The DC Circuit just ruled in the conflicts mineral case. See NAM v. SEC. The court struck down a small aspect of the rule on First Amendment grounds.  

With respect to the administrative law analysis, the court wrote a very strong opinion upholding the analysis by the SEC. The National Association of Manufacturers challenged the final rule by, among other things, alleging an inadequate cost benefit analysis. Among the authority cited: Bus. Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011). That case extended the boundaries of administrative law largely by imposing an almost impossible standard for cost-benefit analysis and ignoring the traditional requirement of agency deference.  

The panel in NAM v. SEC, however, unanimously went back to the traditional approach taken in administrative review of agency rulemaking. As the court stated: “we find it difficult to see what the Commission could have done better.”  

With respect to the first amendment, however, the panel splintered. Two judges agreed to strike down an aspect of the rule. They invalidated the final rule “to the extent the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have not been found to be ‘DRC conflict free.’ ” 

The SEC will have to decide its next step. The case has been sent back to the trial court. Presumably the agency can eliminate the offending language and move forward with the application of the remaining pieces of the rule. Alternatively, the SEC could seek rehearing en banc.

The decision to seek an en banc hearing may be more complicated than usual, as the next post explains.


Rule 14a-4, Unbundling and Getting the Analysis Right: Guidance from The Division of Investment Management

The Division of Investment Managment has put out some guidance on the provision in Rule 14a-4 that prohibits the bundling of matters submitted to shareholders. See Rule 14a-4, 17 CFR 240.14a-4 (proxy card "[s]hall identify clearly and impartially each separate matter intended to be acted upon"). 

With respect to charter amendments submitted to shareholders by mutual funds, the staff stated that each material amendment was to be separated. The staff then provided some guidance on the types of provisions that would be deemed material. As the guidance stated:

  • Division staff has commented that proposed amendments to the charters of investment companies should be "unbundled," providing separate votes for each proposed material amendment. While there is no bright-line test for determining materiality in the context of Rule 14a-4(a)(3), the staff believes that investment companies should consider whether a given matter substantively affects shareholder rights. Examples of proposed material amendments to the charters of investment companies that the staff has commented should be presented separately include, among other things, proposals seeking to: (1) amend voting rights from one vote per share to one vote per dollar of net asset value; (2) authorize a fund to involuntarily redeem small account balances; (3) authorize a fund to invest in other investment companies; (4) change supermajority voting requirements; (5) authorize the board to terminate a fund or merge with another fund without a shareholder vote; and (6) authorize the board to make future amendments to the charter without a shareholder vote.

The staff also indicated that it had no objection to the bundling of "proxy proposals that are ministerial in nature (e.g., proposals involving editorial or non-substantive changes to fund documents) or otherwise immaterial with a single material matter."

While one can quibble with the last observation (to the extent that a provision is material, it really should not be combined with anything else), the analysis is sound and reflects a clear understanding of the unbundling requirement. Contrast this approach, however, with that taken by CorpFin recently. 

In the CorpFin advice, material proposals could be combined if "intertwined." In addition, the CorpFin staff took the position that changes in incentive plans could be bundled, apparently without regard to materiality. In criticizing that position, we had this to say: "The staff interpretations could have been simple and designed to encourage the presentation of proposals individually. Sticking to a materiality analysis, the staff could have reaffirmed that material amendments have to be submitted separately." 

The Division of Investment Management more or less took that approach and, in doing so, has adopted an interpretation far closer to the intent of the anti-bundling requirement than the one stated by CorpFin. 


Bundling the Anti-Bundling Rule: Staff Guidance and Rule 14a-4 (Part 5)

We are discussing the anti-bundling requirement in Rule 14a-4 and the staff's recent guidance issued on Jan. 24, 2014.  

The staff interpretations could have been simple and designed to encourage the presentation of proposals individually.  Sticking to a materiality analysis, the staff could have reaffirmed that material amendments have to be submitted separately.  In the case of incentive plans, the staff could have provided examples of immaterial amendments that would allow an issuer to cluster plan changes in a single proposal.

Instead, the interpretation contains a number of justifications, some new, for bundling.  Put simply, the interpretation makes bundling easier to justify.  Had these interpretations been in effect a year ago, the Apple case may well have come out differently.  The approach conflicts with the fundamental purpose of the 1992 amendments:  "[to] not have the soliciting party determine the shareholders' choices."  Exchange Act Release No. 30849 (June 23, 1992). 

The interpretations are not necessarily the final word.  As a matter of administrative law, informal staff interpretations cannot overturn Commission positions. Moreover, while courts do provide some deference to staff interpretations of their own rules, it does not extend to interpretations that are inconsistent.  See Decker v. Northwest Environmental Defense Center, 133 S. Ct. 1326 (2013) ("It is well established that an agency's interpretation need not be the only possible reading of a regulation—or even the best one—to prevail. When an agency interprets its own regulation, the Court, as a general rule, defers to it 'unless that interpretation is "plainly erroneous or inconsistent with the regulation." ’ ”).  Yet the interpretations provide uncertainty and increase the litigation risk associated with any challenge to bundled proposals.  

The interpretations suggest significant staff unhappiness with the anti-bundling rule.  That in turn further suggests that the staff may not aggressively enforce the requirement when reviewing proxy materials submitted to the Commission.  If that is the case, the incidents of bundling will increase.  Perhaps it is better to repeal the rule than let it wither on the administrative vine.        


Bundling the Anti-Bundling Rule: Staff Guidance and Rule 14a-4 (Part 4)

We are discussing the anti-bundling requirement in Rule 14a-4 and the staff's recent guidance issued on Jan. 24, 2014.  

The guidance included a third question:

  • Management of a registrant intends to present for a vote of shareholders a single proposal covering an omnibus amendment to a registrant’s equity incentive plan.  The amendment makes the following changes to the terms of the plan:
    • increases the total number of shares reserved for issuance under the plan;
    • increases the maximum amount of compensation payable to an employee during a specified period for purposes of meeting the requirements for qualified performance-based compensation under Section 162(m) of the Internal Revenue Code;
    • adds restricted stock to the types of awards that can be granted under the plan; and
    • extends the term of the plan.

