#157581 03 Directors and Officers Liability P4 1. · Chapter 3 Board Committees § 3:1 Overview §...

Chapter 3

Board Committees

§ 3:1 Overview§ 3:2 Delegation to and Reliance on Board Committees

§ 3:2.1 Delegation§ 3:2.2 Reliance

§ 3:3 Board Committees§ 3:3.1 The Independent Director

[A] Definition and Practice[B] Legal Requirements[B][1] Corporate Law[B][2] Stock Exchange Rules[B][3] SEC Disclosure[C] Criticism

§ 3:3.2 Audit Committee[A] Origin and Development[B] Justification[C] Membership and Qualifications[C][1] Independence and Financial Literacy[C][2] The Financial Expert[C][3] Size and Structure[D] Duties[D][1] General; The Charter[D][2] Auditing[D][2][a] External Auditing[D][2][b] Internal Auditing[D][3] Complaint Procedures and Investigations[D][4] Risk Management[D][5] Compliance[E] Related Obligations of Officers and Directors[E][1] Officer Certification[E][1][a] Content of the Certification[E][1][b] Form of Certification[E][1][c] Penalties for Improper Certification

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[E][2] Improper Influence on Audits[E][3] Prohibition on Retaliation Against Whistleblowers[E][3][a] Dodd-Frank Whistleblower Provisions and SEC

Implementing Rules§ 3:3.3 Nominating/Corporate Governance Committee

[A] Justification and Background[B] Composition and Charter[C] Duties[C][1] Nominating Responsibilities[C][1][a] Board Membership Policies[C][1][b] Recruiting and Nominating Directors[C][1][c] Assigning Directors to Committees[C][1][d] Planning for Management Succession[C][2] Corporate Governance Responsibilities[C][2][a] Corporate Governance Guidelines[C][2][b] Management and Board Evaluation[C][2][c] Director Compensation[C][2][d] Review and Revision of Board Policies[C][2][e] Director Orientation and Education[C][2][f] Shareholder Communication

§ 3:3.4 Compensation Committee[A] Justification and Background[B] Composition and Charter[B][1] Relationship with Compensation Consultants[B][2] Risk-Based Compensation[C] Duties[C][1] Determining CEO Compensation[C][1][a] Option Backdating and Other Manipulation[C][2] Other Compensation Policies[C][3] Shareholder Disclosure[C][4] Special Compensation Arrangements[D] Related Executive Compensation Issues[D][1] Clawbacks[D][2] Freeze on Extraordinary Payments

§ 3:3.5 Legal Compliance/Ethics Committee[A] Justification and Background[B] Generalities[C] Duties[C][1] Legal Compliance[C][1][a] Supervision of Compliance[C][1][b] Attorney Reporting/Qualified Legal Compliance

Committee[C][1][c] Internal Investigations[C][2] Ethics[D] Related Restrictions on Executives

§ 3:3.6 Disclosure Committee[A] Background[B] Disclosure Controls

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[C] Disclosure Committee[D] Special Disclosure Issues[D][1] Off-Balance Sheet Disclosure in Management’s

Discussion and Analysis[D][2] Reconciliation of Non-GAAP or Pro Forma Financial

Measures[D][3] Real-Time Disclosures[D][4] Mandatory SEC Review of Disclosure

§ 3:4 Summary

§ 3:1 Overview

The theme of this book is that a public company director isincreasingly more of a professional. The public company seniorexecutive, by contrast, has been a professional for some time, althoughtoday Congress, the SEC and the stock exchanges are increasinglydefining the responsibilities of this position. This professionalizationof the role does not create a problem for the executive, for that is a full-time position, even if it circumscribes his or her freedom of action inparticular domains. Yet the phenomenon produces an inescapablecontradiction for the director, for his or her position will be, for theforeseeable future, part-time. How can a director be a professional inthis situation when he or she often has another full-time occupation?

The solution for the director is twofold and follows the well-knowndivision of labor. First, a longstanding practice in public corporations isthe board committee. In addition to meeting as a full board, directors areassigned to board committees that monitor different aspects of thecorporation’s business and finances. The trend of director professional-ism has enhanced the importance of board committees. As discussedbelow, it is increasingly the case that public company boards must havecertain committees and that these committees have well-defined super-visory tasks. Moreover, the composition of the committees is also partlypre-established, with, in some cases, the majority or all of the directorsbeing outsiders with no financial relationships with the corporation.

The other, related solution is director specialization. This meansthat a corporation recruits directors with specific backgrounds andthen places them on the appropriate committees. For example, aboard may look for directors with considerable financial backgroundand expertise to oversee the company ’s financial reporting. Directorspecialization could run counter to traditional recruitment policiesof boards to attract high-profile executives with high-level connectionsto other businesses and the government. This specialization is byno means as widespread as the enhanced importance of board com-mittees, but it is growing because the law has begun to dictate boardcomposition.

§ 3:1Board Committees

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This chapter explores board committees and director specialization,which Sarbanes-Oxley particularly enhanced. It first discusses thelegal grounds for committees that corporate law provides. It nextreviews the major committees of a public company that either thelaw or best practices mandate, and it studies their composition andresponsibilities. In this context, it considers, where appropriate, anyrequirements of director specialization for participation on the com-mittees. In examining board committees, the chapter also highlightsrelated duties that the law places upon officers.

§ 3:2 Delegation to and Reliance on Board Committees

§ 3:2.1 Delegation

Corporate law empowers boards to establish board committees andto delegate certain of their tasks to them.1 The committees and theirresponsibilities are generally set forth in the bylaws or established byboard resolution, although, as discussed below, they are increasinglyoutlined in a committee charter that is available to shareholders. Thelaw codifies a common law rule reflecting judicial acceptance andapproval of board action through committees. Indeed, when the publiccorporation faces certain circumstances (such as a change of control ora corporate scandal), it may be appropriate for a board to establish aspecial committee to deal with the specific issue or problem. Thesespecial situations will be discussed later in the book.2

This chapter discusses the major committees that are required bylaw or stock exchange rule and that are differentiated by their function.However, given the complexity of public companies and the changingbusiness and financial environment in which they function, a publiccompany may establish a board committee, such as an executivecommittee, to make decisions and to act on behalf of the boardbetween meetings of the full board.

The power of the board to delegate matters to committees islimited, however. Corporate law generally establishes that certainmatters cannot be delegated to committees (although a committeecould make a recommendation on the matter). These restrictionsgenerally refer to major corporate actions, where a resolution of theentire board is appropriate. Depending upon the state of the corpora-tion’s charter, they include any matter involving shareholder action,any amendment to the bylaws of the corporation, the filling of

1. See COMM. ON CORP. LAWS OF THE ABA SECTION OF BUS. LAW, MODELBUS. CORP. ACT § 8.25(a), at 8-26 (2008) [hereinafter MBCA]; see, e.g., DEL.CODE ANN. tit. 8, § 141(c) (2005); N.Y. BUS. CORP. LAW § 712 (McKinney2005).

2. See infra chapter 5.

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vacancies on the board, alteration of a board resolution, the declara-tion of dividends and the authorization of a reacquisition or anissuance of shares.3

Assignment of particular board members to committees is a matterfor decision by the entire board, although a board committee mightmake a recommendation as to the assignment.4 Best practices guide-lines provide that membership on a particular committee should dependupon the expertise of a director.5 In the audit committee to be discussedbelow, the law mandates that its members have a particular background(here financial). In reality, the CEO has considerable influence on whichdirectors sit on which committees. Increasingly, however, both the lawand model codes of board behavior try to remove the CEO from thisappointment role so that the CEO cannot influence board monitoring ofhim or her and other company executives.6

3. The MBCA has the following exclusions:

• authorize or approve distributions, except according to a formula ormethod, or within limits, prescribed by the board of directors;

• approve or propose to shareholders action that this Act requires beapproved by shareholders;

• fill vacancies on the board of directors or . . . on any of its committees;• adopt, amend, or repeal bylaws; . . . .

See MBCA, supra note 1, § 8.25(e), at 8-26. Delaware simply excludesfrom committee authority any matter requiring shareholder action oramendment of the bylaws. See, e.g., DEL. CODE ANN. tit. 8, § 141(2005). New York’s list of exclusions is more expansive. See N.Y. BUS.CORP. LAW § 712 (McKinney 2005) (adding to these the filling of board andcommittee vacancies, fixing director compensation and amending boardresolutions).

4. See MBCA, supra note 1, § 8.25(b), at 8-26 (stipulating that the assign-ment should be by at least a majority of the directors). The corporategovernance committee might be the appropriate committee to make therecommendations. The Business Roundtable explains:

Decisions about committee membership and chairs should be madeby the full board based on recommendations from the corporategovernance committee. Consideration should be given to whetherperiodic rotation of committee memberships and chairs wouldprovide fresh perspectives and enhance directors’ understanding ofdifferent aspects of the corporation’s business, consistent withapplicable listing standards.

See THE BUSINESS ROUNDTABLE, PRINCIPLES OF CORPORATE GOVERNANCE16 (2012), www.businessroundtable.org/sites/default/files/BRT_Principles_of_Corporate_Governance_-2012_Formatted_Final.pdf.

5. See COMMITTEE ON CORPORATE LAWS, CORPORATE DIRECTOR’S GUIDE-BOOK (6th ed. 2011), reprinted in 66 BUS. LAW. 975, 1015 (2011).

6. See COLIN B. CARTER & JAY W. LORSCH, BACK TO THE DRAWING BOARD195–97 (2004) (discussing, among other things, ways of removing CEOfrom this process).

§ 3:2.1Board Committees

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§ 3:2.2 Reliance

Directors are not relieved of their obligations to the corporation,and thus of their liability, by delegating matters to a board committee.7

They retain the responsibility to supervise and monitor committeeactions and practices. In general, board committees prepare reportsand statements on matters within their jurisdiction for action by theentire board. As discussed in an earlier chapter,8 board members whoare not committee members may rely upon these reports in exercisingtheir fiduciary duties so long as this reliance is reasonable and in goodfaith.9 Indeed, as board committees become more specialized withincreasing director professionalism, this reliance is likely to grow andshould be recognized by the courts. For the same reason, the relianceshould reach decisions that are within a committee’s authority tomake, again provided that the non-committee member ’s reliance isreasonable.10 Reasonable reliance returns one to the issue of committee

7. See MBCA, supra note 1, § 8.25(f), at 8-26 (“The creation of, delegation ofauthority to, or action by a committee does not alone constitute compli-ance by a director with the standards of conduct [of a director].”); see also,e.g., N.Y. BUS. CORP. LAW § 712 (McKinney 2005).

8. See supra section 2:2.3[A][2][c].9. 1 AM. LAW INST., PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND

RECOMMENDATIONS § 4.03, at 196 (1994) [hereinafter ALI, PRINCIPLES OFCORPORATE GOVERNANCE].

10. The ALI takes this position insofar as it recommends that board membersare entitled to rely upon the “decisions, judgments, and performance . . . ofa duly authorized committee of the board upon which the director does notserve, with respect to matters delegated to that committee, provided thatthe director reasonably believes the committee merits confidence.” See id.The MBCA commentary explains when reliance upon committee action isappropriate:

Subsection (f)(3) permits reliance on a board committee when it issubmitting recommendations for action by the full board of direc-tors as well as when it is performing supervisory or other functionsin instances where neither the full board of directors nor thecommittee takes dispositive action. For example, the compensationcommittee typically reviews proposals and makes recommenda-tions for action by the full board of directors. In contrast, theremay be reliance upon an investigation undertaken by a boardcommittee and reported to the full board, which form the basisfor a decision by the board of directors not to take dispositive action.Another example is reliance upon a committee of the board ofdirectors, such as a corporate audit committee, with respect to theboard’s ongoing role of oversight of the accounting and auditingfunctions of the corporation. In addition, where reliance on infor-mation or materials prepared or presented by a board committeeis not involved, in connection with board action, a directormay properly rely on oversight monitoring or dispositive actionby a board committee (of which the director is not a member)

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member selection: reliance is likely to be reasonable only if directorshave been placed on committees for which they are competent.11

§ 3:3 Board Committees

§ 3:3.1 The Independent Director

[A] Definition and PracticeThe independent director is discussed here because this director has

come to have an important legal and market practice role on the boardand particularly on board committees. This kind of director must bedistinguished from two other categories, although the independentdirector is a subset of one of them. An inside director is an employee ofthe corporation, generally a senior executive, who also serves as amember of its board of directors. The inside director is contrasted withthe outside director, who is not employed by the firm. Yet an outsidedirector may have other significant connections to the corporationthat could compromise his or her objective monitoring of the execu-tives and the firm. For example, he or she could be a partner of a lawfirm, or a senior executive of an investment bank, that providesservices to the corporation. An independent director is an outsidedirector without these connections, or where the connections are notmaterial.

For at least the last thirty years, legal commentary and marketguidelines have advocated that a public corporation have a majority ofindependent board members.12 The justification was and is thatcorporate executives could be effectively monitored only by thosewho were not influenced by employment or other connections to afirm. The ALI recommends that “large publicly held corporationsshould have a majority of directors who are free of any significantrelationship with the corporation’s senior executives.”13 It defines“significant relationship” in employment and financial terms.14

It justifies this recommendation on the basis that “the board shouldbe composed in a manner that is conducive to objective analysis

empowered to act pursuant to authority delegated under section 8.25or acting with the acquiescence of the board of directors.

See MBCA, supra note 1, § 8.30(d), (e), (f); Official Comment nos. 4–6, at8-31, 8-40 to 8-44.

11. See id. § 8.25 Official Comment, at 8-29.12. For a succinct discussion of this history, see JAMES D. COX & THOMAS L.

HAZEN, BUSINESS ORGANIZATIONS LAW 159–60 (3d ed. 2011).13. See 1 ALI, PRINCIPLES OF CORPORATE GOVERNANCE, supra note 9, § 3A.01(a),

at 110.14. See id. § 1.34, at 34–36.


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of managerial performance.”15 Groups aligned with corporate manage-ment now echo this recommendation on the basis that “[p]rovidingobjective independent judgment is at the core of the board’s oversightfunction, and the board’s composition should reflect this princi-ple.”16 Institutional investors have made board independence a coreprinciple as well.17

These recommendations and practice have become the law, asdiscussed below. Accordingly, the independent director is becomingthe predominant kind of director in public companies.18 Yet this factshould not suggest that public company boards are composed of a kindof professional monitor. An independent director could well be a CEOor a senior executive from another company or a retired CEO fromeither the company or another firm. Indeed, CEOs and senior execu-tives of other firms remain the most prevalent kind of board memberfor most public companies,19 for the understandable reason that theywould understand management’s position and would have relevant

15. See id. § 3A.01 cmt. c, at 111.16. See THE BUSINESS ROUNDTABLE, supra note 4, at 15; see also REPORT OF

THE NACD BLUE RIBBON COMMISSION ON DIRECTOR PROFESSIONALISM 12(2001).

17. See, e.g., CAL. PUB. EMPS.’ RET. SYS. (CALPERS), GLOBAL PRINCIPLES OFACCOUNTABLE CORPORATE GOVERNANCE 8 (May 11, 2010), www.calpers-governance.org (boards should strive for a board composition of “a sub-stantial majority of independent directors.”). However, unlike what issuggested below, institutional investors have more stringent definitionsof independence than those under the law or stock exchange requirements.See, e.g., ISS 2014 U.S. PROXY VOTING SUMMARY GUIDELINES 16–17(Jan. 13, 2014) (stating that an independent director is one who has no“material” connection to the company, other than the board seat, withmaterial defined to mean “a standard of relationship (financial, personal orotherwise) that a reasonable person might conclude could potentiallyinfluence one’s objectivity in the boardroom in a manner that wouldhave a meaningful impact on an individual’s ability to satisfy requisitefiduciary standards on behalf of shareholders”).

18. See SPENCER STUART, BOARD INDEX 2013, at 12, www.spencerstuart.com/research/bi (85% of directors of S&P 500 companies are independent).Spencer Stuart also reports that key board committees are composedexclusively of independent directors. See id. at 27.

19. See id. at 10 (reporting that, in 2013, 67% of the new independentdirectors for S&P 500 companies were CEOs, COOs, other executives,or retired senior executives). Indeed, data shows that the number of formerCEOs on public company boards increased during the nineties through theearly years of the 2000s, possibly because of the need for companies tohave independent directors who were familiar with operating complexglobal organizations. See generally Changmin Lee, What’s Happened overthe Past 10 Years to the Selection of Retired CEOs As Board Members?(May 22, 2007), www.ssrn.com. There is now a downward trend in boardparticipation of current CEOs.


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experience in making strategic business decisions. Besides theseexecutives, independent board members include leaders in investmentand finance fields and in nonprofits.20

[B] Legal Requirements

[B][1] Corporate Law

Corporate statutes impose no requirements for firms about theirboard composition on the matter of inside, outside or independentdirectors. Corporate law jurisprudence, however, places indirect pres-sure on corporations to have a majority of independent directors ontheir boards. This issue is discussed elsewhere in the book,21 but theimport is that, in certain cases when giving deference to boarddecisions, or to decisions of board committees on matters within theirauthority, courts emphasize that the independent director composi-tion of the board or the committee matters.22 Even in this jurispru-dence, courts do not spend time defining who is an independentdirector and accept the market understanding discussed above.23

[B][2] Stock Exchange Rules

As a result of the corporate scandals at the beginning of this century,stock exchange rules now require that a majority of the board membersof each listed company be independent.24 They also require that theboard make an affirmative determination whether an individual direc-tor is independent, which means that they must find that he or she has

20. See SPENCER STUART, BOARD INDEX 2013, supra note 18, at 10.21. See infra chapter 5.22. See, e.g., Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985)

(noting that the existence of a majority of outside independent directors ona board enhances the likelihood that a court will conclude that, in respondingto a tender offer, a target company’s board acted in good faith).

23. There is a caveat to this assertion. As discussed later, see infra section4:3.2, courts may well probe the independence of particular directors whentheir independence as to a particular transaction is at issue.

24. See N.Y. STOCK EXCH., LISTED COMPANY MANUAL § 303A.01 (2009),http://nysemanual.nyse.com/lcm [hereinafter NYSE]; NASDAQ, LISTINGRULES § 5605(b)(1) (2005), http://nasdaq.cchwallstreet.com [hereinafterNASDAQ]. As the commentary to the NYSE rule explains:

Effective boards of directors exercise independent judgment incarrying out their responsibilities. Requiring a majority of indepen-dent directors will increase the quality of board oversight and lessenthe possibility of damaging conflicts of interest.

There are notable exceptions. The rules do not apply to “controlledcompanies” (i.e., companies where 50% of the voting power for the electionof directors is held by an individual, group or another company). SeeNYSE, supra, § 303A.00; NASDAQ, supra, § 5615(c). Moreover, non-U.S.


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“no material relationship” with the company.25 This definition isintended to be broadly construed: “material relationship” could “includecommercial, industrial, banking, consulting, legal, accounting, charita-ble and familial relationships, among others,” but “ownership of even asignificant amount of stock, by itself,” does not require a finding of lackof independence.26

Some individuals are considered not to be independent. UnderNYSE rules, the following directors would not have this status:A director who is an employee, or whose immediate family member(defined to include a close relative)27 is an executive (until three years

listed companies do not have to comply with this requirement, althoughthey must disclose their home country corporate governance practices onthis issue of independence and the differences between them and the U.S.stock exchange listing rules. See NYSE, supra, § 303A.00; NASDAQ,supra, § 5615(a)(3). Under stock exchange rules, the independent directorsand other non-employee directors must meet apart from the insidedirectors at regularly scheduled executive sessions. See NYSE, supra,§ 303A.03 & Commentary (pointing out that this is to allow free discus-sion apart from management and also suggesting that the outside,independent directors meet only once per year). NYSE rules state that, ifa company holds regular meetings of non-management directors, it shouldhold at least one meeting of independent directors a year. NYSE rules alsorequire that the company provide a way (specified in the annual proxystatement, annual report, or the company ’s website) for shareholders orothers to contact the non-management or independent directors, eitheras a group or through the lead or presiding director. NASDAQ, supra,§ 5605(b)(2) is stricter insofar as it requires a meeting of only independentdirectors in executive session, and Interpretative Material, IM-5605-2recommends that they meet at least twice per year.

25. See NYSE, supra note 24, § 303A.02(a); NASDAQ, supra note 24,Interpretative Material, IM-5605 (requiring directors to “not have arelationship with the listed company that would impair theirindependence”).

26. See NYSE, supra note 24, § 303A.02(a) & Commentary. NASDAQInterpretative Material, IM-5605 has a similar definition. A companymust also disclose the basis for its independence findings as to its directorsin its proxy statement or in its Form 10-K in accordance with Item 407 ofRegulation S-K. See NYSE, supra note 24, § 303A.02(a) & Commentary;NASDAQ, supra note 24, § 5605(b)(1). The NYSE suggests that a companyshould make an independence determination using “all relevant facts andcircumstances.” See NYSE, supra note 24, § 303A.02(a) & Commentary.Accordingly, public companies have a relative freedom to consider whatmakes a director independent, or not. These considerations would dealwith issues such as a director ’s relationship with a non-profit that receivescontributions from the company and his or her affiliation with anothercompany that is indebted to the public company. See SHEARMAN &STERLING, CORPORATE GOVERNANCE 2013: 11TH ANNUAL SURVEY OF THELARGEST US PUBLIC COMPANIES 8–9.

27. They include “a person’s spouse, parents, children, siblings, mothers andfathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, andanyone (other than domestic employees) who shares such person’s home.”


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after cessation of the employment relationship); a director who(or whose family member) receives more than $120,000 in yearlydirect compensation from the company (other than director fees, or,for the family member, other than executive compensation); a director(or family member) who is a partner or employee with an internalor external auditor of the company (or has been such during thelast three years); a director (or immediate family member) who is anexecutive officer of a company where the listed company ’s executive(s)sit on its compensation committee (or has been during the last threeyears); a director who is an executive or employee (or the immediatefamily member is an executive) of a company receiving or providingservices to the listed company above a threshold amount (that is, in anyof the last three fiscal years, the greater of $1 million or 2% of thecompany ’s gross revenues).28 As a result of these rules, boardswill have to ensure that adequate due diligence is done about their

See NYSE, supra note 24, § 303A.02(b) & Commentary; see alsoNASDAQ, supra note 24, § 5605(a)(2) (“‘Family Member ’ means aperson’s spouse, parents, children and siblings, whether by blood, marriageor adoption, or anyone residing in such person’s home.”).

28. See NYSE, supra note 24, § 303A.02(b):

(b) In addition, a director is not independent if:

(i) The director is, or has been within the last three years, anemployee of the listed company, or an immediate familymember is, or has been within the last three years, anexecutive officer, of the listed company.

(ii) The director has received, or has an immediate familymember who has received, during any twelve-monthperiod within the last three years, more than $120,000in direct compensation from the listed company, otherthan director and committee fees and pension or otherforms of deferred compensation for prior service (providedsuch compensation is not contingent in any way oncontinued service).

(iii) (A) The director is a current partner or employee of a firmthat is the company ’s internal or external auditor; (B) thedirector has an immediate family member who is acurrent partner of such firm; (C) the director has animmediate family member who is a current employee ofsuch a firm and personally works on the listed company ’saudit; or (D) the director or an immediate family memberwas within the last three years a partner or employee ofsuch a firm and personally worked on the listed com-pany’s audit within that time.

(iv) The director or an immediate family member is, or hasbeen within the last three years, employed as an executiveofficer of another company where any of the listed com-pany’s present executive officers at the same time servesor served on that company ’s compensation committee.


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(v) The director is a current employee, or an immediatefamily member is a current executive officer, of a com-pany that has made payments to, or received paymentsfrom, the listed company for property or services in anamount which, in any of the last three fiscal years,exceeds the greater of $1 million, or 2% of such othercompany ’s consolidated gross revenues.

NASDAQ, supra note 24, § 5605(a)(2) gives different threshold amountsfor independence determinations:

(12) ‘Independent director ’ means a person other than an ExecutiveOfficer or employee of the Company or any other individual havinga relationship which, in the opinion of the Company ’s board ofdirectors, would interfere with the exercise of independent judg-ment in carrying out the responsibilities of a director. . . . Thefollowing persons shall not be considered independent:

(A) a director who is, or at any time during the past three years was,employed by the Company;

(B) a director who accepted or who has a Family Member who acceptedany compensation from the Company in excess of $120,000 duringany period of twelve consecutive months within the three yearspreceding the determination of independence, other than thefollowing:(i) compensation for board or board committee service;

(ii) compensation paid to a Family Member who is an employee(other than an Executive Officer) of the Company; or

(iii) benefits under a tax-qualified retirement plan, or non-discre-tionary compensation.

Provided, however, that in addition to the requirements contained in thisparagraph (B), audit committee members are also subject to additional,more stringent requirements under Rule 5605(c)(2).

(C) a director who is a Family Member of an individual who is, or at anytime during the past three years was, employed by the company asan Executive Officer;

(D) a director who is, or has a Family Member who is, a partner in, or acontrolling Shareholder or an Executive Officer of, any organizationto which the Company made, or from which the Company received,payments for property or services in the current or any of the pastthree fiscal years that exceed 5% of the recipient’s consolidated grossrevenues for that year, or $200,000, whichever is more, other thanthe following:(i) payments arising solely from investments in the Company ’s

securities; or(ii) payments under non-discretionary charitable contribution

matching programs.

(E) a director of the Company who is, or has a Family Member who is,employed as an Executive Officer of another entity where at anytime during the past three years any of the Executive Officers of theCompany serve on the compensation committee of such otherentity; or


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prospective independent members so that the latter are as represented,that is, they are not receiving any direct or indirect benefits from thecompany.

[B][3] SEC Disclosure

The SEC added to a company ’s disclosure information about theindependence of its directors.28.1 Basically, a public company has toidentify the directors and director nominees who are independentunder the standard of independence applicable to it (that is, chiefly,the definition of independence under stock exchange listing rules asdiscussed in the preceding section).28.2 A company would also have todiscuss any transactions or relationships not disclosed under itsconflict disclosure28.3 that were considered in determining whethera director was independent.28.4 If, as will be discussed later in thischapter, a company has independence standards for board auditing,compensation, and nominating committees, it must identify mem-bers of those committees who are not independent under thosestandards.

[C] CriticismThe independent director has become something of a panacea for

all governance problems in public companies, and the role of this kindof director on the board and on board committees has thereforeincreased over the years. Given this trend, it is unlikely that therole and importance will diminish, despite some scholarly debateswhere the value of the independent director for improving companyresults has been questioned.29 Indeed, as the director position becomes

(F) a director who is, or has a Family Member who is, a current partnerof the Company ’s outside auditor, or was a partner or employee ofthe Company ’s outside auditor who worked on the Company ’saudit at any time during any of the past three years.

28.1. See 17 C.F.R. § 229.407(a) (2010); Executive Compensation and RelatedParty Disclosure, Securities Act Release No. 8655, 71 Fed. Reg. 6542, 6577(Feb. 8, 2006) (proposed rule); Securities Act Release No. 8732A, 71 Fed.Reg. 53,158 (Sept. 8, 2006) (final rule). In addition any public companythat uses its own standards of independence (i.e., not listed companies)would have to disclose whether they are available on its website (if they arenot, it must attach them to its annual proxy statement once every threeyears). See 17 C.F.R. § 229.407(a)(2) (2007) (also requiring that materialamendments to the policies be attached to the proxy statement).

28.2. 17 C.F.R. § 229.407(a)(1) (2009).28.3. See infra section 4:3.5.28.4. 17 C.F.R. § 229.407(a)(3).29. See, e.g., Sanjai Bhaghat & Bernard Black, The Non-Correlation Between

Board Independence and Long-Term Firm Performance, 27 J. CORP. L. 231(2002); Ann Gillette et al., Corporate Governance and Outside DirectorPower: The Experimental Evidence (Sept. 10, 2003 draft).


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more professional, independence is likely to be a basic qualification ofa director, as it is of other professionals who provide services to a firm.From this perspective, it is not beyond the realm of possibility thatthere will come a time when all directors will be independent, withinsiders having no position on the board.30 And, of course, the defini-tion of independence does not focus on social ties between and amongdirectors, which may well influence how they conduct themselves.

§ 3:3.2 Audit Committee

[A] Origin and DevelopmentThe audit committee, which oversees the financial reporting of a

corporation, its internal controls and its relationship with outsideauditors, has become the most important board committee in a publiccorporation. Its origin and development lay in a reaction to corporatescandals that generally exhibit financial improprieties by executivesand that go undetected for a long time because of misleading financialstatements and records. The audit committee received its legal im-petus in 1977, following a period of corporate scandals in whichoutside auditors participated, when the SEC approved a rule changeto the New York Stock Exchange listing requirements mandating thateach listed company have an audit committee composed only ofindependent directors.31 In a similar reactive way, the corporatescandals of the 1990s, which again involved misleading financialstatements, led to more reforms of the audit committee. Sarbanes-Oxley prohibits stock exchanges from listing the securities of anycompany that does not have an audit committee formed and function-ing in accordance with its standards.32 The audit committee has thus

30. This situation may come to pass if another reform sometimes advocatedby shareholder activists is implemented: having a two-tiered board, with asupervisory board of independent directors standing over a smaller man-agement board of executives, which is used in large firms in othercountries, such as Germany.

31. See Exchange Act Release No. 13,346, 11 SEC Docket 1945 (1977). (TheNYSE had in fact recommended that a company have a board auditcommittee since 1939.) Nearly at the same time, Congress amended theExchange Act by the Foreign Corrupt Practices Act that required a publiccompany to establish internal accounting controls that would allow it toprepare accurate financial statements. See Pub. L. No. 95-213, tit. I, § 102,91 Stat. 1494 (1977) (adding to 15 U.S.C. § 78m(b)(2) & (3)).

32. Standards Relating to Audit Committees, Sarbanes-Oxley § 301 (codifiedat 15 U.S.C. § 78j-1). The section directed the SEC in turn to ensure thatthe stock exchanges prohibited the listing of any security of a companythat did not have an audit committee in conformance with the standards.The SEC implemented Section 301 by its rule-making, which shaped thestock exchange rules. See Standards Related to Listed Company AuditCommittees, Securities Act Release No. 8220, 68 Fed. Reg. 18,788 (Apr. 16,2003) (setting forth final Rule 10A-3); Securities Act Release No. 8173,


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evolved from a recommended practice to a legal requirement for publiccompanies.32.1

[B] JustificationThe basic justification for an audit committee is to prevent and help

detect fraud in financial reporting that could lead to a financial disasterfor the company.33 The disaster could occur because the corporation hasbeen looted or badly mismanaged, unbeknownst to its shareholders.Even if it remains viable after discovery of the fraud, the corporation mayfounder because investors lose all confidence in it and its management.The audit committee achieves this goal by ensuring that the corpora-tion’s financial reporting is functioning properly, that the corporation’soperations are being conducted in accordance with established policies(that is, it has internal controls) and that its auditors, both internal andexternal, are doing their jobs (and are not being coerced or drawn in byexecutives and other employees engaged in the fraud).33.1

68 Fed. Reg. 2638 (Jan. 17, 2003) (proposed rule). Prior to Sarbanes-Oxley,the SEC had attempted to enhance the quality of audit committees. Thesechanges, among other things, imposed independence requirements uponthe audit committee and required it to have a charter and its members tobe financially literate. See Audit Committee Disclosure, Exchange ActRelease No. 42,266, 64 Fed. Reg. 73,389 (Dec. 30, 1999) (final rule). See,e.g., Audit Committee Requirements and Notice of Filing and OrderGranting Accelerated Approval of Amendments No. 1 and No. 2 Thereto,Exchange Act Release No. 42,233, 64 Fed. Reg. 71,529 (Dec. 21, 1999).

32.1. The SEC centralized, and supplemented, the disclosure requirements of apublic company about its audit committee. See Executive Compensationand Related Party Disclosure, Securities Act Release No. 8655, 71 Fed. Reg.6542, 6623–24 (Feb. 8, 2006) (proposed rule); Securities Act ReleaseNo. 8732A, 71 Fed. Reg. 53,158 (Sept. 8, 2006) (final rule). For example,under the new requirements a company has to disclose the number ofaudit committee meetings.

33. See REPORT OF THE NACD BLUE RIBBON COMMISSION ON AUDIT COM-MITTEES: A PRACTICAL GUIDE 4 (2004). Despite improvements in theoversight of financial reporting, as described below, it appears that the levelof fraud has remained the same. See generally PRICEWATERHOUSECOOPERS,ECONOMIC CRIME: PEOPLE, CULTURE AND CONTROLS, THE 4TH BIENNIALGLOBAL ECONOMIC CRIME SURVEY (2007). However, it has been found thatmarket reactions to announcements of financial restatements, measuredby changes in a company ’s stock price, are narrower following theSarbanes-Oxley reforms. This may suggest that investors believe thatthese restatements convey timelier and higher quality information abouta company and remove more of the uncertainty about it. See JanaHranaiova & Steven L. Byers, Changes in Market Responses to FinancialStatement Restatement Announcements in the Post-Sarbanes-Oxley Era 4,27 (PCAOB Working Paper No. 2007-001, Oct. 11, 2007).

33.1. How well audit committees are performing their task, even after Sarbanes-Oxley reforms, is open to question. See, e.g., Glass Lewis & Co., Getting itWrong the First Time (Mar. 2, 2006) (observing that the number ofcompanies with U.S.-listed securities restating their financial statements


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There is another, related justification for this committee that issocio-psychological. Board members, executives, employees and ser-vice providers of a firm may have knowledge or suspicions about fraudor mismanagement in a public corporation. They might be reluctantto raise or pursue the matter, however, because they are influenced,directly or indirectly, or even intimidated by those engaged in theimpropriety, often powerful senior executives. The audit committee,particularly as transformed by Sarbanes-Oxley, provides both a forumapart from these executives where, free of their social pressure,individuals can report and discuss their concerns, and a countervailingcenter of power in the corporation to the senior executives.34 In manyrespects, a properly functioning audit committee is a model of how theentire board should function.34.1

doubled in 2005 over the preceding year, and noting that restatingcompanies were 8.4% of U.S. public companies). The GovernmentAccountability Office reported that the number of companies announcingfinancial restatements during the period from 2002 to September 2005increased from 3.7% to 6.8%, for 1390 restatements involving 1084companies (some making more than one restatement), which represented16% of the average number of listed companies. See GOV’T ACCOUNT-ABILITY OFFICE, FINANCIAL RESTATEMENTS 4 (GAO-06-678, July 2006).The short-term impact of the restatements (that is, decline in stock priceduring the day of announcement of the restatement) was a loss in share-holder value of $63 billion. The GAO also found that the percentage oflarge public companies making restatements has continued to grow. See id.at 14. It found that more than one-third of the restatements were dueto cost-related reasons (that is, under- or over-statement of costs andexpenses). Id. at 16. The GAO appears to conclude that these restatementshave not resulted in a loss of investor confidence, although it is uncertainabout the reasons for this investor viewpoint (for example, confusion overmeaning of the restatements). The SEC is likely to be aggressive inbringing an enforcement action against audit committee members whofail in their duties, particularly to follow up on “red flags” about financialimproprieties in a company. See SEC Press Release No. 2011-52, SECCharges Military Body Armor Supplier and Former Outside Directors withAccounting Fraud (Feb. 28, 2011) (bringing a lawsuit against members ofaudit committee for failing to follow up on “red flags” of accountingviolations); Amy L. Goodman & Justin S. Liu, SEC Enforcement ActionsAgainst Outside Directors Offer Reminder for Boards, DIRECTOR NOTES(Conference Bd., New York, N.Y.), no. DN-V3N12, June 2011. The threeformer directors of DHB Industries eventually settled the complaintagainst them for $1.6 million in monetary sanctions. See SEC LitigationRelease No. 22,154 (Nov. 15, 2011). See also In re JPMorgan Chase & Co.,Exchange Act Release No. 70,458 (Sept. 19, 2013) (faulting firm for itsinternal controls that did not detect firm’s trading losses in London due toactivities of the trader known as the “London whale”).

34. See CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1016.34.1. It has been reported from surveys of audit committee members that they

believe that, after Sarbanes-Oxley, these committees have become moreeffective in ensuring that public companies release materially accurate


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[C] Membership and Qualifications

[C][1] Independence and Financial Literacy

Under the statute,35 each audit committee member must be anindependent board member and, subject to SEC exemption, cannot beaffiliated with the company36 or accept, directly or indirectly (forexample, through a family member or other company in which he

financial statements and that the changes to the committee and toauditing in general have been positive. See, e.g., CTR. FOR AUDITQUALITY, REPORT ON THE SURVEY OF AUDIT COMMITTEE MEMBERS(Mar. 2008) (discussing results of a survey conducted early in 2008);CENTER FOR AUDIT QUALITY, DETERRING AND DETECTING FINANCIALREPORTING FRAUD: A PLATFORM FOR ACTION (Oct. 2010) (identifyingthree fraud prevention characteristics in companies—(i) ethical toneat the top, (ii) skepticism, and (iii) strong communication amongparticipants in financial reporting). The data on the effectiveness ofaudit committees, as measured by the number of restatements offinancial statements, is somewhat mixed. See Steven Marcy, AuditAnalytics Says Restatements Dropped by 31 Percent for 2007, 6Corp. Accountability Rep. (BNA) 201 (Feb. 29, 2008) (also notingthat the average negative impact from the restatement dropped to$3.64 million in 2007 from $17.8 million in 2006); SUSAN SCHOLZ,THE CHANGING NATURE AND CONSEQUENCES OF PUBLIC COMPANYFINANCIAL RESTATEMENTS 1997–2006 (Dep’t of Treasury, Apr. 2008)(finding, among other things, that the number of restatementsincreases significantly over this period, but that the restatementsdue to fraud declines, as do the negative market reaction to restate-ments, and also noting a decline in restatements by exchange-listedcompanies from 2005 to 2006); Marlene Plumlee & Terri LombardiYon, An Analysis of the Underlying Causes of Restatements (Mar.2008), www.ssrn.com (finding that restatements from 2003–2006 areprimarily due to internal company errors, not to the complexity ofaccounting standards).

35. See 15 U.S.C. § 78j-1(m)(3), which provides:

(3) INDEPENDENCE.—

(A) IN GENERAL.—Each member of the audit committee of theissuer shall be a member of the board of directors of the issuer,and shall otherwise be independent.

(B) CRITERIA.—In order to be considered to be independent forpurposes of this paragraph, a member of an audit committeeof an issuer may not, other than in his or her capacity as amember of the audit committee, the board of directors, or anyother board committee—

(i) accept any consulting, advisory, or other compensatoryfee from the issuer; or

(ii) be an affiliated person of the issuer or any subsidiarythereof.

36. This means that the audit committee member cannot control the com-pany or be an officer or director of it. See 17 C.F.R. § 240.10A-3(e)(1)(2005).


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or she is an officer or director),37 other consulting, compensatory oradvisory fees from the company. The SEC rule implementing the lawechoes these requirements but provides accommodation in somecircumstances, for example by giving a company making an initialpublic offering (IPO) time to bring its audit committee into conformitywith this requirement.38 Stock exchange rules reflect these indepen-dence requirements for audit committee members.39

Under stock exchange rules, audit committee members must also befinancially literate. The NYSE states that an audit committee membermust be financially literate, in accordance with a standard set by theboard, or must become literate within a reasonable time after appoint-ment to the committee.40 NASDAQ is more explicit in its definition: itrequires an audit committee member to “be able to read and understandfundamental financial statements, including a Company ’s balancesheet, income statement, and cash flow statement.”41 In addition tothis basic financial literacy, it is recommended that an audit committeemember “develop an understanding of financial reporting, risk manage-ment (identification and control of key risks), and the audit function,”which are all functions to be reviewed by the committee, as well as anyspecial regulatory issues facing the company and its industry.42

37. Thus, the law and rule are designed to remove from the audit committeelawyers or bankers of firms that do significant business with the company.

38. See 17 C.F.R. § 240.10A-3(b)(1) (2005). For a company doing an IPO,initially only one audit committee member must be independent forninety days following the effectiveness of the registration statement anda minority of committee members may be exempt for one year followingthis date. 17 C.F.R. § 240.10A-3(b)(1)(iv)(A) (2005).

39. The NYSE requires that a listed company have an audit committee thatsatisfies the statutory standards. See NYSE, supra note 24, § 303A.06. Therules then explain that the standards demand that audit committee mem-bers be independent, in accordance with the general NYSE definition ofindependence. See NYSE, supra note 24, §§ 303A.07(a), 303A.02.The NASDAQ follows a similar approach. See NASDAQ, supra note 24,§ 5605(c)(2)(A) (adding that a committee member must not have partici-pated in the preparation of the financial statements of the company or anycurrent subsidiary at any time during the past three years). Rule 5605(c)(2)(B)does allow a board to include on an audit committee for no more than twoyears in “exceptional and limited circumstances” one director who meets thestatutory standards of independence, but not the NASDAQ standards, andwho is not a family member of an officer or employee. The NASDAQremoved this restriction where the director is a family member of a non-executive employee.

40. See NYSE, supra note 24, § 303A.07(a) Commentary.41. See NASDAQ, supra note 24, § 5605(c)(2)(A).42. See NACD BLUE RIBBON COMMISSION ON AUDIT COMMITTEES, supra

note 33, at 8. This emphasis upon financial literacy has not meant thataccounting and finance specialists dominate the audit committee. It wasreported that, in 2008, the number of audit committee members with aCFO or accounting background in S&P 500 companies was 15%; the


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[C][2] The Financial Expert

Sarbanes-Oxley directed the SEC to issue rules requiring a publiccompany to disclose whether it has a “financial expert” on its auditcommittee (or the reasons for this absence) and giving guidance onthe qualifications of this expert.43 The way of understanding thisrequirement is that it is intended to counter the power of seniorexecutives by having a member of the audit committee (itself a seat ofcountervailing power) who will be able to look through any dubioustransactions or accounting schemes proposed by management andwho will have the authority that comes with his or her expert position.The SEC implemented the statute by rule, under which a companymust disclose in its annual report the identity of the financial expert(or why the audit committee has no such expert), who has certainattributes related to the statutory factors.44 The SEC stated that its

typical audit committee member was the same as a typical board member—a CEO or former CEO. See SPENCER STUART, BOARD INDEX 2008, at 28. Bycontrast, in 2013, 35% of audit committee chairs had this background. SeeSPENCER STUART, BOARD INDEX 2013, supra note 18, at 29.

43. See Disclosure of Audit Committee Financial Expert, Sarbanes-Oxley§ 407 (codified at 15 U.S.C. § 7265). The qualifications are as follows:

(b) CONSIDERATIONS—In defining the term ‘financial expert’ forpurposes of subsection (a), the Commission shall considerwhether a person has, through education and experience as apublic accountant or auditor or a principal financial officer,comptroller, or principal accounting officer of an issuer, or froma position involving the performance of similar functions—

(1) an understanding of generally accepted accounting prin-ciples and financial statements;

(2) experience in—

(A) the preparation or auditing of financial statements ofgenerally comparable issuers; and

(B) the application of such principles in connection withthe accounting for estimates, accruals, and reserves;

(3) experience with internal accounting controls; and

(4) an understanding of audit committee functions.

44. See Disclosure Required by Sections 406 and 407 of the Sarbanes-OxleyAct of 2002, Securities Act Release No. 8177, 68 Fed. Reg. 5110 (Jan. 31,2003) (final rule); Securities Act Release No. 8138, 67 Fed. Reg. 66,208(Oct. 30, 2002) (proposed rule). The attributes, slightly different fromthose listed in § 407(b), are:

(A) An understanding of generally accepted accounting principlesand financial statements;

(B) The ability to assess the general application of such principlesin connection with the accounting for estimates, accruals andreserves;


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definition was not meant to be restrictive, so as to expand, not narrow,the class of people who could be financial experts of a public com-pany ’s audit committee. It did this by an expansive definition of howpeople could acquire the relevant attributes that make them a financialexpert and by directing boards to consider all relevant facts andcircumstances pertaining to the expert.45 It also recognized the liabi-lity concerns of an audit committee member designated as a financialexpert by stating that the expert would not be considered an expert forany purpose of securities law liability, such as section 11 under theSecurities Act, and that the expert status did not impose greater dutieson this person than those placed on a board member or auditcommittee member generally (or relieve other board members of anyof their duties).46 The stock exchanges require that the audit commit-tees of a listed company have one member with financial expertise,

(C) Experience preparing, auditing, analyzing or evaluating finan-cial statements that present a breadth and level of complexityof accounting issues that are generally comparable to thebreadth and complexity of issues that can reasonably beexpected to be raised by the registrant’s financial statements,or experience actively supervising one or more persons en-gaged in such activities;

(D) An understanding of internal control over financial reporting;and

(E) An understanding of audit committee functions.

See 17 C.F.R. § 229.407(d)(5)(ii) (2008). Spencer Stuart reports that 18% ofall new directors in 2013 have financial expertise. See SPENCER STUART,supra note 18, at 9. This number has declined from higher percentages inrecent years since boards have by now built up financial expertise on theiraudit committees.

45. They could acquire the financial expert status through:

(A) Education and experience as a principal financial officer, principalaccounting officer, controller, public accountant or auditor or ex-perience in one or more positions that involve the performance ofsimilar functions;

(B) Experience actively supervising a principal financial officer, princi-pal accounting officer, controller, public accountant, auditor orperson performing similar functions;

(C) Experience overseeing or assessing the performance of companies orpublic accountants with respect to the preparation, auditing orevaluation of financial statements; or

(D) Other relevant experience.

See 17 C.F.R. § 229.407(d)(5)(iii) (2008).46. See id. § 229.407(d)(5)(iv) (2008), providing:

(iv) Safe Harbor.

(A) A person who is determined to be an audit committeefinancial expert will not be deemed an expert for anypurpose, including without limitation for purposes of


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even if he or she is not a financial expert.47 The exact role of this expertdepends upon the company, for the expert can assume a specialauthoritative position on the board, or engage in discussions mainlywith the company ’s chief financial officer.

[C][3] Size and Structure

Stock exchange rules require that the audit committee have aminimum of three members.48 Best practices guidelines recommendthat the board nominating committee, in consultation with seniorexecutives, select audit committee members as well as a chair of the

section 11 of the Securities Act of 1933 (15 U.S.C. 77k),as a result of being designated or identified as an auditcommittee financial expert pursuant to this Item 407.

(B) The designation or identification of a person as an auditcommittee financial expert pursuant to this Item 407does not impose on such person any duties, obligations orliability that are greater than the duties, obligations andliability imposed on such person as a member of the auditcommittee and board of directors in the absence of suchdesignation or identification.

(C) The designation or identification of a person as an auditcommittee financial expert pursuant to this Item does notaffect the duties, obligations or liability of any othermember of the audit committee or board of directors.

47. The Commentary to NYSE, supra note 24, § 303A.07(a) states as follows:

In addition, at least one member of the audit committee musthave accounting or related financial management expertise, as thelisted company ’s board interprets such qualification in its businessjudgment. While the Exchange does not require that a listedcompany ’s audit committee include a person who satisfies thedefinition of audit committee financial expert set out in Item407(d)(5)(ii) of Regulation S-K, a board may presume that such aperson has accounting or related financial management expertise.

NASDAQ, supra note 24, § 5605(c)(2)(A) provides:

Additionally, each Company must certify that it has, and willcontinue to have, at least one member of the audit committeewho has past employment experience in finance or accounting,requisite professional certification in accounting, or any othercomparable experience or background which results in the individ-ual’s financial sophistication, including being or having been a chiefexecutive officer, chief financial officer or other senior officer withfinancial oversight responsibilities.

48. See NYSE, supra note 24, § 303A.07(a); NASDAQ § 5605(c)(2)(A). Thereare cure periods for public companies that cannot meet these size require-ments. In practice, audit committees average around four–five members.See SHEARMAN & STERLING, CORPORATE GOVERNANCE 2013, supra note26, at 19.


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committee.49 The chair, in fact, is a critical person in a company ’scorporate governance, given how significant are the committee’sresponsibilities. Although he or she need not be a financial expert,the chair should have strong financial skills.50

[D] Duties

[D][1] General; The Charter

Audit committee responsibilities are numerous and are enumer-ated in statutes and SEC regulations as well as in stock exchangerules. This subsection lays out basic audit committee tasks, some ofwhich are discussed in more detail below. Sarbanes-Oxley amendedthe Exchange Act to require the following audit committee tasks:

(2) Responsibilities relating to Registered Public Account-ing Firms.—The audit committee of each issuer, in itscapacity as a committee of the board of directors, shall bedirectly responsible for the appointment, compensation,and oversight of the work of any registered public account-ing firm employed by that issuer (including resolution ofdisagreements between management and the auditor re-garding financial reporting) for the purpose of preparing orissuing an audit report or related work, and each suchregistered public accounting firm shall report directly tothe audit committee.. . .

(4) Complaints.—Each audit committee shall establish pro-cedures for—

(A) the receipt, retention, and treatment of complaintsreceived by the issuer regarding accounting, internalaccounting controls, or auditing matters; and

(B) the confidential, anonymous submission by employeesof the issuer of concerns regarding questionable ac-counting or auditing matters.

