Should the Board of Directors Have a Disclosure
Committee?
By Warren F. Grienenberger, partner, and Michael C. Lee, associate, at
Chapman and Cutler,
Chicago
| Last summer, the Securities and Exchange Commission's (Commission) Advisory
Committee on the Capital Formation and Regulatory Processes (Advisory Committee),
chaired by Commissioner Steven M.H. Wallman, presented its final Report to
the Commission (Wallman Report). The Advisory Committee's activities are
a part of an intense examination of the federal securities laws that could
result in a major overhaul of the manner in which public companies make
disclosures to the investment community. As the centerpiece of its proposals,
the Advisory Committee recommends company registration, which would allow
public companies to issue additional securities without registering each
individual offering. Considerable attention was also given to improving the
quality and integrity of corporate disclosures, including the role of the
board of directors in overseeing the disclosure process. A key recommendation
was the creation of a disclosure committee of the board.
The Commission has not yet formally proposed any specific changes based upon the recommendations in the Wallman Report. However, in response to the Wallman Report, the Commission did issue a concept release concerning the effect of Securities Act of 1993 (Securities Act) concepts on capital formation.1 In this concept release, the Commission asks for comments on various disclosure issues, including the Advisory Committee's proposal for the use of disclosure committees.
Directors' Responsibilities Under the Securities
Laws Boards of public companies have the obligation under the securities laws to oversee their companies' disclosures, and the policies under which disclosures are made.2 The potential liability for failing to meet this obligation can be quite severe, and in certain circumstances directors can be held personally liable for losses that are determined to result from materially misleading disclosures. In spite of this potential liability, boards and individual directors may be inclined to neglect their oversight obligation and choose simply to rely on management to carry out the corporation's disclosure responsibilities. The Advisory Committee suggests that one way for directors to assume their proper oversight role is to establish a disclosure committee to monitor the corporation's public disclosures. In considering whether this approach should be adopted, boards should carefully weigh both the benefits and drawbacks. In theory, such an approach could have significant advantages for directors; but, as noted below, enormous dangers lurk in such a decision. The practical realities of boardroom life will likely counsel a cautious approach to the use of disclosure committees.
Advisory Committee
Recommendation Recognizing that there is room for improvement in the disclosure practices of many corporations, the Advisory Committee specifically recommends the use of disclosure committees. "Although not a necessary part of the company registration model developed by the Committee, the Committee strongly recommends that the Commission endorse (but not require) a new procedure whereby outside directors use the issuer's audit committee (or a separate committee of one or more outside directors to be known as a 'disclosure committee') to conduct an investigation of the issuer's disclosures. The Committee believes that this proposal has merit whether or not company registration is pursued by the Commission."3 A separate statement by three members of the Advisory Committee also noted with approval the idea of disclosure committees.4 However, the separate statement also observed that premature use of disclosure committees before changes are made in the current legal framework may put directors in an uncomfortable position. The separate statement called on the Commission to specifically authorize the delegating directors to rely on the disclosure committee in satisfying their due diligence obligations and to address the issue of personal liability of disclosure committee members.
Limitations Under the Present
System In a number of ways, directors are handicapped in their ability to participate meaningfully in the preparation and review of public disclosures. Boards of directors of public corporations, which are composed principally of outside directors, are not set up to handle the intense work that is involved in the preparation and thorough review of disclosure documents. Their members usually have major leadership responsibilities with other organizations. They are supervisors and are not detail-oriented. These boards meet only a few times a year to review the basic strategies and goals of the corporation and pass upon major proposals. If the directors are provided with detailed information, they can be expected to devote only a limited amount of time to review and discuss major issues. They cannot fulfill the role usually played by management and key employees. (Editor's note: for a discussion of the duty of directors to become informed about major corporate transactions, see James W Ukropina, "How Informed Is a Well- Informed Board of Directors?" Corporate Governance Advisor, November/December 1996, p. 1.) In spite of these limitations, the board of directors has an important gatekeeper function under the federal securities laws that forces the directors to take a measure of responsibility for the corporation's public disclosures. The issue is to determine how much reliance on management is appropriate. The answer will vary in each case, depending on the experience and reliability of management. A related issue is how much a board can rely on management and still meet the requirements for the due diligence defense found in Section 11 of the Securities Act. Availability of the due diligence defense requires that after reasonable investigation, the directors have no reasonable grounds to believe, and do not believe, that there are material misstatements in a registration statement. Although it is rare for outside directors to be held liable for public disclosures in the absence of outright fraud, certain cases have held that reliance on the representations of management without independent investigation does not constitute due diligence.5 Under the holdings in these cases, directors are required to conduct an independent verification of disclosure by reference to original written records. There was a brief period of excitement following one of these cases - BarChris. Seminars were held; boards were counseled about the implications of the case. But, eventually, life settled back to business-as-usual, and there have been only a few occasions, usually when fraud was involved, where much attention has been given to the board's role in disclosure policy.6 Nevertheless, the potential for liability should give the board the incentive to become more active in the area of disclosure oversight.