The staff then posed the question:  "Must any of these proposed changes be unbundled into a separate proposal pursuant to Rule 14a‑4(a) (3)?"

Having been willing to allow the bundling of material proposals if intertwined and to allow the bundling of a material proposal with an unlimited number of immaterial proposals, the answer to the question was preordained.  The bundling of these proposals would not violate the anti-bundling rule.  The only question was the reasoning that would support the interpretation.   

The staff could easily have said that in most cases these amendments were not material.  Instead, however, the staff opted for an interpretation that was far more categorical.  Relying on a single sentence from a release issued in the early 1990s, the staff essentially took the position that the anti-bundling rule did not apply to compensation plans. As the staff reasoned:

  • While the staff generally will object to the bundling of multiple, material matters into a single proposal--provided that the individual matters would require shareholder approval under state law, the rules of a national securities exchange, or the registrant’s organizational documents if presented on a stand-alone basis--the staff will not object to the presentation of multiple changes to an equity incentive plan in a single proposal.  See Section III of Exchange Act Release No. 33229 (Nov. 22, 1993).  This is the case even if the changes can be characterized as material in the context of the plan and the rules of a national securities exchange would require shareholder approval of each of the changes if presented on a stand-alone basis.  

The guidance contained no rational for the interpretation.  Nor did the staff explain why bundling was permitted only for equity incentive plans and not other matters. The interpretation made no mention of the growing number of law suits (including one against Groupon) challenging the bundling of proposals connected to incentive plans.  

Finally, the categorical nature of the interpretation provided a right to combine amendments without consideration of their actual terms.  An amendment to increase the number of shares slightly and the amount of compensation modestly would not alter the underlying nature of the plan.  More substantial increases, however, would.  Thus, increasing the number of available shares from 1 million to 100 million and simultaneously increasing the maximum amount of compensation from 100,000 shares to 10 million would suddenly provide the board with the discretion to provide massive amounts of additional compensation.  Under the staff guidance, however, the amounts were not relevant to the analysis.

This denies shareholders the right to a separate vote on material matters.  Shareholders could decide, for example, that the increase the number of shares was appropriate but not the increase in the amount of compensation.  Nonetheless, the guidance makes clear that they will not be required to have that choice. Irrespective of their individual importance, issuers apparently can combine seperate changes in an equity plan in the same proposal.    


Bundling the Anti-Bundling Rule: Staff Guidance and Rule 14a-4 (Part 3)

We are discussing the anti-bundling requirement in Rule 14a-4 and the staff's recent guidance issued on Jan. 24, 2014.  

A second question asked: 

  • Management of a registrant intends to present an amended and restated charter to shareholders for approval at an annual meeting.  The proposed amendments would change the par value of the common stock, eliminate provisions relating to a series of preferred stock that is no longer outstanding and is not subject to further issuance, and declassify the board of directors.  Under Rule 14a‑4(a)(3), must the individual amendments that are part of the restatement be unbundled into separate proposals?

Again the staff answered “no.”  

This time, however, the staff applied a materiality analysis.  In effect, the staff took the position that an issuer asking for approval of a material matter could bundle it with an unlimited number of immaterial matters. Thus, while the proposal to declassify the board was treated as material, "the amendments relating to par value and preferred stock do not substantively affect shareholder rights, and therefore both of these amendments ordinarily could be included in a single restatement proposal together with the declassification amendment.”

Bundling a series of immaterial provisions causes no harm to shareholders.  This is not true, however, when matters are bundled together with a material proposal.  Combining a proposal to declassify the board with other changes forces shareholders to make decisions about a group of issues that really turn on their view of the material matter.  They may want to support the technical amendments but find themselves unable to because of the desire to oppose the declassification proposal.   

The approach is inconsistent and, and largely reverses, the position taken by the district court in Apple.  See Greenlight v. Apple (“Permitting Apple to bundle numerous 'technical' matters with a single material matter would appear to still violate the letter of the law--which calls for separate votes for ‘separate matters’--as well as its spirit, because shareholders voting on the ‘blank check’ amendment might still be swayed by the presence of the remaining items such that the resulting vote would not communicate a clear message on the actual popularity of the ‘blank check’ item.”). 

The staff apparently had qualms about the approach.  The guidance indicated that unbundling still had to occur where management “knows or has reason to believe that a particular amendment that does not substantively affect shareholder rights nevertheless is one on which shareholders could reasonably be expected to wish to express a view separate from their views on the other amendments that are part of the restatement." 

The interpretation is complicated (what does it mean for the issuer to have "reason to believe"), largely unenforceable, and potentially unreasonable.  Shareholders generally do not know that matters will be “bundled” until the proxy statement is filed.  Once the proxy statement is filed, shareholders can object. Issuers will then have a choice between rewriting the proxy statement, possibly paying additional distributon costs and incurring additional delay, or ignoring the shareholders' complaints.  If the issuer chooses to ignore shareholders' complaints, shareholders will have to litigate to vindicate their rights. 


Bundling the Anti-Bundling Rule: Staff Guidance and Rule 14a-4 (Part 2)

We are discussing the anti-bundling requirement in Rule 14a-4 and the staff's recent guidance on the requirement.

The staff at CorpFin issued three pieces of guidance on the anti-bundling rule on Jan. 24, 2014.  The advice was provided in the form of a Q&A. With respect to the first question, the staff was asked: 

  • Management of a registrant has negotiated concessions from holders of a series of its preferred stock to reduce the dividend rate on the preferred stock in exchange for an extension of the maturity date.  Must a single proposal submitted by management to holders of the registrant’s common stock to approve a charter amendment containing these modifications be unbundled into separate proposals under Rule 14a‑4(a)(3)--one relating to the reduction of the dividend rate, and another relating to the extension of the maturity date? 

The response was “no.” 

The staff concluded that when “[m]ultiple matters that are so ‘inextricably intertwined’ as to effectively constitute a single matter” they “need not be unbundled.”  These particular matters were intertwined because “each of the proposed provisions relates to a basic financial term of the same series of capital stock and was the sole consideration for the countervailing provision.”  It would not be enough to contend that matters were intertwined “merely because the matters were negotiated as part of a transaction with a third party, nor because the matters represent terms of a contract that one or the other of the parties considers essential to the overall bargain.”

