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Legal Research Paper Series Working Paper No. 09-10
CORPORATE GOVERNANCE AND CORPORATE DISCLOSURE J. Robert Brown, Jr.
University of Denver Sturm College of Law
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© 2009 Aspen Publishers. All Rights Reserved. Reproduced with the permission of Aspen Publishers, Inc. from J. Robert Brown, Jr., The Regulation of Corporate Disclosure, Third Edition. This material may not be used, published, broadcast, rewritten, copied, redistributed or used to create any derivative works without prior written permission from the publisher.
CORPORATE GOVERNANCE AND CORPORATE DISCLOSURE
§ 2B.01 § 2B.02 § 2B.03 Governance and the Limits of Disclosure Disclosure and Compliance with the Securities Law Disclosure and State Fiduciary Obligations  Overview  Director Resignations  Enforcement Proceedings and Governance Disclosure and the Board of Directors  Overview  Disclosure Requirements [a] Independence [b] Meeting Attendance [c] Committee Disclosure [i] Nominating Committee [ii] Audit Committee [iii] Compensation Committee [d] Communications from Shareholders  Problems Independence, Disclosure, and the Securities Laws Disclosure and Conflicts of Interest  Fiduciary Duties  Related Party Transactions and Disclosure Requirements  Procedures  Antifraud Provisions  Issues
§ 2B.05 § 2B.06
Electronic copy available at: http://ssrn.com/abstract=1396353
Electronic copy available at: http://ssrn.com/abstract=1396353
GOVERNANCE AND DISCLOSURE § 2B.01 GOVERNANCE AND THE LIMITS OF DISCLOSURE
The main focus of the securities laws has always been disclosure. In adopting the Securities Act of 1933, Congress expressly rejected a merit-based approach to regulation. Investors could sell shares in a company that promised to extract gold from seawater so long as the risks were fully disclosed.1 Disclosure in general facilitated a transparent trading market, with investment decisions left in the hands of investors.2 The securities laws were not entirely limited to the protection of investors or to rules increasing the amount of disclosure. In particular, Section 14(a) of the Exchange Act3 gave the Commission the authority to regulate proxies, interjecting the agency into the corporate governance process.4 The agency mostly adhered to the traditional approach of protecting shareholders through the use of disclosure,5 with the substance of corporate governance left to the states.6
See Federal Securities Act, Hearing on H.R. 4314, Before the House Comm. on Interstate and Foreign Commerce, 73d Cong., 1st Sess. 57–58 (1933) (statement of Rep. Pettengill); see also H.R. Rep. No. 83, 73d Cong., 1st Sess. 8 (1933) (“The purpose of these sections is to secure for potential buyers the means of understanding the intricacies of the transaction into which they are invited.”). 2 “There cannot be honest markets without honest publicity.” H.R. Rep. No. 1383, 73d Cong., 2d Sess. 11 (1934), reprinted in 1 Securities Law Comm., Federal Bar Ass’n, Federal Securities Laws, Legislative History, 1933–1982, at 792, 804 (1983). The approach was influenced by then professor and later Justice Brandeis in his book, Other People’s Money 92 (1914), where he wrote the memorable phrase “Sunlight is the best disinfectant.” 3 15 U.S.C. § 78n(a). Historically, states imposed a few, ineffective restrictions on management’s use of proxies. Salaried officers could not be proxyholders. Early statutes also limited the number of shares voted by any proxyholder. See Dodd, Statutory Developments in Business Corp. Law 1886–1936, 50 Harv. L. Rev. 27, 33 (1936). Nonetheless, over time, state law ceased to impose any real limits on management’s use of the proxy process. Id. (noting that 1903 revisions of Massachusetts corporate code “marked the end of any attempt . . . to put obstacles in the way of control of the proxy machinery by the management”). 4 As the Senate Report expansively stated: “It is contemplated that the rules and regulations promulgated by the Commission will protect investors from promiscuous solicitation of their proxies, on the one hand, by irresponsible outsiders seeking to wrest control of a corporation away from honest and conscientious corporate officials; and, on the other hand, by unscrupulous corporate officials seeking to retain control of the management by concealing and distorting facts. . . . S. Report No. 1455, 73d Cong., 2d Sess. 77. Even the courts have recognized that the Commission’s authority in the proxy rules goes beyond disclosure. See Business Roundtable v. SEC, 905 F.2d 406, 411 (D.C. Cir. 1986) (“We do not mean to be taken as saying that disclosure is necessarily the sole subject of § 14.”). 5 Not entirely. Rule 14a-4(d)(2) limits the duration of a proxy, overriding state law provisions. 17 C.F.R. § 240.14a-4(d)(2). State law allows proxies of unlimited duration. See, e.g., RMBCA § 7.22. 6 See Cort v. Ash, 422 U.S. 66, 84 (1975) (“Corporations are creatures of state law, and investors commit their funds to corporate directors on the understanding that, except where federal law expressly requires certain responsibilities of directors with respect to stockholders, state law will govern the internal affairs of the corporation.”). See also Santa Fe Indus., Inc. v. Green, 430 U. S. 462 (1977) (refusing to extend Rule 10b-5 liability to allegations of corporate mismanagement). See also
Robert Brown. 1997) (“The shareholder proposal process affects the internal governance of corporations.ssrn. No other single document. See Exchange Act Release No.12 The requirement Exchange Act Release No.com/sol3/papers. 4185 (Nov. 1490 (1970). See also Guth v. 1969) (“In conferences with the Study. Rev. see J. The Legitimacy of the Business Corporation in the United States 94 (1970) (“the core reality of stockholder suffrage in the 2009-2 SUPPLEMENT 2B-4 . see also Hurst. Report and Recommendations to the Securities and Exchange Commission from the Disclosure Policy Study. 2006). 18. the disclosure requirements themselves interfered with the governance process. 432 F. apart from the prospectus.R. Rule 14a-8 expanded the rights of shareholders by providing them with access to management’s proxy statement. the disclosure of related-party transactions allowed shareholders to know about transactions that could violate a director’s duty of loyalty. 1970). the right was accompanied by severe restrictions on the scope of permissible proposals. In addition. 7 17 C. for Human Rights v.8 In addition. See AFSCME v.7 The right was not entirely designed to benefit shareholders but had the additional purpose of removing from management the obligation to disclose proposals that it knew would be made at an upcoming meeting. 462 F. Corporate Governance. First.10 The Commission had its hands full ensuring that shareholders had what they needed to make informed decisions on voting matters.9 With respect to corporate governance. was regarded as containing information of greater usefulness in evaluating the securities of publicly held corporations. and it is state law—not federal securities law—which is primarily concerned with corporate governance matters. 12 The proxy process has largely supplanted the annual meeting as a vehicle for exercising the franchise.”).01 THE REGULATION OF CORPORATE DISCLOSURE Nonetheless.” Eisenberg. disclosure initially appeared to be a sufficient approach to regulation.cfm?abstract_ id=1095032.2d 659 (2d Cir. 11 See Item 404 of Regulation S-K (requiring disclosure of related party transactions). Denver Legal Studies Research Paper No. SEC. Loft.2d 503. a position overturned by the courts. there were some early exceptions. 1489. 08-05.”). 5 A. facilitating their ability to obtain support for proposals they might make. § 240.3d 121 (2d Cir. 83 Harv... Access to the Corporate Proxy Machinery. 510 (Del. it became apparent that disclosure was not enough. 1939) (setting out test for duty of loyalty). More recently. As one commentator stated: “It is well known that proxy voting has become the dominant mode of shareholder decision making in publicly held corporations. The SEC. however. See Medical Comm.11 Over time. 8 For a more in depth discussion of this topic. University of Denver Sturm College of Law. For public companies. at 41 (March 27. Inc. disclosure facilitated the exercise of certain state law rights.§ 2B.. Thus. Inc. Instead. 39093 (Sept. and Shareholder Access to the Board Room. many security analysts stressed the value of merger proxy statements. 1948). The provision was adopted in 1948. American Int’l Group. http://papers.F.14a-8. the proxy process largely supplanted the annual meeting as the mechanism for resolving shareholder issues. 5. the rule shifted the burden to shareholders. L. limiting the usefulness of the newly established right. the courts have overturned the agency’s position with respect to proposals involving the election of directors. Jr. 9 The Commission initially prohibited many proposals involving matters of public debate. 10 See A Reappraisal of Administrative Policies Under the ’33 and ’34 Acts.
1986) (striking down SEC rule requiring one share. Ch. Such a rule undoubtedly proves intimidating and likely discourages many shareholders from attempting to wage a proxy contest. however. yet realizing the need to improve the governance process. Ltd.F.R. 947 A. 953 A. 15 The problem was ameliorated somewhat by the shareholder proposal rule and the ability to use management’s proxy statement.GOVERNANCE AND DISCLOSURE § 2B. 2006). although management is reimbursed for its proxy expenses from the corporate coffers. 1st Sess. 77th Cong. and nominating committee must each reveal information about its inner workings. Aug. 35 (House Comm. big company lay in the use of proxy machinery. 7. shareholders were left risking their own funds. The audit.13 Corporate officials could use the company treasury to pay the costs.01 that solicitations be preceded by a proxy statement added substantial cost to the process. the Commission believes that disclosure of the nonexistence of the named committees serves a valid informational purpose.. Inc. compensation.2d 1120 (Dec.2d 227 (Del. 6. 17 See Exchange Act Release No. at least in part in an effort to pin point the role of the CEO in the process. at least when using the stock exchanges as the mechanism for implementation.17 The result has been dramatic expansion in the amount of disclosure a company must make about its corporate governance process. Print. Report of the Securities and Exchange Commission on Proposals for Amendments to the Securities Act of 1933 and the Exchange Act of 1934.16 Lacking governance authority. designed less to provide investors or shareholders with material information and more to affect the behavior of officers and directors. § 240. The disclosure requirements were.15 Efforts. 14 See Jana Master Fund. nominating and compensation committees. the Commission increasingly tried to use disclosure as a fix.C. contained numerous exclusions. therefore. 1978) (“the Commission recognizes that the adoption of this disclosure requirement in some instances may indirectly stimulate the establishment of audit. AFSCME. The material ranges from board attendance to board independence. SEC.). 905 F. 1941) (“Ownership of securities is so widely diffused that voting by stockholders in corporate meetings is today affected almost entirely by proxies.”).3d 121 (2d Cir. Anything associated with elections required a separate proxy statement. 13 See Rule 14a-3. American Int’l Group. 16 See Business Roundtable v. The courts have recently forced the Commission to reexamine this requirement. Action No. 2B-5 2009-2 SUPPLEMENT . summarily stopped by the courts.14a-3. See also CA v. See AFSCME v. 2008) (concluding that shareholder proposal mandating reimbursement to insurgents who succeeded in electing a candidate to the board violated Delaware law absent a fiduciary out provision).”). 17 C. Civ. something the agency occasionally admitted. Cir. The rule.14 The result was a practical diminution in the ability of shareholders to nominate competing slates of directors. AFF’D.”). 15384 (Dec.”). CNET Networks..”). v. insurgent shareholders finance their own bid and can hope for reimbursement only if that bid is successful. 462 F. including those relating to the election of directors. to more directly intervene in the governance process were. 408 (D. 3447-CC (Del. however. 2008) (“Generally. one vote and noting that requirement was “concededly a part of corporate governance traditionally left to the states.2d 406.