(5) Authority to engage advisors.—Each audit committeeshall have the authority to engage independent counsel andother advisers, as it determines necessary to carry out itsduties.

(6) Funding.—Each issuer shall provide for appropriate fund-ing, as determined by the audit committee, in its capacity as

49. See NACD BLUE RIBBON COMMISSION ON AUDIT COMMITTEES, supra note33, at 8–9.

50. Spencer Stuart reports that 35% of audit committee chairs had CFO oraccounting experience. See SPENCER STUART, supra note 18, at 29. Thirty-eight percent of such chairs are active or retired CEOs.


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a committee of the board of directors, for payment ofcompensation—

(A) to the registered public accounting firm employed bythe issuer for the purpose of rendering or issuing anaudit report; and

(B) to any advisers employed by the audit committee underparagraph (5).51

The NYSE requires audit committees of its listed companies to dothe following additional duties:

(b) The audit committee must have a written charter thataddresses:

(i) the committee’s purpose—which, at minimum, mustbe to:

(A) assist board oversight of (1) the integrity of thelisted company ’s financial statements, (2) thelisted company ’s compliance with legal andregulatory requirements, (3) the independent audi-tor ’s qualifications and independence, and (4) theperformance of the listed company ’s internal auditfunction and independent auditors; and

(B) prepare the disclosure required by Item 407(d)(3)(i)of Regulation S-K;52

51. See 15 U.S.C. § 78j-1(m); see also 17 C.F.R. § 240.10A-3(b)(2), (5) (2005).This SEC rule repeats these statutory requirements with a few differences.For example, Rule 10A-3(b)(2) also refers to the audit committee’s respon-sibility for the “retention” of an outside accounting firm. Rule 10A-3(b)(5)is also more expansive as to the funding for audit committee activities:

(5) Funding. Each listed issuer must provide for appropriate funding, asdetermined by the audit committee, in its capacity as a committeeof the board of directors, for payment of:(i) Compensation to any registered public accounting firm en-

gaged for the purpose of preparing or issuing an audit reportor performing other audit, review or attest services for thelisted issuer;

(ii) Compensation to any advisers employed by the audit com-mittee under paragraph (b)(4) of this section; and

(iii) Ordinary administrative expenses of the audit committeethat are necessary or appropriate in carrying out its duties.

52. This is a reference to the requirement that the audit committee discuss thefinancial statements to be included in the annual report with managementand the outside auditors and recommend that they be so included. See 17C.F.R. § 240.14a-101, Item 7(d) (2009) (making reference to 17 C.F.R.§ 229.407).


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(ii) an annual performance evaluation of the audit com-mittee; and

(iii) the duties and responsibilities of the audit committee—which, at a minimum, must include those set out inRule 10A-3(b)(2), (3), (4) and (5) of the Exchange Act, aswell as to:

(A) at least annually, obtain and review a report by theindependent auditor describing: the firm’s internalquality-control procedures; any material issuesraised by the most recent internal quality-controlreview, or peer review, of the firm, or by any inquiryor investigation by governmental or professionalauthorities, within the preceding five years, re-specting one or more independent audits carriedout by the firm, and any steps taken to dealwith any such issues; and (to assess the auditor ’sindependence) all relationships between the inde-pendent auditor and the listed company;

(B) meet to review and discuss the listed company ’sannual audited financial statements and quarterlyfinancial statements with management andthe independent auditor, including reviewing thecompany ’s specific disclosures under ‘Manage-ment’s Discussion and Analysis of FinancialCondition and Results of Operations’;

(C) discuss the listed company ’s earnings press re-leases, as well as financial information and earn-ings guidance provided to analysts and ratingagencies;

(D) discuss policies with respect to risk assessmentand risk management;

(E) meet separately, periodically, with management,with internal auditors (or other personnel respon-sible for the internal audit function) and withindependent auditors;

(F) review with the independent auditor any auditproblems or difficulties and management’sresponse;

(G) set clear hiring policies for employees or formeremployees of the independent auditors; and

(H) report regularly to the board of directors.53

53. See NYSE, supra note 24, § 303A.07(b).


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The NASDAQ provides a more abbreviated list of duties:

(1) Audit Committee Charter

Each Company must certify that it has adopted a formal writtenaudit committee charter and that the audit committee has re-viewed and reassessed the adequacy of the formal written charteron an annual basis. The charter must specify:

(A) the scope of the audit committee’s responsibilities, andhow it carries out those responsibilities, includingstructure, processes, and membership requirements;

(B) the audit committee’s responsibility for ensuring itsreceipt from the outside auditors of a formal writtenstatement delineating all relationships between the audi-tor and the Company, consistent with IndependenceStandards Board Standard 1, and the audit committee’sresponsibility for actively engaging in a dialogue with theauditor with respect to any disclosed relationships orservices that may impact the objectivity and indepen-dence of the auditor and for taking, or recommendingthat the full board take, appropriate action to oversee theindependence of the outside auditor;

(C) the committee’s purpose of overseeing the accountingand financial reporting processes of the Company andthe audits of the financial statements of the issuer; and

(D) the specific audit committee responsibilities andauthority set forth in Rule 5605(c)(3).

. . .

(3) Audit Committee Responsibilities and Authority

The audit committee must have the specific audit committeeresponsibilities and authority necessary to comply withRule 10A-3(b)(2), (3), (4) and (5) under the Act (subject to theexemptions provided in Rule 10A-3(c)), concerning responsibilitiesrelating to: (i) registered public accounting firms, (ii) complaintsrelating to accounting, internal accounting controls or auditingmatters, (iii) authority to engage advisors, and (iv) funding asdetermined by the audit committee . . . .54

The ABA Committee on Corporate Laws recommends that theaudit committee also consider undertaking these responsibilities:

54. NASDAQ, supra note 24, § 5605(c)(1), (3). The NASDAQ rule alsoprovides that the audit committee may be empowered to review conflict-of-interest transactions. See NASDAQ, supra note 24, § 5630(a).


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• approve (in coordination with the corporation’s nominating orgovernance committee) any related person transactions betweenthe corporation and its officers or directors, or their familymembers or enterprises they control;

• establish a direct or dotted-line reporting relationship betweenthe internal auditor and the audit committee, with appropriateinput in hiring, compensation, performance review, and thereassignment or firing of the head of internal audit, as well asapproving the internal audit plans and the budget for theinternal audit group;

• consider the appropriate reporting relationship between thechief compliance officer (if other than the chief legal officer)and the audit committee;

• review SEC staff comments on filings;

• review the external auditor ’s management letter and manage-ment’s responses to that letter (which generally include com-ments on any control deficiencies observed during the audit andother recommendations arising from the audit);

• review primary components of earnings releases prior to publicdisclosure;

• meet periodically with representatives of the corporation’s dis-closure committee, if any;55 and

• if another committee does not do so, meet privately with thecorporation’s legal counsel or other key advisors to reviewpending litigation, possible loss contingencies and other legalconcerns, including procedures and policies for addressing legaland compliance issues and reduction of legal risk (for publiccompanies, this is generally done quarterly in connection withthe review of the corporation’s Form 10-Q.).56

As noted above, the tasks and responsibilities of a public company ’saudit committee must be formalized in a charter. The SEC requires thata company disclose whether its audit committee has a charter andNYSE rules allow it to be posted on a company ’s website.57 The reality isthus that a company ’s audit committee must have a readily accessiblecharter, and models for it are abundant.58 The charter requirement

55. This committee is discussed below. See infra section 3:3.6.56. CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1018–19.57. See 17 C.F.R. § 240.14a-101 Item 7(d) (2009) (cross-referencing

Item 407(d)(i)); NYSE, supra note 24, § 303A.07.58. See, e.g., NACD BLUE RIBBON COMMISSION ON AUDIT COMMITTEES, supra

note 33, at 42–47 (reprinting model prepared by the law firm of Weil,Gotshal & Manges).


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underscores how professional the audit committee has become, and itpoints to a similar professionalization of the entire board. With all ofthese responsibilities, it can be expected that the time commitment ofan audit committee member is significant because the audit committeeshould meet more frequently than the entire board.59

[D][2] Auditing

[D][2][a] External AuditingA major thrust of Sarbanes-Oxley is to change the relationship to

public companies of the independent public accounting firms thataudit their financial statements. The intent was to remove an account-ing firm from the influence and control of public company executives,which could jeopardize the auditor ’s independence, and to align theaccounting firm with independent board members. It did this by placingthe accounting firm under the direct control and supervision of the auditcommittee. Accordingly, among other things, the accounting firmis hired (and fired) by, reports to, discusses the audit, financial state-ments and accounting disagreements involving executives with, andjustifies its independence to the firm’s audit committee.60

Not only does the law impose duties upon the audit committee, itplaces corresponding responsibilities upon the accounting firm toemphasize that its connection to the firm is through the auditcommittee, not through senior executives.60.1 An outside auditingfirm must report certain critical information about the audit to theaudit committee.61 The auditors have to discuss with the committee,

59. See SPENCER STUART, BOARD INDEX 2013, supra note 18, at 28 (discussingtime commitment of audit committee members; committees average 8.7meetings per year); see also CORP. BD. MEMBER, WHAT DIRECTORS THINK 4(2004).

60. See generally CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1017–21.60.1. However, this fact does not mean that a special duty is created between the

accounting firm and the individual directors who are members of the auditcommittee. In PricewaterhouseCoopers LLP v. Massey, 860 N.E.2d 1252(Ind. Ct. App. 2007), two directors of Conseco, Inc. who were members ofthe board audit committee sued PwC, claiming that they relied upon thefirm’s audit of Conseco’s financial statements to purchase Conseco shares,using loans from Conseco, and that they were harmed when PwC failed todetect fraud occurring within Conseco. The court found that PwC owedthese directors no special duty apart from what it owed all Consecoinvestors, which otherwise would have justified an exception to the rulethat their claim was a derivative one. See id. at 1260. Moreover, thesedirectors were not entitled to maintain a direct action against PwC simplybecause they borrowed money to purchase shares; this fact did not givethem a special claim wholly apart from the harm done to Conseco and itsinvestors from the alleged improper conduct by PwC. See id. at 1261.

61. See Auditor Reports to Audit Committee, Sarbanes-Oxley § 204 (codifiedat 15 U.S.C. § 78j-1(k)), which provides as follows:


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among other things, critical accounting policies, alternativetreatments of financial information and their ramifications, anddisagreements on accounting treatment with management.62 More-over, all audit and otherwise permitted non-audit services to beperformed by the outside accounting firm must be pre-approved bythe audit committee (except for de minimis non-audit services) anddisclosed by the company.63

[D][2][b] Internal Auditing

The emphasis upon the audit committee’s responsibility for internalauditing supervision comes more from stock exchange rules and bestpractices recommendations than it does from the law, which does notrequire that a public company have an internal audit department.64

However, the Exchange Act demands that a public company perform the

(k) REPORTS TO AUDIT COMMITTEES.—Each registered publicaccounting firm that performs for any issuer any audit re-quired by this title shall timely report to the audit committeeof the issuer—

(1) all critical accounting policies and practices to be used;

(2) all alternative treatments of financial information withingenerally accepted accounting principles that have beendiscussed with management officials of the issuer, rami-fications of the use of such alternative disclosures andtreatments, and the treatment preferred by the registeredpublic accounting firm; and

(3) other material written communications between the re-gistered public accounting firm and the management ofthe issuer, such as any management letter or schedule ofunadjusted differences.

62. See Strengthening the Commission’s Requirements Regarding AuditorIndependence, Securities Act Release No. 8183, 68 Fed. Reg. 6006, 6048(Feb. 5, 2003) (laying out new rule 17 C.F.R. § 210.2-07); see also ProposedAuditing Standard Related to Communications with Audit Committee,PCAOB Release No. 2010-001 (Mar. 29, 2010). The proposal was repro-posed. See PCAOB Release No. 2011-008 (Dec. 20, 2011). The newauditing standards, which are to go into effect on Dec. 15, 2012, aredesigned to enhance “two-way communications” between the audit com-mittee and outside auditors. For the final standard, Auditing StandardNo. 16, Communications with Audit Committees, see PCAOB ReleaseNo. 2012-004 (Aug. 15, 2012).

63. See 15 U.S.C. § 78j-1(h), (i). Section 78j-1(g) lists the non-audit activitiesthat are prohibited to an accounting firm that is auditing a company. Seealso ADVISORY COMMITTEE ON THE AUDITING PROFESSION, FINAL REPORTTO THE U.S. DEPARTMENT OF THE TREASURY VII:11-13 (Sept. 6, 2008)(recommending more explicit disclosure by a company when it changes anoutside auditor).

64. The NYSE requires that its listed companies have an internal auditfunction, which can be outsourced. NYSE, supra note 24, § 303A.07(c).


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typical tasks of this department, that is, ensure that accurate books,records and accounts (from which financial statements are prepared)are made and that the internal controls of the firm for the authoriza-tion and recording of transactions and the use of assets are followed.65

The audit committee reviews with internal auditors their activities,any identified problems revealed by their audit and their solutionsor recommendations, and the department’s budget and needs, as wellas supervises the hiring of senior internal audit personnel.66 The

65. See 15 U.S.C. § 78m(b)(2) (addition to Act made by the Foreign CorruptPractices Act). If, for example, a public company fails to have a propersystem of internal controls that would detect improper payments underthe Act and thus improperly records expenditures on its books, it haspotentially violated this section. See, e.g., SEC v. Halliburton Co., Litiga-tion Release No. 20,897, www.sec.gov/litigation/litreleases/2009/lr20897.htm (settlement involving bribery of Nigerian officials; discussing pay-ments of Halliburton and related companies of disgorgement of $177 mil-lion and criminal fines of $402 million); SEC v. Fiat S.p.A., Litig. ReleaseNo. 20,835 (Dec. 22, 2008), www.sec.gov/litigation/litreleases/2008/lr20835.htm (settlement over improper payments and books and recordsviolations concerning Iraqi oil for food program); In re Con-Way, Inc.,Exchange Act Release No. 58,433 (Aug. 27, 2008), www.sec.gov/litigation/admin/2008/34-58433.pdf (settlement over books and records violationrelating to second-tier subsidiary ’s foreign bribes); Complaint, SEC v.Lucent Techs. Inc. (D.D.C. Dec. 21, 2007) (alleging that Lucent spent$10 million to bring Chinese officials (i.e., customers) to the United Statesfor business purposes, but used the funds primarily to entertain them),www.sec.gov/litigation/litreleases/2007/lr20414.htm; Complaint, SEC v.Ingersoll-Rand Co. Ltd., No. 07-CV-01955 (D.D.C. Oct. 31, 2007),www.sec.gov/litigation/complaints/2007/comp20353.pdf (alleging thatfirm made kick-back payments to Iraqi government officials and paid forholiday travel for the same); SEC v. Akzo Nobel N.V., Litigation ReleaseNo. 20,410 (Dec. 20, 2007), www.sec.gov/litigation/litreleases/2007/lr20410.htm (settlement on a similar charge in which Akzo agrees todisgorge profits from improper activities and to pay interest and civilpenalties); SEC v. Robert W. Philip, Litigation Release No. 20,397 (Dec. 13,2007), www.sec.gov/litigation/litreleases/2007/lr20397.htm (describingsettlement based upon charges that former Chairman/CEO of companyauthorized nearly $2 million in improper payments to foreign persons);SEC v. Nature’s Sunshine Prods., Inc., Litigation Release No. 21,162 (July 31,2010) www.sec.gov/litigation/litreleases/2009/lr21162.htm (settlementinvolving cash payments to customs officials). The Foreign Corrupt Prac-tices Act will be discussed elsewhere in this book, see infra section 7:3.1[I],and it is a major area of concern for public companies. It continues to reachmajor U.S. companies. See, e.g., In re Hewlett-Packard Co., Exchange ActRelease No. 71,916 (Apr. 9, 2014) (settlement over improper payments bycompany ’s subsidiaries in Russia, Mexico and Poland).

66. See NACD BLUE RIBBON COMMISSION ON AUDIT COMMITTEES, supra note33, at 17. Under SEC Regulation G, a company must also reconcile anynon-GAAP financial measure with a comparable GAAP financial measureand must not mislead investors with the use of non-GAAP measures.


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committee also reviews the relationship between internal and externalaudit programs.

[D][3] Complaint Procedures and Investigations

The audit committee clearly must establish procedures for receiv-ing, filing, and responding to complaints, including anonymous onesfrom employees, concerning accounting, internal control and audit-ing matters. The SEC has not specified these procedures, but has leftit to companies to develop their own, depending upon their circum-stances.67 At the very least, an audit committee should have aprocedure whereby complaints can be sent anonymously directly toit, if the sender prefers to bypass the firm’s regular complaintprocedure. The audit committee’s response to a particular complaintmay be the most difficult matter, since it includes an initial assess-ment of the complaint and, possibly, an investigation into its allega-tions. Here the independent funding of the committee and its powerto hire its own advisors become critical. It may well be that the auditcommittee generally relies upon a firm’s existing procedures andofficers (such as a general counsel, chief compliance officer, internalaccountants and/or an ombudsmen) for receipt, initial assessmentand even investigation of complaints. However, serious accountingproblems in the firm or matters involving a significant conflict ofinterest with the firm’s senior executives may demand that an auditcommittee look to outside counsel and special accountants to inves-tigate a complaint.68

For an enforcement action relating to officers’ misleading use of non-GAAP earnings results, see SEC v. Safenet, Inc. et al., Litigation ReleaseNo. 21,290 (Nov. 12, 2009), www.sec.gov/litigation/litreleases/2009/lr21290.htm.

67. See Standards Relating to Listed Company Audit Committees, 68 Fed.Reg. 18,788, 18,798.

68. See, e.g., NACD BLUE RIBBON COMMISSION ON AUDIT COMMITTEES, supranote 33, at 67–69 (providing sample “whistleblower” policy for auditcommittee from law firm Weil, Gotshal & Manges). It has been reportedthat audit committees give less credibility to, and expend fewer resourcesinvestigating, anonymous whistleblowing complaints. See James E. Hutton& Jacob M. Rose, Effects of Anonymous Whistle-Blowing & PerceivedReputation Threats on Investigations of Whistle-Blowing Allegations byAudit Committee Members (2008 draft), www.ssrn.com. Experts on whis-tleblowing observe that many whistleblowing procedures in companies donot attract “high-level” whistleblowers because they are flawed in manyrespects. In particular, they often do not guard the anonymity of thewhistleblower and use internal officials to screen complaints, which alsojeopardizes anonymity. For a discussion of these criticisms, see FrederickD. Lipman, From Enron to Lehman Brothers: Lesson for Boards fromRecent Corporate Governance Failures, DIRECTOR NOTES (Conference Bd.,New York, N.Y.), no. DN-V4N6, Mar. 2012.


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[D][4] Risk Management

Companies, particularly financial companies, are exposed to risksthat can bring a company down, almost overnight. These risks areindustry specific, but, if the company engages at all in financialactivities, the risks can arise from these, or from the misbehavior ofa few employees (both were true in Enron’s case). As the NYSE rulesemphasize, the audit committee is responsible for ensuring that thereare procedures in place in the firm for identifying and managing therisks.69 This process is in fact a part of internal controls, for one oftheir purposes is to ensure that a firm conducts its operations withinestablished risk guidelines and limits. The risk management respon-sibility will likely require the audit committee to receive reports fromand conduct discussions with internal and external auditors, as well aslegal counsel.70 Moreover, risk management is inseparable from riskdisclosure, so that the audit committee may be involved in ensuringthat the company accurately discloses its risks.71

The ongoing financial crisis has brought to the forefront the im-portance of oversight of risk management as a critical board task.71.1

Indeed, the crisis was due to the failure of firm risk management in a

69. See NYSE, supra note 24, § 303A.07(b)(iii)(D). The Commentary to thisprovision notes:

While it is the job of the CEO and senior management to assess andmanage the listed company’s exposure to risk, the audit committeemust discuss guidelines and policies to govern the process by whichthis is handled. The audit committee should discuss the listedcompany’s major financial risk exposures and the steps managementhas taken to monitor and control such exposures. The audit commit-tee is not required to be the sole body responsible for risk assessmentand management, but, as stated above, the committee must discussguidelines and policies to govern the process by which risk assessmentand management is undertaken. Many companies, particularly finan-cial companies, manage and assess their risk through mechanismsother than the audit committee. The processes these companies havein place should be reviewed in a general manner by the auditcommittee, but they need not be replaced by the audit committee.

70. On risk oversight, see generally REPORT OF THE NACD BLUE RIBBONCOMMISSION ON RISK OVERSIGHT (2002). See also INST. OF INTERNALAUDITORS ET AL., MANAGING THE BUSINESS RISK OF FRAUD: A PRACTICALGUIDE (2008); MARTIN LIPTON ET AL., WACHTELL, LIPTON, ROSEN & KATZ,RISK MANAGEMENT AND THE BOARD OF DIRECTORS (Nov. 2009); EISNER,CONCERNS ABOUT RISKS CONFRONTING BOARDS: FIRST ANNUAL BOARD OFDIRECTORS SURVEY (2010); PAUL DENICOLA ET AL., THE CONFERENCE BD.,HANDBOOK ON CORPORATE POLITICAL ACTIVITY 21 (2010) (arguing thatmonitoring a corporation’s political activities and spending should be adirector task and part of a firm’s risk management).

71. See infra section 3:3.6.71.1. See, e.g., Ben S. Bernanke, Chairman, Board of Governors of the Fed-

eral Reserve System, Speech at the Council on Foreign Relations: Financial


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similar way that the corporate scandals of the turn of the centuryresulted from accounting failures. Numerous financial firms did nothave robust risk management or did not live within the guidelinesestablished by the risk management department. Moreover, they failedto anticipate the risks generated by new financial activities or by anextension of current ones. They were also caught unprepared for thefinancial cataclysm, which undermined all their expectations aboutfinancial markets and the liquidity of financial assets.71.2

It is likely that, as a result of the crisis, boards will have to takemore seriously their oversight of risk management. This means thatthey will have to understand this function in the firm. Risk manage-ment is designed to identify the different kinds of risks that a firmmight experience from its activities, to monitor the firm for new risks,and to ensure that the firm keeps within the parameters of the risksthat the board (as counseled by management) has accepted. This latertask shows why risk management is often related to internalcontrols.71.3 Often risk management uses quantitative models topredict, on the basis of past data, the probability and extent of lossesin a given domain or with respect to a specific class of assets. It alsouses qualitative approaches, such as stress testing and scenario ana-lysis, which involve testing the firm under extremely adverse scenariosin order to see how it would fare in them and to remedy anydeficiencies that the tests reveal. For the board to perform its oversightfunction adequately, among other things, it must understand the risksgenerated by the firm’s activities, set limits to these risks, comprehendthe basic assumptions and limitations of the risk models used by riskmanagement, and use its judgment as to whether scenarios in thestress testing are sufficiently adverse for the purpose.

Since, as is clear from this chapter, the audit committee’s mandateand tasks are significant and time-consuming, it may make sense for aboard to have a separate risk management committee, or at least asubcommittee composed of the chief risk officer, other executives anddirectors. This model is used in large financial institutions, where riskmanagement is critical to survival. In accordance with the audit

Reform to Address Systemic Risk (Mar. 10, 2009); Alan Greenspan,Testimony before the U.S. House Committee of Government Oversightand Reform (Oct. 23, 2008).

71.2. For reviews of risk management failings in financial firms that resulted inthe crisis, see generally U.S. GOV’T ACCOUNTABILITY OFFICE, FINANCIALREGULATION: REVIEW OF REGULATORS’ OVERSIGHT OF RISK MANAGEMENTSYSTEMS AT A LIMITED NUMBER OF LARGE, COMPLEX FINANCIAL INSTITU-TIONS (2009); SENIOR SUPERVISORS GRP., OBSERVATIONS ON RISK MANAGE-MENT PRACTICES DURING THE RECENT MARKET TURBULENCE (Mar. 6, 2008).

71.3. See, e.g., COMM. OF SPONSORING ORGS. OF THE TREADWAY COMM’N,ENTERPRISE RISK MANAGEMENT—INTEGRATED FRAMEWORK: EXECUTIVESUMMARY 6 (Sept. 2004).


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committee model, a risk management committee should have on thecommittee at least one director who is an expert or who has experienceon the subject (preferably an independent director) and the authorityto engage its own outside consultants on risk management in order toquestion the models and assumptions used by internal risk manage-ment. This committee might also act as a liaison in any discussionswith credit rating agencies, since to a large extent these agencies usestandard risk models in rating a company ’s debt and since it would beuseful for the committee to understand the rating agencies’ viewsabout the risks facing the company.71.4

In this connection and in light of the financial crisis, the SECproposed that a company must disclose the role of the board in thecompany ’s risk management.71.5 In particular, the disclosure wouldhave to address the following issues:

For example, how does the board implement and manage its riskmanagement function, through the board as a whole or through acommittee, such as the audit committee? Such disclosure mightaddress questions such as whether the persons who oversee riskmanagement report directly to the board as whole, to a committee,such as the audit committee, or to one of the other standingcommittees of the board; and whether and how the board, or boardcommittee, monitors risk. We believe that this disclosure willprovide key insights into how a company ’s board perceives andmanages a company ’s risks.71.6

The SEC adopted this proposal substantially as proposed, although itchanged the term “risk management” to “risk oversight.”71.7

Congress has also required that any “systemically important,” pub-licly traded nonbank financial company, as well as any publicly traded

71.4. It is reported that, in 2013, of the top 100 companies seven had a sepa-rate board risk committee and twenty had a board or management riskcommittee. See SHEARMAN & STERLING, CORPORATE GOVERNANCE 2013,supra note 26, at 28–29; see also Parveen P. Gupta & Tim J. Leech, RiskOversight: Evolving Expectations for Boards, DIRECTOR NOTES (ConferenceBd., New York, N.Y.), no. DN-V6N1, Jan. 2014 (reviewing developmentson board involvement in risk management).

71.5. See Proxy Disclosure and Solicitation Enhancements, Securities ActRelease No. 9052, 74 Fed. Reg. 35,076, 35,085 (July 17, 2009).

71.6. Id.71.7. See Proxy Disclosure Enhancements, Securities Act Release No. 9089,

74 Fed. Reg. 68,344–45 (Dec. 23, 2009) (new 17 C.F.R. § 229.407(h)). In arelated move, the SEC staff explained that it would no longer consider ashareholder proposal excludable under Rule 14a-8(i)(7) simply becausethe proponent asked the company to evaluate a particular risk. Rather, theSEC explained that it would look at the risk that was the subject of theproposal and would not allow a company to exclude it if the risk“transcends the day-to-day business matters of the company and raises


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bank holding company with total consolidated assets in excess of$10 billion, establish a risk committee.71.8 The Board of Governors ofthe Federal Reserve System (the “Federal Reserve”) will determine thenumber of “independent” directors who will sit on this committee,which must also include a risk management expert with experience inrisk management of large, complex companies. The risk committeeshall be responsible for the firm-wide risk management practices ofthe company (actually, the financial conglomerate) in question.71.9

[D][5] Compliance

It may well be that, given its supervision of internal controls andof risk management, the audit committee will also participate inoverseeing a firm’s and employees’ compliance with the law andcodes of conduct, unless another board committee has been giventhis responsibility.72 For example, Sarbanes-Oxley required the SEC to

policy issues so significant that it would be appropriate for a shareholdervote.” See SEC Div. of Corp. Fin., Staff Legal Bulletin No. 14E (CF)(Oct. 27, 2009). As discussed above, companies are adopting differentmodels and practices of risk oversight. See, e.g., Louis L. Goldberg &Mutya Fonte Harsch, The Role of the Board in Risk Oversight, DIRECTORNOTES (Conference Bd., New York, N.Y.), no. DN-010, Aug. 2010 (dis-cussing models of oversight, use of committee or full board, in riskoversight).

71.8. Section 165(h) of the Dodd-Frank Wall Street Reform and ConsumerProtection Act of 2010. The Federal Reserve (which will be the supervisorof such companies) may impose the risk committee requirement onpublicly traded bank holding companies under this asset threshold. The“systemically important” designation will be set by a new FinancialStability Oversight Council.

71.9. The Federal Reserve issued proposal rules requiring (i) large bank holdingcompanies (i.e., those with at least $50 billion in consolidated assets),(ii) nonbank “systematically important” financial companies, and(iii) publicly traded medium bank holding companies (i.e., those withbetween $10 and $50 billion in consolidated assets) to have a board riskcommittee to oversee the firm’s risk management practices on a worldwidebasis. In addition, categories (i) and (ii) must also have a chief risk officerwho has appropriate expertise, who receives appropriate compensation andwho reports to the board risk committee and the CEO. The risk committeemust be chaired by an independent director, have a charter and have atleast one member with risk management expertise. The duties of thecommittee and chief risk officer are set out in detail, but essentially dealwith the management and oversight of risks. See Federal Reserve System,Enhanced Prudential Standards and Early Remediation Requirements forCovered Companies, 77 Fed. Reg. 594, 622–25 (Jan. 5, 2012). For thestandards that the Financial Stability Oversight Council will use indetermining what nonbank financial institutions are systemically impor-tant, see Financial Stability Oversight Council, Authority to RequireSupervision and Regulation of Certain Nonbank Financial Companies,77 Fed. Reg. 21,637 (Apr. 11, 2012) (promulgating 12 C.F.R. pt. 1310).

72. CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1018.


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issue rules to ensure that legal counsel would report legal violations“up the ladder” of the firm, including, if necessary, to the auditcommittee.73 The SEC subsequently issued rules setting forth thereporting obligations of both inside and outside counsel.74 The SECrules reinforce that counsel’s duties lie to the corporation, not to officersand directors,75 and impose upon counsel a requirement to reportevidence of material violations of the securities law or material breachesof corporate law duties (or similar violations) by the company, or by anyof its officers, directors, employees or agents, of which he or she becomesaware. The reporting requirements direct counsel to report problems inthe first instance, not to the CEO, but to the firm’s chief legal officer,and, if counsel does not receive an appropriate response from this officer,then to the audit committee, another committee of independent direc-tors (if there is no audit committee) or to the full board (in the absence ofsuch committees).76 The audit committee could thus have a role ininvestigations concerning legal violations arising in the firm.

[E] Related Obligations of Officers and Directors

[E][1] Officer Certification

The audit committee relies upon senior executives for the internalcontrols and other firm procedures making possible the preparation ofits financial statements. Sarbanes-Oxley reinforced this executive

73. See Rules of Professional Responsibility for Attorneys, Sarbanes-Oxley§ 307 (codified at 15 U.S.C. § 7245):

Not later than 180 days after July 30, 2002, the Commission shallissue rules, in the public interest and for the protection of investors,setting forth minimum standards of professional conduct forattorneys appearing and practicing before the Commission in anyway in the representation of issuers, including a rule—

(1) requiring an attorney to report evidence of a material violationof securities law or breach of fiduciary duty or similar violationby the company or any agent thereof, to the chief legal counselor the chief executive officer of the company (or the equivalentthereof); and

(2) if the counsel or officer does not appropriately respond to theevidence (adopting, as necessary, appropriate remedial measuresor sanctions with respect to the violation), requiring the attor-ney to report the evidence to the audit committee of the board ofdirectors of the issuer or to another committee of the board ofdirectors comprised solely of directors not employed directlyor indirectly by the issuer, or to the board of directors.

74. See Implementation of Standards of Professional Conduct for Attorneys,Securities Act Release No. 8185, 68 Fed. Reg. 6296 (Feb. 6, 2003) (settingforth 17 C.F.R. § 205).

75. See 17 C.F.R. § 205.3(a) (2005).76. See 17 C.F.R. § 205.3(b) (2005).


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responsibility by requiring specified certifications dealing with thesestatements. The CEO and CFO, or their equivalents, mustmake a certification as to each quarterly and annual report (or anyamendments to them) filed by the company with the SEC.77 The

77. In effect, two sections of Sarbanes-Oxley have a certification requirement.The first is Corporate Responsibility for Financial Reports, Sarbanes-Oxley§ 302 (codified at 15 U.S.C. § 7241), which provides as follows:

(a) REGULATIONS REQUIRED—The Commission shall, by rule,require, for each company filing periodic reports undersection 13(a) or 15(d) of the Securities Exchange Act of 1934(15 U.S.C. 78m, 78o(d)), that the principal executive officer orofficers and the principal financial officer or officers, orpersons performing similar functions, certify in each annualor quarterly report filed or submitted under either such sectionof such Act that—

(1) the signing officer has reviewed the report;

(2) based on the officer ’s knowledge, the report does notcontain any untrue statement of a material fact or omitto state a material fact necessary in order to make thestatements made, in light of the circumstances underwhich such statements were made, not misleading;

(3) based on such officer ’s knowledge, the financial state-ments, and other financial information included in thereport, fairly present in all material respects the financialcondition and results of operations of the issuer as of, andfor, the periods presented in the report;

(4) the signing officers—

(A) are responsible for establishing and maintaininginternal controls;

(B) have designed such internal controls to ensure thatmaterial information relating to the issuer and itsconsolidated subsidiaries is made known to suchofficers by others within those entities, particularlyduring the period in which the periodic reports arebeing prepared;

(C) have evaluated the effectiveness of the issuer ’s inter-nal controls as of a date within 90 days prior to thereport; and

(D) have presented in the report their conclusions aboutthe effectiveness of their internal controls based ontheir evaluation as of that date;

(5) the signing officers have disclosed to the issuer ’s auditorsand the audit committee of the board of directors (orpersons fulfilling the equivalent function)—

(A) all significant deficiencies in the design or operation ofinternal controls which could adversely affect the is-suer ’s ability to record, process, summarize, and reportfinancial data and have identified for the issuer ’s audi-tors any material weaknesses in internal controls; and


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(B) any fraud, whether or not material, that involvesmanagement or other employees who have a signifi-cant role in the issuer ’s internal controls; and

(6) the signing officers have indicated in the report whetheror not there were significant changes in internal controlsor in other factors that could significantly affect internalcontrols subsequent to the date of their evaluation,including any corrective actions with regard to significantdeficiencies and material weaknesses.

The second is Corporate Responsibility for Financial Reports, Sarbanes-Oxley § 906 (codified at 18 U.S.C. § 1350(a)), which provides that:

(a) CERTIFICATION OF PERIODIC FINANCIAL REPORTS—Each periodicreport containing financial statements filed by an issuer with theSecurities Exchange Commission pursuant to section 13(a) or 15(d)of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d))shall be accompanied by a written statement by the chief executiveofficer and chief financial officer (or equivalent thereof) of the issuer.

(b) CONTENT—The statement required under subsection (a) shallcertify that the periodic report containing the financial statementsfully complies with the requirements of section 13(a) or 15(d) of theSecurities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)) and thatinformation contained in the periodic report fairly presents, in allmaterial respects, the financial condition and results of operationsof the issuer.

The SEC promulgated Exchange Act Rules 13a-14 and 15d-14 for companiesto follow in making the certification. See generally Certification of Disclo-sure in Companies’ Quarterly and Annual Results, Securities Act ReleaseNo. 8124, 67 Fed. Reg. 57,276 (Sept. 9, 2002) (final rule); Exchange ActRelease No. 46,300, 67 Fed. Reg. 51,508 (Aug. 8, 2002) (revised proposedrule); Exchange Act Release No. 46,079, 67 Fed. Reg. 41,877 (June 20, 2002)(proposed rule before passage of Sarbanes-Oxley). See also Management’sReport on Internal Control Over Financial Reporting and Certification ofDisclosure in Exchange Act Periodic Reports, Securities Act ReleaseNo. 8238, 68 Fed. Reg. 36,636 (June 18, 2003) (final rule under whichmanagers of a public company must report on and certify internal controlsystems in their company). Certification of disclosure in annual andquarterly reports, 17 C.F.R. § 240.13a-14 (2005) provides in relevant part:

(a) Each report, including transition reports, filed on Form 10–Q, Form10–K, Form 20–F or Form 40–F (§§ 249.308a, 249.310, 249.220f or249.240f of this chapter) under section 13(a) of the Act(15 U.S.C. 78m(a)), other than a report filed by an Asset-BackedIssuer (as defined in § 229.1101 of this chapter) or a report on Form20-F filed under § 240.13a-19, must include certifications in theform specified in the applicable exhibit filing requirements of suchreport and such certifications must be filed as an exhibit to suchreport. Each principal executive and principal financial officer of theissuer, or persons performing similar functions, at the time of filingof the report must sign a certification. . . .

(b) Each periodic report containing financial statements filed by anissuer pursuant to section 13(a) of the Act (15 U.S.C. 78m(a)) must


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purpose of the certification is to cause these executives to focus on thefacts of their company ’s financial, and even its nonfinancial, disclosureand to prevent them from asserting that they had no knowledge of majorproblems, such as those that surfaced in companies involved in themajor scandals.77.1 It has been reported that the certification obligationsof the CEO and CFO have led to a system of sub-certifications by lower-level executives in the chain of command, as the senior executivesattempt to establish a basis for their mandated certifications. It is notlikely, however, that, given the purpose of the certification requirement,the CEO and CFO can escape liability relating to their certifications byrelying upon these sub-certifications.

[E][1][a] Content of the Certification

The CEO and CFO must certify the following:

That he or she has reviewed the report,78 which would appear tomean reading it with care.

That, on the basis of the officer ’s knowledge, the report ismaterially accurate. Here the law and the SEC rules use thewell-known language of the antifraud Rule 10b-5.79

That, on the basis of the officer ’s knowledge, the financial state-ments and other financial information in the reports fairly present

be accompanied by the certifications required by Section 1350 ofChapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)and such certifications must be furnished as an exhibit to suchreport as specified in the applicable exhibit requirements for suchreport. Each principal executive and principal financial officer ofthe issuer (or equivalent thereof) must sign a certification. Thisrequirement may be satisfied by a single certification signed by anissuer ’s principal executive and principal financial officers.

(c) A person required to provide a certification specified in paragraph(a), (b) or (d) of this section may not have the certification signed onhis or her behalf pursuant to a power of attorney or other form ofconfirming authority.

77.1. Of course, the cerfication cannot always prevent fraud. See, e.g., SEC v.Penthouse Int’l, Inc., 390 F. Supp. 2d 344 (S.D.N.Y. 2005) (executive vicepresident of company files misleading Form 10-Q and Forms 8-K with“electronic” signature of CEO/CFO).

78. See Sarbanes-Oxley § 302(a)(1) (codified at 15 U.S.C. § 7241).79. Sarbanes-Oxley § 302(a)(2) (codified at 15 U.S.C. § 7241) provides:

(2) based on the officer ’s knowledge, the report does not contain anyuntrue statement of a material fact or omit to state a material factnecessary in order to make the statements made, in light of thecircumstances under which such statements were made, not mis-leading; . . . .


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in all material respects the financial condition and results ofoperations of the company, as well as its cash flows, for the peri-ods presented in the report.80

That the officer is responsible for the “disclosure controls” thatallow the company to make materially accurate disclosure,has evaluated their effectiveness and presents his or her conclu-sions about this effectiveness (or lack thereof) in the report.81

Congress and the SEC want to make these executives responsiblefor the process whereby the company produces information, bothfinancial and nonfinancial, for disclosure to the public. The officermust put in place, or have put in place, a system to gather, recordand summarize accurate information about the company and thento disclose it.

That the officer report to the auditors and the board audit commit-tee any “significant deficiencies” and “material weaknesses” in theinternal controls that present a reasonable risk of inaccurate finan-cial reporting, as well as any fraud perpetrated by those with asignificant role in the internal controls. The certification thus

80. Sarbanes-Oxley § 302(a)(3) (codified at 15 U.S.C. § 7241) provides:

(3) based on such officer ’s knowledge, the financial statements, and otherfinancial information included in the report, fairly present in allmaterial respects the financial condition and results of operations ofthe issuer as of, and for, the periods presented in the report; . . . .

The certification of Rule 13a-14 adds a certification regarding “cash flows”to the statutory requirement. This certification, together with the certifi-cation in (2), for all practical purposes satisfies the particular certifyingrequirements of section 906. See infra section 3:3.2[E][1][c].

81. On this point, Sarbanes-Oxley § 302(a)(4) (codified at 15 U.S.C. § 7241)refers to “internal controls,” which, as discussed earlier, generally meanscontrols for financial information:

(4) the signing officers—(A) are responsible for establishing and maintaining internal

controls;(B) have designed such internal controls to ensure that material

information relating to the issuer and its consolidated sub-sidiaries is made known to such officers by others withinthose entities, particularly during the period in which theperiodic reports are being prepared;

(C) have evaluated the effectiveness of the issuer ’s internal con-trols as of a date within 90 days prior to the report; and

(D) have presented in the report their conclusions about theeffectiveness of their internal controls based on their evalua-tion as of that date; . . . .

Exchange Act Rule 13a-14 broadens this requirement with its reference todisclosure controls. Disclosure controls will be discussed below under theDisclosure Committee. See infra section 3:3.6[B].


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imposes upon the officer a responsibility specifically for the internalcontrols that are designed to produce accurate financial reporting.82

Internal controls, as discussed earlier, are designed to ensure theaccuracy of financial information,83 and auditing standards define theinternal control process. Sarbanes-Oxley added the requirement that acompany file an internal control report with its annual report thatwould state management’s responsibility for internal controls and anassessment of their effectiveness, which assessment the firm’s outsideaccounting firm must review.84 The report must include disclosure ofany change in the internal controls that has materially affected itsinternal control over financial reporting. In conjunction with Sarbanes-Oxley and the management certification requirement, the SEC added

82. Sarbanes-Oxley § 302(a)(5) and (6) (codified at 15 U.S.C. § 7241) provide:

(5) the signing officers have disclosed to the issuer ’s auditors andthe audit committee of the board of directors (or personsfulfilling the equivalent function)—

(A) all significant deficiencies in the design or operation ofinternal controls which could adversely affect the issuer ’sability to record, process, summarize, and report financialdata and have identified for the issuer ’s auditors anymaterial weaknesses in internal controls; and

(B) any fraud, whether or not material, that involves manage-ment or other employees who have a significant role inthe issuer ’s internal controls; and

(6) the signing officers have indicated in the report whether or notthere were significant changes in internal controls or in otherfactors that could significantly affect internal controls subse-quent to the date of their evaluation, including any correctiveactions with regard to significant deficiencies and materialweaknesses.

83. See 15 U.S.C. § 78m(b)(2)(B).84. See Management Assessment of Internal Controls, Sarbanes-Oxley § 404

(codified at 15 U.S.C. § 7262) (as further amended by the Jumpstart OurBusiness Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (Apr. 5, 2012)),providing:

(a) RULES REQUIRED—The Commission shall prescribe rules requiringeach annual report required by section 78m(a) or 78o(d) of this titleto contain an internal control report, which shall—

(1) state the responsibility of management for establishing andmaintaining an adequate internal control structure and pro-cedures for financial reporting; and

(2) contain an assessment, as of the end of the most recent fiscalyear of the issuer, of the effectiveness of the internal controlstructure and procedures of the issuer for financial reporting.

(b) INTERNAL CONTROL EVALUATION AND REPORTING—With respectto the internal control assessment required by subsection (a), each


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a definition of “internal control over financial reporting.”85 It appears

registered public accounting firm that prepares or issues the auditreport for the issuer, other than an issuer that is an emerging growthcompany (as defined in section 78c of this title), shall attest to, andreport on, the assessment made by the management of the issuer.An attestation made under this subsection shall be made inaccordance with standards for attestation engagements issued oradopted by the Board. Any such attestation shall not be the subjectof a separate engagement.

(c) EXEMPTIONS FOR SMALLER ISSUERS.—Subsection (b) shall not applywith respect to any audit report prepared for an issuer that is neithera “large accelerated filer” nor an “accelerated filer” as those termsare defined in Rule 12b-2 of the Commission (17 C.F.R. 240.12b-2).

The attestation is done in accordance with standards promulgated by thePublic Company Accounting Oversight Board. See Pub. Co.Accounting Oversight Bd., Auditing Standard No. 2, An Audit of InternalControl over Financial Reporting Performed in Conjunction with anAudit of Financial Statements, 69 Fed. Reg. 20,672 (Apr. 16, 2004). Seegenerally www.pcaobus.org/standards/index.aspx. The constitutionalityof the PCAOB was upheld. See Free Enter. Fund v. PCAOB, 561 U.S. 477(2010). The SEC in fact requires companies to conduct quarterly evaluationsof their internal controls, which is beyond Sarbanes-Oxley ’s mandate.

85. See Management’s Reports on Internal Control over Financial Reportingand Certification of Disclosure in Exchange Act Periodic Reports, Secu-rities Act Release No. 8238, 68 Fed. Reg. 36,636 (June 18, 2003) (finalrule). Rule 13a-15 (17 C.F.R. § 240.13a-15 (2012)) sets forth the SEC ’srequirements as to internal controls as follows:

(c) The management of each such issuer that either had been requiredto file an annual report pursuant to section 13(a) or 15(d) of the Act(15 USC 78m(a) or 78o(d)) for the prior fiscal year or previously hadfiled an annual report with the Commission for the prior fiscal year,other than an investment company registered under section 8 of theInvestment Company Act of 1940, must evaluate, with the parti-cipation of the issuer ’s principal executive and principal financialofficers, or persons performing similar functions, the effectiveness,as of the end of each fiscal year, of the issuer ’s internal control overfinancial reporting. The framework on which management’s eva-luation of the issuer ’s internal control over financial reportingis based must be a suitable, recognized control framework that isestablished by a body or group that has followed due-processprocedures, including the broad distribution of the framework forpublic comment. Although there are many different ways to con-duct an evaluation of the effectiveness of internal control overfinancial reporting to meet the requirements of this paragraph, anevaluation that is conducted in accordance with the interpretiveguidance issued by the Commission in Release No. 34-55929 willsatisfy the evaluation required by this paragraph.

(d) The management of each such issuer, other than an investmentcompany registered under section 8 of the Investment Company Actof 1940, must evaluate, with the participation of the issuer ’sprincipal executive and principal financial officers, or personsperforming similar functions, any change in the issuer ’s internal


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that internal controls are effective if they comply with recognizedaccounting standards.

The internal controls report has proven to be difficult, confusing,costly and controversial for the management of many public compa-nies, particularly smaller public companies.85.1 Indeed, the SEC estab-lished an advisory committee to study the problems of smaller publiccompanies with SEC regulation, including the internal control reportand audit mandated by section 404 of Sarbanes-Oxley, and thecommittee concluded that these companies should be exempt from

control over financial reporting, that occurred during each of theissuer ’s fiscal quarters, or fiscal year in the case of a foreign privateissuer, that has materially affected, or is reasonably likely tomaterially affect, the issuer ’s internal control over financialreporting.

. . .

(f) The term internal control over financial reporting is defined asa process designed by, or under the supervision of, the issuer ’sprincipal executive and principal financial officers, or persons per-forming similar functions, and effected by the issuer ’s board ofdirectors, management and other personnel, to provide reasonableassurance regarding the reliability of financial reporting andthe preparation of financial statements for external purposes inaccordance with generally accepted accounting principles and in-cludes those policies and procedures that:(1) Pertain to the maintenance of records that in reasonable

detail accurately and fairly reflect the transactions and dis-positions of the assets of the issuer;

(2) Provide reasonable assurance that transactions are recordedas necessary to permit preparation of financial statementsin accordance with generally accepted accounting principles,and that receipts and expenditures of the issuer are beingmade only in accordance with authorizations of managementand directors of the issuer; and

(3) Provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use or disposition ofthe issuer ’s assets that could have a material effect on thefinancial statements.

See generally Management’s Report on Internal Control over FinancialReporting and Certification of Disclosure in Exchange Act PeriodicReports—Frequently Asked Questions (rev. Oct. 6, 2004), www.sec.gov/info/accountants/controlfaq/1004.htm.

85.1. Financial Executives International reports that the costs for larger compa-nies to comply with section 404 of Sarbanes-Oxley have declined by one-third since the effective date of this provision, except for costs related to thecertification by outside auditors, which has remained flat. See NewsRelease, FEI, FEI Survey: Management Drives Sarbanes-Oxley ComplianceCosts Down by 23%, but Auditor Fees Virtually Unchanged (May 16,2007).


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both the report and audit requirements until the regulation could betailored to companies of their size.85.2 In the advisory committee’sview, smaller public companies did not have the employees (indepen-dent of management) needed to assess all of the necessary internalcontrols and could not afford the extensive auditing proceduresnecessary for testing the adequacy of the controls.85.3 Moreover, theadvisory committee pointed to problems with the requirement ofmanagement’s assessment of the effectiveness of internal controlsthat apply to all public companies, that is, that management hasnot available a readily applicable framework for making thisassessment.85.4

The SEC declined to grant a blanket exemption to the internalcontrol requirements for any class of public companies. However, iteased the compliance burdens for some companies and provided moreguidance on compliance. For non-accelerated filers (that is, companieswith less than $75 million of equity held by non-affiliates), whichrepresent 44% of domestic reporting companies, the SEC extended thedate for the first filing of the management report on internal controlsto a fiscal year ending on or after December 15, 2007, and the date forthe auditor ’s attestation on this report until the fiscal year ending onor after December 15, 2008.85.5 The purpose here is to lower and

85.2. See FINAL REPORT OF THE ADVISORY COMMITTEE ON SMALLER PUBLICCOMPANIES TO THE SEC 6–7 (Apr. 23, 2006) (recommending that compa-nies with revenues of less than $125 million (representing 1% of U.S.capitalization) be exempted from the report requirement and that compa-nies with revenues less than $250 million be exempted from the auditrequirement as to the internal controls).

