The Directors Letter

Corporate Governance News Since 2006

 

Written by Executives, Read by Executives

March 30, 2019

In This Issue                                 
Boeing Update
The SEC, ISS and Glass Lewis
Audit Changes 2019
Upcoming IPO's

Next week's Executive Insights video will look at the Boeing crisis from a senior executive and board perspective.
What Did They Know? When Did They Know It? What Did They Do About It?"
FLASH:
Timothy Sloan Wells Fargo CEO since 2016, but a 31 year employee abruptly resigned Thursday as CEO. Rumors were that the employees complained of a toxic work environment while at the same time regulators complained of lack of reform at the bank. Yesterday, Mr. Sloan stated, "I could not keep myself in a position where I was becoming a distraction,"

Boeing Software in Question
According to the Wall Street Journal, the team studying the recent 737 Max 8 crash in Ethiopia has reportedly reached a preliminary conclusion that that the automated anti-stall software activated shortly before the plane crashed.

"The emerging consensus among investigators, one of these people said, was relayed during a high-level briefing at the Federal Aviation Administration on Thursday."

It is "the strongest indication yet that the same automated system, called MCAS, misfired in both the Ethiopian Airlines flight earlier this month and a Lion Air flight in Indonesia, which crashed less than five months earlier."

"The preliminary finding from the 'black box' recorders of Ethiopian Airlines Flight 302 is subject to revisions, according to the people briefed on the matter."

Relevant Board Discussion Points    It is too early to come to any conclusions regarding the tragedies related to the two Boeing 737 Max 8 crashes. However, there are numerous observations that each of us can make and perhaps utilize in our own future governance decisions. For example, similar incidents taking place with similar products in a short timeframe is a major factor. The loss of life, which has generated a huge wave of public sentiment. There were multiple parties involved, customers, carriers (airlines), manufacturers and regulatory bodies. Good or bad decisions were slow in being made and leadership was somewhat lacking. The end result is government intervention and now political (US) grand standing. Currently, certain critical issues remain unresolved such as, the complexity of the technology, related training issues and the margins of safety implemented. The axiom applying to most of the parties involved will be the basic legal question, "What Did You Know? When Did You Know It? What Did You Do about It?"

Ed Note: From a senior management and board perspective, all of these are factors are worthy of reflection relative to our own business activities. You could manufacture lawnmowers, develop revolutionary bio/pharma products or sell new investment products and you could easily be confronted with one or more of these scenarios.

Hold on, Proxy Advisory Firms   The SEC is expected to soon propose rules and regulations on how proxy - advisory companies function. This is the result of a concentrated effort by more than 300 public companies that called on the SEC to take "strong regulatory action". They were accompanied by lobbying and advocacy groups such as the US Chamber of Commerce and the National Association of Manufacturers, along with the NYSE and NASDAQ. The targets were primarily the proxy advisory firms ISS and Glass Lewis. The positions of these firms has been that they provide valuable information for investor decisions. In contrast, the listed companies cite a conflict of interest when the proxy advisory firms advise companies on corporate governance and make recommendations to shareholders at the same time.

Ed Note: Frankly, this is a surprising turn of events. Two thoughts come to mind. It is always risky when any self-anointed regulator such as ISS/Glass Lewis begins to believe their own omnipotence. Combine that with the "Chinese Wall." defense and you are in a tenuous position. This is a porous concept often used to deflect an organization's potential conflict of interest. Often, this can sow the seeds of destruction. Hopefully reasonable middle ground will be achieved supporting good corporate governance.

Commentary on Director Compensation Terry Newth a managing director at Pearl Meyer (a sponsor) in Boston 's writes a thoughtful piece about ISS's intention to more actively evaluate public company director compensation.  Pearl Meyer article:  ISS and Director Compensation: New Rules and Associated Predictions 


Audit Changes 2019  If you're on the audit committee of a major publicly held company, this may be old news. However, it is worthy of some additional focus. This action is driven by PCAOB, which oversees public accounting firms. Starting this June, large public firms, whose fiscal year ends on June 30, will see their auditors required to expand their reports regarding those items that the auditors feel are the most challenging components of a company's financial statements. The reports will also cover the manner in those auditor concerns are being dealt with by the company. The items in the report could include goodwill, impairment of critical assets, revenue recognition, tax liability or acquisition integration. These items/procedures could fall under the abbreviation CAMs, "critical audit matters." The goal of PCAOB is to better inform investors on critical events that are taking place within a company in a more robust and descriptive manner. Hopefully, this will help in avoiding future restatements.

