The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Empirical Evidence)
We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.
In this post, we bring the discussion full circle. The first post noted the data cited by the Chair showing the decline in the purchase of equity securities by middle income families. Encouraging the return of these families to the market likely will depend at least in part upon an approach to regulation that is designed to provide small investors with greater confidence in the markets.
One of the structural concerns that has long existed with respect to the stock exchanges is the problem of enforcement. (Concerns over enforcement by the exchanges are discussed in the legislative history to the Exchange Act). Only the exchanges enforce listing standards. Shareholders, according to the current state of the law, lack a right to bring an action for violations of listing standards. Moreover, the exchanges have the authority to exempt companies from listing standards that are designed to protect shareholders. The system for doing so is not transparent. For posts on the issue, go here and here.
Finally, it is clear that there is at least some issuer confusion over the listing standards, something that can lead to non-uniform interpretations. Take as an example the standard for independent directors. Under the rules of the NYSE, directors are not independent if they have a "material" relationship with the company. The determination of "material" is, however, left to the board. In the recent debate over the changes to the listing standards for compensation committees, arguments were made that the NYSE should adopt a more explicit definition of director independence, including an explicit requirements that boards consider personal and business relationships with executive officers.
The NYSE declined, concluding that the requirement to consider "material" relationships already encompassed the requirement. As the NYSE reasoned:
- Brown, the AFL-CIO, IBT and CII all argue that relationships between the director and the senior executives of the listed company should be included as an explicit factor for consideration in compensation committee independence determinations. The NYSE Exchanges note that the existing independence standards of the NYSE Exchanges all require the board to make an affirmative determination that there is no material relationship between the director and the company which would affect the director’s independence. Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary.
In approving the final listing standards, the Commission declined to make the exchanges add personal relationships as an explicit consideration. Nonetheless, the release indicated the SEC's view that the relationships should be considered. As the adopting release noted:
- in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.
The statement is useful but buried in an isolated release. Anyone examining the listing standards will not see an explicit command to consider personal relationships. Moreover, since directors typically receive questionnaires that are based upon the explicit language of the rule, they may not even be asked about their personal relationships. As a result, boards considering whether a director has a "material" personal relationship may not even know about the relationships.
Moreover, even if boards consider these relationships, there is no meaningful guidance in the listing standards on the determination of the materiality of the relationships. Thus, it is likely that boards use very different standards in considering the issue. Investor cannot, therefore, be sure that boards, in determining independence, screen for all material relationships or apply uniform standards. This diminishes investor confidence in the securities markets.
In considering a restructuring of the markets, therefore, thought must be given to the role of the exchanges in the governance process. Thought should likewise be given to the enforcement mechanisms for listing standards. Listing standards benefit investors but only if they impose meaningful standards and are adequately enforced.