FAQs on the Role of the Board in M&A

August 14th, 2015 | By
  1. What is the current trend in M&A?

Right now, M&A deal value is at its highest since the global financial crisis began, according to Dealogic. In the first half of 2015, deal value rose to $2.28 trillion—approaching the record-setting first half of 2007, when $2.59 trillion changed hands just before the onset of the financial crisis. Global healthcare deal value reached a record $346.7 billion in early 2015, which includes the highest-ever U.S. health M&A activity. And total global deal value for July 2015 alone was $549.7 billion worldwide, entering record books as the second highest monthly total for value since April 2007. The United States played an important part in this developing story: M&A deal value in the first half of 2015 exceeded the $1 trillion mark for announced U.S. targets, with a total of $1.2 trillion.

  1. What is the board’s role in M&A?

This question can be answered in two words: readiness and oversight. At any given time, directors may need to consider either the sale of their own company or the purchase of another company. The key word here is may: nothing obliges a board to buy or sell if a transaction is not in the best interests of the company and its owners. After all, internal growth and independence usually remain options for a company under ordinary circumstances. Nonetheless, the board must still carefully weigh all opportunities to buy or sell as part of its routine corporate oversight.

Director responsibilities will vary by industry and company, but in general, corporate directors have duties of care and loyalty under state law which also apply in the M&A context.

  • Duty of care. The duty of care requires that directors be informed and exercise appropriate diligence and good faith as they make business decisions and otherwise fulfill their general oversight responsibilities. When reviewing plans to sell a company unit or to buy or merge with another company, the board must exercise proper oversight of management, especially with respect to issues of strategy and compliance with legal obligations such as mandatory disclosures. Pricing is another important consideration, and boards should be wary of claims of synergy. Academic studies offer mixed opinions on the track record for merger returns. Some find positive returns compared to non-acquiring peers (Petrova and Shafer, 2010), especially for frequent acquirers (Cass Business School and Intralinks, 2014). Other studies, for example a recent Fiduciary Group study citing McKinsey, claim a 70% failure rate.
  • Duty of loyalty. The duty of loyalty requires that a director act in the best interests of the corporation, including in the M&A context. Boards can maintain independence from an M&A transaction by appointing a standing committee of the board composed entirely of independent, non-conflicted directors to review the terms of a particular deal with the help of an independent third party, who can render a fairness opinion. (NACD submitted an amicus curiae letter on this issue in May 2015.) For a substantive legal discussion of the board’s role in M&A transactions, see this article by Holly J. Gregory of Sidley Austin, which appeared in Practical Law (May 2014).
  1. Should the board be proactive in M&A, and if so, what are the most important questions directors should ask management about the opportunities and risks that M&A entails?

Even if your board is not currently considering an M&A transaction, it is important to remain aware of M&A as a strategic potential for the company, whether as buyer or seller. Here are some questions to ask, as noted in a recent article by Protiviti:

  • What potential opportunities and risks are involved in growing through acquisition?
  • Does M&A activity align with our current strategy and in what ways?
  • Looking at our portfolio of products and company units, are there any we might consider selling at this time? Why or why not?
  • Do we know the current market value of our company and its various units (if these are separable)?
  1. What impact will a merger have on the boards of the combining companies, and how can boards weather the change?

M&A typically leads to a change in board composition, with the board of the acquired company (often referred to as the target board) usually being absorbed into the acquiring board. According to a study by Kevin W. McLaughlin and Chinmoy Ghosh of the University of Connecticut, among the mergers of Fortune 500 companies, most directors on the acquiring board (83%) stay on, while only about one-third of directors from the target board (34% of the inside directors and 29% of the outside directors) continue to serve after the merger. The study also shows that for acquiring company boards, outside directors who sit on more than one other outside board have a higher chance of remaining members. For both acquirers and targets, outside directors with CEO experience are more likely to keep their seats.

In the September–October 2014 issue of NACD Directorship, Johanne Bouchard and Ken Smith consider these findings and offer “Advice for Effective Board Mergers.” Their article outlines what boards can do to prepare for their own mergers. “Whether the board composition changes as a result of the merger or acquisition,” they note, “the board will benefit from holding a special session (or sometimes multiple sessions) to regroup and align before going into the first official board meeting.” At that first meeting they can get to know each other and the leadership team, check strategy, transfer knowledge, establish the role of the board chair, and “begin to function as an effective board.”

