The SEC , Corporate Disclosure and the Regulation of Substantive Behavior

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

With listing standards foreclosed and corporate governance standards in decline under state law, the Commission began to use disclosure in an effort to influence behavior. An early example involved the requirement of public companies to disclose disagreements on the board that resulted in a director resigning or deciding not to stand for reelection.  

The information was ostensibly designed to assist shareholders in assessing the “quality of management.” Exchange Act Release No. 14970 (July 18, 1978). More to the point, the information “could enhance the effectiveness of directors by assuring them a forum in which to express differences of opinion on matters that are sufficiently serious to result in termination of the director's association with the issuer.” Id.

In other words, the provision gave the dissenting director leverage. Any resignation over a disagreement would result in public disclosure of the underlying conflict, potentially generating bad publicity and inviting legal scrutiny. The threat, therefore, gave the dissenting director additional bargaining power in connection with any disagreement at the board level.

Even this caused teeth gnashing and threats that it would disrupt the careful balance inside the board room. See Exchange Act Release No. 15384 (Dec. 6, 1978)(adopting release)(“Some commentators who opposed adoption of the proposal were concerned that this disclosure would discourage the evolution of stronger boards by increasing divisiveness among board members. Others noted that the proposal might make it more difficult to attract and retain directors with divergent viewpoints.”).

That the requirement was designed as leverage rather than to provide material information to investors could be seen from the structure of the provision. As originally adopted, the resigning director retained the sole discretion to determine whether disclosure should occur. See Exchange Act Release No. 15384 (Dec. 6, 1978)(adopting release)(“However, after considering the commentary, the Commission believes that, on balance, it is more appropriate to require disclosure only upon the request of the director. If disclosure is triggered by director request, the director will have a forum if he chooses to use it, and the issuer will be relieved of any obligation to document and characterize what it believes are the reasons for director resignations.”). Thus, disclosure depended not upon its importance to investors or shareholders but upon the predilections of the departing director. Only in 2004 did the Commission finally eliminate this discretion and impose an affirmative duty to disclose a disagreement, irrespective of whether the resigning director submitted a letter. See Item 5.02 of Form 8-K.

The impact of the provision is hard to assess since it was structured to encourage resolution of differences in order to prevent disclosure. Certainly it surfaces from time to time, as Hewlett Packard learned when a director resigned, triggering the filing requirement. The Current Report filed by the Company can be found here.  

As for improving the process of corporate governance, the provision demonstrates the limits of disclosure in the regulation of substance. The provision applied only to conflicts at the board level. It did nothing to ensure that the board had any particular information about the activities of the company or that a conflict or problems was addressed at the board level in the first instance.