University of California, Los Angeles School of law Research Paper Series The Creeping Federalization of Corporate Law STEPHEN M. BAINBRIDGE Regulation, Spring 2003 Research Paper No. 03-7 his paper may be downloaded without charge at The Social Science Research Network Electronic Paper Collection http://ssrn.com/abstract=389403 UCLA School of law UCLA OOL OF LI UCLA School of law Los Angeles Ca 90095-1476
University of California, Los Angeles School of Law Research Paper Series UCLA School of Law Research Paper No. 03-7 This paper may be downloaded without charge at: The Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=389403 UCLA School of Law Los Angeles CA 90095-1476 STEPHEN M. BAINBRIDGE The Creeping Federalization of Corporate Law Regulation, Spring 2003
secUrities eXCHaNGes The Sarbanes-Oxley Act extends Washingtons oversight of corporate governance practices but offers questionable benefits to investors The le creeping Federalization of Corporate Law BY STEPHEN M. BAINBRIDGE UCLA School of law HE NEW MILLENNIUM HAS NOT BEEN For over 200 years, corporate governance has been a mat kind to Wall Street. In 2000-01, the stock ter for state law. Even the vast expansion of the federal role market recorded back-to-back years ofloss- begun by the New Deal securities regulation laws left the inter- es for the first time since 1973-74. With a nal affairs and governance of corporations to the states. To be furtherloss in 2002, the market fell for three sure, over the years, there have been countless proposals to fed- consecutive years for the first time since the eralize corporate law.To date, however, none have succeeded Great Depression The collapse of Enron and World Com, along with the varying On top of the continuing retrenchment of the economy fol- degrees of fraud uncovered at too many other companies, rein- lowing thelate'90s bubble, concerns over terrorismand the Mid- vigorated the debate over state regulation of corporate gover- dle East, and uncertainty over oil, investor confidence remains nance. Many politicians and pundits called for federal regulation shaky in the wake of last year's corporate governance revelations. not just of securities but also of internal corporate governance, We all know the litany: repeated accounting scandals, of which claiming it would restore investor confidence in the securities Enron and World Com are merely the most notorious; a high pro- markets. As Congress and market regulators began implement file investigationby New Yorks attorney general calling into ques- ing some of those ideas, there has been a creeping-but steady tion the integrity of stock market analysts; and so or federalization of corporate governance law. The NYSE's new In such an environment, it was inevitable that Congress and listing standards regulating directorindependence are oneexam- the Securities and Exchange Commission would step in toease ple of that phenomenon. Otherexamples appeared to little pub- investors'fears. But how quickly we forget Ronald Reagan's licdebatein thesweeping Sarbanes-Oxley legislation. Takenindi adage: "The nine most terrifying words in the English language vidually, each of Sarbanes-Oxley's provisions constitutes a are:'T'm from the government and Im here to help significant preemption of state corporate law. Taken together, they In responding to the Enron and World Com scandals, Con- constitute the most dramatic expansion of federal regulatory gress and the regulators have implemented a set of reforms that power over corporate governance since the New Deal are deeply flawed. They have adopted policies that have no empirical support or economic justification. Worse yet, in WHO REGULATES CORPORATIONS? doing so, they have eviscerated basic federalism rules that have No one seriously doubts that Congress has the power under the long served us well Commerce Clause, especially as it is interpreted these days create a federal law of corporations if it chooses. The question stephen M,Bainbridge is a professor at the ucLA School of Law where he specializes in of who gets to regulate public corporations thus is not oneof aw and Economics(Foundation Press, 2002). He can be contacted by e-mail at constitutional law but rather of prudence and federalism Until the New Deal, corporate law was exclusively a matter 26 REGULATION SPRING 2003
26 REGULATION SPRING 2003 For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states. To be sure, over the years, there have been countless proposals to federalize corporate law. To date, however, none have succeeded. The collapse of Enron and WorldCom, along with the varying degrees of fraud uncovered at too many other companies, reinvigorated the debate over state regulation of corporate governance.Many politicians and pundits called for federal regulation not just of securities but also of internal corporate governance, claiming it would restore investor confidence in the securities markets. As Congress and market regulators began implementing some of those ideas, there has been a creeping — but steady — federalization of corporate governance law. The nyse’s new listing standards regulating director independence are one example of that phenomenon. Other examples appeared to little public debate in the sweeping Sarbanes-Oxley legislation. Taken individually, each of Sarbanes-Oxley’s provisions constitutes a significant preemption of state corporate law. Taken together, they constitute the most dramatic expansion of federal regulatory power over corporate governance since the New Deal. WHO REGULATES CORPORATIONS? No one seriously doubts that Congress has the power under the Commerce Clause, especially as it is interpreted these days, to create a federal law of corporations if it chooses. The question of who gets to regulate public corporations thus is not one of constitutional law but rather of prudence and federalism. Until the New Deal, corporate law was exclusively a matter SECURITIES & EXCHANGE he new millennium has not been kind to Wall Street. In 2000-’01, the stock market recorded back-to-back years of losses for the first time since 1973-’74. With a further loss in 2002, the market fell for three consecutive years for the first time since the Great Depression. On top of the continuing retrenchment of the economy following the late ’90s bubble, concerns over terrorism and the Middle East, and uncertainty over oil, investor confidence remains shaky in the wake of last year’s corporate governance revelations. We all know the litany: repeated accounting scandals, of which Enron and WorldCom are merely the most notorious; a high profile investigation by New York’s attorney general calling into question the integrity of stock market analysts; and so on. In such an environment, it was inevitable that Congress and the Securities and Exchange Commission would step in to ease investors’ fears. But how quickly we forget Ronald Reagan’s adage: “The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’” In responding to the Enron and WorldCom scandals, Congress and the regulators have implemented a set of reforms that are deeply flawed. They have adopted policies that have no empirical support or economic justification. Worse yet, in doing so, they have eviscerated basic federalism rules that have long served us well. T Stephen M. Bainbridge is a professor at the UCLA School of Law where he specializes in business and corporate law. A prolific writer, Bainbridge recently released Corporation Law and Economics (Foundation Press, 2002). He can be contacted by e-mail at bainbridge@law.ucla.edu. The Sarbanes-Oxley Act extends Washington’s oversight of corporate governance practices but offers questionable benefits to investors. The Creeping Federalization of Corporate Law BY STEPHEN M. BAINBRIDGE UCLA School of Law Bainbridge.Final 3/13/03 2:34 PM Page 26