85.3. See id. at 23–24.85.4. See id. at 30–31. Other complaints regarding the section 404 internal

controls report are that the definition of a material weakness in financialcontrols is too loose, requiring executives and auditors to expend resourceswith little benefit, and that there should be a quantitative definition ofmateriality to guide the internal control review. See INTERIM REPORT OFTHE COMMITTEE ON CAPITAL MARKETS REGULATION 131 (Nov. 30, 2006).

85.5. See Internal Control over Financial Reporting in Exchange Act PeriodicReports of Non-Accelerated Filers and Newly Public Companies, SecuritiesAct Release No. 8760, 71 Fed. Reg. 76,580 (Dec. 21, 2006). The SECadopted the same gradual compliance schedule for foreign private issuersthat were accelerated filers, but not large accelerated filers. The initialmanagement report would also be deemed not to be “filed” for ExchangeAct purposes, which would relieve management of liability under section18 of the Exchange Act, 15 U.S.C. § 78r. The SEC extended the date for thefirst auditor ’s attestation on the management report on internal controlsfor non-accelerated filers until the fiscal year ending on or after Dec. 15,2009. See Internal Control over Financial Reporting in Exchange ActPeriodic Reports of Non-Accelerated Filers, Exchange Act Release No.58,028 (June 26, 2008). Among the reasons given for this delay are thatit would lower the compliance costs of these companies, that the SEC


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spread out the costs of compliance for smaller public companies,which can sequentially come to full compliance with the section 404requirements. In addition, to ease the compliance burdens ofnewly public companies, the SEC allows them to comply with themanagement report and auditor attestation only in their secondannual report filed with the SEC after the company goes public.85.6

However, section 989G of the Dodd-Frank Wall Street Reform andConsumer Protection Act of 2010 (“Dodd-Frank”) removed thesection 404 requirement concerning the auditor ’s attestation on themanagement’s report from non-accelerated filers.85.7 Section 989Galso required the SEC to conduct a study of how it could reduce thecompliance burdens of complying with section 404 for companies thatwere larger than non-accelerated filers, but whose market capitaliza-tion was not greater than $250 million, and whether such reduction,or a complete exemption from that section, might increase the numberof IPOs in the United States. The SEC staff conducted this study and,after receiving public comments, concluded that the costs of comply-ing with the auditor ’s attestation requirement had declined, theattestation had benefitted financial reporting, as well as confidencein it, and the evidence did not conclusively show that the requirementhad affected listing decisions.85.8 It thus recommended continuing theattestation requirement for these accelerated filers and encouragingactivities (for example, staff and other guidance) that would improvethe effectiveness and efficiency of the attestation process.85.9

The SEC also issued a proposed release to give management moreguidance on its internal control report.85.10 In particular, the guidanceaddressed management’s assessment or evaluation of a company ’s

would have the benefit of more information on the implementation of theauditor ’s attestation in companies, and that the PCAOB would havedeveloped more guidance to auditors on this task with respect to smallerpublic companies.

85.6. See Securities Act Release No. 8760, 71 Fed. Reg. at 76,587.85.7. See Internal Control over Financial Reporting in Exchange Act Periodic

Reports of Non-Accelerated Filers, Securities Act Release No. 9142, 75 Fed.Reg. 57,385 (Sept. 21, 2010). The U.S. Government Accountability Office(GAO) recommends that the SEC require companies exempt fromthe attestation requirement to disclose whether they have obtained onevoluntarily. The GAO found that the requirement reduced the number offinancial restatements. See GAO, INTERNAL CONTROLS: SEC SHOULDCONSIDER REQUIRING COMPANIES TO DISCLOSE WHETHER THEY OBTAINEDAN AUDITOR ATTESTATION, GAO-13-522 (July 2013).

85.8. See SEC OFFICE OF CHIEF ACCOUNTANT, STUDY AND RECOMMENDATIONSON SECTION 404(B) OF THE SARBANES-OXLEY ACT OF 2002 FOR ISSUERSWITH PUBLIC FLOAT BETWEEN $75 AND $250 MILLION 7 (Apr. 2011).

85.9. See id. at 8–9.85.10. See Management’s Report on Internal Control over Financial Reporting,

Securities Act Release No. 8762, 71 Fed. Reg. 77,635 (Dec. 27, 2006).


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internal controls over financial reporting, which was a special additionof section 404 to the longstanding requirement that a reportingcompany have internal controls. The purpose of the assessment is toidentify with reasonable assurance any material weakness in theinternal controls that could produce a material misstatement oromission in the company ’s financial statements. In the proposedrelease, the SEC explains that the guidance is based on two principles:(1) management must evaluate the design of controls to determinewhether they adequately address the risks of a misstatement, and(2) management’s evaluation of evidence of the controls should berisk-based (that is, it should focus on areas of highest risk in thecontrols).85.11 Thus, according to the SEC ’s guidance, managementmust first identify the financial reporting risks with respect to itscompany, which should be related to the company itself (for example,larger organizations in complex businesses have greater risks). Man-agement must then determine whether the controls that the companyhas in place adequately deal with these reporting risks, that is,reasonably prevent a material misstatement in financial reporting.Next, management would identify the most significant controls toprevent misstatements in order to test them. Testing here means anevaluation of the effective operation of the controls.85.12 Such evalua-tion may occur through regular monitoring or direct testing of specificcontrols.

It is necessary for management, as a result of the above evaluation,to disclose any material weaknesses in financial controls if there is areasonable possibility that a material misstatement in financial state-ments would not be prevented or detected.85.13 The SEC directsmanagement, in evaluating any deficiency or weakness in financialcontrols, to consider a number of factors, such as the nature of thefinancial statement elements involved, the subjectivity, complexity, orextent of the judgment required to determine the financial amountinvolved, the magnitude of the amount, and the existence of cross-controls to correct the weakness. Management is also mandated not toqualify in any way its assessment that the internal controls areeffective.85.14 If there are material weaknesses in internal controls,management must identify them, explain their impact, and discuss itsplanned remedies to them.85.15

The SEC finalized its interpretive guidance to management oncomplying with section 404 in essentially the same form as described

85.11. See 71 Fed. Reg. at 77,639.85.12. See id. at 77,643.85.13. See id. at 77,646.85.14. See id. at 77,647.85.15. See id. at 77,647–48.


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above.85.16 In addition, the SEC amended Rule 13a-15 and thecompanion Rule 15d-15 dealing with the section 404 requirement toclarify that management could comply with either of these rules ifit evaluated a company ’s internal controls in accordance with theguidelines provided in the interpretative release.85.17 However, man-agement is free to follow any other appropriate procedure; the guide-lines are not mandatory. The SEC also finalized a definition of“material weakness” to mean “a deficiency, or a combination ofdeficiencies, in internal control over financial reporting such thatthere is a reasonable possibility that a material misstatement of theregistrant’s annual or interim financial statements will not be pre-vented or detected on a timely basis.”85.18 Moreover, in a companionrelease issued at the same time as the final interpretive release and rulechanges, the SEC proposed a definition of “significant deficiency” inthe design and operation of internal controls.85.19 Under Sarbanes-Oxley,85.20 management must disclose such deficiencies to the boardaudit committee and to the company ’s auditors, although not to itsinvestors. The proposed (now final) definition is “a deficiency, or acombination of deficiencies, in internal control over financial report-ing that is less severe than a material weakness, yet important enoughto merit attention by those responsible for oversight of a registrant’sfinancial reporting.”85.21

In addition, the NYSE requires a CEO of a listed company to certifyannually that the company is in compliance with the NYSE corporategovernance standards (which include those dealing with the auditcommittee) and to notify the NYSE in the event of material noncom-pliance with them.86

85.16. See Commission Guidance Regarding Management’s Report on InternalControl over Financial Reporting under Section 13(a) or 15(d) of theSecurities Exchange Act of 1934, Securities Act Release No. 8810, 72Fed. Reg. 35,324 (June 27, 2007). For additional guidance on a company ’smonitoring of the effectiveness of internal controls, see COMM. OF SPON-SORING ORGS. OF THE TREADWAY COMM’N, GUIDANCE ON MONITORINGINTERNAL CONTROL SYSTEMS (2009).

85.17. See Amendment to Rules Regarding Management’s Report on InternalControls over Financial Reporting, Securities Act Release No. 8809, 72Fed. Reg. 35,310 (June 27, 2007).

85.18. See 17 C.F.R. § 240.12b-2 (2012).85.19. See Definition of a Significant Deficiency, Securities Act Release No. 8811,

72 Fed. Reg. 35,346 (June 27, 2007).85.20. See supra note 82.85.21. For the final rule, see Definition of the Term Significant Deficiency, 72 Fed.

Reg. 44,924 (Aug. 9, 2007).86. See NYSE, supra note 24, § 303A.12 & Commentary, which reads as

follows:


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The Jumpstart Our Business Startups Act (the “JOBS Act”),86.1

among other things, accommodates certain companies with respect tothe section 404 internal control report. These companies are “emerg-ing growth companies” (EGC), defined to mean a company that doesan initial public offering after December 8, 2011, and that has annualgross revenues of less than $1 billion.86.2 A company remains an EGCuntil one of four triggering events occurs: (i) the fiscal year followingthe year when it has annual gross revenues at least equal to $1 billion,(ii) the fiscal year following the fifth anniversary of its initial publicoffering, (iii) the date on which, during the previous three-year period,the company has issued more than $1 billion in nonconvertible debt,and (iv) the date on which the company is deemed to be a “largeaccelerated filer.”86.3 The JOBS Act specifically exempts an EGC fromthe auditor ’s assessment report requirement of section 404(b).86.4 Inaddition, the JOBS Act also exempts EGCs from any future PCAOBrules requiring mandatory auditor rotation or requiring supplementaryinformation in an auditor ’s report, as well as other future PCAOBrules relating to audits of a public company unless the SEC determines

(a) Each listed company CEO must certify to the NYSE each yearthat he or she is not aware of any violation by the company of NYSEcorporate governance listing standards, qualifying the certificationto the extent necessary.

Commentary: The CEO’s annual certification regarding the NYSE’scorporate governance listing standards will focus the CEO andsenior management on the company ’s compliance with the listingstandards.

(b) Each listed company CEO must promptly notify the NYSE inwriting after any executive officer of the listed company becomesaware of any non-compliance with any applicable provision of thisSection 303(A).

(c) Each listed company must submit an executed Written Affirma-tion annually to the NYSE. In addition, each listed company mustsubmit an Interim Written Affirmation as and when required by theinterim Written Affirmation form specified by the NYSE.

The NASDAQ does not have this certification requirement, although itdoes require an executive officer to notify the NASDAQ if he or she isaware that a firm has failed to comply with the corporate governancestandards. See NASDAQ, supra note 24, § 5625:

A Company must provide Nasdaq with prompt notification after anExecutive Officer of the Company becomes aware of any non-compliance by the Company with the requirements of this Rule5600 Series.

86.1. Pub. L. No. 112-106, 126 Stat. 306 (2012).86.2. See id. § 101, 126 Stat. at 307–308.86.3. See id. The $1 billion amount is adjusted every five years for inflation.86.4. See id. § 103, 126 Stat. at 310.


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that such application is in the public interest.86.5 EGCs also need notcomply with any new or revised financial accounting standards untilsuch apply to private (not public) companies.86.6

[E][1][b] Form of Certification

The SEC requires a form of the certification, which cannot bevaried.87 Each officer signs a separate certification, which need not be

86.5. See id. § 104, 126 Stat. at 310.86.6. See id. § 102, 126 Stat. at 308–09.87. See 17 C.F.R. § 229.601(b)(31) (2005). The certification is as follows:

Certifications

I, [identify the certifying individual], certify that:

I have reviewed this [specify report] of [identify registrant];

Based on my knowledge, this report does not contain any untruestatement of a material fact or omit to state a material factnecessary to make the statements made, in light of the circum-stances under which such statements were made, not misleadingwith respect to the period covered by this report;

Based on my knowledge, the financial statements, and otherfinancial information included in this report, fairly present in allmaterial respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented inthis report;

The registrant’s other certifying officer(s) and I are responsible forestablishing and maintaining disclosure controls and procedures (asdefined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and inter-nal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or causedsuch disclosure controls and procedures to be designed underour supervision, to ensure that material information relatingto the registrant, including its consolidated subsidiaries, ismade known to us by others within those entities, particularlyduring the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, orcaused such internal control over financial reporting to bedesigned under our supervision, to provide reasonable assur-ance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes inaccordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant’s disclosure con-trols and procedures and presented in this report our conclu-sions about the effectiveness of the disclosure controls andprocedures, as of the end of the period covered by this reportbased on such evaluation; and


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notarized.88 The certifications are filed as exhibits to the reports thatare certified.

[E][1][c] Penalties for Improper Certification

For the section 906 certification, an officer knowingly filing afalse certification shall be subject to the criminal penalty of a $1 millionfine or a prison sentence of up to ten years, or both.89 Knowing failureby an executive to file any required certification can also lead tocriminal penalties for the company and the officer who so failed to

(d) Disclosed in this report any change in the registrant’s internalcontrol over financial reporting that occurred during theregistrant’s most recent fiscal quarter (the registrant’s fourthfiscal quarter in the case of an annual report) that hasmaterially affected, or is reasonably likely to materially affect,the registrant’s internal control over financial reporting; and

The registrant’s other certifying officer(s) and I have disclosed,based on our most recent evaluation of internal control overfinancial reporting, to the registrant’s auditors and the audit com-mittee of the registrant’s board of directors (or persons performingthe equivalent functions):

(a) All significant deficiencies and material weaknesses in thedesign or operation of internal control over financial reportingwhich are reasonably likely to adversely affect the registrant’sability to record, process, summarize and report financialinformation; and

(b) Any fraud, whether or not material, that involves manage-ment or other employees who have a significant role in theregistrant’s internal control over financial reporting.

Date: ......................

______________________

[Signature] [Title]

* Provide a separate certification for each principal executive officer andprincipal financial officer of the registrant. See Rules 13a-14(a), 15d-14(a).

88. Both officers can sign a collective section 906 certification, but practi-tioners recommend that they sign individual ones.

89. In effect, section 906 provides for two penalties, depending upon whetherthe violation in the certificate was done knowingly, or willfully andknowingly. See Sarbanes-Oxley § 906 (codified at 18 U.S.C. § 1350(c)):

(c) CRIMINAL PENALTIES—Whoever—

(1) certifies any statement as set forth in subsections (a) and (b) ofthis section knowing that the periodic report accompanyingthe statement does not comport with all the requirements setforth in this section shall be fined not more than $1,000,000or imprisoned not more than 10 years, or both; or


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certify.89.1 An officer who files a false certification may also be liable in acivil lawsuit, whether brought by the SEC or by third parties. If the SECbrings the lawsuit, it may charge the officer with, among other things,failing to comply with its rules as to the certification both as to itsmaterial accuracy and form.89.2 The basis of the third-party lawsuit isantifraud liability, with the false certification being part of the fraudulentconduct of the officer. However, it has been held that the certificationrequirement alone does not change the standard for civil liability forpleading “scienter” in a private civil lawsuit alleging securities fraudunder section 10(b) of the Exchange Act against an officer making thecertification. Rather than being by itself probative of this fraudulentintent, a certification has this effect only “if the person signing thecertification was severely reckless in certifying the accuracy of thefinancial statements. This requirement is satisfied if the personsigning the certification had reason to know, or should have suspecteddue to the presence of glaring accounting irregularities or other‘red flags,’ that the financial statements contained material misstate-ments or omissions.”89.3

(2) willfully certifies any statement as set forth in subsections (a)and (b) of this section knowing that the periodic reportaccompanying the statement does not comport with all therequirements set forth in this section shall be fined not morethan $5,000,000, or imprisoned not more than 20 years, orboth.

A willful violation would appear to require intent specifically to violate thelaw. Practitioners have explained that a failure to file a certificate wouldconstitute a violation of section 3(b)(1) of Sarbanes-Oxley, which makesany violation of the Act a violation of the Exchange Act section 32,resulting in a fine of $5 million or imprisonment of up to twenty years.

89.1. Of course, the certification cannot always prevent fraud. See, e.g., SEC v.Penthouse Int’l, Inc., 390 F. Supp. 2d 344 (S.D.N.Y. 2005) (executive vicepresident of company files misleading Form 10-Q and Forms 8-K with“electronic” signature of CEO/CFO).

89.2. See, e.g., SEC v. Meridian Holdings, Inc., et al., CV No. 07-06335 (C.D.Cal. Sept. 28, 2007) (charging CEO and CFO of Meridian with filingmaterially inaccurate certifications and submitting a certification of theCFO that the CFO had not manually signed); see also SEC v. Das, No.8:10CV102, 2011 WL 4375787, at *9 (D. Neb. Sept. 20, 2011) (for such acharge). In the appeal in SEC v. Das, 723 F.3d 943, 954–56 (8th Cir. 2013),the Court of Appeals for the Eighth Circuit concluded that the SEC hadonly to show that a certifying officer acted negligently, or not reasonably—as opposed to knowingly or with scienter—in falsely certifying financialstatements. For an administrative action where a CEO of a company useda forged CFO certification from someone who was not in fact the CFO, andthe chair of the board’s audit committee, informed about the forgery,did not prevent it, see In re Shirley Kiang, Exchange Act Release No.71,824 (Mar. 27, 2014).

89.3. See Garfield v. NDC Health Corp., 466 F.3d 1255, 1267 (11th Cir. 2006);accord Ind. Elec. Workers’ Pension Tr. Fund IBEW v. Shaw Grp., Inc., 537


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[E][2] Improper Influence on Audits

The corporate scandals often remained hidden because officers anddirectors put pressure upon independent public accountants in theiraudit of the firm not to disclose the insiders’ financial misdeeds.Sarbanes-Oxley prohibits officers and directors, and those acting undertheir direction, directly or indirectly, from fraudulently influencing,coercing, manipulating or misleading these accountants in the con-duct of their audit for the purpose of producing misleading financialstatements.90 Exchange Act Rule 13b2-291 lists some of the actions

F.3d 527, 544–45 (5th Cir. 2008); Glazer Capital Mgmt., LP v. Magistri,549 F.3d 736, 747 (9th Cir. 2008); In re Ceridian Corp. Sec. Litig., 542 F.3d240, 248 (8th Cir. 2008); Zucco Partners, LLC v. Digimarc Corp., 552 F.3d981, 1003–04 (9th Cir. 2009) (agreeing with Glazer); see also Cent.Laborers’ Pension Fund v. Integrated Elec. Serv., Inc., 497 F.3d 546, 555(5th Cir. 2007) (requiring a pleading to link the statements in thecertification about internal controls to “the actual accounting and report-ing problems that arose”). For a discussion of the case law on the useof certifications to establish scienter, see Robert J.A. Zito, Sox 302Certifications: What Are They Good For?, N.Y.L.J. (Corporate Governance),Nov. 19, 2007, at 12 (also observing that the SEC brings actions for falsecertifications, not for technical violations of the certifying rules, but onlywhen there is otherwise a significant accounting fraud in the company).

90. See Improper Influence on Conduct of Audits, Sarbanes-Oxley § 303(codified at 15 U.S.C. § 7242):

(a) RULES TO PROHIBIT—It shall be unlawful, in contravention ofsuch rules or regulations as the Commission shall prescribe asnecessary and appropriate in the public interest or for theprotection of investors, for any officer or director of an issuer,or any other person acting under the direction thereof, to takeany action to fraudulently influence, coerce, manipulate, ormislead any independent public or certified accountant en-gaged in the performance of an audit of the financial state-ments of that issuer for the purpose of rendering suchfinancial statements materially misleading.

(b) ENFORCEMENT—In any civil proceeding, the Commissionshall have exclusive authority to enforce this section andany rule or regulation issued under this section.

(c) NO PREEMPTION OF OTHER LAW—The provisions of subsec-tion (a) shall be in addition to, and shall not supersede orpreempt, any other provision of law or any rule or regulationissued thereunder.

(d) DEADLINE FOR RULEMAKING—The Commission shall—

(1) propose the rules or regulations required by this section,not later than 90 days after July 30, 2002; and

(2) issue final rules or regulations required by this section,not later than 270 days after that date.

91. See Improper Influence on Conduct of Audits, Exchange Act ReleaseNo. 47,890, 68 Fed. Reg. 31,820 (May 28, 2003) (final rule); 17 C.F.R.§ 240.13b2-2 (2005).


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that an officer or director cannot encourage an auditor to do or preventan auditor from doing: for example, to issue a misleading report on thecompany ’s financial statements, not to perform a required auditingprocedure, not to report a matter to the company ’s audit commit-tee.92 In its rule-making release, the SEC also specifies the kinds ofcoercive and manipulative conduct on the part of the officer ordirector that can lead to this action—bribing, making physicalthreats, threatening to withdraw business from the accountingfirm—and broadly construes those who could be seen to be aidingthe directors and officers in their deception. Rule 13b2-2 also prohi-bits an officer or director from lying to an accountant in connectionwith an audit or the preparation of an SEC filing.93

92. See 17 C.F.R. § 240.13b2-2(b)(2) (2012), which notes that such actionswould include:

(i) To issue or reissue a report on an issuer ’s financial statementsthat is not warranted in the circumstances (due to materialviolations of generally accepted accounting principles,generally accepted auditing standards, or other professionalor regulatory standards);

(ii) Not to perform audit, review or other procedures required bygenerally accepted auditing standards or other professionalstandards;

(iii) Not to withdraw an issued report; or

(iv) Not to communicate matters to an issuer ’s audit committee.

93. See 17 C.F.R. § 240.13b2-2(a) (2012), which provides:

(a) No director or officer of an issuer shall, directly or indirectly:

(1) Make or cause to be made a materially false or misleadingstatement to an accountant in connection with; or

(2) Omit to state, or cause another person to omit to state,any material fact necessary in order to make statementsmade, in light of the circumstances under which suchstatements were made, not misleading, to an accountantin connection with:

(i) Any audit, review or examination of the financialstatements of the issuer required to be made pur-suant to this subpart; or

(ii) The preparation or filing of any document or reportrequired to be filed with the Commission pursuantto this subpart or otherwise.

For a case involving a violation of Rule 13b2-2 where a CFO hid materialinformation from the company ’s outside auditors (in their preparation ofits Form 10-K) regarding the company ’s problems in collecting its accountsreceivable, see McConville v. SEC, 465 F.3d 780 (7th Cir. 2006). InMcConville, the CFO was also found to have violated, among other things,Rule 13b2-1 (17 C.F.R. § 240.13b2-1 (2006)), which prohibits any personfrom falsifying or causing to falsify the books and records of a publiccompany, and Rule 10b-5.


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[E][3] Prohibition on Retaliation AgainstWhistleblowers

As described above, one duty of the board’s audit committee is toset up channels for complaint, including for anonymous complaintsfrom employees. The goal here is to encourage the kind of whistle-blowing that would reveal a corporate scandal and to deter anyretaliation against whistleblowers. It is important to remember thatwhistleblowers in Enron and WorldCom made their revelationsabout the scandals despite discouragement and threats from seniorexecutives.94 Sarbanes-Oxley makes it a crime, with a penalty of up toten years in prison, for retaliation (defined as interference withemployment or one’s livelihood) against a whistleblower.95 Moreover,it protects an employee of a public company who reveals fraud fromemployer retribution, such as demotion, firing, and harassment, bygiving him or her a cause of action for reinstatement, compensatory(but not punitive) damages and expenses (such as litigation costs),

94. See, e.g., Susan Pulliam & Deborah Solomon, How Three Unlikely SleuthsExposed Fraud at WorldCom, WALL ST. J., Oct. 30, 2002, at A1 (describingthe story of how Cynthia Cooper and her team of internal auditorsunearthed the WorldCom accounting fraud and tracked it through com-pany accounts despite resistance from executives engaged in the fraud); seealso S. REP. NO. 107-146, at 5 (2002):

For instance, a shocking e-mail from Enron’s outside lawyers to anEnron official was uncovered. This e-mail responds to a request forlegal advice after a senior Enron employee, Sherron Watkins, triedto report accounting irregularities at the highest levels of thecompany in late August 2001. The outside lawyer ’s counseledEnron, in pertinent part, as follows: ‘You asked that I include inthis communication a summary of the possible risks associatedwith discharging (or constructively discharging) employees whoreport allegations of improper accounting practices: 1. Texas lawdoes not currently protect corporate whistleblowers. The supremecourt has twice declined to create a cause of action for whistle-blowers who are discharged.’ In other words, after this high levelemployee at Enron reported improper accounting practices, Enrondid not consider firing Andersen; rather, the company sought adviceon the legality of discharging the whistleblower. Of course, Enron’slawyers would claim that they merely provided their client withaccurate legal advice—there is no protection for corporate whistle-blowers under current Texas law.

95. See Retaliation against Informants, Sarbanes-Oxley § 1107 (codified at 18U.S.C. § 1513(e)), which provides:

Whoever knowingly, with the intent to retaliate, takes any actionharmful to any person, including interference with the lawfulemployment or livelihood of any person, for providing to a lawenforcement officer any truthful information relating to the com-mission or possible commission of any Federal offense, shall befined under this title or imprisoned not more than 10 years, or both.


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with a relatively favorable litigation posture.96 As discussed in thefollowing subsection, Dodd-Frank considerably expanded the rights

96. See Protection for Employees of Publicly Traded Companies Who ProvideEvidence of Fraud, Sarbanes-Oxley § 806(a) (codified at 18 U.S.C.§ 1514A), which provides:

(a) WHISTLEBLOWER PROTECTION FOR EMPLOYEES OF PUBLICLYTRADED COMPANIES.—No company with a class of securitiesregistered under section 12 of the Securities Exchange Act of 1934(15 U.S.C. 78l), or that is required to file reports under section 15(d)of the Securities Exchange Act of 1934 (15 U.S.C. 78o(d)), or anyofficer, employee, contractor, subcontractor, or agent of such com-pany, may discharge, demote, suspend, threaten, harass, or in anyother manner discriminate against an employee in the terms andconditions of employment because of any lawful act done by theemployee—

(1) to provide information, cause information to be provided, orotherwise assist in an investigation regarding any conductwhich the employee reasonably believes constitutes a violationof section 1341, 1343, 1344, or 1348, any rule or regulation ofthe Securities and Exchange Commission, or any provision ofFederal law relating to fraud against shareholders, when theinformation or assistance is provided to or the investigation isconducted by—

(A) a Federal regulatory or law enforcement agency;

(B) any Member of Congress or any committee of Congress; or

(C) a person with supervisory authority over the employee (orsuch other person working for the employer who has theauthority to investigate, discover, or terminate miscon-duct); or

(2) to file, cause to be filed, testify, participate in, or otherwiseassist in a proceeding filed or about to be filed (with anyknowledge of the employer) relating to an alleged violation ofsection 1341, 1343, 1344, or 1348, any rule or regulation ofthe Securities and Exchange Commission, or any provision ofFederal law relating to fraud against shareholders.

(b) ENFORCEMENT ACTION.—

(1) IN GENERAL.—A person who alleges discharge or other dis-crimination by any person in violation of subsection (a) mayseek relief under subsection (c), by—

(A) filing a complaint with the Secretary of Labor; or

(B) if the Secretary has not issued a final decision within180 days of the filing of the complaint and there isno showing that such delay is due to the bad faith ofthe claimant, bringing an action at law or equity forde novo review in the appropriate district court of theUnited States, which shall have jurisdiction over such anaction without regard to the amount in controversy.

(2) PROCEDURE.—


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(A) IN GENERAL.—An action under paragraph (1)(A) shall begoverned under the rules and procedures set forth insection 42121(b) of title 49, United States Code.

(B) EXCEPTION.—Notification made under section 42121(b)(1)of title 49, United States Code, shall be made to the personnamed in the complaint and to the employer.

(C) BURDENS OF PROOF.—An action brought under paragraph(1)(B) shall be governed by the legal burdens of proof setforth in section 42121(b) of title 49, United States Code.

(D) STATUTE OF LIMITATIONS.—An action under paragraph (1)shall be commenced not later than 90 days after the dateon which the violation occurs.

(c) REMEDIES.—

(1) IN GENERAL.—An employee prevailing in any actionunder subsection (b)(1) shall be entitled to all reliefnecessary to make the employee whole.

(2) COMPENSATORY DAMAGES.—Relief for any action underparagraph (1) shall include—

(A) reinstatement with the same seniority status thatthe employee would have had, but for thediscrimination;

(B) the amount of back pay, with interest; and

(C) compensation for any special damages sustained as aresult of the discrimination, including litigation costs,expert witness fees, and reasonable attorney fees.

(d) RIGHTS RETAINED BY EMPLOYEE.—Nothing in this section shallbe deemed to diminish the rights, privileges, or remedies ofany employee under any Federal or State law, or under anycollective bargaining agreement.

A whistleblower uses the same procedure for his or her cause of action asthat set down for private employees who are whistleblowers regardingmatters of air safety. See S. REP. NO. 107-146, at 30 (Senate minority reportpoints out that the analogy to air workers was used because these are alsoemployees in private firms, although clearly engaged in jobs with publicinterest implications). The whistleblowing plaintiff has the burden ofmaking a prima facie showing that retaliation for whistleblowing was acontributing factor in the firing or other workplace harassment (to prompta Department of Labor investigation) and the same burden for establishinga violation. A defendant can either respond to the complaint, or rebut aviolation, if it shows by “clear and convincing evidence” that it would havetaken the adverse personnel action in the absence of the employee’swhistleblowing. See 49 U.S.C. § 42121(b). It is important to understandthat a whistleblower is protected only if he or she reports information onconduct that he or she believes constitutes fraud under enumerated federalstatutes, SEC regulation, or other federal law dealing with fraud againstshareholders. In other words, not every conduct within a company can be abasis for protected whistleblower activity. See Tides v. Boeing Co., Fed. Sec.L. Rep. (CCH) ¶ 96,308 (9th Cir. May 3, 2011) (employees’ reports tomedia do not constitute activities protected by the statute); Vodopia v.


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Koninklijke Phillips Elecs. N.V., 398 F. App’x 657 (2d Cir. 2010) (whistle-blowing involved patent fraud, which was not covered under the statute);Allen v. Admin. Review Bd., 514 F.3d 468 (5th Cir. 2008) (agreeing withboard that whistleblowers had not provided information about conductthat alleged a violation of federal antifraud laws, since, among other things,the whistleblowing focused on internal company documents, not reportsfiled with the SEC, and on company conduct that did not show intent todefraud); Livingston v. Wyeth Inc., 520 F.3d 344 (4th Cir. 2008) (agreeing,over a vigorous dissent, with district court that whistleblower had notadequately pled any actual fraudulent conduct (as opposed to potentialconduct) on the part of Wyeth); Fraser v. Fiduciary Tr. Co. Int’l, 417 F.Supp. 2d 310, 322 (S.D.N.Y. 2006) (discussing what a plaintiff must do tomake a claim under section 806, particularly that his or her whistleblow-ing must provide specific information about fraud to shareholders or aviolation of an SEC rule), aff ’d, 396 F. App’x 734 (2d Cir. 2010); Sharkey v.J.P. Morgan Chase & Co., No. 10 Civ. 3824, 2011 WL 135026 (S.D.N.Y.Jan. 14, 2011) (the misconduct reported by the whistleblower can be that ofa firm client and need not be only a firm’s misconduct) (805 F. Supp. 2d 45(S.D.N.Y. 2011) (allowing amended complaint to proceed)); Platone v. U.S.Dep’t of Labor, 548 F.3d 322 (4th Cir. 2008) (concluding that plaintiff hadnever articulated an allegation of fraud to her superiors in a matterinvolving payment procedures between an airline and the pilots’ unionover payment for pilots’ attendance at union meetings); Wiest v. Lynch,710 F.3d 121 (3d Cir. 2013) (adopting DOL’s Administrative ReviewBoard’s standard for determining whether one’s activity is protectedwhistleblowing, a standard at odds with that articulated in Platone).Moreover, an employee’s belief about fraudulent conduct on the part ofthe company must be objectively reasonable. See, e.g., Day v. Staples, 555F.3d 42, 55–57 (1st Cir. 2009) (discussing situation where employee failedto accept reasonable allegations from company about its practices regard-ing booking of returns, which, in any event, were not disclosed to share-holders); Harp v. Charter Commc’ns, Inc., 558 F.3d 722, 723–26 (7th Cir.2009) (allegations of discharge on account of an employee’s reporting offraud were not objectively reasonable); Harkness v. C–Bass Diamond, LLC,Fed. Sec. L. Rep. (CCH) ¶ 95,640 (D. Md. Mar. 16, 2010) (general counsel’sbelief that CEO of company going public might have violated RegulationFD by his disclosure to an investor was not reasonable where counsel failedto conduct legal research into the question); Barker v. UBS AG, No. 3:09-cv-2084 (CFD), 2011 WL 283993, at *3 (D. Conn. Jan. 26, 2011) (plaintiffsatisfied objective and subjective reasonableness standard where she found$80 million of unreported assets). At least one court has ruled that section1514A provides the whistleblower with no right to a jury trial. See Schmidtv. Levi Strauss & Co., 621 F. Supp. 2d 796 (N.D. Cal. 2008) (basing itsdecision on a reading of the statute and a conclusion that the cause ofaction is primarily equitable, rather than legal, under Seventh Amendmentjurisprudence, and citing other cases on the issue). The ninety-day periodfor bringing a whistleblower complaint begins to run on the date when anemployee receives a definitive notice of a discharge or other discriminatoryact, not when he or she experiences its consequences. See In re MarkCorbett, Arb. Case No. 07-044, U.S. Dep’t of Labor Admin. Review Bd.(Dec. 31, 2008) (definitive notice of employee’s termination came onApril 1, which began running of the ninety-day period, not on April 15when he was terminated); Rzepiennik v. Archstone-Smith, Inc., 331


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and benefits of whistleblowers. Dodd-Frank also amended section1514A to make it more favorable to whistleblowers and to addressjurisprudence that had hindered them. Sections 922 and 929expanded the reach of section 1514A(a) to include (i) subsidiaries oraffiliates of a company whose financial information is includedin consolidated financial statements of a company and (ii) creditrating agencies.96.1 In particular, section 922 amended section1514A(b)(2)(D) to expand the statute of limitations from ninety to180 days and to provide an alternative for its start date as “or after thedate on which the employee became aware of the violation.” It alsoadded a new (E) to section 1514A(b)(2) that gave a whistleblowerbringing an action in court a right to a jury trial. Finally, it added a newsubsection (e) to section 1514A, which, as follows, makes the rights ofthe section nonwaivable and makes void any pre-dispute agreement ofan employee to arbitrate any dispute with the company:

F. App’x 584 (10th Cir. 2009) (statute of limitations began to run whenemployee received notice of offer for bonus in exchange for his agreementto drop assertions of fraud by the company); Coppinger-Martin v. Solis,627 F.3d 745, 750 (9th Cir. 2010) (statute of limitations begins to run onceplaintiff has enough information to make a prima facie case); Jones v.Southpeak Interactive Corp., C.A. No. 3:12cv443, 2013 WL 1155566(E.D. Va. Mar. 19, 2013) (applying four-year statute of limitations toSarbanes-Oxley whistleblowing cases since they do not involve claims offraud, but retaliation). Moreover, the Court of Appeals for the SecondCircuit held that a whistleblower ’s claim under section 1514A is subject tomandatory arbitration pursuant to a valid arbitration agreement becausethere was no conflict between arbitration and the inherent purpose of thissection, which is to compensate employees for their whistleblowingactivity. See Guyden v. Aetna, 544 F.3d 376, 382–84 (2d Cir. 2008). Afederal district court in Massachusetts has held that an employee of anagent of a public company may bring a whistleblowing claim, provided thatthe whistleblowing related to an allegation of fraud in the public company.See Lawson v. FMR LLC, 724 F. Supp. 2d 141 (D. Mass. 2010). For a casereviewing all the elements of a section 1514A claim in the context of thedismissal of two in-house lawyers, see Van Asdale v. Int’l Game Tech., 577F.3d 989 (9th Cir. 2009).

In light of the administrative and procedural hurdles for a whistle-blower, scholars and practitioners have questioned whether the Depart-ment of Labor and the courts have fulfilled the intention of Congress ingranting whistleblower rights under section 1514A (Sept. 2008). See, e.g.,GOV’T ACCOUNTABILITY PROJECT, RUNNING THE GAUNTLET: THE CAM-PAIGN FOR CREDIBLE CORPORATE WHISTLEBLOWING RIGHTS.

96.1. See Leshensky v. Telvent GIT, S.A., 873 F. Supp. 2d 582 (S.D.N.Y. 2012)(applying provision retroactively). For further proceedings in the case, see942 F. Supp. 2d 432 (S.D.N.Y. 2013). In Lawson v. FMR LLC, 134 S. Ct.1158 (2014), the U.S. Supreme Court ruled that section 1514A’s whistle-blower protection extends to employees of a public company ’s privatecontractors and subcontractors.


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(e) NONENFORCEABILITY OF CERTAIN PROVISIONSWAIVING RIGHTS AND REMEDIES OR REQUIRINGARBITRATION OF DISPUTES.—

(1) WAIVER OF RIGHTS AND REMEDIES.—The rightsand remedies provided for in this section may not bewaived by any agreement, policy form, or condition ofemployment, including by a predispute arbitrationagreement.

(2) PREDISPUTE ARBITRATION AGREEMENTS.—Nopredispute arbitration agreement shall be valid or en-forceable, if the agreement requires arbitration of adispute arising under this section.

A federal district court has recently determined, on the lack ofexpressed congressional intent and the little effect on parties’ sub-stantive rights, that subsection (e) can be applied retroactively, that is,to disputes arising before the enactment of Dodd-Frank.96.1.1

[E][3][a] Dodd-Frank Whistleblower Provisions andSEC Implementing Rules

Section 922 of Dodd-Frank added an important, although contro-versial, whistleblower provision to the Exchange Act. This provision,section 21F,96.2 authorized the SEC to pay an award to a whistleblowerwho “voluntarily provided original information to the Commissionthat led to the successful enforcement of the covered judicial oradministrative action.”96.3

“Covered judicial or administrative action”means one brought by the SEC that results in monetary sanctionsexceeding $1 million.96.4 Under the statute, “original knowledge” isessentially information from the whistleblower, not derived frompublic sources, not otherwise known to the SEC.96.5 The amount ofthe award would be between 10%–30% of the monetary sanctionscollected from the violator and would be determined by the SEC inlight of the following factors:

(I) the significance of the information provided by the whistle-blower to the success of the covered judicial or administrativeaction;

96.1.1. See Pezza v. Inv’rs Capital Corp., 767 F. Supp. 2d 225 (D. Mass. 2011). Butsee Henderson v. Masco Framing Corp., No. 3:11-CV-00088-LRH, 2011 WL3022535 (D. Nev. July 22, 2011) (declining to apply subsection (e) retro-actively); accord Holmes v. Air Liquide USA LLC, C.A. No. H-11-2580, 2012WL 267194 (S.D. Tex. Jan. 30, 2012), aff ’d, 498 F. App’x 405 (5th Cir.2012).

96.2. 15 U.S.C. § 78u-6.96.3. 15 U.S.C. § 78u-6(b)(1).96.4. 15 U.S.C. § 78u-6(a)(1).96.5. 15 U.S.C. § 78u-6(a)(3).


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(II) the degree of assistance provided by the whistleblower and anylegal representative of the whistleblower in a covered judicialor administrative action;

(III) the programmatic interest of the Commission in deterringviolations of the securities laws by making awards towhistleblowers who provide information that leads to thesuccessful enforcement of such laws; and

(IV) such additional relevant factors as the Commission mayestablish by rule or regulation.96.6

Certain parties are ineligible to receive the award. They are:

(A) any whistleblower who is, or was at the time the whistlebloweracquired the original information submitted to the Commis-sion, a member, officer, or employee of—

(i) an appropriate regulatory agency;

(ii) the Department of Justice;

(iii) a self-regulatory organization;

(iv) the Public Company Accounting Oversight Board; or

(v) a law enforcement organization;

(B) any whistleblower who is convicted of a criminal violationrelated to the judicial or administrative action for which thewhistleblower otherwise could receive an award under thissection;

(C) any whistleblower who gains the information through theperformance of an audit of financial statements required underthe securities laws and for whom such submission would becontrary to the requirements of section 10A of the SecuritiesExchange Act of 1934 (15 U.S.C. 78j-1); or

(D) any whistleblower who fails to submit information to theCommission in such form as the Commission may, by rule,require.96.7

A whistleblower must eventually reveal his or her identity, but is enti-tled to be represented by counsel and can appeal any award in the appro-priate court of appeals. The statute also provides for the establishment

96.6. See 15 U.S.C. § 78u-6(c)(1)(B)(i).96.7. See 15 U.S.C. § 78u-6(c)(2); see also Nollner v. S. Baptist Convention, Inc.,

852 F. Supp. 2d 986 (M.D. Tenn. 2012) (protection available only ifreported violation falls within SEC jurisdiction).


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of an Investor Protection Fund, which, among other things, will payfor the whistleblower awards, and it requires reports to Congress asto such awards and the administration of the fund.

Section 21F(h)96.8 also provides for the protection of whistleblowers.It prohibits retaliatory action by employers against whistleblowers fortheir lawful action under the statute and gives an aggrieved whistle-blower a cause of action for such retaliation, with relief being reinstate-ment, two times back pay plus interest and attorney ’s fees and otherlitigation expenses. Moreover, the SEC is required to keep the whistle-blower ’s identity confidential until it must be publicly identified in acourt proceeding or for award purposes (subject to disclosure of theidentity to other government agencies). Section 21F(i)96.9 prohibits awhistleblower from receiving an award if the whistleblower:

(1) knowingly and willfully makes any false, fictitious, or fraudu-lent statement or representation; or

(2) uses any false writing or document knowing the writing ordocument contains any false, fictitious, or fraudulent state-ment or entry.

The SEC is authorized to issue rules to implement section 21F.After much comment, the SEC adopted implementing rules as Rule

21F, with an effective date of August 12.96.10 Rule 21F-1 describes thestatute and its purposes, as well as provides for the administration ofthe whistleblower program by the SEC ’s new Office of the Whistle-blower. Rule 21F-2(a) defines whistleblower as an individual (not acompany or other entity) that provides “information relat[ing] to apossible violation of the federal securities laws (including any rules orregulations thereunder) that has occurred, is ongoing, or is about tooccur.” The SEC thus accepted the looser standard of “possibleviolation” for whistleblower status, but clarifies that the personmust follow the statutory procedures for reporting that will be dis-cussed below. Under Rule 21F-2(b), an individual is a whistleblower forpurposes of the anti-retaliation protections (that is, whether he or shequalifies for an award) only if he or she possesses “a reasonable beliefthat the information [he or she is] providing relates to a possiblesecurities law violation (or, where applicable, to a possible violationof the provisions set forth in 18 U.S.C. 1514A(a)) that has occurred,

96.8. 15 U.S.C. § 78u-6(h). See Kramer v. Trans-Lux Corp., No. 3:11cv1424(SRU), 2012 WL 4444820 (D. Conn. Sept. 25, 2012) (allowing a whistle-blower to be someone who provides information to the SEC otherwise inthe manner established by that agency).

96.9. 15 U.S.C. § 78u-6(i).96.10. See Implementation of the Whistleblower Provisions of Section 21F of the

Securities Exchange Act of 1934, Exchange Act Release No. 64,545, 76 Fed.Reg. (June 2011) (setting forth 17 C.F.R. § 240.21F-1 through 21F-17).


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is ongoing, or is about to occur” and follows section 21F(h)(1)(A)’sreporting procedures.96.11 The SEC states in the final rule release that“[t]he ‘reasonable belief ’ standard requires that the employee hold asubjectively genuine belief that the information demonstrates a possibleviolation, and that this belief is one that a similarly situated employeemight reasonably possess,” a standard taken from jurisprudence onrelated anti-retaliation provisions. Rule 21F-2(b)(2) clarifies that theSEC itself may enforce the anti-retaliation provisions.

Rule 21F-3(a) restates the statutory criteria for payment of an awardto a whistleblower. Rule 21F-3(b) provides for payment of an award ina “related action” by the Department of Justice, an appropriateregulatory agency, an SRO or a state attorney general in a criminalaction, provided that the related action is based on the same informa-tion provided to the SEC, which has successfully obtained monetarysanctions of more than $1 million in its action. The SEC uses thesame criteria in making an award in such related actions as it does forwhistleblower awards in its own enforcement actions. The rule alsodenies a “double” award to a whistleblower who has already receivedone under the whistleblowing program of the Commodities FuturesTrading Commission (CFTC). (Moreover, a denial of an award by theCFTC in a related action will preclude an SEC award.)

Rule 21F-4 provides definitions in the whistleblower statute nototherwise supplied there or clarifies others. Rule 21F-4(a) defines“voluntariness” of the provision of information by a whistleblowerto refer to such provision before the whistleblower (or his or herattorney) receives a request, demand or inquiry relating to the subjectmatter from the SEC, from the Public Company Accounting OversightBoard (PCAOB) or a self-regulatory organization (SRO) relating to aninvestigation, inspection or examination, or in connection with aninvestigation by another federal agency, Congress, a state attorneygeneral or a state securities regulatory authority. Note that theregulatory request must be made specifically to the whistleblower orits representative. In the definition, the SEC states that a regulatoryrequest, even if not compelled, removes the voluntariness of a sub-mission, although a request from internal compliance does not, nordoes a request directed at an employer, rather than an employee. By thesame token, a request relating to one subject matter does not precludevoluntariness as to providing information about another subjectmatter. A person who is under a pre-existing legal or contractualduty to provide information to one of the parties named above(but only to such party) cannot act voluntarily in this regard. Rule21F-4(b)(1) uses the statutory definition of “original information” in

96.11. These are more expansive than reporting to the SEC, since they encompassreporting under Sarbanes-Oxley to other government authorities.


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section 21F(a)(3) with the addition that such information mustbe provided the first time after the enactment of Dodd-Frank, whileRule 21F-4(b)(2) defines “independent knowledge” (part of thedefinition of “original information”) as “factual information notderived from publicly available sources.” This definition does notexclude second-hand knowledge. Similarly, Rule 21F-4(b)(3) defines“independent analysis” (also part of the “original information”statutory definition) to mean that the whistleblower brings his orher own analysis to information, even publicly available information,which produces some additional evaluation, assessment or insightthat is not known or publicly available. The SEC explains that this islikely to be a high-quality analysis.

Rule 21F-4(b)(4) lists exclusions from the “independent knowledge”and “independent analysis” definitions, which generally deal withpersons who obtain information subject to a privilege or pursuant toa regulatory or compliance function. Thus, this rule excludes lawyers(as well as others who obtain access to this privileged information)who obtain information that is subject to the attorney-client privilege(unless the privilege is waived or disclosure is otherwise permittedunder ethical or bar rules) and those who acquire information as aresult of their legal representation or that of his or her firm. Legalrepresentation includes that provided by both outside and insidecounsel. Rule 21F-4(b)(4)(iii) also excludes from the independentknowledge and analysis category the following persons:

(A) An officer, director, trustee, or partner of an entity and anotherperson informed you of allegations of misconduct, or youlearned the information in connection with the entity ’s pro-cesses for identifying, reporting, and addressing possible viola-tions of law;

(B) An employee whose principal duties involve compliance orinternal audit responsibilities, or you were employed by orotherwise associated with a firm retained to perform compli-ance or internal audit functions for an entity;

(C) Employed by or otherwise associated with a firm retained toconduct an inquiry or investigation into possible violations oflaw; or

(D) An employee of, or other person associated with, a publicaccounting firm, if you obtained the information through theperformance of an engagement required of an independentpublic accountant under the federal securities laws (other thanan audit subject to § 240.21F-8(c)(4) of this chapter), and thatinformation related to a violation by the engagement client orthe client’s directors, officers or other employees.


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Under Rule 21F-4(b)(4)(v), however, even these individuals are exemptfrom the exclusion in the following circumstances:

(A) You have a reasonable basis to believe that disclosure of theinformation to the Commission is necessary to preventthe relevant entity from engaging in conduct that is likely tocause substantial injury to the financial interest or property ofthe entity or investors;

(B) You have a reasonable basis to believe that the relevant entityis engaging in conduct that will impede an investigation of themisconduct; or

(C) At least 120 days have elapsed since you provided the informa-tion to the relevant entity ’s audit committee, chief legalofficer, chief compliance officer (or their equivalents), or yoursupervisor, or since you received the information, if youreceived it under circumstances indicating that the entity ’saudit committee, chief legal officer, chief compliance officer (ortheir equivalents), or your supervisor was already aware of theinformation.

