GIBSON, DUNN & CRUTCHER LLP Lawyers Jas. A. Gibson, 1852-1922 W. E. Dunn, 1861-1925 Albert Crutcher, 1860-1931 A Registered Limited Liability Partnership Including Professional Corporations 525 University Avenue, Suite 220 Palo Alto, California 94301 Telephone (415) 463-7300 Facsimile (415) 463-7333 ***** Los Angeles 333 South Grand Avenue Los Angeles, California 90071-3197 Century City 2029 Century Park East Los Angeles, California 90067-3026 Orange County 4 Park Plaza Irvine, California 92614-8557 San Diego 750 B Street San Diego, California 92101-4605 San Francisco One Montgomery Street Telesis Tower San Francisco, California 94104-4505 Dallas 1717 Main Street Dallas, Texas 75201-7390 Denver 1801 California Street Denver, Colorado 80202 New York 200 Park Avenue New York, New York 10166-0193 Washington 1050 Connecticut Avenue, N.W. Washington, D.C. 20036-5306 Paris 104 Avenue Raymond Poincare 75116 Paris, France London 30/35 Pall Mall London, SWIY 5LP Hong Kong 10th Floor, Two Pacific Place 88 Queensway Hong Kong Affiliated Saudi Arabia Office Jarir Plaza, Olaya Street P.O. Box 15870 Riyadh 11454, Saudi Arabia October 31, 1996 BY ELECTRONIC MAIL Jonathan G. Katz Secretary United States Securities and Exchange Commission 540 Fifth Street, N.W., Stop 6-9 Washington, D.C. 20549 Re: Comments to Company Registration System Concept Release, File No. S7-19-96 Dear Mr. Katz: Pursuant to the Securities and Exchange Commission's request for comments to its recent Concept Release concerning the proposed Company Registration System, I submit the enclosed paper for consideration by the Commission. The paper, entitled "The SEC's Proposal For Creation of Public Company 'Disclosure Committees:' Directors In The Spotlight," addresses certain issues pertinent to the "disclosure committee" proposal. Specifically, I urge the Commission to consider the significant liability issues engendered by the disclosure committee concept. As detailed more fully in the enclosed paper, the Report issued by the Advisory Committee on the Capital Formation and Regulatory Processes leaves many questions unanswered concerning the duties and liabilities of members of the proposed disclosure committee. Unless these questions are clarified by the Commission, few directors are likely to accept the challenge to participate in a disclosure committee, or the increased potential liability associated with it. Thank you for your consideration of these concerns. Sincerely, /s/ Jonathan C. Dickey Enclosure JCD/pjc THE SEC'S PROPOSAL FOR CREATION OF PUBLIC COMPANY "DISCLOSURE COMMITTEES:" DIRECTORS IN THE SPOTLIGHT BY JONATHAN C. DICKEY* I. INTRODUCTION Earlier this year, the Advisory Committee on the Capital Formation and Regulatory Processes, chaired by SEC Commissioner Steven Wallman, issued its Report recommending sweeping changes to the federal securities regulatory scheme, including a "company registration" model for public companies to more efficiently register and issue securities without the costly and time-consuming filing requirements associated with secondary stock offerings under current law. In keeping with the Commission's recent emphasis on simplifying and modernizing the federal regulations governing securities issuers and broker-dealers, the Advisory Committee's "company registration" proposal envisions a streamlined process that would permit issuers to incorporate by reference their periodic filings under the Securities Exchange Act of 1934 (the "'34 Act"), together with more stringent standards for management review and approval of '34 Act filings. In addition, the Report recommends that public companies create "disclosure committees" comprised of the company's directors, or persons to whom the directors have delegated such duties, to regularly review and approve the issuer's public disclosures. The Advisory Committee recommends adoption of the disclosure committee concept whether or not the "company registration" model is pursued by the SEC.1 The Report leaves many questions unanswered concerning the duties and liabilities of members of the proposed disclosure committee. Until these questions are clarified by the Commission, few directors are likely to accept the challenge to participate in a disclosure committee, or the increased potential liability associated with it. This article examines the SEC's proposal from the viewpoint of one observer who regularly advises public companies on SEC disclosure issues, and defends them in securities class action litigation. II. THE EXISTING REGULATORY FRAMEWORK A. Board Committees. To put the disclosure committee proposal in perspective, it is important to note that under current federal law, public companies are not required to have any committees of the board of directors. However, it is common for public companies to have a number of committees, some of which (the audit and compensation committees, for example) are required under rules promulgated by the national stock exchanges. As well, the corporate governance movement in recent years has placed increasing emphasis on "best practices" of board of directors, and as a result many public companies have implemented variations of the so-called "GM Guidelines," which encourage the active participation of non-management directors in the affairs of the corporation, both directly and through the creation of various committees of the board. Besides these reasons for establishing board committees, many boards and their counsel have used the board committee structure as a means of discharging the directors' duty of care under state law. Delaware, for example, authorizes the creation of board committees (see, e.g., Del. General Corp. Law 141 (c)), and provides that such committees "shall be fully protected" to the extent they rely in good faith on information or opinions provided to them by experts, consultants, employees and outside professionals (Del. General Corp. Law 141(e)). Similar provisions are found in California Corporations Code 309. B. Limitations on Liability. Current federal law affords various limitations