SSRN-id1396353

Electronic copy available at: http://ssrn.com/abstract=1396353

University of Denver Sturm College of Law

Legal Research Paper Series

Working Paper No. 09-10

CORPORATE GOVERNANCE AND CORPORATE DISCLOSURE

J. Robert Brown, Jr.

University of Denver Sturm College of Law

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Paper Collection Original Paper Abstract ID: http://ssrn.com/abstract=1396353

Electronic copy available at: http://ssrn.com/abstract=1396353Electronic copy available at: http://ssrn.com/abstract=1396353

CHAPTER 2B

CORPORATE GOVERNANCEAND CORPORATE DISCLOSURE§ 2B.01 Governance and the Limits of Disclosure

§ 2B.02 Disclosure and Compliance with the Securities Law

§ 2B.03 Disclosure and State Fiduciary Obligations[1] Overview[2] Director Resignations[3] Enforcement Proceedings and Governance

§ 2B.04 Disclosure and the Board of Directors[1] Overview[2] Disclosure Requirements

[a] Independence[b] Meeting Attendance[c] Committee Disclosure

[i] Nominating Committee[ii] Audit Committee[iii] Compensation Committee

[d] Communications from Shareholders[3] Problems

§ 2B.05 Independence, Disclosure, and the Securities Laws

§ 2B.06 Disclosure and Conflicts of Interest[1] Fiduciary Duties[2] Related Party Transactions and Disclosure Requirements[3] Procedures[4] Antifraud Provisions[5] Issues

2B-1 2009-2 SUPPLEMENT

Ellen Fischer

Text Box

© 2009 Aspen Publishers. All Rights Reserved. Reproduced with the permission of Aspen Publishers, Inc. from J. Robert Brown, Jr., The Regulation of Corporate Disclosure, Third Edition. This material may not be used, published, broadcast, rewritten, copied, redistributed or used to create any derivative works without prior written permission from the publisher.

Electronic copy available at: http://ssrn.com/abstract=1396353

§ 2B.01 GOVERNANCE AND THE LIMITS OF DISCLOSURE

The main focus of the securities laws has always been disclosure. Inadopting the Securities Act of 1933, Congress expressly rejected a merit-basedapproach to regulation. Investors could sell shares in a company that promised toextract gold from seawater so long as the risks were fully disclosed.1 Disclosurein general facilitated a transparent trading market, with investment decisions leftin the hands of investors.2

The securities laws were not entirely limited to the protection of investorsor to rules increasing the amount of disclosure. In particular, Section 14(a) of theExchange Act3 gave the Commission the authority to regulate proxies,interjecting the agency into the corporate governance process.4 The agencymostly adhered to the traditional approach of protecting shareholders through theuse of disclosure,5 with the substance of corporate governance left to the states.6

1 See Federal Securities Act, Hearing on H.R. 4314, Before the House Comm. on Interstate andForeign Commerce, 73d Cong., 1st Sess. 57–58 (1933) (statement of Rep. Pettengill); see also H.R.Rep. No. 83, 73d Cong., 1st Sess. 8 (1933) (“The purpose of these sections is to secure for potentialbuyers the means of understanding the intricacies of the transaction into which they are invited.”).

2 “There cannot be honest markets without honest publicity.” H.R. Rep. No. 1383, 73d Cong., 2dSess. 11 (1934), reprinted in 1 Securities Law Comm., Federal Bar Ass’n, Federal Securities Laws,Legislative History, 1933–1982, at 792, 804 (1983). The approach was influenced by then professorand later Justice Brandeis in his book, Other People’s Money 92 (1914), where he wrote the memo-rable phrase “Sunlight is the best disinfectant.”

3 15 U.S.C. § 78n(a). Historically, states imposed a few, ineffective restrictions on management’suse of proxies. Salaried officers could not be proxyholders. Early statutes also limited the number ofshares voted by any proxyholder. See Dodd, Statutory Developments in Business Corp. Law1886–1936, 50 Harv. L. Rev. 27, 33 (1936). Nonetheless, over time, state law ceased to impose anyreal limits on management’s use of the proxy process. Id. (noting that 1903 revisions of Massachu-setts corporate code “marked the end of any attempt . . . to put obstacles in the way of control of theproxy machinery by the management”).

4 As the Senate Report expansively stated: “It is contemplated that the rules and regulations pro-mulgated by the Commission will protect investors from promiscuous solicitation of their proxies,on the one hand, by irresponsible outsiders seeking to wrest control of a corporation away from hon-est and conscientious corporate officials; and, on the other hand, by unscrupulous corporate officialsseeking to retain control of the management by concealing and distorting facts. . . . S. Report No.1455, 73d Cong., 2d Sess. 77. Even the courts have recognized that the Commission’s authority inthe proxy rules goes beyond disclosure. See Business Roundtable v. SEC, 905 F.2d 406, 411 (D.C.Cir. 1986) (“We do not mean to be taken as saying that disclosure is necessarily the sole subject of§ 14.”).

5 Not entirely. Rule 14a-4(d)(2) limits the duration of a proxy, overriding state law provisions. 17C.F.R. § 240.14a-4(d)(2). State law allows proxies of unlimited duration. See, e.g., RMBCA § 7.22.

6 See Cort v. Ash, 422 U.S. 66, 84 (1975) (“Corporations are creatures of state law, and investorscommit their funds to corporate directors on the understanding that, except where federal lawexpressly requires certain responsibilities of directors with respect to stockholders, state law will gov-ern the internal affairs of the corporation.”). See also Santa Fe Indus., Inc. v. Green, 430 U. S. 462(1977) (refusing to extend Rule 10b-5 liability to allegations of corporate mismanagement). See also

GOVERNANCE AND DISCLOSURE § 2B.01


Nonetheless, there were some early exceptions. Rule 14a-8 expanded therights of shareholders by providing them with access to management’s proxystatement, facilitating their ability to obtain support for proposals they mightmake.7 The right was not entirely designed to benefit shareholders but had theadditional purpose of removing from management the obligation to discloseproposals that it knew would be made at an upcoming meeting. Instead, the ruleshifted the burden to shareholders.8 In addition, the right was accompanied bysevere restrictions on the scope of permissible proposals, limiting the usefulnessof the newly established right.9

With respect to corporate governance, disclosure initially appeared to be asufficient approach to regulation.10 The Commission had its hands full ensuringthat shareholders had what they needed to make informed decisions on votingmatters. In addition, disclosure facilitated the exercise of certain state law rights.Thus, the disclosure of related-party transactions allowed shareholders to knowabout transactions that could violate a director’s duty of loyalty.11

Over time, however, it became apparent that disclosure was not enough.First, the disclosure requirements themselves interfered with the governanceprocess. For public companies, the proxy process largely supplanted the annualmeeting as the mechanism for resolving shareholder issues.12 The requirement

Exchange Act Release No. 39093 (Sept. 18, 1997) (“The shareholder proposal process affects theinternal governance of corporations, and it is state law—not federal securities law—which is prima-rily concerned with corporate governance matters.”).

7 17 C.F.R. § 240.14a-8. The provision was adopted in 1948. See Exchange Act Release No. 4185(Nov. 5, 1948).

8 For a more in depth discussion of this topic, see J. Robert Brown, Jr., The SEC, Corporate Gov-ernance, and Shareholder Access to the Board Room, Denver Legal Studies Research Paper No.08-05, University of Denver Sturm College of Law, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095032.

9 The Commission initially prohibited many proposals involving matters of public debate, a posi-tion overturned by the courts. See Medical Comm. for Human Rights v. SEC, 432 F.2d 659 (2d Cir.1970). More recently, the courts have overturned the agency’s position with respect to proposalsinvolving the election of directors. See AFSCME v. American Int’l Group, Inc., 462 F.3d 121 (2d Cir.2006).

10 See A Reappraisal of Administrative Policies Under the ’33 and ’34 Acts, Report and Recom-mendations to the Securities and Exchange Commission from the Disclosure Policy Study, at 41(March 27, 1969) (“In conferences with the Study, many security analysts stressed the value ofmerger proxy statements. No other single document, apart from the prospectus, was regarded as con-taining information of greater usefulness in evaluating the securities of publicly held corporations.”).

11 See Item 404 of Regulation S-K (requiring disclosure of related party transactions). See alsoGuth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939) (setting out test for duty of loyalty).

12 The proxy process has largely supplanted the annual meeting as a vehicle for exercising thefranchise. As one commentator stated: “It is well known that proxy voting has become the dominantmode of shareholder decision making in publicly held corporations.” Eisenberg, Access to the Cor-porate Proxy Machinery, 83 Harv. L. Rev. 1489, 1490 (1970); see also Hurst, The Legitimacy of theBusiness Corporation in the United States 94 (1970) (“the core reality of stockholder suffrage in the

THE REGULATION OF CORPORATE DISCLOSURE§ 2B.01

2B-42009-2 SUPPLEMENT

that solicitations be preceded by a proxy statement added substantial cost to theprocess.13 Corporate officials could use the company treasury to pay the costs;shareholders were left risking their own funds.14 The result was a practicaldiminution in the ability of shareholders to nominate competing slates ofdirectors.15

Efforts, to more directly intervene in the governance process were, however,summarily stopped by the courts, at least when using the stock exchanges as themechanism for implementation.16 Lacking governance authority, yet realizing theneed to improve the governance process, the Commission increasingly tried touse disclosure as a fix. The disclosure requirements were, therefore, designedless to provide investors or shareholders with material information and more toaffect the behavior of officers and directors, something the agency occasionallyadmitted.17

The result has been dramatic expansion in the amount of disclosure acompany must make about its corporate governance process. The material rangesfrom board attendance to board independence. The audit, compensation, andnominating committee must each reveal information about its inner workings, atleast in part in an effort to pin point the role of the CEO in the process.

big company lay in the use of proxy machinery.”); Report of the Securities and Exchange Commis-sion on Proposals for Amendments to the Securities Act of 1933 and the Exchange Act of 1934, 77thCong., 1st Sess. 35 (House Comm. Print; Aug. 7, 1941) (“Ownership of securities is so widelydiffused that voting by stockholders in corporate meetings is today affected almost entirely byproxies.”).

13 See Rule 14a-3, 17 C.F.R. § 240.14a-3.14 See Jana Master Fund, Ltd. v. CNET Networks, Civ. Action No. 3447-CC (Del. Ch.), AFF’D,

947 A.2d 1120 (Dec. 2008) (“Generally, although management is reimbursed for its proxy expensesfrom the corporate coffers, insurgent shareholders finance their own bid and can hope for reimburse-ment only if that bid is successful. Such a rule undoubtedly proves intimidating and likely discour-ages many shareholders from attempting to wage a proxy contest.”). See also CA v. AFSCME, 953A.2d 227 (Del. 2008) (concluding that shareholder proposal mandating reimbursement to insurgentswho succeeded in electing a candidate to the board violated Delaware law absent a fiduciary out pro-vision).

15 The problem was ameliorated somewhat by the shareholder proposal rule and the ability to usemanagement’s proxy statement. The rule, however, contained numerous exclusions, including thoserelating to the election of directors. Anything associated with elections required a separate proxystatement. The courts have recently forced the Commission to reexamine this requirement. SeeAFSCME v. American Int’l Group, Inc., 462 F.3d 121 (2d Cir. 2006).

16 See Business Roundtable v. SEC, 905 F.2d 406, 408 (D.C. Cir. 1986) (striking down SEC rulerequiring one share, one vote and noting that requirement was “concededly a part of corporate gov-ernance traditionally left to the states.”).

17 See Exchange Act Release No. 15384 (Dec. 6, 1978) (“the Commission recognizes that theadoption of this disclosure requirement in some instances may indirectly stimulate the establishmentof audit, nominating and compensation committees, the Commission believes that disclosure of thenonexistence of the named committees serves a valid informational purpose.”).



