In April 2017, the U.S. Securities and Exchange Commission’s (SEC’s) Division of Corporate Finance announced it will not recommend enforcement action for companies that disclose, but do not further investigate usage of conflict minerals which may be from the Democratic Republic of Congo (DRC). Any company manufacturing or contracting to manufacture products using such minerals had previously been required to conduct extensive due diligence on its supply chain and make this diligence publicly known with a note that its products contained minerals which “have not been found to be ‘DRC conflict free.’” However, following a series of partial losses in court, the SEC appears to be backing off the rule—for now.
The Conflict Minerals Rule and Disclosure Requirements
A provision in the Dodd-Frank Act aims to cut off funding sources for armed rebel groups in the DRC and surrounding countries in central Africa. It requires companies manufacturing products containing certain minerals to conduct supply chain audits and disclose if those minerals were known to have originated in the DRC or adjoining countries. The SEC, as the enforcer of this provision, issued a rule requiring issuers of securities who filed reports with the SEC under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 and who manufactured or contracted to manufacture a product in which the defined conflict minerals were a necessary part, to file a separate special disclosure form, Form SD. Although these obligations were placed on manufacturing issuers, in practice, the diligence requirement was imposed on others in the supply chain because many manufacturers required their supply chain partners to certify origin of minerals and compliance with the rule.
When Form SD was first issued, items 101(a) and (b) required companies using conflict minerals to attempt to identify the country of origin of those minerals. If after conducting a “reasonable country of origin inquiry” the company determined that the country of origin was neither the DRC nor an adjacent country, it had to disclose this finding (and a description of the country of origin inquiry conducted) on its website as well as to the SEC. Per item 101(c) of Form SD, if a company’s minerals may have originated in either the DRC or its neighboring countries, the company was required to conduct additional, more extensive due diligence, and then file and publish a conflict minerals report. This report had to include a description of the company’s due diligence efforts, certified results of an independent private audit, and a list of planned changes as a result of the audit. In the report and on its website, companies also had to describe which products had “not been found to be ‘DRC conflict free,’” although for the first two years of enforcement they could use the label “DRC conflict undeterminable.”
The National Association for Manufacturers challenged these regulations on both procedural and constitutional grounds. After the district court granted the SEC summary judgment, the Association appealed to the DC Circuit of Appeals. Ultimately, the appeals court found that forcing companies to note whether or not their products are DRC conflict free was unconstitutional under the First Amendment. The case was remanded to the U.S. District Court for the District of Columbia, which issued its final judgment in April 2017 and set aside the part of the rule that requires companies to add language that their products are “DRC conflict free” or “have not been found to be ‘DRC conflict free.’” Citing both the court decision and the unclear efficacy of the rule, SEC Chair Michael Piwowar reopened comments and the SEC stayed the compliance portions of the rule pending the conclusion of litigation. The SEC announced it would not pursue enforcement actions against companies who only complete Form SD items 101(a) and (b) and do not pursue more extensive diligence on sourcing or secure an independent audit. The SEC has taken the view that the purpose of item 101(c) of Form SD and the related conflict minerals reports was to determine the status of conflict minerals by requiring the “conflict free” or “not conflict free” labels, and that these measures and the requirements for more detailed due diligence are in need of re-evaluation and clarification given recent court rulings on this matter.
Although companies are not currently expected to conduct the extensive due diligence envisioned by item 101(c) of Form SD, they are still expected to conduct in good faith a reasonable country of origin inquiry and disclose this information to the SEC and the public. Companies and boards still need to ensure there are effective diligence programs in place that allow reasonable inquiry into supply chain partners and components, particularly if conflict minerals are necessary to any product the company manufactures. By statute, the SEC is required to issue a rule relating to due diligence for conflict minerals. Although the “conflict free” labeling requirement has been eliminated, the question remains whether conflict minerals reports, in their current form, are otherwise valid. The SEC is currently developing its future enforcement recommendations with respect to the rule.