ers refused to surrender their hopes for a more federal ro ighout the 1930s, there were repeated corporate law. All failed Preserving federalism Legislative inaction is inherently ambiguous l that can be said with ainty is that Con- nevertheless has rou- tinely rejected regula state law and create a de As the Court noted in its 1987 deci sion in cts co A Dynamics Corp,“ State ation of corpo tion of entities whose attributes are a produc of state law” The Court further noted that it " is business landscape in this country forstates to and to define the rights ng th for the states. Around the beginning of the last century, howev-I shares "Concluded the Court, "No principle of corporation law er,economic progressives began arguing for federal preemption and practice is more firmly established than a State's authority frequently in response to various corporate scandals of the to regulate domestic corporations day. After the Great Crash of 1929, serious consideration was It is state law, for example, that determines therights of share- given to creating a federal law of corporations holders. State law tht us determines such questions as which mat The New Dealers'initial response to the Crash, of course, ters the board of directors, acting alone, may authorize and consisted of the now familiar federal securities laws. The key which must be authorized by the shareholders. State law typi statute here is the Securities Exchange Act of 1934, which crit- cally requires, for example, that certain control transactions ics claimed was a federal attempt to usurp corporate gover- such as mergers or sales of substantially all corporate assets be nance powers. On its face, however, the Exchange Act says approved in advance by the shareholders, and establishes the nothing about regulation of corporate governance. Instead, the vote required (often a supermajority) for shareholder approval Acts basic focus is trading of securities and securities pricing. of such matters. State law likewise regulates the conduct of Virtually all of its provisions are addressed to such matters as shareholder meetings, specifies who may call such meetings, the production and distribution of information about issuers and prescribes whether (and the procedures by which)action and their securities, the flow of funds in the market, and the may be taken without a shareholder meeting basic structure of the market The Supreme Court also has consistently recognized that While the federal securities laws thus left the internal affairs state law governs the rights and duties of corporate directors and governance of corporations to the states, many New Deal-I For instance, in its 1979 decision in Burks v. Lasker, the Court REGULATION SPRING 2003 27
REGULATION SPRING 2003 27 for the states. Around the beginning of the last century, however, economic progressives began arguing for federal preemption — frequently in response to various corporate scandals of the day. After the Great Crash of 1929, serious consideration was given to creating a federal law of corporations. The New Dealers’ initial response to the Crash, of course, consisted of the now familiar federal securities laws. The key statute here is the Securities Exchange Act of 1934, which critics claimed was a federal attempt to usurp corporate governance powers. On its face, however, the Exchange Act says nothing about regulation of corporate governance. Instead, the Act’s basic focus is trading of securities and securities pricing. Virtually all of its provisions are addressed to such matters as the production and distribution of information about issuers and their securities, the flow of funds in the market, and the basic structure of the market. While the federal securities laws thus left the internal affairs and governance of corporations to the states, many New Dealers refused to surrender their hopes for a more expansive federal role. Throughout the 1930s, there were repeated proposals to federalize corporate law. All failed. Preserving federalism Legislative inaction is inherently ambiguous. All that can be said with certainty is that Congress chose not to act. Yet, the Supreme Court nevertheless has routinely rejected regulatory efforts to preempt state law and create a de facto federal law of corporations. As the Court noted in its 1987 decision in CTS Corp. v. Dynamics Corp., “State regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law.” The Court further noted that it “is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.” Concluded the Court, “No principle of corporation law and practice is more firmly established than a State’s authority to regulate domestic corporations.” It is state law, for example, that determines the rights of shareholders. State law thusdetermines such questions as which matters the board of directors, acting alone, may authorize and which must be authorized by the shareholders. State law typically requires, for example, that certain control transactions such as mergers or sales of substantially all corporate assets be approved in advance by the shareholders, and establishes the vote required (often a supermajority) for shareholder approval of such matters. State law likewise regulates the conduct of shareholder meetings, specifies who may call such meetings, and prescribes whether (and the procedures by which) actions may be taken without a shareholder meeting. The Supreme Court also has consistently recognized that state law governs the rights and duties of corporate directors. For instance, in its 1979 decision in Burks v. Lasker, the Court MORGAN BALLARD Bainbridge.Final 3/13/03 2:34 PM Page 27
sECURITIes eXchange noted, "As we have said in the past, the first place one must look the provision will mark a substantial restriction on the power to determine the powers of corporate directors is in the relevant of the board. Finally, the audit committee is granted federal state's corporation law. Corporations are creatures of state law authority to retain independent legal and financial advisers and it is state law which is the font of corporate directors'pow- whose fees are paid by the board. Each of those provisions pre- ers "State law defines the directors' powers over the corpora- empts state law governing the board of directors tion, forexample. State law establishes the vote required to elect directors.State law determines whether shareholders have the Directors and officers The Act also partially preempts state ight to cumulative voting in the election of directors, whether law governing the appointment, removal, and compensation he corporation'sdirectors may have staggered terms of office, of directors and officers. As to the former, the SEC is now and whether shareholders have the right to remove directors empowered to remove officers and directors from their posi- prior to the expiration of their term of office tions, as well as bar them from serving at other public corpo- Or, at least, it did so until recently. rations, on mere grounds of"unfitness As to