We have been examining the role of the SEC in the corporate governance process. Before our digression into the Verizon “say on pay” proposal, we were discussing the use of disclosure by the Commission to regulate substantive behavior. My article on this subject can be found here.

In the aftermath of Business Roundtable, the Commission’s approach to governance shifted. Disclosure became a mechanism designed to directly alter the deliberative process inside the board room. The Commission did so in three broad ways. First, the Commission sought to use disclosure to ensure greater independence of those on the board. Second the agency sought to increase the transparency of the decision making process. Third, disclosure requirements were designed to limit the influence of the CEO in the governance process.

Enron and Worldcom resulted in increased regulation of substantive behavior of officers and directors.  There were two principal sources. One was Sarbanes-Oxley, particularly Section 301 and requirement that listed companies have audit committees consisting entirely of independent directors. The other was the stock exchanges. The exchanges adopted listing standards that, among other things, required a majority of the board to consist of independent directors and mandated that each board have an audit, nominating and compensation committee, with each consisting entirely of independent directors.  See NYSE Manual 303A.

Although an improvement in the existing state of affairs, the listing standards suffered from a number of limitations. For one thing, the standards were not sufficiently rigorous. The definition of independent did not adequately capture all potentially disqualifying relationships. They did not address non-family business or personal relationships and generally excluded the consideration of fees in determining material financial relationships with the listed company, irrespective of the amount.  For some posts on this topic, go here and here.  Nor did they address outside business relationships with executive officers, something we have discussed on this Blog.

Most importantly, however, was the problem of enforcement. Shareholders lacked a private right of action for violations. Nor did the Commission enforce the requirements. That left only the self regulatory organizations. They, however, had a history of weak enforcement. Some of it was logistical. The exchanges possessed only a limited array of potential sanctions, largely limited to delisting, suspension from trading and, in some cases, a letter of censure. In addition, however, rigorous enforcement was bad for business. Delisting would result in a loss of fees paid by the company and reduce the trading volume of the exchange.

The Commission used disclosure to alter this basic framework. Public companies were essentially required to reveal compliance with the listing standards imposed by the exchanges. See Item 407 of Regulation S-K, 17 CFR 229.407.  This included the identity of the directors who met the definition of independent, the existence of auditing, nominating and compensation committees, and a considerable amount of information about the activities of the committees.  

The requirements altered the compliance calculation. Violations of the rules of the exchange raised few enforcement concerns. Transforming them into disclosure requirements changed this. For one thing, the Commission could bring an action for violations. More importantly, the approach effectively created a private right of action for misstatements about compliance, whether under the antifraud provisions or the proxy rules.

The use of disclosure in this area to alter substantive behavior, however, highlights a central weakness in the approach.  Disclosure of compliance was only as good as the quality of the underlying standards. Because the definition of independence, for example, does not ensure that the directors are in fact independent, the disclosure requirements can, in some instances, actually mislead investors into thinking that in fact the board is independent.