Corporate boards have a fiduciary responsibility to manage risk, especially against major events that could overwhelm an organization and devastate shareholders’ investments. The Covid-19 pandemic has forced new attention on board’s responsibilities.

It’s tempting to call this pandemic a black swan, a calamity so unexpected that companies could not have prepared for it. But experts have been predicting global pandemics for years, and in January 2020, the World Economic Forum’s Global Risks Report cited infectious diseases as a potential threat. And few companies included a global pandemic in their high risk categories.

Indeed, it’s better to see the pandemic as a “black elephant”—a term derived from a cross between a black swan and the “elephant in the room.” Coined by the investor and environmentalist Adam Sweidan, it describes a looming disaster that’s clearly visible, yet no one wants to address it.

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Thank you, John [Gulliver] and thanks Hal [Scott] for inviting me to be part of this forum. It is a pleasure to be here with you all today. The views I express are my own and do not necessarily represent those of the Commission or my fellow Commissioners. For that matter, they may not represent the views of anyone else sharing this virtual conference hall.

During the COVID era, as has happened to many of you, a new dog came into my life. No, I have not adopted a dog. Much as I would love to have the company, my condo building has a prohibition on dogs with the exception of the large German Shepherd that somehow has negotiated an exemption. The dog I have developed a relationship with is smaller, but no less fierce than that German Shepherd. Her name is Lucy. She walks with her owner in the park during my morning runs. Lucy hates me. She did not always feel that way, but our relationship—along with so many others—COVID-cratered. During an attack earlier this week, her owner assured me that “She is just trying to say hello.” I did not stick around for the rest of the conversation. The source of her dislike of me seems to be my mask. I once ran by without one. Lucy was mildly friendly, but her masked human earnestly called me out for my exposed face and instructed me not to run if I could not do so with a mask. The second time I saw Lucy, her masked owner was wielding a large sign entreating me to: “Please wear a mask.” So now I wear a mask when I run by Lucy and Lucy lunges for me. What surprised me, however, is that her owner has stopped wearing one. To be fair, she does keep one hanging jauntily around her neck. So, here’s how it goes: I wear a mask when I pass Lucy and her owner, Lucy attacks me, her unmasked owner laughs at me while gently chiding Lucy, and I try to keep my cool by thinking about ESG, which is the only reason I told you this story.

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On August 26, 2020, the Securities and Exchange Commission (the “SEC”) adopted amendments to the definition of “accredited investor” in Rule 501(a) of Regulation D under the Securities Act of 1933 (“Securities Act”), which expand the category of investors eligible to participate in private offerings under Regulation D. The amendments create new categories of accredited investors, including those that qualify irrespective of wealth, on the basis that they have the requisite ability to assess an investment opportunity, and codify certain staff interpretative positions. The amendments, which were initially proposed on December 18, 2019, were adopted substantially as proposed with a few modifications, which we discuss below. The final rule will become effective 60 days after publication in the Federal Register.

New Categories of Accredited Investors

The SEC expanded the categories of accredited investors for both natural persons and entities.

Professional Certifications, Designations, or Credentials. Under a new category in the amended definition, natural persons will be able to qualify as accredited investors based on certain professional certifications, designations, or credentials from an accredited educational institution that the SEC designates as qualifying an individual for accredited investor status. Such designations will be issued by an SEC order and posted to the SEC website, as modified from time to time. In the final rule, consistent with commenters’ suggestions, the SEC clarified that it will provide notice and an opportunity for public comment prior to issuing any final order regarding future designations of qualifying credentials.

