We wrote last Wednesday about the rules adopted by the SEC governing short sales (not the complete ban but the rules imposing consequences for failed delivery and making it an antifraud provision to lie about having arranged for shares to cover a short position) and suggested that they may have violated the APA. This view was incorrect.

The interpretation came from reading the SEC's press release (the adopting release hadn't been published) and the belief that the SEC was adopting the rules through traditional rulemaking authority. The press release, for example, noted that at the end of 30 days, the “Commission expects to follow further rulemaking procedures at the expiration of the comment period."

But in fact we have come to learn from Broc Romanek at TheCorporateCounsel.net Blog (and a comment from the former Secretary of the SEC) that the rules were adopted not under the APA but under the emergency authority in Section 12(k)(2), something made clear by the implementing release. As Broc notes:

• I think the discrepancy can be explained - there likely was a shift in the SEC's thinking between the time of issuance of the press release and the later issuance of the emergency order, when the SEC decided to issue its new rules in the form of an emergency order from interim final rules, probably due to the fact that they just didn't have the time to crank out a full-blown release. The whole thing happened very quickly.

The APA does not apply to orders issued under Section 12(k)(2). As a result, the order would not be subject to the requirement of notice and comment. See 15 USCS § 78l(k)(2)(E)(exempting orders from requirements of 5 USC 553). Adoption of the rules could not, therefore, violate the APA.

The very decision to sidestep the APA, however, raises questions. The provisions adopted by the Commission were adopted pursuant to emergency authority. But the provisions were routine in nature and unlikely to have had a significant impact on activities in the market. The adopting release provided little immediate justification for the rules (a concern that naked short selling can harm the markets) or much of an explanation of how the rule would have improved market stability. In other words, while there may have been genuine concern over naked short selling (as there has been since at least the summer), there was no immediate reason to act, no immediate reason to sidestep the traditional rulemaking process in the APA. The APA allows for immediate implementation of a rule, without notice and comment, for good cause but requires an explanation of good cause in the release. By using Section 12(k)(2) rather than the APA, the SEC sidestepped the need to provide this explanation.

The order suggests that these same requirements will eventually be subject to rulemaking under the APA. The press release states that the SEC is seeking comment and intends to follow "further rulemaking procedures" with respect to the rules. In other words, the SEC appears to have used its authority in Section 12(k)(2) not to quell an emergency but to advance a substantive rulemaking agenda while avoiding the APA.

The authority in Section 12(k)(2) is quite broad. But there is nothing in the legislative history of Section 12(k)(2) that suggests that it was meant as a substitute for the APA. The authority was meant to be used to provide short term solutions to unusual market congressional examination.

We have wondered whether the SEC had the authority under Section 12(k)(2) of the Exchange Act to take the extraordinary step of banning short sales for ten days in 799 companies. The authority was given to the SEC back in the Market Reform Act of 1990. The Act was passed in the aftermath of the substantial drop in share prices that occurred in October 1987. In considering the Commission's authority, we took a look at some of the legislative history on the provision. The Senate Report noted that emergency actions by the Commission:

• might include, but would not be limited to, the ability to alter, supplement, suspend or impose requirements or restrictions with respect to hours of trading, position limits, and clearance and settlement.

 THE MARKET REFORM ACT OF 1990,REPORT OF THE COMMITTEE ON BANKING, HOUSING,AND URBAN AFFAIRS, UNITED STATES SENATE TO ACCOMPANY S. 648,101ST CONGRESS, 2d Session 101-300 (1990). While the list wasn't exclusive, it contained nothing like the broad authority to stop all short selling. Moreover, the legislative history suggested that the broader the exercise of the authority, the shorter the duration of the restrictions.

• the actions should be tailored to the specifics of a particular market event. For example, some emergency measures would be necessary only for very short periods, perhaps hours or minutes. However, other matters, such as those relating to hours of business and clearance and settlement, might be put in place for longer periods in order to be effective.

The current ban on short selling was put in place for ten days, with the agency holding out the prospect of an even longer period. In other words, it is much longer and much wider in scope than what the legislative history seemed to suggest.

The SEC's ban on short selling was supported by a similar measure enacted by the FSA in Great Britain.  Other countries have followed suit, although not always in the same heavy handed way.  According to the Journal, Australia and Taiwan have banned short selling, with Taiwan limiting the practice to the 150 largest companies.  Dutch regulators, in comparison, only banned naked short selling, with the article indicating that Belgium and France would do the same.  The article made no mention of the practices in other large markets including Tokyo and Frankfurt. 

In addition to questions about the SEC's authority to implement the ban, the existence of global trading raises issues with the effectiveness of any ban.  At least for companies traded on overseas markets, it would seem that short sales were still possible if executed in foreign markets.

We have noted that the SEC has increasingly been turning its attention to outside and independent directors. It may be an aberration but more likely it reflects the failure of Delaware law to impose meaningful standards on these directors. Increasingly, therefore, the SEC has gotten into the business of defining and enforcing director independence and imposing more meaningful standards on their behavior.

