Editor: Please tell our readers about your practice.
Schpok: My practice involves the representation of various clients in several industries in connection with such matters as capital formation, private and public securities offerings, joint ventures and partnerships, mergers and acquisitions, financing transactions, corporate and regulatory transactions and corporate governance. I often advise corporate boards and board committees regarding corporate governance matters in connection with both best practices as well as in the context of specific transactions or situations. For example, I frequently advise boards and board committees on such matters as issues involving senior management; specific transactions such as a sale of the company or a related party transaction that involve heightened attention by the board; board fiduciary responsibilities; risk management issues; and dealing with communications and proposals from activist shareholders.
Editor: When counseling institutional investors regarding an investment in an early stage company, what elements of corporate governance do you advise that they require as a condition of making an investment?
Schpok: Early stage companies often have a challenge making the transition from a founder- or entrepreneur-controlled environment to the adoption of appropriate governance practices because the early stage company’s primary focus is on developing its business. The exposure of board members for actions taken or not taken by the board is typically derived from the procedures, policies and practices of the board in making its determinations rather than an actual board decision. Accordingly, it is very important for boards to have appropriate corporate governance policies in place and actively followed in order to mitigate challenges by shareholder activists or other parties that may be critical of a board’s actions. Some of the governance-related questions that an institutional investor should ask include the following:
Does the company have internal conflicts of interest, ethics, business conduct and compliance policies? If not, such policies need to be adopted.
Does the company have foreign operations? If so, what policies and practices are in place to assure compliance with anti-corruption laws? If no policies are in place, and it is contemplated that the company has such operations, a requirement is to adopt an appropriate anti-corruption policy.
What management supervisory roles are in place regarding compliance matters? In particular, policies must assure that management and officers of the company are able to report issues directly to the board.
How will board member candidates be identified, selected and elected? What criteria are used, and who has the ability to elect the board? Typically, a voting agreement will be required in order to assure meaningful institutional investor participation in the board selection process.
Editor: What measures regarding board composition do you require? Why are specialized skills on the part of directors often beneficial?
Schpok: Boards should include at least one independent director with financial experience and credentials suitable for serving on an audit committee. Some board members should have industry experience and background suitable to advise the company with respect to its business and strategic planning. Some board members should have experience and background in management in order to advise management with respect to common operational issues, such as employment and benefits matters. Some board members should not represent constituencies with vested interests separate from the shareholders as a whole. Some board members should have prior experience serving on a board.
Specialized skills can be particularly useful to companies that may not have such skills in-house. For example, I once represented a board committee reviewing financial statements of a third party for a potential transaction. The lead independent director was dean of a business school and author of a text on analyzing financial statements. His specialized skills were very useful to the board.
Editor: Are you an advocate of a totally independent board? What members of management should be represented at board meetings?
Schpok: A totally independent board is not common in an early stage company. Typically, the founder or entrepreneur is a board member and has significant input at the board level with respect to all business and strategic decisions. Early stage companies may have difficulty attracting suitable independent board members with significant experience and credentials. However, board members should not consist of friends or acquaintances of management who do not actually have the credentials to serve on the board or are otherwise aligned with management. As a company grows in size, its ability to attract independent board members with suitable credentials will increase so that the board will consist of all or substantially all independent directors.
Normally, the CEO and CFO of the company would be represented at the board meeting for the purpose of reporting to the board and responding to board questions. However, the CEO and CFO can participate as officers reporting to the board and do not have to be board members. Regardless of whether officers serve on the board, corporate governance documents should allow the board, as needed, to act by executive session with the exclusion, if deemed appropriate, of management or management board members.
Editor: What do you consider the key functions of the board to be? How much weight should be placed on risk management and ensuring the integrity of the corporation?
Schpok: My top-10 list for key functions of the board includes the following:
Considerable weight should be placed on risk management procedures and ensuring the integrity of the company. Too often, boards are not prepared in advance to address an unforeseen crisis situation and have “deer in the headlights” syndrome when faced with an impending crisis. The board should be prepared to ensure that management has implemented board policies and adopted suitable practices to mitigate potential risks. The board has overall responsibility to review and implement risk management policies and procedures in two general areas. The first category is risk prevention. This involves assuring the company has appropriate ongoing policies such as internal controls and anti-corruption compliance standards to assure that management operates within appropriate guidelines.