the latter, executive compensation long has been a The anti-federalists strike back For proponents of a bigger fed- controversial issue. Many critics of state corporate law com- eral government, corporate scandals are always a bullish sig- plain that it does not do enough to limit allegedly excessive nal. There is nothing a politician wants more than to persuade compensation. While Sarbanes-Oxley does not directly regu- upset investors that he or she is"doing something"and being late executive compensation, it does contain anumber of pro- aggressive"in rooting out corporate fraud. Hence, it was visions that do so indirectly. First, in theevent a corporation is entirely predictable that the shenanigans at Enron, World Com, obliged to restate its financial statements because of miscon et al, coming after a period of steady decline in the stock mar- duct, the chief executive officer and chief financial officer must ket, would lead to regulation return to the corporation any bonus, incentive, orequity-based President Bush praised the Public Company Accounting compensation they received during the 12 months following Reform and Investor Protection Act of 2002- popularly the original issuance of the restated financials, along with any known as the Sarbanes-Oxley Act-formaking"the most far- profits they realized from the sale of corporate stock during reaching reforms of American business practices since the time that period of Franklin Delano Roosevelt. "Odd praise, indeed, coming There are many objections to that provision from a conservative president. Such praise was especially odd oming from a former state governor with a track record of a It preempts the board's power over executive com- stated respect for basic federalism principles SARBANES-OXLEY AND CORPORATIONS a It fails to define the kinds of misconduct that trigger the reimbursement obligation Because auditing failures by accounting firms, especially Arthur Andersen, received a substantial share of the blame forthe Enron It requires reimbursement even if others committed and World debacles, much of the Sarbanes-Oxley Act focus- the misconduct, and extends to the officers no good es on auditors and their relationship to public corporations. In faith defense regulating that relationship, however, Congress for the first time regulated such matters as the composition,role, and function of All of those problems will tend to encourage CEOs and CFOS he board of directors of public corporations. Forexample, Sar- to resist restating flawed financial statements and/or to game banes-Oxley requires national securities exchanges(such as the the timing of their compensation and stock transactions rela- New York Stock Exchange and NASDAQ)to adopt listing stan- tive to any such restatements dards mandating that listed companies have an audit commit- Second, the Act prohibits a corporation from directlyorindi tee and thatthat committee be comprised solely of independent rectly making or even arranging for loans to its directors and directors. At least one member of the committee must qualify executive officers, subject to some minorexceptions.That pro- as a"financial expert"as defined by the statute. Given the NYSE vision directly preempts the interested-party transaction provi- and NASDAQ's recent expansion of their director independence sions of state corporate law, which currently permit the making standards, it is not clear that those provisions will result in any of loans to directors and officers provided they are authorized substantial newregulation At the veryleast, however, they con- by a majority of the disinterested directors or the shareholders firm andendorse the troubling expansion of stock exchange list- Worse yet, the Sarbanes-Oxley Act fails to define many key ing standards that displace state corporate law terms. Under state corporate law indemnification statutes, for The audit committee must establish a system for employ- example, corporations frequently do(and in some cases must) ees to blow the whistle anonymously on questionable account- advance legal expenses to covered officers and directors.Given ing or auditing matters. Also, the audit committee is charged thesweeping language of the Act s prohibition on insider loans, with being"directly responsible for the appointment, com- some observers believeit preempts state law in that respect and pensation, and oversight"of the corporation's independent therefore prohibits any such advancement of funds auditor. If that provision is interpreted topreclude not only cor- Finally, the Act prohibits executives from trading during so porate officers but also the board of directors as a whole from called blackout periods in which employees participating in being involved in the hiring and firing of independent auditors, I 401(k) and other stock-based pension plans are forbidden from 28 REGULATION SPRING 2003
28 REGULATION SPRING 2003 noted, “As we have said in the past, the first place one must look to determine the powers of corporate directors is in the relevant state’s corporation law. ‘Corporations are creatures of state law’ and it is state law which is the font of corporate directors’ powers.” State law defines the directors’ powers over the corporation, for example. State law establishes the vote required to elect directors. State law determines whether shareholders have the right to cumulative voting in the election of directors, whether the corporation’s directors may have staggered terms of office, and whether shareholders have the right to remove directors prior to the expiration of their term of office. Or, at least, it did so until recently. The anti-federalists strike back For proponents of a bigger federal government, corporate scandals are always a bullish signal. There is nothing a politician wants more than to persuade upset investors that he or she is “doing something” and being “aggressive” in rooting out corporate fraud. Hence, it was entirely predictable that the shenanigans at Enron, WorldCom, et al., coming after a period of steady decline in the stock market, would lead to regulation. President Bush praised the Public Company Accounting Reform and Investor Protection Act of 2002 — popularly known as the Sarbanes-Oxley Act — for making “the most farreaching reforms of American business practices since the time of Franklin Delano Roosevelt.” Odd praise, indeed, coming from a conservative president. Such praise was especially odd coming from a former state governor with a track record of stated respect for basic federalism principles. SARBANES-OXLEY AND CORPORATIONS Because auditing failures by accounting firms, especially Arthur Andersen, received a substantial share of the blame for the Enron and WorldCom debacles, much of the Sarbanes-Oxley Act focuses on auditors and their relationship to public corporations. In regulating that relationship, however, Congress for the first time regulated such matters as the composition, role, and function of the board of directors of public corporations. For example, Sarbanes-Oxley requires national securities exchanges (such as the New York Stock Exchange and nasdaq) to adopt listing standards mandating that listed companies have an audit committee and that that committee be comprised solely of independent directors. At least one member of the committee must qualify as a “financial expert” as defined by the statute. Given the nyse and nasdaq’s recent