The Commission, Corporate Governance, and the Search for Accountability

We are examining the role of the Securities and Exchange Commission in the governance process. It is a topic I explore in my paper, Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure. So far, we’ve made the following conclusions.

First, the Commission already has a role in the process, something we will develop over the next few posts. To the extent a debate occurs, the appropriate topic is not whether but the nature of the role.

Second, Congress from the very beginning viewed the Commission as a source of regulation designed to improve the substance of corporate governance. Specifically, Congress expected the Commission to use its authority, mostly in the area of disclosure, to clear up a number of corporate governance concerns.

Third, the disclosure regime instituted by the Commission largely ended the secrecy that facilitated self interested transactions by management. Early disclosure obligations applied to self interested transactions. See Release No. 34-3347 (December 18, 1942). Rather than eliminate them, however, the disinfectant of sunlight resulted in increased pressure on states to weaken fiduciary obligations. In a topic already discussed on this Blog, the states, particularly Delaware, complied.

A central weakness in the Exchange Act was the disconnect between accurate disclosure and accountability. The Act imposed penalties for false disclosure but did nothing to ensure companies had in place a system designed to produce accurate information. Nor did the Act impose specific duties on officers and directors. This, according to early Commission pronouncements, was a matter of state law. See In re Franchard, 43 SEC 163, 172 (1964)(securities laws did not “define Federal standards of directors' responsibility in the ordinary operations of business enterprises and nowhere empowers us to formulate administratively such regulatory standards. The diligence required of registrant's directors in overseeing its affairs is to be evaluated in the light of the standards established by State statutory and common law.”). This assumed, however, a robust system of governance at state law that imposed the requisite requirements of diligence.

The Commission began to realize this disconnect in a substantial way in the 1970s when it turned out that large numbers of public companies had made illegal campaign contributions and foreign bribes. The Commission understood that at least part of the problem was from the lack of internal controls within companies. Had information about these improper payments made it to top officers and directors, they presumably would have been stopped. In part as a result, the Foreign Corrupt Practices Act added Section 13(b)(2) to the Exchange Act, requiring company to maintain adequate books and records and devise and maintain a system of internal accounting controls.

The legislation, however, only went so far. While requiring certain books and records, it did not assign responsibility for them. The provision quickly became perceived as a technical provision that did little to alter actual governance practices.

Tomorrow, we’ll finish the history lesson and begin the discussion of the Commission’s current role in the governance process.