1990) (providing agency with authority to seek civil monetary penalties in court proceedings and to impose monetary penalties and order disgorgement in administrative proceedings). § 78p(b). & S. Moreover. has not worked effectively in promoting better governance. Section 16(a) of the Exchange Act requires directors. they were designed to increase compliance with the securities laws themselves. The approach expended resources with little apparent success. L. 931 (Oct. 15 U. Bank of Am. however. See also Exchange Act Release No.02 THE REGULATION OF CORPORATE DISCLOSURE Companies must make considerable disclosure about executive compensation. 101-429. That authority only came in 1990. 20 See Exchange Act Release No.C. executive officers. 21 The Commission tried to bring enforcement actions to encourage compliance. SEC v. providing little real illumination of the governance process. 18.S.22 Frustrated with See Section 16(a). for example.02 DISCLOSURE AND COMPLIANCE WITH THE SECURITIES LAW Efforts to influence the behavior of officers and directors have long been a staple of the securities laws.g. for example. Release No. 1988) (noting a delinquency rate in filings of more than 50%). 27148 (Aug. 15 U. 26333 (Dec. providing a private right of action to recover short-swing profits by insiders. See.20 with the Commission at the time having few weapons to combat the delinquent filers. with the beneficial ownership reporting requirements. See Exchange Act Release No.. § 78p(a). on the theory that short-swing transactions (a purchase and sale within six months) present a sufficient likelihood of involving abuse of inside information that a strict liability prophylactic approach is appropriate. See Section 16(b). N. 22 See Exchange Act Release No.A. 15. Part of the problem was the remedy. 1989) (“The Commission is particularly disappointed to find that notwithstanding the publicity and concerns expressed about the substantial delinquency in filings. 1988) (noting a delinquency rate in filings of more than 50%). July 23. Pub.S. 52202 (Aug.D. the agency lacked the authority to penalize those violating the requirements. the approach has often resulted in boilerplate. there has not been a substantial improvement in compliance.21 In 1988. Section 16(b) operates without consideration of whether an insider actually was aware of material non-public information. 3. Disclosure. e.19 The provision was often ignored. Extensive disclosure of executive compensation has not. 1984). At the time.”) (footnotes omitted). In some cases. 26333 (Dec. 13. No. the Commission proposed changes in the proxy rules to require reporting of non-compliance with the reporting requirements.18 Section 16(b) provides a private right of action for paired trades that occur within a six-month period. altered the upward trajectory in CEO pay. See The Securities Enforcement Remedies and Penny Stock Reform Act. and 10 percent shareholders to report changes in their beneficial ownership.C. 10469 (D.. 13. including the process used by the board in determining the amount.C. 2005) (“Unlike insider trading prohibitions under general antifraud provisions. This was true. Section 16(b) operates strictly.§ 2B. § 2B. 104 Stat. In a 19 18 2009-2 SUPPLEMENT 2B-6 .T.
24 The reports must be submitted electronically25 and sent to the company contemporaneously with filing.] 2B-7 2009-2 SUPPLEMENT .16a-3(e). See Exchange Act Release No. e. 38192 (admin. 23 See also Exchange Act Release No.F. 27148 (Aug. 3. See.7% of the transactions reported in calendar year 1988 were reported more than three days late. Corp.g. Exchange Act Release No. 2003). 28869 (Feb. 2003). 25 Exchange Act Release No. The agency all but admitted that the requirements were designed to increase compliance rather than provide investors and shareholders with useful information. the Commission is concerned about the widespread lack of compliance with the reporting requirements under Section 16(a). and (2) reveal the number of violations by each individual.”). The company can meet the requirement by linking to third-party sites if certain conditions are met. 17 C. 27 Section 16(a)(2)(C). including the details of the transactions. 17 C. 8. Where insiders have not filed a Form 5. Item 7(b). 28869 (Feb. proc. the company must: (1) identity all insiders who failed to file or who filed delinquently. The Commission has brought actions for violation of the provision. 1991).. Exchange Act Release No. 28 Rule 16a-3(k). Effective on the same date. companies may assume that the forms received within three calendar days of the required filing date are current. absent designation.26 Sarbanes-Oxley shortened the time period for filing the reports. 18. 1989) (“As stated in the 1988 Release. issuers may rely upon a written representation that no form was required. The requirement of electronic filing was included in the Sarbanes-Oxley Act (SOX).F. See Section 403 of SOX. 47809 (May 13. See Exchange Act Release No.R. the agency set forth a proposal that would place the reporting obligation squarely on the company. 1989.R. 46421 (Aug. 2002).7% for transactions reported in the first five months of 1989. 24 Rule 16a-3(g)(1). 26 Rule 16a-3(e).27 something that has had an impact on the backdating scandal. 1991). Item 405(b)(2). 47809 (May 13. 17 C. 29 See Exchange Act Release No. The form must be sent to the person designated by the company or. 3.16a-3(k). 30 See Schedule 14A. Exchange Act Release No. Not only could disclosure be potentially embarrassing to the company but also it would alert the Commission to violations.02 individual non-compliance. 2002) (adopting two-business-day requirement). 8.R. Jan..”). § 240. 2005). 27. This reinforces the Commission’s conclusion that the proposed proxy disclosure and fines are necessary.28 Item 405 to Regulation S-K in turn requires companies to disclose any violations of the insider reporting requirements in its proxy statement or annual report.F. § 240. to the corporate secretary. No other information need be disclosed. the Commission found 36.29 Specifically. as amended by Section 403 of the Sarbanes-Oxley Act. the Commission adopted rule amendments to implement the accelerated Form 4 due date. Companies with a public Web site are required to post the reports by the end of the business day after filing and leave them there for at least 12 months.30 recent study. The requirement was originally 10 days after the close of the month in which the transaction occurred. In determining compliance. In re Cortland First Fin.GOVERNANCE AND DISCLOSURE § 2B. 52202 (Aug. As of June 10.16a-3(g)(1). 22. 31 [Reserved. § 240. the delinquency rate was 34. 1997).23 Individuals must file reports within two business days of execution of the applicable trade. See Exchange Act Release 46421 (Sept.
58620 (Sept. 172 (1964) (securities laws did not “define Federal standards of directors’ responsibility in the ordinary operations of business enterprises and nowhere empowers us to formulate administratively such regulatory standards. 42 S. See also Exchange Act Release No. Inc.33 The agency ultimately went beyond admonitions and began using a mix of rulemaking and enforcement proceedings in an effort to elevate the behavior of directors.03  DISCLOSURE AND STATE FIDUCIARY OBLIGATIONS Overview The obligations imposed on officers and directors in the management of the company arise mostly out of their fiduciary obligations.”). 1972) (“To this end. 2009-2 SUPPLEMENT 2B-8 .E. the Commission has taken the position that it has no authority to set substantive standards for director behavior. In general.. 2707 (Dec. Compliance no doubt increased.§ 2B.32 This did not prevent occasional Commission pronouncements in the area. in large part because the requirements placed added responsibility on the company. 33 See In re McKesson & Robins. 9548 (March 23. § 2B. 19. 23.”).S.03 THE REGULATION OF CORPORATE DISCLOSURE The disclosure requirement likely had its intended effect. the Commission. Accounting Series Release No. Exchange Act Release No.34 32 See In re Franchard Corp. altering substantive behavior. They must. 2008) (“New Item 16G would require foreign private issuers to provide a concise summary in their annual reports of the significant ways in which the foreign private issuer’s corporate governance practices differ from the corporate governance practices followed by domestic companies under the relevant exchange’s listing standards. in the light of the foregoing historical recital. These in turn depend upon state law. The diligence required of registrant’s directors in overseeing its affairs is to be evaluated in the light of the standards established by State statutory and common law. 5.”). disclose the differences. particularly in the context of corporate disclosure. 163. The approach arose from the recognition that the threat of liability under state law was not sufficient to ensure that boards applied a rigorous enough standard with respect to their disclosure responsibilities. such as the early suggestion that public companies have audit committees consisting of non-officer directors. Foreign issuers are not even obligated to abide by U. companies preferred to avoid something akin to embarrassing disclosure in SEC filings by having to admit that officers and directors filed beneficial ownership reports in an untimely fashion.C. however. In general. 1940). governance standards. endorses the establishment by all publicly-held companies of audit committees composed of outside directors and urges the business and financial communities and all shareholders of such publicly-held companies to lend their full and continuing support to the effective implementation of the above-cited recommendations in order to assist in affording the greatest possible protection to investors who rely upon such financial statements. 34 See Exchange Act Release No..
37 Exchange Act Release No. after considering the commentary. 1989). on balance. It took until 2004 before the Commission finally eliminated Item 5. the Commission eventually reduced the period to five business days. 1978) (adopting release) (“Some commentators who opposed adoption of the proposal were concerned that this disclosure would discourage the evolution of stronger boards by increasing divisiveness among board members. disclosure of this supposedly material information depended not upon its importance to investors or shareholders but upon the predilections of the departing director. 36 35 2B-9 2009-2 SUPPLEMENT .”). Originally requiring the disclosure to be filed within 15 calendar days. Commentators complained that the provision would discourage the development of stronger boards and hamper debate. 6. Exchange Act Release No. It is also expected that the proposals could enhance the effectiveness of directors by assuring them a forum in which to express differences of opinion on matters that are sufficiently serious to result in termination of the director’s association with the issuer. instead. the Commission believes that. 15384 (Dec. As the Commission noted: disclosure of director resignations or declinations to stand for re-election is consistent with the increasing emphasis on the monitoring function of corporate boards and would provide useful information to investors in assessing the quality of management. 6. and the issuer will be relieved of any obligation to document and characterize what it believes are the reasons for director resignations.”). therefore. Others noted that the proposal might make it more difficult to attract and retain directors with divergent viewpoints. allowed a director who objected to any impropriety to force disclosure of the disagreement.35 The requirement had little to do with material information. mostly by providing leverage to a resigning director unhappy with the actions of the board.36 The requirement. See Exchange Act Release No.” Id. 38 Only where the resigning director provided the board with a letter explaining the disagreement was disclosure mandated. This gave boards an incentive to resolve such disagreements and avoid the resulting publicity. at least those leading to a director’s resignation or decision not to stand for re-election.03 An early example of the use of disclosure to impact board behavior was the requirement of disclosure of disagreements at the board level. 14970 (July 18. the director will have a forum if he chooses to use it. The provision did not apply to a resignation or failure to stand for re-election for “personal reasons. 1978) (adopting release) (“However. 1978). whether disclosure related or otherwise. Form 8-K.38 Thus. 15384 (Dec.37 The Commission left to the resigning director the sole discretion to determine whether disclosure should occur.02(a). If disclosure is triggered by director request. it is more appropriate to require disclosure only upon the request of the director. It was. Exchange Act Release No. 26587 (March 2. inextricably linked to the corporate governance process.GOVERNANCE AND DISCLOSURE  Director Resignations § 2B.