The second category is crisis management. The board should determine whether the company has taken the following steps to be prepared to manage “damage control” from unexpected situations: Has the company established an emergency response team consisting of internal management (HR, legal, compliance), outside consultants (PR, legal, security) and possibly governmental resources as may be needed? Has the company conducted a vulnerability analysis for specific risks and response capabilities? Has the company developed an emergency action plan, including procedures for reporting, chain of command and ability to reach specific team members? Has the company implemented its emergency plan so that all personnel and relevant third parties are familiar with the plan and have access to instructions in the event of a crisis?
Editor: What have been the effects on corporate governance of the enactment of Dodd-Frank and, before it, Sarbanes-Oxley?
Schpok: First, both Sarbanes-Oxley and Dodd-Frank have significantly increased the overall awareness of board members of the need to adopt, review and maintain proper governance practices and procedures due to the heightened level of scrutiny facing board actions. Accordingly, even companies that previously had policies in place have had to review and update corporate governance practices to assure compliance with many of the specific requirements under Sarbanes and Dodd-Frank.
Second, these laws have also had the effect of encouraging early stage and emerging growth companies to adopt governance policies much earlier than was typically the case prior to these laws in order to better position the company to attract private capital and new board members and to prepare to go public.
Third, one of the most significant developments arising from the enactment of Dodd-Frank has been the encouragement by the government of whistleblowers through the government’s enhanced whistleblower reward program adopted under Dodd-Frank. The potential exposure from whistleblowers has increased the level of board members’ attention to assuring that proper corporate governance procedures, particularly involving risk management, have been put in place.
Editor: When representing underwriters of securities offerings, what are some of the safeguards that you try to instill to protect the underwriters as well as their client?
Schpok: From a corporate governance standpoint, underwriters must be comfortable with two principal concepts. First, has the company conducted its business to date in a manner that does not create exposure to issues that would arise from inadequate corporate governance practices? In this regard, significant due diligence should be done on behalf of underwriters with respect to any material transactions or activities of the company to assure that appropriate procedures were undertaken. This is particularly critical in the case of an initial public offering in which the company has not previously had a requirement to comply with SEC or stock exchange regulations.
Second, going forward, the underwriters must be comfortable that the company complies with applicable corporate governance rules under securities laws; that it has implemented and complies with corporate governance requirements of the securities exchanges with respect to board composition and related matters; and that it has in place appropriate policies regarding board conduct, compliance (including FCPA and other anti-corruption policies) and internal control procedures.
Editor: When, if ever, do you suggest that an institutional investor agree to assume a seat on a corporate board?
Schpok: In early stage companies, it is not unusual for an institutional investor that makes a substantial direct investment in the company to have a board seat. However, a board seat should only be occupied by an institutional investor if the following three key attributes are in place:
That culture must include respect among the other directors for each director’s viewpoints and expertise, the opportunity to discuss matters presented to the board in a manner to achieve informed and deliberative decisions by the board, and adequate time for board members to prepare for meetings in order to be well-informed and ask and receive answers to questions.
As an alternative to a board seat, some institutional investors will be granted board observer rights to attend board meetings for informational purposes without actually assuming a role as a director.
Editor: Do you consider that there are certain situations that call for separation of the board leadership between the chair and CEO?
Schpok: In early stage companies, it is common for the CEO to remain chair unless the chair is a co-founder of the company as well as the CEO. For public companies, listing requirements require boards to hold executive sessions without the CEO and other members of management present. Proxy advisory firms favor an independent chair unless the company has an independent lead director. The issue is the ability of a company to split the functions of the chair and CEO without creating confusion about leadership roles in the company or inferring the board has a lack of confidence in the CEO. An independent lead director can be an alternative to having a separate chair and CEO. Oftentimes, an independent chair is a person with prior service as a director of the company who would be familiar with the company.
Editor: Is the adoption of an enterprise risk management plan (ERMP) a wise policy for boards to pursue, especially in view of shareholder activism?
Schpok: A board’s attention to reviewing, analyzing and adopting an appropriate risk management plan has become one of the issues focused on by shareholder activists. Shareholder activists frequently ask questions regarding the degree of involvement by the board in assuring proper risk management procedures have been adopted and are being followed.
In particular, recent developments involving concerns regarding cybersecurity and big data have increased the board’s overall responsibility to develop risk management policies. In this regard, the board must assure that its corporate staff continually reviews and improves cybersecurity safeguards and protocols; data vulnerability assessments; incident response and report protocols; review of insurance coverage; and contractual obligations and compliance of third parties, such as vendors and service providers.