Commissioner Daniel M. Gallagher
U.S. Securities and Exchange Commission
Directors Forum 2013, University of San Diego, San Diego, California
Jan. 29, 2013
Thank you Anne [Sheehan] for your very kind introduction. I am honored to be here today. Conferences like this are critically important, and all too rare, opportunities for directors, executives, shareholders, and regulators to interact.
Before I go any further, I need to provide the standard disclaimer that my remarks today are my own and do not necessarily reflect the views of the Commission or my fellow Commissioners.
Today I would like to talk about the proper role of the federal government in the corporate governance realm. In a speech at the Chamber of Commerce two weeks ago, I noted the two and a half year anniversary of the Dodd-Frank Act. Today, we can recognize that tomorrow is the ten and a half-year anniversary of the passage of the Sarbanes-Oxley Act, which represented the most significant federal intervention into corporate governance matters in decades, perhaps since the passage of the Securities Act and Exchange Act in the 1930s.
Corporate governance involves three traditional actors: shareholders, management and boards of directors. Shareholders provide corporations with capital, management makes use of that capital, and the board of directors supervises management to ensure that it is allocating that capital appropriately. Shareholders, in turn, supervise the board’s efforts. Obviously, the interests of these three actors are not always aligned, which is where the law can come into play.
Traditionally, the law has provided a general framework within which those three actors interact. Regulators are tasked with protecting shareholders yet at the same time allowing management and directors to do their jobs growing the company and thereby creating value for shareholders.
Two years ago, in an address to this Forum, my predecessor Commissioner Kathleen Casey noted the enormity of the regulatory reach of the Dodd-Frank Act and its impact on, among other topics, corporate governance. In her remarks, she cited Dodd-Frank as part of a “continuing trend toward the federalization of corporate law.”1
Commissioner Casey’s observation was spot-on. It seems that the standard response to severe economic downturns or epochal corporate scandals is reactive and hurried federal legislation and regulation, often impacting corporate governance standards. A hallmark of this trend is the presentation of proposed new, sometimes misplaced and usually onerous, requirements as “feel good and cure all” responses to perceived problems that one would be hard pressed to disagree with. After all, who could be against “better” corporate governance? The result is that the lofty goals of such legislation and their implementing regulations, often rushed out without serious analysis of costs and benefits, are superseded by a higher law: the law of unintended consequences. Indeed, the risk of unintended consequences looms particularly large in the case of corporate governance, a field in which states have long enjoyed the role of primary steward.
Despite the rhetoric we hear today, the perception that corruption is rampant and we are in the worst of economic times is not a new one. For example, Sir Edward Coke wrote in 1602 that “fraud and deceit abound in these days, more than in former times.”2 After the stock market collapse of 1929 and the onset of the Great Depression, Congress responded, with the benefit of several years of studies, fact-finding, and analysis, by enacting the Securities Act of 1933 and, the next year, the Securities Exchange Act, which created the SEC. Although the scope and breadth of the Exchange Act’s grant of authority to the new Commission was quite large, one area which Congress deliberately excluded from the Commission’s jurisdiction was corporate governance. In fact, preliminary drafts of the Exchange Act contained a provision stating that “nothing in this title should be construed as authorizing the Commission to interfere with the management of the affairs of an issuer.”3 However, according to the legislative history, this language was omitted because it was deemed “unnecessary, since it is not believed that the bill is open to misconstruction in this respect.” 4
Despite the original intent of the drafters of the Exchange Act to leave corporate governance in the hands of the states, Congress and federal regulators have become increasingly engaged in corporate governance matters, albeit via indirect routes. For example, public companies are now subject to complex federal corporate disclosure requirements covering a myriad of activities, including social and political issues rather than issues that would be material to investors. And, of course, there are the federal mandates for national securities exchanges to adopt detailed and complex listing standards for their listed issuers.
As I noted earlier, the federal government’s sporadic involvement in corporate governance matters has usually followed on the heels of great scandals and economic crises. Indeed, one does not need to look further than the very names of Congress’ most recent efforts at corporate governance reform to see the effect of public outrage on the legislative process. The Sarbanes-Oxley Act, which followed the Enron and WorldCom scandals, is formally known as the “Public Company Accounting Reform and Investor Protection Act.” The progeny of the most recent financial crisis is titled, in full, the “Dodd–Frank Wall Street Reform and Consumer Protection Act.” Reforming “Wall Street” and protecting investors and consumers is like standing up for baseball, mom, and apple pie – who can argue with those goals? Yet, if you objectively look at the impact of Dodd Frank and Sarbanes-Oxley, you may wonder whether the unintended consequences of the requirements they impose on market participants, including with respect to corporate governance, will outweigh the lasting benefits to investors and Main Street.