In In re Mercury Interactive, Litigation Release No. 20724 (SD CA Sept. 17, 2008), a settled injunctive proceeding, the complaint "alleges that the outside directors recklessly approved backdated stock option grants and reviewed and signed public filings that contained materially false and misleading disclosures about the company’s stock option grants and company expenses." The directors served on the compensation committee. As part of that assignment, they approved 21 stock option grants that were backdated. According to the complaint, they knew that the stock option plan required pricing to be at the closing price of the company’s stock on the day that they approved and that they "repeatedly executed documents approving grants of stock options while failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval."

The directors were apparently duped by other officials in the company. As an example, the SEC's complaint describes the following approval of options:

• Shamir, Yaron and Kohavi were repeatedly asked to sign written consents memorializing option grants with grant dates months before they had even been contacted by management with respect to approval of a grant. For example, management began assembling a list of grant recipients on March 7, 1999, and contacted the directors by phone that same day to approve the options. Yet the directors signed written consents just two weeks later memorializing the grant with a grant date of January 21,1999, two months prior.

The SEC stopped short of saying that the outside directors knew that the options were backdated. Instead, the backdating was apparent from the documentation. Thus, the directors failed to examine the paperwork before approving the options. In other words, it looks like a Radar O'Reilly type of approval process. The directors were presented with paper work that they simply signed without examining it closely.

In Delaware, this type of behavior would be dismissed out of hand. Shareholders would need to show that demand was excused, which mostly means they must establish a lack of board independence. As a result, the case would be dismissed and the merits never addressed.

At the federal level, however, the merits matter more. With respect to securities matters, directors in fact will be expected to understand the contents of the documents put before them. This effectively amounts to an example of SEC preemption of state law by imposing subsantive standards on directors. Given the lack of standards under Delaware law, this can be expected to happen more and more.

For more on the subject, theD&O Diary has a nice post. 

The Commission has, for the next ten days, banned short sales, an extraordinary intervention by the government into the financial markets. The step impairs liquidity and represents a bureaucratic decision to interfere with the efficient market theory.

It is, therefore, worth taking a look at the statutory authority for the move. According to the adopting release, the SEC exercised its authority under Section 12(k)(2) of the Exchange Act.  See 15 USCS § 78l(k)(2).  As the agency described:

• the Commission is exercising its powers under Section 12(k)(2) of the Act.  Pursuant to Section 12(k)(2), in appropriate circumstances the Commission may issue summarily an order to alter, supplement, suspend, or impose requirements or restrictions with respect to matters or actions subject to regulation by the Commission if the Commission determines such an order is necessary in the public interest and for the protection of investors to maintain or restore fair and orderly securities markets.

The Section provides that the Commission may, "in an emergency," summarily take action with respect to "any matter or action subject to regulation by the Commission" that is, among other things, necessary "to maintain or restore fair and orderly securities markets" or to "reduce, eliminate, or prevent the substantial disruption . . . of the securities markets" 15 USC 78l(k)(2).  Interesting, particularly with respect to an independent agency, the president has the authority to terminate an emergency order.  See 15 USCS § 78l(k)(3).  An emergency is broadly defined as anything that might result in a "sudden and excessive fluctuations of securities prices generally, or a substantial threat thereof, that threaten fair and orderly markets". 

There are several things that are problematic about the SEC's actions.  First, the authority is historically unprecedented.  Section 12(k) has only been used only two other times and both times in a very discrete manner.  It was used back in July to restrict short sales in a specified list of financial institutions.  See Exchange Act Release No. 58166 (July 15, 2008).  But that order only applied to 19 firms, not the 799 firms in the latest efforts, and was only designed to restrict naked short sales, not all short sale.  The other instance was in a post-9/11 environment when the Commission allowed Amex specialists to also serve as floor brokers.  See Exchange Act Release No. 44797 (Sept. 16, 2001)("Amex specialists shall be temporarily exempt from Section 11(a) solely for effecting transactions when acting as floor brokers for Amex orders on the floor of the NYSE for accounts in which they have investment discretion"). 

Second, while the provision gives the agency the authority to address any matter subject to the SEC's regulation, it is unclear that this would apply to a type of transaction.  Thus, there is little doubt that the SEC can use the authority to affect the behavior of market makers or brokers or stop trading.  But the ban on short sales by the SEC prohibits "all persons" from engaging in the sales.  Is it really the case that the provision is broad enough to prohibit certain types of sales practices among private individuals?

Third, Section 12 provides that an order can be challenged in court but only as "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law."  Arbitrary and capricious is a term of art that generally means there's an inadequate explanation in the record to support the decision.  While the case can presumably be made that there is a crisis in the market, the record supporting the Commission's decision is entirely devoid of any evidence that the crisis is a consequence of short selling.  The existence of a crisis, in other words, doesn't justify any response.

Barney Frank has indicated that he will look into whether the Fed, an independent agency, ought to be able to buy 80% of AIG (and rely on a fund of $800 billion to potentially make other purchases) without some oversight.  He also ought to look into whether the SEC's authority under Section 12(k)(2) is so broad (and not subject to oversight) that it can interfere in the markets in such a substantial and unprecedented way without oversight. 