on the liability of directors and officers in connection with public disclosures. For example, federal statutes, rules and regulations provide "safe harbors" for forward-looking statements, and concerning company performance disclosures made in connection with a company's annual proxy statement. Further, by caselaw or explicit statutory exemption, certain SEC rules and regulations do not afford a private right of action (for example, Item 303 of Regulation S-K, which requires companies to include specified information in the "Management's Discussion and Analysis" section of the company's 10-K or 10-Q). Likewise, under various states' laws, a corporation may completely eliminate the liability of a director for breach of fiduciary duty (e.g., Del. 102(7)). The corporate governance laws of most states also uphold the so-called "business judgment rule", which permits a corporation to dismiss a derivative lawsuit upon a showing that the corporation's board (or a special litigation committee of disinterested directors or outside advisors established by the board) investigated the alleged wrongdoing and found the claim to be without merit. III. THE PROPOSED ROLE OF THE DISCLOSURE COMMITTEE The Advisory Committee Report strongly recommends the use of a disclosure committee as a "gatekeeper" to ensure the integrity of the disclosure process. The Committee recommended the disclosure committee concept based in part on the belief that the full board likely would not be capable of adequately discharging the directors' existing due diligence obligations under Sections 11 and 12 of the Securities Act of 1933 ("'33 Act") in the context of the expedited nature of the offering process contemplated by the proposed "company registration" model. Although the Advisory Committee did not articulate any detailed recommendations as to how the members of the committee would discharge their duties, the Report clearly contemplates a review process in which the disclosure committee would continuously and systematically oversee and monitor the integrity and quality of the process in which the issuer's management, underwriters, auditors, and legal counsel create the issuer's public disclosure documents. Through this systematic and continuous oversight process, the Advisory Committee hopes not only to improve the overall quality and utility of the issuer's disclosures, but also to create a mechanism in which the issuer's outside directors would become more integrally involved in the disclosure process. The Advisory Committee Report contemplates that the full board would be entitled to rely on the work performed by the disclosure committee for purposes of discharging their due diligence obligations under federal law -- as well as their state law fiduciary duties -- so long as the delegating directors (i) reasonably believe that the members of the disclosure committee "are sufficiently knowledgeable and capable of discharging due diligence obligations," (ii) maintain appropriate oversight of the work of the disclosure committee, and (iii) reasonably believe that the issuer's disclosures are not materially false or misleading. It must be emphasized, however, that while the delegating directors itself generally would be entitled to rely on the disclosure committee, the work of the committee may create greater exposure for the committee members themselves. For example, committee members may face greater personal liability (i) under the current "group published" doctrine, in which corporate insiders are presumed to have participated in the dissemination of information to the financial markets sufficient to justify holding them individually responsible for the issuer's public disclosures; (ii) as potential "control persons" with secondary liability for any false or misleading statements made by management; (iii) for aiding and abetting a securities law violation in enforcement actions brought by the SEC; and (iv) under any applicable state law causes of action. Additional protections against these and other significant new exposure risks will be necessary before issuers are likely to adopt the disclosure committee concept. IV. POSSIBLE SAFEGUARDS FOR DISCLOSURE COMMITTEES A. No Private Right of Action. The most obvious means for the Commission to encourage directors --or anyone else-- to participate on a disclosure committee is to limit their potential civil liability arising out of the work of such a committee. One recent example of a statutory limitation of liability is found in the Private Securities Litigation Reform Act of 1995, wherein auditors are exempted from any civil liability arising out of their reporting to the SEC of possible illegal acts. The Commission, through its exemptive power, could explicitly provide that there is no private right of action against directors in connection with their work on a disclosure committee, and -- perhaps as importantly -- that the Commission intends to pre-empt any state law anti-fraud remedies that might otherwise permit private civil litigants to bring claims under state law against a director serving on a disclosure committee. B. A Federal Business Judgment Rule. Another approach to limiting liability would be to adopt a federal version of the business judgment rule, that would permit a company to dismiss claims alleging breach of duty against a director in connection with the work of the disclosure committee. Such a federal standard ideally should incorporate a pre-suit demand rule, permitting the company to investigate and respond to a shareholder claim, and dismiss any subsequent suit by such a shareholder after it found the claim to be lacking in merit. Under this approach, as under current state law interpretations of the business judgment rule, the committee would be presumed to have acted properly if it follows specified procedures, and would be "fully protected" -- as is currently the case under Delaware law -- for having relied in good faith on the expert advice of independent legal and accounting advisors. The burden of proof would be on the plaintiff