In the interim, companies should continue to ensure effective supply chain diligence mechanisms are in place that allow them to confirm where components, particularly conflict minerals, are sourced. To the extent that auditing or diligence measures had already been put into place prior to the final judgment and SEC announcement, companies may want to continue to implement these measures given the lingering uncertainty about future application of the rule. Companies also have the ability to submit comments on the rule to the SEC and should make their views known to influence future enforcement on this issue.
At Baker & McKenzie, Joan Meyer is a partner and chairs the North America Compliance, Investigations & Government Enforcement Practice Group. Reagan Demas is a partner and Maria McMahon is a professional support lawyer in the North America Compliance, Investigations & Government Enforcement Practice Group in Washington, DC.
To learn more about strategy and risk, attend the 2017 Global Board Leaders’ Summit where you will have the opportunity to explore emerging risk issues with peers. A detailed agenda of NACD and Marsh & McLennan’s Board Committee Forum on strategy and risk, can be found here.
Investors now see corporate governance as a hallmark of the board’s effectiveness and one of the best sources of insight into the way companies operate. In response to this trend, Farient Advisors LLC, in partnership with the Global Governance and Executive Compensation Group, produced the report 2017—Global Trends in Corporate Governance, an analysis of corporate governance practices in the areas of executive compensation, board structure and composition, and shareholder rights covering 17 countries across six continents.
NACD, Farient Advisors LLC, and Katten Muchin Rosenman LLP cohosted a meeting of the NACD Compensation Committee Chair Advisory Council on April 4, 2017, during which Fortune 500 compensation committee chairs discussed the report’s findings in the context of the current proxy season. The discussion was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.
Global Governance Trends
2017—Global Trends in Corporate Governance finds that governance standards around the world have strengthened in response to financial crises and breakdowns in corporate ethics and compliance. Those crises and breakdowns have led to greater pressure from governments and investors, who are demanding economic stability and safe capital markets. In regard to executive compensation, the report notes a number of global governance trends:
Source: Farient Advisors, 2017—Global Trends in Corporate Governance, p. 18.
Most of the 17 countries surveyed (94%) require executive compensation disclosure, although the disclosures made and the quality of these disclosures varies from country to country. Surveyed countries that had the least developed disclosures are South Africa, China, Brazil, and Mexico.
Say-on-pay voting is mandatory in most developed countries, although there is variance on whether the votes are binding or not. For developed countries where the vote is voluntary (e.g., Canada, Belgium, Germany, and Ireland), it still remains a leading practice.
Common leading practices are to use competitive benchmarks, such as peer groups to establish rationales for pay, and to provide investors with information on components of pay packages and performance goals.
2017 Proxy Season Developments
Meeting participants shared a number of observations and practices from the current proxy season:
Continuous improvement on disclosures Council participants indicated they are sharing more information with shareholders, in a more consumable way. “We want to be in the front ranks as far as providing information to shareholders,” said one director. “Instead of asking ‘why should we share that?’ we’re starting to ask ‘why not?’” Another director added, “Over the last few years we’ve moved from a very dense legalistic document to something that’s much more readable. Our board set up a process to do a deep-dive review every two years; this fall is our next review. It’s a way to ensure our disclosures keep pace with current practices and also reflect where we are as a company and board.”
Council members also discussed the status of Dodd-Frank rulemaking, given the new presidential administration and SEC commission. S. Ward Atterbury, partner at Katten Muchin Rosenmann LLP, said, “While it’s unclear exactly what the SEC will do with Dodd-Frank requirements in the future, investors have spoken on some of the issues, especially on things like say on pay and pay for performance. There may be less formal regulation, but the expectations on companies and boards are still there [to provide pay-for-performance disclosure].”
Growing interest in board processes According to one director, “We’re hearing more interest about CEO succession as it relates to strategy. Investors are asking us to describe our process—they understand we can’t discuss specifics.”