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From a practical standpoint, the most significant part of the 1970 Milton Friedman essay in the New York Times was the headline: “The Social Responsibility Of Business Is to Increase its Profits.” For a half-century, that phrase has been used to summarize the essay, and alongside Friedman’s similar views in a 1962 treatise, also used in support of “shareholder primacy” as the bedrock of American capitalism. “Shareholder primacy” and “Friedman doctrine” became interchangeable. The Friedman doctrine was a precursor to, and became a doctrinal foundation for an era of short-termism, hostile takeovers, extortion by corporate raiders, junk bond financing and the erosion of protections for employees, the environment and society generally, all in support of increasing corporate profits and maximizing value for shareholders. This concept of capitalism took hold in the business schools and the boardrooms, became ascendant in the eighties and continued as Wall Street gospel until 2008, when the perils of short-termism were vividly illuminated by the financial crisis, and the long-term economic and societal harms of shareholder primacy became increasingly urgent and impossible to ignore. Since then, acceptance of and reliance on the Friedman doctrine has been widely eroded, as a growing consensus of business leaders, economists, investors, lawyers, policymakers and important parts of the academic community have embraced stakeholder capitalism as the key to sustainable, broad-based, long-term American prosperity. This is illustrated by the World Economic Forum’s request that I prepare a new paradigm for corporate governance which it published in 2016 and its issuance of the 2020 Davos Manifesto embracing stakeholder and ESG (environment, social and governance) principles, as well as the 2019 abandonment of shareholder primacy and adoption of stakeholder governance by the Business Roundtable. So too, has corporate purpose and stakeholder and ESG governance been embraced by index fund managers BlackRock, State Street, Vanguard and other major investors.

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Executive Summary

Effective long-term capital allocation is fundamental for innovating and creating value; investment in research and development (R&D) fuels this growth. Successful R&D can be transformational for an organization and for broader society. But while worldwide spending on R&D has slowly increased, R&D returns have been declining. What’s driving this decline? Emerging evidence suggests a short-term mindset lies at the heart of this puzzle.

R&D spending, especially long-horizon R&D project spending, faces a unique set of short-term pressures relative to other types of long-term investment. When facing short-term financial pressures, behavioral biases including manager risk aversion and uncertainty around forecasting potential future returns (among other things) lead to a tendency among management teams to cut long-horizon projects first. The declining tenure of managers, the lack of innovation-linked metrics in incentive compensation plans, the typically asymmetric return profile of long-horizon projects, and an investment community that often ignores the potential impact of long-horizon innovation spending in a company’s valuation analysis all contribute to this problem.

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On August 30, 2020, the California State Legislature passed a new and unprecedented bill intended to promote greater diversity in corporate boardrooms. If signed into law by the governor, California’s Assembly Bill (AB) 979 would require each publicly held corporation whose principal executive offices are located in California to have a minimum number of directors from an “underrepresented community” on its board of directors. The bill defines “underrepresented community” to include any individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian or Alaska Native, or who self-identifies as gay, lesbian, bisexual or transgender. Two years ago, California became the first state to enact legislation requiring public companies headquartered in the state to include a minimum number of females on their corporate boards. If enacted, AB 979 would establish nearly identical requirements as the bill related to the representation of females on corporate boards and follow the prior bill as new Section 301.4 of the California Corporations Code.

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In In re Anthem-Cigna Stockholders Litigation (Aug. 31, 2020), the Delaware Court of Chancery characterized the rise and fall of the proposed merger of equals of Cigna, Inc. and Anthem Corporation as a “corporate soap opera, [with] the members of executive teams at Anthem and Cigna play[ing] themselves [and] [t]heir battle for power span[ing] multiple acts.” After the merger agreement was signed, Cigna “turned against the Merger” and created “roadblocks” to its consummation. Ultimately, a final injunction against the merger was issued on antitrust grounds, which resulted in termination of the merger agreement. Following a ten-day trial, Vice Chancellor Laster held, in a 310-page opinion, that Cigna had breached the merger agreement covenants under which it was obligated to try to consummate the merger, but that no damages were payable because the injunction likely would have been issued (and thus the merger would not have closed) anyway. The court also held that Anthem did not breach its covenants to try to obtain antitrust approval; and that, under the language of the merger agreement, Cigna was not entitled to a Reverse Termination Fee. The court summarized: “Neither side can recover from the other [and] [e]ach party must bear the losses it suffered as a result of their star-crossed venture.”

