered a significant setback in its ongoing cybersecurity enforcement efforts when U.S. District Judge Paul Engelmayer dismissed a significant part the SEC’s allegations against SolarWinds in a closely-watched and sprawling case that the SEC has been pursuing for several years. The article notes:
U.S. District Judge Paul Engelmayer in Manhattan dismissed all claims against SolarWinds and chief information security officer Timothy Brown over statements made after the attack, saying the claims were based on “hindsight and speculation.”
In a 107-page decision on Thursday, the judge also dismissed most SEC claims concerning statements predating the attack, apart from securities fraud claims based on a statement on SolarWinds’ website touting the company’s security controls.
The SEC declined to comment on Judge Engelmayer’s decision. There will no doubt be a lot of ink spilled over the coming days analyzing the potential implications of the decision for the SEC’s current Enforcement efforts with respect to cybersecurity disclosure and internal accounting controls, but suffice it to say that this decision pushes back on the some of the agency’s most aggressive enforcement theories in the cybersecurity space.
ESG investing isn’t new, but it is in a new world right now with unprecedented regulatory, financial, macroeconomic and geopolitical dynamics. Both investors and their holdings struggle to keep up with these changes while meeting competing priorities and facing oscillations in strategies.
Nawar Alsaadi, CEO and founder of Kanata Advisors and Marie-Josée Privyk, Founder and ESG Advisor of FinComm Services, will take these matters head-on to help both sides stay focused on what is important rather than running down distractions.
Topics to be covered include:
– Defining “ESG investing” today, especially in relation/contrast to impact investing
– Current investor trends: information needs, decision criteria, engagement v. divestment, use of ESG ratings, impact of naming rules
– Portfolio companies: responding to investors, emphasizing business fundamentals
– Implications of investor dissatisfaction/divestment: does divestment really hurt portfolio companies?
This webcast is presented at no additional cost to members of PracticalESG.com. If you are not already a PracticalESG.com, you can sign up today and take advantage of our no-risk “100-Day Promise” – during the first 100 days as an activated member, you may cancel for any reason and receive a full refund.
This week, I am looking back on almost thirty years of practice and offering up some of the key lessons that I have learned over the course of my career. Today, I am focusing on what I think of as the era of corporate scandals, which was the period of time in the early 2000s when we experienced a large number of corporate scandals that rocked the markets, eroded investor confidence and prompted Congress to act in a bipartisan manner to enact sweeping legislative initiatives that are still very much a part of the fabric of what we do today, nearly a quarter century later. I am of course talking about the spate of high profile financial, disclosure and governance failures at Enron, WorldCom, Tyco, Adelphia, Global Crossing and others. I had the unique experience of seeing these scandals upfront while in private practice, and then dealing with the aftermath when I was back at the SEC for my second tour.
By the early 2000s, I had left the SEC and was in private practice at a firm that seemed to be handling most of the extraordinary corporate scandals of the day. I was incredibly fortunate to have an opportunity to work with a fantastic group of lawyers and other professionals who taught me so much about conducting investigations, addressing intense regulatory and law enforcement attention, managing a crisis and navigating a wide range of incredibly complex regulatory, financial market, governance and ethics issues. With the benefit of that experience and similar experience that I have had since the early 2000s, I offer up a few of my favorite lessons learned:
1. Don’t Violate the First Law of Holes: Those of you who have read my musings here (and in our other publications) have no doubt noticed that I have penchant for using all manner of adages and aphorisms. One of my favorite ones is “the first law of holes,” which goes something along the lines of “when you find yourself in a hole, you should stop digging.” Unfortunately, time and time again, we have observed that corporate executives, directors and employees just can’t seem to avoid violating the first law of holes, and that is how scandals happen. While there are plenty of situations where individuals set out to defraud investors from the outset, there are also plenty of situations where something gets pushed close to the line in one quarter, and then the individuals find themselves digging their hole deeper and deeper in each successive quarter, because they think that they can ultimately dig their way out when circumstances change. This phenomenon really emphasizes the need for effective controls and good governance, so that the individuals are not tempted (or do not feel compelled) to fall into the hole in the first place. And once the potentially illegal conduct has been discovered, it is critical for counsel and other professionals assisting with the crisis to help prevent the company from falling into new holes, or deepening the hole that it already finds itself in. Otherwise, things can go very bad, very quickly, as we saw with those early 2000s corporate scandals.