expansion of their director independence standards, it is not clear that those provisions will result in any substantial new regulation. At the very least, however, they confirm and endorse the troubling expansion of stock exchange listing standards that displace state corporate law. The audit committee must establish a system for employees to blow the whistle anonymously on questionable accounting or auditing matters. Also, the audit committee is charged with being “directly responsible for the appointment, compensation, and oversight” of the corporation’s independent auditor. If that provision is interpreted to preclude not only corporate officers but also the board of directors as a whole from being involved in the hiring and firing of independent auditors, the provision will mark a substantial restriction on the power of the board. Finally, the audit committee is granted federal authority to retain independent legal and financial advisers whose fees are paid by the board. Each of those provisions preempts state law governing the board of directors. Directors and officers The Act also partially preempts state law governing the appointment, removal, and compensation of directors and officers. As to the former, the sec is now empowered to remove officers and directors from their positions, as well as bar them from serving at other public corporations, on mere grounds of “unfitness.” As to the latter, executive compensation long has been a controversial issue. Many critics of state corporate law complain that it does not do enough to limit allegedly excessive compensation. While Sarbanes-Oxley does not directly regulate executive compensation, it does contain a number of provisions that do so indirectly. First, in the event a corporation is obliged to restate its financial statements because of misconduct, the chief executive officer and chief financial officer must return to the corporation any bonus, incentive, or equity-based compensation they received during the 12 months following the original issuance of the restated financials, along with any profits they realized from the sale of corporate stock during that period. There are many objections to that provision: ■ It preempts the board’s power over executive compensation. ■ It fails to define the kinds of misconduct that trigger the reimbursement obligation. ■ It requires reimbursement even if others committed the misconduct, and extends to the officers no goodfaith defense. All of those problems will tend to encourage ceos and cfos to resist restating flawed financial statements and/or to game the timing of their compensation and stock transactions relative to any such restatements. Second, the Act prohibits a corporation from directly or indirectly making or even arranging for loans to its directors and executive officers, subject to some minor exceptions. That provision directly preempts the interested-party transaction provisions of state corporate law, which currently permit the making of loans to directors and officers provided they are authorized by a majority of the disinterested directors or the shareholders. Worse yet, the Sarbanes-Oxley Act fails to define many key terms. Under state corporate law indemnification statutes, for example, corporations frequently do (and in some cases must) advance legal expenses to covered officers and directors. Given the sweeping language of the Act’s prohibition on insider loans, some observers believe it preempts state law in that respect and therefore prohibits any such advancement of funds. Finally, the Act prohibits executives from trading during socalled blackout periods in which employees participating in 401(k) and other stock-based pension plans are forbidden from SECURITIES & EXCHANGE Bainbridge.Final 3/13/03 2:34 PM Page 28
trading. If the executive does so, the corporation may sue to pendence is hardly a panacea for all that ails corporate gover receive any profits. If the corporation fails to do so, a share- nance: The head of Enron's audit committee, Robert Jaedicke holder maybring a derivative action a la the short-swing prof- was a professor of accounting at Stanford University and could it provision under $16(b) hardly have been more qualified for the job. And we all know Even when we turn from the provisions of the Act that direct- what happened at Enron. ly mandate substantive corporate behavior to those that purport merely to regulate disclosure, we find that many provisions Managerial accountability The new standards imposed by the effectively displace applicable state corporate law. The relevant NYSE and Sarbanes-Oxley are premised on the conventionalwis- concept here is so-called"therapeutic disclosure. " In other dom that board independence is an unalloyed goodAs wehave words, the Act uses disclosure requirements to effect changes seen, the empirical evidence on the merits of board independ in substantive behavior. Forexample, the corporation must dis- ence is mixed, at best. Indeed, the clearest take-home lesson to close whetherit has adopted a code of ethics for its financial offi- be gleaned from that evidence is that one size does not fit all cers.The Act identifies a host of issues the code must address, That result should not be surprising. On one side of the such as the handling of conflicts of interest and the like. If a equation, firms do not have uniform needs fo r manage company has not adopted such a code, it must disclose its rea- accountability mechanisms. The need for accountability is sons for not doing so. In addition, the corporation's manage- determined by the likelihood of shirking, which in turn is ment must annually issue an"internal control report"in which determined by management's tastes, which in turn is deter- management acknowledges its responsibility for establishing mined by each firms unique culture, traditions, and compet and maintaining adequate internal financial reporting controls itive environment. We all know managers whose preferences and assesses the effectiveness of those controls include a penchant for hard, faithful work. Firms where that Eventhe widely touted requirement that the CEO and CFo cer- sort of manager dominates the corporate culture haveless need tify the corporations financial statements effects stealth pre- for outside accountability mechanisms emptions ofstate law. Under that provision, the CEO and CFO are On the other side of the equation, firms have a wide range maderesponsible for the establishment, design, and maintenance of accountability mechanisms from which to choose. Inde- of the corporation'sinternal financial controls. Hence, corporate pendent directors are not the sole mechanism by which man- boards have lost their freedom under state law to assign those agement,s performance is monitored. Rather, a variety of forces duties to other corporate officers (let aloneto omit such controls). work together to constrain management's incentive to shirk:the State law governing the boards oversight responsibilities is fur- capital and product markets within which the firm functions her preempted by provisions requiring that the CEo and cFo the internal and external markets for managerial services,the report directly to the audit committee on an array of issues deal- market for corporate control, incentive compensation systems, ing with internal controls and financial reporting auditing by outside accountants, and many others. The impor tance