Corporate Governance

Regime Change and the SEC's Corporate Governance Agenda: #7 Enforcing Item 407

By J. Robert Brown

The SEC has become increasingly involved in the governance process for public companies.  The agency has largely been limited to disclosure and has used this authority to try to affect substantive behavior of officers and directors.  For more on this subject, take a look at Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure. 

The governance requirements have largely been consolidated in Item 407 of Regulation S-K (fittingly titled "corporate governance").  This is the provision that requires disclosure of board independence, attendance at meetings, and assorted practices and policies implemented by the compensation, nominating and audit committees. 

Item 407 is more than just a disclosure provision, however.  To a large degree, it requires disclosure of the degree to which companies conform to the corporate governance provisions imposed by the stock exchanges.  The exchanges require that listed companies have boards with a majority of independent directors and nominating, governance and audit committees, with all members independent.  See Section 303A of the NYSE Manual.  Since no private right of action exists for violations of the stock exchange requirements, private enforcement of these provisions is nonexistent.  Similarly, as for profit companies, the stock exchanges have little incentive to engage in aggressive enforcement of the governance provisions.

The disclosure provisions ostensibly have teeth otherwise lacking in the enforcement process.  To the extent that companies misrepresent director independence, they could be sanctioned for violating the antifraud and/or proxy rules.  Not surprisingly, some companies have gone out of their way to note problems with the definition of independence arising out of the stock exchange rules apparently in the name of full disclosure.

The possible increase in enforcement, however, has been theoretical rather than actual.  The Commission has yet to bring a case under Item 407 (or, apparently, its predecessor provisions).  The Commission has brought a case concerning the failure of an "independent" director to disclose ties with the "independent" auditor.  But the case did not implicate Item 407 and so far is an isolated decision. This suggests that while the SEC has promoted disclosure of corporate governance provisions, it has not opted to devote resources to ensuring that in fact they are followed in any meaningful way.  As the Commission has learned, both in its MD&A project in the 1990s and the CD&A project in the new millennium, absent aggressive oversight, disclosure often suffers.

The Division of Enforcement should be made aware immediately that the Commission considers enforcement of Item 407 a priority.

Full post as published by The Race to the Bottom on January 01, 2009 (boomark / email).