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Speech by SEC Staff:
"Principles Matter: Related Person Transactions Disclosure and Disclosure Controls and Procedures"
Remarks Before the Society of Corporate Secretaries and Governance Professionals
New York Chapter


John W. White

Director, Division of Corporation Finance
U.S. Securities and Exchange Commission

Newport, Rhode Island
October 12, 2006

Thank you Shelley. I am happy to be here today. With my time during lunch, I would like to speak with you all about a topic that has been occupying a lot of my time in the past few months-the revisions to the SEC's executive compensation and related party disclosure rules that the Commission adopted in late July. I imagine the topic is now occupying much of your time. I should first remind you all, however, of the so-called "standard disclaimer". As a matter of policy the SEC disclaims responsibility for any private comments or speeches from its staff, and you should understand that my remarks today represent only my own views and not necessarily those of the Commission or of other members of the staff.

I am assuming that many if not all of you are closely involved with your companies' responses and preparations for the new rules. I have spoken with some of you about a series of speeches I have given in the past month or so which have focused on various aspects of the new rules. Since those remarks are available to you on the Commission's website, I am not going to repeat those comments today. I do, however, want to stick closely to a very important theme that has appeared in many of my prior remarks and is critical to the new disclosure rules-that this rulemaking was a truly principles-based exercise and, as I have said numerous times before, the principles matter. In fact, I have spoken about various parts of executive compensation disclosure from that angle-CD&A, perquisites, options grant disclosure, even plain English.1 Of course, principles come up in many other facets of the rulemaking.

Today I thought I would touch on two additional areas that seemed to me to be particularly within your purview as corporate secretaries and governance professionals. First, I'd like to discuss disclosure of related person transactions, a close cousin of compensation disclosure and another striking example of how the principles matter. Second, I would like to talk for a few minutes about yet another way in which the new rules may intersect with all of you in a frequent and substantive manner-their implications for disclosure controls and procedures-and the interaction those might have with the rulemaking's principles-based structure.

A Principles-Based Approach

I assume many of you are already familiar with the concept of "principles-based disclosure" from the work you have been doing in the securities and disclosure arena. Certainly, "principles-based" was not a new concept for the Commission with the executive compensation disclosure rulemaking. Perhaps the best and most obvious example is MD&A, with which we have all had experience.

There are a wide variety of views on how to define or explain the term "principles-based". Most people probably have a general idea of what it means but I have found it worthwhile when speaking on the topic to review a useful description and make sure we're all on the same page. My favorite is to quote a description that Robert Herz, chairman of the FASB, gave in 2002. Let me read a few sentences:

Under a principles-based approach, one starts with laying out the key objectives of good reporting in the subject area, and then provides guidance explaining the objective and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance, or rules, for every possible situation. Rather, if in doubt, the reader is directed back to the principles.2

One thing I hope my various speeches and remarks can do is to give you, as disclosure lawyers and governance professionals, a tool if you will so that when working with your management (or your directors) in implementing the new rules, you are not left empty-handed if confronted with the often repeated refrain of "where does it say I have to disclose [that]?" (whatever "that" is). As Bob Herz's description explains, if there is not an express rule or a specific example, one cannot just dismiss the question in a principles-based system. One is directed back to the principle.

So in looking at various pieces of the recent rulemaking, I find it useful to walk through the steps of a principle-based system: (1) identifying the key objective of the reporting or disclosure, (2) specifying some detailed rules (but not for every situation), (3) providing descriptive guidance and representative (but not exhaustive) examples about the application of the principle, and (4) remembering that the standard and its expectations really start and end with the principle.

Related Person Transactions

Disclosure of related party transactions is a key, principles-based component of the Commission's July 26 rulemaking. These types of transactions, when they occur, are very closely related to the compensation picture for a named executive officer (or a director) which I think we should all keep in mind. As the Commission stated in the Release, "a materially complete picture of financial relationships with a company involves disclosure regarding related party transactions". Actually, even without the standards and disclosure requirements for related person transactions that are contained in Item 404 of Regulation S-K, I personally would have thought that these types of matters might in many circumstances need to be disclosed and discussed in keeping with the principle of providing context to, and a fair understanding of, executive compensation. But we do not need to dwell on that idea as the Commission has a separate disclosure requirement for these matters.

Item 404 of Regulation S K centralizes and sets forth the standards for disclosure of related person transactions. As the Release expressly states in numerous places, the revisions were designed to make the related person transaction disclosure rule more principles-based. As such, Item 404 contains a broad principle for disclosure-a company must provide disclosure regarding:

  • any transaction since the beginning of the company's last fiscal year, or any currently proposed transaction;
  • in which the company was or is to be a participant;
  • in which the amount involved exceeds $120,000; and
  • in which any related person had or will have a direct or indirect material interest.