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As organizations respond to recent events related to COVID-19 and social justice movements, many strategic businesses, operating, and investment plans for 2020 and beyond have become irrelevant, impracticable, or both. These events have challenged the status quo. As a result, for boards and managements, the ability to lead in highly adaptable and decisive ways is now on the front burner.

After considering the unprecedented challenges of 2020 in the context of preparing the 10th annual report on Human Capital trends, Deloitte released two reports in May 2020: our regular annual report on the top 10 trends for 2020 (The social enterprise at work: Paradox as a path forward) and a special report on the 2020 trends with a focus on the COVID-19 pandemic (Returning to work in the future of work: Embracing purpose, potential, perspective, and possibility during COVID-19). The special report, on the intersection of human capital trends and priorities against the COVID-19 pandemic, is the backdrop of this post.

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There have been several cases in the last two years relating to the landmark Caremark case that established the key precedent surrounding the role and performance of corporate director responsibilities and director liability when it comes to the exercise of risk oversight.

In many of the cases, there is a clear roadmap for plaintiff’s attorneys and claims that is leading straight to cybersecurity litigation. The ongoing failures of most corporate boards to satisfactorily oversee cybersecurity risk could generate a Caremark-type claim.

As advisors, instructors, litigators, observers and advocates for digital and cybersecurity governance reform over much of the last decade, we share the opinion that boardrooms have generally been behind the learning curve in sufficiently understanding and overseeing this critical business risk and its implications to corporate stakeholders. The stage is now being set for litigation to step in and hold corporate boards and directors to new levels of corporate and personal accountability; to hold them accountable for what they’ve failed to do.

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On September 1, 2020, the California Superior Court, San Mateo County, granted a motion to dismiss a putative securities class action brought under the federal Securities Act of 1933 because the company’s charter provided that such lawsuits may only be maintained in federal court. [1] The ruling was long awaited by companies, securities litigators, and observers of the decade-long saga of IPO litigation in state courts. It is the first ruling enforcing such a provision after the Delaware Supreme Court upheld their validity under Delaware law earlier this year in Sciabacucchi.

The ruling confirms that companies about to go public—whether through a public offering, direct listing, or SPAC transaction—should adopt a federal forum provision in their charter or bylaws to eliminate the risk of duplicative securities class actions being filed in state court to extract a quick settlement. The ruling also suggests that a federal forum provision adopted after the going public event may also be enforceable under certain circumstances. Finally, the language of the provision matters and should be carefully weighed with experienced counsel.

The decade-long battle over state IPO litigation

The federal Securities Act of 1933 allows shareholders to sue the company, the signatories of its registration statement, any company control persons, and any underwriters, in connection with a registration statement that allegedly suffers from material misrepresentations or omissions. The plaintiff is not required to plead fraud. Strict liability applies to the company (while the other defendants benefit from an affirmative due diligence defense that realistically can only be established after incurring significant costs of discovery). Most public companies that experience a stock drop after going public are targeted by such lawsuits, styled as class actions and seeking damages sometimes ranging in the billions. Most of these lawsuits are dismissed by federal courts. So plaintiffs began filing them in state courts.

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Introduction

In August 2019, the Business Roundtable (BRT) released its new stakeholder model of the revised purpose of the corporation, stating explicitly that businesses exist to serve multiple stakeholders—including customers, employees, communities, the environment, and suppliers—in addition to shareholders. [1] This new model was publicly supported by 181 CEOs of major corporations. It could have a substantial impact on corporate incentive designs, metrics, and other governance areas as corporations continue or begin to operationalize this stakeholder model into their long-term strategies, as incentive plans are core to reinforcing and communicating business strategy. While there are many opinions on the BRT statement, the stakeholder model is evolving in both importance and sophistication. [2]