The staff could have applied a traditional materiality analysis.  Instead, the staff introduced a new concept into the bundling lexicon.  Material proposals could be combined if “intertwined.”  Not only is there no language to support the interpretation in the Rule or the administrative history, but it arguably returns to the provision a problem that the 1992 amendments deliberately sought to eliminate.  

The SEC originally permitted proposals to be bundled if "related."  The need to show that proposals were "related" created interpretive issues.  In prohibiting bundling, the Commission in part sought to eliminate the need to determine whether proposals were "related."   By allowing issuers to bundle "intertwined" proposals, however, the staff has reintroduced the same issue back into the Rule.      

The staff also did so with minimal guidance.  There was only one example of an intertwined proposal.  As a result, the staff has left open the possibility that some will take an excessively broad view of the term and combine multiple material proposals that are not really "intertwined."  To the extent that they do, shareholders will be forced to litigate to ensure a more reasonable interpretation.  But litigation imposes costs and the absence of administrative guidance creates uncertainty as to the outcome.  Both factors will greatly reduce the likelihood of litigation and allow a broad interpretation to stand, even if incorrect.

To the extent that the underlying premise was to allow bundling where proposals were dependent upon each other, this was expressly addressed at the time the anti-bundling rule was adopted.  Issuers were allowed to condition one proposal on another.  As a result, there was no need to allow "intertwined" proposals to be bundled in order to prevent inconsistent outcomes.   


Bundling the Anti-Bundling Rule: Staff Guidance and Rule 14a-4 (Part 1)

Rule 14a-4 of the proxy rules governs the content of the proxy card.  Subsection (a)(3) contains the anti-bundling requirement.  Under the provision, each “separate matter” should be identified “clearly and impartially.”  This is true “whether or not related to or conditioned on the approval of other matters."  

The provision was adopted in 1992 and replaced language that allowed companies to submit each matter or “group of related matters.”  See Exchange Act Release No. 30849 (June 23, 1992).  As the release explained:

  • 14a-4(b)(1), to allow shareholders to vote for, against or abstain on each matter presented, and not have the soliciting party determine the shareholder's choices. Since the legal effect of a matter approved by shareholders generally is a question of state law, the proposal would not prohibit the soliciting party from conditioning the effectiveness of any proposal on the adoption of one or more other proposals, if permitted by state law. In such case, appropriate disclosure would be required to advise shareholders that a vote against one proposal could have the effect of a vote against the group of mutually conditioned proposals.

It was also clear from the amendment that the Commission intended to simplify the disclosure process.  Rather than have to interpret “related matters,” the SEC eliminated the issue and simply required that matters be identified separately. 

The provision was a relatively sleepy provision until the litigation between Apple and Greenlight Capital.  In that case, Apple combined a number of amendments to the articles, including one that would have repealed the blank check stock provision.

In agreeing with Greenlight that Apple had bundled proposals, the court dispatched a number of arguments made by Apple.  The most interesting was the contention that the company had not violated the Rule because it had bundled the blank check stock provision only with immaterial and technical revisions of the articles.  The argument suggested that bundling was acceptable under the Rule as long as the matters were immaterial or contained no more than one material matter.  In other words, the anti-bundling rule really meant that companies could not bundle material matters together.

The court was not entirely convinced that the proposals bundled with the blank check stock provision were all immaterial.  But even if they were, this did not necessarily authorize bundling.  As the court reasoned: 

  • Finally, even if Proposal No. 2’s remaining items were purely technical, it is not apparent that that would excuse compliance with the “unbundling” rules.  Permitting Apple to bundle numerous “technical” matters with a single material matter would appear to still violate the letter of the law--which calls for separate votes for “separate matters”--as well as its spirit, because shareholders voting on the “blank check” amendment might still be swayed by the presence of the remaining items such that the resulting vote would not communicate a clear message on the actual popularity of the “blank check” item.  

The opinion, therefore, emphasized the fundamental purpose of the requirement:  To give shareholders a say on each individual matter.  Instances where this did not occur were to be viewed with some degree of hesitancy.

With that background in mind, we turn to the new guidance provided by the staff at the Division of Corporation Finance on the application of the bundling requirement.  The guidance, among other things, essentially reverses the analysis in Greenlight v. Apple. 


Federal Law, the SEC, and Defining the Duties of Directors

As we have noted on this Blog, state law does not impose meaningful standards of behavior on boards of director.  Moreover, under state law, directors have an incentive to remain uninformed.  If they know about a problem, they may be in receipt of a red flag and have to react.  If they have no knowledge, there is no duty that can be violated.  In those circumstances, directors confront liability only if there is no reporting system in place, a rare event.

As a result, we are following developments at the federal level that impose duties on officers or directors where state law does not.  An example arose in connection with the SEC's action against JP Morgan Chase.  In a case arising out of the London Whale incident, JPMorgan agreed to pay a $200 million penalty and make certain admissions.  The Order is here

As the Order noted, public companies must have a system of internal accounting controls.  Moreover, management must periodically evaluate the effectiveness of the company's disclosure controls and procedures.  As part of this system, the audit committee of the board plays a critical role.  As the Commission noted:

  • Consistent with Sarbanes-Oxley’s emphasis on the role that the audit committee of a public company’s board of directors should play in corporate governance, JPMorgan’s internal controls include a requirement that its management keep the Audit Committee informed of, among other things, the identification of any significant deficiencies or material weaknesses in the firm’s internal control over financial reporting. Such updates are necessary for the Audit Committee to fulfill its oversight role and help to assure the integrity and accuracy of information JPMorgan discloses in its public filings.

In connection with the internal control issues, the Commission alleged that management had not adequately informed the audit committee of developments. 

  • Before JPMorgan filed its quarterly report on May 10, 2012, however, JPMorgan Senior Management did not adequately update the Audit Committee concerning the facts learned
    during the reviews of CIO-VCG. Nor did it adequately update the Audit Committee on important observations made by the management-commissioned reviews of control breakdowns at CIO-VCG that amounted to, at a minimum, a significant deficiency.

The Commission specified the reasons for the reporting failure.