The letter must be filed as an exhibit within two business days of receipt.. refusal to stand for re-election. pursuant to which such director was selected as a director. Exchange Act Release No. Disclosure includes: • • • the date of resignation. including the CEO and CFO. principal accounting officer.43 39 See In re Hewlett-Packard Company. irrespective of the wishes of the resigning director.com. 41 Item 5. the provision applies to any principal executive officer. 43 See In re NetAir.39 Under Item 5. Silicon Valley venture capitalist and fellow director Thomas Perkins (not the source of the leak) voiced his strong objections to the handling of the matter. or removal. and a brief description of the disagreement. there must also be a “brief description” of any material contract or arrangement involving the director. or practices or whenever a director has been removed for cause. and walked out of the Board meeting. Inc.40 The company must show the disclosure to the departing director and provide an opportunity to submit a letter setting forth any disagreements. or any person performing similar functions. 2002) (“NetAir has violated Section 13(a) of the Exchange Act and Rule 13a-11 by (i) failing to file a Form 2009-2 SUPPLEMENT 2B-10 . 2006.02(d) of Form 8-K. the disclosure must include the board committees assigned to the director and certain related party transactions. The reporting requirement has gone beyond the resignation of directors. Sept. disclosure is required any time a director resigns or refuses to stand for re-election because of a disagreement known to an executive officer of the company in connection with the company’s operations. 42 Specifically. 40 Item 5. or removal. HP failed to disclose to investors the circumstances of Mr.§ 2B. policies.”). principal financial officer. proc. The form must identify the director and date of election and must include “a brief description of any arrangement or understanding between the new director and any other persons. HP’s Board of Directors learned the findings of the company’s leak investigation and voted to request the resignation of a director believed to have violated HP’s policies by providing confidential information to the press. 55801 (admin. refusal to stand for re-election. Finally.42 The Current Report must be filed whenever the officer resigns. Item 5. Companies must file a current report anytime a director is added to the board without shareholder approval. any positions held by the director on any committee of the board at the time of resignation. president. is removed or has refused to stand for election. 46465 (admin. principal operating officer. proc. The provision has also been expanded to include the resignation of top officers. Perkins’ disagreement with the company. 2007) (“On May 18.”41 In addition. naming such persons. Exchange Act Release No. announced his resignation. 6. May 23. Contrary to the reporting requirements of the federal securities laws.02(a) of Form 8-K.02(a) of Form 8-K.03 THE REGULATION OF CORPORATE DISCLOSURE this discretion and imposed an affirmative duty to disclose a disagreement. retires.02(b) of Form 8-K.
which was potentially less likely with directors under the sway of the CEO46 or motivated by friendship. Exchange Act Release No. is terminated or reassigned. Having adequate procedures was not enough to ensure accurate and complete disclosure.401(b). Perhaps the most pronounced intrusion into the governance process through the mechanism of an enforcement proceeding occurred in In re WR 8-K disclosing that its only two officers and directors have resigned from the corporation. 30. Exchange Act Release No. however. 8. date of appointment. (d). 46084 (June 17. We believe that the nature of the relationship between a director and the company’s security holders. 2000) (“He allowed his loyalty to a friend to override his obligations to ensure that the company’s disclosures were accurate and complete. as the result of a disagreement with the company. the departure as it would be if a director departed under similar circumstances. § 229. The agency has used these proceedings to issue pronouncements on the duties of directors in the disclosure process. is sufficiently different to justify the expanded procedures for directors. Jr. with the company not having to provide the reason for an officer’s departure. or seek the officer’s explanation of.R.”).”).F. (d).”). 44 The report must include the information required by Items 401(b).45  Enforcement Proceedings and Governance The Commission also used enforcement proceedings to improve the governance process. 2B-11 2009-2 SUPPLEMENT . including the name. and Item 404(a) of Regulation S-K (17 C. disclosure must also occur of any new appointment.5 (Sept.02(a) is that if an officer resigns.404(a). is weaker than that applicable to directors. remedies imposed on companies provide strong indications of the Commission’s views on the proper form of governance.44 and a brief description of any employment contract.”). (e). 2002) (“One important difference between the proposed disclosure under this Item 5. (e) and § 229. Grace.03 In addition. It also required a board of directors willing to enforce the disclosure requirements.02(b) and the proposed disclosure about a director’s departure because of a disagreement under proposed Item 5. 43129 (admin. and that NetAir now has no officers or directors.GOVERNANCE AND DISCLOSURE § 2B. the company would not be obligated to disclose the reasons for. did not disclose some of his retirement benefits and the proposed transaction with his son in questionnaires which WRG distributed to officers and directors to gather information for disclosure in WRG’s proxy statements and periodic reports. and for “causing” violations of the securities laws. 46 See In re WR Grace. proc. 47 In re Friedberg. WRG’s procedures failed because. this matter demonstrates that corporate disclosure mechanisms cannot compensate for the failures of individuals.47 The Commission has the authority to bring actions against executive officers under the antifraud provisions both as primary or secondary violators. 1997) (Section 21(a) Report) (“Indeed. including the security holders that elect directors. Aug. The function of directors is to oversee the company for the shareholders to whom they are directly answerable. 39157 n. among other reasons. In addition. certain background information. 45 Exchange Act Release No. The disclosure.
48 a Section 21(a) Report.. Exchange Act Release No. Sept. . As the agency noted: Serving as an officer or director of a public company is a privilege which carries with it substantial obligations. Jr. See In re W. use of Company property.’s ‘other benefits’ became public. the proxy statement said nothing about the costs of these benefits. The failure resulted in part from a “corporate culture” at the company in which the CEO had “substantial influence. Exchange Act Release No.” including use of: (a) a Company-owned apartment with a market value estimated to be in excess of $3 million that came with a cook. 39156 (admin. practices or matters which it may deem necessary or proper” in fulfilling its responsibilities under the Exchange Act. The Commission also filed an administrative proceeding.S.§ 2B. 39156 (admin. The CEO had also filled out a D&O questionnaire and made no mention of the perquisites. including. Grace & Co. and (f) security services.’s having access to corporate aircraft. conditions. he or she has an obligation to correct that failure. Section 21(a) allows the Commission to publish information “concerning any . Exchange Act Release No. proc.” The agreement was filed as an exhibit but did not mention the perquisites. Grace & Co.R. WRG disclosed in its 1995 proxy statement that the benefits provided to [the CEO] pursuant to the ‘other benefits’ provision cost the Company $3. 1997).000 was attributable to Grace.”).50 The 1993 proxy statement for the company did not disclose the perquisites. 30.49 The case involved the failure to disclose certain benefits provided to the retiring CEO. (d) corporate aircraft.R. Exchange Act Release No. among other things. These questionnaires contained questions asking whether [the CEO] received certain benefits from the Company during the preceding year. An officer or director may rely upon the company’s procedures for determining what disclosure is required only if he or she has a reasonable basis for believing that In re WR Grace.”) (footnote omitted). proc. Jr..10 (admin. 30. including apartments. proc. reviewed the disclosure before filing. .03 THE REGULATION OF CORPORATE DISCLOSURE Grace. 39156 n.C. stating only that the CEO would receive “certain other benefits. including one outside director.R. violations” and to investigate “any facts. 15 U. with directors’ and officers’ questionnaires in the course of preparing its 1992 Form 10-K and 1993 proxy statement and its 1993 Form 10-K and 1994 proxy statement. and other perquisites. the CEO would continue to receive “various substantial perquisites. Among other things. § 78t(a). 1997) (“After information concerning Grace. 1997) (Section 21(a) Report). 30. housing and other living expenses (including domestic service) provided at his principal and/or vacation residence. [The CEO] incorrectly responded ‘no’ to these questions.500 in fiscal year 1993. 30. Sept.” The Commission viewed the omission as a failing of the board of directors. (b) a limousine and driver on a 24-hour basis.. Grace & Co. Similarly.700. 51 In re W.51 At least two directors aware of the perquisites. of which approximately $2. (c) full-time secretaries and administrative assistants. 50 In re W. Sept. (e) home nursing services. 49 48 2009-2 SUPPLEMENT 2B-12 . If an officer or director knows or should know that his or her company’s statements concerning particular issues are inadequate or incomplete. 39157 (Sept.601. Jr. 1997) (“The Company provided Grace.
1997) (Section 21(a) Report). In re Hycel. The present matter. In re Gould. 39157.”53 In effect.54 There was. The Commission’s disclosure program endeavors to illuminate the information that would allow a shareholder to evaluate the independence of the directors and vote on a more fully informed basis with respect to the election of directors. Dec. See also Exchange Act Release No. 55 Although the importance of independent directors received some attention. Prior cases had emphasized the role of directors in the disclosure process but only when confronting evidence of fraud.” In re WR Grace. Other decisions by the Commission attempted to fix responsibility more specifically. 39157. Moreover. Exchange Act Release No. and is crucial to the objective oversight of management. is the focal point of the corporate governance system. Exchange Act Release No. 14380 (Jan. See In re Cooper Cos. Inc. 1997) (Section 21(a) Report). Exchange Act Release No.2 (Sept. 2003) (“Effective oversight of the financial reporting process is fundamental to preserving the integrity of our markets.GOVERNANCE AND DISCLOSURE § 2B.. “there do not appear to have been any “red flags” or warnings to indicate that this system—which included the employment of respected and competent securities counsel—was breaking down. In re Stirling Homex. composed of members of the board of directors. 30. Exchange Act Release No. As the Commission noted: “Each of these Reports focused on the failure of non-management directors to act effectively when confronted with evidence of management’s involvement in possible securities fraud. however. especially as they concern those matters within their particular knowledge or expertise. 30. 11516 (July 2. or was inadequate to produce documents that would comply with the federal securities laws. 1997). 13612 (June 9. noting that the company had policies and procedures in place that were designed to ensure accurate disclosure. elected by and accountable to shareholders..”). 53 52 2B-13 2009-2 SUPPLEMENT . the case required directors and executive officers to play a more active role in the disclosure process. 20. 9. Inc.” This required a “vigilant” exercise of “authority throughout the disclosure process. e. and maintaining the independence of directors allows the board to fulfill its fiduciary responsibilities objectively and candidly. in contrast. deals with the obligations of officers and directors where a company’s violations do not constitute fraud. The case seemed more about fiduciary obligations than duties under the federal securities laws. 56 See.56 In re WR Grace. proc. July 20.. 35082 (Dec. 1978) (requiring audit committee to review annually certain policies with respect to executive compensation). 2004) (“The independence of directors is a linchpin of sound corporate governance. 14981 (admin. 47654 (Apr. Exchange Act Release No. 1978).” In re WR Grace. Co. little follow-up55 and the decision seemed to have at best marginal impact on board behavior. See In re Walt Disney Corp. Exchange Act Release No.03 those procedures have resulted in full consideration of those issues. Exchange Act Release No. Exchange Act Release No. See also In re National Tel. § V (Sept. The board of directors. The audit committee.g.. 12. Dissent of Commissioner Wallman (Sept. 30.52 Thus. 54 One commissioner dissented. 1975). 1994).”). Exchange Act Release No. officers and directors had an obligation to “take steps to ensure the accuracy and completeness of the statements contained therein. 50882 (admin.. The interests of the shareholders should be the paramount concern of the board of directors. 16. usually by imposing responsibilities on a particular committee of the board. 1977). plays a critical role in providing oversight over and serving as a check and balance on a company’s financial reporting system.. proc. 39157 n.
000 civil penalty and enjoined from violating the securities laws. The three directors sat on the board and served on the audit and compensation committees. 20724 (N.04 THE REGULATION OF CORPORATE DISCLOSURE A more recent example occurred in SEC v.§ 2B. should have conducted their own examination and investigation and relied less on executive management.. at least for listed companies. The changes collectively sought to make the board more independent and less beholden to top officers. Early listing standards centered on disclosure and voting rights and had little to do with board 57 Litigation Release No.57 The case arose out of backdating allegations at Mercury Interactive.04  DISCLOSURE AND THE BOARD OF DIRECTORS Overview With state law playing little role in affirmatively improving the governance process.” Moreover. Cal.D. the directors approved 21 grants upon the recommendation or direct participation of senior management. more recently. including the antifraud provisions. Nonetheless. According to the complaint. Sept. Three outside directors settled charges alleging that they recklessly approved backdated stock option grants and signed SEC filings that were false. through legislative efforts. 17. The requirements have tended to involve reforms at the board level with increased reliance on independent directors and specific committees of the board. The directors were required to pay a $100. The directors. Kohavi. Instead. the directors approved the options “while failing to observe. there were “numerous facts and circumstances” indicating that management had backdated the options. among other things. 2009-2 SUPPLEMENT 2B-14 . the Commission essentially sanctioned the directors for inattention. They should have noticed the surrounding circumstances that suggested backdating and verified the contents of the documents supporting the issuance of the options. the exchanges have taken the lead in imposing more rigorous corporate governance requirements. 2008). attention shifted to the stock exchanges. The NYSE had long played a role in the governance process. The case was notable because it meant the Commission was charging outside directors without proof that the directors actually knew about the backdating. that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval. in other words. Sometimes as a result of jawboning by the Commission and. The directors knew that the options were required to be priced at the closing price of Mercury stock on the date awarded. § 2B.