to demonstrate that the committee did not properly exercise its business judgment. C. Limit Scope of Directors' "Due Diligence" Obligations. Under the Advisory Committee's approach, outside directors who do not serve on the disclosure committee are held to a very rigorous standard of care, one that appears to undermine the entire purpose of the disclosure committee. Specifically, "delegating directors" (i.e., those not serving on the committee) must themselves "reasonably believe that the disclosure is not materially false or misleading." This standard seems to incorporate the existing "due diligence" standard under Section 11 of the '33 Act, which permits reliance by outside directors only on "expertised" statements by accountants, lawyers and the like who have consented to be named as experts in the prospectus. As to such expertised statements, the outside directors must only demonstrate that they "had no reasonable ground to believe, and did not believe" that the statement was untrue. As to all other non-expertised statements, however, the outside directors must establish that they had an affirmative belief that all such statements are true --a standard that is nowhere required of outside directors under current law for statements appearing in 10-Q's, 10-K's, and similar '34 Act filings. Given this fact, the SEC should adopt the standard of care reserved for "expertised" statements if the idea of delegation is to have any meaning at all. D. Modified Proportionate Liability. The Reform Act codified a new proportionate liability rule based upon the relative fault of each defendant in a suit brought under the '34 Act. This proportionate liability rule also was extended to outside directors sued under Section 11 of the 1933 Act. A similar approach to limit the potential liability of outside directors should be included in any SEC rules establishing disclosure committees. However, any proportionate liability rule should not increase the liability of outside directors who serve on a disclosure committee, vis-…-vis other "delegating directors" who choose not to serve. One solution, perhaps, would be to say that the mere involvement of a director on a disclosure committee shall not give rise to any inference that his or her relative fault is higher than that of any other director. E. Limitations on Liability of Outside Advisors. Another area not addressed by the Advisory Committee Report is the potential liability of those persons -- particularly accountants and lawyers -- to whom the disclosure committee may delegate certain responsibilities. Just as it is counter-productive to call for directors to sit on a disclosure committee without addressing liability concerns, it is wishful thinking that outside professionals will be eager to assume unknown new liabilities for having directly participated in the review and approval of an issuer's public disclosures. Although an implied right of action for aiding and abetting was rejected by the United States Supreme Court in 1994 in Central Bank of Denver, outside professionals still may be sued under various state anti-fraud laws, both directly and as aiders and abettors (See, e.g., Cal. Corp. Code 25504.1). To the extent directors are afforded protection against civil liability, similar protection should be extended to the company's outside advisors who directly participate in the work of the disclosure committee. Otherwise, these outside professionals increasingly will become the constituency upon whom most of the responsibility -- and liability -- will be placed as a practical matter. V. A MODEST PROPOSAL FOR SILICON VALLEY PUBLIC COMPANIES The Advisory Committee's conception of a board-supervised disclosure committee, while well-intended, does not fully take into account the unique characteristics of many Silicon Valley public technology companies. These companies are perhaps the fastest-growing industry segment in our country, and many are likely to want to take advantage of the "company registration" model being proposed. Nevertheless, the corporate cultures of many of these companies is contrary to two basic assumptions underlying the Advisory Committee's disclosure committee proposal: (1) that "management" does not adequately consider and participate in their companies public disclosures; and (2) that the outside directors of these companies have sufficient capacity, time, and compensation to add yet another layer of committee work to their existing duties. As to the first point, the experience of this author would indicate that a very active and "hands on" review process already exists in many Silicon Valley companies, normally involving several members of senior management. As to the second point, the experience of this author would indicate that the boards of directors of "younger" public companies in Silicon Valley have only a very few outside directors, and that those directors already have significant responsibilities with respect to other existing committees of the board, and indeed other companies upon whose boards they sit. Putting aside these practical considerations, when viewed in the overall context of the Advisory Committee's "company registration" model, the proposed disclosure committee is perhaps somewhat redundant. Specifically, the Advisory Committee Report proposes that disclosure committees be created in addition to the new certification requirement imposed on management. According to the Report, a minimum of two of four senior executive officers (CEO, COO, CFO or CAO) would be required to file an "attestation" with the Commission in connection with each 10-K, 10-Q or 8-K, indicating their personal belief that all statements therein are correct and that there are no material misstatements or omissions. The report rationalizes that these members of senior management are "in the best position to ensure that the company's disclosures fully and fairly describe the company's financial condition, results of operations, and prospects." If that is so (and this author agrees), the work of the disclosure committee