  • Three primary issues relating to the sharing and synthesis of relevant information contributed to the inadequate communications with the Audit Committee. First, several employees involved in conducting the reviews of CIO-VCG failed to timely escalate important facts regarding control deficiencies at CIO-VCG. Second, JPMorgan Senior Management was concerned about the market sensitivity of the SCP positions and the confidential nature of the review, and required that the review teams keep their work strictly confidential, which had the effect of impeding the exchange of information among the review teams and their ability to analyze collectively the information
    generated by these reviews. Third, despite learning of important information concerning control
    deficiencies at CIO-VCG, JPMorgan Senior Management did not make a considered assessment
    of the significance of that information to determine if it revealed a significant deficiency or
    material weakness at CIO-VCG that had to be disclosed to the Audit Committee.

JPMorgan, as part of the settlement, was required to make certain admissions (attached in Appendix A to the Order).  Among those admissions was the consequence of the failure to report the necessary information to the audit committee.

  • Because the Audit Committee was not apprised of the initiation of the reviews or facts learned as a result of those reviews, it was unable to provide input on the issues before the filing of JPMorgan’s first quarter report, and was unable to engage with those doing the work to
    ensure that it was sufficient from the perspective of the Audit Committee.

In other words, officers have specific disclosure obligations to the board (or to the audit committee) and the failure to make the requisite reports can result in significant corporate liability ($200 million penalty).  Thus, at the federal level, the failure to report information to the board has consequences.  


Social Media, Public Disclosure and Netflix

Under the federal securities laws, public disclosure is a defense to a number of possible violations.  One definition of insider trading, for example, is the purchase or sale of securities on the basis of non-public information.  To the extent the information used to make the trades was public, there is no violation. 

Similarly, under Regulation FD, companies are not allowed to selectively disclose material non-public information to investors or analysts (among others).  To the extent that the information is distributed to these persons, it must also be disclosed to the public.  As the adopting release noted: 

The timing of the required public disclosure depends on whether the selective disclosure was intentional or non-intentional; for an intentional selective disclosure, the issuer must make public disclosure simultaneously; for a non-intentional disclosure, the issuer must make public disclosure promptly.

Exchange Act Release No. 43154 (Aug. 21, 2000). 

All of this begs the question as to what constitutes public disclosure.  The issue has come up because of reports that the SEC is looking into efforts by Netflix to disclose information over social media, particularly Facebook.  According to the WSJ, the SEC warned Netflix about disclosure over Facebook that Netflix "exceeded 1 billion hours of video streaming in a month for the first time."  

Using Facebook to reply, the CEO of Facebook equated disclosure over Facebook with disclosure to the public. 

  • He said further disclosure at the time wasn't necessary because he has more than 200,000 subscribers to his Facebook page, which makes it a "very public" forum. Netflix had also disclosed on its blog in June that it was nearing the 1 billion streaming hours milestone, he said. Mr. Hastings, who is also on the board of Facebook, added that, at any rate, such information isn't a "material" event to investors.

The interaction, therefore, raises the question as to whether disclosure over social media constitutes public disclosure under the federal securities laws.  The answer is a decided "maybe." 

The SEC discussed this issue in the adopting release for Regulation FD.  The Release noted that public disclosure could occur through "press releases distributed through a widely circulated news or wire service, or announcements made through press conferences or conference calls that interested members of the public may attend or listen to either in person, by telephonic transmission, or by other electronic transmission."  Although social media was not in existence at the time of the release, the same rational would apply.

But it was not enough to simply post the information or diclose it in a conference call open to the public.  As the SEC noted, the "public must be given adequate notice of the conference or call and the means for accessing it."  The Commission, however, recognized that sometimes the public would be aware that important information was revealed through a web site.  See Id.  ("As technology evolves and as more investors have access to and use the Internet, however, we believe that some issuers, whose websites are widely followed by the investment community, could use such a method."). 

In 2000, when the release was issued, use of the Internet was uneven.  Companies often did not have web sites.  Move forward more than a decade and things have changed.  Most if not all public companies have web sites and most regularly post press releases, SEC filings, and other important information.  Today, disclosure over the Internet for most public companies likely meets the defintion of public disclosure.

Social media is not in the same position.  At least right now it does not appear to be a common avenue for the exclusive distribution of material nonpublic information.  Thus, it is not enough to contend that the information is accessible to large swathes of the public (as it surely is).  The issue is whether the information is regularly accessed by the investment community.

Eventually, social media will be a regular method of disseminating material nonpublic information.  In the short term, companies can enhance this possibility by giving notice of impending announcements so that the public (and the investment community) will know to access the source.  Moreover, as information is regularly distributed in this fashion, analysts and other members of the investment community will regularly access the source, making notice unnecessary. 

But for now, in this transitional period, companies are better off using social media as an additional rather than exclusive source of public disclosure. 


Rule 506 and Eliminating the Ban on General Solicitations: A 2-1-2 Decision

The Commission by a 4-1 vote recently proposed to lift the ban on general solicitations in Rule 506 of Regulation D.  The proposal came as a result of Section 201 of the JOBS Act.  The substance of the proposal will be worth some serious discussion over the next few months.  For now, though, we take a few minutes to examine the process used by the Commission to implement the proposal.

In fact, an examination of the statements issued by the five commissioners indicates a much more serious division than even the 4-1 vote suggests.  In a statement by the Chairman, she determined that the proposal was consistent with the "narrow mandate" required by Congress in Section 201 of the JOBS Act.  She noted other concerns raised in connection with the lifting of the ban and indicated that the Commission would "take a thorough look at the private placement market in the future."  Specifically, she noted the requirement in Dodd-Frank that the accredited investor standard be reviewed in its "entirety" beginning four years after the enactment of the Act. 

Commissioner Aguilar cast the one dissenting vote.  As he rightfully noted, the elimination of the ban on general solicitations was likely to result in an uptick in fraud.  This was not speculation but, as Yogi Berra would have said, deja vu all over again.  The SEC eliminated the general solicitation ban under Rule 504 in 1992 and had to reinstate it in 1999 because of the rise in microcap fraud.  Commissioner Aguilar declined to support a proposal that contained "no consideration of any of the commenters’ proposals that would have decreased investor vulnerability."  He noted a pair of them, including amending the definition of accredited investor and amending Form D. 