We were treated to the Feds (and Treasury's) decision to purchase 80% of AIG, an extraordinary intervention by the government into the private sector.  This morning we see an equally unprecedented regulatory step, the decision by the SEC to ban short selling in almost 800 companies.   The ban is only for 10 days although it may be extended.  But even with the short term nature of the step, it reflects both panic at the SEC and an extraordinary lack of faith in the market.  

The SEC suggests that short selling is essentially manipulation.  As the release notes:

• Given the importance of confidence in our financial markets as a whole, we have become concerned about recent sudden declines in the prices of a wide range of securities. Such price declines can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence, without a fundamental underlying basis.  This crisis of confidence can impair the liquidity and ultimate viability of an issuer, with potentially broad market consequences.
  

Short sales are a bet that stock prices will go down.  For every short sale, there has to be someone else on the other side of the transaction who thinks the share prices will go up.  In other words, short sales help achieve more accurate price equilibrium.  The transactions are necessary in an efficient market.  When companies release information, some participants may think it will help the prospects of a company and others think it will hurt.  Short sales allow the market to adjust to the information and obtain an efficient price.

By banning all short sales (as opposed to efforts to combat naked short sales), the SEC is merely removing liquidity from the market and impeding the market's ability to set an efficient price for a company's shares.  In other words, it is tantamount to a judgment by the SEC that the market cannot be counted on to accurately set a price.  It is a remarkable vote of no confidence in the efficient market theory, something that has been at the core of the SEC's approach to regulation for a quarter of a century.   

We have discussed John McCain's comments indicating that he would "fire" Christopher Cox as Chairman of the SEC.  This is the Chairman's response:

 

"While I have great respect for Senator McCain, we have sometimes disagreed, and this is one such occasion. The SEC has made plain that we have zero tolerance for naked short selling. In this market crisis, the men and women of the SEC have responded valiantly as they always do—with the utmost dedication and professionalism. Addressing the extraordinary challenges facing our markets, the independent and bipartisan SEC has taken the following decisive actions:

        We adopted a package of measures to strengthen investor protections against naked short selling, including rules requiring a hard T+3 close-out, eliminating the options market maker exception of Regulation SHO and expressly targeting fraud in short selling transactions.

        We issued an emergency order to enhance protections against naked short selling in the securities of primary dealers, Fannie Mae, and Freddie Mac.

        We announced emergency plans for a rule to ensure public disclosure of short selling positions of hedge funds and other institutional money managers.

        We have undertaken sweeping enforcement measures against market manipulation.

        We provided guidance to banks about how to account for credit support of money market funds.

        We've written rules to strengthen the regulation of credit rating agencies, and performed examinations that have led to new rules to reduce rating agency conflicts-of-interest.

        We brought a landmark enforcement action against a trader who spread false rumors designed to drive down the price of stock.

        We have initiated exams of the effectiveness of broker-dealers' controls to prevent the spread of false information intended to manipulate securities prices.

        Our Enforcement Division announced what will be the largest settlements in the history of the SEC for investors in auction rate securities who bought auction rate securities from Merrill Lynch, Wachovia, UBS and Citigroup.

        We entered into a Memorandum of Understanding with the Federal Reserve, to make sure key federal financial regulators share information and coordinate regulatory activities in important areas of common interest.

"There is much more work to be done, and the current crisis is presenting new challenges on an hourly basis. What America and the world needs now is steadiness and reduction of uncertainty. History will judge the quality of our response to this economic crisis, but now is not the time for those of us in the trenches to be distracted by the ebb and flow of the current election campaign. And it is precisely the wrong moment for a change in leadership that inevitably would disrupt the work of the SEC at just the wrong time. I have long made clear my intention to leave the SEC after the end of this Administration. The next President will have an opportunity to look at the major structural questions so important to the regulation and oversight of our financial markets.

"I very much appreciate the strong and immediate support of the President. As someone who has been in public life for over 20 years, I know as well as anyone that occasionally this sort of thing can come with the territory. The best response to political jabs like this is simply to put your head down and not lose a step doing the best job you can possibly do on behalf of those you serve. For my part, I plan to do just that. I leave the political campaigns to pursue their own course."

One thing that is now certain with respect to the Securities and Exchange Commission in November.  The president has the power to designate the chair of the Commission and to fill any openings.  There is no power to remove existing commissioners; the president must wait until their terms expire.  With three seats having just been filled, there will be no openings in the near term unless someone resigns.

With that in mind, Barack Obama can be expected to appoint one of the two democrats on the Commission (Elisse Walter and Luis Aguilar).  Now we hear that if John McCain is elected, he intends to "fire" Cox.  This doesn't mean removing him as a commissioner (something that requires good cause) but replacing him as chair.  In fact as McCain noted:  “The chairman of the SEC serves at the appointment of the president and has betrayed the public’s trust. If I were president today, I would fire him.”  He is quite right on that score. 

So, in this case, firing means removing him as chair.  As a result, under the current configuration, McCain will need to move the position to either Paredes or Casey.  Of course the more likely thing to happen is for Cox to step down either just before or just after the election, allowing the new president to add a member who will serve as chairman.

In an effort to get in the game, the SEC announced new rules (effective on Thursday) designed to restrict naked short selling. According to the SEC press release, the rules would requre:

• that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.

In the case of violations, the new rules provide that:

• any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer.

