Year ends with usual ambiguities for corporate world

In the midst of an improving economy, a robust IPO market and a selective M&A landscape, the corporate world in 2014 leaves us with the usual variety of year-end ambiguities …

• CEO pay

One thing I anticipated addressing remains unresolved. Perhaps by the time you read this, the SEC will have disgorged, several years late, its disclosure regulation comparing the salary of public CEOs to the median workforce salary.

This 2010 Dodd-Frank Act requirement was congressional reaction to perceived runaway CEO compensation. Other mandatory disclosures and advisory “Say on Pay” votes had done little to halt higher CEO comp.

The ratio of CEO earnings to the earnings of a worldwide workforce, with workers living in emerging economies, should be irrelevant to investors. Better to leave analysis of excessive CEO earnings to the proxy advisory firms.

No wonder the SEC still has not issued final regulations.

• NASDAQ Private Market

Rule 144 resales of securities are rising along with increasing numbers of securities sold under SEC Rule 506(c) (allowing public offerings of unregistered securities to accredited investors). These shares can create a chaotic secondary market. Further, having too many stockholders might trigger unwanted ’34 Act registration.

Established private companies with shares becoming available for resale now can “list” on the NASDAQ “Private Market,” a bulletin board controlled by each issuer, where buyers and sellers — each represented by a broker/dealer — can effect resales.

To be eligible, a company must have achieved a certain level of funding, value, assets, revenues, income or shareholder equity, or sponsorship by recognized financial investors. No new enterprise will qualify.

But if an issuer maintains modest reporting to inform the secondary market through annual audits, unaudited quarterlies, management bios, and business and capitalization information, then the Private Market provides a rationalized market to facilitate resale of restricted securities.

This system is heavily weighted to protect share price: Periodically, an issuer can declare a “liquidity window” during which shares held by company-identified sellers become available to selected investors. This allows the company to impact share price and also limit the number of stockholders, while permitting orderly resale by early investors and employees.

• Bylaw wars

Last year, the Delaware Chancery Court, in its Boilermakers Local 154 decision, held it was legal to adopt a bylaw requiring that litigation against the corporation or its directors be brought in Delaware, which was the state of incorporation of the defendant.

The impetus was to control growth of M&A-inspired multi-forum litigation, which was perceived as wasteful and not in the best interest of shareholders. Pundits then speculated that public companies might immediately adopt such bylaws.

The fact that one could adopt a forum selection bylaw did not automatically mean that a corporation invoking that bylaw (to quash shareholder litigation) would be supported by the courts. If a lawsuit was brought outside of the mandated jurisdiction, that jurisdiction would decide whether forum choice was recognized.

There was even discussion as to whether selecting Delaware as a forum was wise; perhaps a corporation with clout in its state of its principal operations might fare better in that jurisdiction.

Finally, the Delaware decision by definition applies only to Delaware entities. Statutory language must be reviewed on a state by state basis.

After the Delaware Supreme Court upheld Boilermakers last May, exclusive forum bylaws have been gaining traction. They can be established by boards without stockholder approval and, where stockholder approval has been sought, generally such approval has been granted.

The literature suggests that companies fearing activist shareholders or a friendly (or unwelcome) acquisition are attracted to the exclusive forum bylaw. In Delaware (as reported in Deal Lawyers), about 75 percent of corporations going public have adopted such provisions. And in California, Illinois and New York, exclusive forum bylaws have been honored through dismissal of claims brought outside the specified forum.

Institutional Shareholders Services, proxy consultants, recently released 2015 guidelines. ISS continues to analyze exclusive venue proposals on a case by case basis. Factors include: Has the company been materially harmed by shareholder litigation; and has the company followed other good governance practices.

For 2015, ISS has expanded its analysis to cover other types of bylaws “which have a material impact on shareholders’ litigation rights,” such as bylaws that mandate fee-shifting or arbitration.

