The SEC, Corporate Governance, and Jawboning the Exchanges

We are discussing the efforts by the Commission to influence substantive standards of corporate governance.  For more on this topic, go to Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure

These efforts arose from the Agency’s growing understanding of the connection between accurate disclosure and internal accountability. Moreover, with fiduciary obligations weakening under state law, the need to impose standards became even more compelling.

As an initial matter, the Commission turned to listing standards as the principal mechanism. The Commission began to pressure the exchanges to increase their corporate governance requirements, particularly by requiring audit committees and independent directors. See Exchange Act Release No. 41987 (Oct. 7, 1999)(“Since the early 1940s, the Commission, along with the auditing and corporate communities, has had a continuing interest in promoting effective and independent audit committees. It was, in large measure, with the Commission's encouragement, for instance, that the self-regulatory organizations first adopted audit committee requirements in the 1970s.”). The initial foray didn’t accomplish much. For one thing, the definition of independent did not actually ensure independence. For another, the requirements did not define the responsibilities of the audit committee, something left to state law. Similarly, enforcement of the new requirement was left to the exchanges, not a particularly robust source.

Moreover, jawboning worked only as long as all of the principal trading markets cooperated. As competition among the self regulatory organizations grew, however, resistance developed, with matters coming to a head over efforts to ensure shareholder voting rights. Confronting the need to delist General Motors or to abandon its longstanding policy of one share one vote, the NYSE opted for the latter. Delisting would have sent GM to Nasdaq, where no comparable rule existed. The decision, therefore, was not about good corporate governance but the result of competitive pressures.

The Commission tried, behind the scenes, to induce the NASD (the owner of Nasdaq) to adopt a comparable rule. Unsuccessful, the agency adopted a rule that required national exchanges and Nasdaq to implement a one share, one vote standard, thereby ensuring uniformity. In what will no doubt be viewed as a Pyrrhic victory, the Business Roundtable challenged the rule and ultimately prevailed, inducing the DC Circuit to conclude that the Commission lacked authority to regulate the substance of corporate governance through the mechanism of listing standards. Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1986). Listing standards represented a method of intervening that only applied to particularly categories of companies and involved regulations that did not give rise to a private right of action. Had the SEC retained this avenue, it is possible that the need for much of SOX could have been avoided.

Without the use of listing standards, the Commission tried to increase accountability through the use of enforcement proceedings. Most noticeable was In WR Grace , Exchange Act Release No. 39157 (admin proc Sept. 30, 1997), a Section 21(a) report. The agency took the opportunity to instruct the board on the need to maintain adequate procedures to ensure accurate and complete disclosure. As the report emphasized:

• "Serving as an officer or director of a public company is a privilege which carries with it substantial obligations. If an officer or director knows or should know that his or her company's statements concerning particular issues are inadequate or incomplete, he or she has an obligation to correct that failure. An officer or director may rely upon the company's procedures for determining what disclosure is required only if he or she has a reasonable basis for believing that those procedures have resulted in full consideration of those issues." 

The Report suggested that directors could be charged for failing to implement adequate procedures, a task typically regulated under state law fiduciary duties.

Although calling on officers and directors to play a more active role in the disclosure process, the legal premise for the approach was unclear. It mostly involved areas traditional regulated under fiduciary obligations rather than the federal securities laws and, therefore, outside the bailiwick of the Commission. Perhaps as a result, there was little follow-up, with the decision having at bet marginal impact on board behavior.

Instead, the Commission was back to the beginning. The only real weapon available to combat the declining standards at state law was disclosure. Beginning in earnest in the 1990s, the Commission began to use disclosure not so much to provide material information but to directly influence the behavior of officers and directors.  We will pick up on this thread tomorrow.