Companies must make considerable disclosure about executive compensation,including the process used by the board in determining the amount.

Disclosure, however, has not worked effectively in promoting bettergovernance. Extensive disclosure of executive compensation has not, forexample, altered the upward trajectory in CEO pay. Moreover, the approach hasoften resulted in boilerplate, providing little real illumination of the governanceprocess.

§ 2B.02 DISCLOSURE AND COMPLIANCE WITH THESECURITIES LAW

Efforts to influence the behavior of officers and directors have long beena staple of the securities laws. In some cases, they were designed to increasecompliance with the securities laws themselves. This was true, for example, withthe beneficial ownership reporting requirements.

Section 16(a) of the Exchange Act requires directors, executive officers,and 10 percent shareholders to report changes in their beneficial ownership.18

Section 16(b) provides a private right of action for paired trades that occur withina six-month period.19 The provision was often ignored,20 with the Commission atthe time having few weapons to combat the delinquent filers.21

In 1988, the Commission proposed changes in the proxy rules to requirereporting of non-compliance with the reporting requirements.22 Frustrated with

18 See Section 16(a), 15 U.S.C. § 78p(a).19 See Section 16(b), 15 U.S.C. § 78p(b). See Exchange Act Release No. 52202 (Aug. 3, 2005)

(“Unlike insider trading prohibitions under general antifraud provisions, Section 16(b) operates with-out consideration of whether an insider actually was aware of material non-public information. Sec-tion 16(b) operates strictly, providing a private right of action to recover short-swing profits byinsiders, on the theory that short-swing transactions (a purchase and sale within six months) presenta sufficient likelihood of involving abuse of inside information that a strict liability prophylacticapproach is appropriate.”) (footnotes omitted).

20 See Exchange Act Release No. 26333 (Dec. 13, 1988) (noting a delinquency rate in filings ofmore than 50%).

21 The Commission tried to bring enforcement actions to encourage compliance. See, e.g., SECv. Bank of Am. N.T. & S.A., Release No. 10469 (D.D.C. July 23, 1984). The approach expendedresources with little apparent success. Part of the problem was the remedy. At the time, the agencylacked the authority to penalize those violating the requirements. That authority only came in 1990.See The Securities Enforcement Remedies and Penny Stock Reform Act, Pub. L. No. 101-429, 104Stat. 931 (Oct. 15, 1990) (providing agency with authority to seek civil monetary penalties in courtproceedings and to impose monetary penalties and order disgorgement in administrative proceed-ings).

22 See Exchange Act Release No. 26333 (Dec. 13, 1988) (noting a delinquency rate in filings ofmore than 50%). See also Exchange Act Release No. 27148 (Aug. 18, 1989) (“The Commission isparticularly disappointed to find that notwithstanding the publicity and concerns expressed about thesubstantial delinquency in filings, there has not been a substantial improvement in compliance. In a



individual non-compliance, the agency set forth a proposal that would place thereporting obligation squarely on the company. Not only could disclosure bepotentially embarrassing to the company but also it would alert the Commissionto violations. The agency all but admitted that the requirements were designed toincrease compliance rather than provide investors and shareholders with usefulinformation.23

Individuals must file reports within two business days of execution of theapplicable trade.24 The reports must be submitted electronically25 and sent to thecompany contemporaneously with filing.26 Sarbanes-Oxley shortened the timeperiod for filing the reports,27 something that has had an impact on the backdatingscandal. Companies with a public Web site are required to post the reports by theend of the business day after filing and leave them there for at least 12 months.28

Item 405 to Regulation S-K in turn requires companies to disclose anyviolations of the insider reporting requirements in its proxy statement or annualreport.29 Specifically, the company must: (1) identity all insiders who failed tofile or who filed delinquently; and (2) reveal the number of violations by eachindividual.30

recent study, the Commission found 36.7% of the transactions reported in calendar year 1988 werereported more than three days late. As of June 10, 1989, the delinquency rate was 34.7% for trans-actions reported in the first five months of 1989. This reinforces the Commission’s conclusion thatthe proposed proxy disclosure and fines are necessary.”).

23 See also Exchange Act Release No. 27148 (Aug. 18, 1989) (“As stated in the 1988 Release,the Commission is concerned about the widespread lack of compliance with the reporting require-ments under Section 16(a).”).

24 Rule 16a-3(g)(1), 17 C.F.R. § 240.16a-3(g)(1). See Exchange Act Release 46421 (Sept. 3, 2002)(adopting two-business-day requirement). The requirement was originally 10 days after the close of themonth in which the transaction occurred. See Exchange Act Release No. 52202 (Aug. 3, 2005).

25 Exchange Act Release No. 47809 (May 13, 2003). The requirement of electronic filing wasincluded in the Sarbanes-Oxley Act (SOX). See Section 403 of SOX.

26 Rule 16a-3(e), 17 C.F.R. § 240.16a-3(e). The form must be sent to the person designated bythe company or, absent designation, to the corporate secretary. In determining compliance, compa-nies may assume that the forms received within three calendar days of the required filing date arecurrent. Where insiders have not filed a Form 5, issuers may rely upon a written representation thatno form was required. Item 405(b)(2). The Commission has brought actions for violation of the pro-vision. See, e.g., In re Cortland First Fin. Corp., Exchange Act Release No. 38192 (admin. proc. Jan.22, 1997).

27 Section 16(a)(2)(C), as amended by Section 403 of the Sarbanes-Oxley Act. Effective on thesame date, the Commission adopted rule amendments to implement the accelerated Form 4 due date.Exchange Act Release No. 46421 (Aug. 27, 2002).

28 Rule 16a-3(k), 17 C.F.R. § 240.16a-3(k). The company can meet the requirement by linking tothird-party sites if certain conditions are met. See Exchange Act Release No. 47809 (May 13, 2003).

29 See Exchange Act Release No. 28869 (Feb. 8, 1991).30 See Schedule 14A, Item 7(b). No other information need be disclosed, including the details of

the transactions. Exchange Act Release No. 28869 (Feb. 8, 1991).31[Reserved.]



The disclosure requirement likely had its intended effect, alteringsubstantive behavior. Compliance no doubt increased, in large part because therequirements placed added responsibility on the company. In general, companiespreferred to avoid something akin to embarrassing disclosure in SEC filings byhaving to admit that officers and directors filed beneficial ownership reports inan untimely fashion.

§ 2B.03 DISCLOSURE AND STATE FIDUCIARY OBLIGATIONS

[1] Overview

The obligations imposed on officers and directors in the management of thecompany arise mostly out of their fiduciary obligations. These in turn dependupon state law. In general, the Commission has taken the position that it has noauthority to set substantive standards for director behavior.32 This did not preventoccasional Commission pronouncements in the area, such as the early suggestionthat public companies have audit committees consisting of non-officerdirectors.33

The agency ultimately went beyond admonitions and began using a mix ofrulemaking and enforcement proceedings in an effort to elevate the behavior ofdirectors, particularly in the context of corporate disclosure. The approach arosefrom the recognition that the threat of liability under state law was not sufficientto ensure that boards applied a rigorous enough standard with respect to theirdisclosure responsibilities. Foreign issuers are not even obligated to abide byU.S. governance standards. They must, however, disclose the differences.34

32 See In re Franchard Corp., 42 S.E.C. 163, 172 (1964) (securities laws did not “define Federalstandards of directors’ responsibility in the ordinary operations of business enterprises and nowhereempowers us to formulate administratively such regulatory standards. The diligence required of reg-istrant’s directors in overseeing its affairs is to be evaluated in the light of the standards establishedby State statutory and common law.”).

33 See In re McKesson & Robins, Inc., Accounting Series Release No. 19, Exchange Act ReleaseNo. 2707 (Dec. 5, 1940). See also Exchange Act Release No. 9548 (March 23, 1972) (“To this end,the Commission, in the light of the foregoing historical recital, endorses the establishment by allpublicly-held companies of audit committees composed of outside directors and urges the businessand financial communities and all shareholders of such publicly-held companies to lend their full andcontinuing support to the effective implementation of the above-cited recommendations in order toassist in affording the greatest possible protection to investors who rely upon such financial state-ments.”).

34 See Exchange Act Release No. 58620 (Sept. 23, 2008) (“New Item 16G would require foreignprivate issuers to provide a concise summary in their annual reports of the significant ways in whichthe foreign private issuer’s corporate governance practices differ from the corporate governance prac-tices followed by domestic companies under the relevant exchange’s listing standards.”).

THE REGULATION OF CORPORATE DISCLOSURE§ 2B.03[1]


[2] Director Resignations

An early example of the use of disclosure to impact board behavior was therequirement of disclosure of disagreements at the board level, at least thoseleading to a director’s resignation or decision not to stand for re-election.35 Therequirement had little to do with material information. It was, instead,inextricably linked to the corporate governance process, mostly by providingleverage to a resigning director unhappy with the actions of the board, whetherdisclosure related or otherwise. As the Commission noted:

disclosure of director resignations or declinations to stand forre-election is consistent with the increasing emphasis on themonitoring function of corporate boards and would provide usefulinformation to investors in assessing the quality of management. It isalso expected that the proposals could enhance the effectiveness ofdirectors by assuring them a forum in which to express differencesof opinion on matters that are sufficiently serious to result in termi-nation of the director’s association with the issuer.36

The requirement, therefore, allowed a director who objected to any improprietyto force disclosure of the disagreement. This gave boards an incentive to resolvesuch disagreements and avoid the resulting publicity.

Commentators complained that the provision would discourage thedevelopment of stronger boards and hamper debate.37 The Commission left tothe resigning director the sole discretion to determine whether disclosure shouldoccur.38 Thus, disclosure of this supposedly material information depended notupon its importance to investors or shareholders but upon the predilections of thedeparting director. It took until 2004 before the Commission finally eliminated

35 Item 5.02(a), Form 8-K.36 Exchange Act Release No. 14970 (July 18, 1978). The provision did not apply to a resignation

or failure to stand for re-election for “personal reasons.” Id.37 Exchange Act Release No. 15384 (Dec. 6, 1978) (adopting release) (“Some commentators who

opposed adoption of the proposal were concerned that this disclosure would discourage the evolutionof stronger boards by increasing divisiveness among board members. Others noted that the proposalmight make it more difficult to attract and retain directors with divergent viewpoints.”).

38 Only where the resigning director provided the board with a letter explaining the disagreementwas disclosure mandated. Exchange Act Release No. 15384 (Dec. 6, 1978) (adopting release) (“How-ever, after considering the commentary, the Commission believes that, on balance, it is more appro-priate to require disclosure only upon the request of the director. If disclosure is triggered by directorrequest, the director will have a forum if he chooses to use it, and the issuer will be relieved of anyobligation to document and characterize what it believes are the reasons for director resignations.”).Originally requiring the disclosure to be filed within 15 calendar days, the Commission eventuallyreduced the period to five business days. See Exchange Act Release No. 26587 (March 2, 1989).

GOVERNANCE AND DISCLOSURE § 2B.03[2]


this discretion and imposed an affirmative duty to disclose a disagreement,irrespective of the wishes of the resigning director.39

Under Item 5.02(a) of Form 8-K, disclosure is required any time a directorresigns or refuses to stand for re-election because of a disagreement known to anexecutive officer of the company in connection with the company’s operations,policies, or practices or whenever a director has been removed for cause.Disclosure includes:

• the date of resignation, refusal to stand for re-election, or removal;• any positions held by the director on any committee of the board at the

time of resignation, refusal to stand for re-election, or removal; and• a brief description of the disagreement.40

The company must show the disclosure to the departing director and provide anopportunity to submit a letter setting forth any disagreements. The letter must befiled as an exhibit within two business days of receipt.

