The SEC and Corporate Governance: The Early Days

We begin the exploration of the Commission’s role in the corporate governance process, something discussed at length in my paper, Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.

The Commission has, since its inception, played a role in the corporate governance process, although the role has evolved. The discussion has to begin with the adoption of the Exchange Act, the law that, among other things created the Commission (the provisions of the Securities Act of 1933 had been administered and enforced by the Federal Trade Commission).

Among the many provisions, at least two Sections sought to correct deficiencies in state law and the ongoing race to the bottom. Section 13(a) gave the Commission the authority to require periodic reports, an area of obvious state failure. With the exception of some annual reporting obligations, state regulation had evolved little beyond the traditional right to inspect. While the NYSE had imposed additional disclosure requirements, the legislative history noted problems with enforcement. It would be up to the Commission, therefore, to set the standards for periodic disclosure.

In addition, Section 14(a) gave the Commission the authority to regulate the proxy process. The language of the section was quite broad, prohibiting solicitations in violation of rules adopted by the Commission “for the protection of investors” The word “disclosure” was not mentioned anywhere in the section. Nonetheless, examination of the legislative history indicates that the provision was primarily (but not entirely) meant to be a disclosure provision. In limiting the Commission's authority, however, Congress was not trying to keep the agency out of the corporate governance process. Quite the contrary. The legislative history indicates that the provision was intended to remedy a number of governance abuses chronicled during the hearing process. As Congressman Lea of California stated:

• "In the main, the men controlling these great corporations are not large owners of the stocks of the corporations they control. Too often they have yielded to the temptation to control these great business institutions to their own interests, and with a zeal out of proportion to the loyalty they have shown their stockholders. Thus in recent years we have seen the directors of corporations, without the knowledge of their shareholders, voting themselves vast bonuses out of all proportion to what legitimate management would justify. We have had revelations of salaries paid to directors and officers of great corporations which showed shameful mismanagement; which showed that the men in charge of some of these corporations were more concerned in managing its affairs for their own benefit than for the benefit of the stockholders." (Cong. Rec. 7990, May 1, 1934).

Similarly, the Senate Report described the proxy provision as, among other things, designed “protect investors from promiscuous solicitation of their proxies . . . by unscrupulous corporate officials seeking to retain control of the management by concealing and distorting facts.” See Senate Report No. 1455, 73^rd Cong., 2d Sess. at 77 (1934). In other words, the Commission was expected to use its authority under the proxy process to alter the behavior of management, both in the area of self dealing and self perpetuation. 

Congress largely limited the Commission’s role to disclosure, not because it wanted the Commission out of corporate governance, but because it expected disclosure to be sufficient to cure most of the abuses. Congress anticipated that with adequate disclosure, shareholders would have greater ability to prevent both, by casting out misbehaving officials or vetoing excessive compensation.

What Congress did not contemplate, among other things, was the resilience of management to find other ways to engage in this type of behavior. Prior to the adoption of the Exchange Act, the primary mechanism was secrecy. Shareholders couldn’t undo what they didn’t know.  Self interested behavior continued in large part because it went undetected. With the advent of the disclosure regime instituted by the Exchange Act, however, it became harder to use secrecy to engage in self serving behavior. For the practices to continue, substantive standards had to weaken. That way, even if disclosed, the practices could continue. 

Thus, we end today with the first of many ironies in this area. Congress tried to eliminate certain managerial abuses by authorizing the Commission to implement a robust disclosure regime. In fact, the disclosure regime probably resulted in pressure on states to weaken substantive standards. In other words, the Commission’s role in the governance process contributed to the race to the bottom.

Comments

[Bob McMahon]

And I would add that back in 1934 when these policies were officially adopted, most Americans were not shareholders of stock and most Americans were fairly ignorant of Wall Street ways. Most Americans didn't go to college and a large number still didn't finish their secondary educations.

Today most common shares are held by large institutions and pension funds and citizens investing through their employers or privately. So by extension, more Americans today have a vested interest in the stock market, shareholder rights and corporate accountability. However, time is limited and most citizens rely upon their investment managers to be the lead authority in exercising shareholder rights and for holding issuers financially accountable for their corporate performance.

Recent years have demonstrated that our investment managers have not necessarily been acting as the fiduciaries we were expecting. The carrot for them is to invest in companies with overwhelming financial performance to enhance their own bottom-line - chasing Alpha for bonus time - whether or not these companies are potential poster-children for corporate governance dysfunction. As former Citigroup Asset Management President, Tom Jones, once blythely stated, "I don't get paid for doing good."

The good Mr. Jones was addressing here could be catergorized as having an eye on uncovering the next potential Enron on the horizon and actually engaging that company to improve its governance profile - so that if Citigroup had a $2 billion equity position in its investment portfolios, that investment grows instead of being duck-walked into bankruptcy.

The reasons behind Mr. Jones not wanting to take such a path are stultifying when you speak them outloud - if Citigroup had taken this position then they would have had to "invest" in engaging that $2 billion equity investment. If there would have been positive outcomes other investment firms would have benefited from Citigroup taking a leadership role in redressing the governance shortcomings of this issuer. Thus the market would not have had to suffer the collapse of a $120 billion market-cap company and all investor boats would have been lifted. That kind of leadership and publicity one cannot buy from an advertising firm.

The SEC is too small to do all the heavy lifting in this market, but investment managers could be doing more in remembering their fiduciary responsibilities to investors by incorporating solid governance screening tools in their processes.

Enron, Tyco, Worldcom, Parmalat, HealthSouth, etc... were, first and foremost, governance failures.