13346 n. 41987 (Oct.9 (March 9. See Roberta S. the Commission. the NYSE put in place the one-share. 1977) (“For example. 328–29 (2001).61 The Exchange duly adopted rules requiring an audit committee consisting entirely of independent directors. 1985). with minimum voting rights for preferred shareholders instituted 14 years later. 1977). 7. 54 SMU L. 58 2B-15 2009-2 SUPPLEMENT . since 1926. that the self-regulatory organizations first adopted audit committee requirements in the 1970s. the NYSE refuses to list a class of stock whose voting rights are subject to unusual restrictions.GOVERNANCE AND DISCLOSURE § 2B. see Exchange Act Release No. Rev.”). tepid suggestions that companies institute audit committees with non-management directors but invariably stopped short of actually imposing the requirement. 1999) (“Since the early 1940s. 54 SMU L. and currently it will delist the voting common stock of a company which creates a class of non-voting common stock or fails to solicit proxies for meetings of its stockholders.5 (March 20.” Id. See also Exchange Act Release No. As a matter of policy. 1977) (noting that “support for audit committees independent of management developed in the wake of recent revelations of questionable and illegal corporate payments. The audit committee had to consist of directors independent of management and free from any relationship that “would interfere with the exercise of independent judgment as a committee member.”). For a brief overview of the listing standards in place prior to 1977. It was. with the Commission’s encouragement. 13346 (Mar.9 (March 9. they should be of approximately equal size and tenure. Karmel. A company whose board of directors is divided into more than three classes may not list its shares. would interfere with the exercise of independent judgment as a committee member. 340 (2001). 13346 n. along with the auditing and corporate communities. Certain redemption schemes are prohibited. 62 See Exchange Act Release No. however.”). in large measure. 60 See Exchange Act Release No. In authorizing additional shares distributed by a stock dividend. the NYSE has refused to list non-voting common stock.”) (footnotes and cites omitted). in the opinion of its Board of Directors.59 In the aftermath of the corporate bribery scandal in the 1970s. 63 The language is quoted in Exchange Act Release No. 1984). 325. 61 See Roberta S. 59 See Exchange Act Release No. 9. See Exchange Act Release No. for instance.62 The definition of independent.58 The NYSE made occasional. 1977) (“The NYSE first suggested the concept of an audit committee in 1940.22602 (Nov. NASDAQ merely required that a majority of the directors on the audit committee be independent. has had a continuing interest in promoting effective and independent audit committees.6 (March 9. 20767 n. The Future of Corporate Governance Listing Requirements. merely required that the directors be “independent of management and free from any relationship that. Karmel. Rev. if the board is divided into classes. listed preferred stock must have certain minimum provisions enabling holders to obtain board representation in the event of dividend default.”63 In 1926. Since 1940. one-vote requirement for shareholders. and in recent years has strongly recommended that each listed company form an audit committee preferably composed exclusively of outside directors. The Future of Corporate Governance Listing Requirements. a company can be required to transfer from earned surplus to permanent capitalization an amount equal to the fair value of such shares. 325. 7.04 behavior. 13346 n.60 the Commission pressured the NYSE into reforming its listing standards to strengthen the system of governance. and the directors’ terms of office should not exceed three years. and must be protected against compulsory change in rights and preferences.
nominating. 68 See Section 10A(m). the governance requirements imposed by the exchanges again underwent substantial revision. 7. 65 See Exchange Act Release No. 17 C. Audit committees were given specific responsibilities. 67 See Exchange Act Release No. That changed with the collapse of Enron and Worldcom. 48745 (Nov. Moreover. 41987 (Oct. with members of the audit committee being prohibited from accepting any payment. The exchanges had little economic incentive to enforce the standards and shareholders lacked a private right of action. such as technological developments and increasing pressure on companies to meet earnings expectations.C.04 THE REGULATION OF CORPORATE DISCLOSURE By the new millennium. however.66 In addition. only went so far. the listing standards could do little to affect the actual process used by the board.64 Listed companies had to have an audit committee consisting of independent directors who were “financially literate. 66 See Exchange Act Release No.68 In addition. however. the governance requirements had toughened somewhat. 11.10A-3.67 SOX and implementing rules by the Commission imposed significant additional obligations on the audit committee. The NYSE required that the boards of listed companies consist of a majority of independent directors. typically had an uncertain or even secondary role in the financial disclosure process. 15 U. The exchange standards. Moreover. the definition of independent was made tougher. other than fees. See Exchange Act Release No. 14. each board had to have a compensation. 1999). 1999) (“We have seen a number of significant changes in our markets.F. there were reasons to believe that enforcement of the standards would remain weak. The definition of independence contained little content and left it to each company to determine. the definition of independent was strengthened. the Commission developed considerable concern with the practice of earnings management. 42233 (Dec. Congress responded by adopting Sarbanes-Oxley. including the right to hire and fire the outside auditor. and audit committee staffed solely by independent directors. 64 2009-2 SUPPLEMENT 2B-16 . there was nothing in the governance standards that prevented the CEO from controlling the director nomination process.§ 2B. 2003).” In addition. 47672 (Apr. § 78j-1(m). directly or indirectly from the company. § 240. the NYSE required a charter delineating the committee’s responsibilities. while useful.”) (footnote omitted). In addition. with most of the responsibility resting remaining with executive officers. 4. The audit committee. While boards were required to have independent directors and key committees. Audit committees with independent directors was perceived as one way to reduce the incidence of the practice. In the 1990s. See also Rule 10A-3.S. particularly in connection with audit committees. an Act that to some degree toughened governance standards.R. 2003). that make it ever more important for the financial reporting process to remain disciplined and credible. Finally.65 Despite these efforts. the governance requirements contained gaps.
much of the Item 407 disclosure concerns independent directors.nyse. and requirements with respect to process by which shareholders can communicate with the board. the requirements had. In general. 71 See NYSE Manual. therefore. Exchange traded companies must have a majority of independent directors on the board.GOVERNANCE AND DISCLOSURE § 2B.71 A survey of the top 100 publicly traded companies.html?nyseref=http%3A//www. [a] Independence The presence of independent directors on the board has become perhaps the most importance change in the corporate governance landscape.F.R. the Commission has consolidated all corporate governance disclosure into Item 407 of Regulation S-K. See Exchange Act Release No. 2008. 72 See Corporate Governance Trends.01 (“Listed companies must have a majority of independent directors.69  Disclosure Requirements In general.04 The Commission responded to these dynamics by requiring substantial disclosure by companies concerning their compliance with listing standards.70 The provision provides for instructions on the disclosure of director independence. therefore. See 17 C. however.R. a goal of highlighting the role of the CEO in the governance process. Much of the disclosure must occur in the proxy statement distributed prior to the annual meeting at which directors will be elected. the Commission adopted a number of disclosure requirements designed to affect the process used by the board and its committees. § 229. Companies. however. 2008) (adopting technical amendments to Item 407). Schedule 14A. audit and nominating). See Item 7. the existence of certain board committees. must make considerable disclosure concerning the independence of directors.407. In 44% of the cases. the three board committees mandated by the exchanges (compensation. with the antifraud provisions made available against a company that misstated its compliance. the CEO was the only non-independent director on the board.”).com/regulation/nyse/ 1101074746736.nyse. § 229. at their core. In addition. Technical amendments to the provision were adopted in 2008. with the intended purpose a reduction in that influence.404. ¶ 303A.402 and § 229.html&displayPage=/lcm/lcm_subsection. 58656 (Sept. board meetings and attendance. Shearman & Sterling.com/Frameset.72 Unsurprisingly.html.F. 70 69 2B-17 2009-2 SUPPLEMENT . This provided an alternative mechanism for enforcing the standards. revealed that most had boards with 75% or more independent directors. http://www. 17 C. and the process used by these committees in making decisions. 30. The two principal exceptions are executive compensation in Item 402 and related party transactions in Item 404.
R. § 229.R. .F. disqualifies directors who have a “material relationship” with the listed company.F. § 229. 54302A (Aug.407(a).F. identify the most recent fiscal year in which the policies were so included in satisfaction of this requirement. Companies must use the definition of the exchange where they are traded.”). be enough detail “to fully describe the nature of the transactions. For those without one of the three committees.407(a)(2) (“If a current copy of the policies is not available to security holders on the registrant’s Web site. 17 C. 74 Item 407(a). and is not included as an appendix to the registrant’s proxy statement or information statement.”80 At one level. however. § 229. determination of independence ultimately rests with the board.407(a)(3). The requirements apply to any person who served as director for any part of the year.F. 17 C.F. See Instruction 2. 80 See Note 3.”). 17 C. relationships.407(a). See Item 407(a)(1) (“If the registrant does not have a separately designated audit. If they are not traded on such an exchange. audit. the companies must pick a definition from an exchange that does require that at least a majority of the board be independent and disclose the choice. 17 C.04 THE REGULATION OF CORPORATE DISCLOSURE Public companies must identify each director and nominee73 and disclose those who meet the definition of independent under rules of the relevant exchange. 2006) (“Consistent with the rule proposals. 79 Item 407(a).76 Under the exchange rules. As a practical matter.407(a). See also Exchange Act Release No.74 The disclosure must specifically identify any director on the compensation. § 229.§ 2B. Item 407(a). need only be made by “specific category or type. it is limited to exchange traded companies.407(a).F. nominating or compensation committee or committee performing similar functions. the amended rule requires that the disclosure be made on a director by director basis. 17 C. 2009-2 SUPPLEMENT 2B-18 . Item 407(a) of Regulation S-K.407(a).R. the registrant must provide the disclosure of directors that are not independent with respect to all members of the board of directors applying such committee independence standards. relationships or arrangements. relationships or arrangements is readily apparent. 77 See NYSE Rule 303A. 17 C. the requirement acts as a double check on management. Item 407(a). Independence Tests. 75 The obligation only applies to companies required to have independent directors on board committees. § 229. § 229.78 Disclosure.F. therefore. with separate disclosure of categories or types of transactions. companies must also disclose any “transactions. relationships or arrangements for each director and director nominee.R. while containing some categorical components. 78 Item 407(a)(3).R.R. assuming the exchange requires that at least a majority of the board be independent. however.75 Definitions adopted by the company must be either posted on the Web or attached as an appendix to the proxy statement at least once every three years. the company must disclose the nonindependent directors for the entire board. § 229. To the extent applying a restrictive definition of “material relationship. 76 See Item 407(a)(2).R. or nominating committee who does not meet the definition of independent.77 Perhaps recognizing the discretion given to the board in making this determination. even if no longer on the board.02. We have also adopted an instruction indicating that the description of the category or type must be sufficiently detailed so that the nature of the transactions. ”79 There must. or arrangement” considered by the board for each director deemed independent.” the board 73 Item 407(a). See Item 407(a)(1). 29.”). 17 C. The NYSE definition. . .