Director Pay Dayna Harris, partner at Farient Advisors LLC, discussed the increased focus on director pay: “Given the recent law suits regarding excessive director compensation and an increase in director pay proposals in 2016, Institutional Shareholder Services (ISS) created a new framework for shareholder ratification of director pay programs and equity plans.” ISS’ framework evaluates director pay programs based on stock ownership guidelines and holding requirements, equity vesting, mix of cash and equity, meaningful limits on director pay, and quality of director pay disclosure. ISS’ updated factors for evaluating director equity plans include relative pay magnitude and meaningful pay limits.
Environmental, social, and governance (ESG) issues Meeting participants agreed that social issues, such as ESG and gender pay equity, are increasing in popularity among investors. In particular, nonbinding shareholder proposals on climate change received majority support this year at Exxon Mobil Corp., Occidental Petroleum Corp., and PPL Corp.
Refining approaches to outreach and engagement with investors Meeting participants discussed leading practices for engaging shareholders. Some directors indicated that investors have turned down their offers to speak on a regular basis because of time constraints. One delegate emphasized that just making the offer to meet with shareholders is appreciated, even if that offer is turned down. One director said, “We invited one of our major long-term shareholders to speak at one of our off-site [meetings] as part of a board-education session. It was a different type of engagement and very valuable.”
Law firms that specialize in suing directors will scrutinize nearly every major transaction, public offering, stock drop, restatement, and press release filed by public companies. For instance, according to Cornerstone Research, stockholders file lawsuits challenging the majority of public company transactions valued at more than $100 million, with an average of three lawsuits per transaction. An effective defense of these almost-inevitable lawsuits can begin long before they are filed. With a few simple steps, directors can reduce the burden of these lawsuits and protect themselves from the most common tactics utilized by stockholders’ attorneys.
1. Vet conflicts early and often. Perhaps the easiest way to avoid fiduciary duty liability is to avoid situations where you have conflicting interests in a transaction or other board decision. Due to various protections under Delaware law, directors are rarely held liable for poor or ill-informed decisions if the directors are not self-interested (unless they are grossly negligent), and articles of incorporation almost universally protect directors from monetary damages for such decisions. By contrast, Delaware fiduciary duty law imposes exacting standards for directors who participate in board decisions when they have a material self-interest in that decision. Thus, any major board initiative should begin with a full analysis of each director’s potential self-interests, and this analysis should be updated throughout the initiative. Of course, this analysis requires you to stay organized with your outside business interests (e.g., your employer’s customers, suppliers, and competitors) and personal financial situation (e.g., ownership interests). Recusing yourself can be the stitch in time that saves nine.
2. Treat all board communications formally. The documents that often cause the most trouble in litigation are informal e-mails between two directors. Even if e-mails contain nothing objectively negative regarding the board decision at issue, such e-mails can raise questions about the board’s deliberative process, especially if the issue raised in an e-mail was not discussed with the full board. A skilled plaintiff’s counsel can often interpret a casually written message in an unintended manner. In most instances, if a director raises any concern outside of a board meeting, the full board should resolve that concern and memorialize the process in a contemporaneous document (e.g., the minutes). If you have said anything in an e-mail that is inconsistent with your ultimate vote on an issue—even if you were just playing “devil’s advocate”—you should be prepared to square your communications with your vote. In other words, make sure your concerns are resolved through the deliberative process before making your decision.
3. Maximize efficiency in pressing circumstances. Perhaps underestimating how quickly and diligently directors and their advisors can work in exigent circumstances, plaintiffs’ attorneys often allege that board decisions were too rushed. For instance, in one of the more infamous Delaware fiduciary duty decisions, a financial advisor did not send any valuation materials to a board of directors until 9:42 p.m. on the night that the directors met to vote on a merger. The board met at 11 p.m. and approved the merger that night. Tight deadlines are often unavoidable, but directors can take steps to maximize the efficiency of the process. For instance, request early drafts of meeting materials, make your advisors work around-the-clock when necessary, and don’t wait until the board meeting to ask questions. At the end of the day, you need to be able to honestly state that you had enough time to fully consider any issues or concerns and come to a reasoned decision. Use your resources efficiently to get to that point.
