Gallagher on the Roles of State and Federal Law in Corporate Governance

The following post comes from remarks delivered by SEC Commissioner Daniel M. Gallagher at the European Corporate Governance & Company Law Conference in Dublin, Ireland on May 17, 2013. 

Thank you Danny [McCoy] for your very kind introduction.  I am delighted to be able to participate in this conference, and especially proud as an Irish-American that it is being held in conjunction with Ireland’s Presidency of the Council of the European Union.  This conference is particularly valuable because it provides a forum for executives, directors, investors, and policy makers to have a frank and productive dialogue on important corporate governance issues.

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 Securities and Exchange Commission or my fellow Commissioners.

Today I would like to talk about the increasing role that governments – particularly, in the United States, the federal government – play in corporate governance as well as the increasingly prominent influence of proxy advisory firms on how companies are governed and on how shareholders vote.  These changes have led to, among other things, new limitations and requirements being imposed on boards of directors and companies.  And while the resulting costs to investors are easily apparent, the purported benefits are harder to discern.  Although today I will for the most part discuss these issues as they apply to U.S. companies, I note that there is a related trend in Europe.  As such, I hope that my comments may help inform your approach to regulating corporate governance as well.

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, discipline the board’s efforts.  The interests of these three actors are not always aligned.

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.  In the United States, governments at the state level have historically been the stewards of corporate governance, a distinction which the federal government has typically respected.  However, this deference has slowly been eroding and a continuing trend has been developing: “the federalization of corporate law”1 and the stripping away of states’ prerogatives with respect to corporate governance matters.

Why has this been the case? In the U.S., federal involvement in corporate governance matters has usually occurred on the heels of scandals and economic crises.  Indeed, one need not look further than the very names of the most recent efforts by Congress 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.”  A hallmark of these sweeping new laws is the imposition of new requirements, often inappropriate and almost always burdensome, as “feel good and cure all” responses to perceived problems presented as grand gestures with which one would be hard pressed to disagree.  For example, who can be against such stated goals as better disclosure, increased transparency, and heightened accountability?

The truth of the matter is that such reactive legislation and the resulting regulatory mandates are often based upon false narratives and in the end lead to the expansion of a universal law: the law of unintended consequences.  This threat is especially acute in the realm of corporate governance, where the costs of good intentions are actually borne directly by “Main Street” investors.

Take Sarbanes-Oxley.  If you were to ask executives and boards of directors today who they believed were the biggest beneficiaries of this well-intentioned legislation, few would cite shareholders.  Instead, many would answer that it was accountants, non-U.S. markets, and lawyers that truly benefited.  For example, the SEC estimated at the time that compliance with Section 404 of Sarbanes-Oxley would cost on average roughly $91,000 a year to implement.2  Instead, the costs of Section 404, in conjunction with the related PCAOB Auditing Standard 2, have been exponentially higher.

U.S. regulators responded, albeit too slowly for some, and attempted to address the issues presented by 404 implementation.  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 Act and last year’s JOBS Act.  Although these were very positive steps that relieved small companies from substantial audit and legal costs and made it more palatable for smaller companies to go public, the damage caused by this provision, in particular to the US capital markets competitiveness, may never be undone.

And then there is Dodd-Frank, the 2,319 page result of a determination to not let a crisis go to waste.  Although it will be many years before the Act is fully implemented and years after that until its impact is fully felt, it has already significantly affected U.S. capital markets and will continue to do so for many years to come.  Indeed, the Act is a good example of many legislative efforts that have followed the crisis — a core concept, in this case regulatory reform, overwhelmed by a grab bag of wish-list items.

Of course this shouldn’t be a surprise given that the statute was not the product of bipartisan compromise and was enacted shortly after the onset of the crisis — many months before the bodies charged by the government with examining the causes of the crisis issued their reports.

In total, the Dodd-Frank Act contains approximately 400 specific mandates to be implemented by agency rulemaking, with approximately a hundred applying directly to the SEC.  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.  Listed companies are already required to disclose the compensation of their executives in granular detail as well as in narrative format.  What do investors gain when a listed company provides additional information regarding how much a CEO’s compensation compares to the “median of the annual total compensation of all employees of the issuer”?3  The Act is filled with a litany of similar requirements that, while small individually, collectively add up to “death by a thousand cuts” to the detriment of investors.