So, walking through the principles-based steps that I just reviewed, we would start with the key objective. As laid out above, here it is to provide investors with material information about a transaction in which the company was or will be a participant and which has a direct or indirect material interest to a related person. The Commission has set forth a few narrow, specific rules and has provided narrative discussion and guidance to help with the application of the principle. But mostly, to answer your questions, you must be ready to return to the basic principle. It is the principle that matters.

Believing that using specific language and examples is an effective way to make a point, let's look at the first two words of the principle: "any transaction". How does that fit in our principles-based system? We know the key objective of related person transaction disclosure involves providing material information to investors about certain "transactions". What is covered? The Commission has provided a definition (and I quote from the Release)-"[t]he term "transaction" has a broad scope in Item 404(a). This term is not to be interpreted narrowly, but rather broadly includes, but is not limited to, any financial transaction, arrangement or relationship or any series of similar transactions, arrangements or relationships." In keeping with the notion that a principles-based system will have some rules, the Commission has set a disclosure floor of transactions worth at least $120,000 and has provided a few narrow exceptions that are carved out from the definition of "transaction." But generally "transaction" is an expansive and inclusive term. The Release also discusses the term and its meaning, but not in application to every situation. Grounded in principles, the term is prepared for the ever evolving nature of transactions, arrangements and relationships as they develop in the future. Ultimately, you may need to return to the principle and to your understanding of the key objective in order to meet your disclosure obligations.

All types of transactions, regardless of whether the Release or the rules mention them by name, must be analyzed and disclosed if appropriate. To further explore this challenge, let's look at how one example or case study-charitable contributions-might fit in the analysis. These are not mentioned by specific rule or example in the Commission's rulemaking. We must return to the principle.

I have heard very intelligent people assert, quite emphatically, that a charitable donation cannot trigger required disclosure, allegedly because it cannot be a transaction ("it's only a gift") for these purposes. I respectfully disagree. Determining whether disclosure is ultimately required under Item 404 involves walking through the entirety of the analysis behind the principle and the key objective (including whether a related person has a direct or indirect material interest) but I do not think there is anything in the language of the rule or in the principle that forecloses the possibility that a charitable contribution may be a transaction or a related person transaction. Remember the broad definition the Commission uses for "transaction" as well as the rest of the key objective behind related person transaction disclosure.

Imagine this hypothetical. A company makes a sizeable (that is, more than $120,000) donation to an environmental organization which the company's CEO particularly likes. Is that a related person transaction that requires disclosure? Going back to our key objective, it seems attenuated to me, without more, to find a "direct or indirect material interest" for our hypothetical related person, the CEO, so disclosure may not be required. But it seems clear to me that it's a transaction based on the Commission's definition and discussion. It may be lack of materiality that precludes disclosure.

Change the facts a little. What if the environmental charity employs the CEO's son? What if the charity was in dire straits before the company's donation and the son was likely, like everyone else who works at the charity, to lose his job? The company's sizeable donation, however, allows the charity to remain in operation. That one seems fairly easy. In that hypothetical, the company's donation has allowed the CEO's son to keep his job, and I imagine most parents would have at least an indirect material interest in their children's employment and careers. Alternatively, what if the prominent and highly regarded head of the charity writes a letter (and pulls some strings) after the contribution is received and lands the CEO's daughter a prestigious internship with an international wildlife agency? I have no idea standing here today what the right answer to that one is, but I believe we could figure it out if we had all the relevant facts and walked through them with the principle in mind. Remember, it's the principle that matters. And I at least think that the fact that the Commission has designed Item 404 to be principles-based tells us pretty quickly that we can't shirk the analysis by saying that a charitable contribution does not fit into someone's preconceived notion of transaction. As an understanding of principles-based rules and disclosure makes clear, lacking express language or a direct example in the rulemaking we must return to the principle. That is not at all the same as saying we can stop our analysis or conclude that disclosure is not required.

Putting Principles in Place: Disclosure Controls and Procedures

Navigating through the demands of principles-based disclosure is an important task and, as suggested by our charitable contribution example, not one conducive to superficial answers. I am happy to remind you, though, that you have some considerable resources at hand to help you meet those challenges. I believe you need to focus on at least a couple of things in this area. First, is your full team in place and on board? Second, how should your disclosure controls and procedures (or "DCP") be functioning in a principles-based world? I will return to the idea of how the entirety of your team intersects with disclosure controls and procedures at your company, but let's first look at the basics and the mechanics of DCP for a moment.

  1. The Basic Structure and Mechanics of Disclosure Controls and Procedures.

As you know, disclosure controls and procedures must operate for all of the disclosures your company makes in its SEC filings, but to my mind our topic today-related person transaction disclosure-poses a particular challenge, and presents a special need, for robust disclosure controls and procedures. As you hopefully sensed while we were walking through our hypothetical about a company's charitable contribution, it is especially important to understand context and to have a broad sense of the facts when making determinations about the need for related person transaction disclosure. This becomes particularly the case when you consider principles-based examples.