of the independent directors' monitoring role in a given OTHER OVERSEERS firm depends in large measure on the extent to which those Congress is not the only regulator getting into the act. Under other forces are allowed to function. Forexample, managers of he NYSE aegis, a blue ribbon panel of usual-suspect Brahmins a firm with strong takeover defenses are less subject to the con- has"anointed boards of directors, especially independent straining influence of the market for corporate control than are directors'as the capitalist cavalry. "Acting on the panels rec- those of a firm with no takeover defenses. The former needs a ommendations, the NYSE adopted new stock exchange listing strong independent board more than the latter does standards requiring that independent directors comprise a The critical mass of independent directors needed to provide majority of any listed corporations board of directors. The new optimallevels of accountability also will varydepending upon the standards also effect a number of changes to the NYSE's long- types of outsiders chosen.Strong, active, independent directors standing audit committee standards, which anticipate(and with little tolerance for negligence or culpable conduct do exist. even exceed)those mandated by Sarbanes-Oxley a board having a few such directors is more likely to act as a faith- ful monitor than is a board having many nominallyindependent Director independence The utility of director independence directors who shirk their monitoring obligations is now so deeply established in the conventional wisdom that it seems almost pointless to ask if corporations really need a Federal preemption The NYSE's new standards strap all list majority of independent directors. But when one answers that ed companies into a single model of corporate governance.By question, it turns out to be pretty complicated establishing a highly restrictive definition of director inde e. The theoretical arguments are complex and highly con- pendence and mandating that such directors dominate both tested. But we can cut to the bottom line: If independent direc- the board and its required committees, the NYSE fails to take tors have utility, there should be an identifiable correlation into account the diversity and variance amongfirms.The NYSE between the presence of outsiders on the board and firm per- and Congress therefore should have allowed each firm todevel- formance. Yet, the empirical data on the issue is decidedly op the particular mix of monitoring and management that best mixed.In fact, the bulk of the evidence suggests that board suits its individual needs composition has no effect on profitability. The NYSE should be especially cautious about promulgat- Anecdotal evidence confirms the view that board inde- I ing corporate governance listing standards because such stan- REGULATION SPRING 200
REGULATION SPRING 2003 29 trading. If the executive does so, the corporation may sue to receive any profits. If the corporation fails to do so, a shareholder may bring a derivative action à la the short-swing profit provision under §16(b). Even when we turn from the provisions of the Act that directly mandate substantive corporate behavior to those that purport merely to regulate disclosure, we find that many provisions effectively displace applicable state corporate law. The relevant concept here is so-called “therapeutic disclosure.” In other words, the Act uses disclosure requirements to effect changes in substantive behavior. For example, the corporation must disclose whether it has adopted a code of ethics for its financial officers. The Act identifies a host of issues the code must address, such as the handling of conflicts of interest and the like. If a company has not adopted such a code, it must disclose its reasons for not doing so. In addition, the corporation’s management must annually issue an “internal control report” in which management acknowledges its responsibility for establishing and maintaining adequate internal financial reporting controls and assesses the effectiveness of those controls. Even the widely touted requirement that the ceoand cfocertify the corporation’s financial statements effects stealth preemptions of state law. Under that provision, the ceoand cfoare made responsible for the establishment, design, and maintenance of the corporation’s internal financial controls. Hence, corporate boards have lost their freedom under state law to assign those duties to other corporate officers (let alone to omit such controls). State law governing the board’s oversight responsibilities is further preempted by provisions requiring that the ceo and cfo report directly to the audit committee on an array of issues dealing with internal controls and financial reporting. OTHER OVERSEERS Congress is not the only regulator getting into the act. Under the nyse aegis, a blue ribbon panel of usual-suspect Brahmins has “anointed boards of directors, especially ‘independent directors’ as the capitalist cavalry.” Acting on the panel’s recommendations, the nyse adopted new stock exchange listing standards requiring that independent directors comprise a majority of any listed corporation’s board of directors. The new standards also effect a number of changes to the nyse’s longstanding audit committee standards, which anticipate (and even exceed) those mandated by Sarbanes-Oxley. Director independence The utility of director independence is now so deeply established in the conventional wisdom that it seems almost pointless to ask if corporations really need a majority of independent directors. But when one answers that question, it turns out to be pretty complicated. The theoretical arguments are complex and highly contested. But we can cut to the bottom line: If independent directors have utility, there should be an identifiable correlation between the presence of outsiders on the board and firm performance. Yet, the empirical data on the issue is decidedly mixed. In fact, the bulk of the evidence suggests that board composition has no effect on profitability. Anecdotal evidence confirms the view that board independence is hardly a panacea for all that ails corporate governance: The head of Enron’s audit committee, Robert Jaedicke, was a professor of accounting at Stanford University and could hardly have been more qualified for the job. And we all know what happened at Enron. Managerial accountability The new standards imposed by the nyseand Sarbanes-Oxley are premised on the conventional wisdom that board independence is an unalloyed good. As we have seen, the empirical evidence on the merits of board independence is mixed, at best. Indeed, the clearest take-home lesson to be gleaned from that evidence is that one size does not fit all. That result should not be surprising. On one side of the equation, firms do not have uniform needs for managerial accountability mechanisms. The need for accountability is determined by the likelihood of shirking, which in turn is determined by management’s tastes, which in turn is determined by each firm’s unique culture, traditions, and competitive environment. We all know managers whose preferences include a penchant for hard, faithful work. Firms where that sort of manager dominates the corporate culture have less need for outside accountability mechanisms. On the other side of the equation, firms have a wide range of accountability mechanisms from which to