Commissioner Walter voted for the proposal but was "disappointed" that comments suggesting ways to "mitigate the risks that the proposed rule might pose" were not subject to a "meaningful[] discussion" in the release.

The two remaining commissioners voted for the proposal but objected to the failure to implement the rule as an interim final rule.  An interim final rule allows the rule to be effective immediately but permits comments in the post-effective period that may or may not be used to modify the rule at some later date.  In other words, they objected to the use of notice and comment prior to the effective date.  

Some of the anger was apparently derived from a sudden change in plans at the SEC.  Commissioner Paredes noted that "[f]or some time the Commission was set to consider an interim final rule" but that the Chairman "abruptly decided to change the rulemaking’s course, turning what was an interim final rule into a proposal."  He asserted that an interim final rule "would have allowed us to satisfy the clear statutory directive of the JOBS Act while setting the stage for a later rulemaking that would account for the actual consequences that resulted once issuers were given flexibility to more readily reach investors when raising capital."

Commissioner Gallagher made it clear that while voting yes "as a matter of substance" he "would certainly vote 'no' on the process that led up to" the proposal.  He noted that "[f]or months, the Commission had been told that the Staff was recommending that we vote on an interim final rule." Nevertheless, "earlier this month, we were told that the Chairman had reconsidered the draft interim final rule and wanted to re-cast it." 

In objecting to the approach, he took the position that the Commission can, "for good cause" adopt an "interim final release - a way to go ahead and make the required change, while at the same time soliciting market reactions to how the change actually works." Or, as he said later in his remarks, "I want to leave no doubt that, charged with quickly implementing Congress's explicit direction to implement a bottom-line mandate simply to remove the prohibition on general solicitation and general advertising in two well-traveled rules, we had plenty of 'good cause' to employ an interim final rule as our chosen procedural tool."

Putting aside the sudden shift in administrative strategy, the decision to avoid an interim final rule must be seen in the context of Business Roundtable v. SEC, the DC Circuit decision that struck down the shareholder access rule.  It is clear from that decision that all controversial rules are vulnerable to challenge and that the DC Circuit will provide little deference to the Agency.  To have undertaken an interim final rule, the SEC would have had to show "good cause."  Good cause is a term of art that means notice and comment was "impracticable, unnecessary, or contrary to the public interest." 5 USC 553(b).   

Courts do not allow notice and comment to be set aside easily.  They do so when there is an emergency.  They do not, typically, do so when the justification is a missed deadline for rulemaking.  See Petry v. Block, 737 F.2d 1193, 1203 (DC Cir. 1984) ("strict congressionally imposed deadlines, without more, by no means warrant invocation of the good cause exception.").  There are exceptions but they do not appear applicable in this case. 

Comments in the press suggested that litigation risk played a role in the Chairman's decision to not adopt an interim final rule.  See WSJ ("An SEC spokesman said implementing rules too hastily could expose the agency to court challenges.").  In the past, the pros and cons of rules were mostly resolved at the agency level.  In the Business Roundtable era, that is simply no longer the case.


Shareholders, the SEC and Mandatory Rotation of Auditors: A Commissioner Speaks

We are discussing the issue of executive compensation.  Later in the day we will begin a series of posts that discuss the recent adoption by the SEC of Rule 10C-1, the rule regulating compensation committees for listed companies.  But for now, we engage in a brief interlude. 

We have, on this Blog, questioned the position taken by the SEC staff with respect to the exclusion of shareholder proposals seeking board consideration of mandatory rotation of auditors.  The staff allowed the proposals to be deleted from the proxy statement under the "ordinary business" exclusion in Rule 14a-8.  The letters are discussed here

The issue has been taken up by Commissioner Aguilar at the SEC.  In a recent speech before the NAPPA 2012 Legal Education Conference, the Commissioner took issue with the characterization of mandatory rotation as an "ordinary business" matter.  See id.  ("I am not convinced that the engagement of the independent auditor should necessarily be considered a matter relating to 'ordinary business operations' within the meaning of the Federal proxy rules.").  He pointed both to applicable legal authority and to the longstanding role of shareholders in the auditor selection process. 

In addition, Commissioner Aguilar took issue with the staff's determination that the public policy exception to the ordinary business exclusion was inapplicable. 

In those cases in which a proposal's underlying subject matter transcends the day-to-day business matters of the company and raises significant policy issues, the proposal is generally not excludable on such grounds.  This is particularly the case when an issue has emerged as a topic of “widespread public debate,” as this issue has been.  Given the extensive public discussion occasioned by the PCAOB’s concept release, and the long history of debate on this issue, a strong case can be made that shareholder proposals relating to auditor independence and objectivity and audit quality raise significant policy issues and should not be excluded on ordinary business grounds.

Mandatory rotation of auditors is an important matter of governance.  The staff's position interferes with the ability of shareholders and managers to collectively resolve the issue.  Perhaps it is time for the staff to reconsider its position.   


Auditor Rotation and the Impediments to Private Ordering (Part 5) 

By depriving shareholders of the right to vote on proposals regarding the rotation of auditors, the Commission is making a mandatory rule inevitable.  It is shareholder access all over again.

Pressure for shareholder access originally centered on the right of shareholders to submit bylaws that would require companies to include nominees in their proxy statements.  This would have allowed for a system of private ordering.  The Commission, however, opted to allow for the exclusion for these types of proposals.  As a result, pressure built for more direct access whereby shareholders could submit nominees for inclusion without having to first adopt the requisite bylaw.  Such a rule was adopted but was not implemented because of a weakly reasoned decision of the DC Circuit.  For an analysis of that case, go here

The same thing is likely to happen here.  Because auditors are paid by the companies they audit, there is always pressure to act in the interests of management rather than the company (and by extension shareholders).  Abuses will sometimes surface, something more likely to be uncovered with the creation of the PCAOB and its more rigorous approach to inspections.  Pressure will, therefore, build for reform.  In particular, pressure will continue to build for mandatory rotation of auditors.

Allowing shareholders to submit and vote on proposals that would require rotation take off some of the pressure for a mandatory and categorical rule.  Moreover, these proposals are not likely to be adopted except in companies that have shown through past behavior the need for greater auditor independence.