In addition, the agency adopted Rule 10b-21 that would short sellers falsely representing that they have borrowed the shares required to be delivered at settlement.

The Commission noted that the rules, although effective immediately, would be subject to a 30 day comment period and, obliquely that the agency "expects to follow further rulemaking procedures at the expiration of the comment period."

Now, there may be a sense of panic at the SEC over the need to get involved, but panic is not one of the justifications for avoiding the requirements of the Administrative Procedures Act with respect to the adoption of new rules. Section 553 of the APA requires agencies to propose rules, provide an opportunity for comment, and wait at least 30 days before they become effective. The provision has a "good cause" exception from these requirements. Good cause requires a showing that notice and comment was "impracticable, unnecessary, or contrary to the public interest." The SEC must invoke good cause in the adopting release.

The implementation of these rules reflects panic at the SEC, but are they so immediately necessary that they must be implemented without notice and comment? The agency allowed the earlier emergency rules to expire (the rules that regulated short selling in the stocks of 19 financial companies) without the apparent need to adopt interim rules. In other words, only a week ago, there appeared be no reason why the rules needed to be rushed. While there is no doubt that the turmoil in the markets has increased, the case has not been made that the turmoil resulted from short selling. In other words, the existence of turmoil cannot be used as an excuse to adopt a rule that will likely have little affect on the current crisis.

Finally, notice and comment is not a mere formality. It is necessary to make sure, in particular, that those who are affected by the rules can weigh in and suggest changes or alternatives. By simply imposing, the SEC has not obtained the necessary feedback that might have enabled it to take a more nuanced approach.

BNA reports that the SEC has approved a rule change by the NYSE in connection with corporate governance requirements. The changes would eliminate the need for an opinion of counsel in connection with any application to list securities. The opinion mainly attested to the legality of the shares and the qualification to do business. The requirement would be replaced with the submission of legal opinions filed in connection with recent stock offerings or, if none where available, a certificate of good standing from the state of incorporation.

More importantly for purposes of this blog, the Exchange proposed eliminating the opinion that effectively attested to the company's compliance with the corporate governance requirements of the Exchange. The reasons for the change? A race to the bottom. As the Exchange described: " No other major exchange requires as a condition to listing an opinion with respect to the issuer’s compliance with the exchange’s corporate governance requirements."

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

In addition, the company must provide at the time of listing a written affirmation 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 committee independence requirements and thereby comprehensively covers the Exchange’s corporate governance requirements."

There are several problems with these substitutes. First, the requirements are legal in nature.  While a board could in good faith attest to compliance, nothing about the process ensures legal involvement.  Thus, for example, in determining whether directors are independent, they may not have a "material relationship" with the company.  Legal advise on the meaning of the phrase is necessary for appropriate application.  Yet the NYSE rule proposal is essentially eliminating a required role for counsel.

Second, the whole approach of SOX was to recognize that boards function better when there are gatekeepers looking over the shoulders of management.  Thus, Section 404 required management to assess the company's internal controls but further mandated that the outside auditor attest to the findings.  In other words, the auditors had to review management's opinion.  The rule change by the NYSE is eliminating a gatekeeper role in the process.   It is doing so despite the existing problems of enforcement.

The NYSE has an incentive to propose the change.  The other exchanges don't do it and it adds a cost to the listing process.  This is a tough thing to require in a competitive environment.  But that is no excuse for the SEC to improve what is an obvious weakening in corporate governance standards administered by the SROs.

We are reviewing Exchange Release No. 58367 (August 15, 2008), where the SEC approved changes to the NYSE definition of director independence.  The changes weaken the definition.  The first change was to raise the amount of "direct compensation" a director could earn and still remain independent.  The second concerned relationships with the outside auditor. 

Section 303A provided that a director lost his/her independence if an immediate family member was a current employee of the accounting firm and worked in the audit practice.  As the release noted: 

• "NYSE's current test has required a listed company's board to conclude that a director may no longer be deemed independent when the director's child took an entry-level job in the audit practice of the listed company's external auditor upon graduation from college, notwithstanding the fact that the child was a low-level employee in a different region and had no involvement with the listed company's audit."  

The solution?  Disqualification occurs only when the family member is a partner of the auditor or works on the lited company's audit.  What does this exclude?  Employees who are not partners but work in the same office where the audit takes place; employees who work on the company's account but are not actually working on the audit (providing, for example, assurances or tax compliance advise); and employees who are not partners but otherwise participate in the setting of standards that could affect the company's audit.

The NYSE identified a problem, albeit one likely to arise rarely.  Nonetheless, in solving the problem, it would have been easy enough to exclude employees who are not partners, not in policy making positions, and conduct no work for the company subject to the audit.  Instead, the change permits a far broader category of relationships than the specific problem identified by the NYSE.

That the NYSE would come up with these changes is no surprise.  The organization is, after all, a for profit business that benefits by making listing standards easier.  It is the SEC that is the gatekeeper and should ensure that investors are protected.  There is no indication with that change that the SEC played this role. 