  1. If the board is approached by management or a third party with a proposal to buy another company, what issues and questions should directors raise?

The extent of the board’s involvement in a proposed transaction will vary depending on the size of the acquisition and the risks it may pose. If a very large company regularly buys smaller companies in its industry and has already developed a process for finding, acquiring, and integrating these firms, boards need not focus on the details of any particular transaction. They can and should, however, periodically review the entire merger process, from strategy to integration, in the context of strategic opportunities, attendant risks, and operational implications, to make sure that the process is sound and functional.

The board’s primary role is to perform a reality check on management’s plans. A common claim in proposed mergers is that the whole will be greater than the sum of its parts—what Mark Sirower of Deloitte calls “the synergy trap” in his classic book of that name. But the challenges of integration can often result in a loss of value, an issue that is explored in noteworthy articles from McKinsey and Protiviti. Drawing on these articles as well as the thoughtful questions raised in the Report of the NACD Blue Ribbon Commission on Strategy Development, we have compiled a few queries the board may wish to put to managers and advisors.

  • Strategic considerations: Why are we considering this deal? If there are synergies, what hard evidence indicates that they will materialize?
  • Tactical considerations: What processes are now in place to create a pipeline of potential acquisitions, close deals, and execute the post-M&A integration?
  • Risk: What is the company’s current risk profile, and how does it correspond to the company’s risk appetite?
  • Capital and cost implications: Does our company have the cash on hand, projected cash flow, and/or available credit to commit to this transaction?
  • Operations: What changes will need to be made to the current operating structure and logistics following the merger? Will the supply chain be affected?
  • Talent: As we blend the human resources from the two companies, will we have the right talent to make this merger a success?
  • Technology: Is the company’s technology infrastructure capable of supporting the planned merger? How will the acquired company’s technology be treated post-merger?
  • Culture: Will the merger involve a blending of two different cultures? Do we foresee conflicts? If so, what are our plans for resolving them? Will there be a new postmerger culture? How can we ensure that all retained employees thrive in the new environment?
  • Monitoring Progress: What are the dashboard components for this deal? What elements will management monitor and how frequently? What dashboard metrics will the board use to measure the transaction’s overall success?
  1. If the board is approached by management or a third party to sell the company or a company unit, what issues and questions should directors raise?

While many constituencies will have a stake in any proposed company sale (including notably employees), shareholders’ main focus will be price. The two critical legal considerations in this regard are the Revlon doctrine (for public companies) and fraudulent conveyance (for asset-based transactions, usually relating to private companies).

  • Revlon doctrine. In the landmark case of Revlon Inc. vs. MacAndrews & Forbes Holdings (1986), the court described the role of the board of directors as that of a price-oriented “neutral auctioneer” once a decision has been made to sell the company. This Revlon “doctrine” or “standard” is alive and well even today. It was cited in the In re: Family Dollar Stores decision of December 2014, in which the court denied a stockholder action claiming that the Family Dollar Stores board had violated its Revlon duty by merging with Dollar Tree Inc. and by failing to consider a bid from Dollar General Corp. According to recent commentary by Francis G.X. Pileggi, a regular columnist for NACD Directorship, this case showed an “enhanced scrutiny standard of review for breach of fiduciary duty claims under the Revlon standard.”
  • Fraudulent conveyance. All company directors, whether of public or private companies, have a duty to make sure that the company being sold is represented accurately to the buyer. Otherwise they can be sued for approving a “fraudulent conveyance,” especially in an asset sale. Fraudulent conveyance lawsuits became very common during the leveraged buyout era of the 1980s, when acquirers that overpaid for assets using borrowed funds failed to generate returns and tried to recoup losses. This longstanding legal concept, like the Revlon doctrine, is still in current use and was recently cited in relation to the LyondellBasell merger, according to the law firm of Kurtzman Carson Consultants LLC.

In light of these concerns, questions to ask before approving the sale of a company or a division might include the following:

  • Are we certain that the sale is our best option? Have we assessed alternatives?
  • Under state law and/or our bylaws, do shareholders need to approve this sale?
  • Have we received a valid fairness opinion on the price?
  • Does this sale conform with the Revlon doctrine?
  • If this is an asset sale, are we sure that the assets have been properly appraised?

By asking the kinds of questions discussed in this brief commentary, boards can improve the chances that any M&A transaction, if pursued, will create optimal value for all participants.