4. Make your advisors an asset, not a liability. The quality and independence of a board’s advisors is a direct reflection on the quality and independence of the board’s process. This scrutiny begins when a board (or committee) selects its outside advisors. Stockholders may cry foul if directors simply accept management’s recommended advisor, especially if any member of management may have a self-interest in the relevant transaction.
To avoid these common allegations, interview multiple advisory firms, thoroughly inspect their potential conflicts, and negotiate for a fee structure that aligns the advisor’s incentivizes with the best interests of the stockholders. Stockholders also regularly allege that advisors are “deal cheerleaders” who bend their analysis to support the board’s wishes. To rebut these allegations, insist that your advisors objectively analyze the relevant issues, and ask them to obtain the board’s approval for any significant assumptions, methodology decisions, and other subjective portions of their analyses. To the extent possible, you should also resist your advisors’ efforts to load their work-product with disclaimers. Above all, carefully analyze your advisors’ work-product, ask questions, and do not rely on their opinions until you understand and approve of the efforts and reasoning underlying those opinions.
5. Ensure that the meeting minutes fully reflect the process. We cannot overstate the importance of minutes in litigation against directors. First, judges and juries typically place more weight on contemporaneous records of a board decision than after-the-fact testimony. Second, depositions often happen several months (if not years) after a challenged board decision, and minutes are an important tool for refreshing directors’ memories. Ask the board secretary to draft minutes promptly after a board meeting so that you can review them while the meeting is still fresh on your mind. When reviewing minutes, make sure that they accurately reflect a summary of the issues discussed, the specifics of any decisions reached, and a list of all attendees (plus mid-meeting arrivals and departures). Not every single statement made during a meeting can or should be part of the minutes, but it is important for the minutes to reflect every topic discussed at the meeting. Ask yourself: “If I’m questioned about this meeting at a deposition next year, will these minutes help me answer questions and show the court that we fulfilled our duties?”
6. Know the boundaries of the attorney-client privilege. The attorney-client privilege is not a guarantee that all correspondences with counsel are shielded from discovery. For instance, contrary to many directors’ (and attorneys’) beliefs, the attorney-client privilege does not protect every e-mail on which an attorney is copied. Rather, an e-mail is generally privileged only if the correspondence is sent in furtherance of requesting or providing legal advice. Parties in litigation are often required to redact the “legal advice” portion of e-mails and produce the remaining portions. Thus, an e-mail (or a portion of an e-mail) concerning purely business issues might not be shielded from production. Additionally, communications with certain persons that would ordinarily be privileged, including in-house and outside counsel, may not be privileged under certain circumstances. Further, even if a document is undisputedly privileged, litigants sometimes waive the attorney-client privilege for strategic reasons, such as when the board asserts that it made a challenged decision in reliance on advice from counsel. While it is vital to have open and honest communications with your counsel, it is also important to remember that those communications may be shown to an opposing party. If there is something you would not write down in a non-privileged e-mail, then consider calling your attorney instead of sending an e-mail.
7. Use a board-specific e-mail address. By exclusively using a non-personal e-mail address for board-related correspondences, you can significantly reduce the odds of personal e-mails (or e-mails concerning your other business endeavors) becoming subject to discovery. Too often, we see directors using their “day job” e-mail addresses for their directorial correspondences; this can lead to situations where your employer’s confidential information must be copied, reviewed by your outside counsel, or (worse yet) produced to the opposing party in litigation. The same holds true for personal e-mail addresses, which some directors use for their family’s bank statements and board-related e-mails. The best way to potentially avoid this situation is to proactively segregate board-related e-mails to a different e-mail account. Some companies create e-mail addresses for their directors. If yours does not, consider creating an e-mail account and conducting board-related business solely from that address.
Craig Zieminski and Andrew Jackson are litigation attorneys at Vinson & Elkins LLP. They specialize in representing companies and their directors in lawsuits alleging breaches of fiduciary duties, partnership agreement duties, merger agreements, and federal securities laws.