 

The NYSE has proposed and the Commisson has approved amendments to the listing standards governing the definition of director independence.  Before the amendment, Section 303A.02(b)(ii) of the NYSE contained a categorical rule providing that directors lose their independence if they receive more than $100,000 in direct compensation.  The rule was adopted in the post-SOX reform era and was little more than a sop to those critical of the existing state of corporate governance. 

Thus, the amount does not include directors fees, something that can result in payments to directors in the vicinity of $700,000.  In other words, a director making $700,000 in fees is independent under the rules of the NYSE while a director making $100,000 in fees and $100,001 in "direct" income is not.  Go figure but this is the system that the Commission has allowed.  

Add in that there is anenforcement problem with the independence requirements at the NYSE.  Rather than exercise increased supervision over the NYSE, the Commission has chosen to bring its own enforcement proceedings in connection with director independence.  

With that in mind, we note that the Commission recently approved amendments to the rules of the NYSE that weaken, albeit modestly, the definition of  independence.  The amendments raise the amount of "direct compensation" that can be earned from $100,000 to $120,000.  The reason?  Absolutely nothing related to the notion of independence.  Instead, it was done to bring the rules into better harmony with the SEC requirements for related party transactions in Item 404 of Regulation S-K.  The Commission had previously raised the threshold for conflict of interest transactions that must be reported from $60,000 to $120,000.  According to the NYSE: "Using a consistent standard would enahance the NYSE's abilty to assess compliance with the independent director requirements because companies are required to disclose compensation in excess of $120,000 but are not necessarily required to disclose compensation between $100,000 and $120,000."

It's a curious way to deal with an assessment problem not by doing anything designed to faciliate assessment but by simply eliminating the enforcement obligation.  Moreover, the carefully worded explanation noted that companies were "not necessarily" required to disclose the compensation.  In fact, Item 402 provides that the director compensation table must include "[c]onsulting fees earned," irrespective of the amount.  In other words, the NYSE often had available information about payments made to directors for amounts between $100,000 and $120,000.  In other words, the NYSE was using Item 404 (self interested transactions) as the excuse to raise the threshold when the issue was one primarily of exeuctive compensation and should have been resolved with reference to Item 402. 

There is one more change that we will discuss. 

The reply briefs have been filed in the CSX case and can be found on the DU Corporate Governance web site.

The SEC brought an administrative proceeding against Mark Thompson for failing to reveal to the boards of public companies where he served as directors that he had a business relationship with the outside auditor that impaired the auditor's independence.  The Commission found that he was a cause of violations of the proxy rules and the periodic reporting requirements, including Rule 14a-9.

We predicted this would occur.  Director independence has become the holy grail of corporate governance.  Shareholders are protected and self serving behavior can be reduced through review by a board that consists primarily of independent directors.  The problem with the approach has been that directors called "independent" often are not.  Neither Delaware nor the stock exchanges has an adequate definition that ensures director independence.  Moreover, even with the existing definition, neither enforces it adequately.  And, because there is no private right of action (so far) for the violation of exchange rules, there is no private enforcement mechanism.

The SEC can't enforce listing standards or state law requirements but it remains concerned with the functioning of the board and the need for director independence.  As discussed at length in The SEC, Corporate Governance, and Shareholder Access to the Board Room, the Commission has attempted to circumvent these limits by requiring companies to disclose their compliance with stock exchange rules on independence.  In other words, incorrectly listing directors as independent will violate the rules of the exchange, which have no meaningful enforcement consequences.  At the same time, however, repeating the false information in a proxy statement or periodic report will violate the securities laws, sometimes even the antifraud provisions.

All of this brings us back to the action against Mark Thompson.  In effect, the Commission sanctioned Thompson for not being independent.  The agency did it by finding that the failure to disclose his relationship with E&Y resulted in disclosure violations under the proxy rules and periodic reporting requirements.  

The case may well be a harbinger of future actions and another example of federal preemption in the area of corporate governance.  In the absence of meaningful enforcement standards under state law, it will be the SEC that ensures directors in fact meet independence standards.  Suits against directors (and disgorgement) will likely have the salutary effect of encouraging better disclosure by directors to the board.  That in turn will force boards to examine conflicts in order to determine whether a director is independent.  The results will be disclosed in SEC filings, with liability for the entire board a risk where the board describes directors as independent who are note.

This is a first step.  The most significant step will be when the SEC charges a company and the board for listing directors as independent who are not.  This will essentially cause the company and the board to play a larger, more careful role in the independence analysis.  Moreover, it will cause directors to realize that the lack of enforcement by the states or stock exchanges no longer provides immunity, that incorrect disclosure will result in sanctions under the federal securities laws. 

The other day, the Commission brought an action against Ernst & Young for violating accountant independent standards.  According to the administrative proceeding, E&Y was paying for services from Mark C. Thompson at the same time Thompson sat on the board of three public companies where E&Y conducted audits (two listed on the NYSE, one on Nasdaq) and, in one case, a a company's audit committee.   According to the WSJ:

• Mr. Thompson began as a director at Best Buy, the Minneapolis-based consumer-electronics retailer, in March 2000, and sat on its audit committee until August 2003. Best Buy secured his resignation in May 2004, after E&Y informed the company about its relationship with Mr. Thompson.