Apparently the Commission viewed the companies as unaware of the conflicting relationship.pdf. proc. that by filing annual reports and proxy statements indicating that the auditor was independent. See Exchange Act Release No. ultimately receiving $377.500 for the work. it did send a significant message that the failure to disclose relationships that could impair independence would be the subject of enforcement proceedings. 5. Shareholders will be aware of the conflicts and can. Thompson completed a D&O questionnaire that asked about the relationship between directors and auditors but failed to “fully furnish the details of his relationship with E&Y in response to these items. the disclosure puts pressure on the board to adopt and implement a realistic definition of “material relationship.pdf. at least in general terms. as a practical matter. During the same period. despite the fact that they were the ones that engaged in the disclosure violations.” The Commission has sanctioned a director for failing to adequately disclose facts that potentially impaired independence. he entered into a collaboration with the accounting firm to create a series of audio CDs. Thompson disgorged $100.04 will nonetheless be forced to reveal the non-disqualifying conflicts.sec. available at http://www.” The relationship was likewise not disclosed in the proxy materials for these companies. The Commission did not charge the companies involved. Thompson also signed the annual reports for the two companies indicating that the auditor was independent.82 The Commission characterized Thompson as a “cause” of the violations. While the case did not involve Item 407. available at http://www. Nonetheless. 81 2B-19 2009-2 SUPPLEMENT .GOVERNANCE AND DISCLOSURE § 2B.81 the Commission relied not on Item 407 but on the independent auditor requirement to address the issue. future actions in the area may be less restrained.gov/ litigation/admin/2008/34-58310. including in one case the audit committee. the company violated the federal securities laws. 58310 (admin. 2008). Exchange Act Release No. proc.sec. 5. In In re Thompson.000 paid in directors fees as well as interest. Aug. 58309 (admin. 82 The Commission likewise sanctioned Ernst & Young. 2008).gov/litigation/admin/2008/34-58309. As part of the settlement. The Commission concluded that the business relationship impaired the appearance of auditor independence and. Aug. In addition. if for no other reason than to encourage greater attention at the company level. discount the director’s independence. Thompson sat on the board of three companies audited by Ernest & Young (“E&Y”). For two of the companies.
theracetothebottom. 15384 (Dec. 17 C.”).87 Another effort to use disclosure to affect substantive behavior. 87 In place of proxy disclosure. § 229. In the Commission’s view.html. the approach reflected in proposed Item 6(e) would elicit such information in the briefest and least burdensome manner. directors will make certain that they attend enough meetings to avoid the public dunning that would occur with disclosure. At the same time. See http:// www.84 In justifying the disclosure. Attendance would provide shareholders with additional opportunity to The instructions provide that the information can be disclosed on the company’s web site rather than in the proxy statement. attendance is an indication of effective board and committee functioning and is relevant to an evaluation of directors for election purposes.407(b)(2). Presumably. Item 407(b)(2). 14970 (July 18. While still public. 85 Exchange Act Release No.”85 In other words.”).R. Instruction. 6. the requirement was designed to affect substantive behavior by increasing board attendance. See Instruction. 1978) (“While the Commission believes that. Item 407(b)(2).04 [b] THE REGULATION OF CORPORATE DISCLOSURE Meeting Attendance The governance disclosure requirements also address meeting attendance. However. we believe that these occasions are likely to be the exception and that. the Commission is not persuaded that the contemplated disclosure would deter responsible boards from holding meetings when it is appropriate to do so. disclosure of attendance records would be of limited usefulness. shareholders succeeded in a withhold campaign against a director who had a poor attendance record. 86 The consequences could be more severe.org/shareholder-rights/shareholders-majority-voting-and-the-continuedneed-for-acce. as a general matter. 83 2009-2 SUPPLEMENT 2B-20 .§ 2B. 1978) (“The Commission recognizes that in particular instances directors may provide the board with valuable insight and expertise without actually attending formal meetings on more than an intermittent basis. the information may be disclosed on the Web site.F. Companies must also reveal any policy governing board attendance at the annual meeting of shareholders and the number of directors who actually attended.86 The requirement has probably worked. In at least one case. 84 Item 407(b). The proxy statement83 must include the number of board and committee meetings and the directors who attended fewer than 75 percent of the total number of meetings (both committee and full board meetings). it is not perfect and does not prevent companies from inserting into the proxy disclosure an explanation for poor attendance. the Commission reasoned that the information would “facilitate shareholder assessment of the [director’s] performance as well as the effectiveness of an issuer’s board and committee system generally. In addition. the requirement was designed to increase director attendance at annual meetings. See also Exchange Act Release No. the option essentially forces shareholders to have to go to multiple locations to obtain all of the relevant data. it has tentatively concluded that disclosure of a director’s failure to achieve a certain minimum level of attendance could provide information which would facilitate shareholder assessment of his performance as well as the effectiveness of an issuer’s board and committee system generally. in general.
2008.01. They provide shareholders with an indication of the number of times the board meets. designed to raise standards for directors. Corporate Governance Trends.89 The requirements are discrete but are. the requirement only goes so far. it does nothing to elevate the standards of behavior once directors are in the boardroom. 90 According to a 2008 study.88 The information may be posted on a company’s Web site rather than in the proxy statement. and compensation committees or “committees performing similar functions. 2003) (“Directors’ attendance at annual meetings can provide investors with an opportunity to communicate with directors about issues affecting the company.04 question members of the board. they encourage oversight. Listed companies are required to have all three committees. and a brief description of the functions performed by each. considerable disclosure has to occur about each specific committee.” the number of meetings held by each committee. more than half of all boards of the top 100 exchange traded companies met eight or fewer times.93 In addition. attempts to use disclosure to affect the processes employed by the committees. [c] Committee Disclosure Exchange traded companies must have at least three board committees. on the margins. the company must state whether the committees have a charter and must either make the charter available on the company’s Web site or attach the charter as an exhibit to the proxy statement at least once every three years. Directors cannot act as a check on management if they do not attend the meetings. 89 See Instruction to Item 407(b)(2) of Regulation S-K. 2B-21 2009-2 SUPPLEMENT . Shearman & Sterling. The gloss goes well beyond membership and. 92 Item 407(b)(3) of Regulation S-K. audit. 24. While encouraging attendance. nominating. 88 See Exchange Act Release No. Nonetheless. as that disclosure will give security holders a more complete picture of a company’s policies related to opportunities for communicating with directors. compensation.92 For all three committees. 93 See Instruction 2 to Item 407 of Regulation S-K. and nominating/governance.91 The SEC has added a gloss of disclosure to the committees.”). 48825 (Nov. See NYSE Rule 303A. A public company must disclose whether it has standing audit. at least in some cases. We are adopting a requirement that companies disclose their policy with regard to director attendance at annual meetings and the number of directors who attend the annual meetings.90 Moreover.GOVERNANCE AND DISCLOSURE § 2B. ¶ 303A. 91 See NYSE Manual.
Instead of facilitating shareholder nominees. 24. have a significant impact on the composition of the board and also can improve the director selection process by increasing the range of candidates under consideration and intensifying the scrutiny given to their qualifications. we intend that increased transparency of the nomination process will make that process more understandable to security holders.97 In fact. although only recently has this included the process used in selecting candidates.”). the justification was quite different and went more to the governance of the company. 2003) (“Finally.98 The impetus for the committee came as a result of increased pressure by shareholder groups for access to the company’s proxy statement for their nominees. the purpose of the disclosure requirements shifted. over time. 98 See Exchange Act Release No. the Commission believes that the institution of nominating committees can represent a significant step in increasing security holder participation in the corporate electoral process. 48825 n. 24. Additionally. 15384 (Dec. as it will provide investors with information that is useful in assessing the actions of the nominating committee. 6. a subject which the Commission will consider further in connection with its continuing proxy rule re-examination.95 The public explanation was the need to make the nominating process more transparent.§ 2B. 48825 (Nov. the Commission sought to use disclosure to reduce the influence of the CEO. 2003) (“This enhanced disclosure is intended to provide security holders with additional.”). an additional. 14970 (July 18. Exchange traded companies must have a nominating committee. Perhaps as a result. It did not work.04 [i] THE REGULATION OF CORPORATE DISCLOSURE Nominating Committee94 The Commission has long required disclosure of the existence of a nominating committee. specific information upon which to evaluate the boards of directors and nominating committees of the companies in which they invest.28 (Nov. specific disclosure requirement regarding the treatment of candidates put forward by large security holders or groups of security holders that have a long-term investment interest is appropriate. Further. Item 407 provides that any company without a standing nominating committee must “state the basis for the view of the board of directors that it is appropriate for the registrant not to have such a committee and identify each director who participates in the consideration of director nominees. 96 Exchange Act Release No. whether committee considered shareholder nominees.” 95 See Exchange Act Release No. 1978) (“Information relating to nominating committees would be important to security holders because a nominating committee can. 97 Exchange Act Release No. 1978) (requiring only disclosure of existence of nominating committee. other public companies need not.”). and process for submission). as earlier releases acknowledged.96 Transparency in turn would permit shareholders to better evaluate the competency of the nominating committee. 94 2009-2 SUPPLEMENT 2B-22 . The Commission declined to provide the authority but opted to pressure companies to open up the nominating process and encourage boards to accept nominees from shareholders.
cfm?abstract_id=1095032. Changes need only appear in a quarterly or annual report. thereby limiting the Board’s discretion. and describe any specific qualities or skills that the nominating committee believes are necessary for one or more of the registrant’s directors to possess. the Commission did not require that boards actually accept qualified nominees from shareholders. Any material changes in the procedures from the last meeting also must be disclosed. an explanation of “the basis for the view” must be provided. For a nomination from shareholders owning more than 5 percent of the voting stock. 101 Item 407(c)(2)(iv) of Regulation S-K. Robert Brown. to the entire board. Further. the proxy statement must reveal99 any policies governing the consideration of nominees recommended by shareholders. see J. Material changes also must be disclosed. in nominating candidates. See Instruction to Item 407(c)(2) of Regulation S-K. Likewise. including any specific qualities or skills deemed by the committee as necessary.com/sol3/papers. 2B-23 2009-2 SUPPLEMENT . although they in fact became common. 24. in particular race and gender. and Shareholder Access to the Board Room. The policy may be as simple as a statement that the committee “will consider director candidates” recommended by shareholders.04 Specifically.102 In addition. will likely be addressed adequately by the new disclosure item requiring companies to disclose their criteria for considering board candidates.101 The obligations extend to any differences in the manner in which the committee evaluates shareholder submitted nominees. where appropriate. 100 Item 407(c)(2)(ii) of Regulation S-K. Id.GOVERNANCE AND DISCLOSURE § 2B. the Commission did not require companies to adopt these policies. as we believe this particular consideration. 103 Item 407(b)(2). we do not view it as appropriate to identify any specific criteria that a company must address in describing the qualities it looks for in board candidates. The more significant effect has likely been to force companies that have in place advance notice bylaws to reveal the standards for director qualifications and prevent boards from disqualifying candidates proposed by insurgents. Limited to disclosure. The rules treat nominees from large shareholders differently. See Exchange Act Release No. Jr. The requirements do not extend to those governing diversity. If no such policy exists.”) (footnote omitted). As a result. See Item 407(c)(2)(iii) of Regulation S-K.. The paper is available athttp://papers. the company must disclose any minimum qualifications for nominees.103 The requirement was probably designed to force boards to publicize qualifications in order to allow shareholders to submit nominees who would not be disqualified.100 including the procedures for submitting nominees. as well as other considerations made by a company. We have not included such a requirement in the standards we are adopting today.ssrn. (2009). The requirement can also apply. 99 The disclosure applies to the nominating committee or any committee or group of directors that provide a similar function.”). Corporate Governance. Instruction (“Describe any specific minimum qualifications that the nominating committee believes must be met by a nominating committee-recommended nominee for a position on the registrant’s board of directors. 48825 (Nov. 2003) (“Many commenters that supported the disclosure requirements suggested that we expand the requirements to require companies to disclose the extent to which they take into consideration diversity. Utah L. the policies have done little to increase shareholder representation on the board. The SEC. Rev. See Item 407(c)(3) of Regulation S-K. 102 For a more detailed discussion of this matter.