Additional NACD Resources

NACD BoardVision – Mergers and Acquisitions

Litmus Test for M&A: Part 5

NACD BoardVision – M&A Information Security

In-Boardroom Development Program: Role of the Board in Mergers & Acquisitions

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Forum Covers Managing Risk ‘Before It Manages You’

August 12th, 2015 | By

While the Internet initially was a communication tool between the U.S. Department of Defense and multiple academic organizations, it has become the backbone of a global economy and government operations, the Hon. Tom Ridge told a rapt audience of more than 200 directors at the NACD Strategy & Risk Forum in San Diego. The first secretary of the U.S. Department of Homeland Security, Ridge currently serves as president and CEO of the strategic consulting firm Ridge Global and is a director for the Hershey Co. Ridge delivered the opening keynote to directors convened for the two-day forum co-hosted by the National Association of Corporate Directors (NACD) and its sponsors.

“We’ve come a long way from a simple communication tool,” Ridge said. “What’s really remarkable is the tool is designed to be an open platform.… It wasn’t designed to be secure. It wasn’t designed to be global. The ubiquity of the Internet is its strength, and the ubiquity of the Internet is its weakness. For every promise of connectivity, there’s a potential vulnerability.”

A report released last year by McKinsey & Co. and the World Economic Forum found that more than half of all respondents surveyed—and 70 percent of executives from financial institutions—view cybersecurity as a strategic risk to their companies. The report was based on interviews with more than 200 chief information officers, chief information security officers, law enforcement officials, and other practitioners in the United States and around the world.

“In this world, you’ve got to manage the risk before it manages you,” Ridge advised the audience.

Support for the forum was provided by BDO USA, the Center for Audit Quality, Dechert, Dentons, ­Diligent, Heidrick & Struggles, KPMG’s Audit Committee Institute, Latham & Watkins, Pearl Meyer & Partners, Rapid7, and Vinson & Elkins.

The Chattering Class

Risks to reputation are nuanced and numerous. Jonathan Blum, senior vice president and chief public affairs and global nutrition officer for Yum! Brands Inc., which operates 41,000 KFC, Pizza Hut, and Taco Bell restaurants worldwide, has seen firsthand the damage that can be done to a company’s reputation. He recounted an incident that hit the brand’s reputation and bottom line, and ultimately spurred substantial changes in the company’s supply chain.

In December 2012, a state-owned television network in China reported that some local poultry suppliers were putting unlawful amounts of antibiotics in chicken. One of the many suppliers investigated happened to be one of KFC’s suppliers, albeit one of the restaurant chain’s smallest. “But, because we’re the largest brand in China, not just the largest restaurant, we obviously bore the brunt of the publicity,” Blum said.

The most damaging aspect of the negative attention, according to Blum, was not the investigative report that aired on television, but rather the chatter on social media in the wake of the report. The fallout was a tarnished reputation, a sharp downturn in sales, and some decisive action.

“Consumer trust plummeted. Belief in our brand plummeted. Our sales plummeted. We saw a huge drop in our stock,” Blum said. “Now, this was at the end of 2012, so the impact on our financial results that year was negligible. Up until 2013, we had had a 10-year run of at least 10 percent [earnings per share] growth year over year, which is pretty unusual. In 2013, given the ditch we were in in China, our earnings per share dropped 9 percent. We lost $270 million in profit as a result of this incident, and it took about a year to rebound.” In the aftermath of the negative publicity, Yum! Brands learned that its stakeholders wanted answers to three questions:

  1. What happened?
  2. What was being done about it?
  3. How would the company would prevent it from happening again?

Yum! Brands apologized to the public, fired about 1,000 small poultry suppliers, and worked with the Chinese government to upgrade the quality of the poultry supply.

“Over time, that rebuilt consumer trust,” Blum said.

The company also took a significant step toward managing its reputation on social media.  “As a result of this incident, around the globe, 24/7, we monitor what consumers are saying about us and we immediately respond,” Blum said.

More information on managing reputation risk is available in the publication Board Oversight of Reputation Risk, part of the Director Dialogue series by NACD and global consulting firm Protiviti.

Additional coverage of the forum is available in the July/August 2015 issue of NACD Directorship magazine.