2. The Cover-up is Worse than the Crime: To borrow a ubiquitous Watergate-era adage, one often observes in the course of a corporate crisis that nothing can be more true than the notion that “the cover-up is worse than the crime.” Efforts to conceal potentially illegal conduct during the course of a crisis always makes things worse for everyone involved, and always puts the board of directors and senior management in a difficult spot with respect to those individuals involved in the conduct. Over the years, I have observed numerous situations where transparency around the subject conduct might have avoided catastrophic consequences, so that is why it critically important that a company’s control environment and governance structure encourages transparency at all levels, even when the going gets tough.
3. It’s All About the Benjamins: I have not run across too many corporate scandal situations where an individual was engaging in the illegal activity purely for the fun of it. There is usually a financial incentive that serves to motivate the unlawful behavior. Since the corporate scandals of the early 2000s, I think that we have collectively gotten much better at structuring compensation programs that seek to address the risk of incentivizing illegal conduct, but no compensation approach is ever perfect, and for each individual involved there are often a variety of motivating factors that have caused them to go astray. I do think that it is incumbent on boards and compensation committee to always consider the risk that financial incentives could encourage bad behavior and take steps to minimize that risk as much as possible under the circumstances.
4. Human, All Too Human: The title of one of my favorite Friedrich Nietzsche books (perhaps because it was written in an aphoristic style?) serves as a reminder that, until artificial intelligence is in a position to replace us in preparing and auditing financial statements and writing SEC disclosure, us humans are going to continue to hack away at it, and we are going to make mistakes. Unfortunately, human nature doesn’t always encourage us to admit our mistakes or exercise good judgment. This is particularly the case when our financial livelihood, professional reputation and self-esteem are on the line. The human element must always be anticipated, and that is why we have such extensive controls in place today in the wake of the Sarbanes-Oxley Act. We should never forget that we are all humans that can (and often do) fail, but we should make sure that no single human’s failure is going to send the company spinning into a corporate scandal.
5. Be Creative When Faced with Calamity: One of the most significant responses to the crisis in market confidence brought about by the early 2000s corporate scandals was when the SEC issued an emergency order under Section 21(a) of the Exchange Act which imposed a one-time certification requirement on CEOs and CFOs of public companies with revenue of $1.2 billion or more. The sworn statements demanded by the order were intended to restore confidence in the financial statements of large public companies and became the model for the certifications later required by the Sarbanes-Oxley Act and SEC rules. There was no precedent for this creative approach taken by the SEC, and it highlighted how important it can be to think “outside of the box” when faced with a crisis situation.
Earlier this week, Nasdaq filed a proposal with the SEC that would modify the suspension and delisting processes for SPACs, representing yet another effort to make life harder for the once high-flying acquisition vehicles. As this Cooley blog notes:
Nasdaq has just filed a proposal, Notice of Filing and Immediate Effectiveness of Proposed Rule Change to Amend Certain Procedures Related to the Suspension and Delisting of Acquisition Companies, designed to address the suspension and delisting process applicable to Acquisition Companies, companies such as SPACs with business plans to complete one or more acquisitions, as described in Rule IM-5101-2. The rule changes would apply to an Acquisition Company that “fails to (i) complete one or more business combinations satisfying the requirements set forth in Listing Rule IM-5101-2(b) (“Business Combination”) within 36 months of the effectiveness of its IPO registration statement; or (ii) meet the requirements for initial listing following the Business Combination.” The proposal would also “limit the Hearings Panels authority to review the Nasdaq Staff’s decision in these instances to a review for factual error only.” Nasdaq also proposes to clarify Listing Rule 5810(c)(1) (with no substantive change) to improve transparency and readability. The rule changes will be operative for Staff Delisting Determination letters issued on or after October 7, 2024.