48825 (Nov. Highly controversial. specifically the CEO’s influence. . The name of the consultant need not be identified.§ 2B. 2003) (proposing release). go beyond those designed to encourage board consideration of shareholder nominees.104 The disclosure requirements. excluding executive officers and those standing for reelection. 24.” Id. or other specified source. The provision provides an out. See Exchange Act Release No. the nomination must be received not later than 120 calendar days before the date of release of the proxy statement for the prior year’s annual meeting.04 THE REGULATION OF CORPORATE DISCLOSURE the proxy statement must identify the shareholder group. 14. The Commission justified the requirement by noting that it would “provide investors with information that is useful in assessing the actions of the nominating committee. companies should ensure that they identify also any person or entity that caused a particular candidate to be recommended. . 48825 (Nov. 106 That is. if the chief executive officer asks a third party to evaluate a potential candidate. the CEO. those included on management’s proxy card. other executive officer. For example.”). third-party search firm. the rules mandate some disclosure of the use of consultants participating in the selection process. chief executive officer. both the chief executive officer and the third party should be identified as recommending parties in the company’s disclosure. the candidate nominated. In a tepid fashion.105 For those selected. no action was ever taken on the proposal. .” See also Exchange Act Release No. and the committee’s disposition of the nomination. 2003) (“In disclosing the category of persons or entities that initially recommended a candidate to the nominating committee. 104 2009-2 SUPPLEMENT 2B-24 . 2003) (“The company would not be obligated to request such materials where a security holder or group does not otherwise provide their consent and proof of ownership.106 the company must identify by category who recommended the nominee. 105 This has to include “any differences in the manner in which the nominating committee evaluates nominees for director based on whether the nominee is recommended by a security holder. The information goes less to qualifications and more to identifying influences in the selection process. nor the fees paid. 48626 n. Categories include “security holder. 48825 (Nov. and the manner in which their candidates are evaluated. however. this is an affirmative requirement imposed on the shareholder group. For disclosure to apply. non-management director. The Commission has also proposed but never adopted a rule that would permit large shareholders to insert nominees into management’s proxy statement. To the extent a nominee comes from that specific source. the market will know. As the instructions indicate. 24. We have provided for disclosure of more than one type of source for a nominee to address the possibility of multiple sources. represents important information for security holders. Disclosure need not occur unless the group and identified candidate both provide written consent. 2003) (“Disclosure as to whether and how they may participate in a company’s nomination process.52 (Oct. 107 See Exchange Act Release No. and that third party ultimately recommends the candidate to the nominating committee. 24. . The Commission has included mandatory disclosure about the nominee selection process. Item 407(c)(2)(vii). including differences between how their candidates and how other candidates are evaluated. The proxy therefore must contain disclosure about the process used to identify and evaluate nominees. therefore.”). Specifically. Item 407(c)(2)(ix). Exchange Act Release No. disclosure must include the function of any firm hired to “identify or evaluate” potential nominees.”107 All of the choices are broad categories except one.
109 Moreover. [A] Item 407(d) of Regulation S-K SOX significantly increased the requirements for audit committees. The Commission. 108 2B-25 2009-2 SUPPLEMENT . The obligation to have an audit committee is a condition of listing and continued listing on a stock exchange. Thus. . . Specifically. Disclosure must include whether: The term is defined in Section 3(a)(56) of the Exchange Act and consists of the committee (or in the absence of a committee. 109 See Section 10A(m). the reforms in SOX fundamentally altered the nature and jurisdiction of the audit committee. the CEO in connection with the nominees. they have been the focus of both the Commission and the stock exchanges in their efforts to improve the efficacy of the financial disclosure process. [ii] Audit Committee Audit committees have long been in the eye of the corporate governance storm. in general.108 Section 301 amended the Exchange Act to require listed companies to have an audit committee with certain specified authority. must be viewed as ineffective in seeking to identify influence over the nomination process. the CEO can have considerable influence over the process in a manner that is not publicly revealed.” 15 U. The disclosure provisions. These committees represent the segment of the board most involved in the financial disclosure process. or advice from.C. While the source of a nominee must be revealed. Likewise. As a result. SOX stopped short of mandating the committees for all public companies. there is nothing in the rules that requires disclosure of any contact with. a proxy statement must reveal considerable information about the inner workings of the committee.C. the entire board) created “for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer. the provisions do not provide adequate disclosure in connection with the use of any consultant employed in the search process. .S. with the requirement not applicable to companies traded in the Pink Sheets or the OTCBB. 15 U. added additional disclosure requirements that to a large degree enhanced the new provisions in SOX. in turn. As such.S. SOX put in place a definition of independence for the directors serving on the audit committee that was much stricter than the one used by the exchanges.04 The disclosure requirements do not extend to any other business conducted by the consultant that might provide evidence of a conflict of interest. While a number of tentative efforts at strengthening the hand of these committees occurred prior to the new millennium. . § 78c(a)(56).GOVERNANCE AND DISCLOSURE § 2B. substantially increasing its role and its importance. § 78j-1(m).
asp?series=300§ion300. See Item 407(d)(4)(i)(C) of Regulation S-K.” and has discussed with the independent accountant the independent accountant’s independence. Despite this convoluted approach. Nor shall the information “be deemed to be incorporated by reference into any filing” unless the company does so expressly. although in a modest fashion. The information must appear in the proxy statement. SOX sought to alter the approach. The NYSE had moved in that direction by generally requiring the appointment of directors to the audit committee who met standards of financial expertise.111 The proxy must identify whether the company has a “separately-designated standing audit committee” and the committee members must appear underneath the disclosure.112 Another significant change wrought by SOX concerned financial expertise on the audit committee. treated as “soliciting material” or as “filed” for purposes of the proxy rules and Section 18 of the Exchange Act. however. State law imposed no requirements of expertise for directors on the board or on any relevant committee.§ 2B. 110 2009-2 SUPPLEMENT 2B-26 . 112 In the absence of a committee. and (D) The committee recommended to the board of directors that the audited financial statements be included in the company’s annual report on Form 10-K. companies could be made to reveal the reasons why they did not. Available at http://www. Section 407 ordered the Commission to adopt rules governing financial experts on the audit committee. Instead. however. The requirement applies in connection with a proxy statement or annual report filed in connection with the election of directors. The approach. (B) The committee has discussed with the independent accountants the matters required to be discussed by the statement on Auditing Standards No. however.04 (A) THE REGULATION OF CORPORATE DISCLOSURE The committee has reviewed and discussed the audited financial statements with management.org/standards/interim_standards/auditing_standards/index_ au. Certain narrow exceptions to the requirements exist. The requirement was. stopped short of requiring the expert.110 (C) The committee has received the written disclosures and the letter from the independent accountants required by “applicable requirements of the Public Company Accounting Oversight Board regarding the independent accountant’s communications with the audit committee concerning independence. It is not.pcaobus. 111 Item 407(d)(3)(i) of Regulation S-K. Otherwise. 61. the practical effect is that public companies now include financial experts on the audit committee and identify the qualifying directors. Item 407(d)(4)(i) of Regulation S-K. the entire board will be treated as the audit committee. the Commission could only require issuers to disclose the expert if they had one. general and contained little content.
17 C. including Section 11 of the Securities Act. To meet the requirement of the financial expert. therefore. accruals. § 229. 114 See Instruction 2 to Item 407(d)(5). Experience preparing.114 • • • Finally. analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant’s financial statements. Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation. • • In addition. the director must have: • • • An understanding of generally accepted accounting principles and financial statements. controller. auditing or evaluation of financial statements. Nor does designation For a definition of financial expert. auditor or person performing similar functions. required disclosure of the identity of a financial expert on the audit committee.407(d)(5).GOVERNANCE AND DISCLOSURE § 2B. principal accounting officer. The ability to assess the general application of such principles in connection with the accounting for estimates.04 The Commission has. If there are others on the committee.” Where no such expert exists. the company also must “provide a brief listing of that person’s relevant experience. and An understanding of audit committee functions. the company “is not required to disclose the names of those additional persons. the expert must have acquired the attributes through: • Education and experience as a principal financial officer. and reserves. controller. the company must provide an explanation for the absence. public accountant or auditor. 113 2B-27 2009-2 SUPPLEMENT . auditing. The Instructions specify that only one expert need be revealed. or experience in one or more positions that involve the performance of similar functions. 115 Item 407(d)(5)(ii). An understanding of internal control over financial reporting. principal accounting officer. public accountant. Experience actively supervising a principal financial officer.”115 The designated individual does not qualify as an expert under the securities laws. or experience actively supervising one or more persons engaged in such activities.113 including the name of the individual and whether he or she qualifies as independent based upon the relevant listing standard. see Item 407(d)(5)(ii).R. or Other relevant experience.F.
it also toughened the requirements for those serving on the committee.118 [B] Rule 10A-3 of the Exchange Act SOX sought to regulate audit committees but did so in an indirect way. Director Independence. there is an exemption for some directors who also sit on the board of an affiliate and for directors of foreign private issuers. More over.§ 2B. SOX did more than regulate the jurisdiction of the audit committee. 122 Rule 10A-3(b)(iv)(B)-(E).407(d)(5) (“The disclosure under paragraph (d)(5) of this Item is required only in a registrant’s annual report.F.119 As a result.F. the appropriate remedy is delisting.R. 118 See Instruction 1 to Item 407(d)(5). allows the Commission to create exemptions to the requirement.121 Similarly. obligations and liability imposed on such person as a member of the audit committee and board of directors in the absence of such designation or identification. 121 For 90 days after the effectiveness of the registration statement. obligations or liability that are greater than the duties. The registrant need not provide the disclosure required by paragraph (d)(5) of this Item in a proxy or information statement unless that registrant is electing to incorporate this information by reference from the proxy or information statement into its annual report pursuant to General Instruction G(3) to Form 10-K (17 C.”).122 The rules do not See Item 407(d)(5)(iv)(B) (“The designation or identification of a person as an audit committee financial expert pursuant to this Item 407 does not impose on such person any duties. As a result.R. See Rule 10A-3(d). The provision.310). § 78j-1(m). Thereafter. Any reliance on the exception must be disclosed. § 249.”).S.120 Section 10A requires that directors on the audit committee be independent. members of the audit committee for listed companies must meet a stricter definition of independent than those applicable to the other committees. 15 U. The exemption expires one year after the effectiveness of the registration statement. 117 Item 407(d)(5)(iv)(C) (“The designation or identification of a person as an audit committee financial expert pursuant to this Item does not affect the duties. however.C. 119 See Section 10A(m). obligations or liability of any other member of the audit committee or board of directors. the board may have a minority of directors who are not exempt. See Rule 10A3(b)(1)(iv). 17 C. § 229. 120 The rule contains certain exceptions to the independence requirements. 116 2009-2 SUPPLEMENT 2B-28 . Rule 10A3(b)(iv)(A). the failure to meet the requirements is not enforceable by the Commission but by the exchange. the board need only have one independent director.”). Newly public companies have an extended compliance period. Section 301 commanded the Commission to “direct” the exchanges to prohibit the listing of any company that did not have an audit committee in compliance with the requirements of the provision.117 Disclosure concerning financial experts need only appear in the annual report rather than in the proxy statement.04 THE REGULATION OF CORPORATE DISCLOSURE increase the responsibilities of the director116 or decrease the responsibilities of the other directors.