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FAQs on the New SEC Pay-Ratio Rule

August 7th, 2015 | By

On August 5, 2015, the Securities and Exchange Commission released its final pay-ratio rule under the Dodd–Frank Wall Street Reform and Consumer Protection Act (hereafter Dodd–Frank). The announcement comes more than five years after Congress passed Dodd–Frank in July 2010 and nearly two years after the SEC first proposed the pay-ratio rule in September 2013. The release describing the new rule is a 294-page document that will be analyzed and applied in the weeks and months to come. Meanwhile, here are some basic FAQs to help boards and compensation committees understand the implications of this much-anticipated development.

  1. What disclosure will the new rule require?

While the release explaining it demands further study, the new rule can be summarized as follows:

  • Companies will be required to disclose the ratio of the median pay of all employees, excluding the “principal executive officer” (in most cases, the CEO), to the total pay of that principal executive officer for the most recently completed fiscal year, as disclosed in that year’s summary compensation table. The calculation for median employee pay can be made for any time during the last three months of the year.

The final rule defines employees as “any U.S. and non-U.S. full-time, part-time, seasonal, or temporary worker (including officers other than the [CEO]) employed by the registrant or any of its subsidiaries as of the last day of the registrant’s last completed fiscal year” (p. 216). Like the proposed rule, the final rule allows statistical sampling and estimates as long as these are “reasonable” (p. 14). Although the word reasonable appears at least 100 times in the release announcing the rule, it is not defined because the SEC believes that “companies would be in the best position to determine what is reasonable in light of their own employee population and access to compensation data.”[1]The ratio would have to appear in any filing that requires executive compensation disclosure, including 10-K annual reports, registration statements, and proxy statements. The SEC final rule specifically mentions the compensation discussion and analysis (CD&A) and the summary compensation table. “In this manner, the pay ratio information will be presented in the same context as other information that shareholders can use in making their voting decisions on executive compensation” (p. 39).

  1. When will the new rule go into effect?

Companies must begin reporting the new data in the first fiscal year beginning on or after January 1, 2017. The pay ratio will appear in the 2018 proxy statement disclosing compensation for 2017. After that, companies will be required to update the disclosure at least once every three years.

  1. To whom will the new rule apply?

The new rule will apply to all U.S. public companies but exempts smaller reporting companies (defined as having a public float of less than $75 million) and emerging growth companies (defined as a having total annual gross revenues of less than $1 billion during their most recently completed fiscal year). It also exempts foreign companies (including Canadian companies listing in the United States) and investment companies (mutual funds). The rule also contains an exemption for U.S.-based global companies that cannot access the median pay data due to foreign data-privacy laws. New public companies would not need to comply with the new rule until their first annual report and proxy statement after they register with the SEC.

  1. What aspects of the rule are likely to raise concerns in boardrooms?

In a comment letter filed on December 1, 2013, NACD expressed concerns that the rule defined the term employees too broadly. We encouraged the SEC to increase the flexibility of the pay-ratio rule by permitting the use of industry averages, by defining employees as full-time U.S. employees, and by permitting supplemental notes to correct any distortions caused by the use of “total pay” figures. The SEC’s final rule does not specifically authorize the use of industry averages, although it appears to permit their use to supplement company-based data. Nor does the final rule exclude part-time workers or foreign workers, allowing an exclusion of only up to 5 percent of a non-U.S. workforce.

In combination, these factors in the final rule may cause the ratio of median employee to CEO pay to appear relatively small in industries that employ part-time or non-U.S. workers. Over time an industry pattern may emerge, but initially there could be a hit to reputation. Boards can start now in preparing for potential impact on company reputation and employee morale.

  1. What do boards and committees need to do in the short term?

First, board members should become familiar with the requirements of the new rule, with help from their compensation committees and their compensation advisor. Then they will be in a position to ask informed questions. Compensation committees can begin by asking their chief human resources officer (CHRO) and chief financial officer (CFO) the following questions:

  • Do we have the information available to calculate the two numbers required for the ratio so that the board can begin its analysis? What technical and definitional issues, if any, may arise in this calculation, and what support might you need to resolve those issues? What is your rough estimate of the cost of calculation (e.g., staff time, data systems requirements, and/or third-party analysis)?
  • Will you work with an external compensation firm or other external consultant (such as a payroll expert) to determine the ratio?
  • Can the external advisor estimate the ratios of peer companies on the basis of publicly available data? What are the pros and cons of having the company’s consultant collaborate with the board’s compensation advisor in calculating such estimates?