The reporting requirement has gone beyond the resignation of directors.Companies must file a current report anytime a director is added to the boardwithout shareholder approval. The form must identify the director and date ofelection and must include “a brief description of any arrangement orunderstanding between the new director and any other persons, naming suchpersons, pursuant to which such director was selected as a director.”41 Inaddition, the disclosure must include the board committees assigned to thedirector and certain related party transactions. Finally, there must also be a “briefdescription” of any material contract or arrangement involving the director.

The provision has also been expanded to include the resignation of topofficers, including the CEO and CFO.42 The Current Report must be filed when-ever the officer resigns, retires, is removed or has refused to stand for election.43

39 See In re Hewlett-Packard Company, Exchange Act Release No. 55801 (admin. proc. May 23,2007) (“On May 18, 2006, HP’s Board of Directors learned the findings of the company’s leak inves-tigation and voted to request the resignation of a director believed to have violated HP’s policies byproviding confidential information to the press. Silicon Valley venture capitalist and fellow directorThomas Perkins (not the source of the leak) voiced his strong objections to the handling of the mat-ter, announced his resignation, and walked out of the Board meeting. Contrary to the reportingrequirements of the federal securities laws, HP failed to disclose to investors the circumstances ofMr. Perkins’ disagreement with the company.”).

40 Item 5.02(a) of Form 8-K.41 Item 5.02(d) of Form 8-K.42 Specifically, the provision applies to any principal executive officer, president, principal finan-

cial officer, principal accounting officer, principal operating officer, or any person performing similarfunctions. Item 5.02(b) of Form 8-K.

43 See In re NetAir.com, Inc., Exchange Act Release No. 46465 (admin. proc. Sept. 6, 2002)(“NetAir has violated Section 13(a) of the Exchange Act and Rule 13a-11 by (i) failing to file a Form



In addition, disclosure must also occur of any new appointment, including thename, date of appointment, certain background information,44 and a brief descrip-tion of any employment contract. The disclosure, however, is weaker than thatapplicable to directors, with the company not having to provide the reason for anofficer’s departure.45

[3] Enforcement Proceedings and Governance

The Commission also used enforcement proceedings to improve thegovernance process. Having adequate procedures was not enough to ensureaccurate and complete disclosure. It also required a board of directors willing toenforce the disclosure requirements, which was potentially less likely withdirectors under the sway of the CEO46 or motivated by friendship.47

The Commission has the authority to bring actions against executiveofficers under the antifraud provisions both as primary or secondary violators,and for “causing” violations of the securities laws. The agency has used theseproceedings to issue pronouncements on the duties of directors in the disclosureprocess. In addition, remedies imposed on companies provide strong indicationsof the Commission’s views on the proper form of governance.

Perhaps the most pronounced intrusion into the governance processthrough the mechanism of an enforcement proceeding occurred in In re WR

8-K disclosing that its only two officers and directors have resigned from the corporation, and thatNetAir now has no officers or directors,”).

44 The report must include the information required by Items 401(b), (d), (e), and Item 404(a) ofRegulation S-K (17 C.F.R. § 229.401(b), (d), (e) and § 229.404(a).

45 Exchange Act Release No. 46084 (June 17, 2002) (“One important difference between the pro-posed disclosure under this Item 5.02(b) and the proposed disclosure about a director’s departurebecause of a disagreement under proposed Item 5.02(a) is that if an officer resigns, is terminated orreassigned, as the result of a disagreement with the company, the company would not be obligatedto disclose the reasons for, or seek the officer’s explanation of, the departure as it would be if a direc-tor departed under similar circumstances. We believe that the nature of the relationship between adirector and the company’s security holders, including the security holders that elect directors, is suf-ficiently different to justify the expanded procedures for directors. The function of directors is tooversee the company for the shareholders to whom they are directly answerable.”).

46 See In re WR Grace, Exchange Act Release No. 39157 n.5 (Sept. 30, 1997) (Section 21(a)Report) (“Indeed, this matter demonstrates that corporate disclosure mechanisms cannot compensatefor the failures of individuals. WRG’s procedures failed because, among other reasons, Grace, Jr. didnot disclose some of his retirement benefits and the proposed transaction with his son in question-naires which WRG distributed to officers and directors to gather information for disclosure in WRG’sproxy statements and periodic reports.”).

47 In re Friedberg, Exchange Act Release No. 43129 (admin. proc. Aug. 8, 2000) (“He allowedhis loyalty to a friend to override his obligations to ensure that the company’s disclosures were accu-rate and complete.”).



Grace,48 a Section 21(a) Report.49 The case involved the failure to disclosecertain benefits provided to the retiring CEO. Among other things, the CEOwould continue to receive “various substantial perquisites,” including use of: (a)a Company-owned apartment with a market value estimated to be in excess of $3million that came with a cook; (b) a limousine and driver on a 24-hour basis; (c)full-time secretaries and administrative assistants; (d) corporate aircraft; (e) homenursing services; and (f) security services.50

The 1993 proxy statement for the company did not disclose the perquisites,stating only that the CEO would receive “certain other benefits.” The agreementwas filed as an exhibit but did not mention the perquisites. Similarly, the proxystatement said nothing about the costs of these benefits.51 At least two directorsaware of the perquisites, including one outside director, reviewed the disclosurebefore filing. The CEO had also filled out a D&O questionnaire and made nomention of the perquisites. The failure resulted in part from a “corporate culture”at the company in which the CEO had “substantial influence.”

The Commission viewed the omission as a failing of the board of directors.As the agency noted:

Serving as an officer or director of a public company is a privilegewhich carries with it substantial obligations. If an officer or directorknows or should know that his or her company’s statements con-cerning particular issues are inadequate or incomplete, he or she hasan obligation to correct that failure. An officer or director may relyupon the company’s procedures for determining what disclosure isrequired only if he or she has a reasonable basis for believing that

48 In re WR Grace, Exchange Act Release No. 39157 (Sept. 30, 1997) (Section 21(a) Report).49 Section 21(a) allows the Commission to publish information “concerning any . . . violations”

and to investigate “any facts, conditions, practices or matters which it may deem necessary or proper”in fulfilling its responsibilities under the Exchange Act. 15 U.S.C. § 78t(a). The Commission alsofiled an administrative proceeding. See In re W.R. Grace & Co., Exchange Act Release No. 39156(admin. proc. Sept. 30, 1997).

50 In re W.R. Grace & Co., Exchange Act Release No. 39156 (admin. proc. Sept. 30, 1997) (“TheCompany provided Grace, Jr. with directors’ and officers’ questionnaires in the course of preparingits 1992 Form 10-K and 1993 proxy statement and its 1993 Form 10-K and 1994 proxy statement.These questionnaires contained questions asking whether [the CEO] received certain benefits fromthe Company during the preceding year, including, among other things, use of Company property,including apartments; housing and other living expenses (including domestic service) provided at hisprincipal and/or vacation residence; and other perquisites. [The CEO] incorrectly responded ‘no’ tothese questions.”) (footnote omitted).

51 In re W.R. Grace & Co., Exchange Act Release No. 39156 n.10 (admin. proc. Sept. 30, 1997)(“After information concerning Grace, Jr.’s ‘other benefits’ became public, WRG disclosed in its1995 proxy statement that the benefits provided to [the CEO] pursuant to the ‘other benefits’ pro-vision cost the Company $3,601,500 in fiscal year 1993, of which approximately $2,700,000 wasattributable to Grace, Jr.’s having access to corporate aircraft.”).



those procedures have resulted in full consideration of thoseissues.52

Thus, officers and directors had an obligation to “take steps to ensure the accu-racy and completeness of the statements contained therein, especially as theyconcern those matters within their particular knowledge or expertise.” Thisrequired a “vigilant” exercise of “authority throughout the disclosure process.”53

In effect, the case required directors and executive officers to play a moreactive role in the disclosure process. The case seemed more about fiduciaryobligations than duties under the federal securities laws.54 There was, however,little follow-up55 and the decision seemed to have at best marginal impact onboard behavior. Other decisions by the Commission attempted to fixresponsibility more specifically, usually by imposing responsibilities on aparticular committee of the board.56

52 In re WR Grace, Exchange Act Release No. 39157, § V (Sept. 30, 1997).53 Prior cases had emphasized the role of directors in the disclosure process but only when con-

fronting evidence of fraud. See In re Cooper Cos., Exchange Act Release No. 35082 (Dec. 12, 1994).See also In re National Tel. Co., Exchange Act Release No. 14380 (Jan. 16, 1978); In re Gould, Inc.,Exchange Act Release No. 13612 (June 9, 1977); In re Stirling Homex, Exchange Act Release No.11516 (July 2, 1975). As the Commission noted: “Each of these Reports focused on the failure ofnon-management directors to act effectively when confronted with evidence of management’sinvolvement in possible securities fraud. The present matter, in contrast, deals with the obligations ofofficers and directors where a company’s violations do not constitute fraud.” In re WR Grace,Exchange Act Release No. 39157 n.2 (Sept. 30, 1997) (Section 21(a) Report).

54 One commissioner dissented, noting that the company had policies and procedures in place thatwere designed to ensure accurate disclosure. Moreover, “there do not appear to have been any “redflags” or warnings to indicate that this system—which included the employment of respected andcompetent securities counsel—was breaking down, or was inadequate to produce documents thatwould comply with the federal securities laws.” In re WR Grace, Exchange Act Release No. 39157,Dissent of Commissioner Wallman (Sept. 30, 1997) (Section 21(a) Report).

55 Although the importance of independent directors received some attention. See In re Walt Dis-ney Corp., Exchange Act Release No. 50882 (admin. proc. Dec. 20, 2004) (“The independence ofdirectors is a linchpin of sound corporate governance, and is crucial to the objective oversight of man-agement. The interests of the shareholders should be the paramount concern of the board of direc-tors, and maintaining the independence of directors allows the board to fulfill its fiduciaryresponsibilities objectively and candidly. The Commission’s disclosure program endeavors to illumi-nate the information that would allow a shareholder to evaluate the independence of the directors andvote on a more fully informed basis with respect to the election of directors.”).

56 See, e.g., In re Hycel, Inc., Exchange Act Release No. 14981 (admin. proc. July 20, 1978)(requiring audit committee to review annually certain policies with respect to executive compensa-tion). See also Exchange Act Release No. 47654 (Apr. 9, 2003) (“Effective oversight of the financialreporting process is fundamental to preserving the integrity of our markets. The board of directors,elected by and accountable to shareholders, is the focal point of the corporate governance system.The audit committee, composed of members of the board of directors, plays a critical role inproviding oversight over and serving as a check and balance on a company’s financial reportingsystem.”).



A more recent example occurred in SEC v. Kohavi.57 The case arose out ofbackdating allegations at Mercury Interactive. Three outside directors settledcharges alleging that they recklessly approved backdated stock option grants andsigned SEC filings that were false. The three directors sat on the board and servedon the audit and compensation committees.

According to the complaint, the directors approved 21 grants upon therecommendation or direct participation of senior management. The directorsknew that the options were required to be priced at the closing price of Mercurystock on the date awarded. Nonetheless, the directors approved the options“while failing to observe, among other things, that the exercise price of stockoptions they were approving was less than the market price of the company’sstock at the time of approval.” Moreover, there were “numerous facts andcircumstances” indicating that management had backdated the options. Thedirectors were required to pay a $100,000 civil penalty and enjoined fromviolating the securities laws, including the antifraud provisions.

The case was notable because it meant the Commission was chargingoutside directors without proof that the directors actually knew about thebackdating. Instead, the Commission essentially sanctioned the directors forinattention. They should have noticed the surrounding circumstances thatsuggested backdating and verified the contents of the documents supporting theissuance of the options. The directors, in other words, should have conductedtheir own examination and investigation and relied less on executivemanagement.