Yet by allowing for the exclusion of shareholder proposals regarding auditor rotation and independence, the staff at the Commission merely permits the pressure for reform to grow.  Shareholders and other interest groups will not get relief appealing to state law since these are management friendly jurisdictions and not likely to increase the authority of shareholders at the expense of management. 

They can appeal to other agencies, such as the PCAOB.  But as SOX has shown with respect to the separation of auditing and non-auditing functions and Dodd-Frank has shown with respect to say on pay, the more accommodating forum will be Congress.  Eventually when the right accounting scandal erupts, Congress will act and, when it does, the rule concerning rotation will likely be categorical.

Predicting the future is not easy, but in this case the direction is clear enough.  As long as the SEC gives shareholders no meaningful role in ensuring auditor independence, shareholders will seek, and eventually get, the authority from other sources.  

Finally, it should be noted that this issue with respect to staff interpretation is not limited to auditor independence.  In fact, the staff needs to essentially get out of the role of determining both "ordinary business" and public policy.  But that issue, discussed in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors, is for another day.


Auditor Rotation and the Impediments to Private Ordering (Part 4) 

Moreover, the staff has gone further than banning proposals that seek to require rotation.  Even proposals that call for reports on auditor independence have been allowed to be excluded.  In connection with Dell, shareholders submitted a proposal asking management to create a report on auditor independence.  Specifically, the proposal requested: 

Therefore, Be It Resolved: That the shareholders of Dell Inc. request that its Board Audit Committee prepare and disclose to Company shareholders an annual Audit Firm Independence Report that provides the following:

1. Information concerning the tenure of the Company's audit firm if such information is not already provided, as well as the aggregate fees paid by the Company to the audit firm over the period of its engagement; 2. Information as to whether the Board's Audit Committee has a policy or practice of periodically considering audit firm rotation or seeking competitive bids from other public accounting firms for the audit engagement, and if not, why; 3. Information regarding the mandated practice of lead audit partner rotation that addresses the specifics of the process used to select the new lead partner, including the respective roles of the audit firm, the Board's Audit Committee, and Company management; 4. Information as to whether the Board's Audit Committee has a policy or practice of assessing the risk that may be posed to the Company by the long-tenured relationship of the audit firm with the Company; 5. Information regarding any training programs for audit committee members relating to auditor independence, objectivity, and professional skepticism; and  6. Information regarding additional policies or practices, other than those mandated by law and previously disclosed, that have been adopted by the Board's Audit Committee to protect the independence of the Company's audit firm.

Dell (May 3, 2012).  The staff again allowed for exclusion, again because the proposal intruded into the ordinary business of the corporation.  As the staff reasoned:

There appears to be some basis for your view that Dell may exclude the proposal under rule 14a-8(i)(7), as relating to Dell's ordinary business operations. In this regard, we note that while the proposal addresses the issue of auditor independence, it also requests information about the company's policies or practices of periodically considering audit firm rotation, seekig competitive bids from other public accounting firms for audit engagement, and assessing the risks that may be posed to the company by the long-tenured relationship of the audit firm with the company. Proposals concernng the selection of independent auditors or, more generally, management of the independent auditor's engagement, are generally excludable under rule 14a-8(i)(7).  Accordingly, we will not recommend enforcement action to the Commission if Dell omits the proposal from its proxy materials in reliance on rule 14a-8(i)(7).

The analysis was repeated in letters to Xilnx, McKesson, Computer Sciences Corporation, and CA, Inc.

In addition to the questionable analysis about the application of the ordinary business exclusion (and non-application of the public policy exception), these proposals raise another more critical issue.  The truth is that most companies submit the auditor to shareholders for approval.  This is discussed in see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

But the disclosure companies must give when submitting the matter to shareholders provide no meaningful basis for shareholders to determine the quality of the services provided.  For the most part, companies only have to disclose fees, dividing them into audit and non-audit services. Specifically, Item 9 of Schedule 14A does not require any meaningful qualitative disclosure. 

It does require disclosure of audit related fees, tax fees, and all other fees.  But this information is out of date and not particularly useful in the shareholder voting process.  These categories were developed prior to SOX when shareholders needed to know the relationship between audit and non-audit fees.  In SOX, however, Congress largely prohibited auditors from performing most non-audit services, rendering the disclosure for the most part irrelevant.

Thus, these proposals are designed to fill a gap left by the SEC's disclosure regime.  They seek to ensure that shareholders when approving auditors have available meaningful information on the qualitative aspects of the relationship. 


Auditor Rotation and the Impediments to Private Ordering (Part 3)

We are discussing the issue of mandatory rotation of auditors and the impediments imposed by the staff of the SEC in permit the development of a system of private ordering on the issue.

As we noted, the SEC has allowed for the exclusion of auditor rotation proposals under Rule 14a-8, agreeing that they constitute "ordinary business" and therefore fall into subsection (i)(7).  The staff, however, is wrong on this issue.

First, this is not a matter of ordinary business.  This is not the case where shareholders are asking the board to open a new office or change a term of employment.  This is an instance where shareholders are asking the board to ensure that a gatekeeper designed to protect the interest of shareholders can better peform that task.  For most of the history of the SEC, the staff took the position (as have the courts) that shareholders had a right to participate in the auditor selection process.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

Second, it is a matter of important public debate.  To argue otherwise is extraordinary.  The PCAOB issued a concept release on whether auditor rotation should be made mandatory.  The release chronicles the very public nature of the debate, something that has been ongoing for more than two decades. The release has generated a deluge of statements, meetings, and comments.  For a review of the 639 comment letters (as of May 24, 2012), go here.  That the matter is somehow deemed not sufficiently important to take it out of the ordinary business exclusion is to show the ruderless and standard less nature of the application of that provision. 

The staff, therefore, has gotten the analysis wrong.  Moreover, the burden with the exclusion of a proposal is supposed to rest with the party seeking exclusion.  Finally, to the extent companies disagree, they have yet another forum to litigate the issue.  If shareholders pass a resolution mandaing rotation, companies can challenge the provision in state law, arguing that it is a matter left to the discretion of the board. 


Auditor Rotation and the Impediments to Private Ordering (Part 2)

We are discussing the issue of mandatory rotation of auditors and the impediments imposed by the SEC staff to any resolution of the issue through private ordering.