• Mr. Thompson was a director at Korn/Ferry, an executive-search firm based in Los Angeles, from March 2000 until September 2003, and a director of TeleTech Holdings Inc., a Denver technology-consulting firm, from February 2004 until May 2004. Of the three, only Korn/Ferry is still an E&Y client.

As settlement of the case, E&Y among other things had to pay disgorgement of $2,381,965 and prejudgment interest of $537,022.79.

The most interesting thing about the case, however, was that the Commission also charged Thompson.  In a separately settled administrative proceeding, the Commission found that Thompson in filling out his annual D&O questionnaire "did not fully furnish the details of his relationship with E&Y in response to these items."  In addition, as a director, he participated in votes to retain E&Y as outside auditor but, at the time of the vote, "did not disclose his business relationship with E&Y, and the proxy solicitations likewise did not disclose the relationship."   In other words, Thompson, according to the Commission, did not make adequate disclosure of his relationship to E&Y to the companies where he sat as director. 

So what was the charge against Thompson since non-disclosure to a board doesn't per se violate the securities laws?  The Commission concluded that the companies violated the proxy rules and the periodic reporting requirements by filing financial statements from non-independent audit reports and "by recommending E&Y’s retention as auditor without disclosing that one of the directors favoring the recommendation had a business relationship with E&Y."  Thompson was required to disclose $100,662.33 and prejudgment interest of $23,254.94, for a total of $123,917.27.  

This is a ground breaking case and we will offer some observations on it in a post later today.

On Friday, Commissioner Paredes took the oath of office and joined the Commission. Continuing a long line of law faculty who have served on the Commission, Paredes most significant contribution so far is to replace Paul Atkins.

While one republican steps into the shoes of the other, it is hard to imagine that the change will do anything but improve the output of the Commission and reduce the shrill tone often emanating from the body.

Atkins, in his six or so years on the Commission, managed to be on the opposite side of almost every shareholder friendly initiative of any great importance. Stoneridge? Against the position taken by shareholder. Access? Against the position taken by shareholders. The Enforcement division, the office responsible for enforcing the investor protection requirements of the securities laws? Constant criticism and calls for a panel to evaluate (read weaken) the division. Fines imposed on companies that commit fraud? In general, against them. The credit crunch and the subprime problem? A paean to his anti-regulatory philosophy and a call not to "immediately jump" to the conclusion that the problems are from market or regulatory failure. His parting shot in the corporate governance area? To participate in the Commission's decision to certify a shareholder proposal to the Delaware Supreme Court, an act that resulted in a predictably anti-shareholder decision that will now make proposals harder to insert in proxy statements.

With all of that in mind, we turn to Atkin's last set of remarks on access. The speech was delivered on July 22, reflecting how Atkins wanted to be remembered with respect to his involvement in the access issue. Of course the content was predictable given the audience: The Chamber of Commerce, the organization probably most in sync with Atkin's views. The talk began with an attack on Rule 14a-8. "Some would argue — and perhaps correctly — that the SEC's Rule 14a-8 on shareholder proposals inappropriately infringes upon state laws that govern the relationships among shareholders and between shareholders and the corporations that they own."

The comment wasn't explained and perhaps for a non-lawyer it was enough to just say it. But most lawyers will recognize that the view is wrong. Rule 14a-8 addresses the right to include proposals in a proxy statement, a document that is entirely a creation of federal law. Proposals are excluded if they violate state law, providing states with an ultimate veto over the availability of the rule. The comment isn't any kind of statement about the law. Its a reflection of Atkin's anti-shareholder bias. He simply dislikes that Rule 14a-8 provides shareholders with an opportunity to express their views, invariably in a non-binding manner, on managerial issues they consider important. In other words, shareholders should be seen (by providing capital) but not heard. It is a view that is belied by reality, particularly as public companies are more and more owned by institutional investors. These investors want greater opportunity to communicate their views with management whether Atkins likes it or not.

He rightfully realizes that the anti-shareholder approach he struggled to promote may not survive long after his departure. In the speech he expressed concern that the agency permit access in time for the 2009 proxy season.

• My most significant concern is that the Commission could try to move to adopt a final rule based on the long release without additional public notice or comment. The long proposal was controversial with almost every group commenting on it — including procedural aspects as well as specific thresholds contained in the rule. Of course, it suffered from concerns as to the SEC's authority to do it, plus it undermines the proxy disclosure and solicitation regime. In addition, much has happened since the comment period closed on October 2, 2007.

Atkins had no difficulty with the adoption of the short proposal (denying access) despite vociferous criticism. He made no effort to compromise or try to address the interests of a large number of commentators, including almost all significant shareholder groups. He was able to have an accentuated degree of influence because of the makeup of the Commission, with no democrats present at the most critical junctures.

But Atkins no longer has a decision making role and the agency has its full complement of democrats. Perhaps Chairman Cox will revisit access for the 2009 proxy season as Atkins suspects. But it hardly matters. With regime change coming following the November 2008 elections, access will be revisited one way or another. The pressure of shareholders is simply too great (take a look at my paper, The SEC, Corporate Governance, and Shareholder Access to the Boardroom). In fact, while Atkins struggles to oppose access of any kind, the truth is that Chairman Cox has a brief window to put in place a system of access that will likely be rarely used and lead to few changes on the board. If he doesn't, the form of access ultimately implemented will likely to be far more invasive. Chairman Cox knows this, Paul Atkins does not.