§ 2B.04 DISCLOSURE AND THE BOARD OF DIRECTORS

[1] Overview

With state law playing little role in affirmatively improving the governanceprocess, attention shifted to the stock exchanges. Sometimes as a result ofjawboning by the Commission and, more recently, through legislative efforts, theexchanges have taken the lead in imposing more rigorous corporate governancerequirements, at least for listed companies. The requirements have tended toinvolve reforms at the board level with increased reliance on independentdirectors and specific committees of the board. The changes collectively soughtto make the board more independent and less beholden to top officers.

The NYSE had long played a role in the governance process. Early listingstandards centered on disclosure and voting rights and had little to do with board

57 Litigation Release No. 20724 (N.D. Cal., Sept. 17, 2008).



behavior.58 The NYSE made occasional, tepid suggestions that companiesinstitute audit committees with non-management directors but invariably stoppedshort of actually imposing the requirement.59

In the aftermath of the corporate bribery scandal in the 1970s,60 theCommission pressured the NYSE into reforming its listing standards tostrengthen the system of governance.61 The Exchange duly adopted rulesrequiring an audit committee consisting entirely of independent directors.62 Thedefinition of independent, however, merely required that the directors be“independent of management and free from any relationship that, in the opinionof its Board of Directors, would interfere with the exercise of independentjudgment as a committee member.”63

58 In 1926, the NYSE put in place the one-share, one-vote requirement for shareholders, withminimum voting rights for preferred shareholders instituted 14 years later. See Roberta S. Karmel,The Future of Corporate Governance Listing Requirements, 54 SMU L. Rev. 325, 328–29 (2001).For a brief overview of the listing standards in place prior to 1977, see Exchange Act Release No.13346 n.6 (March 9, 1977) (“For example, since 1926, the NYSE has refused to list non-voting com-mon stock, and currently it will delist the voting common stock of a company which creates a classof non-voting common stock or fails to solicit proxies for meetings of its stockholders. As a matterof policy, the NYSE refuses to list a class of stock whose voting rights are subject to unusual restric-tions. Certain redemption schemes are prohibited. In authorizing additional shares distributed by astock dividend, a company can be required to transfer from earned surplus to permanent capitaliza-tion an amount equal to the fair value of such shares. A company whose board of directors is dividedinto more than three classes may not list its shares; if the board is divided into classes, they shouldbe of approximately equal size and tenure, and the directors’ terms of office should not exceed threeyears. Since 1940, listed preferred stock must have certain minimum provisions enabling holders toobtain board representation in the event of dividend default, and must be protected against compul-sory change in rights and preferences.”) (footnotes and cites omitted).

59 See Exchange Act Release No. 13346 n.9 (March 9, 1977) (“The NYSE first suggested the con-cept of an audit committee in 1940, and in recent years has strongly recommended that each listedcompany form an audit committee preferably composed exclusively of outside directors.”).

60 See Exchange Act Release No. 13346 n.9 (March 9, 1977) (noting that “support for audit com-mittees independent of management developed in the wake of recent revelations of questionable andillegal corporate payments.”).

61 See Roberta S. Karmel, The Future of Corporate Governance Listing Requirements, 54 SMUL. Rev. 325, 340 (2001). See also Exchange Act Release No. 41987 (Oct. 7, 1999) (“Since the early1940s, the Commission, along with the auditing and corporate communities, has had a continuinginterest in promoting effective and independent audit committees. It was, in large measure, with theCommission’s encouragement, for instance, that the self-regulatory organizations first adopted auditcommittee requirements in the 1970s.”).

62 See Exchange Act Release No. 13346 (Mar. 9, 1977). The audit committee had to consist ofdirectors independent of management and free from any relationship that “would interfere with theexercise of independent judgment as a committee member.” Id. NASDAQ merely required that amajority of the directors on the audit committee be independent. See Exchange Act Release No.22602(Nov. 7, 1985).

63 The language is quoted in Exchange Act Release No. 20767 n.5 (March 20, 1984).



By the new millennium, the governance requirements had toughenedsomewhat, particularly in connection with audit committees.64 Listed companieshad to have an audit committee consisting of independent directors who were“financially literate.” In addition, the NYSE required a charter delineating thecommittee’s responsibilities.65

Despite these efforts, the governance requirements contained gaps. Thedefinition of independence contained little content and left it to each company todetermine. The audit committee, while useful, typically had an uncertain or evensecondary role in the financial disclosure process, with most of the responsibilityresting remaining with executive officers. Moreover, there was nothing in thegovernance standards that prevented the CEO from controlling the directornomination process.

That changed with the collapse of Enron and Worldcom. Congressresponded by adopting Sarbanes-Oxley, an Act that to some degree toughenedgovernance standards. In addition, however, the governance requirementsimposed by the exchanges again underwent substantial revision. The NYSErequired that the boards of listed companies consist of a majority of independentdirectors.66 In addition, each board had to have a compensation, nominating, andaudit committee staffed solely by independent directors. Finally, the definition ofindependent was strengthened.67

SOX and implementing rules by the Commission imposed significantadditional obligations on the audit committee. Audit committees were givenspecific responsibilities, including the right to hire and fire the outside auditor.68

In addition, the definition of independent was made tougher, with members of theaudit committee being prohibited from accepting any payment, other than fees,directly or indirectly from the company.

The exchange standards, however, only went so far. While boards wererequired to have independent directors and key committees, the listing standardscould do little to affect the actual process used by the board. Moreover, therewere reasons to believe that enforcement of the standards would remain weak.The exchanges had little economic incentive to enforce the standards andshareholders lacked a private right of action.

64 In the 1990s, the Commission developed considerable concern with the practice of earningsmanagement. See Exchange Act Release No. 41987 (Oct. 7, 1999) (“We have seen a number of sig-nificant changes in our markets, such as technological developments and increasing pressure on com-panies to meet earnings expectations, that make it ever more important for the financial reportingprocess to remain disciplined and credible.”) (footnote omitted). Audit committees with independentdirectors was perceived as one way to reduce the incidence of the practice.

65 See Exchange Act Release No. 42233 (Dec. 14, 1999).66 See Exchange Act Release No. 47672 (Apr. 11, 2003).67 See Exchange Act Release No. 48745 (Nov. 4, 2003).68 See Section 10A(m), 15 U.S.C. § 78j-1(m). See also Rule 10A-3, 17 C.F.R. § 240.10A-3.



The Commission responded to these dynamics by requiring substantialdisclosure by companies concerning their compliance with listing standards. Thisprovided an alternative mechanism for enforcing the standards, with the antifraudprovisions made available against a company that misstated its compliance. Inaddition, however, the Commission adopted a number of disclosure requirementsdesigned to affect the process used by the board and its committees. In general,the requirements had, at their core, a goal of highlighting the role of the CEO inthe governance process, with the intended purpose a reduction in that influence.

Companies, therefore, must make considerable disclosure concerning theindependence of directors, the existence of certain board committees, and theprocess used by these committees in making decisions. Much of the disclosuremust occur in the proxy statement distributed prior to the annual meeting atwhich directors will be elected.69

[2] Disclosure Requirements

In general, the Commission has consolidated all corporate governancedisclosure into Item 407 of Regulation S-K.70 The provision provides forinstructions on the disclosure of director independence, board meetings andattendance, the three board committees mandated by the exchanges(compensation, audit and nominating), and requirements with respect to processby which shareholders can communicate with the board.

[a] Independence

The presence of independent directors on the board has become perhaps themost importance change in the corporate governance landscape. Exchange tradedcompanies must have a majority of independent directors on the board.71 Asurvey of the top 100 publicly traded companies, however, revealed that most hadboards with 75% or more independent directors. In 44% of the cases, the CEOwas the only non-independent director on the board.72 Unsurprisingly, therefore,much of the Item 407 disclosure concerns independent directors.

69 See Item 7, Schedule 14A.70 See 17 C.F.R. § 229.407. The two principal exceptions are executive compensation in Item 402

and related party transactions in Item 404. 17 C.F.R. § 229.402 and § 229.404. Technical amend-ments to the provision were adopted in 2008. See Exchange Act Release No. 58656 (Sept. 30, 2008)(adopting technical amendments to Item 407).

71 See NYSE Manual, ¶ 303A.01 (“Listed companies must have a majority of independent direc-tors.”), http://www.nyse.com/Frameset.html?nyseref=http%3A//www.nyse.com/regulation/nyse/1101074746736.html&displayPage=/lcm/lcm_subsection.html.

72 See Corporate Governance Trends, Shearman & Sterling, 2008.



Public companies must identify each director and nominee73 and disclosethose who meet the definition of independent under rules of the relevantexchange.74 The disclosure must specifically identify any director on thecompensation, audit, or nominating committee who does not meet the definitionof independent.75 Definitions adopted by the company must be either posted onthe Web or attached as an appendix to the proxy statement at least once everythree years.76

Under the exchange rules, determination of independence ultimately restswith the board. The NYSE definition, while containing some categoricalcomponents, disqualifies directors who have a “material relationship” with thelisted company.77 Perhaps recognizing the discretion given to the board inmaking this determination, companies must also disclose any “transactions,relationships, or arrangement” considered by the board for each director deemedindependent.78 Disclosure, however, need only be made by “specific category ortype. . . . ”79 There must, however, be enough detail “to fully describe the natureof the transactions, relationships or arrangements.”80

At one level, the requirement acts as a double check on management. Tothe extent applying a restrictive definition of “material relationship,” the board

73 Item 407(a), 17 C.F.R. § 229.407(a). The requirements apply to any person who served asdirector for any part of the year, even if no longer on the board. See Instruction 2, Item 407(a) ofRegulation S-K.

74 Item 407(a), 17 C.F.R. § 229.407(a). Companies must use the definition of the exchange wherethey are traded, assuming the exchange requires that at least a majority of the board be independent.If they are not traded on such an exchange, the companies must pick a definition from an exchangethat does require that at least a majority of the board be independent and disclose the choice. SeeItem 407(a)(1).

75 The obligation only applies to companies required to have independent directors on board com-mittees. Item 407(a), 17 C.F.R. § 229.407(a). As a practical matter, therefore, it is limited to exchangetraded companies. For those without one of the three committees, the company must disclose the non-independent directors for the entire board. See Item 407(a)(1) (“If the registrant does not have a sepa-rately designated audit, nominating or compensation committee or committee performing similarfunctions, the registrant must provide the disclosure of directors that are not independent with respectto all members of the board of directors applying such committee independence standards.”).

76 See Item 407(a)(2), 17 C.F.R. § 229.407(a)(2) (“If a current copy of the policies is not avail-able to security holders on the registrant’s Web site, and is not included as an appendix to the reg-istrant’s proxy statement or information statement, identify the most recent fiscal year in which thepolicies were so included in satisfaction of this requirement.”).

77 See NYSE Rule 303A.02, Independence Tests.78 Item 407(a)(3), 17 C.F.R. § 229.407(a)(3). See also Exchange Act Release No. 54302A (Aug.

29, 2006) (“Consistent with the rule proposals, the amended rule requires that the disclosure be madeon a director by director basis, with separate disclosure of categories or types of transactions, rela-tionships or arrangements for each director and director nominee. We have also adopted an instruc-tion indicating that the description of the category or type must be sufficiently detailed so that thenature of the transactions, relationships or arrangements is readily apparent.”).

79 Item 407(a), 17 C.F.R. § 229.407(a).80 See Note 3, Item 407(a), 17 C.F.R. § 229.407(a).



will nonetheless be forced to reveal the non-disqualifying conflicts, at least ingeneral terms. Shareholders will be aware of the conflicts and can, as a practicalmatter, discount the director’s independence. In addition, the disclosure putspressure on the board to adopt and implement a realistic definition of “materialrelationship.”