Benefits of a Disclosure
Committee The disclosure committee envisioned by the Advisory Committee would take primary responsibility on behalf of the board for conducting periodic reviews into the corporation's public disclosures. Under this approach, the delegating directors would make sure that the delegation of responsibilities to the disclosure committee is reasonable by ensuring that the members of the committee (either alone or with any professional advisers they may deem appropriate to use) are knowledgeable and capable of conducting due diligence for the board. Delegating directors would also assure that the committee is provided the resources necessary to conduct a thorough investigation and maintain appropriate oversight of the disclosure committee by periodically reviewing the committee's procedures for ensuring the integrity of disclosure. Delegating directors would, of course, retain the obligation to read the corporation's disclosures to confirm that they believe that the disclosure is not materially false or misleading; however, such delegation would allow the disclosure committee to satisfy the board's investigative responsibilities. Creation of a disclosure committee might confer certain benefits on a corporation and its board. As the diversity of a corporation increases and the corporation becomes active in multiple product lines and possibly multiple countries, directors will find that disclosure issues become more numerous and complex. Rapid market or technological change in a product or industry can also make disclosure issues more complex. As the complexity of disclosure issues increases, disclosure becomes more difficult to address in a periodic fashion. Greater complexity suggests more continuous and focused attention, which a disclosure committee could provide. Even where a company is not involved in a wide variety of activities, it may still benefit from a disclosure committee. The committee can be more involved in the ongoing disclosure process at an earlier date. This helps avoid situations where time pressures are building and the board is presented with a disclosure document that is, for all intents and purposes, a fait accompli. The disclosure committee can also be composed of those directors who are most knowledgeable concerning financial and disclosure issues. If there are no directors with such expertise, service on the disclosure committee and heightened attention to disclosure would have to serve as on-the-job training. A disclosure committee would almost certainly provide benefits to those directors not serving on the committee. The committee, with the help of its advisors, should be able to sift out the routine disclosure issues and bring only the more pressing ones to the attention of the full board of directors. Even more important, however, the existence and functioning of the disclosure committee would help insulate the non-disclosure committee directors from liability under the federal securities laws by performing for the delegating directors an investigation into the accuracy of the disclosures. As explained above, the due diligence defense of the Securities Act requires a director to conduct a reasonable investigation. By delegating this duty to a disclosure committee, a delegating director could assure a more thorough investigation than any individual director could complete. The delegating directors' reasonable investigation would be limited to a reading of major disclosures and to oversight of the disclosure committee, as described above. The existence of a disclosure committee also may put the board in a stronger position should confrontations with management over disclosure issues arise. Solidarity as a group is a critical source of power that directors can use to their advantage.7 When boards address disclosure issues in an episodic manner, the process of building consensus may be discouraged, both because individual directors feel the obligation to defer to management in the absence of clear authority and because boardroom norms frequently inhibit directors from communicating freely with one another. The disclosure committee may serve as a reference authority independent from management and form the basis for facilitating solidarity among the directors. Presumably, the work of the disclosure committee would benefit the corporation by helping to produce more accurate and complete disclosures. To the extent that this ultimate goal is achieved, the corporation would benefit from a decreased likelihood of being sued over misleading disclosures. The benefits of using a disclosure committee would become even more pronounced if the Commission adopts the company registration model suggested by the Advisory Committee. Under this model, the focus of disclosure would shift from a transaction-specific system to one in which the company continuously updates its disclosures. Under the company registration system, once a company is registered under the Securities Exchange Act of 1934 (Exchange Act) and filing the necessary reports thereunder, the company could issue and sell new securities without the delay of registration under the Securities Act as long as information regarding the issuance and any material developments is disclosed at the time of the issuance. The effect would be similar to universal shelf registration, where companies keep their public information current and are able to tap the capital markets at any time. But one problem with continuing trickles of securities into the market is that transactions occur too quickly, and potentially too often, for traditional due diligence procedures.8 This necessitates that such due diligence be kept continuously up-to-date.