The ordinary business exclusion in Rule 14a-8 provides that management may exclude from the proxy statement matters that fall within the ordinary or day to day business of the company. The theory is that state law vests in the board, not shareholders, the authority to make ordinary business decisions.  The problem, however, is that there is very little state law dileneating what is and is not an ordinary business decision.  As a result, for the most part, the matter is within the discretion of the staff, unguided by state law, to determine. 

Moreover, whatever state law suggests, the SEC has grafted onto the exclusion an exception that is not contained in state law.  Since 1976, the staff has allowed the inclusion of proposals that implicate this exclusion so long as it implicated issues of important public or social policy.  The SEC was forced into this position after a history of allowing the exclusion of proposals that called for the end of segregation on buses and the production of napalm.  All of this is discussed in detail in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

This is another area where the staff has no meaningful guidance.  These are not terms of art.  There are no recognized standards.  And, because it is not an exception recognized under state law, there is not even meaningful philosophical guidance on when to apply the public/social policy exception.  Thus, this is determined entirely by the staff, a matter not within its traditional expertise and one that changes from Commission to Commission (another matter discussed in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors). 

The problems with the interpretation of the ordinary business exclusion can be seen with particular vigor in connection with the auditor rotation issue. 

In AT&T Inc. (Jan. 5, 2012), for example, shareholders submitted a proposal that called for the following:  

Be it Resolved: That the shareholders of AT&T Inc. hereby request that the Company's Board Audit Review Committee establish an Audit Firm Rotation Policy that requires that at least every seven years the Company's audit firm rotate off the engagement for a minimum of three years.

The staff, however, allowed for the exclusion of the proposal.  The reason?  It fell within the "ordinary business" of the company.  As the staff reasoned:

There appears to be some basis for your view that AT&T may exclude the proposal under rule 14a-8(i)(7), as relating to AT&T's ordinary business operations. In this regard, we note that the proposal relates to limiting the term of engagement of AT&T's independent auditors. Proposals concerning the selection of independent auditors or, more generally, management of the independent auditor's engagement, are generally excludable under rule 14a-8(i)(7). Accordingly, we will not recommend enforcement action to the Commission if AT&T omits the proposal from its proxy materials in reliance on rule 14a-8(i)(7).

The analysis was repeated in a number of other letters.  See ITT Corp. (Jan. 13, 2012), ConocoPhillips (Jan. 13, 2012), Dominion Resources (Jan. 4, 2012).  Moreover, the staff took the position irrespective of the particular circumstances at each company.  Thus, the staff allowed GE to exclude a mandatory rotation proposal (See GE (Dec. 23, 2011)) despite the fact that GE has been sanctioned for accounting problems (See SEC v. General Electric, Litigation Release No. 21166, Aug. 4, 2009) and appears to have a very, even excessively, close relationship with its auditor.

We will discuss the analysis use by the staff in the next post.


Auditor Rotation and the Impediments to Private Ordering (Part 1)

Last year, the PCAOB issued a concept release on whether there should be mandatory rotation of accounting firms.  The release is here.  It is a tough issue.  There is the disurption that comes from mandatory rotation.  At the same time, there is concern over the complacency that sets in when the same auditor peforms that function for decades or more. 

The debate for the most part is over a mandatory rule.  In other words, the proposal would potentially require all public companies to rotate their auditor after a specified number of years.  In general, this again triggers the debate over the choice between mandatory rules and private ordering.  Private ordering contemplates that each company will select the appropriate approach depending upon the company's particular circumstances.  In theory, private ordering involves a debate between owners and managers.  Thus, the approach contemplates some say in the matter by shareholders.  

Because management (specifically the audit committee) already has the right to select (and change) the auditor, a system of private ordering requires the creation of a mechanism for involvement by shareholders.  The obvious mechanism is Rule 14a-8, the shareholder proposal rule.  Under the rule, shareholders can submit proposals calling for mandatory rotation. 

To the extent a proposal is allowed, management can campaign against them and try to ensure their defeat by shareholders.  Alternatively, management can conceded the point or negotiate over a compromise to get the shareholders to withdraw the proposal.  Either way, shareholders have a say in the decision and mandatory rotation is resolved on a company by company basis.

Only the staff at the SEC has shut the door to proposals concerning mandatory rotation.  A series of noaction letters have found that these type of proposals can be deleted under Section (i)(7), the infamous "ordinary business" exclusion. We will discuss the use of this exclusion in greater detail in subsequent posts.  In the meantime, for a detailed history and analysis of the ordinary business exclusion, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.


The Relationship between Bad Corporate Governance and Bad Corporate Performance

One of the conundrums in the corporate governance world is the difficulty in showing a relationship between good corporate governance and performance.  Increasing the number of independent directors from a majority to a super majority, for example, does not typically result in better performance.  There are many reasons for this, not the least of which is that "independent" directors are often not really independent so the benefit to the company is questionable. 

But can bad governance result in a decline in share prices?  If Chesapeake Energy is any indication, the answer is yes.  The company has engaged in any number of governance practices that have raised eyebrows, from purchasing the CEO's map collection to supporting the legislation in Oklahoma that would mandate staggered boards. 

The board is almost entirely lacking in diversity and until recently combined chairman and CEO.  Directors are lavishly paid, with total compensation for most of them exceeding $500,000 in 2011 and perqs that include the personal use of the corporate aircraft.  See Proxy Statement, at 10.  Perhaps unsurprisingly, shareholder proposals calling for say on director pay have garnered considerable support (in 2010, the proposal received 192 million votes in favor; 222 million against; the proposal passed in 2009).  

Concerns over governance, however, came to a head with the breaking of stories about loans by the CEO and outside investment activities.  A Reuters report described the CEO's activities as running a hedge fund "that traded in the same commodities Chesapeake produces."  Another report indicated that the CEO had "used his personal stake in Chesapeake wells as collateral for up to $1.1 billion in loans used mostly to pay his share of the costs of Chesapeake wells in which he had invested."

All of this suggests a board that has been passive with respect to the CEO and has displayed a tin ear when it comes to the governance interests of shareholders.  So how has this been viewed in the market?  Not favorably.  Chesapeake share prices have taken a beating.  While some of that is attributable to the failure to meet analyst expectations, the revelations about the CEO have played a role.