These exemptions are likely to be available only in extreme circum-stances (for example, where the whistleblower must demonstrate thatfirm management is refusing to take action as to a possible violation).Moreover, with respect to the 120-day period of (C) above, the SECexplains that it is not intended to give a company a “grace period” as tohow to proceed with respect to the internal reporting of a violation; asusual, the SEC will consider the promptness of a firm’s reporting asjustifying leniency with respect to the prosecution of the firm as acontrolling person or otherwise under the federal securities laws. Anyobtaining of information in violation of federal or state criminal law(as determined by a domestic court), but not civil law or foreign law,takes a person out of the independent knowledge or analysis category,as does obtaining information from someone otherwise excluded byone of the above provisions (unless that person is subject to the above-listed exemptions).

As to the definition of “original source” with respect to originalinformation obtained from another party, Rule 21F-4(b)(5) providesthat it must be established that a person is the source of such originalinformation. The SEC emphasizes here that, while such originalsource may be eligible for a whistleblower reward, his or her statusdoes not exclude an award from someone who obtained the informa-tion from this source and reported it first; indeed, the first reportingperson might receive a larger award for having caused an investigationto be launched. Moreover, an original source can also be someone whomaterially adds to information already in the SEC ’s possession,Rule 21F-4(b)(6). Even more significantly, a person who uses internal


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reporting and compliance channels to report original information, orwho reports this information to another authority, will be deemed tobe the original source of the information if he or she reports it to theSEC within 120 days of a report to internal compliance, even if, inthe meantime, another person has made a submission that has causedthe SEC to begin an investigation (see Rule 21F-4(b)(7)). This “look-back” is designed to encourage whistleblowers to use a company ’sinternal reporting procedures by preserving the whistleblower ’s statusas an original source, although, despite the request of many commen-ters on the proposed rule, the SEC declined to require a whistleblowerfirst to use such procedures.

Rule 21F-4(c) defines what constitutes information leading to“successful enforcement,” the term in section 21F(b)(1). The SECmakes a distinction here between information relating to conductnot under investigation and that relating to conduct already underinvestigation by the SEC or another authority. In the former case, theinformation must be “specific, credible, and timely” to cause the SECto open an investigation, to reopen one, or to cause an investigationto go in a new direction, and the SEC ’s action must be successfulbased “in whole or in part” on the information provided. In the lattercase, the whistleblower must establish that the information “signifi-cantly contributed” to the success of the action. The SEC explainsthat this standard means that the information saved the SEC timeand resources, allowed it to bring additional claims or enabled it toreach more individuals and firms, and that it cannot be met by awhistleblower who withholds, or delays in providing, information tothe SEC concerning an investigation that the whistleblower is awareof. Finally, a whistleblower may satisfy the successful enforcementrequirement if he or she provides information internally before or atthe same time as provided to the SEC; the firm later gives thatinformation, or the results of its own investigation or audit based onthat information, to the SEC; and the information (or results)satisfies one of the prior criteria of “successful enforcement” (thatis, dealing with conduct either not under investigation or alreadyunder investigation). This means that a whistleblower may meet thesection 21F(b)(1) criterion, even if his or her information is less thanadequate, but it leads to a company investigation that producesresults that lead to a successful enforcement. In other words, awhistleblower can benefit financially from using a company ’s internalcompliance procedures—and an intention of the rule is to encouragethis use.

Under Rule 21F-4(d), an “action” (for the purposes of determiningthe $1 million award threshold) generally refers to a single judicial oradministrative proceeding brought by the SEC. However, there aretwo exceptions favorable to whistleblowers: (i) for award purposes,action also encompasses two or more proceedings arising from the


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same nucleus of facts; and (ii) in situations where an award is basedon one action for award payment purposes, action also includesfurther SEC proceedings where monetary sanctions of $1 million orless have been assessed. The first exception allows recovery to thewhistleblower in cases where none of the proceedings individuallyresults in sanctions reaching the statutory $1 million threshold. Thesecond is designed to reward whistleblowers completely for theirprovision of original information by adding to an award based uponan action that results in the statutory threshold other actions wheremonetary sanctions fall under it, provided that the actions are allbased on the same nucleus of facts. Rule 21F-4(e) defines “monetarysanctions” to include penalties, disgorgement, interest and moniesdeposited in a disgorgement or other fund.96.12

Section 21F(b)96.13 provides for awards between 10%–30% of themonetary sanctions in the action and related actions. Rule 21F-5repeats this statutory limitation, but states that awards are at theSEC’s discretion. It also underlines that the above percentage amountsapply to the total awards to all whistleblowers. Thus, if there were twoeligible whistleblowers, 30% of the monetary sanctions would be thecollective limit on their awards; each could not receive 30% or apercentage that, when added to that received by the other, wouldexceed 30%.

Section 21F(c)(1)(B)96.14 set forth the statutory criteria (listedabove) that the SEC would use in determining the amount of awhistleblower ’s award. In putting the statute into effect, Rule 21F-6lists factors that can increase, and those that can decrease, an award.The first “increasing” factor (which is a statutory factor) is thesignificance of the information provided to the success of the SEC ’saction. The second (also a statutory factor) is the assistance providedby the whistleblower and any legal representative to the SEC ’saction. Here the SEC explains that it will consider the followingsubfactors:

(i) Whether the whistleblower provided ongoing, extensive, andtimely cooperation and assistance by, for example, helping toexplain complex transactions, interpreting key evidence, oridentifying new and productive lines of inquiry;

(ii) The timeliness of the whistleblower ’s initial report to theCommission or to an internal compliance or reporting systemof business organizations committing, or impacted by, thesecurities violations, where appropriate;

96.12. Other Rule 21F-4 definitions concern “appropriate regulatory authority”and “self-regulatory organization.”

96.13. 15 U.S.C. § 78u-6(b).96.14. 15 U.S.C. § 78u-6(c)(1)(B).


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(iii) The resources conserved as a result of the whistleblower ’sassistance;

(iv) Whether the whistleblower appropriately encouraged orauthorized others to assist the staff of the Commission whomight otherwise not have participated in the investigation orrelated action;

(v) The efforts undertaken by the whistleblower to remediatethe harm caused by the violations, including assisting theauthorities in the recovery of the fruits and instrumentalitiesof the violations; and

(vi) Any unique hardships experienced by the whistleblower as aresult of his or her reporting and assisting in the enforcementaction.

The third “increasing” factor, also drawn from the statute, is the SEC ’slaw enforcement interest in deterring violators, pursuant to which itconsiders the following factors:

(i) The degree to which an award enhances the Commission’sability to enforce the federal securities laws and protectinvestors;

(ii) The degree to which an award encourages the submission ofhigh quality information from whistleblowers by appropriatelyrewarding whistleblowers’ submission of significant informa-tion and assistance, even in cases where the monetary sanc-tions available for collection are limited or potential monetarysanctions were reduced or eliminated by the Commissionbecause an entity self-reported a securities violation followingthe whistleblower ’s related internal disclosure, report, orsubmission;

(iii) Whether the subject matter of the action is a Commissionpriority, whether the reported misconduct involves regulatedentities or fiduciaries, whether the whistleblower exposed anindustry-wide practice, the type and severity of the securitiesviolations, the age and duration of misconduct, the number ofviolations, and the isolated, repetitive, or ongoing nature ofthe violations; and

(iv) The dangers to investors or others presented by the underlyingviolations involved in the enforcement action, including theamount of harm or potential harm caused by the underlyingviolations, the type of harm resulting from or threatened bythe underlying violations, and the number of individuals orentities harmed.


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The fourth and final “increasing” factor is new: whether, and towhat extent, the whistleblower and its legal representative participatedin internal compliance systems. Here the SEC considers (i) whetherthe whistleblower reported the information internally before or at thesame time as he or she reported it to the SEC, and (ii) whether he orshe assisted the internal processes.

By contrast, the SEC enumerates (although not in order of im-portance) the factors that might decrease an award. First is theculpability of the whistleblower, which involves the followingconsiderations:

(i) The whistleblower ’s role in the securities violations;

(ii) The whistleblower ’s education, training, experience, and posi-tion of responsibility at the time the violations occurred;

(iii) Whether the whistleblower acted with scienter, both generallyand in relation to others who participated in the violations;

(iv) Whether the whistleblower financially benefitted from theviolations;

(v) Whether the whistleblower is a recidivist;

(vi) The egregiousness of the underlying fraud committed by thewhistleblower; and

(vii) Whether the whistleblower knowingly interfered with theCommission’s investigation of the violations or related en-forcement actions.

The second such factor involves the whistleblower ’s unreasonable delayin reporting a securities violation, which includes the additional issueswhether he or she knew of the facts, but failed to report or to prevent theviolation, whether he or she only reported after learning of an inquiry orinvestigation in progress and whether the whistleblower had a legitimatereason for the delay. Third and finally, the SEC considers whether, ininteracting with internal compliance systems, the whistleblower under-mined their integrity. This factor includes the considerations whetherthe whistleblower “knowingly” interfered with the systems to preventor to delay detection of the violation, made any materially false,fictitious or fraudulent statements that hindered internal complianceor provided any false writing or document with such statements thatinterfered with the systems. With respect to both “increasing” and“decreasing” factors, there is an effort to encourage whistleblowers touse, and thus be rewarded for using, internal compliance systems.

Rule 21F-7 enacts section 21F(h)(2)’s requirements on maintainingthe whistleblower ’s confidentiality (with some additional strengthen-ing when the SEC considers whether to disclose the identity to a foreign


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authority). This rule also provides that a whistleblower may remainanonymous, so long as he or she is represented by an attorney andprovided that his or her identity is revealed for payment of any awardas required by the statute. Rule 21F-8 requires that a whistleblowerprovide information to the SEC in the form and manner that theCommission requires (to be discussed below) and that the whistle-blower may be asked to supply additional explanations, informationand testimony, as well as to enter into a confidentiality agreementwith respect to non-public information supplied by the SEC to himor her. The rule also implements the statutory exclusions fromwhistleblower eligibility enumerated in section 21F(c)(2)96.15 andadds several other categories to the exclusions list (for example, aperson who makes false or misleading statements in a whistleblowersubmission to the SEC).

Rule 21F-9 then outlines the procedure for a whistleblowingsubmission, which must be made either on a new SEC form, theForm TCR (for tip, complaint or referral), and mailed or faxed to theSEC or through the SEC online reporting mechanism. Among otherthings, the Form TCR (a copy is supplied in the rule release) requiresan affidavit from the whistleblower about the accuracy of the sub-mission and his or her eligibility for an award (an anonymouswhistleblower submits such form through his or her attorney).Whistleblowers can submit the Form jointly and are required tostate whether they reported the violation internally. Rule 21F-10sets forth the procedures for submitting a claim for a whistlebloweraward. Essentially, the SEC files a public notice that there has been asuccessful action(s) meeting the statutory awards amount. Claimantswould then have ninety days after such notice to file a Form WB-APP(Application for Award) (copy included in the rule release), where thewhistleblower has an opportunity to make his or her case of eligibilityfor an award (a whistleblower who has worked closely with the SECwould be dispensed from making such a case). The claims reviewprocess would begin once the time for appeals has expired or appealshave been concluded. The SEC ’s Office of the Whistleblower wouldmake a preliminary determination of an award (or denial) for eachapplicant. An applicant could contest this, request to see the back-ground information upon which the SEC based its determination andsubmit additional information supporting his or her position. TheSEC’s Office of the Whistleblower would then make a proposed finaldetermination, which any Commission member could request thatthe entire Commission review. In the absence of such request, theproposed final determination would become a final SEC order.Rule 21F-11 has a claims procedure for an award in a related (that

96.15. 15 U.S.C. § 78u-6(c)(2).


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is, non-SEC) action, which generally follows that for an award froman SEC action. Rule 21F-12 sets forth the materials constituting therecord on appeal, and Rule 21F-13 establishes the appeals rights ofwhistleblowers (tracking section 21F(f)96.16) (the final amount of theaward is not appealable). Rule 21F-14 lays out the procedures forpayment of awards, which, among other things, make paymentcontingent upon collection of the monetary sanctions (a statutoryrequirement) and upon completion of the appeals process concerningawards, and it sets forth the priority of payment for whistleblowers.

Rule 21F-15 clarifies that a whistleblower will not receive amnestyfor his or her own securities violations. Rule 21F-16 addresses issuesrelated to participation of a “culpable” whistleblower in an award.Although declining to bar such a whistleblower from receiving anaward, the rule excludes from the calculation of the $1 millionsanctions threshold, or from any awards calculation, any sanctionsof the culpable whistleblower or of an entity associated with awhistleblower ’s misconduct. To facilitate communications to theSEC, Rule 21F-17 prohibits any impediments to whistleblowing,including enforcement of a confidentiality agreement to impede suchcommunications, and allows the SEC to communicate directly with adirector, officer, member, agent or employee of an entity, without theentity ’s counsel, if such person has first contacted the SEC.

This new whistleblowing procedure is filled with uncertainties as tohow it will work in practice. The main concern of companies has beenthe interaction between whistleblowing and a firm’s internal compli-ance processes, which include internal investigations and whoseexistence, as noted elsewhere in this book, justifies leniency for acompany when an employee violates the law within the course of hisor her employment.96.17 While the SEC refused to require a whistle-blower to bring his or her complaint first to the firm’s internalcompliance, it did modify the rules (as discussed above) to encouragewhistleblowers to do so. However, contradictions remain, and compa-nies are now under considerable pressure to hurry to report possibleviolations of the securities laws to the SEC before completing, or evenbeginning, a full investigation, out of fear that the SEC or federalprosecutors will look upon them unfavorably if a whistleblower fromthe company sets an investigation in motion before a company reportsa problem. Accordingly, much depends upon how the SEC administersthe whistleblowing program (for example, will it in fact rewardwhistleblowers who raise an issue first with the company itself? Will

96.16. 15 U.S.C. § 78u-6(f).96.17. For an expression of these concerns, see, e.g., Phyllis Diamond, Whistle-

blower Bounty Provisions Will Have Large Impact, Washington LawyerPredicts, 42 Sec. Reg. & L. Rep. (BNA) 1788 (Sept. 27, 2010).


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it punish a company that does not report a violation before awhistleblower does?).

Given the newness of the whistleblowing statute, there were initiallyfew reported decisions on it. In Egan v. Tradingscreen, Inc.,96.18 a federaldistrict court faced the issue whether a whistleblowing report to the SECwas necessary for a whistleblower to receive the protection of the anti-retaliation part of section 21F, unless one of the statutory protectionsapplied. Answering in the affirmative, the court basically relied uponthe plain language of the statute. By contrast, the Court of Appeals forthe Fifth Circuit disagreed, determining that the plain language of thestatute requires a whistleblower to report a violation to the SEC tohave this status.96.19

In accordance with Dodd-Frank, the SEC reports annually on theactivities and results of the new whistleblower provisions and, morespecifically, its own Office of the Whistleblower. It has provided its firstsuch report.96.20 The SEC acknowledged that the initial activities ofthe Office involved its organization, including staffing. Nonetheless, itreceived approximately 3,000 tips, with nearly half of them focusingon problems in corporate disclosure, offerings, and manipulation. Italso referred to its initial payments to a whistleblower for a judgmentmeeting the $1 million threshold, although the collected amount forsuch was only $50,000.

§ 3:3.3 Nominating/Corporate Governance Committee

[A] Justification and BackgroundIf a board is to serve as an objective monitor of senior executives,

particularly the all-powerful CEO, its members cannot be handpickedby the CEO, even if they are independent. They may feel beholdento him or her for their membership on the board, which mightprevent them from criticizing his or her projects and strategies. If,moreover, the board is independently to perform its monitoring andadvisory functions with respect to management, it makes sense thatit should have the major role in identifying qualified individuals to bepotential board members.97 Under corporate law, the board proposes

96.18. No. 10 Civ. 8202 (LBS), 2011 WL 1672066 (S.D.N.Y. May 4, 2011); seealso Asadi v. G.E. Energy (USA), LLC, C.A. No. 4:12-345, 2012 WL2522599 (S.D. Tex. June 28, 2012) (finding anti-retaliation provisioninapplicable to foreign employee termination allegedly for whistleblowingoffshore).

96.19. See Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (2013).96.20. See SEC, ANNUAL REPORT ON THE DODD-FRANK WHISTLEBLOWER PRO-

GRAM: FISCAL YEAR 2012 (Nov. 2012). For its second report, see SEC, 2013ANNUAL REPORT TO CONGRESS ON THE DODD-FRANK WHISTLEBLOWERPROGRAM.

97. See generally 1 ALI, PRINCIPLES OF CORPORATE GOVERNANCE, supra note 9,§ 3A.04 cmt. c, at 122.


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directors to the shareholders for election to the board.98 Since, inthe absence of a proxy fight, these nominees are generally the onlyones proposed, director nomination is synonymous with directorelection.

The result of the effort to remove board selection from CEO control isto have a board committee pick board nominees. This committeebecame a “best practices” guideline: a nominating committee composedof independent directors is to be responsible for board nominations.99 Asa result of the corporate scandals, where boards in troubled companieswere seen to be too beholden to management, new attention was focusedon, and new tasks were given to, this committee, and the NYSE made itmandatory in public companies.100 Not only would it be responsible forboard nominations, but it would be the supervisor of overall corporategovernance of the firm. Moreover, pushed by shareholders dissatisfiedwith the board nominations process, the SEC required a public companyto disclose how it conducted the process.101 More controversially, theSEC contemplated substantively regulating board nominations in publiccompanies.102

[B] Composition and CharterThe NYSE mandates that the nominations/corporate governance

committee be composed of independent directors.103 The NasdaqStock Market–listed companies need not have this kind of committee,but that market’s rules require that either an independent nomina-ting committee or a majority of the board’s independent directors

98. See, e.g., DEL. CODE ANN. tit. 8, § 141 (2005).99. See THE BUSINESS ROUNDTABLE, supra note 4, at 22–25 (calling it the

corporate governance committee).100. See NYSE, supra note 24, § 303A.04(a) & Commentary. Under this rule, a

company has freedom to allocate the responsibilities of this committee toanother committee, so long as it is composed of independent directors.

101. See Disclosure Regarding Nominating Committee Functions and Com-munications Between Security Holders and Boards of Directors, ExchangeAct Release No. 48,825, 68 Fed. Reg. 66,992 (Nov. 28, 2003) (final rule).The SEC indirectly compels companies to have this committee by requir-ing disclosure of whether a company has such a committee, the identifica-tion of its members, the number of its meetings and its functions. See 17C.F.R. § 240.14a-101 Item 7(d) (2010) (referencing, among other things, 17C.F.R. § 229.407(b), (c) (2010)).

102. This proposal would have allowed shareholders to use the company ’sproxy for nominations to the board of directors in certain limited circum-stances. See Security Holder Director Nominations, Exchange ActRelease No. 48,626, 68 Fed. Reg. 60,784 (Oct. 23, 2003) (proposed rulethat would allow a shareholder or shareholder group holding 5% or more ofthe voting securities of a firm to use company ’s proxy to nominate acertain number of directors in limited circumstances). See discussion,infra, of other proposals regarding shareholder nominations.

103. See NYSE, supra note 24, § 303A.04(a).


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make board nominations.104 As noted above, best practice guidelinesreinforce these independence requirements.105 In addition, the SECindirectly ensures that a public company have a nominating/corporategovernance committee composed of independent directors by requir-ing that a company disclose whether it has this committee and, ifit does not, explain its absence.106 Under the disclosure requirements,a company must also disclose whether it is complying with theindependence requirements of the applicable stock exchange as tothe committee or, if it is unlisted, whether the members of itsnominating committee are independent.107

The NYSE requires that the committee have a charter settingforth, among other things, the qualifications of its members and itsresponsibilities,108 while the NASDAQ mandates that a charter orboard resolution describe the board nominations process and relatedmatters.109 Once again, the SEC lends support to the charter byrequiring a company to state in its annual proxy statement whetherits nominating/corporate governance committee has a charter and tomake the charter available to shareholders.110

[C] Duties

[C][1] Nominating Responsibilities

[C][1][a] Board Membership PoliciesIn its nominating role, the committee should establish the policies

and criteria for board membership beyond the basic ones enumerated

104. Under NASDAQ, supra note 24, § 5605(e)(1), board nominations can bedone by a majority of the independent directors on the board or anominating committee of independent board members. In exceptionalcircumstances, moreover, the nominating committee can include a direc-tor who is not independent so long as he or she is not a current officer ofthe company, although this situation cannot last longer than two years.See NASDAQ, supra note 24, § 5605(e)(3).

105. See supra note 99; see also CORPORATE DIRECTOR’S GUIDEBOOK, supranote 5, at 1033–39.

106. See 17 C.F.R. § 240.14a-101 Item 7(d) (2007) (referring to 17 C.F.R.§ 229.407(b)(3) and (c) (2007)). These requirements also include informa-tion about the number of committee meetings and the existence of andaccess to its charter.

107. See 17 C.F.R. § 240.14a-101 Item 7(c) (2007) (referring to 17 C.F.R.§ 229.407(a) (2007)).

108. See NYSE, supra note 24, § 303A.04(b). A company must make thischarter available on its website and disclose this availability in its annualproxy statement or (if it does not file such) in its annual report.

109. See NASDAQ, supra note 24, § 5605(e)(2).110. See 17 C.F.R. § 240.14a-101 Item 7 (2007) (referring to 17 C.F.R.

§ 229.407(c)(2)(i) (2007)). A company can satisfy the availability require-ment by posting the charter on its website or, once every three years,attaching it to the annual proxy statement.


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in the charter or bylaws (for example, age).111 As discussed above,these criteria would have to include the qualifications of indepen-dence and financial literacy, as well as any other special expertiseneeded by a board member in the particular company. The committeeshould also develop policies on board composition, which meansthe appropriate mix of inside and outside directors and the idealdiversity of board members. Diversity here means more than genderand ethnic diversity since it would also look to useful backgrounds(such as legal, governmental and financial) for board members of aparticular company.111.1 SEC disclosure echoes this committeeresponsibility.112

[C][1][b] Recruiting and Nominating Directors

The principal nominating task of the committee is to recommenddirector nominees to shareholders, or to the board for further recom-mendation to shareholders, for election to the board. This task

111. See CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1036; 1 ALIPRINCIPLES, supra note 9, § 3A.04 cmt. e, at 124.

111.1. However, gender and ethnic diversity is increasingly a criterion for a boardmember of a public company, as boards seek to have more women andminority group members. In a 2006 survey of the top 200 companies in theS&P 500 index, Spencer Stuart found that 16% of board members werewomen (and 97% of such companies had at least one woman director) andthat minorities accounted for 15% of all directors (and 50% of such compa-nies had at least one minority group member). See SPENCER STUART, 2006BOARD DIVERSITY REPORT, at 3, http://content.spencerstuart.com/sswebsite/pdf/lib/Board_Diversity_Report_2006.pdf. Of the minority group members,Asians had the smallest representation (0.8% of these directors). See id. at 4.Both women and minority group members lag behind other board membersin board leadership roles (for example, lead director), reflecting perhaps theirrelative newness to the board. Because women and minority group membersare not as well represented as others in the traditional background of boardmembers (CEOs and former CEOs), they are often drawn from other seniorexecutive positions in companies or from comparable leadership roles innonprofits. See id. at 11–12; see also SPENCER STUART, supra note 18, at 7–19(reporting that 93% of S&P 500 boards have at least one woman director, 73%have at least one African-American director, 46% have at least one Hispanicdirector and 19% have at least one Asian director). On new disclosureregarding the role of diversity in the nominations process, see infra.

112. See 17 C.F.R. § 240.14a-101 Item 7(d) (2007) (referring to 17 C.F.R.§ 229.407(c)(2)(v) (2007)), which provides:

Describe any specific, minimum qualifications that the nominatingcommittee believes must be met by a nominating committee-recommended nominee for a position on the registrant’s board ofdirectors, and describe any specific qualities or skills that thenominating committee believes are necessary for one or more ofthe registrant’s directors to possess; . . . .

See also section 6:2.1[A][2] infra.


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requires that the committee establish a process whereby it identifiesqualified individuals for board membership and decides upon therenomination of existing directors.113 The need for new boardmembers comes in the natural order of events when directors leavethe board upon retirement, illness, resignation, etc., or in extraordin-ary circumstances when they are removed.114

A main part of the process is the identification and screening ofpersons eligible to be directors. As in many other areas of boardpractice, there are professionals who can assist the committee in

113. See NYSE, supra note 24, § 303A.04(b)(i) (“[T]he committee’s purpose andresponsibilities—which, at minimum, must be to: identify individualsqualified to become board members, consistent with criteria approved bythe board, and to select, or to recommend that the board select, the directornominees for the next annual meeting of shareholders . . . .”); 17 C.F.R.§ 240.14a-101 Item 7(d) (2007) (referring to 17 C.F.R. § 229.407(c)(2)(vi)(2007)) (“Describe the nominating committee’s process for identifying andevaluating nominees for director . . . .”).

The SEC amended Item 407(c)(2)(vi) as follows to incorporate the roleof diversity in director nominations:

Describe the nominating committee’s process for identifying andevaluating nominees for director, including nominees recom-mended by security holders, and any differences in the manner inwhich the nominating committee evaluates nominees for directorbased on whether the nominee is recommended by a securityholder, and whether, and if so how, the nominating committee(or the board) considers diversity in identifying nominees fordirector. If the nominating committee (or the board) has a policywith regard to the consideration of diversity in identifying directornominees, describe how this policy is implemented, as well as howthe nominating committee (or the board) assesses the effectivenessof its policy;

See Proxy Disclosure Enhancements, Securities Act Release No. 9089, 74Fed. Reg. 68,334, 68,364 (Dec. 23, 2009). Although diversity would appearto deal with gender, racial and ethnic diversity, the SEC declined to definethe term and left it broad:

We recognize that companies may define diversity in various ways,reflecting different perspectives. For instance, some companies mayconceptualize diversity expansively to include differences of view-point, professional experience, education, skill and other individualqualities and attributes that contribute to board heterogeneity, whileothers may focus on diversity concepts such as race, gender andnational origin. We believe that for purposes of this disclosurerequirement, companies should be allowed to define diversity inways that they consider appropriate. As a result we have not defineddiversity in the amendments.

See id. at 68,344.114. Under corporate law, the board can fill vacant directorships until the next

annual meeting of shareholders. See, e.g., DEL. CODE ANN. tit. 8, § 223(2005).


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this task, such as professional director and executive search firms.115

Just as for audit committees, the independence of the nominatingcommittee from senior executives is enhanced by giving this commit-tee the authority to hire and fire, and to determine the appropriate feesfor these outside professionals, who should report only to it.116 Inother words, separating the director search firm from managementshould ensure that this firm does not recommend for directorshipsonly individuals pre-screened by the CEO and other senior executives.

The nominating process should include a procedure whereby exist-ing directors and executives can propose names for directors. Since theboard’s duty is not only to monitor senior management, but also toadvise it, it is recognized that senior executives and particularly theCEO should have a major role in proposing names to the nominatingcommittee. This recognition simply reflects the practical reality that aCEO (who is usually the board’s chair) will be best able to identify thekinds of people who might be particularly suited to assist the firm,who fill a firm’s needs and with whom he or she is comfortable. As theALI notes, the CEO is often instrumental in persuading an individualto join a board.117 The main caution is to ensure that the CEO doesnot overly influence the nominating committee’s recruitment ofdirectors, even if his or her recommendations are given considerableweight. The committee’s serious application of the requirement thatboard members be independent may well eliminate from directornomination individuals who have too many ties to the CEO or toother senior executives.118

The most sensitive area in the nominating process is the extent towhich (if at all) the committee accepts recommendations from those

115. These include firms like Spencer Stuart and Heidrick Struggles. SECdisclosure requirements mandate identification of any such professionaladvisor. See 17 C.F.R. § 240.14a-101 Item 7(d) (2007) (referring to 17 C.F.R.§ 229.407(c)(2)(viii) (2007)) (“If the registrant pays a fee to any third partyor parties to identify or evaluate or assist in identifying or evaluatingpotential nominees, disclose the function performed by each such thirdparty.”). Indeed, Spencer Stuart reports that, in 2013, it conducted morethan 400 director searches. See SPENCER STUART, supra note 18, at 2.

116. See NYSE, supra note 24, § 303A.04 & Commentary (“In addition, thecharter should give the nominating/corporate governance committee soleauthority to retain and terminate any search firm to be used to identifydirector candidates, including sole authority to approve the search firm’sfees and other retention terms.”).

117. See 1 ALI, PRINCIPLES OF CORPORATE GOVERNANCE, supra note 9, § 3A.04cmt. c, at 122–23.

118. Social ties, however, may be difficult to identify and to use in the indepen-dence determination. See supra section 3:3.1. The SEC does ask companiesto identify the origin of a director ’s nomination, including whether a directorwas recommended by the CEO. See 17 C.F.R. § 240.14a-101 Item 7(d)


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outside the inner circle of the search firms and existing directors andexecutives: most importantly, from the shareholders. Under the law,if a shareholder wants to nominate proposed directors to theother shareholders, for election to the board, he or she must preparehis or her own proxy statement with the nominations for the annualmeeting, an expensive venture justified only if the shareholderis attempting to take control of, or significantly influence, thefirm.119 Institutional shareholders argue that, as collective holders ofoften over 50% of a public firm’s capital, as representatives of publicinvestors and as parties with no interest in control of a firm, theyshould have a role in director nominations.120 Giving them a rolewould also contribute to board independence since they would

(2007) (referring to 17 C.F.R. § 229.407(c)(2)(vii) (2010)). Surprisingly,many boards retain former CEOs as directors although often for only atransition period. See Jason D. Schoetzer, Retaining Former CEOs on theBoard, DIRECTOR NOTES (Conference Bd., New York, N.Y.), no. DN-015,Sept. 2010.

119. In some cases, a shareholder may use the company ’s annual proxystatement to offer proposals for shareholder vote. The proposal of namesfor directors is not one of the approved subjects for this use. See 17 C.F.R.§ 240.14a-8(i)(8) (2005). But see discussion infra. Rule 14a-8 will bediscussed from time to time, where relevant, throughout the book.Typically, an eligible shareholder (determined by share ownership andlength of shareholding; see SEC Staff Legal Bulletin No. 14F (CF)(Oct. 18, 2011)) will send a proposal in to the company regarding one ofthe approved subjects. If the company concludes that the proposal isimproper, and/or that the proponent has not satisfied the other require-ments of the rule, it will notify the proponent and request a “no-action”position from the SEC staff (i.e., that the SEC will not take enforcementaction if the company does not include the proposal on its proxy state-ment). For an interesting case concerning the proper way for a shareholderto establish the required ownership of shares under the rule in the currentsystem where most shareholders hold their securities through intermedi-aries, see Apache Corp. v. Chevedden, 696 F. Supp. 2d 723 (S.D. Tex. 2010)(implying, but not holding, that more proof of ownership is needed than aletter from an introducing broker, which does not have an account with theDepository Trust Company). See also KBR Inc. v. Chevedden, C.A. No.H-11-0196, 2011 WL 1463611 (S.D. Tex. Apr. 4, 2011) (dealing with howa shareholder establishes its ownership eligibility to submit a proposal),aff ’d, 478 F. App’x 213 (5th Cir. 2012) (per curiam). Empirical data onshareholder proposals suggest that three groups of shareholders submitnearly all the proposals: (i) corporate “gadflies,” (ii) pension funds affiliatedwith labor unions, and (iii) social policy investment vehicles. This data canbe read to mean that most proposals are “interested” and thus not for thebenefit of all shareholders. See JAMES R. COPELAND, PROXY MONITOR2011: A REPORT ON CORPORATE GOVERNANCE AND SHAREHOLDER ACTI-VISM (Sept. 2011).

120. See, e.g., COUNCIL OF INSTITUTIONAL INV’RS, CORPORATE GOVERNANCEPOLICIES 4 (2008) (“Companies should provide access to managementproxy materials for a long-term investor or group of long-term investors


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nominate qualified individuals who would not be beholden to the CEOand who would safeguard shareholder interests.

A recent development in the effort of institutional shareholders tohave a role in nominating directors, without themselves preparingtheir own proxy statement, is in the shareholder proposal and bylawsareas. Institutional shareholders would like to amend a corporation’sbylaws so that the bylaws would allow certain shareholders, in somecircumstances, to place shareholder nominees on the company ’s proxystatement for election to the board. Under the corporate law of manystates, shareholders have the power to amend the bylaws of theircorporation, although the certificate of incorporation may also conferthis power on the board.120.1 They can use the Rule 14a-8 procedureallowed under the SEC’s proxy rules to put proposals dealing withbylaw amendments on the company ’s proxy statement. However, thequestion arises whether the company can exclude this proposalbecause it deals, albeit indirectly, with director elections.120.2 A courtin the Southern District of New York ruled that this kind of proposalcan be excluded because, under the applicable SEC rule, Rule 14a-8,and interpretations of that rule, it might result in a contested directorelection.120.3 On appeal, the Court of Appeals for the Second Circuitreversed, basically on administrative procedure grounds.120.4 Thecourt determined that, when the SEC clarified in 1976 the exclusionfor proposals “relat[ing] to an election,” the SEC understood theexclusion to apply only to proposals that would result in an immediateelection contest, not to proposals that would put in place proceduresmaking such contests more likely. In 1990, the SEC began to adopt abroader interpretation. Since the SEC never explained its change ofposition, the court deferred only to the SEC ’s 1976 interpretation,which meant that a proposal for a bylaw giving shareholders access toa company ’s proxy statement for director elections would not beexcludable under Rule 14a-8.120.5

owning in aggregate at least 5 percent of a company ’s voting stock tonominate less than a majority of the directors. Eligible investors must haveowned the stock for at least three years. Company proxy materials andrelated mailings should provide equal space and equal treatment ofnominations by qualifying investors.”). It is reported that public compa-nies are increasingly asking for shareholder input on identifying candidatesfor open directorships. See Kaja Whitehouse, Investors May Get More Sayin Selecting Directors, WALL ST. J., Apr. 16, 2007, at B3.

120.1. See DEL. CODE ANN. tit. 8, § 109(a) (2005).120.2. See supra note 119.120.3. See Am. Fed’n of State, Cty. & Mun. Emps. v. Am. Int’l Grp., 361 F. Supp.

2d 344 (S.D.N.Y. 2005).120.4. See 462 F.3d 121 (2d Cir. 2006).120.5. See id. at 131.


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The SEC promoted the institutional shareholders’ position, butindirectly. It requires companies to disclose whether they acceptnominations from shareholders and, if not, to explain their reasonsfor declining to accept them. It also requires disclosure of differentialtreatment of shareholder nominations from nominations comingfrom other sources.121 More controversially, it proposed a regulationthat would affect substantively the nominating process in public

121. See 17 C.F.R. § 240.14a-101 Item 7(d) (2007) (referring to 17 C.F.R.§ 229.407(c)(2) (2007)), which provides:

(ii) If the nominating committee has a policy with regard to theconsideration of any director candidates recommended bysecurity holders, provide a description of the material ele-ments of that policy, which shall include, but need not belimited to, a statement as to whether the committee willconsider director candidates recommended by securityholders;

(iii) If the nominating committee does not have a policy withregard to the consideration of any director candidates recom-mended by security holders, state that fact and state the basisfor the view of the board of directors that it is appropriate forthe registrant not to have such a policy;

(iv) If the nominating committee will consider candidates re-commended by security holders, describe the proceduresto be followed by security holders in submitting suchrecommendations;

. . .

(vi) Describe the nominating committee’s process for identifyingand evaluating nominees for director, including nomineesrecommended by security holders, and any differences in themanner in which the nominating committee evaluates nomi-nees for director based on whether the nominee is recom-mended by a security holder, and

. . .

(ix) If the registrant’s nominating committee received, by a datenot later than the 120th calendar day before the date of theregistrant’s proxy statement released to security holders inconnection with the previous year ’s annual meeting, a re-commended nominee from a security holder that beneficiallyowned more than 5% of the registrant’s voting common stockfor at least one year as of the date the recommendation wasmade, or from a group of security holders that beneficiallyowned, in the aggregate, more than 5% of the registrant’svoting common stock, with each of the securities used tocalculate that ownership held for at least one year as of thedate the recommendation was made, identify the candidateand the security holder or security holder group that recom-mended the candidate and disclose whether the nominating


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companies by giving a large shareholder, in certain circumstances,the right to nominate a director for shareholder election. Thecircumstances are limited, for they would apply only to the largestshareholder of a company in a situation where a director proposed bythe company has previously received a significant “no” vote fromthe shareholders.122 Even as framed, the SEC’s proposal provoked afirestorm of opposition from companies,123 and the SEC did not moveforward with it.

However, the SEC then reentered the area of shareholder nomina-tions of directors with two somewhat contradictory releases. In onerelease,123.1 the SEC proposed to allow shareholders to include in acompany’s proxy statement proposals for bylaw amendments relating toprocedures for shareholder nomination of directors for election to theboard, provided that the bylaw amendments are permissible underthe company ’s charter and the applicable state corporate law. Underthe proposal, only a shareholder who is eligible to use Schedule 13G andmeets the threshold for the Schedule 13G filing can make such a proxystatement proposal. As explained in the release, this means that ashareholder (or group of shareholders) must not intend to influence orchange the control of the company, and must have beneficial ownershipof more than 5% of the company ’s securities for at least one year beforemaking the proposal (as well as otherwise comply with Rule 14a-8). TheSEC asked for comment on this proposal, including whether the shareownership percentage for making this kind of proposal to allow share-holder nomination of directors should be lower or higher. In addition,the SEC would require, by amending Schedule 13G, disclosure ofbackground information on the shareholder (or group) making theproposal and an extensive description of its dealings and relationshipswith the company (as well as a requirement to keep the disclosurecurrent). The purpose here is to give the other shareholders informationabout the shareholder proponent. The information that a shareholderproponent would have to disclose is extensive, and it would include, forexample, any pending or threatened litigation against the company, orany of its officers or directors, any discussions regarding its proposalwith a proxy advisory firm, its holding of more than 5% of the securitiesof a competitor of the company, a detailed description of meetings and

committee chose to nominate the candidate, provided, how-ever, that no such identification or disclosure is requiredwithout the written consent of both the security holder orsecurity holder group and the candidate to be so identified.

122. See supra note 102.123. See, e.g., The Business Roundtable, Detailed Comment on the SEC ’s

Proposed Election Context Rules (Dec. 22, 2003).123.1. See Shareholder Proposals, Exchange Act Release No. 56,160, 72 Fed. Reg.

43,466 (Aug. 3, 2007).


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discussions that it has had with the company, and a description of thebackground of the shareholder or group. The company would alsohave to provide its own disclosure of its relationship and dealings withthe shareholder proponent.

In this same release, the SEC also proposed a new rule, Rule 14a-17,to govern the disclosure by a shareholder who is permitted, by bylaw, tomake a nomination of a person for election to a company ’s board, whichis to be proposed to the other shareholders. This proposed rule wouldrequire the nominating shareholder to provide information about itselfand its nominee for inclusion on the company ’s proxy statement. Theshareholder, rather than the company, would be liable for the informa-tion under the antifraud provisions of the federal securities laws. Thenominating shareholder would also have to provide the kind of Schedule13G information, discussed above, with respect to a shareholder pro-posing a bylaw amendment relating to shareholder nominations fordirectors. The nominating shareholder would also have to file anysoliciting material that it uses in trying to get its nominee elected.

Moreover, in this release the SEC proposed an amendment tofacilitate the use of electronic shareholder forums. It observes thatthe proxy statement for the annual meeting is only one example ofcommunication among shareholders, when they use Rule 14a-8, andthat the Internet facilitates shareholder communication on an ongoingbasis. Under proposed (now adopted) Rule 14a-18, a company, itsshareholders, and a third party acting on the company ’s or the share-holder ’s behalf may establish an electronic shareholder forum withoutincurring any liability under the federal securities laws (for example,for conducting an illegal proxy solicitation), and Rule 14a-2(b)(6)would exempt from most of the proxy rules a solicitation made onthis forum.123.2 However, those using the forum would be liable underthe antifraud provisions of these laws. In addition, a statement madeon the forum would be exempt from the definition of solicitation underthe federal proxy rules, provided that the person posting the statementdid not seek a proxy and made the statement more than sixty days beforethe company ’s annual or special shareholder meeting (if the companyannounces a meeting that will occur sooner than sixty days after itsannouncement, the person is exempt for any postings made up to twodays following this announcement). The SEC did not resolve such issuesas what should happen to postings on the forum once the sixty-day safeharbor period begins to run (should they be removed?).123.3

123.2. See Electronic Shareholder Forums, Exchange Act Release No. 57,172, 73Fed. Reg. 4450 (Jan. 25, 2008).

123.3. It suggests that a shareholder who intends to solicit proxies may want toerase his or her prior postings, or a sponsor of the forum may have it go“dark” once the sixty-day period starts to run. See id. at 4454.


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Finally, in this release the SEC solicited comment on the subject ofshareholders making proposals for bylaw change dealing with thesubmission of nonbinding shareholder proposals on companyproxy statements. These are historically the proposals that cannotbe binding, since they would infringe upon the directors’ decision-making power. Thus, the proposals are precatory and couched assuggestions to the board. The SEC asks a number of questionsregarding this matter: for example, whether the shareholder makingthis kind of proposal should be subject to enhanced disclosure or shareownership; what kind of general disclosure should be included withthis proposal (for example, that state law would govern the interpreta-tion of what constitutes a proper subject for a nonbinding proposal);whether the SEC should consider the potential for the company ’sboard to adopt a bylaw prohibiting shareholders from introducingproposals for nonbinding resolutions; and whether the SEC shouldallow for an electronic petition mechanism for use by shareholders.

In a proposed interpretive release, issued the same day asthe foregoing release,123.4 the SEC took the opposite position onshareholder use of Rule 14a-8 for director nominations. It offers anarrow interpretation of the meaning of the exclusion for proposalsrelating to the election of directors under Rule 14a-8(i)(8).This interpretive release was issued in reaction to the Second Circuit’sdecision in American Federation of State, County & Municipal Employ-ees v. American International Group,123.5 which is discussed earlier inthis section. The SEC objects to the Second Circuit’s reading thatRule 14a-8(i)(8) should be limited to proposals regarding shareholderelections pertaining to a specific board seat and not, more generally, toshareholder proposals (such as a bylaw amendment allowing share-holder nominations of directors) making a contested election morelikely. The basis for the SEC’s position is that any contested electionrequires a full proxy solicitation by the shareholder proposing a nomineefor director, in opposition to any nominee proposed by the board; tointerpret the rule so that shareholders can ultimately propose nomineeson the company ’s proxy circumvents the proxy rules. In the proposedinterpretive release, the SEC explains that, contrary to the understand-ing of the Second Circuit, it has consistently considered any election-related proposal to be excludable by Rule 14a-8(i)(8) (although proposalsrelated to shareholder voting and voting rights in general, and boardqualifications would not be excluded by this provision). Accordingly, itproposed to change the language of Rule 14a-8(i)(8) so that a proposal is

123.4. Shareholder Proposals Relating to the Election of Directors, Exchange ActRelease No. 56,161 (July 27, 2007).

123.5. Am. Fed’n of State, Cty. & Mun. Emps. v. Am. Int’l Grp., 462 F.3d 121 (2dCir. 2006).


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excluded if it “relates to a nomination or an election for membership onthe company ’s board of directors or analogous governing body or aprocedure for such nomination or election.” Thus, it could excludeproposals relating to procedures that could result in a contested election,such as a proposal to amend a company ’s bylaws to allow for share-holder nominations of directors.

In other words, the SEC made two proposals that could not bereconciled. This apparently reflected disagreement among the mem-bers of the Commission as to the position that the SEC should take onshareholder nominations of directors. The SEC was then subjected tolobbying by groups supporting each of the proposals. For example,Senator Christopher Dodd, chairman of the Senate Committee onBanking, Housing, and Urban Affairs, recommended that the SECadopt neither proposal (he found even the shareholder-friendly one tobe too restrictive) and that it put off consideration of the matter untilthere were five commissioners.123.6 Then–SEC Chairman Cox at firsttook an equivocal position, stating both that he wanted a rule in placefor the 2008 proxy season and that the SEC must go back to thedrawing board on the shareholder nominations issue.123.7

The SEC then came down in favor of the restrictive position.123.8

After reiterating that the point of the exclusion for shareholderproposals relating to elections in Rule 14a-8(i)(8) is to ensure thatthe proxy rules are followed for any contested election, the SECreasons that any proposal that would allow such a contested electionto occur without the proxy rules being followed (such as a shareholdernomination of a director on the company ’s proxy) should be exclud-able by this provision. It disagreed with the view of the Court ofAppeals for the Second Circuit that it had not offered a consistentinterpretation of Rule 14a-8(i)(8) over the years, and it found addi-tional support in a recent decision of the U.S. Supreme Courtrequiring courts to defer to reasonable agency interpretations of itsrules, even if the most recent interpretation is not consistent with

123.6. See Press Release, Chris Dodd, Chairman, Senate Banking Comm. (Nov. 1,2007). That is, the two Republican-nominated commissioners, KathleenCasey and Paul Atkins, were in favor of the proposal not allowing shareholderuse of the company ’s proxy for the election purpose, whereas the twoDemocratic-nominated commissioners, Roel Campos and AnnetteNazareth, favored the proposal enhancing shareholder rights. ChairmanChristopher Cox (also a Republican nominee) voted for the issuance of bothproposals. Campos and Nazareth then left the SEC, as did Atkins. They havenow all been replaced.

123.7. See Cox Says It’s Back to Drawing Board on Shareholder Nominations ofDirectors, 39 Sec. Reg. & L. Rep. (BNA) 1693 (Nov. 5, 2007) (reporting hisremarks).

123.8. See Shareholder Proposals Relating to the Election of Directors, ExchangeAct Release No. 56,914, 72 Fed. Reg. 70,450 (Dec. 11, 2007).


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past interpretations.123.9 Moreover, the SEC believed that adoption ofthe proposal was necessary to prevent confusion by companies andshareholders concerning the SEC ’s position on this issue. Accord-ingly, it amended Rule 14a-8(i)(8) to provide as follows: “Relates toelection: If the proposal relates to a nomination or an election formembership on the company ’s board of directors or analogousgoverning body or a procedure for such nomination or election.”Thus, a company could exclude a shareholder proposal nominatinga director or one that “would set up a process for shareholders torequire the company to include shareholders’ director nominees inthe company ’s proxy materials for subsequent meetings.” In animportant footnote, the SEC contrasts the kinds of proposals thatwould be excludable under the clarifying amendment to the rule andthose that would not be:

For example, we note that, as stated in the Proposing Release, thestaff has taken the position that a proposal relates to “an electionfor membership on the company ’s board of directors or analogousgoverning body” and, as such, is subject to exclusion underRule 14a-8(i)(8) if it could have the effect of, or proposes aprocedure that could have the effect of, any of the following:

• disqualifying board nominees who are standing for election;

• removing a director from office before his or her term expired;

• questioning the competence or business judgment of one ormore directors; or

• requiring companies to include shareholder nominees fordirector in the companies’ proxy materials or otherwise result-ing in a solicitation on behalf of shareholder nominees inopposition to management-chosen nominees.

Conversely, the staff has taken the position that a proposal maynot be excluded under Rule 14a-8(i)(8) if it relates to any of thefollowing:

• qualifications of directors or board structure (as long as theproposal will not remove current directors or disqualify currentnominees);

• voting procedures (such as majority or plurality voting stan-dards or cumulative voting);

• nominating procedures (other than those that would result inthe inclusion of a shareholder nominee in company proxymaterials); or

• reimbursement of shareholder expenses in contested elections.

123.9. See Long Island Care at Home, Ltd. v. Coke, 551 U.S. 158 (2007).


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These lists represent non-exclusive examples of types of proposalsthat the staff has found to be excludable and non-excludableunder the election exclusion.123.10

The SEC certified to the Delaware Supreme Court (which agreed toreview the question) whether the following shareholder proposal couldbe excluded by the company under Rule 14a-8: a proposal to amend acompany ’s bylaws to require the company to reimburse a shareholdergroup its reasonable expenses for attempting to elect a “short slate” ofdirectors (that is, not a majority) to the company ’s board, providedthat one of the slate’s members was in fact elected.123.11 The com-pany ’s basic ground for objection is that the bylaw would violateDelaware law because it would allow shareholders to infringe uponthe power of the board. The court ultimately agreed with thecompany.123.12 It first observed that the shareholders’ power to adopt abylaw was circumscribed by the power of the board to manage thecorporation (unless that latter power was itself limited in the certificateof incorporation of a company, which was not the case here). Yet itexplained that it was difficult to establish clearly the line beyond whichshareholder action could not go without infringing upon the board’spower (that is, not every shareholder bylaw touching upon the board’spower was illegal). As a way of deciding this case, the court observed thatan important distinction lay in “process” versus “substance”: process-oriented bylaws that established how directors made decisions werepermissible while bylaws that dictated directors’ decisions were not.Since the subject of the contested bylaw is ultimately the process of theelection of directors, the court first concluded that the bylaw was aproper subject for shareholder action. However, the court then decidedthat the bylaw, if adopted, might cause the company to violate the law.In other words, the bylaw would place the directors in a situation where,although, in the exercise of their fiduciary duties, they could decide thatthey should not reimburse a particular dissident slate of directors (forexample, if the dissidents were motivated by an improper desire to harmthe firm), they would be unable to act in accordance with their duty. Alegal bylaw on this subject would have to reserve to the directors thepower to deny reimbursement if their fiduciary duty demanded it.

