Corporate Governance

Commission Disclosure Requirements and a Private Right of Action for Violation of Listing Requirements

By J. Robert Brown

In Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure I took the position that the Commission was increasingly using disclosure to affect substantive behavior by officers and directors.  One of the ways this has occurred has been through mandatory disclosure of a company's compliance with the listing standards of the relevant stock exchange.  Most listed companies must have a majority of independent directors.  If they do not, they violate the relevant listing requirements.  While the exchange can take steps against the offending company, there is unlikely to be any private right of action.  Case law to date has largely concluded that a private right of action does not exist for violation of the rules of the stock exchange (including listing standards).

But because compliance must be disclosed under the periodic and proxy reporting requirements, a company that states it has a majority of independent directors when it does not runs the risk of violating the antifraud provisions (much less Section 13(a)).  Of course, all of the elements of an antifraud violation must be present, including scienter and materiality.   

All of this brings us to the 2007 proxy statement filed by Merrill Lynch.  The company more or less concluded that a majority of directors met the independence standards of the NYSE.  As the proxy statement noted:

• For a Director to be considered independent under NYSE rules, the Board of Directors must determine that the Director does not have any direct or indirect material relationship with Merrill Lynch other than as a Director. The Board of Directors has adopted categorical standards to assist in making its determinations of director independence required by the NYSE rules. The Director Independence Standards, which are consistent with the NYSE rules, describe certain relationships between the Directors and the Company that the Board of Directors has determined to be categorically immaterial.  

Based upon these standards, the proxy statement concludes that all directors except the CEO/chairman are independent.  Typical enough.  But then something unusual occurs.  A table title "Key to Descriptions of Client Relationships and Charitable Contributions" has a footnote noting that "[c]ompensation for service as a Director is not considered in making independence determinations." Merrill Lynch2007 proxy statement.  In other words, Merrill Lynch is stating that fees were not used in determining independence.  The table for director compensation shows total compensation of some directors above $300,000, with most receiving compensation above $250,000.  In other words, these are hefty payments to "not consider" in making an independence determination. 

One might wonder why Merrill felt compelled to admit this fact.  One possible answer is the concern over the antifraud provisions.  The listing standards of the NYSE provide that directors with a "material relationship" with the company are not independent.  Neither the standard nor the instructions exempt fees from the analysis.  Thus, one can fairly read the standards as requiring consideration of fees.  The listing requirements do exclude fees when calculating whether a director received more than $100,000 in direct compensation during the prior three years. 

Thus, an argument could be made that any company disclosing compliance with the stock exchange rules without taking into consideration the fees paid would be violating the antifraud provisions.  Merrill, to the extent concerned about this possibility, has neatly sidestepped the issue.  It has made full disclose that the fees are not included in the calculation, cutting off any serious allegation that the market was mislead. 

The approach is prudent.  Other companies may want to consider the same step.  Better still, the NYSE should require listed companies to include fees in the materiality determination and enforce the requirement. 

Full post as published by The Race to the Bottom on January 25, 2008 (boomark / email).