Ed Note: The changes were adopted by PCAOB in 2017. They were adopted by large companies this year with smaller firms facing a deadline of 2021. Similar requirements are already in existence in Europe.

You Should Know

According to the Motion Picture Association of America audiences spent more on online entertainment than they did purchasing tickets at the movie theaters. $42.6 billion last year up from $32.9 billion in 2017. This is already the situation in the US, but this is a first-time global event.

Jumbo mortgages which are defined as those too big to be sold to Fannie Mae and Freddie Mac dropped by 12% last year in dollar volume. This outpaced the 7% decline in more traditional mortgages. Jumbos are defined in most parts of the country as loans above $484,000 and in more expensive locations $726,000.

Brexit continues to be a disaster with no reasonable solution in sight. The only lesson of value is plan ahead and don't depend on elected officials.

 
On Boarding New Directors

Part 3 Defining Responsibilities

We end our discussion with Anthony Goodman of Russell Reynolds' Board Advisory Group focusing on what a contributing director needs to understand.
Click image to view video


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5G Patent Count  There are ongoing discussions about the threat Chinese dominance poses to 5G technology. According to data - analytics firm IPlytics, Huawei, ZTE and several state-owned telecommunication firms China owns 36% of all 5G "standard essential patents. These patents apply to items such as handset components, base stations and extend to driverless car technology. By contrast, US firms including Qualcomm and Intel hold just 14% of these critical patents. When equipment from Huawei, is off limits, most likely royalties will be due related to their patents if they are utilized in another manufacturer's equipment.

Ed Note: The US government's concern about the impact of China on the security of 5G communications appears to be valid and will continue. Currently global support for our position is not particularly strong for a variety of political reasons.

On the positive side, the US has an extremely broad based and sophisticated cellular network already in place which can be upgraded without Chinese gear to 5G. However, any upgrade effort will take time and significant investment. R&D in this country is not government dependent and R&D is well established in multiple geographic locations. Add to that US's outstanding ability to develop appropriate apps that could be utilized in 5G networks which remains impressive.

Pressure must be placed on the government at the federal and local level to ensure that network rollout takes place in an efficient and orderly fashion without being subject to burdensome and inefficient regulatory review. While we are playing catch up, we are still very much in the game based on the reasons cited above. Corporations and consumers should play a proactive role in demanding that we will not be a second-tier player in 5G technology.

Doing It Wrong    Related to the above, US semi- conductor companies have stated publicly that they do not want their products to be part of $1 trillion trade deal between the US and China. John Neuffer president of the Semi - conductor Industry Association said, "The market should determine commercial success, not government fiat." They feel that because US production costs are higher that any deal with mandatory purchase quotas would force US chipmakers to locate facilities in China. This would result in Chinese bureaucrats/government having more control over US production and technology.

Soybeans and semi -conductors are both products we would like to export to China. However, trade negotiators should realize that from a cost, logistics and IP standpoint they have little in common.

The Race to Charge You More  In the 5G race, Verizon is the first to announce that it will charge subscribers $10 more per month to utilize their 5G service. They stated that in April on a 90-day free basis they will roll it out in Chicago and Minneapolis (at selected locations). At this time, it appears that Verizon will sell a device, Motorola's Moto Z3 with a clip-on modem that makes it compatible. We assume that this makes it compatible with existing networks. Samsung announced it will have a 5G compatible device later this year.

Ed Note: Some marketing whiz convinced senior management that it was "really good business to be the first," to announce the $10 subscriber price increase (90 days free). This is for limited geographic service that also requires an adapter. Our reaction, start with the value proposition of how great 5G is, how easy it is to use and its broad accessibility. Then ask me to pay for it. In the meantime, I would be happy if AT&T could just provide me with continuous voice service (based on any G) along the superhighways traveling from Boston to Cape Cod..
 
Bitcoin Reality Check First, let us say that we were slow to become excited about bitcoin. On the surface, from an investment standpoint it seemed to be more a game of financial musical chairs. Buy some bitcoin, hold it, watch it increase in value, sell it and grab a chair. When no chairs or buyers were left, then you lost. To those individuals who cashed in and made money, congratulations. To those individuals who rode bitcoin down, Well? Cboe Global Markets, the first US exchange to launch bitcoin futures (2017), informed traders they would no longer be providing related services.

Ed Note: Our comments do not apply to block chain, the underlying technology that appears to have legitimate and broad-based adaptability in terms of transactions and record keeping. Looking back, you heard blue-chip corporate names like IBM and J.P. Morgan investigating the use of block chain technology. That's a very big difference.