We are discussing the much awaited  interpretive release from the SEC containing guidance on the use of company websites. 

The release discusses the issue of hyperlinks and the problem of adopting third party statements linked to the company's web site.  The general rule is that companies are not liable for third party statements.  To the extent they "adopt" them, however, the company will be treated as having made the statement and potentially liable for any inaccuracies.  The issue arises in the Internet context most severely where a company links third party statements, whether analyst reports or media commentary, on a selective basis.  This creates the appearance that the company is linking only to content that it approves.   As the release noted:

• While the use of "exit notices" or "intermediate screens" helps to  avoid confusion as to the source of the third-party information, no one type of "exit notice" or "intermediate screen" will absolve companies from antifraud liability for third party hyperlinked information. For example, if there is only one analyst report out of many that provides a positive outlook on the company's prospects, and the company provides a hyperlink to the one positive analyst report and to no other, and does not mention the fact that all the other analyst reports are negative on the company's prospects, then even the use of an "exit notice" or "intermediate screen" or explanatory language may not be sufficient to avoid the inference that the company has approved or endorsed the one positive analyst's report.

Sound advice, although even mentioning that there are other reports that disagree will probably not insulate the link from successful allegations that the company approved the one positive report.  To avoid this, the traditional advice (other than don't do it, particularly with respect to links to analyst reports), is to have the company link to all materials within a classification, good or bad (along with a relevant legend or "exit notice"), whether all articles on the company or all analyst reports.  The key is to have the selection of material that will be linked to the page not be in any way influenced by the contents.   The release repeats this advice. 

• "[I]f a company has a media page and simply provides hyperlinks ot recent news articles, both positive and negative, about a company, the risk that a company may have liability regarding a particular article or that it endorsed or approves of each and every news article may be reduced."

All straightforward enough except that the release also notes that "a company would not be shielded from the antifraud liability for hyperlinks to information it knows, or is reckless in not knowing is materially false or misleading." 

This is true even if the company "uses a disclaimer and/or other features designed to indicate that it has not adopted the false or misleading information to which it has provided the hyperlink."  

Presumably officials in the company read all articles and analyst reports linked to the page.  As a result, they know if there are any inaccuracies.  The release seems to say that if they know, the company will be treated as having approved the false statement.  The approach squarely contradicts the advice that  companies can post all materials within a category, irrespective of the content.  If means that companies must delete or remove materials because of their contents.  Said another way, the SEC is effectively stating that companies must vouch for the contents of the material linked to its page.

Assume, therefore, that a company links to all analyst reports.  If one of the analyst reports falsely states that the company has had a breakthrough in its product development (assuming the information came from sources outside the company), the release suggests that the company may be deemed to have adopted the statement.  Similarly, what if an analyst report contains a projection that the company knows is lacking in a reasonable basis.  Perhaps the company is liable for these as well, assuming they know (which they will). 

There is no question that conveying false information to the market through the medium of third parties can violate the antifraud requirements.  Linking to false information can constitute fraud where the company somehow suggests that it has approved the contents.  But linking to all publications, consistently over time, without editorial comment, in a neutral matter, is effectively a disclaimer at any effort to approve or disapprove the contents.  In those circumstances, it is hard to see why or how a company would be liable for inaccurate information in the third party statement, even if it knows of the inaccuracy. 

The SEC's statement is too blunt.  It in fact may well have the effect of discouraging links to third party information, even if done in a neutral and comprehensive way. 

On Friday, the Commission issued its much awaited  interpretive release containing guidance on the use of company websites.  Most of the "interpretation" was common sense applications of Regulation FD and the antifraud provisions, neither novel nor particularly useful but relatively harmless.  In some places, however, the Commission confused the analysis and made matters more, rather than less difficult for lawyers trying to ensure compliance with the securities laws.

Take the discussion of the republication problem.  Unlike hard copies, which become stale automatically over time, web disclosure that has been drafted long ago can still be current.  Everytime an investor hits the web site and reads the disclosure, he or she may well rely on the information.  As long as it remains on the page, therefore, the information is effectively republished.  

In the interpretive release, the Commission noted that it does not believe that "companies maintaining previously posted materials or statements on their web sites are reissuing or republishing the materials . . . just because the materials or statements remain accessible to the public."   Fair enough, although no serious securities lawyer would take the position that the posting of materials always, irrespective of the circumstances (including positioning on the page and legends), automatically results in republication.  

The observation suggests that republication is the exception but the remaining tone of the release suggests otherwise.  The release went on to note that that "where it is not apparent to the reasonable person that the posted materials or statements speak as of a certain date or earlier period" then "we believe" that the materials should be moved to a section "identified as historical" and on "a separate section of the company's web site." 

In other words, if the disclosure is not written in a way that telegraphs it's limited time span, it will in fact be republished.  This is another way of saying that date specific material is not republished, date unspecific material is.  Why is this important?  Because the Commission provides only one solution to the republication problem, moving the material to an archived section of the web site.  The solution is limited and potentially misleading. 