47654 n.” Rule 10A-3 prohibits a member from accepting “directly or indirectly” any fee other than fixed compensation under retirement plans123 or director’s fees. maintaining customer accounts.”126 The Commission specifically rejected a de minimis exception for payments to directors. affiliates of the company do not qualify as independent. investment banking or financial advisory services.”). 2003) (“The requirement that the compensation be fixed precludes retirement payments that are tied to the continued performance of the relevant entity. 123 2B-29 2009-2 SUPPLEMENT .127 In addition. 47654 (Apr. or otherwise. 128 Rule 10A-3(e).”) (footnote omitted). if the level of compensation that the member or associated entity receives is truly de minimis and immaterial. Affiliate does not include anyone owning less than 10 percent of a class of voting shares or any executive officer of the shareholder. 2003) (“Further. as previously discussed.57 (April 9. 126 Rule 10A-3(e)(8) (“an entity in which such member is a partner. 2003) (“The final rule does not specify any limits or restrictions on fees paid for capacity as a member of the board of directors or any board committee. legal. 124 Exchange Act Release No. investment banking or financial advisory services to the issuer or any subsidiary of the issuer. The requirement that the compensation be fixed does not preclude customary objectively determined adjustment provisions such as cost of living adjustments. stock brokerage services or custodial and cash management services. in each case. have no active role in providing services to the entity) and which provides accounting. or occupies a similar position (except limited partners.”). whether through the ownership of voting securities. consulting.04 condone an exception for unusual circumstances. the lack of a de minimis exception should be less necessary. Moreover.124 An indirect payment includes fees paid to certain family members125 and businesses providing “accounting. Nonetheless. by contract. 9. 125 Rule 10A-3(e)(8) (“a spouse. of the power to direct or cause the direction of the management and policies of a person. we expect that SROs will contain restrictions on additional services and activities in their own listing standards.”). an officer such as a managing director occupying a comparable position or executive officer.R. check clearing. the prohibitions in Exchange Act Rule 10A-3 do not include non-advisory financial services such as lending.”). we are not persuaded that requiring an issuer to locate another provider so that the member can remain qualified for audit committee service would be overly burdensome. consulting. the Commission has provided that a company must explain any “exceptional or limited or similar circumstances” that explain the appointment of a non-independent director.46 (April 9. § 240-10A-3(e). 47654 (April 9. See also Exchange Act Release No. 129 More than 10% does not automatically mean the person has affiliate status.”128 The rule provides a safe harbor from the definition. a minor child or stepchild or a child or stepchild sharing a home with the member”). although.GOVERNANCE AND DISCLOSURE § 2B.F. 47654 n. direct or indirect. member. Rule 10a3(e)(1)(ii)(B). 17 C.129 Exchange Act Release No. including the reasons “for the board of directors’ determination. legal. Affiliate status turns on control and includes “the possession. 127 Exchange Act Release No. 2003) (“Other commercial relationships are not covered by the final rule. non-managing members and those occupying similar positions who. For example. given the narrow class of services covered by the final rule.
131 Committee responsibilities include hiring. 2003). 47654 (April 9. It also does not require an audit committee to retain independent counsel. 47654 (April 9. and the firm must report directly to the audit committee. statutory audits. See Exchange Act Release No. See Exchange Act Release No. The committee must have the authority to engage counsel and other advisors necessary to carry out its duties and appropriate funding (as determined by the audit committee). In particular. See also Exchange Act Release No. 47654 n. including ordinary administrative expenses.114 (April 9. 13. 54599 (admin. 47654 n.”136 Exchange Act Release No. The Commission did not set limits on funding. financial reporting or legal matters” and may be necessary to provide advice “to identify potential conflicts of interest and assess the company’s disclosure and other compliance obligations with an independent and critical eye. 2003) (“In addition to services necessary to perform an audit or review in accordance with Generally Accepted Auditing Standards (“GAAS”).”133 Funding. attest services. 134 Rule10A-3(b)(4)–(5). 2003) (“As proposed. The final rule does not set funding limits. 131 130 2009-2 SUPPLEMENT 2B-30 .”) (footnote omitted). 132 Exchange Act Release No. firing. the relevant listing standards) also specifies some of the responsibilities of the audit committee. 133 Exchange Act Release No. 47654 (April 9. compensation.”). 2003) (“The auditing process may be compromised when a company’s outside auditors view their main responsibility as serving the company’s management rather than its full board of directors or its audit committee. 135 The provision does not prohibit a committee from seeking advice of counsel or other advisors employed by the company. The committee may be given other functions.”). The rule (and. 136 Exchange Act Release No. 2003).132 As the Commission has noted this authority “would help to align the auditor’s interests with those of shareholders. and setting of all engagement fees and terms of outside auditors.114 (April 9. apparently accepting the view that these were sufficiently controlled by the fiduciary obligations of directors on the committee. See In re Statoil. Exchange Act Release No. 47654 (April 9.”130 As a result. the committee must be “directly responsible” for the “appointment. 2003).”135 They may also be necessary to “independently investigate questions that may arise regarding financial reporting and compliance with the securities laws. the requirement does not preclude access to or advice from the company’s internal counsel or regular outside counsel. as a result. consents and assistance with and review of documents filed with the Commission. Oct.§ 2B. such as comfort letters.04 THE REGULATION OF CORPORATE DISCLOSURE Duties.134 Advisors may include those with expertise in “accounting. a primary function is “to enhance the independence of the audit function. this category also may include services that generally only the independent accountant reasonably can provide.”). retention and oversight” of the outside auditor. proc. 47654 (April 9. thereby furthering the objectivity of financial reporting. 2006) (requiring compliance officer to report possible violations of the Foreign Corrupt Practices Act to the audit committee). 2003) (“These commenters argued that audit committee members’ own fiduciary duties to the issuer and natural oversight by the board of directors as a whole over the audit committee would address any concerns over abuse. Rule 10A-3(b)(2).
if not. the Commission has required that the audit committee retain independent counsel and review the MD&A disclosure. For example.” As a result. 138 137 2B-31 2009-2 SUPPLEMENT . proc. 2. As usual.D. the Commission sanctioned a company that misrepresented the status of an internal investigation and the conclusions of the audit committee. a statement of the “basis for the view of the board of directors that it is appropriate” not to have such a committee and identify “each director Rule 10A-3(b)(3). 19772 (C. The concern has always been that executive compensation is not determined though a sufficiently thorough. retaining. 140 SEC v. 2006).140 In other instances. See Exchange Act Release No.. Endocare.138 [C] Enforcement With the responsibility of the audit committee often clear. In addition. 141 See In re Coca-Cola Co.”).137 The system for employee complaints recognized that “[m]anagement may not have the appropriate incentives to self-report all questionable practices” while employees had concerns about “management reprisal. the system also had to protect employees by permitting confidential. The Commission has tried to intervene.04 Complaints. 2005). We do not believe that in this instance a ‘one-size-fits-all’ approach would be appropriate. 139 In re Hansen. with few substantive limitations. Inc. 54689 (admin. the Commission has sanctioned members responsible for violations of the securities laws. Nov. the company had to have in place procedures for receiving.139 Similarly. July 25. Exchange Act Release No. the Commission sanctioned the chairperson of an audit committee who improperly recommended that the company not file an annual report on a timely basis. deliberative and independent process. once again relying on disclosure. the company must disclose that it has a compensation committee or. and treating complaints from the auditor and employees. proc. Exchange Act Release No. State law imposes mostly procedural requirements on compensation.. anonymous submissions.GOVERNANCE AND DISCLOSURE § 2B. 47654 (April 9. Executive compensation has been in the eye of the corporate governance debate. by requiring illumination of the process used in determining executive compensation. Litigation Release No. Cal.141 [iii] Compensation Committee The last area of corporate governance disclosure with respect to the operations of the board concerns the compensation committee. 51565 (admin. multi-national corporations with thousands of employees in many different jurisdictions. 2006). The Commission specifically declined to specify the necessary procedures. 2003) (“The procedures that will be most effective to meet the requirements for a very small listed issuer with few employees could be very different from the processes and systems that would need to be in place for large. April 18.
Related-party transactions are those that meet the standards in Item 404 of Regulation S-K. 145 Item 407(e)(4) of Regulation S-K. or (3) an executive officer serving as a member of the compensation committee of another entity where an executive officer of the entity serves on the company’s board. Item 407 mandates disclosure of other types of relationships that might suggest a conflict of interest.144 In addition. (2) an executive officer of the company serving as a director of another entity where an executive officer of the entity serves on the compensation committee. remains inadequate.”142 The company must provide a description of the processes and procedures used to determine compensation. 144 See Item 407(e)(4) of Regulation S-K. the role of executive officers in recommending or determining compensation. Item 407(e) says nothing about the CEO’s interaction with the consultant or any other business conducted by the consultant that might suggest a conflict of interest.” the company also must disclose whether the committee has reviewed the Compensation Discussion and Analysis required by Item 402(b) and has recommended to the board of directors that it be included in the Item 407(e)(1) of Regulation S-K. To the extent attempting to get at CEO influence. This includes members of the compensation committee who. information on related party transactions also must be disclosed. For directors identified in these categories. disclosure must include each officer or employee. the proxy also must disclose certain director interlocks and participation by corporate officers. the proxy materials must provide information about the role of any consultants. during the prior year. Under the caption “Compensation Committee Report.04 THE REGULATION OF CORPORATE DISCLOSURE who participates in the consideration of executive officer and director compensation. As for membership on the committee.§ 2B. describe the scope of authority. For companies without a compensation committee. including the scope of authority and any authority delegated to other persons. were officers or employees of the company. disclosure about the compensation consultants.143 The disclosure must identify the consultants. the requirements are unlikely to provide useful information. In particular. In addition. who previously served as an officer. Item 407(e)(4)(ii) of Regulation S-K.145 These obligations to some degree overlap with the executive compensation disclosure requirements. These include: (1) an executive officer of the company serving as a member of a compensation committee of another entity that has an executive officer serving as a director on the company’s compensation committee. describe whether they were retained by the committee. Item 407(e)(3) of Regulation S-K. and any former officer who participated in compensation deliberations. 143 142 2009-2 SUPPLEMENT 2B-32 . or who engaged in any related-party transactions. and set forth the material elements of the instructions with respect to their duties. a source of growing controversy.
See Instruction 1.150 The decision by the NYSE in the 1980s to abandon its one-share. Relating to Amendments to the Exchange’s Voting Rights Listing Standards for Domestic Companies. 41634 (July 21. Bad for business.724 (Oct. 149 See Instruction 2.149  Problems Listing requirements as a means of ensuring good corporate governance suffer from a number of problems.146 The names of the committee members must be included beneath the report. able only to suspend or delist.407(e). 17 C. delisting has rarely occurred. 17 C. if no such procedures exist. See Exchange Act Release No.R. § 240.R. 407(e)(5). 1986). however.04 appropriate SEC filing. 17. As an alternative. Only the exchanges may enforce the requirements.F.147 In addition to these requirements. Proposed Rule Change by New York Stock Exchange. companies must state whether they have in place a process for shareholders to send communications to directors. 147 Rule 10A-3(b)(3).F. Inc.GOVERNANCE AND DISCLOSURE § 2B. 151 Self Regulatory Organizations. disclose any policies and procedures regulating the submission of nominees for the board by shareholders. The information pertaining to the compensation committee report is not considered soliciting materials for purpose of the proxy rules or filed for purposes of Section 18 of the Exchange Act. 148 This information is ordinarily included in the proxy statement. 17 C.R. one-vote rule rather than enforce it illustrated the competitive pressures faced by the self-regulatory organizations. Item 407(f) of Regulation S-K. Companies must. if the communications do not automatically go to the board. Exchange Act Release No. Traditionally. 150 Thus. it may be included on the company’s Web site. 2B-33 2009-2 SUPPLEMENT .F. if they have them. [d] Communications from Shareholders The disclosure requirements in Item 407 also attempt to enhance communications between shareholders and the board of directors.407(f). The disclosure must explain the manner of communicating and. There is no private right of action for violations. the NYSE had a weak record in delisting companies for non-compliance. § 229. § 229.”) (footnote omitted). Item 407(e)(5). audit committees of listed companies must have in place procedures for receiving complaints and anonymous submissions from employees.R.F. exchanges have had a limited arsenal.10A-3(b)(3). not the least of which concerns enforcement. only one issuer has delisted its securities from the NYSE. must explain the process for determining which ones will be forwarded. 17 C. In addition.151 SOX required delisting for companies not meeting the audit 146 Item 407(e).148 The latter need not be explained if the process is approved by independent directors. § 229. 23. As usual. the company must explain their absence. 1999) (“Over the past sixty years.