Since at least 2002, public companies have been working with disclosure controls and procedures and hopefully reaping the benefits of having effective ones in place. Pursuant to Rule 13a 15(a) under the Securities Exchange Act of 1934, the Commission requires that public companies maintain disclosure controls and procedures. Those are then defined by Rule 13a 15(e) as

controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

I have elsewhere suggested that in light of the new executive compensation disclosure rules, companies should be reviewing and revamping as necessary their disclosure controls and procedures to make sure they're up to the task of complying with the new rules. I have heard numerous outside commentators make the same point, and I believe your company's disclosure controls and procedures are probably already a priority and very much in focus for many if not all of you. Similarly, I would guess you have already begun the task of reviewing and updating them as necessary.

In a speech I gave last spring even before the final rules were adopted-or, I can assure you, drafted or finalized in any way-I attempted to focus people on what kinds of questions they might want to be asking and what kinds of changes to their disclosure controls and procedures they might need to be considering.3 For example, I had asked (and if I were still in private practice I would have been asking my clients throughout this year) questions such as:

  • Who will collect and aggregate these different types of information, which may not fit neatly with information collected to meet prior disclosure requirements?
  • Who will be responsible for maintaining the information? For analyzing it? For ensuring that the company's compensation story (that's the new CD&A) is told correctly?
  • Are existing disclosure committees properly positioned for the task? Do they include the right people?

Those types of questions and considerations are important, in my opinion, for the structure and mechanics of DCP generally and would probably apply for any type of new disclosure requirements. I do not want to diminish those factors in any respect, but I'd also like to take a few moments and drill down into some specialized questions and issues that I see as being particularly raised by the new executive compensation and related person disclosure requirements.

  2. An Expansive View of the DCP Team.

I referred a couple of moments ago to your company's "team"-which might include disclosure counsel and advisors but also compensation specialists, management (including officers) and directors. Hopefully everyone in this room understands the substantive contributions you yourselves can make in addition to your role in operating your company's disclosure controls and procedures. I think your contributions to both substance and to process are important. And as I alluded a few moments ago, I think the same is true for the rest of your team.

I have spoken in the past about how officers (specifically CFO's but much of the same would apply to CEO's) fit in this mix, as well as how directors do.4 I would like to encourage all of you, among others, to do that same type of analysis for yourselves and for your companies. How can or should your officers and directors be involved and what kind of contributions does your company need from them? Does your company need your compensation committee members, or some subset of them, to be engaged in your disclosure processes earlier than they have in the past? Do your officers? Some of you may have frequent interaction with the human resources and compensation specialists at your company (whether internal employees or outside consultants); others of you may not. I think all of you, however, should ask what input your company will need from those members of its team in order to provide the best executive compensation and related person disclosures that it can. Make sure, if you can, that those lines of communications are well-established well in advance at your company.

I very briefly referred to drafting the new Compensation Discussion and Analysis section as a DCP consideration. This new disclosure challenge seems to me to be one that particularly requires a close working relationship among a cross-section of your team. I have heard some outside commentators refer to it as a "multi-disciplinary approach", and that makes a lot of sense to me. Remember specifically that your certifying officers (your CEO and CFO) may have a special interest in the CD&A given that it will be filed company disclosure and covered by their certifications. Also, your compensation committee should have a special interest in it, in light of their new Compensation Committee Report in which they must disclose whether they have reviewed the CD&A with management and whether they recommended to the board that the CD&A be included in the company's proxy statement and Report on Form 10 K.

Again, when preparing the new executive compensation and related person disclosures, for many companies the whole team will need to be at the table, at different points, for the benefit of investors through improved disclosure as well as to facilitate various team members meeting their own obligations under the securities laws. I would challenge each of you then with this question. In your positions as corporate secretaries, disclosure counsel and governance professionals, how can you facilitate that involvement of everyone on your company's team and encourage communication and input from all the necessary players? Now is the time to do this-this fall-prior to your upcoming proxy.

  3. Disclosure Controls and Procedures in a Principles-Based World.

In order to properly achieve principles-based disclosure, I believe a company would need disclosure controls and procedures even if they weren't required by our rules in order to capture and contextualize the necessary information and formulate the necessary disclosure. Understanding the substance of and complying with the new disclosure requirements includes, in my opinion, embracing the principles-based theme. Principles-based disclosure is all about providing the relevant, material information to your investors. It is not about boilerplate or copying from precedent. Think back to the steps that Bob Herz laid out for how such a system works, what it requires. Also keep in mind that the Commission's definition of disclosure controls and procedures talks about information being "accumulated and communicated" to management and about disclosure decisions being made. Your disclosure controls and procedures-already in place and hopefully well-designed for the task at hand-should further your ability to confidently have all the necessary information at hand so that you and your colleagues can analyze it in light of the principles-based disclosure requirements and decide what exactly your company needs to disclose. I hope it will work that way for your companies at least, and I encourage you to have that goal in mind.