The Commission has sanctioned a director for failing to adequatelydisclose facts that potentially impaired independence. In In re Thompson,81 theCommission relied not on Item 407 but on the independent auditor requirementto address the issue. Thompson sat on the board of three companies audited byErnest & Young (“E&Y”), including in one case the audit committee. During thesame period, he entered into a collaboration with the accounting firm to create aseries of audio CDs, ultimately receiving $377,500 for the work.

For two of the companies, Thompson completed a D&O questionnaire thatasked about the relationship between directors and auditors but failed to “fullyfurnish the details of his relationship with E&Y in response to these items.” Therelationship was likewise not disclosed in the proxy materials for thesecompanies. Thompson also signed the annual reports for the two companiesindicating that the auditor was independent.

The Commission concluded that the business relationship impaired theappearance of auditor independence and, that by filing annual reports and proxystatements indicating that the auditor was independent, the company violated thefederal securities laws.82 The Commission characterized Thompson as a “cause”of the violations. As part of the settlement, Thompson disgorged $100,000 paidin directors fees as well as interest.

While the case did not involve Item 407, it did send a significant messagethat the failure to disclose relationships that could impair independence would bethe subject of enforcement proceedings. The Commission did not charge thecompanies involved, despite the fact that they were the ones that engaged in thedisclosure violations. Apparently the Commission viewed the companies asunaware of the conflicting relationship. Nonetheless, future actions in the areamay be less restrained, if for no other reason than to encourage greater attentionat the company level.

81 Exchange Act Release No. 58310 (admin. proc. Aug. 5, 2008), available at http://www.sec.gov/litigation/admin/2008/34-58310.pdf.

82 The Commission likewise sanctioned Ernst & Young. See Exchange Act Release No. 58309(admin. proc. Aug. 5, 2008), available at http://www.sec.gov/litigation/admin/2008/34-58309.pdf.



[b] Meeting Attendance

The governance disclosure requirements also address meeting attendance.The proxy statement83 must include the number of board and committee meetingsand the directors who attended fewer than 75 percent of the total number ofmeetings (both committee and full board meetings).84

In justifying the disclosure, the Commission reasoned that the informationwould “facilitate shareholder assessment of the [director’s] performance as wellas the effectiveness of an issuer’s board and committee system generally.”85 Inother words, the requirement was designed to affect substantive behavior byincreasing board attendance. Presumably, directors will make certain that theyattend enough meetings to avoid the public dunning that would occur withdisclosure.86 The requirement has probably worked. At the same time, it is notperfect and does not prevent companies from inserting into the proxy disclosurean explanation for poor attendance.

Companies must also reveal any policy governing board attendance at theannual meeting of shareholders and the number of directors who actuallyattended.87 Another effort to use disclosure to affect substantive behavior, therequirement was designed to increase director attendance at annual meetings.Attendance would provide shareholders with additional opportunity to

83 The instructions provide that the information can be disclosed on the company’s web site ratherthan in the proxy statement. See Instruction, Item 407(b)(2), 17 C.F.R. § 229.407(b)(2). While stillpublic, the option essentially forces shareholders to have to go to multiple locations to obtain all ofthe relevant data.

84 Item 407(b). See also Exchange Act Release No. 15384 (Dec. 6, 1978) (“The Commission rec-ognizes that in particular instances directors may provide the board with valuable insight and exper-tise without actually attending formal meetings on more than an intermittent basis. However, webelieve that these occasions are likely to be the exception and that, in general, attendance is an indi-cation of effective board and committee functioning and is relevant to an evaluation of directors forelection purposes. In addition, the Commission is not persuaded that the contemplated disclosurewould deter responsible boards from holding meetings when it is appropriate to do so.”).

85 Exchange Act Release No. 14970 (July 18, 1978) (“While the Commission believes that, as ageneral matter, disclosure of attendance records would be of limited usefulness, it has tentatively con-cluded that disclosure of a director’s failure to achieve a certain minimum level of attendance couldprovide information which would facilitate shareholder assessment of his performance as well as theeffectiveness of an issuer’s board and committee system generally. In the Commission’s view, theapproach reflected in proposed Item 6(e) would elicit such information in the briefest and least bur-densome manner.”).

86 The consequences could be more severe. In at least one case, shareholders succeeded in a with-hold campaign against a director who had a poor attendance record. See http://www.theracetothebottom.org/shareholder-rights/shareholders-majority-voting-and-the-continued-need-for-acce.html.

87 In place of proxy disclosure, the information may be disclosed on the Web site. Instruction,Item 407(b)(2).



question members of the board.88 The information may be posted on a company’sWeb site rather than in the proxy statement.89

The requirements are discrete but are, on the margins, designed to raisestandards for directors. They provide shareholders with an indication of thenumber of times the board meets.90 Moreover, they encourage oversight.Directors cannot act as a check on management if they do not attend themeetings. Nonetheless, the requirement only goes so far. While encouragingattendance, it does nothing to elevate the standards of behavior once directors arein the boardroom.

[c] Committee Disclosure

Exchange traded companies must have at least three board committees,compensation, audit, and nominating/governance.91 The SEC has added a glossof disclosure to the committees. The gloss goes well beyond membership and, atleast in some cases, attempts to use disclosure to affect the processes employedby the committees.

A public company must disclose whether it has standing audit, nominating,and compensation committees or “committees performing similar functions,”the number of meetings held by each committee, and a brief description of thefunctions performed by each.92 For all three committees, the company must statewhether the committees have a charter and must either make the charter availableon the company’s Web site or attach the charter as an exhibit to the proxystatement at least once every three years.93

In addition, considerable disclosure has to occur about each specificcommittee.

88 See Exchange Act Release No. 48825 (Nov. 24, 2003) (“Directors’ attendance at annual meet-ings can provide investors with an opportunity to communicate with directors about issues affectingthe company. We are adopting a requirement that companies disclose their policy with regard todirector attendance at annual meetings and the number of directors who attend the annual meetings,as that disclosure will give security holders a more complete picture of a company’s policies relatedto opportunities for communicating with directors.”).

89 See Instruction to Item 407(b)(2) of Regulation S-K.90 According to a 2008 study, more than half of all boards of the top 100 exchange traded com-

panies met eight or fewer times. Corporate Governance Trends, Shearman & Sterling, 2008.91 See NYSE Manual, ¶ 303A.01.92 Item 407(b)(3) of Regulation S-K. Listed companies are required to have all three committees.

See NYSE Rule 303A.93 See Instruction 2 to Item 407 of Regulation S-K.



[i] Nominating Committee94

The Commission has long required disclosure of the existence of anominating committee, although only recently has this included the process usedin selecting candidates.95 The public explanation was the need to make thenominating process more transparent.96 Transparency in turn would permit share-holders to better evaluate the competency of the nominating committee.97

In fact, the justification was quite different and went more to thegovernance of the company, as earlier releases acknowledged.98 The impetus forthe committee came as a result of increased pressure by shareholder groups foraccess to the company’s proxy statement for their nominees. The Commissiondeclined to provide the authority but opted to pressure companies to open up thenominating process and encourage boards to accept nominees from shareholders.It did not work. Perhaps as a result, the purpose of the disclosure requirementsshifted. Instead of facilitating shareholder nominees, the Commission sought touse disclosure to reduce the influence of the CEO.

94 Exchange traded companies must have a nominating committee; other public companies neednot. Item 407 provides that any company without a standing nominating committee must “state thebasis for the view of the board of directors that it is appropriate for the registrant not to have sucha committee and identify each director who participates in the consideration of director nominees.”

95 See Exchange Act Release No. 15384 (Dec. 6, 1978) (requiring only disclosure of existence ofnominating committee, whether committee considered shareholder nominees, and process for sub-mission).

96 Exchange Act Release No. 48825 (Nov. 24, 2003) (“This enhanced disclosure is intended toprovide security holders with additional, specific information upon which to evaluate the boards ofdirectors and nominating committees of the companies in which they invest. Further, we intend thatincreased transparency of the nomination process will make that process more understandable tosecurity holders.”).

97 Exchange Act Release No. 48825 n.28 (Nov. 24, 2003) (“Finally, an additional, specific dis-closure requirement regarding the treatment of candidates put forward by large security holders orgroups of security holders that have a long-term investment interest is appropriate, as it will provideinvestors with information that is useful in assessing the actions of the nominating committee.”).

98 See Exchange Act Release No. 14970 (July 18, 1978) (“Information relating to nominatingcommittees would be important to security holders because a nominating committee can, over time,have a significant impact on the composition of the board and also can improve the director selectionprocess by increasing the range of candidates under consideration and intensifying the scrutiny givento their qualifications. Additionally, the Commission believes that the institution of nominating com-mittees can represent a significant step in increasing security holder participation in the corporateelectoral process, a subject which the Commission will consider further in connection with its con-tinuing proxy rule re-examination.”).



Specifically, the proxy statement must reveal99 any policies governing theconsideration of nominees recommended by shareholders,100 including theprocedures for submitting nominees.101 The obligations extend to any differencesin the manner in which the committee evaluates shareholder submitted nominees.Limited to disclosure, the Commission did not require companies to adopt thesepolicies, although they in fact became common. Likewise, the Commission didnot require that boards actually accept qualified nominees from shareholders. Asa result, the policies have done little to increase shareholder representation on theboard.102

In addition, the company must disclose any minimum qualifications fornominees, including any specific qualities or skills deemed by the committee asnecessary.103 The requirement was probably designed to force boards to publicizequalifications in order to allow shareholders to submit nominees who would notbe disqualified. thereby limiting the Board’s discretion. The more significanteffect has likely been to force companies that have in place advance noticebylaws to reveal the standards for director qualifications and prevent boards fromdisqualifying candidates proposed by insurgents.

The rules treat nominees from large shareholders differently. For anomination from shareholders owning more than 5 percent of the voting stock,

99 The disclosure applies to the nominating committee or any committee or group of directors thatprovide a similar function. The requirement can also apply, where appropriate, to the entire board.See Instruction to Item 407(c)(2) of Regulation S-K.

100 Item 407(c)(2)(ii) of Regulation S-K. The policy may be as simple as a statement that thecommittee “will consider director candidates” recommended by shareholders. Id. If no such policyexists, an explanation of “the basis for the view” must be provided. See Item 407(c)(2)(iii) of Regu-lation S-K. Any material changes in the procedures from the last meeting also must be disclosed.

101 Item 407(c)(2)(iv) of Regulation S-K. Material changes also must be disclosed. See Item407(c)(3) of Regulation S-K. Changes need only appear in a quarterly or annual report.

102 For a more detailed discussion of this matter, see J. Robert Brown, Jr., The SEC, CorporateGovernance, and Shareholder Access to the Board Room, Utah L. Rev. (2009). The paper is avail-able athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095032.

103 Item 407(b)(2), Instruction (“Describe any specific minimum qualifications that the nominat-ing committee believes must be met by a nominating committee-recommended nominee for a posi-tion on the registrant’s board of directors, and describe any specific qualities or skills that thenominating committee believes are necessary for one or more of the registrant’s directors to pos-sess.”). The requirements do not extend to those governing diversity. See Exchange Act Release No.48825 (Nov. 24, 2003) (“Many commenters that supported the disclosure requirements suggested thatwe expand the requirements to require companies to disclose the extent to which they take into con-sideration diversity, in particular race and gender, in nominating candidates. We have not includedsuch a requirement in the standards we are adopting today, as we believe this particular consider-ation, as well as other considerations made by a company, will likely be addressed adequately by thenew disclosure item requiring companies to disclose their criteria for considering board candidates.Further, we do not view it as appropriate to identify any specific criteria that a company must addressin describing the qualities it looks for in board candidates.”) (footnote omitted).



the proxy statement must identify the shareholder group, the candidatenominated, and the committee’s disposition of the nomination.104

The disclosure requirements, however, go beyond those designed toencourage board consideration of shareholder nominees. The Commission hasincluded mandatory disclosure about the nominee selection process. Theinformation goes less to qualifications and more to identifying influences in theselection process, specifically the CEO’s influence. The proxy therefore mustcontain disclosure about the process used to identify and evaluate nominees.105

For those selected,106 the company must identify by category who recommendedthe nominee. Categories include “security holder, non-management director,chief executive officer, other executive officer, third-party search firm, or otherspecified source.”107 All of the choices are broad categories except one, the CEO.To the extent a nominee comes from that specific source, the market will know.