§ 2B. and. 58413 (Aug.” There are several problems with these substitutes. In 2008.”). if none where available. the Commission’s efforts in this area can be seen as an attempt to overcome some of these weaknesses. Separate non-profit subsidiaries handle enforcement matters. if approved for listing. Indeed.04 THE REGULATION OF CORPORATE DISCLOSURE committee requirements but also provided for mandatory warnings and opportunities to correct. have to be disclosed. 22. 2008). Both the NYSE and NASDAQ have become for-profit. nothing about the process ensures legal involvement. intends to continue to be in compliance with. a certificate of good standing from the state of incorporation. The disclosure requirement does not apply. 2004) (“An early warning notice that merely informs the company that it is in danger of falling out of compliance with a rule or standard for continued listing on the exchange or association is not a notice that the company no longer satisfies that rule or standard. First.152 Enforcement may be an even bigger concern given the changes in the organization of the stock exchanges. a company’s receipt of such a notice will not trigger a disclosure obligation under the item. To some degree. publicly traded. however. . however. See Item 3. but that the company will not be delisted if it cures the problem within a specified time. However.” The first was that an authorized officer had to execute a listing application attesting to the fact that he/she had “read and understood the Exchange’s Listings Rule. 152 2009-2 SUPPLEMENT 2B-34 . in Notices will. . . at the time of initial listing. While a board could in good faith attest to compliance.02 of Form 8-K. the requirements are legal in nature. the exchange proposed eliminating the requirement that companies obtain an opinion of counsel in connection with an application to list securities. such a notice will trigger a Form 8-K filing requirement. the Exchange’s listing and corporate governance rules and requirements. the NYSE has sought to weaken one of the few remaining mechanisms for ensuring compliance with the listing requirements. a company is in compliance with the Exchange’s corporate governance requirements. The NYSE promised to amend the written affirmation to have it include “compliance with the Exchange’s nominating and compensation committee independence requirements and thereby comprehensively covers the Exchange’s corporate governance requirements. to an “early warning” notice of an impending violation. the company must provide at the time of listing a written affirmation that it is in compliance with the director independence requirement. and fully believes itself to be in compliance with. Thus. Thus.153 The opinion mainly attested to the legality of the shares and the qualification to do business. See Exchange Act Release No. for example. if the warning notice informs the company that it is out of compliance with a rule or standard for continued listing.” In addition. The requirement would be replaced with the submission of legal opinions filed in connection with recent stock offerings or. 153 Exchange Act Release No. The Exchange took the position that there were two other “sources of assurance that. 49424 (March 16.
The agency did not adopt its own definitions or requirements. Legal advice on the meaning of the phrase is necessary for appropriate application. DISCLOSURE. In other words. the Commission had little ability to adopt its own definitions or impose its own requirements. directors labeled as independent in the proxy statement were not always independent. mostly those promulgated by the stock exchanges. The Commission. Thus. the auditors had to review management’s opinion. Yet the NYSE rule proposal is essentially eliminating a required role for counsel. Absent any direct nexus with the securities laws. substantially undercutting the value of disclosure. the whole approach of SOX was to recognize that boards function better when there are gatekeepers looking over the shoulders of management. the Commission has provided a private right of action for violations. Reliance on third-party definitions occurred in part because the corporate governance requirements had no independent purpose under the federal securities laws.GOVERNANCE AND DISCLOSURE § 2B. however. relied on definitions and rules in defining these director responsibilities. and essentially exempted directors who had executive positions with non-profits that received funds from the company. § 2B. the rule did not address personal friendships. the Commission did not correct the deficiencies and weaknesses in the corporate governance requirements. AND THE SECURITIES LAWS The corporate governance requirements in general entailed disclosure of director qualifications and the process the directors used in performing their duties on various committees. As a result. The NYSE has an incentive to propose the change. By essentially requiring companies to disclose conformity with exchange requirements in the area of corporate governance.05 INDEPENDENCE. for example. they may not have a “material relationship” with the company.05 determining whether directors are independent. focused on payments from the company and not the CEO. The NYSE. 2B-35 2009-2 SUPPLEMENT . Thus. Section 404 required management to assess the company’s internal controls but further mandated that the outside auditor attest to the findings. The rule change by the NYSE is eliminating a gatekeeper role in the process. contained a definition of independent director that did not adequately capture all potentially disqualifying relationships. This is a tough thing to require in a competitive environment. particularly those in the proxy rules. The other exchanges do not have similar requirements and it adds a cost to the listing process. Inaccurate disclosure may violate the antifraud rules. Second. The securities laws did not require the use of independent directors or play a role in the committee process. Thus. But that is no excuse for the SEC to approving what is an obvious weakening in corporate governance standards administered by the SROs.
SEC. as applicable. used the exchange rules to implement a substantive requirement under the securities laws.156 Ultimately. 1. the agency determined that the securities laws benefited from reliance on a board’s fiduciary obligations. 54684 (Nov. In effect. that has independence requirements for compensation committee members that have been approved by the Commission (as those requirements may be modified or supplemented). it may be more appropriate for the Commission to adopt its own definition. therefore.155 The Commission. Rule 14d-10 contains a safe harbor from the best-price rule for compensation payments that are approved by a committee of independent directors. Despite comments suggesting otherwise. with an accommodation for foreign private issuers. that the Commission for the first time conditioned the applicability of the securities laws on independent approval in amending the all-holders rule. apply the issuer’s or affiliate’s definition of independence that it uses for determining that the members of the compensation committee are independent in compliance with the listing standards applicable to compensation committee members of the listed issuer.10A-3 of this chapter) whose securities are listed either on a national securities exchange . 905 F. is a listed issuer (as defined in § 240. We disagree and are adopting the provisions related to the independence standards as proposed.C. it has limited ability to refuse or to require changes. 156 See Business Roundtable v. 154 2009-2 SUPPLEMENT 2B-36 . See Instruction 1. The same definition is included in Rule 13e-4(f)(12)(ii). The approach is a risk precedent. significant.”). Rule 14d-10(f)(12)(ii) (“If the issuer or affiliate. Other commenters suggested that codifying an independence definition similar to other definitions provided in some Exchange Act rules—as opposed to relying upon a definition that is determined by reference to the listing standards. as we have in other Exchange Act rules—would be a better approach because this would provide a consistent definition. Cir. separate definition of independent. 1986). 155 Exchange Act Release No. 2006) (footnote omitted). the agency specifically rejected the use of its own. the rule defined independence by incorporating the definitions used by the relevant stock exchanges. . therefore.05 THE REGULATION OF CORPORATE DISCLOSURE It was. . While it is the case that the agency approved the exchange rules. We believe this approach is appropriate because the definitions under the listing standards have previously been approved by us and are consistent with the approach we have followed in the past.154 In doing so.2d 406 (D.§ 2B.
In other words. the amount of the related party’s interest. the amount owed at the latest practicable date. or is to be.R. the interest in the transaction. the approximate dollar amount involved. a participant. With respect to directors.157 Transaction is deliberately broad and includes “any financial transaction. trustee under a trust indenture. involves certain services such as transfer agent and trustee under an indenture.” Certain additional requirements apply to loans from banks. § 229. The same is true of a limited partnership interest of less than 10% of the partnership and where the individual is not a general partner and does not hold another position in the partnership.GOVERNANCE AND DISCLOSURE § 2B.” 157 2B-37 2009-2 SUPPLEMENT . 160 The instructions to Item 404(a) exclude interests arising solely because of “such person’s position as a director of another corporation or organization that is a party to the transaction. and expense payments and for other transactions in the ordinary course of business. 158 The disclosure must include the largest amount of the principal outstanding during the relevant period. the provision governing executive compensation.000. 159 Transactions with a director owning less than 10% of a company engaging in the transaction will be excluded. 17 C. These are essentially transactions between fiduciaries and the company.06  DISCLOSURE AND CONFLICTS OF INTEREST § 2B. the transactions would generally be subject to the duty of loyalty under state law. the amount involved exceeds $120. transfer agent. registrar. The provision generally requires the disclosure of any transaction in which the company is. the provision does not apply to transactions arising from competitive bids. Item 404(a)(5) of Regulation S-K. Certain transactions are excluded.” 161 Specifically. Employment agreements need not be reported under this Item if they are covered by Item 402. federal disclosure requirements implicate state law duties. or similar services.06 Fiduciary Duties The other place where governance and disclosure intersect is in the area of related party transactions. and the related party has a direct or indirect material interest.160 Finally.158 and any other material facts. the provision exempts transactions involving services “as a bank depositary of funds. arrangement or relationship (including any indebtedness or guarantee of indebtedness) or any series of similar transactions.F. the amount of principal and interest paid during the period. for ordinary business travel. arrangements or relationships.  Related Party Transactions and Disclosure Requirements Related party transactions are covered by Item 404 of Regulation S-K.404(a)(5). and the interest rate. with special rules governing debt. At the same time. the provision does not cover debt for “purchases of goods and services subject to usual trade terms.161 and interests arising from stock ownership where all of the shareholders of the same class share pro-rata.” The company must reveal the person involved.159 particularly those that arise solely because of an interlocking director relationship.
if not. proper approval of the transactions can result in insulation from legal challenge.R.C.855 F. also must be disclosed.162 Related party transactions also must be included for shareholders owning 5% or more of the equity securities of the company (and their immediate family members). Cir. Inc. Financial General Bankshares. Inc. the applicable standards. there may well be contracts that raise a conflict of interest but do not result in the participation of the issuer. the same would be true. This includes the types of transactions covered.F.164 As a result. of the antifraud provisions.06 THE REGULATION OF CORPORATE DISCLOSURE The disclosure obligations apply to directors and nominees.”  Antifraud Provisions While Regulation S-K requires disclosure of related party transactions. They also apply in some instances to promoters and certain control persons. 515 (D. generally covering transactions of any significant size between the company and a fiduciary. avoiding any appearance that insiders are taking advantage of the company for their own benefit. 164 See Wilson v. 1988) (failure to disclose that a director had a “long-standing business relationship” with individuals controlling the acquiring company violated Rule 14a-9 thereunder).. and the persons responsible for applying the policies. 162 2009-2 SUPPLEMENT 2B-38 . Aside from those benefits. 17 C. and certain immediate family members.404(c). Under state law. 1986) (directors’ relationship with a party to a proposed transaction “would in all probability have assumed actual significance in the deliberations of a reasonable shareholder”).  Issues The provision provides useful information to shareholders. or where the policies were not followed. Consistent with these views. accord Kas v.796 F. See Item 404(c) of Regulation S-K.2d 508.  Procedures Conflict of interest transactions raise issues of process. state “how such policies and procedures are evidenced. 993-94 (2d Cir. The main weaknesses are twofold. 163 Transactions required to be disclosed but not subject to the procedures and policies. § 229. Great American Industries. transactions not covered by the regulation may still require disclosure.. First.§ 2B.2d 987. at least in some cases.163 The text of the policies need not be disclosed but the company must represent that they are in writing or. shareholders presumably want to know that these types of transactions are subject to heightened scrutiny. Item 404(b) provides that companies must disclose any policies or procedures applicable to conflict of interest transactions. executive directors.
2B-39 2009-2 SUPPLEMENT . nor must there be meaningful disclosure about how they work in practice.GOVERNANCE AND DISCLOSURE § 2B. Second.06 The transaction may be among fiduciaries (particularly the CEO) or involve others with economic connections to the issues. The policies themselves need not be disclosed. the process requirements allow for the disclosure in boiler plate format of the process employed by companies in considering the transactions.
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