First, archiving materials is not a silver bullet.  Even when this is done, reliance does not automatically cease.  This is particularly true if the material is archived shortly after posting.  Take for example the speech of the CEO who makes projections for the year.  Moving it within a few weeks from the main page to an archive will probably not end reliance.

Second, the focus on location obscures the more important solution.  In fact, the best way to avoid republication is through careful drafting.  In other words, materials on the web ought to state that they are current as of a time certain or contain legends indicating that they speak as of a specific time.  Routinely taking these steps will reduce investor reliance, whether or not ultimately moved to an archived section of the web site.

A huge component of corporate governance is disclosure.  The SEC uses disclosure for a variety of purposes including to influence the substantive behavior of officers and directors.  This is discussed at length in Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.

Last week, the SEC put out the long awaited interpretive release containing guidance on the use of company websites.  The release is a great disappointment, containing nothing that the average security lawyer doesn't already know.  Take a look at the chapter on Electronic Communications in The Regulation of Corporate Disclosure.  The Release largely deals with Regulation FD and the antifraud provisions, covering such topics as hyperlinks and republication.  So, does disclosure over a public website fulfill the disclosure requirements of Regulation FD?  It depends upon the facts and circumstances.  Will hyperlinks result in a company "adopting" the linked material?  It depends upon the facts and circumstances.  Will a document placed on a website be constantly "reaffirmed" or "republished" each day it appears?  It depends upon the facts and circumstances.

These areas, particularly the antifraud provisions, are full of uncertainty so the "facts and circumstances" test will often be the answer.  But there is no reason to use an interpretive release to repeat well known lore (or in this case, to confuse well known lore).  Instead, the release should have pushed the luddite companies without web pages to start using them.  Indeed, the Commission confessed in the release that "today we have reached a point where the availability of information in electronic form – whether on EDGAR or a company web site – is the superior method of providing company information to most investors, as compared to other methods.”  if its superior then why dance around the need for a web page?  Companies are only required to post filings and beneficial ownership reports on their website "if they have one."     Isn't it time to make them have one and to subject them to uniform standards? 

The Commission had a chance to use the release to push companies in a direction of increased public availability of information and real time disclosure.  The avenue was Regulation FD.  Regulation FD prohibits intentional selective disclosure of material non-public information.  See 17 CFR 243.100.  Thus, if information is already public, the Regulation does not apply. 

The Commission could have provided a safe harbor for companies that maintained a public web page and met certain standards (perhaps initially limited to accelerated filers).  The exemption might, for example, apply to companies with web sites that have an easily accessible page dedicated entirely to shareholders (investor relations) and has had the page in place for a specified time period (perhaps a year).  It's not enough to have a page.  Shareholders need to know that it will be used to disseminate important information.  The safe harbor could extend, therefore, to companies that post all periodic reports simultaneously with filing in EDGAR, post all press releases and other disclosure made to the market simultaneously with release, and agree to broadcast all earnings conferences and shareholder meetings by webcast and keep the webcast posted on the site at least a year. 

They would need to have written standards for what will appear on the web site and both post the standards and repeat them in periodic reports.  Shareholders would then know that the company's web site would be the "superior" method of disseminating important information.  In those circumstances, defining information disclosed on the web site as public for purposes of Regulation FD would be appropriate.

The Commission knows this and danced around the issue.  Information disclosed on the website would sometimes be public.  In resolving whether and when, companies were left with an amorphous set of standards that they already knew. 

• companies must consider whether and when: (1) a company web site is a recognized channel of distribution, (2) posting of information on a company web site disseminates the information in a manner making it available to the securities marketplace in general, and (3) there has been a reasonable waiting period for investors and the market to react to the posted information.

In other words, it depends.  The release provides no real security and no real safe harbor.  The existence of a facts and circumstances test has long been recognized.

A safe harbor under Regulation FD would likely have been a considerable impetus to the use and standardization of corporate web sites.  All public companies are subject to the regulation and therefore must worry about its applicability.  A safe harbor would have alleviated these concerns while, at the same time, benefiting shareholders. 

With respect to Regulation FD, this release provides nothing new.  More importantly, it was an opportunity not taken.  The Release could have taken huge steps in ensuring the use of corporate web sites and ensuring that shareholders received a predictable and uniform stream of disclosure.  Perhaps with regime change after the 2008 elections the agency will revisit the issue. 

So where does all of this leave the case?  There is some possibility that the hedge funds will win on the merits, that the Second Circuit panel will agree with the defendants and find that the "intent to evade" language applies to efforts to hide actual beneficial ownership (the belts and suspenders interpretation of Rule 13d-3).  The reasoning would do damage to the rule but it is an approach that would leave the ultimate solution to the SEC.  The Second Circuit is very unlikely to overturn the decision with respect to group formation.  That is a highly fact specific issue.  The Court will, therefore, have to wrestle with the problem of the appropriate remedy for violations of Section 13(d).  What will the Court do?  Agree that equitable relief is not limited to disclosure and return the case to the district court to determine the appropriate relief.

Oral argument on August 25.  Stay tuned. 

The briefs on appeal, including those filed as amicus are posted on the DU Corporate Governance web site.