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If a company has a partner from a top law firm on its board of directors, it’s certainly going to meet all of its legal obligations, right? Not necessarily. Businesses frequently tap partners from their outside counsel for their boards, as we’ve previously reported ["A Risky Perch," June, and "The Power, The Glory-The Risk," September]. According to SEC rules, a corporation must always disclose a client relationship with a director’s law firm in its proxy statement. But our survey of Am Law 100 partners who serve on the boards of Nasdaq-listed corporations turned up an unexpected result. Nine businesses (out of approximately 100) failed to disclose a relationship with a director in their proxy filings. The companies are unlikely to face any serious penalty or extra scrutiny from the SEC, overburdened as it is in dealing with the current flood of other corporate transgressions. Still, even a small disclosure failure is significant in the current environment, when CEOs and CFOs must personally certify the accuracy of their company’s filings with the agency. We asked the nine companies why they hadn’t disclosed the director-client relationship. Almost every one said that according to their attorneys’ interpretation of the SEC rule, they didn’t think they needed to. But they’re wrong. Some of the rationales they gave: The relationship is mentioned elsewhere: Spokespersons for some companies, such as Digital Generation Systems, Inc., and CNB Florida Bancshares, say that they have disclosed the relationship in other SEC filings. And indeed, when we reviewed other filings from all nine companies, we found that four had identified the director-client relationship in reports such as a 10-K, 10-Q, or 8-K. But that isn’t enough, says George Washington University law professor Lawrence Mitchell. He explains that the intent behind requiring disclosure in the proxy statement “is to make it easy for the investor to find potential conflicts of interest, not more difficult.” The legal fees were under $60,000: A member of the legal staff at Cirrus Logic, Inc., initially said that the company’s interpretation of the SEC rule was that it required disclosure only if legal fees were over $60,000 per year. This threshold is indeed contained in SEC regulations, which exempt a company from reporting a relationship with a director if it pays less than $60,000 to his or her business. However, there’s one exception. If a director works for a law firm, the company must report the relationship no matter how much it pays in fees. The fees didn’t exceed 5 percent of the law firm’s income: An official at insurer Harleysville Group gave this response, which apparently comes from the misapplication of another SEC requirement. The agency requires a company to disclose the amount of fees paid to a firm if the amount exceeds 5 percent of the firm’s gross revenue for the year. The existence of a director-client relationship still must be disclosed, regardless of the fee amount. The fees were de minimis, or not material: A securities lawyer at Zila, Inc., says that the firm of one of its board members doesn’t work for the company on a regular basis, and that the fees paid to the firm were less than 0.1 percent of the firm’s annual revenue. However, the requirement to disclose director-client relationships makes no de minimis or materiality exceptions. According to Professor Mitchell, “When the SEC specifies disclosure, they are telling you that it is material.” While we identified nine companies that failed to report a director-client relationship, the total number of corporations who also didn’t report is probably much larger. Our analysis didn’t look at non-Am Law 100 firms or non-Nasdaq corporations. (The more than 4,100 companies listed on Nasdaq make up about a third of all public companies subject to SEC proxy filing requirements.) We also didn’t look at of counsel who serve as directors on a client’s board. If companies send work to those directors’ firms, that relationship must also be reported. Fortunately for the nine non-reporting companies in our survey, their disclosure failure has yet to cause them any problems. Given how busy the SEC is these days, fines are unlikely, and at most the agency would require the companies to file an amended proxy. However, that step could extract its own penalty, in the form of lower shareholder confidence. The SEC’s lack of interest in these omissions isn’t surprising, according to Laurence Lese. Formerly a special counsel for the agency’s corporation finance division, Lese is now a partner in the Washington, D.C., office of Philadelphia-based Duane Morris. Many years ago, he says, the SEC reviewed all company filings. But the huge increase in required paperwork has forced the agency to be selective. Businesses are flagged for scrutiny only if they’re seeking new capital or making an initial public offering, or if their CEO and CFO appear reluctant in certifying their company’s filings. Because of the past year’s corporate scandals, however, the Bush administration has promised sharp increases in the SEC’s budget and staff. And if that happens, the agency may eventually regain the ability to review all filings. What could seem like a minor omission may then turn out to be a very big deal indeed.

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