Drawbacks of a Disclosure
Committee While the use of a disclosure committee may provide certain benefits to a corporation, the drawbacks should also be considered. First, to the extent that the committee functions in the place of the full board, the corporation loses the benefit of the full range of business and leadership experience represented on the board. Second, determining membership on the disclosure committee could present difficulties. If the board has several inside directors, they may be the best qualified in terms of knowledge and available time for the assignment. On the other hand, given the increasing role of outside directors in corporate governance, the committee should probably be composed mainly or solely of outside directors. Since the outside directors' time and talent for detail work are both likely to be limited, the best solution may be to follow the audit committee model and staff the committee with outside directors. These directors would work with representatives of management, auditors and counsel to achieve the committee's objectives. Third, the disclosure committee will incur expenses that may be significant The committee may believe it necessary to hire staff and special counsel to participate with management and company counsel in the preparation of disclosures. In many cases, it may be inappropriate for company counsel to advise the disclosure committee, both because company counsel's loyalty will naturally lie with management and because company counsel is one of the participants in the disclosure process the directors should be overseeing. A side effect of the introduction of additional parties to the disclosure preparation process is the likelihood that friction may develop among the several participants because of differences in disclosure philosophy. In a difficult situation, where the future of the company depends on avoiding premature or unduly negative disclosures, management may take an aggressive position, with the support of company counsel. Counsel for the directors may, in contrast, have protection of the directors against personal liability as the primary objective and argue for a more conservative approach. While management should not have unregulated discretion in the area of disclosure, it also should not be forced into arm's-length negotiations every time it needs to make a decision. As the separate statement of members of the Advisory Committee cautioned, the right of the directors to delegate to a disclosure committee is not absolutely clear.9 It appears that delegating duties to a disclosure committee is permissible under state corporate law. Corporate law generally permits directors to rely on a committee to satisfy their duties, and in fact committees are used for various purposes. Delaware General Corporation Law, Section 141, authorizes committees of the board to exercise extensive powers on the board's behalf. Model Business Corporation Act (MBCA), Section 8.30, specifically permits a director to rely on a committee on which the director does not serve.10 The duty of due diligence, though, arises under federal, not state, law, and duties that may be delegated under state law may not necessarily be delegated under federal standards. Despite the perceived benefits of disclosure committees, the use of such committees is not specifically sanctioned by the Commission. However, considering the legislative history of the securities laws and the use of committees in other areas, it seems likely that the Commission would not object to a partial delegation of a board's due diligence obligations to a disclosure committee. The Conference Report on the Securities Act describes how the conference committee specifically considered the duty of care of directors and officers of an issuing corporation. Rejecting what was described as "insurer's liability," which would have imposed liability for misleading statements without regard to whatever care the directors might have used, the conference committee instead imposed the duty to use reasonable care to assure the accuracy of the statements.11 While the committee found it impossible to define statutorily the extent to which a director could delegate his or her duties, the report language envisioning delegation was included deliberately "in the hope that that language as an expression of the 'intent' of Congress would control the administrative and judicial interpretation of the act."12 The true danger in disclosure committees, however, is the threat of liability for the members of the committee. There is a very real possibility that these members may find themselves subjected to a higher standard of care. Having specifically been charged with oversight of the corporation's disclosures, and knowing that other directors are relying on the integrity of their work, the expected "reasonable investigation" is likely to be much more complete. The extent to which liability may be enhanced is difficult to predict. However, cases have indicated that the reasonableness of a director's investigation may well depend upon how active that director was in the preparation of the disclosure and the level of the director's knowledge and experience. Directors who are most directly concerned with preparing disclosure and assuring its accuracy may have more expected of them in the way of reasonable investigation.13 Considering the potential liability involved in violations of the securities laws and the time and expense of defending unwarranted claims, even if indemnified or insured at company expense, this heightened standard is one which few directors may be willing to accept.
Establishing a Disclosure Committee: The
Audit Committee
Model For those corporations that decide that they can benefit from a disclosure committee, and whose directors are willing to accept such enhanced liability, the next question is how to define the scope of such a committee's operations. The committee's obligations should be specifically delineated in the corporation's by-laws, both to provide a reasonable basis for the delegating directors' reliance and to avoid later suggestions that the disclosure committee should have undertaken tasks that it was never intended to perform. A recent search of Exchange Act filings suggests that few, if any, corporations are currently using disclosure committees. Because there seem to be no concrete examples, probably the best model for such a committee would be the audit committee, which the Advisory Committee suggested could perform this function. Public companies that trade on national securities exchanges are required to establish audit committees composed of independent directors.14 Audit committees are clearly useful in improving the company's internal controls and enhancing the quality of financial reporting. The audit committee, however, does not itself prepare the financial statements of the company. In the absence of indications of impropriety, the audit committee limits itself to oversight of the system for preparing and reviewing the financial statements of the company.15 This may be a key element in determining the role of the disclosure committee. The disclosure committee would not itself prepare the corporation's disclosures, but would rather oversee the system of disclosure preparation in order to assure that it is functioning correctly.
A Disclosure Committee in
Operation The principal responsibility of the disclosure committee would be to review management's development and presentation of the corporation's disclosure. In so doing, the disclosure committee could have varying degrees of oversight. The proper measure of these duties is difficult to determine because the due diligence obligations of the delegating directors is ill-defined. The more responsibilities a committee accepts, the greater protection afforded the delegating directors, but the greater potential liability for the committee members. Accepting more authority also runs the risk that the disclosure committee might become overly intrusive and begin to interfere with, rather than enhance, the disclosure process. Nevertheless, the responsibilities of the disclosure committee might include: Obtaining familiarity with disclosure laws and standards.