123.10. See 72 Fed. Reg. at 70,454 n.56.123.11. See Certification of Questions of Law (June 27, 2008), www.sec.gov/rules/

other/2008/ca14a8cert.pdf.123.12. See CA, Inc. v. AFSCME Emps. Pension Plan, 953 A.2d 227 (Del. 2008).


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In another turn of events, with the Obama administration inWashington and a new SEC chair both more favorable to shareholderpower, the SEC proposed to facilitate shareholder nominations ofdirectors in the proxy process.123.13 The justification for this changeis that, since the proxy process has essentially replaced the shareholdermeeting (where, under a corporation’s bylaws, any shareholdermight be allowed to nominate a director), it must be made morefavorable to shareholder nominations of directors because the nomi-nation often determines the election outcome, whether under asystem of plurality or majority voting. The SEC believes that theproposal is necessary despite improvements to the nominating com-mittee and to the director election process, such as increased use ofmajority voting for director election.

Under the proposal, the SEC would promulgate a new Rule 14a-11that, under certain circumstances, would require a company to includeshareholder nominations of directors in the company ’s proxy statement,unless the state law governing the company or the company ’s governingdocuments prohibited this form of nomination. A major condition isthat the shareholder or shareholder group making the nominationcannot be seeking to take control of the company. Unlike past SECproposals in this area, no “triggering event” (e.g., “no” or “withhold” voteon an existing director) is necessary for the nomination. A shareholder orshareholder group is eligible to make a nomination if it satisfies aminimum one-year holding period, commits to hold the requirednumber of shares through the shareholders’ meeting, and owns anamount depending upon the size of the company (1% for large acceler-ated filers, 3% for accelerated filers, and 5% for all other public compa-nies). (Schedule 13G, which is the reporting form for share ownership bylarge holders, would be altered to make it clear that a shareholder orgroup making a nomination would be eligible to continue to use thisform, that is, it is not seeking control of the company by the nomina-tion.) The eligible shareholder or group would notify the company of,and establish its eligibility to make, a nomination on a new Schedule14N in accordance with a notice requirement established by the rule.The Schedule 14N (which must be amended if there is a material changein the information provided) includes information about and represen-tations from the nominating shareholder or shareholder group and thenominee(s), including a statement not exceeding 500 words in support

123.13. See Facilitating Shareholder Director Nominations, Securities Act ReleaseNo. 9046 (June 10, 2009).


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of the nomination. Any shareholder nominees must meet any objectivedirector independence standards applicable to the company and mustnot be “disguised” nominees of the company. A shareholder or share-holder group would be allowed to nominate one director, or 25% of thedirectors, whichever is greater, but a company is not required to includeadditional shareholder nominations if there are already shareholder-nominated board members on the board up to these limits. If separateshareholders or shareholder groups nominate directors, the companymust accept the first nomination and then later nominations only up tothe limit of eligible places for shareholder nominated directors.

A company has to include the shareholder nominees and anysupporting statement on its proxy, in accordance with the abovelimitations. The nominating shareholder or group, but not the com-pany, would have antifraud liability on any information provided by itfor inclusion in the company ’s proxy statement. If shareholder nomi-nees are included in the company ’s proxy statement, the companycould recommend to shareholders how to vote with respect to them,but it could not include on the proxy card a “group” vote for companynominees where a shareholder nominee appears on it. A company anda shareholder or group proposing nominees could solicit votes for theirnominees in accordance with the proxy rules, although there wouldbe exemptions for certain written solicitations by the nominatingshareholder or group in its contact with other shareholders regardingthe nomination (that is, the nominating shareholder would not haveto prepare a proxy statement because of these written solicitations).Rule 14a-11 would also provide for a procedure whereby a companywould reject a shareholder nomination and allow a shareholder orgroup an opportunity to cure any deficiencies in the nomination(e.g., it proposes too many nominees). If a company determines thatit has grounds to exclude a shareholder nomination, it must notify theshareholder or group and the SEC, and it must ask for a “no-action”letter from the SEC staff (that is, that the SEC will not take anyenforcement action if the company excludes the nomination). Theshareholder or group could make a filing with the SEC in opposition tothe company ’s rejection and it could ask the staff to submit the matterto the SEC Commissioners for an official decision.

In addition, the SEC proposes to alter Rule 14a-8(i)(8) to make it clearthat a shareholder proposal to amend a company ’s charter or othergoverning documents regarding the director nomination process ordisclosures relating to shareholder nominations could not be excludedunder that rule. These proposals could be more expansive (that is, differ-ent holding period, different ownership thresholds), but not morerestrictive, than the provisions of Rule 14a-11. In addition, state cor-porate law or a company ’s governing documents might also provide for


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shareholder nominations. In these cases, proposed Rule 14a-19 wouldrequire certain disclosures from the nominating shareholder, again onSchedule 14N, such as the background of the shareholder or group, itsownership percentage, and any material relationships between it and thecompany. These disclosures would be included in the company ’s proxystatement. The SEC also proposes to codify staff positions as follows:while a company could, in certain circumstances, exclude a shareholderproposal relating to a particular director election and proposals thatcould result in an election contest between company and shareholdernominees, Rule 14a-8(i)(8) should not be used to exclude proposals“regarding the qualifications of directors, shareholder voting procedures,board nomination procedures and other election matters of importanceto shareholders that would not directly result in an election contestbetween management and shareholder nominees, and that do notpresent significant conflicts with the Commission’s other proxy rules.”As the SEC explains, the excludable proposals would fall into thefollowing categories of a proposal that:

• would disqualify a nominee who is standing for election;

• would remove a director from office before his or her term expired;

• questions the competence, business judgment, or character ofone or more nominees or directors;

• nominates a specific individual for election to the board ofdirectors, other than pursuant to Rule 14a-11, an applicablestate law provision, or a company ’s governing documents; or

• otherwise could affect the outcome of the upcoming election ofdirectors.

The Delaware legislature recently amended its corporate code topermit companies, among other things, to allow shareholders to makedirector nominations on a company ’s proxy statement. A new pro-vision, section 112, would allow a company to provide in its bylaws forshareholder director nominations, subject to conditions imposed undersuch bylaw dealing with matters such as the number of shareholder-nominated directors and the provision of information to the companyabout the candidates (the company can tailor these conditions as it seesfit, provided that they are otherwise legal).123.14 In addition, section 113permits a company to include in its bylaws a provision for reimbursingshareholders for proxy solicitation expenses that they incur, againsubject to any conditions specified in the bylaws.123.15

123.14. See DEL. CODE ANN. tit. 8, § 112 (2009).123.15. See id. § 113.


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In addition, Congress also entered this governance debate. In Dodd-Frank, the SEC is allowed to impose upon public companies proce-dures for the inclusion of shareholder nominees for the board ofdirectors in a company ’s proxy solicitation materials.123.16 Moreover,the SEC reopened for comment its proxy access proposal and thenissued a final rule.123.17 The final Rule 14a-11 generally follows thestructure of the proposed rule. However, it requires a shareholder, orshareholder group, to have held shares for three years and to have 3%of the voting power of the company in order to be eligible to makedirector nominations. Moreover, if competing shareholder groups areattempting to use the new process, the shareholder nomination will goto the shareholder or group with the largest qualifying voting percen-tage (rather than the first to make the nomination, as was proposed).If there is director nomination eligibility remaining after this share-holder (or group) proposes its nominees, the remaining nominees willgo to the next largest nominating shareholder (or group), and so on.Yet, while the new proxy rules were scheduled to go into effect for mostcompanies for the 2011 proxy season, the Business Roundtable and theChamber of Commerce filed a petition in the Court of Appeals for theD.C. Circuit seeking a review of the rules. Among other things, peti-tioners claimed that the SEC had not adequately assessed the costsproxy access would impose upon companies and was inappropriatelyinterfering with the governance structure of corporations establishedunder state corporate law.123.18 In light of this petition, the SEC stayedthe effectiveness of the rule (including the proposed changes to Rule14a-8(i)(8)), pending the outcome of the legal challenge.123.19 The Court

123.16. Section 971 (amending Section 14(a) of the Exchange Act to add a newSection 14(a)(2)).

123.17. See Facilitating Shareholder Director Nominations, Securities Act ReleaseNo. 9086, 74 Fed. Reg. 67,144 (Dec. 18, 2009); see also BETH YOUNG,ET AL., THE LIMITS OF PRIVATE ORDERING: RESTRICTIONS ON SHARE-HOLDERS’ ABILITY TO INITIATE GOVERNANCE CHANGE AND DISTORTIONSOF THE SHAREHOLDER VOTING PROCESS (Nov. 2009) (questioning ability ofshareholders of approximately 40% of public companies to be able toimpose a shareholder nomination process on a company, if it is optional,given the prevalence of super-majority voting requirements and classvoting in these companies). The proposal, as well as the change toRule 14a-8 discussed above, was adopted in Facilitating ShareholderDirector Nominations, Securities Act Release No. 9136, 75 Fed. Reg.56,668 (Sept. 16, 2010).

123.18. See Petition for Review, Bus. Roundtable & Chamber of Commerce v. SEC(Sept. 29, 2010).

123.19. See Facilitating Director Nominations, Securities Act Release No. 9151,75 Fed. Reg. 64,641 (Oct. 20, 2010).


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of Appeals then struck down the rule since it found this regulation to bean arbitrary and capricious exercise of the SEC ’s power.123.20 In particular,it concluded that the SEC had failed to consider the economic con-sequences of the rule and thus to fulfill its statutory mandate to evaluateits effect upon efficiency, competition and capital formation. Specifi-cally, the SEC had failed properly to quantify the costs that companiesmight incur in resisting directors nominated by shareholders, to justifyits views that the rule would improve board performance, to take intoconsideration the effects upon boards of the new rule (for example, itsdistraction to the company’s business), to consider seriously that therule would be used also exclusively by shareholders with a specialinterest, to estimate realistically the frequency of the use of the newrule and to account for the need for the rule in investment companies.

[C][1][c] Assigning Directors to Committees

Since the committee oversees the board’s composition and member-ship, it is the appropriate board committee to design policies regarding,and to implement, the makeup of board committees.124 Whileassignment of individual directors to committees and appointment ofcommittee chairs are a board function, the nominating committeeshould make detailed recommendations to the board on this subject.125

Once again, it is appropriate for the committee to take the advice ofsenior executives, particularly the CEO, as to the assignments. However,if the board is serious about maintaining its independence from theCEO, it must make committee assignments with care and not simplydefer to the CEO’s recommendations. Nearly all the committees arecritical in the board’s monitoring of executives, but the audit, nominat-ing/corporate governance and compensation committees have a specialrole in the oversight. Thus, the selection of chairs for these committeesis important, for they must be completely independent from the CEO (ifpossible, even more independent than what the independence require-ments of stock exchange rules demand).

123.20. See Bus. Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011). The SEC,however, has allowed the amendment to Rule 14a-8(i)(8), which was nota subject of the lawsuit, to go forward. Securities Act Release No. 9259(Sept. 15, 2011).

124. See, e.g., 1 ALI, PRINCIPLES OF CORPORATE GOVERNANCE, supra note 9,§ 3A.04(b)(3) & cmt. d, at 124.

125. See THE BUSINESS ROUNDTABLE, THE NOMINATING PROCESS AND CORPO-RATE GOVERNANCE COMMITTEES: PRINCIPLES AND COMMENTARY 4 (Apr.2004). The Business Roundtable observes that this committee may also setpolicies about mandatory rotation of directors through committees.


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[C][1][d] Planning for Management Succession

This committee is often the appropriate forum to plan for manage-ment succession.126 The most important succession plan involves theCEO, and too frequently boards are ill prepared to find a replacementquickly in an emergency vacancy. The committee should establish aprocedure for firm leadership in these emergencies and should ensurethat senior executives are being developed internally for this situationas well as for an orderly replacement of the CEO.126.1 This committeewill also conduct the search for a CEO, regardless of the circum-stances of the need.127 Moreover, the SEC announced that share-holder proposals dealing with CEO succession planning will no longerbe excludable under the ordinary business operations exception ofRule 14a-8(i)(7). The SEC “now recognize[s] that CEO successionplanning raises a significant policy issue regarding the governanceof the corporation that transcends the day-to-day business matterof managing the workforce.”127.1 This means that the board andthe nominating/corporate governance committee must give moreattention to this issue, particularly since shareholders are focusingon it.127.2

[C][2] Corporate Governance Responsibilities

As will be clear below, the corporate governance responsibilities ofthe committee overlap with its nominating tasks, which is why

126. See id. at 12. The National Association of Corporate Directors observesthat this issue has historically been treated by the compensation commit-tee, but that boards are increasingly removing the task from this commit-tee. See REPORT OF THE NACD BLUE RIBBON COMMISSION ON CEOSUCCESSION 17 (2000). In a 2013 survey of S&P 500 companies, 96% ofboards said that they discuss CEO succession in their corporate govern-ance committee guidelines. See SPENCER STUART, supra note 18, at 31.

126.1. See generally id. at 34–35.127. See RAKESH KHURANA, SEARCHING FOR A CORPORATE SAVIOR (2002) (dis-

cussing generally the CEO search process within the board). Spencer Stuartreports that the median tenure of a CEO with a company (in his or her role asCEO and including his or her time in lesser positions) in the S&P 500 hassteadily declined (to fifteen years in 2005). SPENCER STUART, 2005 ROUTE TOTHE TOP 5 (Nov. 11, 2005). Median tenure only as CEO (i.e., not includingother roles in the company) is only five years. See id. at 6.

127.1. See SEC Div. of Corp. Fin., Staff Legal Bulletin No. 14E (CF) (Oct. 27,2009).

127.2. See generally Edward Ferris & Justus O’Brien, Examining the Impact ofSEC Guidance Changes on CEO Succession Planning, DIRECTOR NOTES(Conference Bd., New York, N.Y.), no. DN-007, Apr. 2010 (describing thechange of SEC policy and its implications for boards of public companies).


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they are often combined in a nominating/corporate governancecommittee.

[C][2][a] Corporate Governance Guidelines

The NYSE assigns this committee the task of developing, andrecommending to the board the adoption of, corporate governanceguidelines,128 which are themselves an NYSE requirement.129 TheNYSE also requires that these guidelines be posted on a company ’swebsite and that the firm’s annual proxy statement (or its Form 10-K,if it does not have a proxy) direct shareholders to the site. Thedevelopment and publication of these guidelines have become one ofthe recommended “best practices” for firms.130

The NYSE lists the following issues that the guidelines must cover,in addition to the enumeration of major board committees and theirresponsibilities:

• Director qualification standards. These standards should, atminimum, reflect the independence requirements set forth insections 303A.01 and 303A.02. Companies may also addressother substantive qualification requirements, including policieslimiting the number of boards on which a director may sit, anddirector tenure, retirement and succession.

• Director responsibilities. These responsibilities should clearlyarticulate what is expected from a director, including basicduties and responsibilities with respect to attendance at boardmeetings and advance review of meeting materials.

• Director access to management and, as necessary and appro-priate, independent advisors.

• Director compensation. Director compensation guidelinesshould include general principles for determining the formand amount of director compensation (and for reviewing thoseprinciples, as appropriate). The board should be aware that

128. See NYSE, supra note 24, § 303A.04(b)(i).129. See NYSE, supra note 24, § 303A.09. The NASDAQ has no guidelines

requirement.130. See, e.g., THE BUS. ROUNDTABLE, THE NOMINATING PROCESS AND COR-

PORATE GOVERNANCE COMMITTEES, supra note 125, at 8. Of course, thecommittee has to be aware of the concerns of institutional shareholdersand their advisory firms in developing these guidelines. See, e.g., ISS,GOVERNANCE RISK INDICATORS 2.0: TECHNICAL DOCUMENT (Mar. 6,2012) (explaining “GRID” methodology to evaluate governance risk atfirms).


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questions as to directors’ independence may be raised whendirectors’ fees and emoluments exceed what is customary.Similar concerns may be raised when the listed company makessubstantial charitable contributions to organizations in which adirector is affiliated, or enters into consulting contracts with (orprovides other indirect forms of compensation to) a director.The board should critically evaluate each of these matters whendetermining the form and amount of director compensation,and the independence of a director.

• Director orientation and continuing education.

• Management succession. Succession planning should includepolicies and principles for CEO selection and performancereview, as well as policies regarding succession in the event ofan emergency or the retirement of the CEO.

• Annual performance evaluation of the board. The boardshould conduct a self-evaluation at least annually to determinewhether it and its committees are functioning effectively.131

As discussed above and as will be discussed below, many of these tasksbelong to the nominating/corporate governance committee.

[C][2][b] Management and Board Evaluation

The NYSE specifically assigns this task to the committee, as doesthe Business Roundtable.132 In essence, this task demands an assess-ment of the performance of the CEO, the board and individual boardmembers in relation to the goals and performance criteria establishedby the committee and the board (as set forth in the firm’s corporategovernance guidelines).133 Professional associations, like the NACD,provide templates for this evaluation.134 Although evaluation cansupport a board’s performance of its task of management supervisionand general care, it can present liability risks if the board fails to act

131. See NYSE, supra note 24, § 303A.09 & Commentary.132. See NYSE, supra note 24, § 303A.04(b)(i); THE BUS. ROUNDTABLE, THE

NOMINATING PROCESS AND CORPORATE GOVERNANCE COMMITTEES, supranote 125, at 6 (referring only to board evaluation).

133. In a related vein, the SEC requires disclosure in the company ’s annualproxy statement of any director who attended fewer than 75% of the boardor committee meetings. See 17 C.F.R. § 240.14a-101 Item 7(d) (2010)(cross-referencing 17 C.F.R. § 229.407(b) (2010)).

134. See REPORT OF THE NACD BLUE RIBBON COMMISSION ON PERFORMANCEEVALUATION OF CHIEF EXECUTIVE OFFICERS, BOARDS, AND DIRECTORS(1995); REPORT OF THE NACD BLUE RIBBON COMMISSION ON BOARDEVALUATION (2001).


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following identification of problems in an executive or director that is aresult of the evaluation.135 Evaluation also includes the committee’sevaluation of its own performance.136

[C][2][c] Director Compensation

This task, which includes a determination of all benefits receivedby directors (for example, compensation, retirement, insurance, in-demnification), may be performed by the compensation committee.State corporate law empowers directors to set their own compensa-tion.137 SEC rules require disclosure of director compensation(including any special compensation) in a company ’s proxystatement.138

Director compensation has, in fact, become an increasingly sensi-tive issue in corporate governance. This is not surprising. Directors,primarily independent directors, are now being asked to performmore supervisory and monitoring tasks in public companies, andthus the issue of the appropriate compensation for their enhancedprofessional responsibilities is inevitably being raised. Since, more-over, there is renewed focus on their independent professionalism, afurther concern is that they receive compensation that is inappropri-ate for a disinterested professional or that suggests an attempt by thesenior executives improperly to influence them.

Business groups have provided guidelines on,139 and surveys ofcurrent practices in, director compensation.139.1 Moreover, organizationsof institutional investors and proxy firms providing voting guidance for

135. See REPORT OF THE NACD BLUE RIBBON COMMISSION ON BOARD EVALUA-TION, supra note 134, at 26–27.

136. See NYSE, supra note 24, § 303A.04(b)(ii).137. See, e.g., DEL. CODE ANN. tit. 8, § 141(h) (2005).138. See 17 C.F.R. § 240.14a-101 Item 8 (2007); 17 C.F.R. § 229.402(k) (2007).139. See, e.g., REPORT OF THE NACD BLUE RIBBON COMMISSION ON DIRECTOR

COMPENSATION (2001) (discussing, among other things, recommendedpolicy of paying directors in stock or options and avoiding retirementbenefits and other perquisites). The NACD also provides yearly surveys ofdirector compensation practices.

139.1. See, e.g., THE CONFERENCE BD., DIRECTORS’ COMPENSATION AND BOARDPRACTICES IN 2005 (2005) (annual report on this topic); see also PEARLMEYER & PARTNERS, 2005 DIRECTOR COMPENSATION (reporting thatmedian director compensation in the top 200 U.S. corporations is$182,304, with the majority of the value coming from a director ’s equityholding). For a more recent summary of director compensation trends, seeFREDERIC W. COOK & CO., INC., 2008 DIRECTOR COMPENSATION:NASDAQ 100 VS. NYSE 100 (Oct. 2008) (report on non-employee directorcompensation at these companies; includes information that a boardmember (i.e., not a committee chair or member) receives an average of$230,000 in the Nasdaq 100 and $205,000 in the NYSE 100, thatcompanies are increasingly using stock awards, rather than stock options


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these investors have taken positions on director compensation, generallyadvising that institutional investors support shareholder resolutionsrecommending that directors receive a cash retainer, a more significantequity component that would align the directors’ and shareholders’interests, no director meeting fees and no suspect side benefits, such asretirement, health or charitable contributions.139.2 In addition, the SECenhanced public company disclosure pertaining to director compensa-tion and benefits.139.3 As opposed to requiring disclosure of aggregatedirector compensation, the revisions demand that a company present achart with the yearly compensation of individual directors broken downinto major compensation categories, similar to the chart for the com-pensation of major company executives, together with a narrativedescription and explanation.139.4

[C][2][d] Review and Revision of Board Policies

Since the nominating/corporate governance committee is respon-sible for the corporate governance guidelines, which basically set forththe responsibilities of directors, board committees and the board,another of its tasks should be to review the overall functioning ofthe board and its committees and to make recommendations forchanges in its structure and procedures.140 This responsibility couldinclude such tasks as evaluating whether directors receive adequate,timely information from management and have adequate access to

(although Nasdaq companies still predominantly use stock options), thatequity portion of compensation generally equals or exceeds board andboard committee retainers and meeting fees that are paid in cash, and thatthere are increasingly stock ownership or retention requirements fordirectors). See also SHEARMAN & STERLING, 2013: 11TH ANNUAL SURVEYOF THE LARGEST U.S. PUBLIC COMPANIES: COMPENSATION GOVERNANCE?2013 40 (2013) (reviewing director compensation trends in the 100 largestU.S. public companies and pointing to the continued popularity of cashretainers for board, committee, and committee chair service); SPENCERSTUART, supra note 18, at 33 (reporting that average director compensationfor S&P 500 directors is $249,168).

139.2. See, e.g., SUBODH MISHRA, 2006 U.S. PROXY SEASON TRENDS (June 12,2009); COUNCIL OF INSTITUTIONAL INV’RS, CORPORATE GOVERNANCEPOLICIES (May 1, 2009).

139.3. See Executive Compensation and Related Party Disclosure, Securities ActRelease No. 8655, 71 Fed. Reg. 6542, 6564 (Feb. 8, 2006) (proposed rule);Securities Act Release No. 8732A, 71 Fed. Reg. 158 (Sept. 8, 2006) (finalrule).

139.4. 17 C.F.R. § 229.402(k)(1)–(3) (2007). The rule allows for the grouping oftwo or more directors in the table if their compensation is uniform, so longas the names of these directors are clearly identified.

140. See THE BUS. ROUNDTABLE, THE NOMINATING PROCESS AND CORPORATEGOVERNANCE COMMITTEES, supra note 125, at 5–6.


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executives and outside professionals (itself a corporate governanceguideline), determining whether their meetings are long enough andin suitable locations and proposing the formation of new boardcommittees. This committee should also keep up with corporategovernance and board developments and for this purpose consultwith, or retain, appropriate consultants.141 It might also be thecommittee’s role to gather information about, and to enforce theboard’s policy on, director positions in other companies that a directoroccupies or proposes to fill.

[C][2][e] Director Orientation and Education

This responsibility is enumerated in the NYSE’s list of mandatorycorporate governance guidelines. A new director needs to be orientedas to his or her responsibilities on a particular board, as well as to hisor her duties as a public company director and board committeemember, and he or she requires basic information about the company.Moreover, directors must be continually educated about their respon-sibilities and legal developments concerning their roles. It makes sensethat the committee responsible for director nomination and evalua-tion should oversee this task, with the aid of management. Thecommittee should thus plan an orientation program for new directors,organize board retreats, collect and distribute educational materials toboard members and gather information and set policies about atten-dance at particular outside director institute programs.142

[C][2][f] Shareholder Communication

As noted earlier, some institutional shareholders (and their advis-ors) are increasingly active in corporate governance and have strongviews about corporate governance issues in general, as well as thosepertaining to a particular company. They want board members, astheir fiduciaries, to be receptive and responsive to their concerns,particularly if the concerns deal with a company ’s performance. A“best practice” has developed to provide an established avenue ofcommunications to the board for these shareholders (although itmust be available to all shareholders).143 Again, it makes sense for

141. The number of corporate governance and board consultants is growing.They are mentioned from time to time in the book. Ratings agencies infact use management and governance in the ratings. See STANDARD &POORS, RATINGS DIRECT: HOW WE USE MANAGEMENT AND GOVERNANCECREDIT FACTORS (Nov. 13, 2012).

142. Indeed, further director education may be a condition for a particulardirector to remain on the board. The Conference Board, for example,conducts a Directors’ Institute.

143. See THE BUS. ROUNDTABLE, THE NOMINATING PROCESS AND CORPORATEGOVERNANCE COMMITTEES, supra note 125, at 11.


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the nominating/corporate governance committee to provide this ac-cess, since shareholder communications generally deal with nomina-tions and corporate governance matters. It also falls to the committee,in certain cases, to meet with shareholders, or otherwise to commu-nicate with them, in order to answer their concerns or to explain whythe company is not acceding to their requests. In a related vein, thecommittee’s members (and, if possible, the entire board) should attendthe annual shareholders’ meeting and take questions from thefloor.143.1 Once again, the SEC lends its support to these best practicesby requiring a public company to disclose its process for shareholdercommunications (or to explain why it does not have one) and its policyregarding, and actual director attendance at, shareholder meetings.144

Meetings with shareholders can be sensitive. As discussed earlier,activist institutional shareholders have certain corporate governancereforms (for example, end of staggered boards and poison pills), andthey might approach the committee to advocate their positions.Moreover, they may place on the company ’s annual proxy statementa resolution addressing their reform by recommending that theboard take particular action.145 If the resolution garners significantshareholder support, institutional shareholders may return to thecommittee to push their case. The nominating/corporate governancecommittee must thus be well prepared to argue the board’s positionson these corporate governance matters if these positions differ fromthose of the institutional shareholders. It must also be ready to facepotentially negative publicity generated by the institutional share-holders when the company does not accede to their requests.

The nominating/corporate governance committee should alsosupervise, and thus be up to date on, all practices of communication

143.1. The committee should also be aware of current developments in share-holder voting. See, e.g., DEL. CODE ANN. tit. 8, § 213 (2009) (allowing aboard to “bifurcate” the record date for shareholders who receive notice of ashareholder meeting and a later date to determine shareholders eligible tovote at the meeting; the purpose of the amendment is to prevent formershareholders of record, but who no longer hold the shares, from voting atthe meeting).

144. See 17 C.F.R. § 240.14a-101 Item 7(d) (2007) (referring to 17 C.F.R.§ 229.407(b)(2), (f) (2007)). Spencer Stuart finds that 54% of S&P 500boards report that all of their members attended the most recent annualmeeting. See SPENCER STUART, BOARD INDEX 2005, www.spencerstuart.com. Spencer Stuart also reports that in 2013 58% of survey respondentsstated that their board or management reached out to shareholders. SeeSPENCER STUART, supra note 18, at 32.

145. Shareholders can put resolutions for shareholder vote on a company ’sproxy under the procedures of Rule 14a-8, although certain matters areexcluded and most of the resolutions must be cast as recommendations tothe board. See 17 C.F.R. § 240.14a-8 (2005); see also supra note 119.


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with the firm’s shareholders. Increasingly, the main form of thiscommunication is by the Internet, with a firm posting its SEC filingsas well as corporate governance information on its website.145.1 In fact,the SEC allows companies (as of July 1, 2007) to conduct proxysolicitations (other than with respect to a business combination)and to provide proxy statements, proxy cards, annual reports, etc.,essentially by way of a website posting of the proxy statement.145.2 Thejustification is the increasing use of the Internet by ordinary share-holders to receive proxy materials and to exercise their vote.145.3 Underthe Internet alternative, a company would have to send its share-holders, at least forty calendar days before the shareholders’ meeting,notice of the current Internet availability of the proxy statement andnotice of their right to request an email copy or a hard copy of proxymaterials (among other information).145.4 Generally, a company woulduse its own website (it cannot use the SEC ’s website) for the posting ofthese materials. The alternative, like any involving shareholder voting,is not without complications, primarily because most shareholdershold their shares, and thus vote, through financial intermediaries, whoin effect vote the shares pursuant to the beneficial holders’ instructions(but see below).145.5 Accordingly, it establishes a procedure whereby, ifa company uses the notice and Internet access procedure, the brokerwould have to replace the company ’s notice with its own notice aboutvoting instructions and either direct beneficial owners to the com-pany ’s website or post all the proxy materials on the broker ’s ownwebsite.145.6 The Internet alternative highlights that a nominating/corporate governance committee must be aware of any technologicaland regulatory developments in the means of communicating withshareholders.

145.1. See, e.g., supra section 3:3.3[C][2][a].145.2. See Internet Availability of Proxy Materials, Exchange Act Release No.

55,146, 72 Fed. Reg. 4148 (Jan. 29, 2007) (final rule); Exchange ActRelease No. 52,926, 70 Fed. Reg. 74,598 (Dec. 15, 2005) (proposed rule).

145.3. See 72 Fed. Reg. at 4149; 70 Fed. Reg. at 74,599.145.4. See 72 Fed. Reg. at 4150; 70 Fed. Reg. at 74,601. Under the rule, the proxy

card cannot be sent with the notice, but can be sent ten calendar days afterthe notice, provided that a copy of the notice accompanies it. This is toensure that a shareholder has time to access the proxy statement beforevoting. The company must post a proxy card on its website and must thereprovide at least one method of executing a proxy vote.

145.5. See 72 Fed. Reg. at 4156; 70 Fed. Reg. at 74,605–06. Under state corporatelaw, generally only a shareholder of record, not a beneficial owner, canexecute a proxy.

145.6. See 72 Fed. Reg. at 4156; 70 Fed. Reg. at 74,606.


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It is important to note that the new Internet access model appliesto persons other than the company who are soliciting proxies, forexample, a party attempting to wrest control of the firm from currentmanagement.145.7 These persons have always been able to engage inproxy contests and, unlike the company, they can target their solicita-tion to less than all the shareholders, such as the largest shareholders.In general, a person other than the company may follow the sameInternet access procedure as does the company, with a noticeand Internet posting of proxy materials and proxy card. However,since such person is often responding to a company ’s proxy state-ment, it may send its notice on the later of forty calendar days beforethe shareholders’ meeting or ten days after the company sends outits notice or proxy statement.145.8 Moreover, under the federal proxyrules, a company has the alternative of providing a soliciting person alist of its shareholders or forwarding the person’s materials tothe company ’s shareholders. In the case of Internet access, thismeans that if it so elects and does not provide the shareholder list,then the company must send the soliciting person’s notice to theshareholders.145.9 Thus, while the new Internet access model facil-itates the company ’s access to its shareholders, it also allows out-siders more ease in mounting proxy contests against existingmanagement.

Indeed, while approving the Internet proxy access, the SEC alsoissued a proposal to require, as opposed to just allowing, companiesand soliciting persons to use the Internet for proxy materials.145.10

Under the proposal, large public companies (essentially a publiccompany with a $700 million equity float not held by affiliates) wouldhave to provide the Internet access by January 1, 2008, and all otherpublic companies and a soliciting person with respect to any companywould have to do so by January 1, 2009. The purpose of the require-ment would be “to enhance the ability of investors to make informedvoting decisions and to expand use of the Internet to ultimately lowerthe costs of proxy solicitations.”145.11 The main difference between thecurrent voluntary model of Internet availability and the proposedmandatory model is that, in the latter, a company (or soliciting person)may send a full set of the proxy materials with the notice of Internet

145.7. See 72 Fed. Reg. at 4158.145.8. See id.145.9. See id. at 4159.145.10. See Universal Internet Availability of Proxy Materials, Exchange Act

Release No. 55,147, 72 Fed. Reg. 4176 (Jan. 29, 2007).145.11. See 72 Fed. Reg. at 4177.


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availability (which is not allowed in the voluntary model). Therefore, ifInternet availability is required, but a company (or soliciting person)prefers to send hard copies of proxy materials to all its shareholders,then the company (or person) can make one mailing, that is, with boththe Internet notice and the proxy materials, rather than two separatemailings.145.12 In other words, under the proposal the company (orsoliciting person) has two options: follow the procedure set up in thevoluntary model described above (that is, where notice is given ofInternet availability of the proxy materials and a shareholder canrequest a hard copy), or send a hard copy of proxy materials to allshareholders with a notice of their Internet availability (which noticemay be incorporated into the proxy materials and proxy card). In thelatter option, a company (or soliciting person) does not have torespond to a shareholder request for a hard copy of the proxy materialsbecause it has already sent one to him or her. The SEC adopted theproposal, substantially as proposed.145.13

Initial experience with the two methods of Internet availability ofproxy materials suggested that companies preferred using a notice oftheir Internet availability (the “notice and access” method) becauseof the cost savings associated with this method. However, companieswere concerned that, as a result of investor confusion, there was lessshareholder participation when this method was used. Accordingly,the SEC revised the requirements to allow companies more flexibilityin the language used in the notice and in the ability to explain therethe purposes of this method, as well as the voting procedure.145.14

Moreover, to enhance the use of the notice and access method by third-party soliciting persons, the SEC amended the rule to allow such aperson to file its preliminary proxy statement (rather than a definitivestatement) within ten calendar days after the company files itsdefinitive proxy statement, provided that the person sends out its

145.12. See id. at 4179.145.13. See Shareholder Choice Regarding Proxy Materials, Exchange Act Release

No. 56,135, 72 Fed. Reg. 42,222 (Aug. 1, 2007). It has been reported thatthirty-nine of the largest companies still use the traditional method ofsending all their shareholders printed copies of the proxies. See SHEARMAN& STERLING, 2010 CORPORATE GOVERNANCE OF THE LARGEST U.S. PUBLICCOMPANIES: GENERAL GOVERNANCE PRACTICES 15 (2011).

145.14. See Amendments to Rules Requiring Internet Availability of Proxy Materi-als, Securities Act Release No. 9108, 75 Fed. Reg. 9074 (Feb. 26, 2010)(amending Rule 14a-16). A decline in shareholder participation in proxyvoting after the reforms remains a problem. See, e.g., Fabio Saccone,E-Proxy Reform, Activism, and the Decline in Retail Shareholder Voting,DIRECTOR NOTES (Conference Bd., New York, N.Y.), no. DN-021, Dec.2010.


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notice to shareholders no later than the filing of its own definitiveproxy statement.

Related to this development in SEC regulation that may facilitateshareholder proxy voting is a possible future transformation in one ofthe subjects on which a broker may vote on behalf of a shareholderwho holds shares through the broker. In reality, as discussed above,most shareholders (that is, 70%–80%) hold their shares through afinancial intermediary in “street name.”145.15 A public companytypically distributes its proxy materials through the intermediariesto its shareholders. The New York Stock Exchange permits itsmembers to cast shareholder votes on “routine” matters if they donot receive any voting instructions from a shareholder by ten daysbefore the date of the shareholder meeting.145.16 A main function ofthis rule is to allow companies to obtain a quorum at shareholders’meetings. An uncontested election of directors has been interpreted tobe such a routine matter.145.17 However, in light of developmentsfacilitating Internet shareholder voting, as discussed above, and the

145.15. That is to say, the company does not know the identity of its shareholders,who are not registered as such on its books. Rather, shareholders hold theirsecurities through intermediaries, which in turn hold the securities withother intermediaries or through accounts with the Depository TrustCompany (which is the record holder for many of a company ’s shares).Thus, in order to obtain the identities of shareholders a company mustconstruct a list from intermediaries, but only if the beneficiaries do notobject to their identification (in reality, brokers and banks outsource thistask to a company called Broadridge Financial Solutions Inc.). Sincemany shareholders in fact refuse to have themselves identified to thecompany, a company can communicate with them (i.e., send themmaterials) only through the intermediaries. For a complete discussionand criticism of the current structure of securities holding and its effectupon company-shareholder communications, see ALAN BELLER ET AL., THEOBO/NOBO DISTINCTION IN BENEFICIAL OWNERSHIP: IMPLICATIONS FORSHAREHOLDER COMMUNICATIONS AND VOTING (Council of InstitutionalInvestors White Paper, Feb. 2010). The basic criticism is that directcommunications with shareholders, by either the company or anothershareholder, makes more sense today, particularly given advances intechnology that would facilitate them. However, parties who profit fromthe current system (i.e., brokers and banks) resist change.

145.16. Approximately only one-fourth of shareholders who hold shares through afinancial intermediary are even aware of this rule. See OPINION RESEARCHCORP., INVESTOR ATTITUDES SURVEY 3, 18 (Apr. 7, 2006).

145.17. See New York Stock Exchange Rule 452.11, rules.nyse.com/NYSE/Rules(listing the non-routine matters on which an NYSE member may notvote). This conclusion is arrived at in a negative manner, because a brokercannot vote on any contested matter, such as a contested election (where aslate of directors is put up in opposition to the company ’s slate).


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enhanced shareholder attention even to uncontested director elec-tions (for example, when shareholders register their dissatisfactionwith a director by withholding their votes),145.18 a working group ofthe New York Stock Exchange recommended that an uncontesteddirector election be considered a non-routine matter on which abroker cannot cast a beneficial shareholder ’s votes without instruc-tions from the shareholder.145.19 The New York Stock Exchangesubsequently adopted the working group’s recommendation, propos-ing that a broker may not vote in elections, without a client’sinstructions.145.20 The SEC initially did not act on the proposal, sinceit was considering its own changes to rules relating to directorelections. It then issued the proposal, making it applicable to proxyvoting for shareholder meetings held after January 1, 2010.145.21 TheSEC then approved the proposal, essentially as proposed.145.22 More-over, Dodd-Frank included a provision requiring exchanges to prohibitany member (that is, a broker) from granting a proxy to vote on theelection of directors, executive compensation or on any other“significant matter” (as determined by the SEC) unless it has receivedan instruction from the beneficial owners.145.23 This will eliminate

145.18. See supra section 2:2.2[E].145.19. See REPORT AND RECOMMENDATIONS OF THE PROXY WORKING GROUP TO

THE NEW YORK STOCK EXCHANGE 3–4, 7–21 (June 5, 2006). For a variety ofreasons, including the desire not to alienate a public company, financialintermediaries have typically cast their votes in favor of existing directorsand have not withheld them. See id. at 14.

145.20. See NYSE News Release, NYSE, NYSE Adopts Proxy Working GroupRecommendation to Eliminate Broker Voting in 2008 (Oct. 24, 2006).

145.21. See Exchange Act Release No. 59,464, 74 Fed. Reg. 9864 (Mar. 6, 2009).For an example of opposition to this proposal, see David A. Katz & LauraA. McIntosh, Corporate Governance, N.Y.L.J., Mar. 26, 2009. The Busi-ness Roundtable, among other organizations, believes that the entiresubject of the regulation of communications between a company and itsshareholders must be revisited in light of advances in communicationtechnology. See BUS. ROUNDTABLE ET AL., COALITION VIEWS ON SHARE-HOLDER COMMUNICATIONS (Aug. 13, 2008).

145.22. See Exchange Act Release No. 60,215, 74 Fed. Reg. 33,293 (July 10, 2009).145.23. See Dodd-Frank Wall Street Reform and Consumer Protection Act of

2010, Pub. L. No. 111-203, § 957 This section amended section 6(b) of theExchange Act (dealing with regulation of stock exchanges), 15 U.S.C. § 78f(b),to provide the following regulation on broker voting on executive compensa-tion matters:

(10)(A) The rules of the exchange prohibit any member that is notthe beneficial owner of a security registered under section 12 fromgranting a proxy to vote the security in connection with a share-holder vote described in subparagraph (B), unless the beneficialowner of the security has instructed the member to vote the proxyin accordance with the voting instructions of the beneficial owner.


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broker voting on any major issue.145.24

This could be a significant change. Although it would not preventthe election of a director, unless a company had adopted a majority

(B) A shareholder vote described in this subparagraph is a share-holder vote with respect to the election of a member of the board ofdirectors of an issuer, executive compensation, or any other sig-nificant matter, as determined by the Commission, by rule, anddoes not include a vote with respect to the uncontested election of amember of the board of directors of any investment companyregistered under the Investment Company Act of 1940 (15 U.S.C.80b–1 et seq.).

(C) Nothing in this paragraph shall be construed to prohibit anational securities exchange from prohibiting a member that isnot the beneficial owner of a security registered under section 12from granting a proxy to vote the security in connection with ashareholder vote not described in subparagraph (A).

The NYSE rapidly amended its Rule 452 on broker voting to bring it in linewith the above Dodd-Frank amendment. In Rule 452.11, which lists thematters on which a broker may not vote without customer instructions, itclarified the following matter with commentary:

(21) relates to executive compensation.

Commentary to Item 21—A matter relating to executive compensa-tion would include, among other things, the items referred to inSection 14A of the Exchange Act (added by Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act), including(i) an advisory vote to approve the compensation of executives, (ii) avote on whether to hold such an advisory vote every one, two or threeyears, and (iii) an advisory vote to approve any type of compensation(whether present, deferred, or contingent) that is based on or other-wise relates to an acquisition, merger, consolidation, sale, or otherdisposition of all or substantially all of the assets of an issuer and theaggregate total of all such compensation that may (and the conditionsupon which it may) be paid or become payable to or on behalf of anexecutive officer. In addition, a member organization may not give orauthorize a proxy to vote without instructions on a matter relating toexecutive compensation, even if such matter would otherwise qualifyfor an exception from the requirements of Item 12, Item 13 [dealingwith implementation of an equity compensation plan or a profitsharing plan] or any other Item under this Rule 452. Any vote onthese or similar executive compensation-related matters is subject tothe requirements of Rule 452.

145.24. The NYSE has recently taken the position that, henceforth under Rule452, a broker-dealer may not vote uninstructed shares on corporategovernance matters, such as “proposals to de-stagger the board of directors,majority voting in the election of directors, eliminating supermajorityvoting requirements, providing for the use of consents, providing rightsto call a special meeting, and certain types of anti-takeover provisionoverrides.” See NYSE Euronext, Application of Rule 452 to Certain Typesof Corporate Governance Proxy Proposals, Information Memo No. 12-4(Jan. 25, 2012). The list of examples is not exclusive. Practitioners are


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voting rule for directors rather than the standard plurality voting, itcould increase situations where a director is elected with very littleshareholder support, which would create negative publicity for thecompany and the director. It could also increase the power of institu-tional investors and particularly their proxy advisors because they,more than retail investors, are likely to vote in director elections.

The SEC highlighted the importance of the Internet for a com-pany ’s communications with shareholders by summarizing its gui-dance to companies regarding the use of their websites.145.25 The SECemphasizes that it promoted website use by companies, given thatmost investors have access to the Internet, but that it wishes to clarifycertain legal issues regarding this use. One of these issues is the role ofdissemination on a company ’s website for purposes of Regulation FD,which, in general, prohibits selective disclosure of material nonpublicinformation. In the interpretive guidance, the SEC explains the factorsthat will make website disclosure of material information “public”disclosure for Regulation FD purposes: for example, the extent that acompany regularly uses its website for information disclosure, theaccessibility of the website to the public, and the regular use of thewebsite by investors for accessing information about the company.These purposes include preventing a violation of Regulation FD byhaving information placed on the website before disclosing it tospecific analysts or investors, or remedying an inadvertent selectivedisclosure through a subsequent website posting. In addition, the SECclarifies that website postings by a company must be materiallyaccurate for antifraud purposes at the time of their posting, but notgoing forward (that is, every time they are accessed by someonevisiting the website), provided that the postings are not reaffirmedby the company and that their historical nature is clear (for example, aposting has a date).145.26 Moreover, the SEC gives guidance on thesensitive subject of a company ’s liability because of a hyperlink on itswebsite to statements on a third-party website, where the issue iswhether by the hyperlink the company has approved of, or endorsed,

concerned that, where a company has a significant non-institutionalshareholder group, these changes could impede adoption of corporategovernance changes supported by management, because retail investors,unlike institutions, often fail to vote. See, e.g., Leigh P. Ryan et al., NYSEImplements New Restrictions on Broker Discretionary Voting, Broker/Dealer Compliance Rep. (BNA) (Apr. 4, 2012). They thus recommendthat, in this case, a company may have to enlist more help from proxyfirms to get out the retail vote.

145.25. See Commission Guidance on the Use of Company Web Sites, ExchangeAct Release No. 58,288, 73 Fed. Reg. 45,862 (Aug. 7, 2008).

145.26. See id. at 45,869–70.


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the third party ’s statements. On this point, the SEC emphasizes that acompany must make considerable effort to disassociate itself fromhyperlinked statements, and that disclaimers and a transitional screensignaling the departure from the company ’s website are not enough forthis purpose. On another legal issue, the SEC explains that, if acompany uses a summary of information on its website, the summarymust be identified as such and provide access to more completeinformation. The SEC also notes with approval the increased use ofcompany “blogs” and shareholder forums, but cautions that thecompany and its representatives have antifraud liability for participa-tion in them and that a company cannot condition blog participationon a participant’s waiver of any rights under the federal securities laws.

The SEC issued a concept release discussing the proxy system andinquiring about possible reforms to it.145.27 The concept release firstdescribes in useful detail the current proxy system, discusses currentproblems with it, such as over- and under-voting and the need for asystem for confirmation of an individual owner ’s voting (and how theproblems arise), and asks for any concerns, ideas or resolutions ofthe problems. Other issues highlighted by the SEC in the releaseinclude problems associated with voting by institutional shareholderswho lend their securities, disclosure issues relating to voting byinvestment companies that also lend their securities (that is, percen-tage of their actual voting of shares), and fees charged to issuers fordistribution by intermediaries of proxy materials (and concerns aboutthe competitive nature of the providers of proxy distribution services).The SEC also explored communications with shareholders and share-holder participation in the proxy process, focusing particularly onpotential reforms to the current system that favors shareholderanonymity (that is, beneficial owners may keep their identities hiddenfrom the issuer), a possible system of allowing retail investors to givevoting instructions to their brokers in advance of a proxy, a change toproxy rules to allow more investor-to-investor communications, moreuse of the Internet for the distribution of proxy materials, and thepossible provision of results of proxy solicitations in XML format.Finally, the SEC discussed developments with respect to the divorcebetween voting and economic interests: the use of proxy advisoryfirms by institutional investors (and the lack of regulation of suchfirms), the bifurcation of notice dates and record dates for shareholdermeetings (to increase the likelihood that those voting at the meetingwill have an economic interest) and the implications and possibleregulation of “empty voting” (that is, where those voting no longer, ornever had, an economic interest in a company ’s shares).

145.27. See Concept Release on the U.S. Proxy System, Exchange Act Release No.62,495, 75 Fed. Reg. 982 (July 22, 2010).


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§ 3:3.4 Compensation Committee

[A] Justification and BackgroundOne of the most important parts of the board’s monitoring role is to

design and implement compensation arrangements for senior execu-tives, particularly the CEO.146 If the arrangements are appropriatelyand objectively crafted and are administered by directors actingindependently from executives, the executives should receive adequateincentives, and will be rewarded, to perform well. If, on the other hand,executives overly influence the compensation process, they can receiverewards uncorrelated with their performance and seriously destroyfirm value by slacking off in performance and by taking too muchcompensation from the firm. Because a CEO in a large publiccorporation without a controlling shareholder exerts so much powerand is generally the board chair, there has been a longstandingconcern that executive compensation arrangements in these firmsfavor executives and are not determined as a result of an arm’s-lengthnegotiating process.147 The concern became particularly acute as aresult of the corporate scandals when it was revealed that executivesin scandal-plagued firms received enormous compensation and otherbenefits.147.1

As discussed in a later chapter, corporate law statutes do notdirectly address executive compensation: it is simply another decisionfor the board that is generally accorded “business judgment” defer-ence.148 The practice has developed for a public company board to

146. See generally 1 ALI, PRINCIPLES OF CORPORATE GOVERNANCE, supranote 9, § 3A.05 cmt. d, at 128.

147. For an excellent discussion of the problem, see LUCIEN BEBCHUK & JESSEFRIED, PAY WITHOUT PERFORMANCE (2004).

147.1. Even though it concerned compensation in a not-for-profit, litigation overthe enormous compensation of former NYSE president Richard Grassoinvolved alleged inappropriate action by the NYSE’s board compensationcommittee. See New York v. Richard A. Grasso, 42 A.D.3d 126 (2007)(dismissing four counts against Grasso); 816 N.Y.S.2d 863 (Sup. Ct. 2006)(discussing, among other things, report finding that Grasso had “hand-picked” members of the NYSE board compensation committee). In sub-sequent appeals, the claims against Grasso and the NYSE compensationcommittee regarding his compensation were dismissed. See People v.Grasso, 54 A.D.3d 180 (2008) (explaining that, with respect to some ofthe claims against Grasso, the N.Y. attorney general lost his capacity to sueonce the NYSE was converted into a for-profit corporation and that therewas not an adequate factual basis with respect to the other claims againsthim and members of the compensation committee); People v. Grasso, 11N.Y.3d 64 (2008) (affirming dismissal of N.Y. attorney general’s prosecu-tion of common law claims against Grasso).