Nasdaq notes in the filing that the proposal to remove the stay provision so that a SPAC’s securities will be suspended from trading on Nasdaq during the pendency of the Hearings Panel’s review is consistent with the rules of the NYSE.
I was attending the Society for Corporate Governance National Conference this week, and it reminded me of how beneficial it is to network with new contacts and meet with old friends at a good old-fashioned in-person conference. While conference content can be easily streamed through virtual channels, there is really no substitute for getting out there and making that human connection. My experience this week made me even more excited to see all of you in San Francisco on October 14th & 15th at our “2024 Proxy Disclosure & 21st Annual Executive Compensation Conferences.”
In case you missed my sales job earlier this week, the early bird rate for the Conferences expires on Friday, July 26, so you should act now to lock in that rate and secure your spot at the conference. You will not want to miss all that we have planned for you and the great practical guidance that our talented speakers will provide.
As I officially enter my thirtieth year of practicing securities law, I think it is only natural to look back and reflect on some the lessons that I have learned over the years. Also, as we slog through the dog days of summer, new developments in the world of securities law and corporate governance are few and far between, forcing your intrepid blogger to dig deep for content. So today I launch my mini-series of blogs on some of my top lessons learned.
I begin with some of my formative experiences as a newly minted lawyer working in Corp Fin at the SEC, where I had the benefit of some great mentors who literally taught me everything I needed to know about the securities laws, as well as how to practice law in a regulatory environment. The time was the last half of the 1990s, and there was a little something called the Internet that was changing just about everything, and spawning and extraordinary IPO boom as innovative companies seemed to be born every day and shortly thereafter go public. As an examiner reviewing IPO filings in Corp Fin, I found myself on the front lines of an enormous market bubble that spectacularly burst soon after I left the SEC. Reviewing all of those Form S-1 registration statements definitely brought about a few lessons learned:
1. Be Skeptical, But Open-Minded: I distinctly recall sitting in the office looking at all of the Form S-1s that were being filed and being very skeptical (along with my colleagues) of the freshly-minted business that were seeking to go public. When the Form S-1 for Amazon.com was filed, we wondered aloud why anyone would buy books using the Internet when they could go to their local bookstore or Barnes & Noble. When the Form S-1 for eBay was filed, we scoffed that it seemed unlikely people would be excited about buying used Pez dispensers through an Internet-based auction. When the Form S-1 for Yahoo! was filed, we just scratched our heads. While there were certainly both winners and losers in that timeframe, I had a good lesson in being open to the possibility of new business ideas and ways of doing things, while maintaining a healthy degree of skepticism to ask the tough questions and seek the best disclosure for investors so they could make an informed investment decision.
2. Don’t Overdo It: If you can imagine, back in those days of that late 1990s Internet boom it was not uncommon to send an initial comment letter on a Form S-1 that had over 150 comments. In retrospect, that seems like an extreme result, and if I had it to do all over again, I would likely be more circumspect in the comments that I would raise. All of the commenting tended to drag out the process, but I would say that they approach undoubtedly elicited better disclosure and more accurate financial statements. With the benefit of perspective, I am not sure how much incrementally better the disclosure was as compared to the effort of dealing with all of those comments.