Further, the COVID-19 pandemic, the associated economic impacts, and increased focus on social justice illustrate the increasing expectations on—and willingness of—corporate leaders to address social issues that may extend beyond a traditionally narrower view of the business purpose of the corporation. Given these circumstances, some companies are taking a fresh look at their impact on numerous stakeholder groups and their reinforcing impact on company success. For example: Will increased focus on employee wellness initiatives enhance the resilience of corporations? Will sustainable supply chains and real estate differentiate a company in both the consumer and talent markets, or are these practices rapidly becoming baseline expectations of employees, investors, customers, and the broader community? The answers to these questions are beyond the scope of our expertise, but these and similar questions are at the center of the discussion on ESG metrics and their applicability to incentive compensation.

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Audit firms provide many services beyond those related to the audit of financial statements (FS). Historically, many of these “non-audit” services were provided to audit clients, causing regulators to be concerned about potential auditor independence impairment. The basic idea behind this concern is that by selling significant non-audit fees to their audit clients, auditors might compromise the quality of their FS audits. Thus, the Sarbanes-Oxley Act of 2002 (SOX) banned the sale of many non-audit services to public audit clients and required public-company audit committees to pre-approve all other non-audit services. Subsequently, three of the current Big 4 accounting firms spun off their consulting arms but have since rebuilt their consulting practices both organically and through acquisitions, with a focus on selling non-audit services to non-audit clients. In our study, we examine how the acquisition of consulting practices by the Big 4 might affect the quality of the audits they provide.

Though today the Big 4 provide most of their consulting services to non-audit clients, regulators have expressed concern about whether the shift in focus towards growing consulting practices could negatively affect audit quality. Specifically, regulators are concerned that the growth of consulting business at the Big 4 could lead to the firms becoming primarily consulting firms rather than primarily audit firms. This could result in the audit practice, and thus, audit quality, not being of primary importance to firm leadership. Overall, regulators are concerned that firm culture could shift away from an audit mindset to a consulting mindset (one focused on client advocacy).

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As a long-term investor in more than 10,000 public companies across the world, State Street Global Advisors believes that the single most important driver of long-term value is a strong, independent and effective board exercising high-quality oversight. In turn, we have long appreciated the positive correlation among diversity at the workforce and board levels, effective boards and oversight and sustainable long-term financial performance. As such, whether through our long-standing stewardship focus on gender diversity and board effectiveness, amplified by our Fearless Girl campaign, or the integration of Sustainability Accounting Standards Board (SASB—see Figure 1) diversity metrics into our Environmental, Social and Governance (ESG) scoring system, R-Factor,™ [1] we have called on companies to disclose more details regarding the diversity of their boards and workforces.

The ongoing issue of racial equity has caused us to focus more closely on the ways in which racial and ethnic diversity impacts us as investors. As such, we are writing to inform you that starting in 2021, State Street Global Advisors will ask companies in our investment portfolio to articulate their risks, goals and strategy as related to racial and ethnic diversity, and to make relevant disclosure available to shareholders.

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On August 26, the SEC’s Division of Trading and Markets took action, pursuant to delegated authority, to approve a proposed NYSE rule change that would allow companies going public to raise capital through a primary direct listing.  (See this PubCo post.) This week, that rule change hit a “snag,” as the WSJ put it—the SEC notified the NYSE that the approval order had been stayed because the SEC had received a notice of intention to petition for review of the approval order. What’s that about?

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The Securities and Exchange Commission issued its long-awaited amendments to Regulation S-K, the regulation which contains the detailed disclosure requirements (other than financial statements) applicable to registration statements, periodic reports, proxy statements, and other filings under the United States federal securities laws. The rulemaking includes a new requirement that public companies disclose information about “human capital resources” in these filings.