choose. Independent directors are not the sole mechanism by which management’s performance is monitored. Rather, a variety of forces worktogether to constrain management’s incentive to shirk: the capital and product markets within which the firm functions, the internal and external markets for managerial services, the market for corporate control, incentive compensation systems, auditing by outside accountants, and many others. The importance of the independent directors’ monitoring role in a given firm depends in large measure on the extent to which those other forces are allowed to function. For example, managers of a firm with strong takeover defenses are less subject to the constraining influence of the market for corporate control than are those of a firm with no takeover defenses. The former needs a strong independent board more than the latter does. The critical mass of independent directors needed to provide optimal levels of accountability also will vary depending upon the types of outsiders chosen. Strong, active, independent directors with little tolerance for negligence or culpable conduct do exist. A board having a few such directors is more likely to act as a faithful monitor than is a board having many nominally independent directors who shirk their monitoring obligations. Federal preemption The nyse’s new standards strap all listed companies into a single model of corporate governance. By establishing a highly restrictive definition of director independence and mandating that such directors dominate both the board and its required committees, the nyse fails to take into account the diversity and variance among firms. The nyse and Congress therefore should have allowed each firm to develop the particular mix of monitoring and management that best suits its individual needs. The nyse should be especially cautious about promulgating corporate governance listing standards because such stanBainbridge.Final 3/13/03 2:34 PM Page 29
sECURITIes eXchange dards effectively preempt state corporate law by creating a uni- ing strongly supports the race to the top hypothesis. If share- form quasi-federal law of public corporations. There is no rea- holders thought that Delaware was winning a race to the bot son to believe that the exchanges will do a better job of creat- tom, shareholders should dump the stock of firms that rein ing corporate law than do the states; indeed, there is good corporate in Delaware, driving down the stock price of such reason to believe that they will do a worse job. In addition, by firms. As Romano found, and all of the other majorevent stud virtue of the SEC's considerable influence over the exchanges, ies confirm, there is a positive stock price effect upon reincor- he expansion of exchange listing standards in the corporate poration in Delaware governance area permits a backdoor power grab by the SEC he event study findings are buttressed by robert Daines over matters that Congress and the courts have left to the states. study comparing the Tobin'sQofDelaware and non-Delaware By virtue of the unique relationship between the SEC and the corporations (Tobin,s Q is the ratioof a firm,'s market value to exchanges, the commission naturally exercises considerable its book value and is a widely accepted measure of firm value. informal influence over exchange rulemaking. The late Don- Daines found that Delaware corporations in the period 1981 ald Schwartz aptly referred to that influence as the SECs"raised 1996 had a higher Tobins Q than those of non-Delaware cor eyebrow"power. In light of the adoption of the NYSE com- porations, suggesting that Delaware law increases sharehold mittee'sinitiatives, the exchanges role in corporate governance er wealth. Although subsequent research suggests that the and, hence, the SECs ability to influence the rules by which effect may not hold for all periods, Daines'study remains an corporations are governed-will expand dramatically. Federal important confirmation of the event study data preemption of state corporation law will have finally arrived, Additional support for the event study findings is provided at least de facto by takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing FEDERALISM AND INCORPORATION ferocity, Delaware's single takeover statute is relatively friend Who has it right-Congress or the states? Does the Supreme ly to hostile bidders. An empirical study of state corporation Court's defense of what might be called"corporate federalism"I codes by John Coates confirms that the Delaware statutes the make least restrictive and imposes the least delay on a hostile bidder. The basic case for federalizing corporate law rests on the so- Given the clear evidence that hostile takeovers increase share- called"race to the bottom"hypothesis. States compete in grant- holder wealth, Coates' finding is especially striking.The sup- ing corporate charters. After all, the more charters the state posed poster child of bad corporate governance, Delaware, grants, the more franchise and other taxes it collects. Accord- turns out to be quite takeover-friendly and, by implication, ing tothe race to the bottom theory, becauseit is corporate man- equally shareholder-friendly agers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit Federalism and liberty The takeover regulation evidence is shareholders. As the clear winner in this state competition, especially important because state anti-takeover laws are the Delaware is usually the poster-child for bad corporate gover- principal arrow in the quiver of modern race-to-the-bottom nance. Interestingly, the two main poster-children for reform, theorists. In a series of articles, Lucian Bebchuk and his co- Enron and WorldCom, were not Delaware corporations; they authors point out that state takeover regulation demonstrably yere incorporated in Oregon and Georgia, respectively. reduces shareholder wealth but that most states have never Basic economic common sense tells us that investors will not theless adopted anti-takeover statutes. Even many advocates of purchase, or at least not pay as much for, securities of firms the race-to-the-top hypothesis concede that state regulation of incorporated in states that cater tooexcessively to management. corporate takeovers appears to be an exception to the rulethat Lenders will not lend to such firms without compensation for efficient solutions tend to win out. But so what? Nobody claims the risks posed by management's lack of accountability. As a that state competition is perfect. The question is only whether result, those firms' cost of capital will rise, while their earnings some competition is better than none. Delaware's relatively will fall. Among other things, such firms become more vul- hospitable environment for takeovers suggests an affirmative nerable to a hostile takeover and subsequent management answer to that question. purges. Corporate managers therefore have strong incentives to Bebchuk et al 's arguments in favor of federal preemption incorporate the business in a state offering rules preferred by moreover, betray a complete lack of sympathy for the vital rela investors.competitionforcorporatechartersthusshoulddetertionshipbetweenfederalismandlibertyInotherwords,even states from adopting excessively pro-management statutes. if Bebchuk could prove that state competition is a race to the bottom, basic federalism principles would still counsel against Academic research The empirical research bears out that view federal preemption of corporate law. The corporation is acrea- of state competition, suggesting that efficient solutions to cor- ture of the state"whose very existence and attributes are prod- porate law problems win out over time. Consider the following: uct of state law. "States have an interest in overseeing the firms Roberta Romano's event study of corporations changing they create. States also have an interest in protecting the share- eir domicile by reincorporating in Delaware, for example, holders of their corporations. Finally, as the Court noted in CTS found that such firms experienced statistically significant pos- v. Dynamics, a state has a legitimate"interest in promoting sta- itive cumulative abnormal returns. In other words, reincor- ble relationships among parties involved in the corporations porating in Delaware increased shareholder wealth. That find-I it charters, as well as in ensuring that investors in such corpo- 0 REGULATION SPRING 2003