148. See infra section 4:3.6.


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have a compensation committee that oversees executive compensa-tion, and executive compensation reforms have been aimed at thiscommittee. “Best practices” for this committee have developed, andsome have been codified in stock exchange rules after the passage ofSarbanes-Oxley.149

As will be discussed further below, executive compensation is a “hotbutton” issue for institutional investors and is even a general politicalissue.149.1 Accordingly, those who determine executive compensation,chiefly members of the compensation committee, increasingly facescrutiny and criticism when the compensation that they award theircompany ’s executives is deemed to be too high. Indeed, institutionalinvestors and their advisors may single out compensation committeemembers in campaigns to show their disapproval of a firm’scompensation policies (for example, by withholding votes for thereelection of directors who sit on the compensation committee).149.2

Compensation committee members should thus expect to defend theircompensation policies.149.3

[B] Composition and CharterCodifying best practice guidelines,150 the NYSE requires a listed

company to have a compensation committee composed of directors

149. On best practices, see 1 ALI, PRINCIPLES OF CORPORATE GOVERNANCE,supra note 9, § 3A.05 Comments & Reporter ’s Note, at 127–33; THE BUS.ROUNDTABLE, EXECUTIVE COMPENSATION: PRINCIPLES AND COMMENTARY(Nov. 2003); REPORT OF THE NACD BLUE RIBBON COMMISSION ONEXECUTIVE COMPENSATION AND THE ROLE OF THE COMPENSATION COM-MITTEE (2003). For comprehensive guidance on compensation committeepractices, see MICHAEL SEGAL ET AL., WACHTELL, LIPTON, ROSEN & KATZ,COMPENSATION COMMITTEE GUIDE (2014).

149.1. For a brief survey of the problems of executive compensation, see Joann S.Lublin & Scott Thurm, Behind Soaring Executive Pay, Decades of FailedRestraints, WALL ST. J., Oct. 12, 2006, at A1 (discussing history ofunsuccessful efforts to rein in executive pay).

149.2. See David A. Katz & Laura A. McIntosh, Corporate Governance Update:Institutional Investors Ready Proxy Season ‘Wish Lists’, N.Y.L.J., Nov. 30,2006, at 2; see also, ISS, 2013 U.S. PROXY VOTING SUMMARY GUIDELINES8 (Jan. 31, 2013) (recommending a vote against compensation committeemembers if management’s “say on pay” vote received less than 70% of thevotes, depending upon the company ’s reaction to the vote).

149.3. It has been reported that a compensation committee spends on averagebetween twenty-five and fifty hours on committee business. See PEARLMEYER & PARTNERS, EXECUTIVE COMPENSATION: STRONG GOVERNANCE INUNCERTAIN TIMES 6 (2009).

150. See, e.g., THE BUS. ROUNDTABLE, EXECUTIVE COMPENSATION, supra note149, at 4; REPORT OF THE NACD BLUE RIBBON COMMISSION ON EXECUTIVECOMPENSATION, supra note 149, at 15.


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independent in accordance with its guidelines.151 The NASDAQrequires that executive compensation be determined by a similarlycomposed committee, or by a majority of the independent directors.152

SEC disclosure requirements strongly reinforce the necessity of havingthis committee and its independent composition. Its existence mustbe disclosed in the annual proxy statement.153 Specific disclosure mustalso be made if any member of the compensation committee is anofficer of the company, a former officer of the company or any officer,director or controlling party (or members of their immediate families)who has engaged in a transaction with the company that requiresdisclosure.154 Even more specifically, SEC rules mandate disclosure ofany “interlocks” on the compensation committee that mightinfluence compensation indirectly: where, for example, an executiveof the company sits as a director on the compensation committee ofanother company, one of whose executives sits as a director on thecompany ’s compensation committee.155 In addition, option grants todirectors and officers are exempt from the profit recapture determined

151. See NYSE, supra note 24, § 303A.05 (a). A listed company could assign thecompensation task to another committee similarly composed (so long as ithas a committee charter).

152. See NASDAQ, supra note 24, § 5605(d)(1) (CEO compensation can be setby a majority of the independent directors on the board or a compensationcommittee of independent board members). In exceptional circumstances,moreover, the committee can include a director who is not independent solong as he or she is not a current officer of the company (or family memberof such), although this situation cannot last longer than two years. SeeNASDAQ, supra note 24, § 5605(d)(3).

153. See 17 C.F.R. § 240.14a-101 Item 7(d) (2010) (cross-referencing 17 C.F.R.§ 229.407(b)(1) and (3), (e) (2010)) (requiring disclosure of its existence, aswell as its composition and the number of its meetings).

154. This occurs through a cross-reference of proxy disclosure to Regulation S-Kcompensation disclosure. See 17 C.F.R. § 240.14a-101 Item 8 (2005); 17C.F.R. § 229.407(e) (2008) (this kind of disclosure applies even if there isno compensation committee and another board committee determinescompensation).

155. See 17 C.F.R. § 229.407(e)(4)(iii) (2008), which provides:

(iii) Describe any of the following relationships that existed duringthe last completed fiscal year:

(A) An executive officer of the registrant served as a memberof the compensation committee (or other board commit-tee performing equivalent functions or, in the absence ofany such committee, the entire board of directors) ofanother entity, one of whose executive officers served onthe compensation committee (or other board committeeperforming equivalent functions or, in the absence of anysuch committee, the entire board of directors) of theregistrant;


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by short-swing trading rules (as discussed later in the book)156 ifgranted by “non-employee directors.”157 Furthermore, federal tax lawaffects the composition of the compensation committee because, ingeneral, it prohibits companies from taking an expense deduction forperformance-based compensation in excess of $1 million for the fivemost senior executives unless it is approved by a committee of“outside directors,” as they are defined in tax regulations.158 Finally,given the sensitivity of executive compensation, best practice guide-lines recommend that there be no connection whatsoever between theCEO and a compensation committee member,159 and that compensa-tion committee members be rotated.160

The NYSE requires that the committee have a charter setting forth,among other things, its responsibilities.161 The NASDAQ has nocharter requirement for its companies. The SEC initially did notrequire disclosure of a compensation committee charter, although it

(B) An executive officer of the registrant served as a directorof another entity, one of whose executive officers servedon the compensation committee (or other board commit-tee performing equivalent functions or, in the absence ofany such committee, the entire board of directors) of theregistrant; and

(C) An executive officer of the registrant served as a memberof the compensation committee (or other board commit-tee performing equivalent functions or, in the absence ofany such committee, the entire board of directors) ofanother entity, one of whose executive officers served asa director of the registrant.

156. See infra section 6:3.2[B].157. See 17 C.F.R. § 240.16b-3(b)(3)(i), (d) (2005) (excluding any director who is

an officer of the company or one of its subsidiaries, who receives more thande minimis consulting payments from the company or a subsidiary orwhose transactions with the company would otherwise need to be dis-closed under SEC rules).

158. See I.R.C. § 162(m); 26 C.F.R. § 1.162-27(e)(3) (2005) (excluding from thedefinition of outside director a former officer, or a former employeereceiving compensation for former services).

159. See CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1025.160. See THE BUS. ROUNDTABLE, EXECUTIVE COMPENSATION, supra note 149,

at 5.161. See NYSE, supra note 24, § 303A.05(b). One of the specified responsi-

bilities is to produce an annual performance evaluation of the committee.The commentary to the rule notes that the charter should deal withmatters such as committee board structure: “committee member qualifi-cations; committee member appointment and removal; committee struc-ture and operations (including authority to delegate to subcommittees);and committee reporting to the board.” Id. § 303A.05(b) & Commentary.The NYSE requires a company to post the charter on its website and todisclose this posting in its annual proxy statement or, if it does not filesuch a statement, in its annual report.


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mandated that a company describe the duties of this committee.162

The SEC, however, centralized and expanded the requirementsfor compensation committee disclosure in Item 407 of RegulationS-K.162.1 The goal here is to make this disclosure comparable to thatdealing with board audit and nominating committees. Not only doesthe disclosure deal with matters discussed above, such as compensa-tion committee interlocks, but it also includes discussion about thecompensation committee’s authority, any delegation of its powers toothers, the existence and availability of its charter, its use of con-sultants and the independent status of its members.

In light of the financial upheaval, the Obama administrationaddressed executive compensation practices in public firms becauseof its perception that they contributed to excessive risk-taking byexecutives. One of the reforms was to enhance the independenceand authority of compensation committees.162.2 The administrationpromised to introduce legislation that would require compensationcommittee members to meet independence standards comparable tothose imposed upon audit committee members,162.3 would providecompensation committees with appropriate funding from a companyand authority to engage compensation consultants and legal counsel,and would impose standards of independence upon the compensationconsultants. These enhancements to the compensation committeewould transform what were best practices into legal obligations. Theadministration quickly followed through on its promise and intro-duced legislation with the above reforms.162.4

The legislation was enacted in Dodd-Frank.162.5 In line with theObama administration’s direction, the legislation requires the SEC todirect the stock exchanges to mandate that each compensation com-mittee member of a listed company be independent (considering

162. See 17 C.F.R. § 240.14a-101 Item 7(d)(1) (2005) (now superseded).162.1. See Executive Compensation and Related Party Disclosure, Securities Act

Release No. 8655, 71 Fed. Reg. 6542, 6624–25 (Feb. 8, 2006) (proposedrule); Securities Act Release No. 8732A, 71 Fed. Reg. 53,158 (Sept. 8,2006) (final rule).

162.2. See Fact Sheet: Providing Compensation Committees with New Indepen-dence (June 10, 2009), www.treasury.gov/press/releases/reports/fact_sheet_indepcompcmte.pdf.

162.3. See supra section 3:3.2[C][1].162.4. See Press Release, U.S. Dep’t of the Treasury, Fact Sheet: Administration’s

Regulatory Reform Agenda Moves Forward, New Independence forCompensation Committees (July 16, 2009), www.treasury.gov/press-center/press-releases/Pages/tg218.aspx; Investor Protection Act of 2009,H.R. 3817, 111th Cong. § 942 (entitled Compensation CommitteeIndependence).

162.5. See of the Dodd-Frank Wall Street Reform and Consumer Protection Actof 2010, Pub. L. No. 111-203, § 952 (adding a new section 10C to theExchange Act, 15 U.S.C. § 78j-3).


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factors enumerated in the legislation)162.6 and that the committeeselect any consultant, legal counsel and advisor after considering itsindependence (again, in light of factors enumerated in the legisla-tion).162.7 The new law also authorizes the compensation committeeto hire a compensation consultant, legal counsel and other advisors,who report only to it and who must be funded by the company.162.8

The company would also have to disclose the use of a compensationconsultant by the committee, as well as any conflicts of interest raisedby the consultant (and how they are being addressed). The lawspecifically provides that the use of any consultant or advisor doesnot mean that the committee has to follow the recommendations ofsuch consultant or advisor or that the members of the committee arenot to use their own judgment in exercising their own duties.162.9

The SEC issued a rule proposal to implement the compensationcommittee reforms of Dodd-Frank.162.10 In the release, the SEC

162.6. These factors include:

(A) the source of compensation of a member of the board ofdirectors of an issuer, including any consulting, advisory, orother compensatory fee paid by the issuer to such member ofthe board of directors; and

(B) whether a member of the board of directors of an issuer isaffiliated with the issuer, a subsidiary of the issuer, or anaffiliate of a subsidiary of the issuer.

15 U.S.C. § 78j-3(a)(3).162.7. Such factors include the following:

(A) the provision of other services to the issuer by the person thatemploys the compensation consultant, legal counsel, or otheradviser;

(B) the amount of fees received from the issuer by the person thatemploys the compensation consultant, legal counsel, or otheradviser, as a percentage of the total revenue of the person thatemploys the compensation consultant, legal counsel, or otheradviser;

(C) the policies and procedures of the person that employs thecompensation consultant, legal counsel, or other adviser thatare designed to prevent conflicts of interest;

(D) any business or personal relationship of the compensationconsultant, legal counsel, or other adviser with a member ofthe compensation committee; and

(E) any stock of the issuer owned by the compensation consul-tant, legal counsel, or other adviser.

Id. § 78j-3(b)(2).162.8. See id. § 78j-3(c)–(e).162.9. See 15 U.S.C. § 78j-3(c)(1)(C), (d)(3).162.10. See Listing Standards for Compensation Committees, Securities Act

Release No. 9199, 76 Fed. Reg. 18,966 (Apr. 6, 2011).


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proposes Exchange Act Rule 10C-1, which will apply to a compensationcommittee, or to any other board committee that overseesexecutive compensation (the rule would not apply if there is nocompensation committee and the directors themselves determine com-pensation). The proposed rule would allow the exchanges latitude toestablish their own definition of independence as it applies to compen-sation committee members, with reference to the factors set forth by thestatute. The SEC observes that, while the exchanges may use theircurrent definition of board member independence for this purpose, theremay be reasons why a different definition could be used (for example,it may not matter, for compensation independence purposes, that aboard member is affiliated with a major shareholder, who will have anincentive to scrutinize executive compensation). The proposed rule alsoimplements the statute’s mandate giving the compensation committeethe authority to hire, compensate and oversee compensation advisorsand consultants and requiring a company to fund this hiring, although,also in accordance with the statute, the rule would make the hiring ofindependent legal counsel discretionary with the committee. The rulethen implements the statutory requirement that the compensationcommittee consider factors bearing on a consultant’s or advisor ’sindependence, without mandating that a consultant be independentor without establishing any “bright-line” rules with respect to thestatutory factors (for example, stipulating the amount of fees that wouldmake a consultant not independent). After dealing with technical issuesrelating to committees curing rule problems (for example, a directorbecomes not independent) and with exemptions (the rule does not applyto exchanges listing only security futures or to FINRA), the SEC clarifiesthat the rule applies only to issuers listing equity securities anddelegates to the exchanges the power to make exemptions and accom-modations with issuers. Finally, the SEC implements the disclosurerequirements of the statute as to a committee’s use of a compensationconsultant and a company ’s identification of any conflict of interestassociated with it (and a resolution of such conflict) by proposing torevise current Item 407(e) of Regulation S-K to integrate these require-ments, such as broadening the disclosure about a consultant’s specificconflict of interest (as determined in light of the statutory factors) even ifthe consultant provides advice only on broad-based plans.

The SEC adopted the rule substantially as proposed.162.11 Underthe final rule, exchanges and securities associations must provide theSEC with their own proposed rules by September 25, 2012 (with these

162.11. See Listing Standards for Compensation Committees, Securities ActRelease No. 9330, 77 Fed. Reg. 38,422 (June 27, 2012) (promulgating anew Rule 10C-1 under the Exchange Act).


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rules to be finalized by June 27, 2013), although companies mustcomply with disclosure regarding compensation consultants in proxyor information statements for any meeting at which directors areelected occurring after January 1, 2013. The final rule clarifies that(unlike in the proposed rule) certain aspects of it apply if a company ’sboard, other than through a board committee, determines executivecompensation (that is, requirements of director independence, ofdetermining compensation advisor independence, and of appoint-ment, qualification and compensation of such advisor). The finalrule follows the proposed rule in allowing exchanges to establish theirown definition of independence for compensation committee mem-bers (although, as noted above, the definition must apply to any boardmember supervising executive compensation). In particular, while adirector affiliated with a major shareholder might still be “indepen-dent” for compensation committee purposes, the SEC invites theexchanges to consider whether there are “other ties between a listedissuer and a director, in addition to share ownership, that mightimpair the director ’s judgment as a member of the compensationcommittee.”162.12 The final rule adopts the proposed rule’s configura-tion of the compensation committee’s powers relating to consultantsand advisors and its articulation of the factors bearing on a compensa-tion consultant’s independence. It does clarify that a compensationcommittee can listen to consultants and counsel retained by manage-ment, as well as to independent consultants and counsel. In additionto the statutory factors dealing with a consultant’s independence,exchange listing standards must also direct a compensation commit-tee to consider, on this independence issue, “any business or personalrelationships between the executive officers of the issuer and thecompensation adviser or the person employing the adviser.”162.13 Onthe disclosure issues, in the final rule, the SEC decided to retain thedisclosure of Regulation S-K Item 407(e)(3)(iii) about compensationconsultants who have any role in determining or recommendingexecutive compensation. To this it added a new Item 407(e)(3)(iv),which deals with disclosure of conflicts of interest of those compensa-tion consultants subject to the (e)(3)(iii) disclosure (that is, not otheradvisors).162.14

The NYSE and NASDAQ subsequently proposed their rules govern-ing compensation committees, which were eventually approved by the

162.12. Id. at 38,428.162.13. Id. at 38,432.162.14. Id. at 38,443. The final rule does exempt conflicts disclosure with respect

to advisors who provide advice only on broad-based plans or provide onlynon-customized survey data.


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SEC.162.15 As a result, NASDAQ was requiring its listed companies forthe first time to have such a committee. Both trading venues estab-lished special rules as to a board’s determination of the specialindependence of compensation committee members,162.16 althoughNASDAQ allows the committee one non-independent board memberin certain circumstances.162.17 The rules specify the committee’spower to select advisers, to evaluate their independence and to receivetheir advice, the latter only after considering enumerated factors,which are the same for both sets of rules.162.18 The committee isrequired to have a charter setting out its new responsibilities,162.19 andthere are accommodations for smaller companies in NASDAQ.162.20

The rules are in effect as of July 2013 for NYSE and NASDAQcompanies that already had a committee, and will be in effect forother NASDAQ companies the earlier of the annual meeting occurringafter January 1, 2014, or October 31, 2014 (although the directors ofsuch companies have the right to engage advisers as of July 2013).

162.15. See NYSE, supra note 24, § 303A.05; NASDAQ, supra note 24, § 5605(d).162.16. See NYSE, supra note 24, § 303A.05(a) (referring to enhanced standards of

§ 303A.02(a)(ii)); NASDAQ, supra note 24, § 5605(d)(2)(A).162.17. See NASDAQ, supra note 24, § 5605(d)(2)(B).162.18. See NYSE, supra note 24, § 303A.05(c)(iv); NASDAQ, supra note 24,

§ 5605(d)(3)(D). These factors are (using the NYSE’s words) the following:

(A) The provision of other services to the listed company by the personthat employs the compensation consultant, legal counsel or otheradvisor;

(B) The amount of fees received from the listed company by the personthat employs the compensation consultant, legal counsel or otheradviser, as a percentage of the total revenue of the person thatemploys the compensation consultant, legal counsel or otheradviser;

(C) The policies and procedures of the person that employs the com-pensation consultant, legal counsel or other adviser that are designedto prevent conflicts of interests;

(D) Any business or personal relationship of the compensation con-sultant, legal counsel or other adviser with a member of thecompensation committee;

(E) Any stock of the listed company owned by the compensationconsultant, legal counsel or other adviser; and

(F) Any business or personal relationship of the compensation con-sultant, legal counsel, other adviser or the person employing theadviser with an executive officer of the listed company.

162.19. NYSE, supra note 24, § 303A.05(b); NASDAQ, supra note 24, § 5605(d)(1).162.20. See NASDAQ, supra note 24, § 5605(d)(5).


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[B][1] Relationship with Compensation Consultants

Historically, board compensation committees have used outsideconsultants to help them determine appropriate executive compensa-tion, particularly that of the CEO. The justification for this use is thatcompensation consulting firms, such as Pearl Meyer & Partners,Towers Perrin, and Watson Wyatt, can bring to the compensationcommittee their wealth of knowledge about compensation practices incomparable companies and can make appropriate recommendationsas to executive compensation in the company. Moreover, given theincreased burden placed upon compensation committees as a result ofthe financial crisis, which is to make compensation more risk-based, itis likely that compensation committees will need the services ofcompensation consultants all the more.162.21 These firms are notregulated by the SEC. However, under SEC disclosure rules a companymust identify them, describe their role in determining director andexecutive compensation and the instructions given to themregarding this role, and explain whether the consultant was hired bythe compensation committee itself or by someone else (such asthe CEO).162.22 A best practice would be for the compensationcommittee itself, not the CEO or another executive, to hire andinstruct the compensation consultant.162.23

However, just as occurred with respect to accountants, there havebeen concerns raised that compensation consultants have conflicts ofinterest with respect to their recommendations on executive compen-sation.162.24 The conflict does not arise because they are hired by theCEO on compensation matters, but because they provide otherservices (employee benefits administration, human resources) to apublic firm in addition to compensation consulting, which services areprofitable to them. Therefore, even if the CEO or another executivedoes not hire them directly to determine his or her compensation,he or she can exert an indirect influence upon them, that is, if theconsulting firm does not make a sufficiently high recommendation asto CEO and executive compensation, it will not be given the

162.21. See Tina Chi, Compensation Committees: As Boards Revise Exec Pay, Roleof Independent Consultants Will Change, 7 Corp. Accountability Rep.(BNA) 333 (Mar. 13, 2009).

162.22. See 17 C.F.R. § 229.407(e)(3)(iii) (2007).162.23. This practice is recommended by the NYSE. See NYSE, supra note 24,

§ 303A.05 Commentary.162.24. For a long time, it was argued that accounting firms were induced to cave

in on company financial practices in their auditing in order to maintaintheir lucrative non-auditing consulting practices with companies.Sarbanes-Oxley brought an end to some of these outside relationships.See supra section 3:3.2[D][2][a].


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non-executive compensation business. Indeed, a congressional reportfound that, in the Fortune 250 companies, compensation consultantsoften receive substantially more for their non-executive compensationservices than they do for compensation committee consulting, there isgenerally no disclosure of the compensation consultants’ conflicts ofinterest, and the amount received for these other services oftencorrelates with higher CEO pay.162.25 In light of these findings, acompensation committee may be advised, as a best practice, toapprove all the relationships that a compensation consultant haswith the company or to use a consultant that offers only executivecompensation services. Indeed, the SEC proposed, and then adopted,expanded disclosure about compensation consultants, requiring in-formation about their fees if they provide services to the companyother than executive compensation consulting and a description ofthese services.162.26

162.25. See EXECUTIVE PAY: CONFLICTS OF INTEREST AMONG COMPENSATIONCONSULTANTS, A REPORT PREPARED FOR CHAIRMAN HENRY A. WAXMAN,U.S. HOUSE OF REPRESENTATIVES COMMITTEE ON OVERSIGHT AND GOV-ERNMENT REFORM (Comm. Print Dec. 2007). But see Brian Cadman et al.,The Role and Effect of Compensation Consultants on CEO Pay (Mar.2008) (unpublished working paper) (with respect to 2006 data, authors areunable to find more lucrative CEO contracts when the firm’s compensa-tion consultant has other business relations with the firm, i.e., has aconflict of interest).

162.26. See Proxy Disclosure and Solicitation Enhancements, Securities ActRelease No. 9052, 74 Fed. Reg. 35,076, 35,086–87 (July 17, 2009)(proposed rule); Securities Act Release No. 9089, 74 Fed. Reg. 68,334,68,345–49 (Dec. 23, 2009) (final rule) (new 17 C.F.R. § 229.407(e)(3)(iii)).In general, compensation consultants must provide fee and fee-relateddisclosure (but not disclosure of the nature and extent of non-executivecompensation services) in the following circumstances: (i) the board (orboard committee) hires the compensation consultant to provide executivecompensation services and the consultant receives over $120,000 in yearlyfees for non-executive compensation related services (whether or not theboard was involved in approval of these other services); or (ii) the board’scompensation consultant is not retained by the board and it provides non-executive compensation services for yearly fees exceeding the aboveamount. No disclosure is required of compensation consultants retainedby management for executive compensation and non-executive compensa-tion services if the board has its own compensation consultant (which doesnot provide these non-executive compensation services). A consultant’sprovision of broad-based nondiscriminatory plan services (i.e., that do notfavor executives or directors) or the general provision of information nottailored to the company or not customized based on parameters estab-lished by the consultant is not considered to be executive compensationservices. Note also the Dodd-Frank reform that deals with the relationshipbetween compensation consultants and compensation committees, as wellas the SEC proposed rule, both discussed in the immediately precedingsection.


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[B][2] Risk-Based Compensation

As has been discussed above, the financial crisis, which includedthe collapse of numerous financial institutions, generated considerableattention to executive compensation and to the role of the compensa-tion committee in determining it in the troubled institutions. Oneconcern is that compensation committees established executive com-pensation without considering the ways in which particular compen-sation designs enhanced the risk of the firm. For example, acompensation scheme might reward an executive for short-termperformance by encouraging him or her to engage in transactionsthat would appear profitable in the short term, but that would imposelong-term costs upon the firm. In the worst case, as seen in thefinancial crisis with respect to many financial firms, ignoring risks inexecutive compensation might destroy a firm.

The legislation and regulations that resulted from the crisis imposevarious requirements upon compensation committees of firms receiv-ing government assistance from the Troubled Asset Relief Program(TARP) to evaluate their compensation policies from a risk perspectivein order to ensure that the policies do not enhance a firm’s risks. Theinitial Emergency Economic Stabilization Act of 2008162.27 set forththe general requirement that executive compensation standards im-posed on firms receiving government aid would exclude incentives forexecutives to take “unnecessary and excessive risks.” The AmericanRecovery and Reinvestment Act of 2009 (ARRA) significantlyamended this requirement by adding more obligations on a compen-sation committee in its evaluation of compensation in light of risks. Inparticular, it required that a compensation committee composed ofindependent directors be established, which committee would meet atleast semiannually to evaluate the risks posed to a firm by itscompensation plans.162.28 Both before and after passage of theARRA, the U.S. Treasury Department issued regulations in which itprovided details on these requirements imposed upon compensationcommittees of TARP firms. Essentially, under Treasury regulations, acompensation committee must meet every six months, with a firm’srisk managers, to conduct its risk-focused evaluation of compensationplans and arrangements, must report on its evaluations and its effortsto eliminate the risk effect of these plans, and must certify that it hasundertaken the evaluation.162.29

162.27. 12 U.S.C. § 5221 et seq.162.28. Pub. L. No. 111-5, § 111(c). It also required that compensation plans not

encourage a manipulation of earnings in order to increase compensation.See id. § 111(b)(3)(E).

162.29. For the Treasury guidelines on executive compensation in TARP firms, seeTARP Standards for Compensation and Corporate Governance, 74 Fed.Reg. 28,394, 28,398–99 (June 15, 2009).


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The purpose of this discussion is not to examine the requirements.Rather, it is to emphasize that the focus on risks in the executive andother employee compensation determinations is likely to become amandate of the compensation committee in all public firms, whetherthrough law or best practices. As noted in an earlier section, thefinancial crisis reaffirmed the board’s obligation, often through anaudit or other special committee, to supervise a firm’s risk manage-ment.162.30 Moreover, former U.S. Treasury Secretary Timothy Geith-ner, in conjunction with other financial and market regulators andwith the advice of compensation experts and specialists, promulgatedlong-term principles of executive compensation, including the follow-ing that specifically focus on making compensation more risksensitive:

First, compensation plans should properly measure and rewardperformance.

Compensation should be tied to performance in order to link theincentives of executives and other employees with long-term valuecreation. Incentive-based pay can be undermined by compensationpractices that set the performance bar too low, or that rely onbenchmarks that trigger bonuses even when a firm’s performanceis subpar relative to its peers.

To align with long-term value creation, performance-based payshould be conditioned on a wide range of internal and externalmetrics, not just stock price. Various measurements can be used todistinguish a firm’s results relative to its peers, while taking intoaccount the performance of an individual, a particular businessunit and the firm at large.

Second, compensation should be structured to account for thetime horizon of risks.

Some of the decisions that contributed to this crisis occurred whenpeople were able to earn immediate gains without their compen-sation reflecting the long-term risks they were taking for theircompanies and their shareholders. Financial firms, in particular,developed and sold complex financial instruments that yieldedlarge gains in the short-term, but still presented the risk of majorlosses.

Companies should seek to pay top executives in ways that aretightly aligned with the long-term value and soundness of thefirm. Asking executives to hold stock for a longer period of timemay be the most effective means of doing this, but directors andexperts should have the flexibility to determine how best to align

162.30. See supra section 3:3.2[D][4].


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incentives in different settings and industries. Compensationconditioned on longer-term performance will automatically losevalue if positive results one year are followed by poor performancein another, obviating the need for explicit clawbacks. In addition,firms should carefully consider how incentives that match thetime horizon of risks can extend beyond top executives to thoseinvolved at different levels in designing, selling and packaging bothsimple and complex financial instruments.

Third, compensation practices should be aligned with soundrisk management.

At many firms, compensation design unintentionally encouragedexcessive risk-taking, providing incentives that ultimately put thehealth of the company in danger. Meanwhile, risk managers toooften lacked the stature or the authority necessary to impose acheck on these activities.

Compensation committees should conduct and publish riskassessments of pay packages to ensure that they do not encourageimprudent risk-taking. At the same time, firms should explorehow they can provide risk managers with the appropriatetools and authority to improve their effectiveness at manag-ing the complex relationship between incentives and risk-taking.162.31

In sum, a board compensation committee should now begin toevaluate executive and other compensation arrangements from theperspective of its effects on a firm’s risks and, in this connection, toconsult with a firm’s risk managers and outside risk consultants. Fornow (with the exception of TARP firms), this evaluation will consti-tute a best practice, although in time it may have the force of law.

Indeed, the SEC released a proposal to reform compensation dis-closure, which includes a requirement that a company discuss the riskconsequences of its compensation policies and practices and itsmanagement of these risks.162.32 The proposed disclosure required acompany to discuss, at a minimum, the following issues:

• The general design philosophy of the company ’s compensationpolicies for employees whose behavior would be most affectedby the incentives established by the policies, as such policiesrelate to or affect risk-taking by those employees on behalf of thecompany, and the manner of its implementation;

162.31. See Press Release, Dep’t of Tresury, Statement by Treasury SecretaryTimothy Geithner on Compensation (June 10, 2009).

162.32. See Proxy Disclosure and Solicitation Enhancements, Securities ActRelease No. 9052, 74 Fed. Reg. 35,076, 35,077–79 (July 17, 2009).


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• The company ’s risk assessment or incentive considerations, ifany, in structuring its compensation policies or in awarding andpaying compensation;

• How the company ’s compensation policies relate to the realiza-tion of risks resulting from the actions of employees in both theshort term and the long term, such as through policies requiringclawbacks or imposing holding periods;

• The company ’s policies regarding adjustments to its compensa-tion policies to address changes in its risk profile;

• Material adjustments the company has made to its compensa-tion policies or practices as a result of changes in its risk profile;and

• The extent to which the company monitors its compensationpolicies to determine whether its risk management objectivesare being met with respect to incentivizing its employees.

• The level of detail required will necessarily depend on theparticular facts at a company and within various business unitsof a company.162.33

In its final rule release, the SEC clarified that the compensationdisclosures are required if they are “reasonably likely to have a materialadverse effect” on a company.162.34 Moreover, it explained that, con-trary to the proposal, this disclosure would not be part of theCompensation Discussion and Analysis (which focuses on executivecompensation), but just part of a company ’s risk disclosure. It alsoincluded a non-exclusive list of compensation situations that mightpose particular risks to companies:

• At a business unit of the company that carries a significantportion of the company ’s risk profile;

• At a business unit with compensation structured significantlydifferently than other units within the company;

• At a business unit that is significantly more profitable thanothers within the company;

• At a business unit where the compensation expense is asignificant percentage of the unit’s revenues; and

• That vary significantly from the overall risk and reward struc-ture of the company, such as when bonuses are awarded upon

162.33. Id. at 35,078.162.34. See Proxy Disclosure Enhancements, Securities Act Release No. 9089, 74

Fed. Reg. 68,334, 68,336 (Dec. 23, 2009).


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accomplishment of a task, while the income and risk to thecompany from the task extend over a significantly longer periodof time.162.35

The final rule (codified at 17 C.F.R. § 229.402(s)) also essentiallymaintained the non-exclusive list of issues cited in the rule proposal toguide this disclosure.

On this issue of regulating compensation in relationship to risk, itshould be noted that section 956 of Dodd-Frank required federalfinancial regulators to promulgate regulations or guidelines that,among other things, would require a financial institution (with assetsgreater than $1 billion) to disclose information about the structure ofincentive-based compensation sufficient to determine if it could im-pose a “material loss” on a financial institution. In addition, theregulations would prohibit any incentive-based payment arrangement,or any feature of such, that financial regulators determine encouragesinappropriate risks in the financial institution either:

(1) by providing an executive officer, employee, director, or prin-cipal shareholder of the covered financial institution withexcessive compensation, fees, or benefits; or

(2) that could lead to material financial loss to the coveredfinancial institution.

Financial regulators are to model their standards on those used by theFederal Deposit Insurance Corporation to regulate compensation ininsured banks. The regulators release their proposed rules on thissubject.162.36 The proposed rules, which are modeled upon existingbanking regulations and guidance, are designed to involve the boardmore in oversight and approval of compensation arrangements ofpersons, such as senior executives, who have the ability to exposetheir institution to material losses. Although these regulations wouldbe relevant for a public company that is a financial institution coveredby them, it is likely that board practices developed in this context mayinfluence compensation committee oversight of compensation andrisk in the non–financial company context.

162.35. See id. at 68,337.162.36. See Incentive-Based Compensation Arrangements, Exchange Act Release

No. 64,140, 76 Fed. Reg. 21,170 (Apr. 14, 2011). These rules have not yetbeen finalized.


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[C] Duties

[C][1] Determining CEO Compensation

The main task of the compensation committee is to determineCEO compensation.163 This is a complex responsibility since itinvolves establishing the goals of the compensation arrangement,evaluating the CEO’s performance relative to these goals and thenmaking a recommendation to the board as to the specific compensa-tion to be awarded to the CEO. Further complexity is added by the factthat the determination occurs in different circumstances: the initialhiring of a CEO, regular performance evaluations, and the departure ofa CEO. Even more complexities are added by the bewildering forms ofdirect and indirect compensation that a CEO may receive during orafter his or her tenure with the firm.

This is not the place to engage in a detailed description of the kinds ofCEO compensation, a complex area that underscores how difficult canbe the job for a member of a company ’s compensation committee.Generally, it consists of an annual salary, a bonus, long-term compensa-tion tied to a company ’s stock, retirement benefits and special perqui-sites (for example, security services, cars, use of company apartmentsand airplanes).164 There has been much discussion of a CEO’s stock-based compensation, whether in the form of stock options or shares ofstock, because it can be made sensitive to increases (or decreases) inshareholder value and because it has been the one component that haspropelled CEO compensation into the stratosphere.165 It is widelyacknowledged that stock-based compensation for CEOs has not beenperformance sensitive and can easily be manipulated by boards andCEOs: that is, it rewards them no matter how badly they perform.166

163. See NYSE, supra note 24, § 303A.05(b)(i)(A).164. See, e.g., REPORT OF THE NACD BLUE RIBBON COMMISSION ON EXECU-

TIVE COMPENSATION, supra note 149, at 23 (chart presenting “elements ofexecutive pay”). The SEC disclosure rules on executive compensation alsopoint to the kinds of compensation executives receive. See generally 17C.F.R. § 229.402 (2005).

165. See, e.g., REPORT OF THE NACD BLUE RIBBON COMMISSION ON EXECUTIVECOMPENSATION, supra note 149, at 7–8 (citing report suggesting that stockoption value makes up over half the compensation of CEO pay in thelargest 200 firms; also noting widespread concern about size of CEO pay).On this component of the CEO’s compensation, see NYSE, supra note 24,§ 303A.05 Commentary (“In determining the long-term incentive compo-nent of CEO compensation, the committee should consider the listedcompany ’s performance and relative shareholder return, the value ofsimilar incentive awards to CEOs at comparable companies, and theawards given to the listed company ’s CEO in past years.”).

166. See generally CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at1027–29.


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The specialization of executive compensation again underscores theheightened professionalism of a director ’s role. Here, as with othercommittees, the compensation committee must rely on advisors andconsultants, both external and internal. The main external consultantis the compensation expert, and it is appropriate to make the hiring ofthis expert a committee responsibility so as to prevent the CEO fromoverly influencing the process.167 Internal support would come fromthe human resources and legal department, but a committee should befree to obtain outside legal, accounting and tax support, as needed.168

The professionalism of the compensation committee appears in itsarriving at its own assessment of executive compensation, as opposedto accepting the views of outside experts,169 and in its understandingthe totality of compensation of the CEO.

The decision of the Delaware Supreme Court in In re Walt DisneyCo. Derivative Litigation169.1 presents a cautionary tale about aless-than-ideal functioning of a compensation committee. That caseconcerned a shareholder challenge to, among other things, an extra-ordinarily lucrative compensation arrangement awarded to MichaelOvitz, who was named President and a director of Disney. Thisarrangement led to an extremely high severance if Ovitz were termi-nated without cause (which is what occurred). The court found firstthat, under Disney ’s chartering documents, the compensation commit-tee, rather than the full board, had the power to determine an executive’scompensation.169.2 In an interesting commentary, the court thenexplained how a duly empowered compensation committee should actwhen deciding upon an executive’s compensation contract:

In our view, a helpful approach is to compare what actuallyhappened here to what would have occurred had the committeefollowed a “best practices” (or “best case”) scenario, from a process

167. See NYSE, supra note 24, § 303A.05 Commentary (“Additionally, if acompensation consultant is to assist in the evaluation of director, CEO orexecutive officer compensation, the compensation committee chartershould give that committee sole authority to retain and terminate theconsulting firm, including sole authority to approve the firm’s fees andother retention terms.”); THE BUS. ROUNDTABLE, EXECUTIVE COMPENSA-TION, supra note 149, at 9. Given the power of the CEO in the firm, he orshe may influence the opinion of the outside consultant, even if he or shedoes not appoint it.

168. See, e.g., REPORT OF THE NACD BLUE RIBBON COMMISSION ON EXECUTIVECOMPENSATION, supra note 149, at 18–20.

169. This independence would counter the tendency of compensation commit-tees to accept outside consultants’ benchmarks and to peg the compensa-tion of their CEOs to the top portion of the scale, which produces anescalating rise in executive pay.

169.1. In re Walt Disney Co. Derivative Litig., 906 A.2d 27 (Del. 2006).169.2. See id. at 53.


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standpoint. In a “best case” scenario, all committee memberswould have received, before or at the committee’s first meeting onSeptember 26, 1995, a spreadsheet or similar document preparedby (or with the assistance of) a compensation expert (in this case,Graef Crystal). Making different, alternative assumptions, thespreadsheet would disclose the amounts that Ovitz could receiveunder the [agreement] in each circumstance that might foreseeablyarise. One variable in that matrix of possibilities would be the costto Disney of a non-fault termination for each of the five years ofthe initial term of the [agreement]. The contents of the spread-sheet would be explained to the committee members, either by theexpert who prepared it or by a fellow committee member similarlyknowledgeable about the subject. That spreadsheet, which ulti-mately would become an exhibit to the minutes of the compensa-tion committee meeting, would form the basis of the committee’sdeliberations and decision.169.3

On the basis of the lower court’s factual findings after a full trial,the court observed that, while the Disney compensation committeedid not act in this way, because its deliberations were disparate, notwell-documented (for example, the committee’s minutes were sparse),and not led by an expert, it nevertheless met the standards of due carein agreeing upon Ovitz’s contract. This result was hardly an unqua-lified success for Disney: because of its sloppy decision-makingprocedures, which had much to do with the passivity of the Disneyboard and compensation committee in the face of Disney ’s imperialCEO, Michael Eisner, Disney ’s compensation committee, amongothers, endured years of distracting litigation. As the court observed,if Disney ’s compensation committee had followed best practicesas outlined above), there would have been no litigation on its deci-sion-making, or it would have been summarily dismissed.169.4

[C][1][a] Option Backdating and Other Manipulation

Indeed, in a well-publicized scandal involving executive stockoptions, directors and officers were found to have “backdated”or otherwise inappropriately timed the dates for the granting ofstock options. Executive stock options are a form of compensationthat is supposed to align the interests of executives and shareholders.If the stock price rises as a result of executive effort, the executives will berichly compensated, and shareholders will also find their wealthenhanced. Typically, when an executive is granted stock options, theydo not “vest” to him or her immediately; rather, as an incentive device,

169.3. See id. at 56.169.4. See id.


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they vest only at the end of a specified period and can also be forfeited ifcertain events (for example, early termination) occur prior to vesting.The options are generally not transferable. Historically, executive stockoptions are granted “at the money” (that is, the option price is theprice of the underlying stock on the grant date), in contrast to typicalmarket options that are “out of the money” (the option price is greaterthan the current market price). This feature gives the executives anincentive to increase the value of the stock above the grant price andallows the options to be characterized by the company as performance-based compensation for federal tax purposes.169.5

Option backdating means that the reported grant date for anexecutive stock option is not the date of the actual grant, but is usuallysome earlier date when the stock was trading at a price lower than theprice on the actual grant date. As a result of this kind of backdating, onthe actual grant date executives receive a guaranteed return consistingof the difference between the stock price on the earlier fictional grantdate and the higher stock price at the actual grant date (this return isnot realizable until the options vest). In certain cases, directors andofficers also disguised that they were engaging in this backdating (forexample, by falsifying records pertaining to the grant date). A relatedpractice (known as “spring loading”) is to grant options prior to therelease of favorable news about the company, which also ensures that,at the time of the option grant, executives receive a certain return.169.6

These practices make a mockery of executive stock options, which, asnoted above, are designed to expose executives to the same risks asshareholders.169.7

169.5. See SUNIL PANIKKATH, NERA, OPTIONS BACKDATING: A PRIMER, PART I 8(Oct. 5, 2006) [hereinafter PANIKKATH], www.nera.com.

169.6. See id. at 9. Despite all the controversy surrounding option grant practices,abuses continue to surface. See, e.g., Mark Maremont, Option GrantsDraw Scrutiny, WALL ST. J. (Oct. 12, 2009) (companies grant options toexecutives while in negotiations to be acquired).

169.7. Yet another option backdating abuse has been reported and is beinginvestigated. In this case, an executive backdates not the grant date, butthe exercise date. The purpose of this backdating is tax-related. Anexecutive is taxed at ordinary income rates on the difference between theoption price and the fair value on the date that it is exercised. If theexecutive then continues to hold the stock for an additional year, he orshe is taxed on any gain at the lower capital gains rate. By backdating theexercise date, the executive reduces the amount taxed at ordinary incomerates and increases the amount taxed at the capital gain rate, thus loweringhis or her taxes on the shares. See Mark Maremont & Charles Forelle,How Backdating Helped Executives Cut Their Taxes, WALL ST. J., Dec. 12,2006, at A1. In yet another abuse, executives have been found to havetimed or backdated their donations of stock to charities (often family


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It is particularly disturbing to observe that option backdatingand related executive stock option manipulation were revealed to bewidespread in public companies.169.8 Backdating resulted in enormousshareholder losses.169.9 The SEC and the DOJ launched investigationsinto this practice, and numerous companies restated their financialstatements for years in which the backdating occurred.169.10 Tohead off, or at least to show their cooperation with SEC and DOJ

foundations controlled by them) in order to select donation dates when thestock is at a monthly or yearly high so as to maximize their charitablededuction. See generally James Bandler & Mark Maremont, Stock GiftsThat Give Back, WALL ST. J., Mar. 5, 2008, at C1.

169.8. See PANIKKATH, supra note 169.5, at 10–11 (listing over 100 publiccompanies being investigated for these practices); see also Lucien Bebchuk,Lucky CEOs (Harvard Law, Econ. & Bus., Discussion Paper No. 566, 2006)(presenting data showing that option backdating occurred in firms withouta majority of independent directors and with CEOs with longer tenure,took place not exclusively in new economy firms, and was not a substitutefor other forms of executive compensation, but was substantially inaddition to existing compensation); Lucien Bebchuk, Lucky Directors(Harvard Law, Econ. & Bus. Discussion Paper No. 573, 2007) (presentingempirical work concerning option backdating that favored directors, thatinvolved 460 firms and 1,400 outside directors, and that was often linkedto executive option backdating); JAMES M. BICKLEY & GARY SHORTER,STOCK OPTIONS: THE BACKDATING ISSUE (CRS Report for Congress,updated Jan. 2, 2008) (surveying issue and research). But see RENZOCOMOLLI, NERA, OPTIONS BACKDATING: THE STATISTICS OF LUCK, PARTIII (Mar. 8, 2007), www.nera.com (pointing out misunderstandings con-cerning the statistical probability of options backdating in individualcompanies).

169.9. See Gennaro Bernile, The Effect of the Options Backdating Scandal on theStock Price Performance of 110 Accused Companies 5 (Simon Sch.,Working Paper No. FR 06-10, 2006) (finding shareholder losses of $100billion, on the basis of a conservative estimate with respect to 110companies identified in September 2006 as having backdated executiveoptions, during the period from the revelation of the backdating (May2006) until November 2006; these losses are found to be permanent, nottemporary).

169.10. See Stephen J. Crimmins, Stock Options: Sorting Out the Option Back-dating Cases, 38 Sec. Reg. & L. Rep. (BNA) 1955 (Nov. 20, 2006) (dis-cussing what factors in backdating will likely bring on a DOJ or SECinvestigation, given the huge number of companies involved in backdatingand emphasizing the factor of participants intentionally backdating whileaware of accounting rules prohibiting the practice); SEC Div. of Corp. Fin.:Sample Letter Sent in Response to Inquiries Related to Filing RestatedFinancial Statements for Errors in Accounting for Stock Option Grants(Jan. 2007), www.sec.gov (providing guidance to companies on how tocorrect financial statements). Moreover, option backdating can lead toaction against a company by a state attorney general. See UnitedHealthGrp. Inc. v. Minnesota ex. rel. Swanson, No. A06-2013, 2007 WL4234545 (Minn. Ct. App. Dec. 4, 2007) (allowing investigation to proceed


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investigations, companies launched their own internal investiga-tions of these practices, with the help of outside legal counsel.169.11

Numerous directors (particularly members of compensation commit-tees) and officers (including general counsel) resigned as a result ofbackdating scandals in their companies.169.12 Moreover, option back-dating exposed certain officers, directors, and companies involved tocriminal and civil charges of securities fraud (that is, issuing mislead-ing financial statements that understate compensation expenses and,thus, overstate income) brought by the DOJ and/or the SEC and taxfraud.169.13 A notorious example of potential liability for officers

by Minnesota Attorney General against UnitedHealth on the basis of theMinnesota False Statements in Advertising Act, which allows AttorneyGeneral to prosecute any false statements made to Minnesota residentsrelating to securities).

169.11. See, e.g., REPORT OF WILMER CUTLER PICKERING HALE AND DORR LLP TOTHE SPECIAL COMMITTEE OF THE BOARD OF DIRECTORS OF UNITEDHEALTHGROUP INC. (Oct. 15, 2006) [hereinafter WILMERHALE REPORT] (describ-ing extensive backdating practices within UnitedHealth with respect toexecutive stock options and highlighting governance failings within thecompany). As a result of its extraordinary cooperation in the investigationof its option backdating, the SEC declined to charge UnitedHealth withfraud or to seek a monetary penalty against it. See SEC v. UnitedHealthGrp. Inc., Litigation Release No. 20,836 (Dec. 22, 2008), www.sec.gov/litigation/litreleases/2008/lr20836.htm. The SEC will proceed againstcompanies that conduct an inadequate internal investigation. See SEC v.H&W Celestial Grp., Inc., Litigation Release No. 21,195 (Sept. 3, 2009),www.sec.gov/litigation/litreleases/2009/lr21195.htm.

169.12. See James Bandler & Charles Forelle, In Internal Probes of Stock Options,Conflicts Abound, WALL ST. J., Aug. 11, 2006, at A1 (discussing fact thatboard members investigating option backdating often themselves benefitedfrom the practice, directly or indirectly); Angelo G. Savino & Russell A.Witten, Timing of Option Grants and Directors’ and Officers’ Liability,N.Y.L.J., July 28, 2006 (listing, as of that date, companies involved in thepractice and potential legal issues).