Given all of these unintended consequences and the lack of a discernible benefit in federally regulating corporate governance, it is important that the SEC and Congress remain mindful of the traditional role of the states in regulating corporate governance.  As I have noted in the past, states are inherently better suited to address the varied and complex issues that arise in corporate governance.  Allowing states the flexibility to tailor their corporate governance regimes can lead to corporate innovation, while applying prescriptive boundaries and a one-size fits all corporate governance regime can correspondingly stunt such innovation.

With respect to legislative and regulatory oversight, state law confers greater flexibility than federal law to deal effectively with the myriad of different circumstances that legislators and rule makers cannot anticipate.  State laws and regulations have the benefit of being more easily revisited than federal legislation, thus allowing the legislature to amend rules and regulations that are failing to meet their intended purpose.  Additionally, given the historical treatment of companies as creatures of state law, there is a wide body of legal precedent, attentive industries and experienced state judges who are well versed in corporate matters.

State courts have also been able to build a greater body of jurisprudence which has enabled private ordering as opposed to forcing companies to comply with one-size fits all mandates.  Deference to private ordering enables a body of law to evolve based on competition, market discipline, and efficiencies.  I agree with my friend and colleague Troy Paredes that the “enabling” rather than “mandatory” approach to corporate governance adopted by states is the proper one.4  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.  And who bears the costs of these unintended consequences? The answer is investors in particular, and the U.S. capital markets in general.

Alas, the encroachment of the federal government on corporate governance and the strain on the director-shareholder dynamic has not been limited to our side of the Atlantic.  Both the European Parliament and national governments in Europe have increasingly proposed corporate governance measures and mandates, ostensibly providing shareholders more influence in matters traditionally left to the discretion of boards.  One example of this has been with respect to “say-on-pay” legislation, where there is a push to let shareholders have a louder, and often final, voice with respect to executive compensation.  In 2012, the European Commission announced its intention to allow shareholders to approve the remuneration policy of listed companies incorporated in the E.U.,5  and there have been recent indications from E.C. officials that such legislation is in the works.6  In addition, proposals to regulate executive compensation have been announced in Germany, Spain, Switzerland, and the United Kingdom.7  In fact, in March of this year, 68% of Swiss voters voted to approve the so-called “popular initiative against excessive pay,” sometimes referred to as the “Rip-Off Initiative.”8  This initiative requires, among other things, that shareholders have a binding vote to approve the pay of executives and board members of public companies, that pension funds holding shares in a company vote and disclose how they voted, and that golden handshakes and parachutes be eliminated.  It further mandates that violations of these new requirements could result in severe fines and even prison time.

The Swiss legislature is now obligated to pass legislation implementing this proposal within one year.  Additionally, a potential new proposal which seeks to limit salaries of certain executives to 12 times those of a company’s lowest-paid employee has garnered more than 100,000 signatures of support in Switzerland.9

At the E.U. level, the European Parliament approved last month certain elements of Capital Requirements Directive IV, which include restrictions on bonus payments to employees of certain financial institutions.  The bonus cap will apply to institutions in the E.U. as well as non-E.U. subsidiaries and will affect not only European employees, but certain non-European employees (of E.U. companies) that are located in Europe.10

This movement to national and federal corporate governance standards, towards a one-size-fits-all set of standards, is troubling.  From a practical perspective, I question efforts to strip away oversight of executive compensation from boards of directors.  They have traditionally been left with this responsibility for many reasons, including the sheer complexity of executive compensation, as we have seen in the financial services area.  Executive compensation decisions are incredibly complicated decisions that are made by boards after a long and deliberative process.  This process cannot be reduced to a few over-simplified propositions, or to a simple yes or no, without sacrificing all of the benefits flowing from a serious and thoughtful debate among directors knowledgeable about the company.  And, of course, eroding the board’s authority with respect to executive compensation also reduces their leverage and weakens their ability to oversee executives.

The question that policymakers need to answer at the end of the day is: do all of these mandates aid the average investor?  At best, it is questionable.  For example, an unintended consequence of the disclosure requirements imposed at the federal level in the U.S. over the past 15 years is that proxy statements now resemble law school text books.  Who can blame an investor for not voting when reading a proxy and voting a proxy card evoke memories of studying for a final exam?

Another arguably unintended consequence of stricter and more prescriptive corporate  governance rules is the rise of proxy advisory firms and the increasing willingness of investment advisers and large institutional investors to rely on such firms to meet their fiduciary duties.

