The SEC, Rule 14a-8, and Shareholder Approval of the Auditor: Time for a Change in Policy (The Administrative History) (Part 2)

Shareholder ratification of outside auditors is a common practice.  Approximately 90% of the companies in the S&P 500 and the Russell 3000 engage in the practice.  Unlike the laws in other common law countries, however, states do not mandate shareholder approval, despite occasional calls that they do so.  Instead, companies submit the matter to shareholders on a voluntary basis.  This occurs in part because of the benefits.  Auditor approval is rarely controversial and brokers can vote uninstructed shares on the matter, ensuring that the shares are present for quorum purposes. 

The Commission has long favored and encouraged the practice.  Following the adoption of the Exchange Act, the Commission emphasized the importance of shareholder ratification.  In In the matter of McKesson & Robbins, Inc., Exchange Act Release No. 2707, 1940 WL 977 (Dec. 5, 1940),  the Commission issued a Section 21(a) Report addressing the fraud committed by McKesson & Robbins.  The Company had reported fictitious sales and assets.  The Commission viewed the audit as deficient and blamed the results at least in part on the selection process for the outside auditor.  With the process dominated by management, the Commission recommended the “[e]lection of auditors for the current year by vote of the stockholders at the annual meeting”.  Id. 

The Report stopped short of an imposition.  Nonetheless, the view did find its way into the law.  At the same time the SEC was investigating McKesson & Robbins, Congress had under consideration the Investment Company Act of 1940.  The investigation made a cameo appearance in the legislative history and the Commission insisted that the Act include mandatory shareholder approval of auditors. 

Section 32 ultimately required that the outside accountant be “submitted for ratification or rejection” at the annual meeting, although disinterested directors could fill vacancies that occurred between meetings.  The benefit was described as “psychological” but one that would “bring home to the independent public accountant that . . . under the existing statutes and existing practice that independent public accountant is really acting for the security holders rather than for the management.”

The topic is developed more fully in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.