seems unnecessary, save and except to add another layer of accountability. That having been said, one can expect that pension funds and other institutional investors soon will pick up on the theme struck by the Advisory Committee regarding the desirability of disclosure committees, and that some of the bigger Silicon Valley companies therefore may choose (or be cajoled) to implement a disclosure committee. Assuming that liability concerns are adequately addressed by the Commission, outlined below is a possible template for a disclosure committee, taking into account the practical considerations noted above: A. Composition. Although the Report suggests that the work of the disclosure committee could be performed by the audit committee, this author recommends that the two functions be separated. Borrowing from the Advisory Committee's proposal for a mandatory management certification process, at least two members of senior management should sit on the Committee, with one outside director chairing the Committee. A three-person Committee should be adequate. B. Scope of Review. The work of the Committee should be limited to a review of the Management Discussion and Analysis ("MD&A") section of the company's periodic SEC filings, and any related material appearing in the quarterly and annual reports (including the "President's Letter" or similar material). The Advisory Committee Report appears to recommend that the disclosure committee review and approve all company disclosures (impliedly including press releases, earnings announcements, and the like), but that seems unrealistic. As is the current practice, financial statement disclosures should continue to be the responsibility of the audit committee, since that committee is in the best position to monitor and assess the work of the issuer's accounting staff and independent auditors. For the same reasons, recommended disclosure of "known trends or uncertainties" (as required by Item 303 of Regulation S-K) relating to financial matters should originate with the audit committee. C. The Review Process. The Committee should have a written charter document specifying the specific (and limited) duties and responsibilities of the Committee, and enumerating its power to retain and utilize the services of outside professionals and consultants as needed. The Committee should be authorized to retain legal counsel independent from the company's regular inside or outside counsel, to the extent necessary to fully discharge its duties. A regular and well-defined process should be outlined in the charter document, including which company officers and employees may be expected to provide input to the committee. Although every company will want to customize the process to best suit the skills and experience of its management team, ideally every operational department head (e.g., sales, marketing, engineering, manufacturing), should provide input on the MD&A. Depending on the company's structure, other persons with primary management responsibility for major business lines also should provide input. To the extent feasible, those department heads or others providing input should have a required sign-off that they have read the MD&A and are not aware of any material misstatements or omissions therein relating to their areas of responsibility (including known trends or uncertainties). Management (other than members of the Committee) should be responsible for preparing the draft MD&A. Review by inside or outside counsel with reasonable "lead time" (at least 5 business days prior to filing) should be a required step. D. Meetings and Documentation. The Committee should meet at least once a quarter, in person, with outside advisors participating as needed. This meeting would be directed to a review of the MD&A section in the company's 10-Q's or 10-K. In addition, to the extent the company includes interim period results in any other public disclosures (other than the normal press release of quarterly or annual results), the committee should have a meeting or conference call to review and update the MD&A discussion for inclusion in such interim public disclosures. Presence of legal counsel (in-house or outside counsel) at such meetings is encouraged to provide professional advice as needed, and to create a privileged context for discussion of sensitive topics. Drafts of the MD&A or other disclosure documents normally should not be retained. Formal committee minutes should document the process undertaken, in compliance with the process outlined in the Committee's charter document. The persons consulted during the process, and the timing and sequence of the review process relative to the company's formal release of information should be documented in the minutes, in order to establish that the committee devoted sufficient time and resources to the review process. CONCLUSION The Advisory Committee's disclosure committee proposals can benefit public companies, and promote investor protection, only if reasonable limitations on liability are forthcoming. Outside directors already face many challenges in the corporate governance arena, and should not be placed on outside directors - -as opposed to management-- to manage the day-to-day activities of the companies they serve. Nevertheless, to the extent liability concerns are ultimately addressed by the Commission, a disclosure committee can be implemented, and a review process established, that will better insure that public companies engage in "good disclosure." FA963050.105/-1+ _______________________________ * Mr. Dickey is a partner in the Palo Alto office of Gibson, Dunn & Crutcher LLP, where he specializes in the defense of public companies and directors and officers in shareholder litigation. Comments or feedback may be directed to Mr. Dickey at jdickey@gdclaw.com. 1 The public comment period on the SEC's concept release, incorporating the recommendations of the Advisory Committee, expired on October 31, 1996. The concept release and the Report are available on the Commission Website at http://www.sec.gov.