The SEC has played a significant role in this area.  In 2003, the SEC adopted a new rule and rule amendments under the Investment Advisers Act of 1940 addressing an investment adviser’s fiduciary obligation to its clients when such adviser has authority to vote its clients’ proxies.  Pursuant to the new rule, an investment adviser that exercises voting authority over its clients’ proxies became required, among other things, to adopt policies and procedures reasonably designed to ensure that it votes those proxies in the best interests of its clients.11  One concern that the SEC was trying to address was an adviser’s potential conflicts of interest when it voted a client’s securities on matters that affected its own interests.  In the 2003 adopting release, the SEC noted that “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”12  I am sure this was music to proxy advisors’ ears.  As it had earlier done with the credit rating agencies, the SEC had essentially mandated the use of third party opinions.  In fact, proxy advisors became focused on this and asked the SEC staff for guidance and clarity.  In two SEC staff no-action letters issued in 2004 the proxy advisers got their wish.13

It has been argued that these two letters provide institutional money managers and other investment advisers a potential safe harbor against claims of conflicts of interest when they vote their client proxies.  In one  letter, the SEC staff advised that “[A]n investment adviser that votes client proxies in accordance with a pre-determined policy based on the recommendations of an independent third party will not necessarily breach its fiduciary duty of loyalty to its clients even though the recommendations may be consistent with the adviser’s own interests.  In essence, the recommendations of a third party that is in fact independent of an investment adviser may cleanse the vote of the adviser’s conflict.”14

One proxy adviser asked whether a proxy voting firm would be considered independent if it received compensation from an issuer for providing advice on corporate governance issues.  In its response letter, the Staff noted that the mere fact that a proxy voting firm provided advice and received compensation from an issuer for its services, “generally would not affect the firm’s independence from an investment adviser.”15  The effects of these letters were not lost on the judiciary.  In a 2005 law review article, a vice Chancellor of the Delaware court of Chancery wrote that following the recommendation of a proxy advisory firm “constitutes a form of insurance against regulatory criticism” and results in such firm having a large voice in the affairs of American corporations.16

I have previously spoken about my concern with the increased role of proxy advisory firms in today’s corporate governance world, and particularly whether investment advisers are fulfilling their fiduciary duties when they rely on and follow recommendations from proxy advisory firms.  I am not alone, as former SEC Chairman Harvey Pitt has recently voiced similar concerns,17 and the Mercatus Center at George Mason University recently published a paper on the proxy advisory system and concerns raised by its current structure.18  I am concerned that unless these no-action letters are reviewed and possibly revisited, the SEC may find it difficult to ensure that fiduciaries are conducting proper due diligence with respect to proxy votes.19

Some would argue that the role of proxy advisers has been overstated.  However, one would be hard pressed not to notice the stream of concern from regulators, directors, and even shareholders themselves over the increasing role that proxy advisory firms play in the board room.  A recent survey found that more than 70 percent of directors and executives reported that their compensation programs were influenced by guidelines and policies of proxy advisory firms.20  As discussed in the Mercatus Center paper, a concern many people have is that “to a large degree, corporate directors and executives are now subject to decision making on critical issues by organizations that have no direct stake in corporate performance and make poor decisions as a result.”21  Commenters have also raised other concerns about the lack of standing and skin in the game that proxy advisory firms have in advising shareholders.  As stated in one law review article, “Proxy advisors do not have a financial stake in the companies about which they provide voting advice; they owe no fiduciary duties to the shareholders of these companies; and they are not subject to any meaningful regulation.”22

I understand that there is concern in Europe as well regarding the increased role of proxy advisory firms.  The European Securities and Markets Authority recently suggested that the proxy advisory industry may want to provide greater clarity to subscribers and stakeholders on what they can rightfully expect from them.  ESMA’s chair noted that “[t]here are a number of concerns regarding conflicts of interest management and the transparency of analysis and advice, which we believe would benefit from improved clarity on the part of the industry.”23  ESMA also concluded that although it currently did not favor the introduction of binding measures, it encouraged the proxy advisory industry to develop its own code of conduct focusing on certain principles, including identifying, disclosing and managing conflicts of interest and fostering transparency to ensure the accuracy and reliability of the advice it provides, which entails disclosing general voting policies and methodologies, considering local market conditions and providing information on engagement with issuers.24  I hope the proxy advisory industry follows this advice and look forward to seeing such a code of conduct.  I believe these issues of conflicts and transparency identified by ESMA and market participants are the same on both sides of the Atlantic.  It is critically important for policymakers to understand, evaluate, and if necessary address the practices and business models of proxy advisory firms.