SECURITIES & EXCHANGE dards effectively preempt state corporate law by creating a uniform quasi-federal law of public corporations. There is no reason to believe that the exchanges will do a better job of creating corporate law than do the states; indeed, there is good reason to believe that they will do a worse job. In addition, by virtue of the sec’s considerable influence over the exchanges, the expansion of exchange listing standards in the corporate governance area permits a backdoor power grab by the sec over matters that Congress and the courts have left to the states. By virtue of the unique relationship between the sec and the exchanges, the commission naturally exercises considerable informal influence over exchange rulemaking. The late Donald Schwartz aptly referred to that influence as the sec’s “raised eyebrow” power. In light of the adoption of the nyse committee’s initiatives, the exchanges role in corporate governance — and, hence, the sec’s ability to influence the rules by which corporations are governed — will expand dramatically. Federal preemption of state corporation law will have finally arrived, at least de facto. FEDERALISM AND INCORPORATION Who has it right — Congress or the states? Does the Supreme Court’s defense of what might be called “corporate federalism” make policy sense? The basic case for federalizing corporate law rests on the socalled “race to the bottom” hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state ofincorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders. As the clear winner in this state competition, Delaware is usually the poster-child for bad corporate governance. Interestingly, the two main poster-children for reform, Enron and WorldCom, were not Delaware corporations; they were incorporated in Oregon and Georgia, respectively. Basic economic common sense tells us that investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not lend to such firms without compensation for the risks posed by management’s lack of accountability. As a result, those firms’ cost of capital will rise, while their earnings will fall. Among other things, such firms become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus shoulddeter states from adopting excessively pro-management statutes. Academic research The empirical research bears out that view of state competition, suggesting that efficient solutions to corporate law problems win out over time. Consider the following: Roberta Romano’s event study of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive cumulative abnormal returns. In other words, reincorporating in Delaware increased shareholder wealth. That finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware. The event study findings are buttressed by Robert Daines’ study comparing the Tobin’s Q of Delaware and non-Delaware corporations. (Tobin’s Q is the ratio of a firm’s market value to its book value and is a widely accepted measure of firm value.) Daines found that Delaware corporations in the period 1981- 1996 had a higher Tobin’s Q than those of non-Delaware corporations, suggesting that Delaware law increases shareholder wealth. Although subsequent research suggests that the effect may not hold for all periods, Daines’ study remains an important confirmation of the event study data. Additional support for the event study findings is provided by takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware’s single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. Given the clear evidence that hostile takeovers increase shareholder wealth, Coates’ finding is especially striking. The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly. Federalism and liberty The takeover regulation evidence is especially important because state anti-takeover laws are the principal arrow in the quiver of modern race-to-the-bottom theorists. In a series of articles, Lucian Bebchuk and his coauthors point out that state takeover regulation demonstrably reduces shareholder wealth but that most states have nevertheless adopted anti-takeover statutes. Even many advocates of the race-to-the-top hypothesis concede that state regulation of corporate takeovers appears to be an exception to the rule that efficient solutions tend to win out. But so what? Nobody claims that state competition is perfect. The question is only whether some competition is better than none. Delaware’s relatively hospitable environment for takeovers suggests an affirmative answer to that question. Bebchuk et al.’s arguments in favor of federal preemption, moreover, betray a complete lack of sympathy for the vital relationship between federalism and liberty. In other words, even if Bebchuk could prove that state competition is a race to the bottom, basic federalism principles would still counsel against federal preemptionof corporate law. The corporation is a creature of the state “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, as the Court noted in CTS v. Dynamics, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corpo- 30 REGULATION SPRING 2003 Bainbridge.Final 3/13/03 2:34 PM Page 30
rations have an effective voice in corporate affairs. "In other be a powerful engine for focusing the efforts of individuals to words, state regulation not only protects shareholders, but also maintain the requisite sphere of economic liberty.Those protects investor and entrepreneurial confidence in the fairness whose livelihoods depend on corporate enterprise cannot be and effectiveness of the state corporation law. neutral about political systems. Only democratic capitalist According to the Supreme Courts CTS decision, the country societies permit voluntary formation of private corporations as a whole benefits from state regulation in this area. As Justice and allot them a sphere of economic liberty within which to Powell explained, the markets that facilitate national and inter- function, which gives those who value such enterprises a pow national participation in ownership of corporations are essen- erfulincentive to resist both statism and socialism. As Michael tial for providing capital not only for new enterprises but also for Novak observed in Toward a Theology of the Corporation, private established companies that need to expand theirbusinesses. This property and freedom of contract were"indispensable if pri- beneficial free market system depends at its core upon the fact vate