Similarly, they might consider asking the following two questions of the independent firm that advises the board on CEO and senior management pay:

  • What information, if any, is currently available on estimated ratios of employee/
    CEO pay for our industry peers so we know where we stand?
  • If you will be working with the company’s external advisor in collecting relevant data and/or preparing estimated ratio information (if one is retained by CHRO/
    CFO), would such activity be perceived as compromising your independence under current SEC rules? If so, how can we proactively counteract such a perception?

Having gained insights from these initial questions, directors might want to consider the following:

  • How comprehensive and compelling are our current published disclosures about our pay philosophy? Have we clearly communicated the link between our strategy, pay plan design, and pay outcomes?
  • Does our pay philosophy include employee pay beyond the executive level? Are there opportunities to address this issue in a more detailed way? For example, does our published pay philosophy specifically discuss the issue of pay distribution patterns and/or “fairness”? If not, is this something we might consider addressing?[2]
  • What information, if any, have we received from surveys regarding employee satisfaction with compensation levels?
  • What feedback, if any, have we received from our major shareholders about our compensation plan and our pay-for-performance track record? If we have heard concerns, what have we done to resolve them?
  • If the early estimated ratio for total pay appears out of proportion to any available estimates for our peers and/or industry, how should we interpret this discrepancy? What would this tell us about the structure of our reward system?
  • What would be the impact of early voluntary disclosure?
  1. What implications might this new rule have for D&O liability?

Any new disclosure rule immediately triggers potential director liability, absent a safe harbor provision. Although shareholder lawsuits against companies are often triggered by weak stock prices, the putative grounds for lawsuits are usually based on alleged disclosure violations, particularly in changes-of-control.[3] For more on D&O litigation, see the May–June 2015 issue of NACD Directorship.

  1. Is the new rule likely to be challenged?

It is possible that trade groups such as the U.S. Chamber of Commerce may try to get the rule vacated by a federal court. In a statement released via e-mail on August 5, David Hirschmann, president of the Chamber’s Center for Capital Markets Competitiveness, stated,We will continue to review the rule and explore our options for how best to clean up the mess it has created.” In the past this type of cleanup has meant legal action. In July 2011, the Chamber joined the Business Roundtable to successfully vacate a proxy access rule under Dodd–Frank that would have mandated a particular form of shareholder access to director nominations via the proxy ballot. Similarly, in April 2014, the National Association of Manufacturers and others succeeded in getting a court to declare an aspect of the conflict minerals rule under Dodd–Frank to be a violation of free speech.

  1. What long-term impact might the new rule have on human capital at corporations?

Compliance with the new rule is important, but the core issue for companies remains the same: developing a pay structure, at all levels of the organization, that is aligned with the firm’s strategy and aimed at long-term value creation. Sustained corporate performance is based in large part on human talent, and compensation is one of the key factors in motivating employees. Furthermore, payroll and benefits represent a significant percentage of capital allocation at many companies. For these reasons, among others, many boards will likely take a greater interest in pay at lower levels, and they will want independent verification of a wider band of pay practices. More broadly, a growing number of boards are stepping up their oversight of management’s talent development activities across the organization. For guidance, directors can turn to the Report of the NACD Blue Ribbon Commission on Talent Development.

  1. What resources does NACD have to help compensation committees cope with this and other current compensation matters?

The following NACD resources may be helpful:

NACD will continue to monitor the pay-ratio disclosure issue and other Dodd–Frank compliance matters as they evolve, providing further guidance and perspective on these and related matters.


[1] “Consistent with the proposal, the final rule does not specify any required methodology for registrants to use in identifying the median employee. Instead, the final rule permits registrants the flexibility to choose a method to identify the median employee based on their own facts and circumstances“ (p. 113). “The proposed rule did not prescribe specific estimation techniques or confidence levels for identifying the median employee because we believed that companies would be in the best position to determine what is reasonable in light of their own employee population and access to compensation data” (p. 98).

[2] Note: “Fairness” was one of the five principles of pay recommended by NACD in the Report of the NACD Blue Ribbon Commission on Executive Compensation (2003), and was also cited in the more recent Report of the NACD Blue Ribbon Commission on the Compensation Committee (2015).

[3] Josh Bradford, D&O Claims Trends: Q2 2015, Advisen Ltd., July 2015.

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