Adding an independent director or forming a risk committee of the board may not raise share prices.  But suggestions that a board that does not pay sufficient attention to the activities of the CEO apparently does, at least if Chesapeake is any example.  


Corporate Governance: The Textbook

Corporate Governance, the textbook is now out in hardcopy, published by LexisNexis. 

Corporate Governance is a traditional legal textbook that examines corporate governance issues using cases, excerpts from law review articles, and assorted primary materials, including SEC releases.  The book examines the legal regime regulating corporate governance under state law, the federal securities laws, and the stock exchanges.  

More specifically, the textbook explores such topics as the benefits, if any, of corporate governance, the structural changes in the markets that impact governance, including the transformation of stock exchanges into for profit companies, the structure of public company boards and the role of diversity, and governance practices outside the United States.

For those teaching courses on corporation law, the textbook contains a thorough discussion of the board of directors, fiduciary obligations, takeovers and proxy contests, and the role of shareholders.  It therefore covers in great detail a significant portion of traditional corporations courses.   

The table of contents can be found here.


The Growing Federalization of the Duty to Monitor (Part 2)

Reporting obligations to the board have begun to develop, with the SEC at the center.  Sarbanes Oxley took some tentative steps in this direction by requiring boards to have in place a mechanism that allowed employees to report directly any problems and concerns.  Thus, Rule 10A-3 requires audit committees of exchange traded companies to have a system that allows for the "confidential, anonymous submission by employees of the listed issuer of concerns regarding questionable accounting or auditing matters." In other words, these concerns should not be filtered through officers and left to their discrtion to report.  Instead, they must go directly to the board.

But the place where more specific reporting requirements are developing is under Section 13(b)(2) of the Exchange Act.  The provision requires companies to "devise and maintain a system of internal accounting controls."  Such a system may sometimes require that certain types of information be reported to the board.  An example of this type of development occurred in  In re Symmetry Medical, Inc.,  Exchange Act Release No. 66268 (admin proc Jan. 30, 2012).

In that case, the Commission brought an action against the person who "served as [the Company's] Chief Financial Officer and Senior Vice President since March 2004."  The CFO received a report from the director of internal audit that identified certain problems with the Company's financial data.  The report was not given to the audit committee of the board.  As the Release described:

[The CFO] forwarded the status report to the Company’s independent auditor as well as Symmetry’s controller and they discussed it with the IA [director of internal audit].  After the IA resigned on or about July  19, 2006, [the CFO] did not, however, include the report in the board packet for the July 26 Audit Committee meeting.  According to the minutes of that meeting, [the CFO] told the Committee that the IA had “tested all facilities and all were acceptable with a few exceptions found [at the Company]" The Audit Committee discussed the IA’s resignation and thereafter the chair of the Audit Committee conducted an exit interview with the IA.  However, [the CFO] did not provide the IA’s report to the Audit Committee, and the Committee did not otherwise learn of the report until after the fraud at [the Company] was discovered. 

In considering the circumstances, the Commission cited the Company for failing "to devise and maintain effective internal accounting controls".  The Commission also found that the the CFO "knowingly circumvented" the system of internal accounting controls by "failing to furnish the IA's Report to [the Company's] Audit Committee." 

The case, therefore, sends a message to companies about their reporting system.  Unlike state law, the federal system requires that certain matters be presented to the board.  This case suggests that significant problems uncovered by an internal audit need to be reported to the board.  In this case, the Commission placed the burden on the CFO.  It was the officer's obligation to ensure that the report made its way to the audit committee.  Future cases might just as easily sanction directors for failing to have in place a reporting system that mandated disclosure of this type of information to the board.  


The Growing Federalization of the Duty to Monitor (Part 1)

The Delaware courts were slow to come to the realization that directors ought to have a duty to monitor.  The doctrine was only developed in Caremark, a case decided in 1996.  The Delaware courts came to the area late.  As the court in Caremark noted, obligations to monitor were already arising from other areas, such as the sentencing guidelines. 

The decision was at some level a legal oddity.  The lower court effectively overturned the higher court, reversing Graham v. Allis-Chalmers, the Supreme Court decision from three decades earlier that had effectively held there was no such duty.  Of course, it still took another decade before the Supreme Court actually affirmed the reasoning in Stone v. Ritter, 911 A.2d 362 (Del. 2006).  See also In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106 (describing Caremark as a "reassessment" of Graham). 

The "classic" Caremark claim involved allegations of "directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation . . ."  In other words, the claim sought to impose liability for matters unknown to the board.  In those circumstances, liability could arise where the board should have known about the harmful activity.

The court went on to define the circumstances where ignorance could nonetheless result in liability.  Plaintiffs had to show "a sustained or systematic failure of the board to exercise oversight--such as an utter failure to attempt to assure a reasonable information and reporting system exists".  According to the Court in Stone v. Ritter, this occurred when directors "utterly failed to implement any reporting or information system or controls" or where they implemented a system but "consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention."

In effect, this standard gave directors a pass on liability whenever they had a reporting system in place.  What the courts did not do and have not done is define the minimum content of an adequate reporting system.  It was simply enough to have one in place, irrespective of the type or quality of information provided to the board. 

Thus, in Amylin, for example, the Chancery Court, in a decision upheld by the Supreme Court, found that directors did not have to have a reporting system that made them aware of contractual provisions that "materially reduce[d] the shareholder franchise."  Rather than require a reporting system robust enough to provide that type of information to the board, the court merely encouraged outside counsel to "be especially mindful of the board’s continuing duties to the stockholders to protect their interests."

Having a reporting system is not enough.  To the extent that the system has little specific content, disclosure to the board becomes a matter of discretion.  Officers and other employees can find justifications to withhold important information  from the board.  Officers have a particular incentive to do so where the information will make them look bad (the board can, after all, dismiss any officer, including the CEO).  The incentive to keep boards uninformed is discussed at greater length here:  Essay: Neutralizing the Board of Directors and the Impact on Diversity

For the foreseeable future, Delaware courts are unlikely to provide content to the reporting system in place at the board level.  Standards will, however, develop.  It will be the federal government that fills the vacuum, something that has already begun to occur as we will discuss in the next post.