In a tepid fashion, the rules mandate some disclosure of the use ofconsultants participating in the selection process. Specifically, disclosure mustinclude the function of any firm hired to “identify or evaluate” potentialnominees. The name of the consultant need not be identified, nor the fees paid.

104 For disclosure to apply, the nomination must be received not later than 120 calendar daysbefore the date of release of the proxy statement for the prior year’s annual meeting. Item407(c)(2)(ix). The provision provides an out. Disclosure need not occur unless the group and iden-tified candidate both provide written consent. As the instructions indicate, this is an affirmativerequirement imposed on the shareholder group. See Exchange Act Release No. 48825 (Nov. 24, 2003)(“The company would not be obligated to request such materials where a security holder or groupdoes not otherwise provide their consent and proof of ownership.”). The Commission justified therequirement by noting that it would “provide investors with information that is useful in assessingthe actions of the nominating committee.” Id. The Commission has also proposed but never adopteda rule that would permit large shareholders to insert nominees into management’s proxy statement.Exchange Act Release No. 48626 n.52 (Oct. 14, 2003) (proposing release). Highly controversial, noaction was ever taken on the proposal.

105 This has to include “any differences in the manner in which the nominating committeeevaluates nominees for director based on whether the nominee is recommended by a securityholder; . . . .” See also Exchange Act Release No. 48825 (Nov. 24, 2003) (“Disclosure as to whetherand how they may participate in a company’s nomination process, and the manner in which their can-didates are evaluated, including differences between how their candidates and how other candidatesare evaluated, therefore, represents important information for security holders.

106 That is, those included on management’s proxy card, excluding executive officers and thosestanding for reelection. Item 407(c)(2)(vii).

107 See Exchange Act Release No. 48825 (Nov. 24, 2003) (“In disclosing the category of personsor entities that initially recommended a candidate to the nominating committee, companies shouldensure that they identify also any person or entity that caused a particular candidate to be recom-mended. For example, if the chief executive officer asks a third party to evaluate a potential candi-date, and that third party ultimately recommends the candidate to the nominating committee, boththe chief executive officer and the third party should be identified as recommending parties in thecompany’s disclosure. We have provided for disclosure of more than one type of source for a nomi-nee to address the possibility of multiple sources.”).



The disclosure requirements do not extend to any other business conducted bythe consultant that might provide evidence of a conflict of interest.

The disclosure provisions, in general, must be viewed as ineffective inseeking to identify influence over the nomination process. While the source of anominee must be revealed, there is nothing in the rules that requires disclosureof any contact with, or advice from, the CEO in connection with the nominees.As a result, the CEO can have considerable influence over the process in amanner that is not publicly revealed. Likewise, the provisions do not provideadequate disclosure in connection with the use of any consultant employed in thesearch process.

[ii] Audit Committee

Audit committees have long been in the eye of the corporate governancestorm. These committees represent the segment of the board most involved in thefinancial disclosure process. As such, they have been the focus of both theCommission and the stock exchanges in their efforts to improve the efficacy ofthe financial disclosure process. While a number of tentative efforts atstrengthening the hand of these committees occurred prior to the newmillennium, the reforms in SOX fundamentally altered the nature and jurisdictionof the audit committee, substantially increasing its role and its importance.

[A] Item 407(d) of Regulation S-K

SOX significantly increased the requirements for audit committees.108

Section 301 amended the Exchange Act to require listed companies to have anaudit committee with certain specified authority.109 Moreover, SOX put in placea definition of independence for the directors serving on the audit committee thatwas much stricter than the one used by the exchanges.

The Commission, in turn, added additional disclosure requirements that toa large degree enhanced the new provisions in SOX. Specifically, a proxystatement must reveal considerable information about the inner workings of thecommittee. Disclosure must include whether:

108 The term is defined in Section 3(a)(56) of the Exchange Act and consists of the committee (orin the absence of a committee, the entire board) created “for the purpose of overseeing the account-ing and financial reporting processes of the issuer and audits of the financial statements of theissuer; . . . .” 15 U.S.C. § 78c(a)(56).

109 See Section 10A(m), 15 U.S.C. § 78j-1(m). The obligation to have an audit committee is acondition of listing and continued listing on a stock exchange. Thus, SOX stopped short of mandat-ing the committees for all public companies, with the requirement not applicable to companies tradedin the Pink Sheets or the OTCBB.



(A) The committee has reviewed and discussed the audited financialstatements with management;

(B) The committee has discussed with the independent accountants thematters required to be discussed by the statement on Auditing Stan-dards No. 61;110

(C) The committee has received the written disclosures and the letter fromthe independent accountants required by “applicable requirements ofthe Public Company Accounting Oversight Board regarding the inde-pendent accountant’s communications with the audit committee con-cerning independence,” and has discussed with the independentaccountant the independent accountant’s independence; and

(D) The committee recommended to the board of directors that theaudited financial statements be included in the company’s annualreport on Form 10-K.111

The proxy must identify whether the company has a “separately-designatedstanding audit committee” and the committee members must appear underneaththe disclosure.112

Another significant change wrought by SOX concerned financial expertiseon the audit committee. State law imposed no requirements of expertise fordirectors on the board or on any relevant committee. The NYSE had moved inthat direction by generally requiring the appointment of directors to the auditcommittee who met standards of financial expertise. The requirement was,however, general and contained little content.

SOX sought to alter the approach, although in a modest fashion. Section407 ordered the Commission to adopt rules governing financial experts on theaudit committee. The approach, however, stopped short of requiring the expert.Instead, the Commission could only require issuers to disclose the expert if theyhad one. Otherwise, companies could be made to reveal the reasons why they didnot. Despite this convoluted approach, the practical effect is that publiccompanies now include financial experts on the audit committee and identify thequalifying directors.

110 Available at http://www.pcaobus.org/standards/interim_standards/auditing_standards/index_au.asp?series=300&section300.

111 Item 407(d)(3)(i) of Regulation S-K. The information must appear in the proxy statement. Itis not, however, treated as “soliciting material” or as “filed” for purposes of the proxy rules and Sec-tion 18 of the Exchange Act. Nor shall the information “be deemed to be incorporated by referenceinto any filing” unless the company does so expressly.

112 In the absence of a committee, the entire board will be treated as the audit committee. Therequirement applies in connection with a proxy statement or annual report filed in connection withthe election of directors. Item 407(d)(4)(i) of Regulation S-K. Certain narrow exceptions to therequirements exist. See Item 407(d)(4)(i)(C) of Regulation S-K.



The Commission has, therefore, required disclosure of the identity of afinancial expert on the audit committee,113 including the name of the individualand whether he or she qualifies as independent based upon the relevant listingstandard.

To meet the requirement of the financial expert, the director must have:

• An understanding of generally accepted accounting principles andfinancial statements;

• The ability to assess the general application of such principles in con-nection with the accounting for estimates, accruals, and reserves;

• Experience preparing, auditing, analyzing or evaluating financial state-ments that present a breadth and level of complexity of accountingissues that are generally comparable to the breadth and complexity ofissues that can reasonably be expected to be raised by the registrant’sfinancial statements, or experience actively supervising one or morepersons engaged in such activities;

• An understanding of internal control over financial reporting; and• An understanding of audit committee functions.

In addition, the expert must have acquired the attributes through:

• Education and experience as a principal financial officer, principalaccounting officer, controller, public accountant or auditor, or experi-ence in one or more positions that involve the performance of similarfunctions;

• Experience actively supervising a principal financial officer, principalaccounting officer, controller, public accountant, auditor or person per-forming similar functions;

• Experience overseeing or assessing the performance of companies orpublic accountants with respect to the preparation, auditing or evalua-tion of financial statements; or

• Other relevant experience.114

Finally, the company also must “provide a brief listing of that person’s relevantexperience.”115 The designated individual does not qualify as an expert under thesecurities laws, including Section 11 of the Securities Act. Nor does designation

113 For a definition of financial expert, see Item 407(d)(5)(ii). The Instructions specify that onlyone expert need be revealed. If there are others on the committee, the company “is not required todisclose the names of those additional persons.” Where no such expert exists, the company must pro-vide an explanation for the absence.

114 See Instruction 2 to Item 407(d)(5), 17 C.F.R. § 229.407(d)(5).115 Item 407(d)(5)(ii).



increase the responsibilities of the director116 or decrease the responsibilities ofthe other directors.117 Disclosure concerning financial experts need only appearin the annual report rather than in the proxy statement.118

[B] Rule 10A-3 of the Exchange Act

SOX sought to regulate audit committees but did so in an indirect way.Section 301 commanded the Commission to “direct” the exchanges to prohibitthe listing of any company that did not have an audit committee in compliancewith the requirements of the provision.119 As a result, the failure to meet therequirements is not enforceable by the Commission but by the exchange. Moreover, the appropriate remedy is delisting.

Director Independence. SOX did more than regulate the jurisdiction of theaudit committee; it also toughened the requirements for those serving on thecommittee. As a result, members of the audit committee for listed companiesmust meet a stricter definition of independent than those applicable to the othercommittees.120

Section 10A requires that directors on the audit committee be independent.The provision, however, allows the Commission to create exemptions to therequirement. Newly public companies have an extended compliance period.121

Similarly, there is an exemption for some directors who also sit on the board ofan affiliate and for directors of foreign private issuers.122 The rules do not

116 See Item 407(d)(5)(iv)(B) (“The designation or identification of a person as an audit commit-tee financial expert pursuant to this Item 407 does not impose on such person any duties, obligationsor liability that are greater than the duties, obligations and liability imposed on such person as a mem-ber of the audit committee and board of directors in the absence of such designation or identifica-tion.”).

117 Item 407(d)(5)(iv)(C) (“The designation or identification of a person as an audit committeefinancial expert pursuant to this Item does not affect the duties, obligations or liability of any othermember of the audit committee or board of directors.”).

118 See Instruction 1 to Item 407(d)(5), 17 C.F.R. § 229.407(d)(5) (“The disclosure under para-graph (d)(5) of this Item is required only in a registrant’s annual report. The registrant need not pro-vide the disclosure required by paragraph (d)(5) of this Item in a proxy or information statementunless that registrant is electing to incorporate this information by reference from the proxy or infor-mation statement into its annual report pursuant to General Instruction G(3) to Form 10-K (17 C.F.R.§ 249.310).”).

119 See Section 10A(m), 15 U.S.C. § 78j-1(m).120 The rule contains certain exceptions to the independence requirements. See Rule 10A-

3(b)(1)(iv). Any reliance on the exception must be disclosed. See Rule 10A-3(d).121 For 90 days after the effectiveness of the registration statement, the board need only have one

independent director. Thereafter, the board may have a minority of directors who are not exempt. Theexemption expires one year after the effectiveness of the registration statement. Rule 10A-3(b)(iv)(A).

122 Rule 10A-3(b)(iv)(B)-(E).



condone an exception for unusual circumstances. Nonetheless, the Commissionhas provided that a company must explain any “exceptional or limited or similarcircumstances” that explain the appointment of a non-independent director,including the reasons “for the board of directors’ determination.”