ISS will generally advise voting against directors who pass bylaws mandating fee-shifting whenever plaintiffs are not completely successful on the merits. ISS fears that “a large number of companies are now expected to adopt such by-laws,” either through board action or by putting such revisions to a shareholder vote, and further fears provisions mandating arbitration instead of litigation, or which would “require a plaintiff to demonstrate that his or her case is supported by a significant number of shareholders.”

• Fixing the unfixable

Practitioners faced with older corporations, or acquirors looking at targets, sometimes are dismayed to find that shares were issued in excess of the number authorized, in violation of charters.

In most jurisdictions, the practical fix has been to take affidavits from everyone with historical information, amend the charter to provide the requisite number of authorized shares, and take a director and stockholder vote declaring all shares on an annexed list as duly issued.

In Delaware, this logical approach long has been understood to be unavailable. Over-issued shares are void and consequently cannot be ratified.

The only choice was to issue new shares and to ratify all corporate actions based on votes of the voided shares (this might include naming the board, which in turn named the officers, which in turn meant that every vote or contract in the last 25 years had to be ratified).

In 2004, the Delaware General Corporation Law was amended to permit a retroactively effective fix, provided the board of directors (and shareholders, if required) adopted a resolution authorizing the issuance of the stock as of its original issuance date.

A “certificate of validation” also must be filed with the Secretary of State’s Office.

What if a corporation were to “stonewall” the fix, intending to freeze out parties who received “void” shares? A new section allows a petition to Chancery in such circumstances.

• Materiality scrapes

This year there was much discussion of materiality scrapes in private M&A transactions.

A materiality scrape eliminates the requirement that any misrepresentation must be “material” when calculating whether aggregate misrepresentations exceeded the “trigger amount” (invoking indemnification from seller to buyer), and whether the amount of indemnified loss includes all damages even if individual damages were not themselves material.

Sellers resist materiality scrapes on the theory that making exact representations requires undo expense to obtain perfect disclosure. Further, the “scrape” arguably eliminates the benefit of the MAE (Material Adverse Effect) qualifiers that protect the seller from liability, if any given misrepresentation is immaterial.

Every business, sellers claim, has inherent risks; buyers should not be able to nickel and dime.

There are a variety of solutions: Use the scrape to calculate losses but not to determine whether the indemnity trigger was reached; increase the size of the indemnity basket; make the indemnity basket a deductible; sort representations between those that are scraped and those that are not; and use specific dollar amounts rather than the general standard of “materiality.”

According to the ABA, in 2012 only 28 percent of private M&A deals over $17 million contained some materiality scrape. Other studies have suggested greater frequency. The trend is that materiality scrape provisions are on the rise.

Query whether the pressure from buyers to include materiality scrapes is driven by higher M&A multiples, making buyers more wary since they are paying “top dollar.”

• Attorney-client privilege in M&A

Who owns the attorney-client privilege in an acquisition?

Last year’s Great Hill Equity case in the Delaware Chancery held that, when a merger agreement is silent, 100 percent of the rights possessed by the target passes to the survivor, including rights to assert attorney-client privilege.

That means that the buyer gets to see, and bring suit based on, privileged disclosures the seller gave to counsel. The issue would not arise in asset deals; a list of transferred assets typically would not include the seller’s attorney-client privilege.

Specific language negating transfer of the attorney-client privilege to the surviving merger partner should become standard in well-drafted merger M&As. That may solve the technical problem, but leaves the problem of actual access by the survivor to the seller’s privileged materials, regardless of contract terms. How many sellers are assiduous in removing physical files that are privileged? Further, as anyone familiar with electronic litigation discovery is aware, purging a computer system is easier said than done.

While agreement drafting can assert that no accidental physical or electronic transfer of privileged information to the acquiror constitutes waiver of the seller’s attorney-client privilege, the embarrassment (or worse) to target management, who often end up working for the acquiror, remains significant.

There also is a choice of law issue. Not everything is controlled by Delaware law, so the law in deal-appropriate jurisdictions must be consulted.

At the end of each year, some issues in corporate law get resolved, but others are fuzzed up even further. As ever, there is no substitute for remaining current.