Given the increased questions raised about proxy advisory firms, I think it is important to ensure that advisers to institutional investors – which, let’s not forget, are generally simply collections of individual investors – are not over-relying on analyses by proxy advisory firms.  No one should be able to outsource their fiduciary duties, a point that is especially poignant in light of the fact that we are still dealing with the painful fallout from the actions and role of credit rating agencies in the subprime mortgage securitization fiasco – but that’s a topic for another time.

Ultimately, I think policy makers, regulators, fiduciaries, and market participants need to ask tough questions about the current proxy advisory regime, such as:

  • Does following recommendations by proxy advisory firms increase shareholder value?
  • What research do proxy advisory firms conduct to ensure that their recommendations increase shareholder value, and how is that research documented?
  • How much transparency should proxy advisory firms provide subscribers with respect to how such research is conducted?
  • Should proxy advisory firms be subject to proxy solicitation rules?
  • Do governments provide preferred treatment to proxy advisory firms and advisors that rely on them, and is that appropriate?
  • How can proxy advisory firms be held accountable for their recommendations?
  • How should proxy advisory firms, and subscribers which use their recommendations, address potential conflicts of interest?

I hope that increased awareness of the role of proxy advisory firms in today’s corporate governance world encourages advisers, investors and policymakers to think about what that role should be.

Thank you all for your attention.  I’ve appreciated the opportunity to be here today and share my views on these vitally important subjects, and I wish you a successful conclusion to this conference.

1 See Commissioner Kathleen L. Casey, Remarks before the Forum for Corporate Directors (March 22, 2011) (available at

2 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).”

3 Dodd–Frank Wall Street Reform and Consumer Protection Act § 953(b)(1)(A).

4 See Commissioner Troy A. Paredes, Remarks at the 22nd Annual Tulane Corporate Law Institute (April 15, 2010) (available at

5 See Recent European Compensation Developments: Financial Institutions and Beyond, Davis Polk Client Memorandum, April 23, 2013.

6 “EU Commission to propose shareholders vote on executive pay”, no author, March 6, 2013

7 See fn 5.

8 See “Swiss to Vote on Executive Pay”, by John Revill, March 20, 2013.

9 Id.

10 See fn 5.

11 Final Rule: Proxy Voting by Investment Advisers, 68 FR 6585,

12 Id.

13 See “Investment Advisers Act of 1940—Rule 206(4)-6: Institutional Shareholder Services, Inc.” SEC letter to Mari Anne Pisarri, September 15, 2004, and “Investment Advisers Act of 1940—Rule 206(4)-6: Egan-Jones Proxy Services,” SEC letter to Kent S. Hughes, May 27, 2004,

14 “Investment Advisers Act of 1940—Rule 206(4)-6: Egan-Jones Proxy Services,” SEC letter to Kent S. Hughes, May 27, 2004,

15 Id.

16 See Leo E. Strine, Jr., “The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (And Europe) Face,” Delaware Journal of Corporate Law 30 (2005): 688.

17 Remarks given by Harvey Pitt at U.S. Chamber of Commerce seminar entitled “Examining the Role of Proxy Advisory Firms” on December 5, 2012, See “Former SEC Chair Pitt Says Two No-Action Letters Block SEC Review of Outsourcing Voting to Proxy Advisory Firms,” Jim Hamilton, January 2, 2013,

18 See “How to Fix Our Broken Proxy Advisory System”, by James K. Glassman and J. W. Verret, April 16, 2013,

19 See fn 17.

20 See “How to Fix Our Broken Proxy Advisory System”, by James K. Glassman and J. W. Verret, April 16, 2013, 
The Conference Board, NASDAQ, and Stanford Rock Center for Corporate Governance, “The Influence of Proxy Advisory Firm Voting Recommendations on Say-on-Pay Votes and Executive Compensation Decisions,” (March 2012), /proxy.html.

21 See “How to Fix Our Broken Proxy Advisory System”, by James K. Glassman and J. W. Verret, April 16, 2013,

22 See Stephen Choi, Jill Fisch, and Marcel Kahan, “The Power of Proxy Advisors: Myth or Reality?,” Emory Law Journal 59 (2010): 872.

23 See “ESMA recommends EU Code of Conduct for proxy advisor industry”, February 19, 2013,  See “Final Report: Feedback statement on the consultation regarding the role of the proxy advisory industry”, European Securities and Markets Authority, February 19, 2013.

24 Id.