And while process is critical, don't forget the importance of the substance to the required disclosures. The two are closely connected of course. Think about your "team" from each angle. Other than their involvement with the processes, what specific information might you need substantively from your officers and directors? Obviously there's a lot of compensation information that will need to be collected, evaluated and disclosed as appropriate for your directors and many of your officers (at least your CEO, your CFO and the three other highest paid). Your company should be positioned and in command of that information on its own though. But what about our topic earlier this afternoon-related person transactions-and my suggestion that robust disclosures controls and procedures may be especially critical in this area?

For related person disclosure, you may well need information-principles-based input-that you will only be able to obtain from the related persons themselves. You may need broader types of information-context-from sources within your own company. You may need to be able to match the two up, but only after the basic information has been collected in disparate ways. Are you prepared for all of this?

Perhaps one of the most obvious resources for obtaining information from related persons is your company's D&O questionnaires. Has your company updated those? Do they need to be updated? I know that anytime there are new disclosure requirements that cross paths with officers and directors, conscientious disclosure counsel add questions to questionnaires as needed or revise existing questions as appropriate. For example, this year I expect you may add questions derived from the new S K Item 407 disclosure requirements. But as with so much in this area, I would urge you not to stop with the most obvious responses or changes.

Think about your D&O questionnaires in terms of principles-based disclosure. Are they structured to capture principles-based information? Are your questionnaires still asking the right questions given the new disclosure requirements? Are they going to elicit all of the information that your company might need to craft the disclosure your investors deserve? For example, think about the charitable contributions example that I discussed earlier. Are you ever going to hear about a situation like that at your company so that you can even do the analysis and decide if it warrants disclosure or not? What about indirect interests that aren't expressly identified as such (nor excluded from being such) by the specific language of any relevant rule text, but should be picked up under the principles-based approach of the Commission's rulemaking? Shouldn't you make sure your processes (questionnaires or otherwise) are designed so that you can expect to be given that information? And in fact, isn't that another part of reviewing and revamping as necessary your disclosure controls and procedures? Again, we see that DCP is integrally connected to the substantive end-point of your public disclosure.

As part of "being at the table", I have also recommended in prior remarks that everyone on the team should be informed and well-advised about the substance of the new disclosure regime and how it will work. Your company needs substantive information from many on your team; they may also need substantive information from you. I have encouraged different people in various roles to ask questions and to seek out the answers they need. You can meet them in this effort. Are there training sessions or materials that you might provide that could help your officers and directors understand the new disclosure requirements and in particular how principles-based standards function? Is there anything you might do to help the rest of your team understand how the rules impact them, how disclosure about them may be required and in return how they can contribute to your company's compliance with the rules? I understand that each of you is in a slightly different situation. Every company is run slightly differently. Different entities have, for different but equally valid reasons, different hierarchies and ways of organizing their processes and lines of communications. So I can't speak to how it would or should work at your specific company. But I hope you will step back and consider what is needed and what works, within your company. And I hope the officers and directors at your company would welcome your outreach and listen to your counsel if you try to bring them on board and help them understand the new principles-based disclosure requirements. Not only could that teamwork improve your company's disclosures for the benefit of investors, but it could also help your officers and your directors as they review those disclosures and, for some of them, as applicable, sign their certifications or approve a Compensation Committee Report that speaks to their having reviewed and recommended inclusion of the company's CD&A in its public filings.


In helping your companies comply with its new disclosure obligations, all of you as disclosure counsel and governance professionals can, in my opinion, be well-served and guided by embracing the principles. And as I said earlier, I would also urge you to do anything you can do to bring the rest of your company's team into the principles-based fold-it will serve you, your officers and directors, your company, and your investors very well. The new rules will go effective in about a month, and companies and their disclosures will be called upon to comply with and reflect the new rules, and the principles, for the first time in public filings and reports after that. As is hopefully clear, I believe that the Commission has taken a significant step and significantly advanced the interests of investors by adopting its new principles-based disclosure standards. But in order for that to have the meaning it should (and to benefit investors as it should), we need America's public companies to embrace the principles and provide their own principles-based disclosures. Each of you can be a key team member in giving life to that promise, and I hope you will answer the call. I also hope we have given you some sense of how the principles can be an aid and provide important guidance to you and to your companies in this endeavor.

Thank you for sharing your time with me today. I would be happy to take any questions you might have.



Modified: 10/30/2006