Although the stated purpose of Sarbanes-Oxley was to help protect investors, if you were to ask executives and boards of directors today who they believed were the biggest beneficiaries of the passage of the Act, many would answer that it was accountants, foreign markets, and lawyers that truly benefited. One example relates to compliance with Section 404 of Sarbanes Oxley, which the Commission estimated would cost on average roughly $91,000 a year to implement.5 Section 404 of Sarbanes-Oxley (in conjunction with the related PCAOB Auditing Standard 2) caused a fury when the associated costs of compliance ended up being substantially higher than anticipated by policymakers. Most of the costs related to auditors, who were perhaps overly cautious in the wake of the failure of Arthur Andersen. Or maybe they simply found Section 404 compliance to be a lucrative new revenue source.
Regulators responded, albeit too slowly for some, to the complaints and attempted to address the issues presented by 404 implementation. This is evidenced by the refinements in Auditing Standard No. 5, the release of SEC interpretive guidance, and the SEC’s 2006 rule that provided newly public companies with up to two years before they were required to comply with Section 404(a) and 404(b). Congress also heard the complaints and created certain exemptions from 404(b) for emerging growth companies and non-accelerated filers in both the Dodd-Frank and the JOBS Acts. Although these were very positive steps to address the problems with Sox 404, much of the damage caused by this provision may be irreparable.
There has been much discussion about the impact of Sarbanes-Oxley, in particular Section 404, on the competitiveness of the U.S. capital markets. Reports indicate that shortly after the Act’s passage there was a marked decrease in the number of IPOs and a marked increase in going private transactions in the U.S. And this was happening at a time when policymakers, academics, and business interests were fretting about the loss of IPOs to London. Those concerns seem dated and quaint now, especially with the rise of Asian IPO markets over the last few years. Fortunately, the JOBS Act took important steps to address some of these issues, and while it’s far too early to judge the impact of the new legislation, it is my hope that the law will have the intended effect of incentivizing companies to re-engage in the U.S. public capital markets.
When it comes to impactful legislation, however, few statutes can rival Dodd-Frank, which will significantly affect the U.S. capital markets and the regulators overseeing those markets for years to come. The sheer volume of required Dodd-Frank rulemaking for the SEC set forth in the Act’s 2,319 pages is astounding.
These federally mandated rulemakings include several relating to corporate governance, for example, rules concerning advisory “say-on-pay” votes and golden parachute payments, which the Commission adopted in 2011, and rules establishing disclosure requirements for institutional investment managers regarding “say-on-pay” votes, which were proposed in 2010.
Several Dodd-Frank required rulemakings, although couched as disclosure rules, are, it would appear, in fact meant to affect the behavior of companies and boards rather than to provide information that investors would find useful. Take executive compensation for example. What benefit to investors is there for a listed company, already required to disclose the salaries of its executives, to provide information regarding how much a CEO’s compensation compares to the “median of the annual total compensation of all employees of the issuer”?6 It is even harder to find the utility for investors of the new disclosure rules relating to conflict minerals from the Congo and extractive resource payments made by U.S. listed oil, gas and mining companies. Don’t get me wrong – the social, humanitarian goals of these provisions are laudable. However, mandating that the SEC issue disclosure rules to address this terrible suffering in Africa is like mandating that the Departments of State and Defense draft rules to deter accounting fraud. These rules are simply not material to the general population of investors. And although the status of the rules is not yet certain as they have been challenged in court, it is certain that they will be incredibly costly for issuers if upheld by the courts. And lest we forget, because so many in Washington often do, shareholders bear the burden of increased costs on issuers.
Some Dodd-Frank provisions seem destined to strain the relationship between directors and shareholders and potentially affect how directors do their jobs. Compensation of senior management has long been in the remit of the board of directors. Dodd-Frank requires listed companies to have non-binding shareholder “say-on-pay” votes. The Act explicitly stipulates that these votes are not binding and should not be construed either as overruling a decision by the board or creating or implying any additional fiduciary duties for the board. However, as directors of companies who have lost say-on-pay votes can attest, this limiting language has not prevented shareholder suits.
In addition to lawyers and accountants – for whom Dodd-Frank is essentially an economic stimulus package – another group that stands to benefit from the Act is proxy advisors.
As I’m sure all of you know, shareholder voting has undergone a tremendous transformation. The changes include a notable decrease in the number of retail investors holding shares in their own names, the rise of institutional investors as majority owners of companies and increased restrictions on what matters intermediaries who hold shares can vote on behalf of retail investors.
So, given the combined effect of these developments, does the increased disclosure mandated by the Dodd-Frank Act aid the average investor? At best, it’s questionable. Proxies today are remarkably different than they were twenty, ten or even five years ago. Disclosure requirements have made them increasingly longer, more technical and more difficult to read. I have no doubt that many – indeed, most - retail investors find it too time consuming and daunting to attempt to dissect the issues they must vote on. This phenomenon is paralleled by the rise of proxy advisory firms and the increasing willingness of investment advisers to large institutional investors to rely on such firms to do this work for them.