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Global Geopolitical Events with Economic Impacts    Italy and China have recently signed an agreement to cooperate with China's global infrastructure plan, the Belt and the Road Initiative. Italy is the first member of the Group of Seven, advance economies, to sign up for the initiative. Italy in recent weeks has stressed to the US and EU that the agreement is not legally binding. Usually this type of agreement would involve a partnership or significant Chinese investment (often secured debt) in major Italian infrastructure projects with future "quid pro quo".

Oman signed an agreement with the United States Navy to give it operating access to two major Arabian seaports. Both are located just south of the Strait of Hormuz. This is the very narrow entrance to the Arabian Sea boarded on the west by Iran and on the east by the United Arab Emirates.

As direct hostilities wind down in Syria, Iran moves to capitalize on its battlefield support of victorious but weakened Pres Assad by assisting war refuges with aid and influence. These efforts will have a broad- based, economic. military and political impacts. They will extend well beyond Syria to neighboring Iraq, Turkey, Lebanon, and over time Jordan and Israel.

Venezuela continues to spiral downward into a tragic crisis with global ramifications.

The Roadshow Returns    In the past, we have written about the simplicity and merits of direct listing (Spotify) of first-time new stock issues. As Lfyt prepares for its traditional IPO it fills the rooms with potential investors as it travels the country promoting its stock. The previously targeted price was $62-$68 a share and now it appears a price in the low 70s will be the magic number. This would value Lyft at approximately $23 billion. On the road, some concern was expressed that last year's loss was $911 million, the biggest of any US startup in 12 months prior to its IPO. Except for Fidelity, there are few mutual funds who are currently investors. Conceivably, that group could be a powerful driving force of new investors. Meanwhile, Uber is in the wings and begins its IPO process in the coming weeks.

Ed Note: We could reference the disastrous IPOs of the late 1990s, some of whom showed nothing but losses while others had no revenue at all. But this is 2019, and we are better served looking back at the reincarnation of Apple and the number of years that Amazon had nothing but revenue growth and red ink at the bottom line. Yet there are some key differences, beginning with Steve Jobs and Jeff Bezos.

Uber Is Not in Neutral    Lfyt may have beat Uber to the IPO starting line but new CEO Dara Khosrowshahi (formerly Expedia) is not treading water. He understands that ridesharing is a global market and you grab as much as you can, when you can. With that in mind Uber is buying its Middle Eastern rival Careem Networks FZ for $3.1 billion. $1.4 billion in cash and $1.7 billion in convertible notes (at $55/share).

It is worthwhile looking at some of the Pre- IPO logic behind Uber's largest acquisition. The Middle East is a large and sophisticated marketplace with 400 million people comfortable with smart phones and apps. Previously, Uber had been involved in costly competitive battles in China, Russia and Southeast Asia. They lost the battles but, in some cases, came out with a respectable ownership share of the remaining entity. In the Careem case, the decision was made to buy rather than do battle. Careem is active in about 15 Middle Eastern countries. Its client list will bring Uber close to 1 billion users prior to their IPO and suggest a public value of $120 billion.

Ed Note: Several interesting side notes. Careem's drivers are known as "captains" to remove the stigma of being a blue-collar profession. In Saudi Arabia, where women started driving last year, Uber's female drivers can opt to be connected exclusively to female passengers. These Uber actions are both tactical and strategic and seem to be smart moves that make a lot more sense than the brawling and bragging that took place under former CEO Travis Kalanick.

Pacific Gas & Electric is currently pursuing Chapter 11 bankruptcy and is under pressure from various institutional investors and activists to change its executive leadership and board. Potential liability costs could exceed $30 billion. Bill Johnson retiring head of the Tennessee Valley Authority, TVA, is currently the leading CEO candidate. New board members currently under consideration include experts in cybersecurity, nuclear security and restructurings. These individuals will rotate off the board as the company emerges from bankruptcy and according to some investors will be replaced with former utility executives.

Ed Note: Positive elements include the facts that action is being taken in a prompt and orderly fashion and that these actions are being effectively communicated. What will be the authority of the new CEO, the relationship with the board and what will be the authority/role of the board in terms of decision-making? At the same time, there is the significant challenge of ensuring that the company continues to operate and can maintain its ongoing relationships with various energy suppliers.

Looking through a somewhat cynical lens, we would ask the question why would these individuals take the job? Just as important, who is overseeing the recruitment process and structuring the deals? Are they asking the tough questions?

The Directors Letter

by Daly & Company Inc.

184 High Street, Boston, MA 02110
Dan Daly, Publisher

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