169.13. See, e.g., SEC v. Shanahan, No. 4:07CV270 JCH, 2010 WL 148440 (E.D.Mo. Jan. 12, 2010) (allowing certain fraud counts to proceed againstdirector who allegedly aided and abetted backdating); SEC v. Ryan AshleyBrant, No. 1:07-CV-1075 (DLC) (S.D.N.Y. Feb. 14, 2007) (SEC ’s com-plaint against former CEO/Chair of Take-Two Interactive Software Inc.detailing securities law claims against him for backdating options forhimself and others, including violations of antifraud, proxy, books andrecords, and internal controls laws and rules); SEC v. Kent H. Roberts, No.1:07-CV-0407 (D.D.C. Feb. 28, 2007) (SEC’s complaint against formergeneral counsel of McAfee, Inc. laying out similar securities law claimsagainst him for his backdating of options for himself and others); SEC v.Maxim Integrated Prods., Inc., No. CV 07-6121 (N.D. Cal. Dec. 4, 2007)(SEC’s complaint against Maxim and former CEO for option backdating;CEO was allowed to grant options to employees, new employees, andoutside directors); SEC v. Carl W. Jaspar, No. CV 07-6121 (N.D. Cal.


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Dec. 4, 2007) (complaint against former CFO of Maxim relating to back-dating); SEC v. Robert J. Therrien, No. 07-CA-11364 (D. Mass. July 25,2007) (complaint against former Chairman/CEO of Brooks Automation,Inc. for his involvement in backdating at the company, which scheme ranfrom 1999 to 2005); SEC v. Brooks Automation, Inc., Litigation ReleaseNo. 20,584 (May 19, 2008), www.sec.gov (settlement with company overits responsibilities for Therrien’s backdating); SEC v. Nancy M. Tullos,Litigation Release No. 20,476 (Mar. 4, 2008), www.sec.gov (settlementwith former vice president for human resources of Broadcom Corporationfor her participation in option backdating involving $1.3 million disgorge-ment and prejudgment interest and $100,000 civil penalty); Press ReleaseNo. 2008-63, SEC, SEC Charges Broadcom with Fraudulent Stock OptionBackdating (Apr. 22, 2008), www.sec.gov (discussing charges and settle-ment with Broadcom pursuant to which firm agreed to pay a $12 millionpenalty); SEC v. Marvell Tech. Grp., Litigation Release No. 20,559 (May 8,2008), www.sec.gov (settlement with company and former Chief OperatingOfficer over backdating); SEC v. Bruce E. Karatz, Litigation Release No.20,717 (Sept. 15, 2008), www.sec.gov (settlement with former Chair/CEOof KB Homes over multi-year options backdating) (Karatz was lateracquitted of securities fraud charges related to the backdating, but con-victed of lying to accountants and others during the investigation intobackdating at KB Homes); SEC v. Blue Coat Sys., Inc. & Robert P. Verheeke,Litigation Release No. 20,801 (Nov. 12, 2008), www.sec.gov (settlementwith company and former CFO over $50 million in options backdating);SEC v. Monster Worldwide Inc., Litigation Release No. 21,042 (May 18,2009), www.sec.gov ($2.5 million settlement with company over optionbackdating); SEC v. Nancy R. Heinen, Litigation Release No. 20,683(Aug. 14, 2008), www.sec.gov ($2.2 million settlement with former generalcounsel of Apple Inc. over her involvement in the company ’s optionsbackdating); SEC v. Kenneth Selterman & Patti Tay, Litigation Release No.21,163 (Aug. 3 2009), www.sec.gov (settlement with former GeneralCounsel and Controller of Take-Two Interactive Software, Inc. for theirparticipation in options backdating); SEC v. Pattison, No. C-08-4238EMC, 2011 WL 723600 (N.D. Cal. Feb. 23, 2011) (imposing penaltiesfollowing judgment in jury trial); SEC v. Schroeder, No. C-07-03798 JW,2010 WL 4789441 (N.D. Cal. Nov. 17, 2010) (declining to agree with theSEC’s motion to impose a five-year officer-and-director bar on defendantwho had settled with the SEC over option backdating charges). Forexample, under “intrinsic value” accounting rules, a company mustrecognize as compensation expenses, over the vesting period of the option,the difference between the option exercise price and the fair value of thestock on the option date. When options are backdated, there is anunrecognized compensation expense, which means that a company ’sincome is overstated and its financial statements are misleading. More-over, it is possible that, in certain circumstances with respect to executivecompensation, a company would not be able to deduct this expense for taxpurposes, since it is compensation that is not performance based. See PaulH. Dawes & Kory Sorrell, Stock Options: The Specter Haunting OptionGrants, 39 Sec. Reg. & L. Rep. (BNA) 18 (Jan. 8, 2007). The tax issuesarising from backdating are complex: it does not appear that there was anytax benefit to companies (as opposed to executives) from the optionbackdating. See PAUL HINTON, NERA, OPTIONS BACKDATING: ACCOUNT-ING, TAX, AND ECONOMICS, PART II 4–9 (Nov. 30, 2006), www.nera.com.


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and directors is Comverse Technology Inc. (“Comverse”), an S&P 500company. David Kreinberg, the former CFO of Comverse, was indictedon, among other things, a conspiracy to commit securities fraud byengaging in schemes to effect the backdating of options for Comverseemployees (which benefited him personally).169.14 The former Com-verse CEO, Jacob Alexander, was also indicted, but he is currently afugitive in Namibia.169.15

In many cases, a company could incur penalties from failing to withholdtaxes on the ordinary income attributable to a backdated option.

169.14. See SEC v. David Kreinberg, Litigation Release No. 19,878 (Oct. 24, 2006)(Kreinberg pled guilty to the charges and cooperated with the government),www.sec.gov/litigation/litreleases/2006/lr19878.htm. The former CEO/Chair and Vice-President of Human Resources of Brocade Communica-tions Systems, Inc. were each convicted of criminal charges based onbackdating. See Steve Stecklow & Peter Waldman, Former Brocade CEO IsFound Guilty on All Counts in Backdating Case, WALL ST. J., Aug. 7, 2007(Gregory Reyes is convicted of ten felony counts); Brocade CEO Reyes Gets21 Months Following Verdict on Option Backdating, 40 Sec. Reg. & L. Rep.(BNA) 100 (Jan. 21, 2008) (Reyes received a twenty-one-month prisonsentence with a $1 million fine although Reyes’s original conviction wasreversed on the basis of prosecutorial misconduct, at a new trial he wasconvicted again); United States v. Reyes, 660 F.3d 454 (9th Cir. 2011)(affirming new conviction); Former Brocade CEO Agrees to Settle SECOptions Backdating Case for $850,000, 43 Sec. Reg. & L. Rep. (BNA) 1766(Aug. 22, 2011); Brocade Ex-Official Convicted, WALL ST. J., Dec. 6, 2007,at C7 (former Vice President of Human Resources Stephanie Jensen isconvicted of conspiracy and falsifying corporate records); United States v.Jensen, 537 F. Supp. 2d 1069 (N.D. Cal. 2008) (recounting the facts andimposing sentence). Jensen was sentenced to four months in prison andordered to pay a $1.25 million fine. See 6 Corp. Accountability Rep. (BNA)291 (Mar. 21, 2008). Brocade itself settled with the SEC by paying a $7million fine. See SEC v. Brocade Commc’ns Sys., Inc., Litigation ReleaseNo. 20,137 (May 31, 2007), www.sec.gov; see also SEC v. MercuryInteractive, LLC, Litigation Release No. 20,136 (May 31, 2007), www.sec.gov (Mercury agrees to a $28 million fine and injunction in connectionwith backdating practices).

169.15. See Affidavit in Support of Arrest Warrants, United States v. JacobAlexander (E.D.N.Y. Sept. 8, 2006). Alexander has, however, settled withthe SEC and with the DOJ (in a civil forfeiture action) for, among otherthings, an officer-and-director ban and a disgorgement of $53 million. SeeIn re Jacob (“Kobi”) Alexander, Litigation Release No. 21,753 (Nov. 23,2010), www.sec.gov/litigation/litreleases/2010/lr21753.htm. State crim-inal law may also be violated by option backdating. Ryan Brant, thefounder and former Chairman/CEO of Take-Two Interactive SoftwareInc. pled guilty to charges of falsifying business records, in violation ofNew York criminal law, in connection with option backdating thatbenefited him, among others. See Matt Richtel, Founder of U.S. VideoGame Company Pleads Guilty, N.Y. TIMES (Feb. 15, 2007), http://www.nytimes.com/2007/02/15/technology/15iht-options.4605975.html?_r=0;see also CFO Gets Six Months, $1 Million Fine After Pleading Guilty inBackdating Ploy, 6 Corp. Accountability Rep. (BNA) 115 (Feb. 1, 2008)


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Shareholders have filed lawsuits over option backdating and relatedissues in both federal and state courts.169.16 The Delaware and other

(describing sentence of former CFO of SafeNet Inc.); SEC Settles ChargesAgainst Former CEO of Monster Worldwide, Inc. for Stock Options Back-dating, Press Release 2008-7 (Jan. 23, 2008), www.sec.gov (disgorgement ofapproximately $276,000 and lifetime bar from serving as director or officerof public company, but not penalty because of personal circumstances ofindividual who is terminally ill); United States v. James J. Treacy, Indict-ment (S.D.N.Y. Apr. 30, 2008) (on, among other things, securities fraud forhis involvement in backdating of Monster Worldwide, Inc.) (Treacy wasconvicted of securities fraud and sentenced to two years in federal prison,see 41 Sec. Reg. & L. Rep. (BNA) 1672 (Sept. 14, 2009), a convictionaffirmed on appeal, 639 F.3d 32 (2d Cir. 2011) (remanding for recalculationof forfeiture amount)). At times, the federal courts will insist uponsignificant sentences for executives involved in the backdating who havebeen convicted or who have pled guilty. See, e.g., United States v. Samueli,575 F. Supp. 2d 1154 (C.D. Cal. 2008) (court rejects plea agreement ofco-founder of Broadcom who was actively involved in a $2.2 billionbackdating scheme, where agreement called for no prison time nor forcooperation from defendant); 582 F.3d 988 (9th Cir. 2009) (dismissingappeal of this rejection).

169.16. For a review of the problems with and success of private federal and statelawsuits dealing with backdating, see Lee G. Dunst, Private Civil Litiga-tion: The Other Side of Stock Option Backdating, 39 Sec. Reg. & L. Rep.(BNA) 1344 (Sept. 3, 2007) (discussing, among other problems, problemsin the lawsuits arising from statutes of limitations and pleading scienter infederal securities lawsuits). A typical basis for a shareholder lawsuit infederal court is the same as that used by the SEC, fraud under section 10(b)on various grounds (e.g., misrepresentation of option grant dates, under-statement of compensation expenses, overstatement of income). In thesecases, as in all private federal securities litigation based upon this section,plaintiff shareholders must meet exacting pleading standards: it is notenough to allege, without more, that options were granted at the loweststock price for the year or the month. See Britton v. Parker, 2007 WL2871003 (D. Colo. Sept. 26, 2007) (dismissing shareholders’ securities lawclaims for pleading failures, although granting them leave to amend thecomplaint); see also In re Openwave Sys. Sec. Litig., 528 F. Supp. 2d 236(S.D.N.Y. 2007) (dismissing Securities Act claims on account of statute oflimitations, dismissing Exchange Act antifraud claims against certaindefendants for failure adequately to plead scienter, but allowing ExchangeAct antifraud and controlling person claims, as well as insider tradingclaims under Section 20A of the Exchange Act, to proceed against certaindefendants); Edward J. Goodman Life Income Tr. v. Jabil, 560 F. Supp. 2d1221 (M.D. Fla. 2008) (dismissing complaint for various pleading failures,although allowing leave to amend complaint); Rosenberg v. Gould, 554F.3d 962 (11th Cir. 2009) (dismissing securities law claims against officersthat were based on backdating because of pleading problems regardingscienter, particularly given the de minimis effect of the backdating on thecompany ’s financial statements); City of Westland Police & Fire Ret.Sys. v. Sonic Sols., No. C 07-05111 CW, 2009 WL 942182 (N.D. Cal.


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courts addressed these matters. In Ryan v. Gifford,169.17 ChancellorChandler considered a shareholder lawsuit over backdating at MaximIntegrated Products, Inc. (“Maxim”), which had a stock option planproviding that no option would be granted at a value less than the fairmarket value on the grant date. Nevertheless, the Maxim compensa-tion committee, with the approval of other board members, engaged inoptions backdating. Finding that the case presented novel issues oflaw, the court declined to dismiss the action in favor of earlier-filed,related lawsuits in California.169.18 The chancellor then found that theshareholder had satisfied one of the tests for a “demand excused”

Apr. 6, 2009) (finding securities fraud claims based upon section 10(b)insufficient on scienter grounds). But see Take-Two Interactive Software,Inc. v. Ryan Brant, 2010 WL 1257351 (S.D.N.Y. Mar. 31, 2010) (dismiss-ing several claims against backdating defendants as time-barred, butallowing others to proceed); Wilamowsky v. Take-Two Interactive Software,Inc., 818 F. Supp. 2d 744 (S.D.N.Y. 2011) (dismissing claims of short-sellerof corporation’s stock who had opted out of class action settlementinvolving backdating, because, in his securities law claims, seller failedadequately to plead loss causation); Rudolph v. UTStarcom, No. C 07-04578 SI, 2008 WL 4002855 (N.D. Cal. Aug. 21, 2008) (finding allega-tions in complaint regarding scienter sufficient in backdating case). For asignificant settlement of securities law claims relating to backdating atMercury Interactive Corp., see Class Suit Against Mercury Interactive IsResolved For Record $117.5 Million, 39 Sec. Reg. & L. Rep. (BNA) 1631(Oct. 22, 2007). See also Broadcom to Pay $160.5 Million to Settle ClassAction on Stock Option Backdating, 42 Sec. Reg. & L. Rep. (BNA) 69(Jan. 11, 2010); Plaintiff Law Firms Announce $62M Settlements inComverse Case, 42 Sec. Reg. & L. Rep. (BNA) 37 (Jan. 4, 2010); In reBrocade Sec. Litig., 2008 WL 2050847 (N.D. Cal. May 13, 2008) (deter-mining on summary judgment, in a lawsuit where Brocade was one of thedefendants, that Brocade’s CEO was acting within the scope of Brocade’semployment when he signed a Form 10-K that was misleading because ofhis backdating activity); Maverick Fund, L.O.C. v. Comverse Tech., Inc.,801 F. Supp. 2d 41 (E.D.N.Y. 2011) (allowing certain federal securities lawclaims by hedge funds, who had opted out of class settlement, to proceedagainst Comverse and various Comverse parties).

169.17. Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007).169.18. See id. at 350. The court also declined to dismiss the case on forum non

conveniens grounds. Vice Chancellor Lamb followed similar reasoning,and relied upon Ryan, when he refused to dismiss a derivative lawsuitchallenging option backdating in Affiliated Computer Services, Inc., thathad been filed before related Texas lawsuits (which were in federal court).Not only did he conclude that the Delaware lawsuit raised unresolvedissues of Delaware law, but that it was inappropriate for a Delaware courtalways to defer to a related federal lawsuit simply because of the existenceof federal securities law claims that could be decided only in federal court.See Brandin v. Deason, 941 A.2d 1020, 1027 (Del. Ch. 2007) (“Nor doesthe court believe that it is necessarily sound practice for the Court ofChancery to stay a prior-filed derivative action in blind deference to a later-filed derivative action in a federal court in which the federal securities laws


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derivative lawsuit when he had raised a reasonable doubt that theboard, in granting backdated options, had validly exercised its businessjudgment.169.19 The reasonable doubt arose from the facts presentedabout the suspicious timing of the grant dates (that is, at the loweststock price for a given quarter) and about the absence of the board’sauthority to alter the grant dates.169.20 On the substance of thecomplaint, the court denied the defendants’ motion to dismiss onthe grounds of business judgment, since it found that the complainthad sufficiently alleged a violation of the duty of good faith:

Based on the allegations of the complaint, and all reasonableinferences drawn therefrom, I am convinced that the intentionalviolation of a shareholder approved stock option plan, coupledwith fraudulent disclosures regarding the directors’ purportedcompliance with that plan, constitute conduct that is disloyal tothe corporation and is therefore an act in bad faith. Plaintiffs allegethe following conduct: Maxim’s directors affirmatively representedto Maxim’s shareholders that the exercise price of any option grantwould be no less than 100% of the fair value of the shares,measured by the market price of the shares on the date the optionis granted. Maxim shareholders, possessing an absolute right torely on those assurances when determining whether to approvethe plans, in fact relied upon those representations and approvedthe plans. Thereafter, Maxim’s directors are alleged to havedeliberately attempted to circumvent their duty to price the sharesat no less than market value on the option grant dates bysurreptitiously changing the dates on which the options weregranted. To make matters worse, the directors allegedly failed todisclose this conduct to their shareholders, instead making falserepresentations regarding the option dates in many of their publicdisclosures.

claims (over which the federal court has exclusive jurisdiction) are pre-dicated on the same fiduciary misconduct that animates the state lawclaims. Although federal courts are quite capable of deciding cases involv-ing Delaware corporate law, the stockholders of companies incorporated inthis state would suffer a disservice if Delaware courts suddenly became aforum of last resort, available for only that small percentage of representa-tive suits which do not, at least in theory, overlap with issues of the federalsecurities laws.”); see also Ekas v. Burris, Nos. 07-61156-CIV, 07-61157-CIV, 2007 WL 4055630 (S.D. Fla. Nov. 14, 2007) (refusing to allowremoval of a state court lawsuit dealing with option backdating becauseit found no basis in the claims for federal court jurisdiction).

169.19. See 918 A.2d at 354.169.20. In addition, the chancellor concluded that demand was excused because

the board had a disabling conflict of interest to pursue the lawsuit on itsown, since their actions in either awarding or approving backdated optionsin violation of the plan and with deception of shareholders were likelyviolations of their duty of loyalty, which would be the basis of the lawsuit,as well as potentially criminal violations. See id. at 355–56.


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I am unable to fathom a situation where the deliberate violation ofa shareholder approved stock option plan and false disclosures,obviously intended to mislead shareholders into thinking that thedirectors complied honestly with the shareholder-approved optionplan, is anything but an act of bad faith. It certainly cannot be saidto amount to faithful and devoted conduct of a loyal fiduciary.Well-pleaded allegations of such conduct are sufficient, in myopinion, to rebut the business judgment rule and to survive amotion to dismiss.169.21

The chancellor did dismiss some of the shareholder ’s claims becausethe shareholder did not own Maxim stock at the time of certain of thebackdating, declined to dismiss the remaining claims on statute-of-limitations grounds, and allowed a claim of unjust enrichment of theCEO (as a result of receiving the backdated options) to proceed.169.22

In a companion case released the same day as Ryan,169.23 Chancel-lor Chandler considered a motion to dismiss with respect to complexshareholder claims addressing, among other things, the self-interestedbehavior of board members of Tyson Foods, Inc. (“Tyson”), a publiccorporation controlled by Don Tyson. One claim dealt with thecompensation committee’s granting of “spring-loaded” options,which, as described earlier, are options awarded shortly before thecompany ’s release of favorable news.169.24 The chancellor denieddefendants’ effort to dismiss this claim on statute-of-limitationsgrounds because, although the granting of the options had beendisclosed, information about the grants was incomplete and selective(that is, their timing before favorable news).169.25 On the substantivepoint as to whether the shareholders had made out a sufficient claimthat Tyson’s compensation committee had violated its fiduciary dutyin granting spring-loaded options, the court stated:

Granting spring-loaded options, without explicit authorizationfrom shareholders, clearly involves an indirect deception. A direc-tor ’s duty of loyalty includes the duty to deal fairly and honestlywith the shareholders for whom he is a fiduciary. It is inconsistentwith such a duty for a board of directors to ask for shareholderapproval of an incentive stock option plan and then later todistribute shares to managers in such a way as to undermine the

169.21. Id. at 357–58 (footnote omitted).169.22. See id. at 358–61; see also Ryan v. Gifford, C.A. No. 2213-CC, 2009 WL

18143 (Del. Ch. Jan. 2, 2009) (approving settlement of litigation andawarding of plaintiffs’ attorney ’s fees in this case).

169.23. See In re Tyson Foods, Inc. Consol. S’holder Litig., 919 A.2d 563 (Del.Ch. 2007).

169.24. See id. at 576.169.25. See id. at 590–91.


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very objectives approved by shareholders. This remains true evenif the board complies with the strict letter of a shareholder-approved plan as it relates to strike prices or issue dates.

The question before the Court is not, as plaintiffs suggest, whetherspring-loading constitutes a form of insider trading as it would beunderstood under federal securities law. The relevant issue iswhether a director acts in bad faith by authorizing options witha market-value strike price, as he is required to do by a share-holder-approved incentive option plan, at a time when he knowsthose shares are actually worth more than the exercise price.A director who intentionally uses inside knowledge not availableto shareholders in order to enrich employees while avoidingshareholder-imposed requirements cannot, in my opinion, besaid to be acting loyally and in good faith as a fiduciary.169.26

Chancellor Chandler declined to dismiss the options claims because theshareholders had made an adequate presentation that the stock optionplan required a fair value option grant and, knowing favorable insideinformation, the compensation committee had circumvented the pur-pose of the plan.169.27

The Delaware Court of Chancery is not receptive to every casedealing with option backdating. In Desimone v. Barrows,169.28 Desi-mone, a shareholder of Sycamore Networks, Inc. (“Sycamore”),brought multiple claims as a derivative action against the Sycamoreboard for allowing this improper practice to occur in the company.After first dismissing a large part of Desimone’s claims becausehe was not a shareholder at the time of the alleged problematicpractices, Vice Chancellor Strine evaluated the remaining claimsupon the defendants’ motion to dismiss. Before doing so, he cau-tioned that not every claim of violation of fiduciary duties againstdirectors with respect to backdating stock options was alike, and hepointed out that the preferred approach of the Delaware courts wasto look at the alleged violation from an equitable standpoint.169.29

From this perspective, the vice chancellor dismissed claims involving

169.26. Id. at 592–93.169.27. See id. at 593; see also In re Tyson Foods, Inc. Consol. S’holder Litig., No.

Civ. A. 1106-CC, 2007 WL 2351071 (Aug. 15, 2007) (court again refusesto dismiss certain spring-loading claims). Vice Chancellor Lamb reliedupon the reasoning of Tyson in Weiss v. Swanson, 948 A.2d 433 (Del.Ch. 2008), which dealt with allegations of spring-loading and bullet-dodging options (in the latter, issuing options right after the release ofnegative information about the company). He determined that, as inTyson, the complaint was sufficient by alleging failure by the board tomake complete disclosure of these kinds of option-granting practices.

169.28. Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007).169.29. See id. at 932–36.


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backdating of employee (non-executive) stock options because Desi-mone had failed to plead adequate grounds for demand futility in thiscase, where Sycamore directors were empowered to delegate to theCFO responsibility for these option grants and where no factssuggested that the board had failed in its oversight role. Vice Chan-cellor Strine similarly dismissed Desimone’s claims with respect toexecutive stock options because he had failed to plead director knowl-edge of and participation in backdating with respect to theseoptions.169.30

Vice Chancellor Strine also evaluated Desimone’s allegations that thedirectors had approved “spring loading” of certain executive optionsfollowing “bullet dodging” (issuing options after the release of negativenews but before the release of positive news). The vice chancellorquestioned whether the granting of executive stock options after therelease of negative news could ever amount to a breach of fiduciaryduties, provided that directors did not know of impending good news orother circumstances did not suggest their bad faith. With respect to the“spring loading” aspect of the complaint, he observed that there was noparticularized allegation that the directors knew of the soon-to-be-released good news when they awarded the options in question andthat the news was in fact materially positive.169.31 He contrasted thesituation here with that in Tyson, which involved a multi-year pattern ofmaking option grants before favorable news. Finally, the vice chancellorhad to consider claims with respect to options granted to Sycamore’sdirectors themselves. Here he excused demand because the majority ofthe directors were interested, insofar as they were grant recipients. Yet hefound the claims inadequate and dismissed them because the directoroption grants occurred annually at a set time, which was always after therelease of quarterly earnings. That is, there was no allegation that thedirectors manipulated the timing of the grant or of the release, as well asno allegation of backdating (it involved, rather, an inadequate allegationof “bullet dodging”).169.32

The Court of Chancery is likely to look with disfavor upon a com-pany that sweeps any past backdating under the rug. In Conrad v.Blank,169.33 a shareholder brought a derivative lawsuit against theboard of Staples, Inc. (“Staples”), Staples executives, and others foralleged backdating that had taken place at Staples from 1997 to 2006.Staples’ audit committee had investigated the backdating and in one ofthe company ’s SEC filings appeared to have admitted that the practice

169.30. See id. at 941–42.169.31. See id. at 945–46.169.32. See id. at 946–50.169.33. Conrad v. Blank, 940 A.2d 28 (Del. Ch. 2007).


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had taken place. However, the disclosure was terse and cryptic, statingthat there had been an unintentional wrongdoing without explaininghow the backdating had occurred. When the defendants moved todismiss the complaint on the ground that the shareholder ’s demandwas not properly excused, Vice Chancellor Lamb disagreed. He firstobserved that, given the cryptic disclosure of Staples about its back-dating, he was not particularly inclined to defer to the recommenda-tions of Staples’s board about the derivative lawsuit. As he acerbicallyobserved:

Coming as this complaint does in the middle of a national scandalinvolving backdated options, there never was any doubt thatvarious theories exist on which to recover from the corporation’sofficers and directors where evidence of improperly dated optionsexists. Nonetheless, after finding substantial evidence thatoptions were, in fact, mispriced, the company and the auditcommittee ended their “review” without explanation and appar-ently without seeking redress of any kind. In these circumstances,it would be odd if Delaware law required a stockholder to makedemand on the board of directors before suing on those very sametheories of recovery.169.34

Moreover, he found that, because five directors of the current ten-person board were implicated in the wrongdoing (two had receivedbackdated options and three were members of the compensationcommittee that had awarded the options), the shareholder ’s demandwas properly excused.169.35 He did agree with the defendants that theplaintiff could not challenge instances of backdating that had occurredbefore she became a shareholder. However, disturbed by Staples’ lack of

169.34. Id. at 37–38.169.35. For similar reasoning in a lawsuit in federal court over option backdating

in a Delaware corporation, see Edmonds v. Getty, 524 F. Supp. 2d 1267(W.D. Wash. 2007) (excusing presuit demand because the plaintiff hassufficiently alleged that a majority of the existing board was interestedeither because of their receipt of backdated options or because of theirmembership on the compensation committee granting those options). Seealso London v. Tyrrell, C.A. No. 3321-CC, 2008 WL 2505435 (Del. Ch.June 24, 2008) (allowing complaint alleging, among other things, that thedirector intentionally granted stock options in contravention of the fairmarket value requirement to proceed because of demand futility); Lynch v.Rawls, 429 F. App’x 641 (9th Cir. 2011) (reversing district court andholding that shareholders had adequately pled demand futility underDelaware law where majority of board were alleged to have approvedoption backdating). But see Nach v. Baldwin, No. C 07-0740 SI, 2008WL 410261 (N.D. Cal. Feb. 12, 2008) (applying Delaware law to situationof a Washington corporation and dismissing backdating claim for, amongother things, failure to make demand where plaintiff had not adequatelypled that a majority of the board had received backdated options and in fact


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disclosure about its backdating and failure to discipline any director orofficer in the matter, he conditioned dismissal of her ineligible claimson the possibility of another Staples shareholder intervening in thelawsuit who might have standing to pursue them.169.36

The New York State Supreme Court Appellate Division took asimilar approach in In re Comverse Technology, Inc.169.37 That caseinvolved a shareholder derivative action under New York law againstComverse on account of the widespread backdating that had occurredin the company. Comverse attempted to have the lawsuit dismissed,partly on the basis that the lawsuit was unnecessary because thecompany had appointed a special committee to look into the matter.Reversing the lower court that had dismissed the lawsuit, the Appel-late Division concluded that the lawsuit should be allowed to proceed.Among other reasons, it concluded that the appointment of a specialcommittee did not justify dismissal. On this point, it noted that one ofthe members of this two-person committee was a director who hadbeen on the company ’s compensation committee when some of thebackdating had occurred. Moreover, it also found that the specialcommittee took action against the executives who were behind thebackdating only when they became targets of criminal and SECactions. As the court observed,

In conclusion, the picture presented in the complaint is that of aspecial committee taking a tepid rather than a vigorous approach tothe misconduct and the resultant harm. Under such circumstances,the board should not be provided with any special protection. There-fore, because we cannot conclude that the appointment of the specialcommittee, and the steps it has so far undertaken, establish as amatter of law the board’s willingness to take appropriate action toprotect the interests of the corporation, we hold that the grant ofComverse’s motion to dismiss this shareholder derivative actionpursuant to CPLR 3211 was erroneous.169.38

that there was any pattern of backdating, where the harm to the corpora-tion (i.e., from restating financials) was de minimis, and where thecorporation had conducted an independent investigation of thebackdating).

169.36. In In re Zoran Corp. Derivative Litig., No. C. 06-05503 WHA, 2008 WL941897 (N.D. Cal. Apr. 7, 2008), the district court refused to approve asettlement involving derivative claims over option backdating. The courtfound that the corporation received no funds in the settlement, but only arepricing of previously granted options that were in any event considerablyunderwater. It also discovered that this repricing had in fact occurred a fewyears before the settlement and that, similarly, corporate governancereforms promised in the settlement had already taken place.

169.37. 56 A.D.3d 49, 866 N.Y.S.2d 10 (2008).169.38. 866 N.Y.S.2d at 18–19 (underlining in original); see also In re Maxim

Integrated Prods., Inc. Derivative Litig., 574 F. Supp. 2d 1046 (N.D. Cal.


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It may well be that the backdating practices brought to light in thescandals are unlikely to recur. Part of what made them possible was thefact that former SEC rules allowed a considerable period of time topass (even as much as a year) before disclosure of option grants. Undercurrent SEC rules, by contrast, disclosure must be made by the secondbusiness day following the grant.169.39 This real-time disclosure maymake it more difficult to backdate options.169.40

However, the backdating scandal also suggests that the practices andthe operation of compensation committees in awarding executive stockoption compensation were often too informal and thus subject tomanipulation by top executives. Frequently, this manipulation waspossible because a compensation committee (often without meeting)rubber-stamped a CEO’s decisions pertaining to the awarding of stockoptions, or delegated to the CEO or another executive considerablepower with respect to the awarding of stock options to other executives.Practitioners have thus recommended that compensation committeeseliminate the opportunities for stock option manipulation by adoptingcertain best practices: setting prospectively regular dates for optiongrants; conducting a meeting whenever a committee must approve thegrant of options (as opposed to doing this by written consent) and

2008) (allowing derivative complaint based on option backdating toproceed because of, among other things, interestedness of the majority ofthe board at the time of the filing of the complaint).

169.39. See infra section 6:3.2[A] (discussing insider reporting requirements).169.40. For example, once the new disclosure regime came into effect, option

backdating at UnitedHealth effectively ceased. See WILMERHALE REPORT,supra note 169.11, at 7. However, backdating may continue despite thenew SEC disclosure rule if companies simply do not comply with it. SeeSOX Rules Not Eliminating Backdating of Stock Options, Glass LewisReport Says, 38 Sec. Reg. & L. Rep. (BNA) 1879 (Nov. 6, 2006) (discussingreport showing that backdating has continued because many companies donot comply with the SEC two-day disclosure rule and that the SEC doesnot enforce it). See generally Lewis D. Lowenfels & Alan R. Bromberg, TheEnd of Backdating Stock Options: The Crescendo Has Passed!, 39 Sec. Reg.& L. Rep. (BNA) 1511 (Oct. 1, 2007) (discussing reasons why practicessuch as stock option backdating will not recur: in addition to thosediscussed in the text concerning real-time reporting, changed accountingdisclosure regarding options (i.e., fair value accounting on grant date),more detailed executive compensation disclosure, shareholder approval ofequity awards and changes thereto, the elimination of stock option awardsby many companies). For an example of fair value accounting of grantedemployee stock options that is based on a market approach to valuation ofthe options, see Zions Bancorp., SEC No-Action Letter, 2007 WL 3317996(Oct. 17, 2007) (the fair value of employee stock option grant is allowed tobe determined from an auction of Employee Stock Option AppreciationRights Securities conducted by the company).


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documenting immediately the minutes of the meeting; eliminating orrestricting delegation to executives of the power to grant options(or, if delegation is necessary, circumscribing the officer ’s authorityand reviewing any grants made under it); and granting only “at themoney” options with the grant date being the authorization date.169.41

[C][2] Other Compensation Policies

The compensation committee also makes recommendations oncompensation policies and arrangements for other senior executives,as well as on incentive or equity-based compensation plans morebroadly applicable in the company that require board approval.170

These duties would include a regular review of executive compensa-tion policies, programs and their administration and a modification ofthem, where necessary. Other best practice recommendations oncompensation committee duties include:

• Review of employment and consulting agreements with officersand directors;

• Setting of policies regarding, and reviewing, management per-quisites; and

• Determine director compensation (if not done by anothercommittee).171

169.41. See Joshua R. Cammaker et al., How to Grant Equity CompensationAwards: A Roadmap of Best Practices (Oct. 19, 2006); see also Dawes &Sorrell, supra note 169.13. Both federal securities law and federal tax lawconsiderations essentially require that stock option grants to the topexecutives be approved by a compensation committee composed of non-executive directors. Delegation is thus used for lower-ranking executivesand other employees.

170. See NYSE, supra note 24, § 303A.05(b)(i)(B). The equity-based plans arethose requiring a shareholder vote for approval under stock exchange rules.See NYSE § 303A.08; NASDAQ, supra note 24, § 5635(c). Corporate lawmay also require board involvement (i.e., recommendations to share-holders) if the plans necessitate amendment to the charter to authorizemore company shares. The legal effect of shareholder involvement inexecutive compensation will be discussed in a later chapter. See infrasection 4:3.6[A].

171. See CORPORATE DIRECTOR’S GUIDEBOOK, supra note 5, at 1026–27.Director compensation has been rising, perhaps reflecting director ’s en-hanced responsibilities after Sarbanes-Oxley. See SPENCER STUART, supranote 18, at 33. This trend in the rise of director compensation hascontinued. See Equilar, Inc., 2006 Fortune 500 Director Pay Trends,Executive Compensation Trends (May 2007), www.equilar.com (reportingthat median director pay for non-employee directors increased by 10% in2006 to $165,000). See supra section 3:3.3[C][2][c] (on directorcompensation).


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[C][3] Shareholder Disclosure

In a reform to the disclosure of executive compensation, the SECchanged the requirement that the annual proxy statement include acompensation committee report.172 The SEC explains that thesereports have become little better than boilerplate, as opposed toreflecting a committee’s thoughtful determination of executive com-pensation policies. The SEC replaces the substance of the compensa-tion report with a “Compensation Discussion and Analysis” section inits annual proxy statement and annual report that explains a firm’scompensation policies and that would introduce executive compensa-tion disclosure.173 However, the compensation committee now has toprepare a report that it reviewed this disclosure and recommended thatit be placed in the proxy statement and annual report.174

[C][4] Special Compensation Arrangements

The compensation committee may be asked to design or to approvespecial compensation arrangements in extraordinary transactions,such as mergers or acquisitions. These arrangements could concernexecutives of a target firm (who are being enticed to remain or aregiven severance) or those of the acquiring firm itself (if its executivesare affected by the transaction). Approval of the arrangements by thecompensation committee may well indicate that the transaction hasitself been designed for the primary benefit of the shareholders of thefirm, not to enrich the executives. Indeed, the SEC adopted amend-ments to the “best price” rule, Rule 14d-10, governing tender offers, toclarify that the rule applies only to consideration paid for shares thatare the subject of the tender offer, not to compensation arrangementswith executives or directors of the target.175 Among other things, theamendments create a safe harbor for payments pursuant to employee

172. See Executive Compensation and Related Party Disclosure, Securities ActRelease No. 8655, 71 Fed. Reg. 6542, 6546–47 (Feb. 8, 2006) (proposed rule);Securities Act Release No. 8732A, 71 Fed. Reg. 53,158 (Sept. 8, 2006) (finalrule).

173. For a discussion of this section, see infra section 4:3.6.174. See Securities Act Release No. 8732A, 71 Fed. Reg. 53,158 (codified

at 17 C.F.R. § 229.407(e)(5) (2009)); see also NYSE, supra note 24,§ 303A.05(b)(i)(C).

175. See Amendments to the Tender Offer Best-Price Rule, Exchange Act ReleaseNo. 54,684, 71 Fed. Reg. 65,393 (Nov. 8, 2006) (final rule); Exchange ActRelease No. 52,968, 70 Fed. Reg. 76,116 (Dec. 22, 2005) (proposed rule).There has been considerable litigation on the Rule’s application to executivecompensation arrangements established during or around a tender offer,because shareholders have argued that the arrangements were an indirectway of paying executives a higher price for their shares. See 70 Fed. Reg. at76,117–18.


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compensation, benefits and severance arrangements if they are ap-proved by a compensation committee (or other equivalent boardcommittee) of the target or bidder (depending upon which is a partyto the arrangements), composed only of independent directors.175.1

[D] Related Executive Compensation Issues

[D][1] Clawbacks

There will be more discussion of executive compensation-relatedissues in a later chapter on a director or officer ’s conflicts of interestwith the corporation.176 It is appropriate to mention here severalrestrictions on executive compensation added by Sarbanes-Oxleythat a compensation committee should be aware of.177 As a measureto address the situation where senior executives are unaffected by theaccounting restatements that their behavior resulted in, Sarbanes-Oxley requires the CEO and the CFO to return to the company anybonuses, incentive- or equity-based compensation or profits from thesale of company securities received during the twelve months follow-ing the first public issuance or SEC filing of a financial report that thecompany must subsequently restate as a result of material noncom-pliance with financial reporting requirements, where the noncompli-ance arises from misconduct.178 The kind of restatement that wouldtrigger the penalty is not entirely clear. If the provision is interpretedbroadly, it could reach any restatement by a company of any releasedaccounting numbers even on account of negligence. If the term is givena restrictive interpretation, it would reach material errors under GAAP

175.1. See id. at 76,121 (citing and describing new Rule 14d-10(c)(3)). See infrasection 5:4.5.

176. See infra section 4:3.6.177. Others include restrictions on executive loans. See infra section 4:3.3.178. See Forfeiture of Certain Bonuses and Profits, Sarbanes-Oxley § 304

(codified at 15 U.S.C. § 7243):

(a) ADDITIONAL COMPENSATION PRIOR TO NONCOMPLIANCEWITH COMMISSION FINANCIAL REPORTING REQUIREMENTS—If an issuer is required to prepare an accounting restatementdue to the material noncompliance of the issuer, as a result ofmisconduct, with any financial reporting requirement underthe securities laws, the chief executive officer and chief finan-cial officer of the issuer shall reimburse the issuer for—

(1) any bonus or other incentive-based or equity-based com-pensation received by that person from the issuer duringthe 12-month period following the first public issuance orfiling with the Commission (whichever first occurs) of thefinancial document embodying such financial reportingrequirement; and

(2) any profits realized from the sale of securities of the issuerduring that 12-month period.


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affecting financial statements only in SEC filed reports, such as a Form10-K, that are caused by intentional misconduct. The SEC ’s firstnotable use of this provision involved a $448 million reimbursementto UnitedHealth Group, Inc. by its former chairman and CEO WilliamW. McGuire, M.D. through a settlement with the SEC.178.1 The SECalleged that McGuire had caused the company to backdate stockoptions over a twelve-year period, and, among other things,he agreed to return his incentive- and equity-based compensationreceived from 2003 through 2006.178.2 However, the SEC sought abonus recovery under section 304 from a former CEO who was notinvolved in a financial fraud that caused his company ’s financialstatements to be misleading.178.3 The question is whether the SEC ’snovel approach will prevail in the litigation.

Subsection (b) of this provision gives the SEC exemptive authority regard-ing this requirement. See Neer v. Pelino, 389 F. Supp. 2d 648 (E.D. Pa.2005) (holding that section 304 does not create a private right of action forshareholders); accord In re Bisys Grp. Inc. Derivative Action, 396F. Supp. 2d 463 (S.D.N.Y.); In re Whitehall Jewelers, Inc. S’holder Deriva-tive Litig. No. 05 C 1050, 2006 WL 468012 (N.D. Ill. Feb. 27, 2006); seealso In re iBasis, Inc. Derivative Litig., 532 F. Supp. 2d 214, 224 (D. Mass.2007) (also finding no private right of action under section 304 in lawsuitinvolving option backdating).

178.1. See Litigation Release No. 20,387 (Dec. 6, 2007), www.sec.gov; see alsoVanessa Fuhrmans & James Bandler, Ex-CEO Agrees to Give Back $620Million, WALL ST. J., Dec. 7, 2007, at A1. For a discussion of uncertaintiesin section 304 and of its likely use by the SEC in the future, see Nader H.Salehi & Elizabeth A. Marino, § 304 of Sarbanes-Oxley Act: New Tool forDisgorgement?, N.Y.L.J., May 21, 2008.

178.2. However, for section 304 to be applicable the company must have actuallybeen compelled to prepare, and to have filed, an accounting restatement.See SEC v. Shanahan, 624 F. Supp. 2d 1072, 1077–78 (E.D. Mo. 2008)(rejecting SEC argument that section 304 is applicable if a company shouldhave filed, but did not file, restated financial statements).

178.3. See SEC v. Jenkins, Litigation Release No. 21,149A (July 23, 2009), www.sec.gov/litigation/litreleases/2009/lr21149a.htm. In an initial decision onthis case, SEC v. Jenkins, 718 F. Supp. 2d 1070 (D. Ariz. 2010), the districtcourt, declining to dismiss the lawsuit, ruled that the language of section304 required the misconduct of only the issuer, not the CEO or CFO, fortriggering the reimbursement obligation. It also declined to resolve, at thisstage of the proceedings, the issue of whether the SEC had to state exactlythe amounts that were received by the defendant and that were attributableto the issuer ’s misstated financial statements (the contention being thatamounts recovered, but not related to misstatements, would be “punitive”against a CEO or CFO who did not participate in the fraud). The courtnoted in passing that there might be a remedial purpose to imposing therecovery on an “innocent” CEO or CFO, since both such officers hadobligations to ensure that financial statements were materially accurate. Inaddition, the court refused to dismiss the case on the grounds that thecorporation in question had subsequently merged into another, sincesection 304 established liability as of a certain time from a CEO or CFO


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Under the influence of Sarbanes-Oxley, “clawbacks” or forcedreturns of executive compensation in certain circumstances, generallyinvolving financial misstatements, have become more prevalent inpublic companies. It has been reported that, in 2013, eighty-seven ofthe top 100 companies have instituted a clawback policy regarding areturn of all, or a portion of, a performance-related bonus.178.4 Moreover,

to the company when it had in fact been in existence. Jenkins (the CEO)eventually agreed to return $2.8 million in bonus compensation and stockprofits to the company. See SEC Press Release No. 2011-243 (Nov. 15,2011). The SEC is reported to be taking a similar approach as Jenkins inother enforcement actions. See Yin Wilczek, Wells Notice to Beazer HomesCEO Shows SEC Commitment to Controversial Clawback Tool, 41 Sec.Reg. & L. Rep. (BNA) 2158 (Nov. 23, 2009); SEC Charges Diebold andFormer Financial Executives with Accounting Fraud, Litigation ReleaseNo. 21,543 (June 2, 2010), www.sec.gov/litigation/litreleases/2010/lr21543.htm (stating that the SEC also brought a section 304 actionagainst former Diebold CEO, who was not accused of fraud, and that hesettled with the SEC). The SEC reached a settlement with Ian McCarthy,the President and CEO of Beazer Homes, to recover McCarthy ’s entirebonus for 2006, a year for which Beazer had to restate its financial resultsdue to fraud in the company, which was not attributable to McCarthy. SeeLitigation Release No. 21,873 (Mar. 4, 2011), www.sec.gov/litigation/litreleases/2011/lr21873.htm; see also In re James O’Leary, LitigationRelease No. 22,074 (Aug. 30, 2011) (settlement involving clawback ofcompensation from Beazer CFO). Similarly, the SEC settled with DanielUstian and Robert Lannert, respectively the Chairman/CEO and ViceChairman/CFO of Navistar, for, among other things, recovery of theirbonuses for 2004, as a result of restatements of Navistar ’s financialstatements due to widespread fraud in the company, again not alleged tohave been committed by either Ustian or Lannert (although they wereaccused of not having dedicated sufficient resources in internal controls toprevent the fraud). See In re Navistar Int’l Corp., Securities Act Rel. No.9132 (Aug. 5, 2010). For an extensive discussion of the Jenkins litigationand its implications, see Quinton F. Seamons, Reimbursement ‘Clawback’Under Section 304 Without Requiring Any Personal Misconduct, 42 Sec.Reg. & L. Rep. (BNA) 2289 (Dec. 6, 2010). There is currently litigationover the correct interpretation of section 304(a)(1)’s language, “first publicissuance or filing,” which starts the running of twelve-month period forbonus recapture. See SEC v. Mercury Interactive, LLC, No. 5:07-cv-02822-JF/PVT, 2010 WL 3790811, at *5 (N.D. Ca. Sept. 27, 2010) (holding that itcan be triggered by both a quarterly report and annual report filing); No.5:07-cv-02822-JF/PVT, 2011 WL 1335733 (N.D. Ca. Apr. 7, 2011) (certi-fying issue for appeal). For a decision following Jenkins and upholding theconstitutionality of the provision applied in a case where the executiveofficers were not alleged to have committed any violation, see SEC v. Baker,No. A-12-CA-285-55, 2012 WL 5499497 (W.D. Tex. Nov. 13, 2012).

178.4. See SHEARMAN & STERLING, 2012 COMPENSATION GOVERNANCE, supranote 139.1, at 14 (2012). The Business Roundtable reports that, in 2007,of the leading companies surveyed (160), 31% reported that their boardor compensation committee had adopted a “clawback” policy whereby a


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this clawback is likely to become the norm, given legal developmentsas a result of the financial crisis. Among other things, the ARRAimposed a clawback upon “bonus, retention award, or incentive com-pensation” paid to the five senior executives and the next twenty mosthighly compensated employees on the basis of financial statementsor “other criteria” later found to be materially inaccurate.178.5 Thisclawback generally applied only to these executives of any institutionthat received financial assistance from the federal government underTARP, so long as that assistance has not been repaid. It departs fromthe Sarbanes-Oxley clawback insofar as it goes beyond the CEO andCFO to reach other senior executives, as well as “highly compensatedemployees.” Although this clawback by its terms applied only toinstitutions receiving government support in the crisis, it is likely tohave an effect on compensation policies in public firms more generally,as will other executive compensation restrictions imposed in the crisisand discussed elsewhere. One question, among others, will be how todesign a clawback for those other than the top executives that isappropriate, that is, that ties the clawback penalty for a misstatementto conduct by an executive or other highly paid employee.

As part of financial reform legislation, Congress enacted a newSection 10D of the Exchange Act, which required the SEC to impose a“clawback” requirement as part of the listing standards for any exchangeor securities association.178.6 This clawback would apply to any currentor former executive officer (thus, it is broader than the Sarbanes-Oxleyprovision) and is triggered by “an accounting restatement due to thematerial noncompliance of the issuer with any financial reportingrequirement under the securities laws.” The amount of the clawbackis the excess of any incentive compensation that such officer hasreceived during the three years preceding the date when the companyis required to prepare the restatement. There is no specification aboutwhether only the compensation of culpable parties will be recovered andwhat the standard governing the restatement is (for example, negli-gence). The firm, not the SEC, recovers the funds.

company could recover compensation paid to executives if the companyhad a financial restatement. See BUSINESS ROUNDTABLE CORPORATEGOVERNANCE SURVEY: KEY FINDINGS (Oct. 22, 2007). However, commen-tators contend that the typical clawback policy is often too weak (e.g., theboard is given discretion whether to invoke it or it is triggered only bymisconduct of a particular executive). See Jesse M. Fried & Nitzan Shilon,Excess Pay and the Dodd-Frank Clawback, DIRECTOR NOTES (ConferenceBd., New York, N.Y.), no. DN-V3N20, Oct. 2011.

178.5. See Pub. L. No. 111-5, § 111(b)(3)(B), 123 Stat. 115, 517 (2009).178.6. See Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,

Pub. L. No. 111-203, § 954. The SEC has yet to issue any rule proposal onthis matter.


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[D][2] Freeze on Extraordinary Payments

Sarbanes-Oxley also addresses the risk that executives might re-move funds from firms in which they had engaged in fraud, evenshortly before its discovery, by giving the SEC a power to petition acourt for a temporary freeze on “extraordinary payments” (whethercompensation or other) made by the firm to, among others, officersand directors and a placing of them in escrow.179 The freeze is initiallyfor forty-five days, but can be extended for an additional forty-five days(in no case longer than ninety days total). If, however, the person or

179. See Temporary Freeze Authority for the Securities and Exchange Commis-sion, Sarbanes-Oxley § 1103 (codified at 15 U.S.C. § 78u-3(c)(3)):

(3) TEMPORARY FREEZE—

(A) IN GENERAL—

(i) ISSUANCE OF TEMPORARY ORDER—Whenever, duringthe course of a lawful investigation involving possi-ble violations of the Federal securities laws by anissuer of publicly traded securities or any of itsdirectors, officers, partners, controlling persons,agents, or employees, it shall appear to the Commis-sion that it is likely that the issuer will makeextraordinary payments (whether compensation orotherwise) to any of the foregoing persons, theCommission may petition a Federal district courtfor a temporary order requiring the issuer to escrow,subject to court supervision, those payments in aninterest-bearing account for 45 days.