Rule 10A-3 prohibits a member from accepting “directly or indirectly” anyfee other than fixed compensation under retirement plans123 or director’s fees.124

An indirect payment includes fees paid to certain family members125 andbusinesses providing “accounting, consulting, legal, investment banking orfinancial advisory services.”126 The Commission specifically rejected a deminimis exception for payments to directors.127

In addition, affiliates of the company do not qualify as independent.Affiliate status turns on control and includes “the possession, direct or indirect,of the power to direct or cause the direction of the management and policies ofa person, whether through the ownership of voting securities, by contract, orotherwise.”128 The rule provides a safe harbor from the definition. Affiliate doesnot include anyone owning less than 10 percent of a class of voting shares or anyexecutive officer of the shareholder.129

123 Exchange Act Release No. 47654 n.57 (April 9, 2003) (“The requirement that the compen-sation be fixed precludes retirement payments that are tied to the continued performance of the rel-evant entity. The requirement that the compensation be fixed does not preclude customary objectivelydetermined adjustment provisions such as cost of living adjustments.”).

124 Exchange Act Release No. 47654 n.46 (April 9, 2003) (“The final rule does not specify anylimits or restrictions on fees paid for capacity as a member of the board of directors or any boardcommittee.”).

125 Rule 10A-3(e)(8) (“a spouse, a minor child or stepchild or a child or stepchild sharing a homewith the member”).

126 Rule 10A-3(e)(8) (“an entity in which such member is a partner, member, an officer such asa managing director occupying a comparable position or executive officer, or occupies a similar posi-tion (except limited partners, non-managing members and those occupying similar positions who, ineach case, have no active role in providing services to the entity) and which provides accounting,consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary ofthe issuer.”). See also Exchange Act Release No. 47654 (April 9, 2003) (“Other commercial relation-ships are not covered by the final rule, although, as previously discussed, we expect that SROs willcontain restrictions on additional services and activities in their own listing standards. For example,the prohibitions in Exchange Act Rule 10A-3 do not include non-advisory financial services such aslending, check clearing, maintaining customer accounts, stock brokerage services or custodial andcash management services.”) (footnote omitted).

127 Exchange Act Release No. 47654 (Apr. 9, 2003) (“Further, given the narrow class of servicescovered by the final rule, the lack of a de minimis exception should be less necessary. Moreover, ifthe level of compensation that the member or associated entity receives is truly de minimis andimmaterial, we are not persuaded that requiring an issuer to locate another provider so that the mem-ber can remain qualified for audit committee service would be overly burdensome.”).

128 Rule 10A-3(e), 17 C.F.R. § 240-10A-3(e).129 More than 10% does not automatically mean the person has affiliate status. Rule 10a-

3(e)(1)(ii)(B).



Duties. The rule (and, as a result, the relevant listing standards) alsospecifies some of the responsibilities of the audit committee. In particular, aprimary function is “to enhance the independence of the audit function, therebyfurthering the objectivity of financial reporting.”130 As a result, the committeemust be “directly responsible” for the “appointment, compensation, retention andoversight” of the outside auditor, and the firm must report directly to the auditcommittee.131 Committee responsibilities include hiring, firing, and setting of allengagement fees and terms of outside auditors.132 As the Commission has notedthis authority “would help to align the auditor’s interests with those ofshareholders.”133

Funding. The committee must have the authority to engage counsel andother advisors necessary to carry out its duties and appropriate funding (asdetermined by the audit committee), including ordinary administrativeexpenses.134 Advisors may include those with expertise in “accounting, financialreporting or legal matters” and may be necessary to provide advice “to identifypotential conflicts of interest and assess the company’s disclosure and othercompliance obligations with an independent and critical eye.”135 They may alsobe necessary to “independently investigate questions that may arise regardingfinancial reporting and compliance with the securities laws.”136

130 Exchange Act Release No. 47654 (April 9, 2003).131 Rule 10A-3(b)(2). See also Exchange Act Release No. 47654 (April 9, 2003) (“The auditing

process may be compromised when a company’s outside auditors view their main responsibility asserving the company’s management rather than its full board of directors or its audit committee.”).

132 Exchange Act Release No. 47654 (April 9, 2003) (“In addition to services necessary to per-form an audit or review in accordance with Generally Accepted Auditing Standards (“GAAS”), thiscategory also may include services that generally only the independent accountant reasonably canprovide, such as comfort letters, statutory audits, attest services, consents and assistance with andreview of documents filed with the Commission.”) (footnote omitted).

133 Exchange Act Release No. 47654 (April 9, 2003). The committee may be given other func-tions. See In re Statoil, Exchange Act Release No. 54599 (admin. proc. Oct. 13, 2006) (requiringcompliance officer to report possible violations of the Foreign Corrupt Practices Act to the audit com-mittee).

134 Rule10A-3(b)(4)–(5). The Commission did not set limits on funding, apparently accepting theview that these were sufficiently controlled by the fiduciary obligations of directors on the commit-tee. See Exchange Act Release No. 47654 (April 9, 2003) (“These commenters argued that audit com-mittee members’ own fiduciary duties to the issuer and natural oversight by the board of directors asa whole over the audit committee would address any concerns over abuse. The final rule does not setfunding limits.”).

135 The provision does not prohibit a committee from seeking advice of counsel or other advisorsemployed by the company. See Exchange Act Release No. 47654 n.114 (April 9, 2003) (“As pro-posed, the requirement does not preclude access to or advice from the company’s internal counsel orregular outside counsel. It also does not require an audit committee to retain independent counsel.”).

136 Exchange Act Release No. 47654 n.114 (April 9, 2003).



Complaints. In addition, the company had to have in place procedures forreceiving, retaining, and treating complaints from the auditor and employees.137

The system for employee complaints recognized that “[m]anagement may not havethe appropriate incentives to self-report all questionable practices” while employeeshad concerns about “management reprisal.”As a result, the system also had to protectemployees by permitting confidential, anonymous submissions.138

[C] Enforcement

With the responsibility of the audit committee often clear, the Commissionhas sanctioned members responsible for violations of the securities laws. Forexample, the Commission sanctioned the chairperson of an audit committee whoimproperly recommended that the company not file an annual report on a timelybasis.139 Similarly, the Commission sanctioned a company that misrepresentedthe status of an internal investigation and the conclusions of the auditcommittee.140 In other instances, the Commission has required that the auditcommittee retain independent counsel and review the MD&A disclosure.141

[iii] Compensation Committee

The last area of corporate governance disclosure with respect to theoperations of the board concerns the compensation committee. Executivecompensation has been in the eye of the corporate governance debate. State lawimposes mostly procedural requirements on compensation, with few substantivelimitations. The concern has always been that executive compensation is notdetermined though a sufficiently thorough, deliberative and independent process.The Commission has tried to intervene, once again relying on disclosure, byrequiring illumination of the process used in determining executivecompensation.

As usual, the company must disclose that it has a compensation committeeor, if not, a statement of the “basis for the view of the board of directors that itis appropriate” not to have such a committee and identify “each director

137 Rule 10A-3(b)(3).138 The Commission specifically declined to specify the necessary procedures. See Exchange Act

Release No. 47654 (April 9, 2003) (“The procedures that will be most effective to meet the require-ments for a very small listed issuer with few employees could be very different from the processesand systems that would need to be in place for large, multi-national corporations with thousands ofemployees in many different jurisdictions. We do not believe that in this instance a ‘one-size-fits-all’approach would be appropriate.”).

139 In re Hansen, Exchange Act Release No. 54689 (admin. proc. Nov. 2, 2006).140 SEC v. Endocare, Inc., Litigation Release No. 19772 (C.D. Cal. July 25, 2006).141 See In re Coca-Cola Co., Exchange Act Release No. 51565 (admin. proc. April 18, 2005).



who participates in the consideration of executive officer and directorcompensation.”142

The company must provide a description of the processes and proceduresused to determine compensation, including the scope of authority and anyauthority delegated to other persons, the role of executive officers inrecommending or determining compensation. In addition, the proxy materialsmust provide information about the role of any consultants.143 The disclosuremust identify the consultants, describe whether they were retained by thecommittee, describe the scope of authority, and set forth the material elements ofthe instructions with respect to their duties.

To the extent attempting to get at CEO influence, the requirements areunlikely to provide useful information. In particular, disclosure about thecompensation consultants, a source of growing controversy, remains inadequate.Item 407(e) says nothing about the CEO’s interaction with the consultant or anyother business conducted by the consultant that might suggest a conflict ofinterest.

As for membership on the committee, the proxy also must disclose certaindirector interlocks and participation by corporate officers. This includes membersof the compensation committee who, during the prior year, were officers oremployees of the company, who previously served as an officer, or who engagedin any related-party transactions.144 In addition, Item 407 mandates disclosure ofother types of relationships that might suggest a conflict of interest. Theseinclude: (1) an executive officer of the company serving as a member of acompensation committee of another entity that has an executive officer servingas a director on the company’s compensation committee; (2) an executive officerof the company serving as a director of another entity where an executive officerof the entity serves on the compensation committee; or (3) an executive officerserving as a member of the compensation committee of another entity where anexecutive officer of the entity serves on the company’s board.145

These obligations to some degree overlap with the executive compensationdisclosure requirements. Under the caption “Compensation Committee Report,”the company also must disclose whether the committee has reviewed theCompensation Discussion and Analysis required by Item 402(b) and hasrecommended to the board of directors that it be included in the

142 Item 407(e)(1) of Regulation S-K.143 Item 407(e)(3) of Regulation S-K.144 See Item 407(e)(4) of Regulation S-K. Related-party transactions are those that meet the stan-

dards in Item 404 of Regulation S-K. For companies without a compensation committee, disclosuremust include each officer or employee, and any former officer who participated in compensationdeliberations. Item 407(e)(4)(ii) of Regulation S-K.

145 Item 407(e)(4) of Regulation S-K. For directors identified in these categories, information onrelated party transactions also must be disclosed.



appropriate SEC filing.146 The names of the committee members must beincluded beneath the report.

[d] Communications from Shareholders

The disclosure requirements in Item 407 also attempt to enhancecommunications between shareholders and the board of directors. Companiesmust, if they have them, disclose any policies and procedures regulating thesubmission of nominees for the board by shareholders. In addition, auditcommittees of listed companies must have in place procedures for receivingcomplaints and anonymous submissions from employees.147

In addition to these requirements, companies must state whether they havein place a process for shareholders to send communications to directors. As usual,if no such procedures exist, the company must explain their absence. Thedisclosure must explain the manner of communicating and, if thecommunications do not automatically go to the board, must explain the processfor determining which ones will be forwarded.148 The latter need not beexplained if the process is approved by independent directors.149

[3] Problems

Listing requirements as a means of ensuring good corporate governancesuffer from a number of problems, not the least of which concerns enforcement.There is no private right of action for violations. Only the exchanges may enforcethe requirements. Traditionally, exchanges have had a limited arsenal, able onlyto suspend or delist. Bad for business, delisting has rarely occurred.150 Thedecision by the NYSE in the 1980s to abandon its one-share, one-vote rule ratherthan enforce it illustrated the competitive pressures faced by the self-regulatoryorganizations.151 SOX required delisting for companies not meeting the audit

146 Item 407(e), 17 C.F.R. § 229.407(e). The information pertaining to the compensation commit-tee report is not considered soliciting materials for purpose of the proxy rules or filed for purposesof Section 18 of the Exchange Act. See Instruction 1, Item 407(e)(5), 17 C.F.R. § 229. 407(e)(5).

