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: The Race to the Bottom

Director Independence and SEC Enforcement (Part 2)

By J. Robert Brown

The SEC brought an administrative proceeding against Mark Thompson for failing to reveal to the boards of public companies where he served as directors that he had a business relationship with the outside auditor that impaired the auditor's independence.  The Commission found that he was a cause of violations of the proxy rules and the periodic reporting requirements, including Rule 14a-9.

We predicted this would occur.  Director independence has become the holy grail of corporate governance.  Shareholders are protected and self serving behavior can be reduced through review by a board that consists primarily of independent directors.  The problem with the approach has been that directors called "independent" often are not.  Neither Delaware nor the stock exchanges has an adequate definition that ensures director independence.  Moreover, even with the existing definition, neither enforces it adequately.  And, because there is no private right of action (so far) for the violation of exchange rules, there is no private enforcement mechanism.

The SEC can't enforce listing standards or state law requirements but it remains concerned with the functioning of the board and the need for director independence.  As discussed at length in The SEC, Corporate Governance, and Shareholder Access to the Board Room, the Commission has attempted to circumvent these limits by requiring companies to disclose their compliance with stock exchange rules on independence.  In other words, incorrectly listing directors as independent will violate the rules of the exchange, which have no meaningful enforcement consequences.  At the same time, however, repeating the false information in a proxy statement or periodic report will violate the securities laws, sometimes even the antifraud provisions.

All of this brings us back to the action against Mark Thompson.  In effect, the Commission sanctioned Thompson for not being independent.  The agency did it by finding that the failure to disclose his relationship with E&Y resulted in disclosure violations under the proxy rules and periodic reporting requirements.  

The case may well be a harbinger of future actions and another example of federal preemption in the area of corporate governance.  In the absence of meaningful enforcement standards under state law, it will be the SEC that ensures directors in fact meet independence standards.  Suits against directors (and disgorgement) will likely have the salutary effect of encouraging better disclosure by directors to the board.  That in turn will force boards to examine conflicts in order to determine whether a director is independent.  The results will be disclosed in SEC filings, with liability for the entire board a risk where the board describes directors as independent who are note.

This is a first step.  The most significant step will be when the SEC charges a company and the board for listing directors as independent who are not.  This will essentially cause the company and the board to play a larger, more careful role in the independence analysis.  Moreover, it will cause directors to realize that the lack of enforcement by the states or stock exchanges no longer provides immunity, that incorrect disclosure will result in sanctions under the federal securities laws. 

Full post as published by The Race to the Bottom on August 11, 2008 (boomark / email).