We have several observations on the new rule:

1. The SEC stopped short of addressing a broad range of ESG issues, such as climate change, and this led two Commissioners, Allison Herren Lee and Caroline A. Crenshaw, to vote against the rule and to issue dissents. Although SASB has long believed that existing regulatory requirements (in particular, the Management Discussion and Analysis requirement) should prompt companies to disclose financially material ESG risks and opportunities such as climate change, there is little doubt that a broad regulatory ESG mandate would help lead to more (and more comparable) disclosure. But we should not lose sight of what the SEC accomplished via this amendment: this is the first time that the Commission has issued a specific ESG disclosure requirement. This is a step forward.

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A recent decision of the Delaware Court of Chancery in the ongoing WeWork/SoftBank litigation addressed a previously unresolved question: can management withhold its communications with company counsel from members of the board of directors on the basis that such communications are privileged? Building on past Delaware decisions concerning directors’ rights to communications with company counsel, including in the CBS case we previously discussed here, the court clarified that directors are always entitled to communications between management and company counsel unless there is a formal board process to wall off such directors (such as the formation of a special committee) or other actions at the board level demonstrating “manifest adversity” between the company and those directors. See In re WeWork Litigation, C.A. No. 0258-AGB (Del. Ch. August 21, 2020). In other words, management cannot unilaterally decide to withhold its communications with company counsel from the board (or specified directors management deems to have a conflict).

Background

This case concerns a series of transactions involving The We Company (“WeWork”) and SoftBank and its affiliate (collectively referred to here as “SoftBank”) that resulted in SoftBank acquiring effective control of WeWork from Adam Neumann, one of the company’s founders. As part of the transactions, SoftBank also agreed to commence a tender offer to acquire additional WeWork shares from existing stockholders. Due to control of the company shifting from Neumann to SoftBank, a Special Committee of WeWork’s board of directors was empaneled and negotiated the transactions with SoftBank and Neumann. In April of this year, however, Softbank terminated the tender offer, claiming that certain closing conditions were incapable of being satisfied. Shortly thereafter, the Special Committee brought an action on behalf of WeWork against SoftBank for breach of contract and breach of fiduciary duty. Neumann separately commenced litigation against SoftBank based on similar allegations.

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When the Covid-19 pandemic began in March 2020, its economic impact significantly affected the annual incentive plans at many companies. In those early days, thinking the pandemic’s impact would be short-lived, directors discussed several ways to respond. Ideas included resetting goals in light of the macroeconomic impact, calculating bonuses on a ten-month basis (excluding the worst of March and April), or setting a new six-month plan for the second half of the year.

Now, with more than half of the year already past, the level of uncertainty remains extraordinarily high for many companies and industries. A ‘reset’ or other adjustment to incentive plans under ‘business as usual’ is fraught with challenges; for most companies, it is practically impossible for management and Boards to adjust existing plan goals or establish new goals for the second half of the year. That said, Boards can still work to ensure they position their companies as well as possible to enter FY2021. Some companies, facing financial constraints, will decide they just can’t pay bonuses this year, but others want to recognize management’s herculean efforts to preserve the company’s ability to thrive in the future. How can the Board best keep management motivated in these circumstances?
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The SEC issued new rules on August 26, 2020 which affect the business description, litigation disclosure, and risk factor disclosure of SEC-reporting companies in their annual and quarterly reports (10-K and 10-Q), registration statements (S-1 and S-3), and M&A disclosure filings (S-4 and 14A) filed with the SEC. [1] These provisions had not been significantly revised for more than 30 years.

One or another of these rules could affect some of the disclosure of virtually every US public company, and we recommend that public companies review their existing disclosures in light of the new rules, particularly their risk factors. The new rules will become effective in about 1 month.

Described below are the key changes adopted by the SEC and how they impact company disclosures.

Risk Factors

Summary of Risk Factors

If the risk factor section exceeds 15 pages (which is often the case for many companies), the company must include a 2-page summary of the risk factors using “concise, bulleted or numbered statements” in the forepart of the prospectus or annual report. This will require a change for many companies—the SEC estimates that 40% of companies have risk factor sections which exceed 15 pages.  (more…)