147 Rule 10A-3(b)(3), 17 C.F.R. § 240.10A-3(b)(3).148 This information is ordinarily included in the proxy statement. As an alternative, however, it

may be included on the company’s Web site.149 See Instruction 2, Item 407(f) of Regulation S-K, 17 C.F.R. § 229.407(f).150 Thus, the NYSE had a weak record in delisting companies for non-compliance. See Exchange

Act Release No. 41634 (July 21, 1999) (“Over the past sixty years, only one issuer has delisted itssecurities from the NYSE.”) (footnote omitted).

151 Self Regulatory Organizations, Proposed Rule Change by New York Stock Exchange, Inc.Relating to Amendments to the Exchange’s Voting Rights Listing Standards for Domestic Compa-nies, Exchange Act Release No. 23,724 (Oct. 17, 1986).



committee requirements but also provided for mandatory warnings andopportunities to correct.152

Enforcement may be an even bigger concern given the changes in theorganization of the stock exchanges. Both the NYSE and NASDAQ have becomefor-profit, publicly traded. To some degree, the Commission’s efforts in this areacan be seen as an attempt to overcome some of these weaknesses. Separatenon-profit subsidiaries handle enforcement matters.

Indeed, the NYSE has sought to weaken one of the few remainingmechanisms for ensuring compliance with the listing requirements. In 2008, theexchange proposed eliminating the requirement that companies obtain an opinionof counsel in connection with an application to list securities.153 The opinionmainly attested to the legality of the shares and the qualification to do business.The requirement would be replaced with the submission of legal opinions filedin connection with recent stock offerings or, if none where available, a certificateof good standing from the state of incorporation.

The Exchange took the position that there were two other “sources ofassurance that, at the time of initial listing, a company is in compliance with theExchange’s corporate governance requirements.” The first was that an authorizedofficer had to execute a listing application attesting to the fact that he/she had“read and understood the Exchange’s Listings Rule, and fully believes itself to bein compliance with, and, if approved for listing, intends to continue to be incompliance with, the Exchange’s listing and corporate governance rules andrequirements, . . .”

In addition, the company must provide at the time of listing a writtenaffirmation that it is in compliance with the director independence requirement.The NYSE promised to amend the written affirmation to have it include“compliance with the Exchange’s nominating and compensation committeeindependence requirements and thereby comprehensively covers the Exchange’scorporate governance requirements.”

There are several problems with these substitutes. First, the requirementsare legal in nature. While a board could in good faith attest to compliance,nothing about the process ensures legal involvement. Thus, for example, in

152 Notices will, however, have to be disclosed. See Item 3.02 of Form 8-K. The disclosurerequirement does not apply, however, to an “early warning” notice of an impending violation. SeeExchange Act Release No. 49424 (March 16, 2004) (“An early warning notice that merely informsthe company that it is in danger of falling out of compliance with a rule or standard for continuedlisting on the exchange or association is not a notice that the company no longer satisfies that rule orstandard. Thus, a company’s receipt of such a notice will not trigger a disclosure obligation underthe item. However, if the warning notice informs the company that it is out of compliance with a ruleor standard for continued listing, but that the company will not be delisted if it cures the problemwithin a specified time, such a notice will trigger a Form 8-K filing requirement.”).

153 Exchange Act Release No. 58413 (Aug. 22, 2008).



determining whether directors are independent, they may not have a “materialrelationship” with the company. Legal advice on the meaning of the phrase isnecessary for appropriate application. Yet the NYSE rule proposal is essentiallyeliminating a required role for counsel.

Second, the whole approach of SOX was to recognize that boards functionbetter when there are gatekeepers looking over the shoulders of management.Thus, Section 404 required management to assess the company’s internalcontrols but further mandated that the outside auditor attest to the findings. Inother words, the auditors had to review management’s opinion. The rule changeby the NYSE is eliminating a gatekeeper role in the process.

The NYSE has an incentive to propose the change. The other exchanges donot have similar requirements and it adds a cost to the listing process. This is atough thing to require in a competitive environment. But that is no excuse for theSEC to approving what is an obvious weakening in corporate governancestandards administered by the SROs.

By essentially requiring companies to disclose conformity with exchangerequirements in the area of corporate governance, the Commission has provideda private right of action for violations. Inaccurate disclosure may violate theantifraud rules, particularly those in the proxy rules.

§ 2B.05 INDEPENDENCE, DISCLOSURE, AND THE SECURITIES LAWS

The corporate governance requirements in general entailed disclosure ofdirector qualifications and the process the directors used in performing theirduties on various committees. The Commission, however, relied on definitionsand rules in defining these director responsibilities, mostly those promulgated bythe stock exchanges. The agency did not adopt its own definitions orrequirements. As a result, the Commission did not correct the deficiencies andweaknesses in the corporate governance requirements, substantially undercuttingthe value of disclosure.

The NYSE, for example, contained a definition of independent director thatdid not adequately capture all potentially disqualifying relationships. Thus, therule did not address personal friendships, focused on payments from the companyand not the CEO, and essentially exempted directors who had executive positionswith non-profits that received funds from the company. Thus, directors labeled asindependent in the proxy statement were not always independent.

Reliance on third-party definitions occurred in part because the corporategovernance requirements had no independent purpose under the federal securitieslaws. The securities laws did not require the use of independent directors or playa role in the committee process. Absent any direct nexus with the securities laws,the Commission had little ability to adopt its own definitions or impose its ownrequirements.



It was, therefore, significant, that the Commission for the first timeconditioned the applicability of the securities laws on independent approval inamending the all-holders rule. Rule 14d-10 contains a safe harbor from thebest-price rule for compensation payments that are approved by a committee ofindependent directors. In effect, the agency determined that the securities lawsbenefited from reliance on a board’s fiduciary obligations.

Despite comments suggesting otherwise, the rule defined independence byincorporating the definitions used by the relevant stock exchanges.154 In doingso, the agency specifically rejected the use of its own, separate definition ofindependent.

Other commenters suggested that codifying an independence defini-tion similar to other definitions provided in some Exchange Actrules—as opposed to relying upon a definition that is determined byreference to the listing standards, as we have in other Exchange Actrules—would be a better approach because this would provide a con-sistent definition. We disagree and are adopting the provisionsrelated to the independence standards as proposed, with an accom-modation for foreign private issuers. We believe this approach isappropriate because the definitions under the listing standards havepreviously been approved by us and are consistent with the approachwe have followed in the past.155

The Commission, therefore, used the exchange rules to implement asubstantive requirement under the securities laws. The approach is a riskprecedent. While it is the case that the agency approved the exchange rules, it haslimited ability to refuse or to require changes.156 Ultimately, it may be moreappropriate for the Commission to adopt its own definition.

154 See Instruction 1, Rule 14d-10(f)(12)(ii) (“If the issuer or affiliate, as applicable, is a listedissuer (as defined in § 240.10A-3 of this chapter) whose securities are listed either on a national secu-rities exchange . . . that has independence requirements for compensation committee members thathave been approved by the Commission (as those requirements may be modified or supplemented),apply the issuer’s or affiliate’s definition of independence that it uses for determining that the mem-bers of the compensation committee are independent in compliance with the listing standards appli-cable to compensation committee members of the listed issuer.”). The same definition is included inRule 13e-4(f)(12)(ii).

155 Exchange Act Release No. 54684 (Nov. 1, 2006) (footnote omitted).156 See Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1986).



§ 2B.06 DISCLOSURE AND CONFLICTS OF INTEREST

[1] Fiduciary Duties

The other place where governance and disclosure intersect is in the area ofrelated party transactions. These are essentially transactions between fiduciariesand the company. With respect to directors, the transactions would generally besubject to the duty of loyalty under state law. In other words, federal disclosurerequirements implicate state law duties.

[2] Related Party Transactions and Disclosure Requirements

Related party transactions are covered by Item 404 of Regulation S-K. Theprovision generally requires the disclosure of any transaction in which thecompany is, or is to be, a participant, the amount involved exceeds $120,000, andthe related party has a direct or indirect material interest.157 Transaction isdeliberately broad and includes “any financial transaction, arrangement orrelationship (including any indebtedness or guarantee of indebtedness) or anyseries of similar transactions, arrangements or relationships.”

The company must reveal the person involved, the interest in thetransaction, the approximate dollar amount involved, the amount of the relatedparty’s interest, with special rules governing debt,158 and any other material facts.Certain transactions are excluded,159 particularly those that arise solely becauseof an interlocking director relationship.160 Finally, the provision does not applyto transactions arising from competitive bids, involves certain services such astransfer agent and trustee under an indenture,161 and interests arising from stockownership where all of the shareholders of the same class share pro-rata.

157 Employment agreements need not be reported under this Item if they are covered by Item 402,the provision governing executive compensation.

158 The disclosure must include the largest amount of the principal outstanding during the rel-evant period, the amount owed at the latest practicable date, the amount of principal and interest paidduring the period, and the interest rate. Item 404(a)(5) of Regulation S-K, 17 C.F.R. § 229.404(a)(5).At the same time, the provision does not cover debt for “purchases of goods and services subject tousual trade terms, for ordinary business travel, and expense payments and for other transactions inthe ordinary course of business.” Certain additional requirements apply to loans from banks.

159 Transactions with a director owning less than 10% of a company engaging in the transactionwill be excluded. The same is true of a limited partnership interest of less than 10% of the partner-ship and where the individual is not a general partner and does not hold another position in the part-nership.

160 The instructions to Item 404(a) exclude interests arising solely because of “such person’s posi-tion as a director of another corporation or organization that is a party to the transaction.”

161 Specifically, the provision exempts transactions involving services “as a bank depositary offunds, transfer agent, registrar, trustee under a trust indenture, or similar services.”



The disclosure obligations apply to directors and nominees, executivedirectors, and certain immediate family members.162 Related party transactionsalso must be included for shareholders owning 5% or more of the equitysecurities of the company (and their immediate family members).

[3] Procedures

Conflict of interest transactions raise issues of process. Under state law,proper approval of the transactions can result in insulation from legal challenge.Aside from those benefits, shareholders presumably want to know that thesetypes of transactions are subject to heightened scrutiny, avoiding any appearancethat insiders are taking advantage of the company for their own benefit.

Consistent with these views, Item 404(b) provides that companies mustdisclose any policies or procedures applicable to conflict of interest transactions.This includes the types of transactions covered, the applicable standards, and thepersons responsible for applying the policies.163 The text of the policies need notbe disclosed but the company must represent that they are in writing or, if not,state “how such policies and procedures are evidenced.”

[4] Antifraud Provisions

While Regulation S-K requires disclosure of related party transactions, thesame would be true, at least in some cases, of the antifraud provisions.164 As aresult, transactions not covered by the regulation may still require disclosure.

[5] Issues

The provision provides useful information to shareholders, generallycovering transactions of any significant size between the company and afiduciary. The main weaknesses are twofold. First, there may well be contractsthat raise a conflict of interest but do not result in the participation of the issuer.

162 They also apply in some instances to promoters and certain control persons. See Item 404(c)of Regulation S-K, 17 C.F.R. § 229.404(c).

163 Transactions required to be disclosed but not subject to the procedures and policies, or wherethe policies were not followed, also must be disclosed.

164 See Wilson v. Great American Industries, Inc.,855 F.2d 987, 993-94 (2d Cir. 1988) (failure todisclose that a director had a “long-standing business relationship” with individuals controlling theacquiring company violated Rule 14a-9 thereunder); accord Kas v. Financial General Bankshares,Inc.,796 F.2d 508, 515 (D.C. Cir. 1986) (directors’ relationship with a party to a proposed transaction“would in all probability have assumed actual significance in the deliberations of a reasonable share-holder”).



The transaction may be among fiduciaries (particularly the CEO) or involveothers with economic connections to the issues.

Second, the process requirements allow for the disclosure in boiler plateformat of the process employed by companies in considering the transactions.The policies themselves need not be disclosed, nor must there be meaningfuldisclosure about how they work in practice.



SSRN-id1396353

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