3. Communications Matter: There once was a time when Section 5 of the Securities Act was sacrosanct and gun-jumping was an issue that the Staff of Corp Fin was very concerned about, because the whole point of the Securities Act registration provisions is to channel the communications about the offering into a prospectus that includes the material information about the company and the offering, so that investors can make an informed investment decision. As a result, ginning up interest in an IPO through news articles and other extraneous communications is problematic because investors do not get the full picture that way. I got to defend the ramparts of Section 5 with a 1999 offering by a company called Webvan, which no one remembers today but was a once a highly anticipated IPO of a business delivering groceries ordered on the Internet. A Forbes article ran during the IPO that had some wild claims by the CEO, and the Staff came down hard on the gun-jumping violation, forcing a delay of the IPO to facilitate a cooling-off period following the media hype. Of course the IPO went on to be a big success but the company was bankrupt within a few years – a little bit of healthy skepticism might have gone a long way with that one!
4. Stick to the Fundamentals: One of the challenges faced during the 1990s Internet IPO boom was that many of the companies going public had not been in existence for very long and had not generated profits or revenues that would typically be used to determine their value, so they turned to a wide range of alternative measures outside of the financial statements as a means for describing their market opportunity. This trend presented a considerable challenge to the Corp Fin Staff, because there was no real framework in the SEC’s rules for dealing with disclosure about the number of “clicks” or “eyeballs” that a company cited as proof of concept. The experience really emphasized for me that there is really no substitute for the information provided in financial statements and MD&A for getting a true picture of the fundamentals of a company for the purpose of making an investment decision.
5. What Goes Up Must Come Down: We all know how the 1990s Internet boom ended up – with a pretty spectacular bust that resulted in quite a few companies with good ideas going out of business or never realizing their full potential due to a lack of access to capital. In looking back today, it seems to me that the overall frenzy that fueled the bubble was just unnecessary – we would all have been better off if those companies has spent more time in gestation and had not flocked to the public markets before they were ready. Investors ended up losing a lot of money just because the market collectively suspended belief for a few years and was willing to let too many companies go public before it was their time. I think this is definitely a lesson learned that we should keep in mind today
While I mentioned the looming resource extraction issuer disclosure deadline back in the March, I feel compelled to mention it again because we now find ourselves just a couple months away from when affected issuers will be required to file a Form SD to disclose the payments contemplated by the rule. I feel that because the rule has had such a tortured history, it is somehow sneaking up on us now, with the Form SD deadline being 270 days after the end of the resource extraction issuer’s fiscal year. The SEC has had the notion of revisiting the resource extraction issuer disclosure rule on its Reg Flex Agenda for some time, but now all hope is lost that any changes will be made or a delay in the deadline will be adopted before the September 26, 2024 Form SD filing deadline for calendar year end companies.
If your company falls within the definition of a resource extraction issuer and you have not yet started preparing your Form SD, I encourage you to check out our “Resource Extraction” Practice Area.
We have posted the transcript for our recent CompensationStandards.com webcast, “Proxy Season Post-Mortem: The Latest Compensation Disclosures,” during which I was joined by Mark Borges, Principal, Compensia and Editor, CompensationStandards.com and Ron Mueller, Partner, Gibson Dunn & Crutcher, for a discussion focusing on the “lessons learned” that companies can start carrying forward into next proxy season. The webcast covered the following topics:
– The State of Say-on-Pay During the 2024 Proxy Season
– Highlights and Tips from this Year’s CD&As
– Best Practices for Disclosing Incentive Compensation Adjustments and Outcomes
– Trends in Disclosure Regarding Operational and Strategic Metrics
– Pay-versus-Performance: SEC Staff Guidance Issues and Year 2 Enhancements
– Compensation Clawback Policies – Multiple Policies/Potential Disclosure Issues
– Proxy Advisory Firms – Is Their Influence Starting to Wane?
– Perquisites Disclosure and Recent Enforcement Focus
– Shareholder Proposals – Company Strategies; No-Action Trends; Activists and Universal Proxies
– Rule 10b5-1 Plan Disclosure Developments
– Pending SEC Rulemaking
It is always great to be on a webcast with rock stars like Mark and Ron. As I said during the webcast, getting together for this annual webcast always feels like when the Rolling Stones get together for their latest tour! If you do not have access to all of the great resources on CompensationStandards.com, I encourage you to sign up today.