(ii) STANDARD—A temporary order shall be entered un-der clause (i), only after notice and opportunity for ahearing, unless the court determines that notice andhearing prior to entry of the order would be imprac-ticable or contrary to the public interest.

(iii) EFFECTIVE PERIOD—A temporary order issued underclause (i) shall—(I) become effective immediately;(II) be served upon the parties subject to it; and(III) unless set aside, limited or suspended by a

court of competent jurisdiction, shall remaineffective and enforceable for 45 days.

(iv) EXTENSIONS AUTHORIZED—The effective period ofan order under this subparagraph may be extendedby the court upon good cause shown for not longerthan 45 additional days, provided that the combinedperiod of the order shall not exceed 90 days.

(B) PROCESS ON DETERMINATION OF VIOLATIONS—

(i) VIOLATIONS CHARGED—If the issuer or other persondescribed in subparagraph (A) is charged with anyviolation of the Federal securities laws before the


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persons who are the subject of the freeze order are charged with federalsecurities law violations, the freeze can continue until the terminationof the legal proceedings.180

§ 3:3.5 Legal Compliance/Ethics Committee

[A] Justification and BackgroundAs part of its supervision of and policy-setting for a company, the

board must ensure that the corporation is complying with the law. Inaddition, it should establish guidelines for the overall behavior of thefirm and of firm employees. The need for this supervision is very real.Violations of the law by firm employees can result in drastic legal

expiration of the effective period of a temporaryorder under subparagraph (A) (including any applic-able extension period), the order shall remain ineffect, subject to court approval, until the conclusionof any legal proceedings related thereto, and theaffected issuer or other person, shall have the rightto petition the court for review of the order.

(ii) VIOLATIONS NOT CHARGED—If the issuer or otherperson described in subparagraph (A) is not chargedwith any violation of the Federal securities lawsbefore the expiration of the effective period of atemporary order under subparagraph (A) (includingany applicable extension period), the escrow shallterminate at the expiration of the 45-day effectiveperiod (or the expiration of any extension period, asapplicable), and the disputed payments (with ac-crued interest) shall be returned to the issuer orother affected person.

180. See SEC v. Gemstar TV Guide Int’l, Inc., 367 F.3d 1087 (9th Cir. 2004)(holding that the provision requires the SEC to show what is an ordinarypayment so as to determine that a particular payment is extraordinary);vacated on reh’g en banc, 384 F.3d 1090 (9th Cir. 2004), rev’d, 401 F.3d1031 (9th Cir.) (no SEC showing of what constitutes ordinary paymentrequired), cert. denied, 546 U.S. 933 (2005). The SEC was eventually ableto return the $29.5 million severance package to be paid to formerGemstar CEO Henry Yuen, which had been escrowed under section1103, to the company. See Press Release No. 2008-58, SEC, SEC ActionReturns Former Gemstar CEO’s Pending Severance Payment to Companyand Shareholders (Apr. 9, 2008), www.sec.gov/news/press/2008/2008-58.htm. After trial, Yuen was found to have committed securities fraud, whichverdict was upheld on appeal. See SEC v. Henry C. Yuen, 272 F. App’x 615(9th Cir. 2008). He has also been indicted on a felony charge of obstructingan SEC investigation. See Former Chairman and CEO of Gemstar-TvGuide International, Inc. Charged with Obstruction of an SEC Investiga-tion, Litigation Release No. 20,599 (May 23, 2008), www.sec.gov/litigation/litreleases/2008/lr20599.htm.


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penalties for the firm, which can threaten its reputation and existence.Ethical violations can have a similarly drastic effect, for, if publicized,they can cause a firm’s employees, customers and capital providers tolose faith in it.

The impetus for a board to establish legal compliance policies for afirm has existed for some time. Under the Sentencing Guidelinespromulgated by the U.S. Sentencing Commission, penalties for crimesattributed to a corporation because of the behavior of its agents can bereduced if a company has in place an effective compliance program inaccordance with these Guidelines.181 In light of the many violations ofthe law implicated in the corporate scandals, Sarbanes-Oxley andrelated stock exchange reforms reinforced the importance of publiccompanies’ legal compliance. The NYSE specifically assigned the auditcommittee the responsibility for supervising legal compliance.182 Inaddition, concerned that inside and outside legal counsel to a firmoften neglected their responsibility to the company as a whole andturned a blind eye to legal violations by its executives, Sarbanes-Oxleyimposed a reporting requirement for counsel that could lead torevelation of problems to a board committee or the full board.183

Moreover, Sarbanes-Oxley requires a public company to have a code ofethics for financial officers, which has been expanded by the SEC andstock exchange rules to cover all directors, officers and employees andto reach legal, as well as ethical, violations.184 The oversight of a firm’sethics is thus squarely the board’s responsibility.

[B] GeneralitiesBecause the NYSE requires that the audit committee alone

perform the designated audit committee functions, legal oversight andcompliance must rest with that committee in NYSE-listed firms.185

Other public firms can place responsibility for legal compliance/ethics inanother, or in a stand-alone, committee. At a minimum, the committeeshould be composed of independent directors, if only because it mustevaluate alleged legal and ethical violations by firm employees (includingsenior executives). Following the practice of other major board commit-tees, the legal compliance/ethics committee should have a charter, partof which includes the firm’s code of ethics.

181. The guidelines are available at www.ussc.gov.182. See NYSE, supra note 24, § 303A.07(b)(i)(A)(2).183. See infra section 3:3.5[C][1][b].184. See infra section 3:3.5[C][2].185. The audit committee may delegate the responsibilities to a subcommittee.

Only 5% of S&P 500 companies have a legal/compliance committee. SeeSPENCER STUART, supra note 18, at 29.


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It is possible, as discussed below, for the committee to have asmembers several specific executives, or at least to have these execu-tives report to and work with it. These would be the chief compliance/ethics officer and the general counsel of the firm, for the former will beimplementing compliance policies and the latter will be conductinginvestigations into compliance problems on behalf of the committee.The committee should also have the freedom and the funding to retainindependent counsel and consultants, where necessary.186

[C] Duties

[C][1] Legal Compliance

[C][1][a] Supervision of ComplianceA good place to obtain an overview of the legal compliance duties of

the committee is to consider the requirements stated by the U.S.Sentencing Commission. These requirements were enhanced bySarbanes-Oxley, which directed the Commission, among other things,to amend the Guidelines and accompanying policy statements toensure that “the guidelines that apply to organizations in United StatesSentencing Guidelines, chapter 8, are sufficient to deter and punishorganizational criminal misconduct.”187 As amended, the guidelinesfor organizations mandate that an organization have an “effectivecompliance and ethics program” so that it can receive sentencingleniency.188 The requirements of the program are that it “exercisedue diligence to prevent and detect criminal conduct” and “otherwisepromote an organizational culture that encourages ethical conduct anda commitment to compliance with the law.” At a minimum, theserequirements mean that the firm should do the following:

• The firm should establish standards and procedures to preventand detect criminal conduct (the large number of laws applyingto firms suggests how detailed the procedures have to be).

• The board committee should be knowledgeable about thecompliance and ethics program and supervise it. Specific execu-tives (or a director) should be responsible for the program’s

186. On these issues, see generally EDWARD A. DAUER ET AL., NACD CORPO-RATE DIRECTOR’S ETHICS AND COMPLIANCE HANDBOOK 25 (2003).

187. See Review of Federal Sentencing Guidelines for Obstruction of Justice andExtensive Criminal Fraud, Sarbanes-Oxley § 805(a)(5) (codified at 28 U.S.C.§ 994).

188. See U.S. SENTENCING GUIDELINES MANUAL § 8B2.1 (Nov. 1, 2011). Theleniency applies here only in certain circumstances (i.e., the organizationdid not keep the criminal activity hidden).


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implementation and operation (that is, compliance officer(s)).There should be a chain of compliance reporting from lower levelsin the firm, to the compliance officer, and then to the boardcommittee.

• The firm should keep out of positions of authority individualswith questionable legal and ethical backgrounds.

• The firm needs to ensure that its compliance and ethics policiesare adequately communicated to everyone in the firm and thatthere is regular compliance training.

• The firm needs to ensure that the compliance program is followed(through, say, a compliance audit), that its effectiveness is eval-uated and that whistleblowing procedures are established foremployees to report (anonymously, if need be) questionableactivity.

• The program needs to be enforced through adequate incentivesto employees, and through punishment of violations.

• The firm needs to respond adequately to criminal violations andto review the adequacy of its program in light of them. Thelatter would include conducting a periodic risk assessment ofthe potential for criminal law violations.

It is fair to say that the legal compliance/ethics committee should beresponsible for seeing that the firm satisfies these tasks.189 Moreover,the existence of an effective committee, which uncovers violationsand takes remedial steps, will lessen the possibility that the SEC willassess the firm with civil monetary penalties if violations of the federalsecurities laws occur within the firm.189.1

[C][1][b] Attorney Reporting/Qualified LegalCompliance Committee

As part of its duties, the legal compliance/ethics committee mustalso put into place procedures for receiving reports from attorneysabout, and conducting investigations of, violations of the law withinthe firm. Congress was concerned that attorneys, rather than prevent-ing scandals in public firms, had themselves either participated in thescandals or turned a blind eye to them. Sarbanes-Oxley thus directedthe SEC to issue rules for the professional conduct of attorneys

189. The relationship between the responsible board committee and these tasksis fully spelled out in NACD CORPORATE DIRECTOR’S ETHICS AND COM-PLIANCE HANDBOOK, supra note 186, at 29–42.

189.1. See Statement of the SEC Concerning Financial Penalties, Press ReleaseNo. 2006-4 (Jan. 4, 2006).


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practicing before the SEC, including rules dealing with reporting by anattorney of questionable activity within a public company.190 The SECsubsequently issued rules setting forth the reporting obligations ofboth inside and outside counsel to a public firm.191 The SEC rulesreinforce that legal counsel’s duties lie to the corporation, not toofficers and directors,192 and impose upon counsel an “up-the-ladder”reporting requirement of evidence of material violations of the secu-rities law or material breaches of corporate law duties (or similarviolations) that he or she becomes aware of. These violations can be bythe company, or by any of its officers, directors, employees or agents.

The reporting requirements of the SEC ’s attorney conduct rulesstrongly encourage a firm to establish a legal compliance/ethicscommittee. They direct counsel to report legal problems in the firstinstance, not to the CEO, but to the firm’s chief legal officer (CLO),and, if counsel does not receive an appropriate response from thisofficer, then to either the audit committee, another committee ofindependent directors (if there is no audit committee) or to the fullboard (in the absence of any committee composed only of independentdirectors).193 As an alternative reporting chain, counsel is allowed toreport legal and other violations to a firm’s “qualified legal compliance

190. See Rules of Professional Responsibility for Attorneys, Sarbanes-Oxley§ 307 (codified at 15 U.S.C. § 7245):

Not later than 180 days after the date of enactment of 17 this Act,the Commission shall issue rules, in the public interest and for theprotection of investors, setting forth minimum standards of profes-sional conduct for attorneys appearing and practicing before theCommission in any way in the representation of issuers, includinga rule—

(1) requiring an attorney to report evidence of a material violationof securities law or breach of fiduciary duty or similar violationby the company or any agent thereof, to the chief legal counselor the chief executive officer of the company (or the equivalentthereof); and

(2) if the counsel or officer does not appropriately respond to theevidence (adopting, as necessary, appropriate remedial measuresor sanctions with respect to the violation), requiring the attor-ney to report the evidence to the audit committee of the board ofdirectors of the issuer or to another committee of the boardof directors comprised solely of directors not employed directlyor indirectly by the issuer, or to the board of directors.

191. See Implementation of Standards of Professional Conduct for Attorneys,Securities Act Release No. 8185, 68 Fed. Reg. 6296 (Feb. 6, 2003) (settingforth 17 C.F.R. § 205).

192. See 17 C.F.R. § 205.3(a) (2005).193. See id. § 205.3(b).


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committee” (QLCC), which is made up of independent directors(including one audit committee member) and which is authorized toreceive and act on these reports.194 Under the SEC rules, the QLCC(which is in effect the legal compliance/ethics committee) should havethe authority, and should establish procedures, to receive reports fromcounsel, to keep them confidential, and to decide whether to under-take an investigation of alleged material violations (and to hire counseland other advisors to assist in this investigation) and to inform theaudit committee or the entire board, the CEO and the CLO of theresults of the investigation (and the need for remedial measures).195

[C][1][c] Internal Investigations

As suggested above, an adequate legal compliance program requiresthat a firm have in place investigative procedures for detecting wrong-doing. If illegal or improper (that is, against company policy) activitieswithin the firm are reported or come to light because of complianceoversight, the firm must investigate them and determine if and whento report them to governmental authorities. Indeed, these authoritiesexpect that a firm must conduct such investigations in order todemonstrate cooperation, which would be one ground for not pursuingthe firm for criminal and civil violations of the law.195.1 The legalcompliance/ethics committee (or the audit committee, as the case maybe) should supervise all investigations and follow them closely. Theactual investigations would be conducted by the general counsel,perhaps with the assistance of the chief compliance officer, and hisor her staff.

However, the legal compliance/ethics committee must decide whenthe illegal or unethical activities are of such magnitude and impor-tance that an investigation of them cannot remain in-house. Suchactivities would include a revelation of widespread illegality in the firm

194. See id. §§ 205.2(k), 205.3(c). The QLCC may in fact be the auditcommittee, or a subcommittee of the audit committee. The SEC has notimposed additional obligations upon counsel, in particular a “noisy with-drawal” obligation, which would compel them to withdraw from firmrepresentation and report matters to the SEC if they are not satisfied withthe firm’s handling of the reporting of violations. It is not entirely clearwhat the attorney who is not satisfied with the firm’s response to thereporting now does, other than to inform the legal officer, the CEO and theboard of his or her lack of satisfaction. However, the SEC ’s new whistle-blower rules provide guidance on such additional reporting outside thefirm. See supra section 3:3.2[E][3][a].

195. See 17 C.F.R. § 205.2(k)(2)–(4) (2005).195.1. See NEW YORK CITY BAR, REPORT OF THE TASK FORCE ON THE LAWYER’S

ROLE IN CORPORATE GOVERNANCE 152–53 (Nov. 2006).


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that would clearly be “material” to investors under the federal secu-rities laws or of involvement by board members or senior executives,such as the CEO. A good example of this kind of significant illegality isa scandal involving options backdating.195.2 In this case, the commit-tee should bring the matter, and the results of the preliminary internalinvestigation, to the entire board with its recommendation that a fullinvestigation be conducted by outside counsel experienced in theseprocedures, and preferably counsel that is not the firm’s regularoutside counsel for corporate transactions.195.3 Moreover, the veryfact that outside counsel has conducted an investigation, shared itsresults with government authorities, and made a recommendation foraction, which the board has followed, may convince the authoritiesthat they need not conduct their own examination of the firm.

On September 10, 2015, the U.S. Department of Justice announcedrevisions to its Principles of Federal Prosecution of Business Organiza-tions. The new policies sent to federal prosecutors across the countryencourage them to consider cases against individuals responsible forwrongdoing and instruct them to focus their efforts to secure evidenceagainst such individuals. The most significant change is that in orderto qualify for “any cooperation credit” with the DOJ, a corporationmust identify “all relevant facts relating to the individuals responsiblefor the misconduct.”195.4 Only if a corporation satisfies this thresholdrequirement will the DOJ give the company credit for cooperation andevaluate the remaining elements of the company ’s cooperation. Thispolicy change applies in both criminal and civil cases. This constitutesa strengthening and codification of the DOJ’s practice of requiringcompanies under investigation to turn over all evidence againstindividual wrongdoers. This, of course, presents challenges with

195.2. See supra section 3:3.4[C][1][a].195.3. For a discussion of the advantages of using outside counsel in significant

investigations, see David Fein & Robert Hoff, Internal Investigations:Hewlett-Packard’s Lessons, N.Y.L.J., Nov. 6, 2006. See also infra section7:6 (discussing current trends in prosecution of corporations); NEW YORKCITY BAR, supra note 195.1, at 156–57. The reforms of Dodd-Frank, andthe accompanying SEC rules, on whistleblowing, discussed above, haveheightened the pressure on boards to ensure that an adequate investigationis undertaken, once a “red flag” of possible improprieties surfaces. Seegenerally Michael R. Smith & Michael M. Raeber, The Board’s Role inInternal Investigation, 42 Sec. Reg. & L. Rep. (BNA) 2176 (Nov. 15, 2010)(discussing recommended steps for board involvement in investigationsand necessary actions as a result of them in order to fulfill their duties).

195.4. U.S. Dep’t of Justice, Memorandum: Individual Accountability for Corpo-rate Wrongdoing, at 3 (Sept. 9, 2015), www.justice.gov/dag/file/769036/download.


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respect to a DOJ investigation following on the heels of a companyinternal investigation, and will increase the pressure on boards toproduce to the government “all facts” gleaned from an internalinvestigation.

[C][2] Ethics

The enforcement of a firm’s ethics by the legal compliance/ethicscommittee overlaps with legal compliance, for ethical violations oftenlead to or coincide with legal violations. Because it found a relation-ship between ethical and legal violations, particularly in chief financialofficers in the scandals,196 in Sarbanes-Oxley, Congress directed theSEC to issue rules requiring a company to disclose whether it has acode of ethics for senior financial officers applicable to the principalfinancial officer and comptroller or principal accounting officer (orperson performing similar functions) and to disclose rapidly (in a Form8-K) any change in or waiver of such code.197 The code of ethics wouldcover ethics, proper company disclosure and legal compliance. TheSEC implemented this requirement, but broadened it to apply to

196. One thinks of Andrew Fastow of Enron, Scott Sullivan of WorldCom andMark Swartz of Tyco International.

197. See Code of Ethics for Senior Financial Officers, Sarbanes-Oxley § 406(codified at 15 U.S.C. § 7264), providing as follows:

(a) CODE OF ETHICS DISCLOSURE.—The Commission shall issuerules to require each issuer, together with periodic reportsrequired pursuant to section 13(a) or 15(d) of the SecuritiesExchange Act of 1934, to disclose whether or not, and if not,the reason therefor, such issuer has adopted a code of ethics forsenior financial officers, applicable to its principal financialofficer and comptroller or principal accounting officer, orpersons performing similar functions.

(b) CHANGES IN CODES OF ETHICS.—The Commission shallrevise its regulations concerning matters requiring promptdisclosure on Form 8–K (or any successor thereto) to requirethe immediate disclosure, by means of the filing of such form,dissemination by the Internet or by other electronic means, byany issuer of any change in or waiver of the code of ethics forsenior financial officers.

(c) DEFINITION.—In this section, the term ‘code of ethics’ meanssuch standards as are reasonably necessary to promote—

(1) honest and ethical conduct, including the ethical hand-ling of actual or apparent conflicts of interest betweenpersonal and professional relationships;

(2) full, fair, accurate, timely, and understandable disclosure inthe periodic reports required to be filed by the issuer; and

(3) compliance with applicable governmental rules andregulations.


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principal executive officers and to require the code to mandate areporting procedure for code violations and accountability for adher-ence to the code.198

Although a public company can decide not to have a code of ethics,it must explain its reasons for refusing to adopt one, which is likely toshame companies into having one. Under the SEC ’s code of ethicsrule, a public company has the option of filing its code with its annualreport on Form 10-K, posting the code on its website and referringshareholders to it or alerting shareholders in its annual report thatthey may obtain, upon request, a copy of the code of ethics.199 Inaddition, a company must disclose in a current report on Form 8-Kany material amendment of the code or waiver (or implicit waiver, thatis, failure to take action on a material departure from the code) as to anofficer.200

Stock exchange rules give listed companies no choice in the matter:they must adopt codes of ethics broadly applicable to all officers,directors and employees.201 As the NYSE explains, a code “can focusthe board and management on areas of ethical risk, provide guidanceto personnel to help them recognize and deal with ethical issues,

198. See Disclosure Required by sections 406 and 407 of the Sarbanes-OxleyAct of 2002, Securities Act Release No. 8177, 68 Fed. Reg. 5110 (Jan. 31,2003) (final rule) (codified at 17 C.F.R. § 229.406 (2005)) (requiring,among other things, that a company disclose whether it has a code ofethics applicable to its “principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions” and post the code, as well as deviations from it, on itswebsite).

199. See 17 C.F.R. § 229.406(c) (2005). The SEC explains that, because the codemay constitute part of a larger set of compliance rules for the firm, the firmneed file or make available only the code.

200. Form 8-K Item 5.05 (Aug. 23, 2004). In the alternative, a company canpost the amendment or notice of a waiver to the code within four businessdays on its website (and leave that information up for twelve months andotherwise retain it for a minimum of five years).

201. See NYSE, supra note 24, § 303A.10:

Listed companies must adopt and disclose a code of business conductand ethics for directors, officers and employees, and promptly discloseany waivers of the code for directors or executive officers.

NASDAQ, supra note 24, § 5610 provides:

Each Company shall adopt a code of conduct applicable to alldirectors, officers and employees, which shall be publicly available.A code of conduct satisfying this rule must comply with the defini-tion of a ‘code of ethics’ set out in Section 406(c) of the Sarbanes-Oxley Act of 2002 (‘the Sarbanes-Oxley Act’) and any regulationspromulgated thereunder by the Commission. See 17 C.F.R. 228.406and 17 C.F.R. 229.406. In addition, the code must provide for anenforcement mechanism. Any waivers of the code for directors orExecutive Officers must be approved by the Board. Companies,


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provide mechanisms to report unethical conduct, and help to foster aculture of honesty and accountability.” Moreover, the NYSE specifiesin detail the kinds of matters that the code must cover (which, again,highlights the intersection of legal and ethical compliance):

• Conflicts of interest. A “conflict of interest” occurs when anindividual’s private interest interferes in any way—or evenappears to interfere—with the interests of the corporation as awhole. A conflict situation can arise when an employee, officeror director takes actions or has interests that may make itdifficult to perform his or her company work objectively andeffectively. Conflicts of interest also arise when an employee,officer or director, or a member of his or her family, receivesimproper personal benefits as a result of his or her position inthe company. Loans to, or guarantees of obligations of, suchpersons are of special concern. The listed company should havea policy prohibiting such conflicts of interest, and providing ameans for employees, officers and directors to communicatepotential conflicts to the listed company.

• Corporate opportunities. Employees, officers and directorsshould be prohibited from (a) taking for themselves personallyopportunities that are discovered through the use of corporateproperty, information or position; (b) using corporate property,information, or position for personal gain; and (c) competingwith the company. Employees, officers and directors owe a dutyto the company to advance its legitimate interests when theopportunity to do so arises.

• Confidentiality. Employees, officers and directors shouldmaintain the confidentiality of information entrusted to themby the listed company or its customers, except when disclosure isauthorized or legally mandated. Confidential information in-cludes all non-public information that might be of use to compe-titors, or harmful to the company or its customers, if disclosed.

• Fair dealing. Each employee, officer and director should endea-vor to deal fairly with the company ’s customers, suppliers,competitors and employees. None should take unfair advantageof anyone through manipulation, concealment, abuse of privi-leged information, misrepresentation of material facts, or anyother unfair-dealing practice. Listed companies may write their

other than Foreign Private Issuers, shall disclose such waivers in aForm 8-K within four business days. Foreign Private Issuers shalldisclose such waivers either in a Form 6-K or in the next Form 20-For 40-F.


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codes in a manner that does not alter existing legal rights andobligations of companies and their employees, such as “at will”employment arrangements.

• Protection and proper use of company assets. All employees,officers and directors should protect the company ’s assets andensure their efficient use. Theft, carelessness and waste have adirect impact on the listed company ’s profitability. All companyassets should be used for legitimate business purposes.

• Compliance with laws, rules and regulations (includinginsider trading laws). The listed company should proactivelypromote compliance with laws, rules and regulations, includinginsider trading laws. Insider trading is both unethical andillegal, and should be dealt with decisively.

• Encouraging the reporting of any illegal or unethical behavior.The listed company should proactively promote ethicalbehavior. The company should encourage employees to talk tosupervisors, managers or other appropriate personnel when indoubt about the best course of action in a particular situation.Additionally, employees should report violations of laws, rules,regulations or the code of business conduct to appropriatepersonnel. To encourage employees to report such violations,the listed company must ensure that employees know that thecompany will not allow retaliation for reports made in goodfaith.202

The listing rules also mandate that the code be publicly availableon or through its website and that the company disclose in its annualproxy statement or annual report on Form 10-K this availability. If acompany grants a waiver to the code, it must disclose this to itsshareholders within four business days by a press release, websitedisclosure, or by a filed Form 8-K.

Development, enforcement and disclosure of the firm’s code ofethics are thus responsibilities of the legal compliance/ethics commit-tee. There are many models for codes of ethics203 and, like other boardcommittees, this committee can use outside consultants (for example,law firms and ethics consultants) to assist in the development andongoing review of appropriate codes. It is also appropriate for thecommittee to delegate to the chief compliance officer the administra-tion of the code and to the general counsel the initial investigation of

202. See NYSE, supra note 24, § 303A.10.203. See, e.g., NACD CORPORATE DIRECTOR’S ETHICS AND COMPLIANCE HAND-

BOOK, supra note 186, at 63–76.


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ethical violations, although, as mentioned above, the committee isempowered, when necessary, to hire outside counsel for investigations.

[D] Related Restrictions on ExecutivesClearly, the requirements that a public company have a code of ethics

and that it disclose waivers of the code were designed to place significantrestrictions on self-interested behavior by senior executives, chiefly theCEO and CFO. All directors and executives, not just members of thelegal compliance/ethics committee, must then be familiar and complywith their company ’s ethics code. Moreover, it is understood thatdirectors not on the committee, as well as senior executives, cannotinterfere with the committee’s work or its outside consultants, particu-larly its investigations. In addition, the SEC’s attorney conduct rulesunderscore that the duty of legal counsel, including the general counsel,is not to the CEO or to any individual director, but to the company. Justas an executive should not hinder an accountant in the latter ’s perfor-mance of his or her tasks, so also should he or she not obstructcompliance-related and investigatory activities of legal counsel. Further-more, an executive should be careful not to retaliate against anywhistleblower reporting ethical violations because, in certain circum-stances, this retaliation may be impermissible under the whistleblowerprotection provisions of Sarbanes-Oxley and Dodd-Frank.204

§ 3:3.6 Disclosure Committee

[A] BackgroundBefore passage of Sarbanes-Oxley, some public companies no doubt

had in place procedures to produce the company ’s periodic SECdisclosure and to ensure its accuracy. In Sarbanes-Oxley, Congressexpressed its discontent with company disclosure by adding morecompany disclosure requirements on problematic areas and, asdiscussed earlier, by making senior executives responsible for itthrough certification.205 It is fair to say that the target of Congress’sattention was financial disclosure and the internal controls ensuringits accuracy. In implementing the directions of Congress, however, theSEC addressed the responsibility of senior executives for nonfinancialdisclosure as well. It did this by, among other things, recommendingthat a public company have a committee, here composed of firmexecutives, that would supervise the process whereby the firm pro-duced materially accurate disclosure for SEC reporting.

204. See supra section 3:3.2[E][3]; infra section 7:3.1[E].205. See supra section 3:3.2[E][1].


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[B] Disclosure ControlsAs discussed earlier, Congress imposed upon the CEO and the CFO

certification requirements as to the material accuracy of the com-pany ’s financial disclosure and the existence and effectiveness of aninternal control system for the production and verification of financialinformation.206 In implementing the certification mandate, the SECadded to it the requirements that the certifying officer attest to theexistence and adequacy of a firm’s “disclosure controls” and that afirm have in place these controls. The SEC was not going too far in itsextension of powers insofar as the express import of Sarbanes-Oxleywas to make the certifying officer responsible for a public company ’sentire disclosure, not just its financial disclosure.207

In its disclosure rules, the SEC requires that a public companymaintain disclosure controls and that management of the companyattest to their effectiveness at the end of each fiscal quarter.208 Theapplicable rule defines “disclosure controls” as follows:

(e) For purposes of this section, the term disclosure controls andprocedures means controls and other procedures of an issuer thatare designed to ensure that information required to be disclosed bythe issuer in the reports that it files or submits under the Act (15U.S.C. 78a et seq.) is recorded, processed, summarized andreported, within the time periods specified in the Commission’srules and forms. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensurethat information required to be disclosed by an issuer inthe reports that it files or submits under the Act is accumulated

206. See id.207. That is, Sarbanes-Oxley § 302(a)(2) (codified at 15 U.S.C. § 7241) required

the officer to certify as to the report’s material accuracy (i.e., “the reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary in order to make the statements made, in light ofthe circumstances under which such statements were made, not mislead-ing”), and such a certification implicates the entire disclosure process.

208. See Certification of Disclosure in Companies’ Quarterly and AnnualReports, Securities Act Rel. No. 8124, 67 Fed. Reg. 57,276 (Sept. 9,2002) (final rule); 17 C.F.R. § 240.13a-15 (2005). Rule 13a-15 provides,in pertinent part:

(a) Every issuer that has a class of securities registered pursuantto section 12 of the Act (15 U.S.C. 78l) . . . must maintaindisclosure controls and procedures (as defined in paragraph (e)of this section) . . . .

(b) Each such issuer ’s management must evaluate, with theparticipation of the issuer ’s principal executive and principalfinancial officers, or persons performing similar functions, theeffectiveness of the issuer ’s disclosure controls and proce-dures, as of the end of each fiscal quarter . . . .


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and communicated to the issuer ’s management, including itsprincipal executive and principal financial officers, or personsperforming similar functions, as appropriate to allow timelydecisions regarding required disclosure.209

The quarterly reports on Form 10-Q and the annual report on Form10-K refer to the necessary disclosure about the effectiveness of thedisclosure controls.210 And the requirements for exhibits to the formsinclude the text for the officer certification relating to thesecontrols.211

[C] Disclosure CommitteeIn implementing the certification requirements, the SEC recom-

mended, but did not require, that a public company have a committee,composed of executives and other employees, who would institutedisclosure procedures and review and verify the company ’s periodicdisclosure with the SEC (and address disclosure issues and problems).In fact, it is difficult to understand how a CEO or a CFO could give therequired certification of SEC-filed reports in the absence of this kindof committee, which would ensure that a company ’s disclosure ismaterially accurate. The SEC describes the kinds of company officerswho should be on the committee:

Officers and employees of an issuer who have an interest in, andthe expertise to serve on, the committee could include the princi-pal accounting officer (or the controller), the general counsel orother senior legal official with responsibility for disclosure matterswho reports to the general counsel, the principal risk managementofficer, the chief investor relations officer (or an officer withequivalent responsibilities) and such other officers or employees,including individuals associated with the issuer ’s business units,as the issuer deems appropriate.212

What is envisioned here is that in a company there is a hierarchy ofreporting and verification of information that flows up to the disclo-sure committee, which is ultimately responsible for its synthesis andverification.

The board is also responsible for disclosure controls. Under the law,directors need to sign the annual report on Form 10-K filed with the

209. 17 C.F.R. § 240.13a-15 (2005).210. See Form 10-Q Item 4; Form 10-K Item 9A (both referring to disclosure in

17 C.F.R. § 229.307 (2005)).211. See 17 C.F.R. § 229.601(b)(31) (2005).212. See Certification of Disclosure in Companies’ Quarterly and Annual

Reports, Securities Act Release No. 8124, 67 Fed. Reg. 57,276, 57,280n.60 (Sept. 9, 2002) (final rule).


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SEC, and they are liable for material misstatements or omissions inthe reports.213 Accordingly, it is necessary that a board committeesupervise the disclosure committee, which should report to it. Becausethe board audit committee is responsible for a firm’s internal controlsand financial reporting, it is appropriate for this committee to have thesupervisory duty. In large capitalization public companies, the auditcommittee may delegate to a subcommittee this task.

[D] Special Disclosure IssuesBecause the corporate scandals involved perceived gaps in financial

and nonfinancial disclosure, in Sarbanes-Oxley, Congress directed theSEC to enhance company disclosure to address these failings. Thesedisclosure issues are highlighted below and will need to be addressedby internal controls or disclosure controls, as the case may be.

[D][1] Off-Balance Sheet Disclosure in Management’sDiscussion and Analysis

The most well-known corporate scandal, Enron, involved the use ofoff-balance sheet entities and transactions, which disguised the truefinancial condition of the company.214 In order to discourage thesearrangements, Congress required the SEC to promulgate rules requir-

213. See, e.g., 17 C.F.R. § 240, Form 10-K, General Instruction D(2)(a) (2005)(“The report must be signed by the registrant, and on behalf of theregistrant by its principal executive officer or officers, its principal financialofficer or officers, its controller or principal accounting officer, and by atleast the majority of the board of directors or persons performing similarfunctions.”). Liability may be imposed upon a signing director or officer,depending upon the facts, under 15 U.S.C. § 78r(a) (misstatements in fileddocuments) and 15 U.S.C. § 78t(a) (controlling person liability).

214. For a detailed discussion of this scandal and its use of the off-balance sheetarrangements, see REPORT OF INVESTIGATION BY THE SPECIAL INVESTIGATIVECOMMITTEE OF THE BOARD OF DIRECTORS OF ENRON CORPORATION (Feb. 1,2002); First Interim Report of Neil Batson, Court Appointed Examiner, In reEnron Corp. et al., No. 01-16034 (AJG) (Bankr. S.D.N.Y. Sept. 21, 2002);Second Interim Report of Neil Batson, Court Appointed Examiner, In reEnron Corp. et al., No. 01-16034 (AJG) (Bankr. S.D.N.Y. Jan. 21, 2003)(focusing on role of special purpose entities in the fraud); Third InterimReport of Neil Batson, Court Appointed Examiner In re Enron Corp. et al.,No. 01-16034 (AJG) (Bankr. S.D.N.Y. June 30, 2003) (discussing the role offinancial institutions in designing these arrangements); Final Report of NeilBatson, Court Appointed Examiner, In re Enron Corp. et al., No. 01-16034(AJG) (Bankr. S.D.N.Y. Nov. 4, 2003) (discussing the role of Enron’s advisorsand financial institutions with respect to same); and Report of HarrisonJ. Goldin, The Court-Appointed Examiner in the Enron North AmericaCorp. Bankruptcy Proceeding No. 01-16034 (AJG) (Bankr. S.D.N.Y.Nov. 14, 2003) (same). See also In re Enron Corp. Sec., Derivative & ERISALitig., 235 F. Supp. 2d 549, 613–37 (S.D. Tex. 2002) (describing in detail theEnron scandal).


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ing companies to disclose in their quarterly and annual reportsmaterial off-balance sheet arrangements.215 The SEC fulfilledthis requirement in its Regulation S-K Item 303(a)(4), which essen-tially is designed to elicit information about “off-balance sheetarrangements.” These include contractual obligations or contingenciesof companies, such as guarantees or contingent interests, toentities that are not consolidated with the company in its financialstatements.216 The disclosure only pertains to arrangements that are

215. See Disclosures in Periodic Reports, Sarbanes-Oxley § 401(a) (codified at15 U.S.C. § 78m(j)):

(j) OFF-BALANCE SHEET TRANSACTIONS—Not later than 180 daysafter the date of enactment of the Sarbanes-Oxley Act of 2002,the Commission shall issue final rules providing that eachannual and quarterly financial report required to be filed withthe Commission shall disclose all material off-balance sheettransactions, arrangements, obligations (including contingentobligations), and other relationships of the issuer with un-consolidated entities or other persons, that may have amaterial current or future effect on financial condition,changes in financial condition, results of operations, liquidity,capital expenditures, capital resources, or significant compo-nents of revenues or expenses.

216. See 17 C.F.R. § 229.303(a)(4) (2005), providing:

(4) Off-balance sheet arrangements.

(i) In a separately-captioned section, discuss the registrant’soff-balance sheet arrangements that have or are reason-ably likely to have a current or future effect on theregistrant’s financial condition, changes in financial con-dition, revenues or expenses, results of operations, liquid-ity, capital expenditures or capital resources that ismaterial to investors. The disclosure shall include theitems specified in paragraphs (a)(4)(i)(A), (B), (C) and (D)of this Item to the extent necessary to an understandingof such arrangements and effect and shall also includesuch other information that the registrant believes isnecessary for such an understanding.

(A) The nature and business purpose to the registrant ofsuch off-balance sheet arrangements;

(B) The importance to the registrant of such off-balancesheet arrangements in respect of its liquidity, capitalresources, market risk support, credit risk support orother benefits;

(C) The amounts of revenues, expenses and cash flowsof the registrant arising from such arrangements; thenature and amounts of any interests retained, secu-rities issued and other indebtedness incurred by the

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registrant in connection with such arrangements;and the nature and amounts of any other obligationsor liabilities (including contingent obligations orliabilities) of the registrant arising from such ar-rangements that are or are reasonably likely tobecome material and the triggering events or circum-stances that could cause them to arise; and

(D) Any known event, demand, commitment, trend oruncertainty that will result in or is reasonably likelyto result in the termination, or material reduction inavailability to the registrant, of its off-balance sheetarrangements that provide material benefits to it,and the course of action that the registrant has takenor proposes to take in response to any suchcircumstances.

(ii) As used in this paragraph (a)(4), the term off-balancesheet arrangement means any transaction, agreement orother contractual arrangement to which an entity un-consolidated with the registrant is a party, under whichthe registrant has:

(A) Any obligation under a guarantee contract that hasany of the characteristics identified in paragraph 3 ofFASB Interpretation No. 45, Guarantor’s Account-ing and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness ofOthers (November 2002) (‘FIN 45’), as may bemodified or supplemented, and that is not excludedfrom the initial recognition and measurementprovisions of FIN 45 pursuant to paragraphs 6 or 7of that Interpretation;

(B) A retained or contingent interest in assets trans-ferred to an unconsolidated entity or similar arrange-ment that serves as credit, liquidity or market risksupport to such entity for such assets;

(C) Any obligation, including a contingent obligation,under a contract that would be accounted for as aderivative instrument, except that it is both indexedto the registrant’s own stock and classified in stock-holders’ equity in the registrant’s statement of fi-nancial position, and therefore excluded from thescope of FASB Statement of Financial AccountingStandards No. 133, Accounting for Derivative In-struments and Hedging Activities (June 1998), pur-suant to paragraph 11(a) of that Statement, as maybe modified or supplemented; or

(D) Any obligation, including a contingent obligation,arising out of a variable interest (as referenced inFASB Interpretation No. 46, Consolidation of Vari-able Interest Entities (January 2003), as maybe modified or supplemented) in an unconsolidatedentity that is held by, and material to, the registrant,

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reasonably likely to have a material current or future effect on thecompany, but must be meaningful to investors (such as by the use oftables).

[D][2] Reconciliation of Non-GAAP or Pro FormaFinancial Measures

After the bursting of the bubble of the late 1990s, the SEC wasconcerned that many companies misled the public by emphasizing proforma financial numbers, which presented a favorable view of acompany, at the expense of financial numbers prepared underGenerally Accepted Accounting Principles (GAAP), which had theopposite result. Pro forma numbers, moreover, were often not easilycomparable from company to company, which undermines SEC dis-closure that is designed to produce comparable data about companies.In section 401(b) of Sarbanes-Oxley Congress directed the SEC toissue rules that would ensure that pro forma numbers were notmaterially misleading and that they were reconciled with financialresults prepared in accordance with GAAP.217 The SEC did so inRegulation G.218 This regulation requires that, whenever a companyreleases a material non-GAAP “financial number” (publicly within or

where such entity provides financing, liquidity, mar-ket risk or credit risk support to, or engages inleasing, hedging or research and development ser-vices with, the registrant.

For the disclosure requirements, see 17 C.F.R. § 240, Form 10-K, Item 7;Form 10-Q, Item 2 (2005).

217. See Sarbanes-Oxley § 401(b) (codified at 15 U.S.C. § 7261), whichprovides:

(b) COMMISSION RULES ON PRO FORMA FIGURES.—Not later than180 days after the date of enactment of the Sarbanes-OxleyAct of 2002, the Commission shall issue final rules providingthat pro forma financial information included in any periodicor other report filed with the Commission pursuant to thesecurities laws, or in any public disclosure or press or otherrelease, shall be presented in a manner that—

(1) does not contain an untrue statement of a material fact oromit to state a material fact necessary in order to make thepro forma financial information, in light of the circum-stances under which it is presented, not misleading; and

(2) reconciles it with the financial condition and results ofoperations of the issuer under generally accepted account-ing principles.

218. See Conditions for Use of Non-GAAP Financial Measures, Securities ActRelease No. 8176, 68 Fed. Reg. 4820 (Jan. 30, 2003) (final rule); 67 Fed.Reg. 68,054 (Nov. 8, 2002) (proposed rule) (codified at 17 C.F.R. § 244.100et seq. (2008)).

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outside of an SEC filing), which means a number dealing with thecompany ’s financial performance, financial position or cash flows, itmust reconcile it to the most directly comparable GAAP number andquantify the difference between the pro forma and GAAP num-ber.219 These requirements apply even if a company presents thenon-GAAP number orally or electronically (for example, on a website)and covers forward-looking information (although reconciliation isnot mandated in this latter case where there is no forward-lookingGAAP number). A company ’s failure to comply with Regulation Gmay be grounds for liability under Rule 10b-5, or an SEC enforcementproceeding for compliance with the regulation.220

[D][3] Real-Time Disclosures

Sarbanes-Oxley requires a company to disclose additional materialinformation on its financial conditions and operations on “a rapidand current” basis, in accordance with SEC rules.221 By amendingForm 8-K, which mandates that a public company report to the market

219. See 17 C.F.R. § 244.100(a) (2005):

(a) Whenever a registrant, or person acting on its behalf, publiclydiscloses material information that includes a non-GAAPfinancial measure, the registrant must accompany that non-GAAP financial measure with:

(1) A presentation of the most directly comparable financialmeasure calculated and presented in accordance withGenerally Accepted Accounting Principles (GAAP); and

(2) A reconciliation (by schedule or other clearly understand-able method), which shall be quantitative for historicalnon-GAAP measures presented, and quantitative, to theextent available without unreasonable efforts, forforward-looking information, of the differences betweenthe non-GAAP financial measure disclosed or releasedwith the most comparable financial measure or measurescalculated and presented in accordance with GAAP iden-tified in paragraph (a)(1) of this section.

The SEC also promulgated Item 10(e) of Regulation S-K, which imple-ments Regulation G when pro forma numbers are used in SEC filings. See17 C.F.R. § 229.10(e) (2005). Among other things, Item 10(e) would alsorequire management to explain why it believes that the non-GAAPmeasures are useful to investors and the specific purposes of this kind ofdisclosure. As an additional part of its rule-making designed to havecompanies make accurate financial information disclosure, the SEC re-quires a company releasing material, non-public information about aquarter that is already ended to make a filing with the SEC on a Form 8-K.

220. Sarbanes-Oxley § 3(b) (codified at 15 U.S.C. § 7202) makes a violation ofany provision of that Act or any implementing SEC rule a violation of theExchange Act.

221. See Real Time Issuer Disclosures, Sarbanes-Oxley § 409 (codified at 15U.S.C. § 78m(l)), which provides:

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and to the SEC significant events, the SEC implemented this real timedisclosure.222 The revision shortened the reporting time to fourbusiness days and added new disclosure items, including entry intoa material agreement, termination of such an agreement, creation of anew material financial obligation or a similar obligation under an off-balance sheet arrangement, triggering of an event increasing or accel-erating such obligation, exit or disposal activities associated with amaterial asset or business, material impairments to asset (tangible orintangible), receipt of notice of delisting or failure to satisfy listingrules, conclusion by board or authorized officer that a company ’spreviously issued financial statements should not be relied upon, andrevised existing ones, such as sale of unregistered securities, materialalterations to rights of security holders, enhanced disclosure about thedeparture of any director or officer and the reasons therefore (includingdisagreements with management), as well as the election or appoint-ment of new directors or officers.223

(l) REAL TIME ISSUER DISCLOSURES—Each issuer reporting undersection 13(a) or 15(d) shall disclose to the public on a rapidand current basis such additional information concerningmaterial changes in the financial condition or operations ofthe issuer, in plain English, which may include trend andqualitative information and graphic presentations, as theCommission determines, by rule, is necessary or useful forthe protection of investors and in the public interest.

222. See Additional Form 8-K Disclosure Requirements and Accelerationof Filing Date, Exchange Act Release No. 49,424, 69 Fed. Reg. 15,594(Mar. 25, 2004) (final rule). In a related vein, over the past few years, theSEC considered accelerating the filing dates of the annual report on Form10-K and the quarterly report on Form 10-Q. It resolved to require largecapitalization companies (i.e., those having a worldwide market value ofoutstanding voting and nonvoting equity of $700 million or more) to filetheir Form 10-K within sixty days of the end of their fiscal year (thesecompanies are known as large accelerated filers), beginning on the fiscalyear ending after December 31, 2006. Companies with outstanding votingand nonvoting equity of $75 million or more (but less than $700 million)must file their Form 10-K within seventy-five days of the end of their fiscalyear (these are accelerated filers). Both large accelerated filers and acceler-ated filers must file their Form 10-Q within forty days of the end of thefiscal quarter. A ninety-day filing requirement and a forty-five-day filingrequirement, for the Form 10-K and the Form 10-Q respectively, apply toall other companies. See generally Revisions to Accelerated Filer Definitionand Accelerated Deadlines for Filing Periodic Reports, 70 Fed. Reg. 76,626(Dec. 27, 2005) (discussing the evolution of accelerated filing and settingforth the new filing rules).

223. See 17 C.F.R. § 240 Form 8-K (2005).

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[D][4] Mandatory SEC Review of Disclosure

Many companies involved in the scandals were seasoned largecapitalization reporting companies under the federal securities laws.This meant that they generally received little, or even no, attentionfrom the SEC because of this status. Sarbanes-Oxley mandatesthat the SEC regularly review the disclosure of all reporting compa-nies (no less frequently than once every three years) and that itprioritize the review to reflect specific company disclosure issues(for example, companies making material restatements of financialresults).224

§ 3:4 Summary

This chapter, perhaps more than any other, points to the profes-sionalization and thus specialization of the director ’s role in publiccompanies. It first showed how, under the pressure of federal

224. See Enhanced Review of Periodic Disclosures by Issuers, Sarbanes-Oxley§ 408 (codified at 15 U.S.C. § 7266):

(a) REGULAR AND SYSTEMATIC REVIEW.—The Commissionshall review disclosures made by issuers reporting undersection 13(a) of the Securities Exchange Act of 1934 (includingreports filed on Form 10-K), and which have a class ofsecurities listed on a national securities exchange or tradedon an automated quotation facility of a national securitiesassociation, on a regular and systematic basis for the protec-tion of investors. Such review shall include a review of anissuer ’s financial statement.

(b) REVIEW CRITERIA.—For purposes of scheduling the reviewsrequired by subsection (a), the Commission shall consider,among other factors—

(1) issuers that have issued material restatements of finan-cial results;

(2) issuers that experience significant volatility in their stockprice as compared to other issuers;

(3) issuers with the largest market capitalization;

(4) emerging companies with disparities in price to earningratios;

(5) issuers whose operations significantly affect any materialsector of the economy; and

(6) any other factors that the Commission may considerrelevant.

(c) MINIMUM REVIEW PERIOD.—In no event shall an issuer re-quired to file reports under section 13(a) or 15(d) of theSecurities Exchange Act of 1934 be reviewed under thissection less frequently than once every 3 years.

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§ 3:4Board Committees

securities law and stock exchange rules, the director must satisfyindependence criteria. Even more significantly, so complicated anddetailed has the director ’s role become that to function appropriatelyand competently the board must establish certain committees, eachwith a charter, a composition of independent directors and well-defined responsibilities. Accordingly, the chapter reviewed the keyboard committees, the audit committee, the nominating/corporategovernance committee and the compensation committee, as well asseveral new additions, the legal compliance/ethics committee and thedisclosure committee. It discussed in some detail their tasks andresponsibilities, which have increasingly progressed beyond beingdictated by business best practices to being established by the lawand stock exchange rules. It also explained what necessary disclosureof its responsibilities and accomplishments a committee must maketo shareholders. The chapter described the relationship between eachcommittee and senior executives, which often means the kind ofexecutive supervision a committee is designed to accomplish, and anyexecutive duties that are specifically related to a committee’s respon-sibilities, as in the connection between officer certification and theboard audit committee’s tasks.

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§ 3:4 DIRECTORS’ AND OFFICERS’ LIABILITY

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