In addition to raising the vital question of whether advisers are fulfilling their fiduciary duties when they rely on recommendations from proxy advisory firms – a question I don’t have time to address today but one to which I hope you all give serious thought – this shift by institutional investors has resulted in increased influence by proxy advisory firms over investors and the companies in which they invest. The Dodd-Frank mandated say-on-pay requirement has only increased this influence. As Professor Stephen Bainbridge wrote in his article Quack Federal Corporate Governance Round II, the proponents of say-on-pay ignore “the probability that say-on-pay really will shift power from boards of directors not to shareholders but to advisory firms[.]”7
Given these developments, I think it is important to ensure that advisers to institutional investors – and let’s not forget that these institutions are generally just a collection of individual investors – are not over-relying on analyses by proxy advisory firms. We learned a significant lesson about overreliance on the diligence of others in the run up to the financial crisis, as investors and regulators relied on credit rating agencies with disastrous results. As with credit rating agencies, it is important for policymakers to understand, evaluate, and if necessary address the practices and business models of proxy advisory firms. Of particular interest should be accountability for accuracy as well as potential conflicts of interests, such as proxy advisory firms advising companies on their corporate governance while also rating them on it.
As for the role of state law in these matters, the Commission stated in the proposing release for the proxy access rules, which of course preceded the final rules that were ultimately struck down by the D.C. Circuit, that “the Commission has been mindful of the traditional role of the states in regulating corporate governance.”8 It is important that the Commission remain mindful of this history, because states are inherently better suited to address varied and complex corporate governance issues. There is a fundamental problem with a one-size fits all corporate governance regime. Public companies are diverse entities, not only in business enterprises but in corporate structure. To apply prescriptive and mandatory parameters for how companies should be governed curtails and may even eliminate the flexibility and nimbleness that are critical for corporate innovation. In its comment letter addressing the proxy access proposal, the Delaware State Bar Association asserted that “the thrust of our comment is that a single rule would necessarily deprive Delaware corporations of the flexibility state law confers to deal effectively with myriad different circumstances that legislators and rule makers cannot anticipate, and would thereby undermine a key element of the state system of corporate governance that has been largely successful for decades.”9
With respect to legislative and regulatory oversight, this flexibility can be found more in states than in the federal government. There are many reasons for this. One is that state laws and regulations are more easily amended or refined over time than federal legislation, allowing the states to more effectively rectify overly burdensome or poorly drafted or misconstrued requirements. Also, since corporations are ultimately viewed as creatures of state law, most states already have substantial legal precedent, active bars, and expert judges who deal with corporate governance matters on a regular basis. The best example of this is in Delaware, where the majority of all U.S. publicly-traded companies and 63% of the Fortune 500 have their legal home.10 Delaware is widely considered to be the pre-eminent center of corporate law thanks to, among a panoply of reasons, its active and engaged judiciary and the related, significant body of legal precedent relating to corporate matters.
The advantages of state regulation of corporate governance, are coupled with the fact that the federal government, as demonstrated so clearly by the implementation of Section 404 of Sarbanes-Oxley, has not been very effective at predicting the costs and outcomes of federal corporate governance legislation. At a minimum, this combination calls into question the wisdom of increased federalization of corporate law.
As I mentioned earlier, the SEC has already noted that it needs to be mindful of the traditional role of the states in regulating corporate governance. I believe that the Commission should be more than mindful, it should be respectful of the role of state law and resist the urge to intrude upon state matters absent compelling reasons to do so. We need to use the right tool for the right job. If most corporate governance issues are a nail, the states represent a hammer, while the SEC represents, say, a wrench, or worse yet a sledge hammer! Let’s not become the wrench in the works of corporate governance when we have a toolbox full of fifty hammers.
I appreciate the opportunity to be here today, and I wish you a successful conclusion to this terrific conference.
2 Twyne's Case, 3 Rep. 80b.
3 S. 9323, 73d Cong., 2d Sess. (1934), at § 13(d).
4 H.R. Rep. No. 1383, 73d Cong., 2d Sess., at 35 (1934).
5 Stephen M. Bainbridge, Dodd-Frank: Quack Federal Corporate Governance Round II, 95 Minn. L. Rev. 1779, 1781 (2011). Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8238, 68 Fed. Reg. 36,636, 36,657 (June 18, 2003), “Using our PRA [Paperwork Reduction Act] burden estimates, we estimate the aggregate annual costs of implementing Section 404(a) of the Sarbanes-Oxley Act to be around $1.24 billion (or $91,000 per company).”
6 Dodd–Frank Wall Street Reform and Consumer Protection Act § 953(b)(1)(A).
7 Bainbridge supra note 5 at 1811.
8 Facilitating Shareholder Director Nominations, Release No. 33-9046, 34-60089, 74 Fed. Reg. 29024, 29025 (June 10, 2009).
9 See Letter from James L. Holzman, Chair, Council of the Corporation Law Section,
Delaware State Bar Association, to Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange Commission (July 24, 2009) (available at http://www.sec.gov/comments/s7-10-09/s71009-65.pdf).