Conclusion The Advisory Committee has recommended that public companies establish disclosure committees in order to improve their public disclosures. Corporations evaluating this recommendation should consider it with an eye towards the practical realities of board operations and the potential liabilities sought to be avoided. In spite of the theoretical benefits that disclosure committees could provide, they are likely to cause as many problems in the disclosure process as they eliminate. They also may be unappealing to outside directors who, under current norms, are rarely held personally liable for misleading corporate disclosures. Boards with the desire to improve their corporate disclosures should look for other, more incremental, means or wait for legislation or rulemaking that will make disclosure committees more attractive. Any such legislation should address the liability of directors and define with more particularity the scope of investigation necessary to satisfy the board's due diligence obligations.
NOTES
1. Release No. 33-7314. July 25, 1996. In the concept release, the Commission asked whether a disclosure committee would operate as an effective gatekeeper and improve the accuracy of disclosure, Whether the rest of the board would lessen their oversight, What effect a disclosure committee would have on director liability, whether any directors would be willing to serve on the committee, and how the committee would operate differently from the audit committee. 2. Under Section 11 of the Securities Act, directors may be held liable for misleading disclosures in registration statements. To the extent that reports under the Securities Exchange Act of 1934 are incorporated into registration statements, directors may also be liable for disclosures therein. 3. Wallman Report, p. 31. 4. Separate statement of John C. Coffee, Jr., Edward F. Greene, and Lawrence W. Sonsini. 5. Escott v. BarChris Construction Corporation, 283 F. Supp. 643, 690 (S.D. N.Y. 1968); Feit v. Leasco Data Processing Equipment Corporation, 332 F. Supp. 544 (E.D. N.Y. 1971). 6. See e.g., Report of Investigation In the Matter of the Cooper Companies, Inc. as It Relates to the Conduct of Cooper's Board of Directors, Release No., 34-35082 (Dec. 12, 1994) where the SEC noted "it [is] essential for board members . . . to ensure that the company's public statements are candid and complete." For a discussion of this Report, see Theodore Soude and Bettina M. Lawton, "'The SEC's 21 A Report on The Cooper Companies: The Message to Directors," The Corporate Governance Advisor, March/April 1995, p. 1. 7. Jay W. Lorsch, "Empowering the Board," Harvard Business Review (Jan.-Feb. 1995). 8. JohnC.Coffee,Jr."An 'Evergreen' Company Registration Approach Would Modernize the 1933 Act:" The National Law Journal (Sept. 11, 1995). 9. Supra note 4. 10. Under the MBCA, in order for such reliance to be justifiable, certain procedures should be followed: (1) the composition of the committee should be appropriate to its purpose; (2) the full board should review the committee's meetings, agendas and procedures; (3) the committee should adhere to limits on committee action imposed by law; and (4) the committee's duties should be clearly defined. Corporate Director's Guidebook, Second Ed., 1994, ABA Section of Business Law, p. 25. 11. Conference Report to H.R. 5480. 12. James M. Landis, The Legislative History of the Securities Act of 1933, 28 Geo. Wash. L. Rev. 29 (1959). 13. BarChris, 283F.Supp.643, 690; Feit, 332F. Supp.544. 14. See e.g., New York Stock Exchange Listed Company Manual, Section 303.00. 15. Corporate Director's Guidebook, Second Ed., 1994, ABA Section of Business Law, p.27. For more information on the responsibilities of audit committees, see John F. Olson, Josiah 0. Hatch, 111, and Shahin Rezai, "Audit Committees of the Board of Directors: Duties and Liabilities," Practising Law Institute, June 4, 1992, and Frederick D. Lipman, "What Should the Audit Committee Do?" The Corporate Governance Advisor, March/ April 1995, p.22. |
||
 |
|
|
Warren F. Grienenberger is a partner, and Michael C. Lee is an associate,
at Chapman and Cutler in Chicago.
Mr. Grienenberger may be reached at 312-845-3775 or by e-mail at
Warren_Grienenberger@mail.chapman.com
The information offered here is not intended as legal advice or opinion applicable in specific circumstances. You are urged to consult an attorney concerning your particular situation. Under professional rules, this article may be regarded as advertising material.
Copyright © 1997 - Reprinted from Corporate Governance Advisor, March/April 1997, 5:2, pages 11 - 17, with permission from Aspen Publishers, Inc., Gaithersburg, MD 20878 - 1-800-638-8437. All Rights Reserved Aspen Publishers, Inc. may be located on the Internet at its website address: http://www.aspenpub.com/