business corporations were to come into existence. "In that corporations generally are organized under, and governed turn, the corporation gives"liberty economic substance over by, the law of the state of theirincorporation. That is so in large and against the state part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a CONCLUSION valuable opportunity forexperimentation with alternative solu- What then is to be done? In the first place, Congress should tions to the many difficult regulatory problems that arise in cor- back off. Edmund Burke famously echoed Plato in his assertion porate law. As Justice Brandeis famously pointed out in his dis- that prudence was the chiefvirtue of true statesmen.Prudence senting opinion to New York Ice Co. v Liebman, "It is one of the demands that the law of unintended consequences be given its happy incidents of the federal system that a single courageous due. The prudent legislator is hesitant to promulgate purported state may, fits citizens choose, serve as a laboratory and try novel reforms that may give rise to new and unforeseen abuses worse social and economic experiments without risk to the rest of the than the evil to be cured. Sarbanes-Oxley's many so-called country."So long as state legislation is limited to regulation of reforms likely to do just that. At the very least, prudence firms incorporated within the state, as it generally is, there is no demands that Congress allow Sarbanes-Oxley to shake out and riskofconflictingrules applying to the same corporation. Exper- reveal its flaws before attempting further tinkering imentation thus does not result in confusion, but instead may Second, in implementing Sarbanes-Oxley, the SEC and other lead to more efficient corporate law rules regulators must pay due respect to the principles of federalism In contrast, the uniformity imposed by Sarbanes-Oxley will that have governed corporation law since the New Deal.As a preclude experimentation with differing modes of regulation. general rule of thumb, federal law appropriately is concerned As such, there will be no opportunity for new and better reg- mainly with disclosure obligations, as well as procedural and ulatory ideas to be developed-no"laboratory"of federalism. antifraud rules designed to make disclosure more effective.In Instead, we will be stuck with rules that may well be wrong contrast, regulating the substance of corporate governancestan from the outset and, in any case, may quickly become obsolete. dards is appropriately left to the states.Sarbanes-Oxley disrupted The point is not merely to restate the race to the top argu- that balance. The SEC now should set about restoringit. R ment. Competitive federalism promotes liberty as well as share holder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impac tical. If one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, exit is no longer an option and an essential check on excessive regulation is lost In other words, by promoting the economic freedom to pur- sue wealth, competitive federalism does more than just expand the economic pie. A legal system that pursues wealth maxi- mization necessarily must allow individuals freedom to pursue READINGS the accumulation of wealth. Economic liberty, in turn, is a ne a major factor in destroying arbitrary class distinctions, more- ."Does Delaware Law Improve Firm Values?"by Robert over, by enhancing personal and social mobility. At the same Daines Joumal of Financial Economics, Vol. 62(2001) time, the manifest failure of socialist systems to deliver reason-."Federalism and Corporate Law: The Race to Protect able standards ofliving has undermined their viability as an alter- Managers from Takeovers, "by Lucian Ayre Bebchuk and Allen native to democratic capitalist societies in which wealth maxi- mization is a paramount societal goal. Accordingly, it seems fair ."Law as a Product: Some Pieces of the Incorporation Puzzle to argue that the economic liberty to pursue wealth is an effec- by Roberta Romano. Journal of legal Economics and Organization, tive means for achieving a variety of moral end Vol.1(1985) In turn, the modern public corporation has turned out to REGULATION SPRING 2003 31
rations have an effective voice in corporate affairs.” In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law. According tothe Supreme Court’s CTSdecision, the country as a whole benefits from state regulation in this area. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. That is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis famously pointed out in his dissenting opinion to New York Ice Co. v. Liebman, “It is one of the happy incidents of the federal system that a single courageous state may, if its citizens choose, serve as a laboratory and try novel social and economic experiments without risk to the rest of the country.” So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules. In contrast, the uniformity imposed by Sarbanes-Oxley will preclude experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed — no “laboratory” of federalism. Instead, we will be stuck with rules that may well be wrong from the outset and, in any case, may quickly become obsolete. The point is not merely to restate the race to the top argument. Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. If one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, exit is no longer an option and an essential check on excessive regulation is lost. In other words, by promoting the economic freedom to pursue wealth, competitive federalism does more than just expand the economic pie. A legal system that pursues wealth maximization necessarily must allow individuals freedom to pursue the accumulation of wealth. Economic liberty, in turn, is a necessary concomitant of personal liberty — the two have almost always marched hand in hand. The pursuit of wealth has been a major factor in destroying arbitrary class distinctions, moreover, by enhancing personal and social mobility. At the same time, the manifest failure of socialist systems to deliver reasonable standards of living has undermined their viability as an alternative to democratic capitalist societies in which wealth maximization is a paramount societal goal. Accordingly, it seems fair to argue that the economic liberty to pursue wealth is an effective means for achieving a variety of moral ends. In turn, the modern public corporation has turned out to be a powerful engine for focusing the efforts of individuals to maintain the requisite sphere of economic liberty. Those whose livelihoods depend on corporate enterprise cannot be neutral about political systems. Only democratic capitalist societies permit voluntary formation of private corporations and allot them a sphere of economic liberty within which to function, which gives those who value such enterprises a powerful incentive to resist both statism and socialism. As Michael Novak observed in Toward a Theology of the Corporation, private property and freedom of contract were “indispensable if private business corporations were to come into existence.” In turn, the corporation gives “liberty economic substance over and against the state.” CONCLUSION What then is to be done? In the first place, Congress should back off. Edmund Burke famously echoed Plato in his assertion that prudence was the chief virtue of true statesmen. Prudence demands that the law of unintended consequences be given its due. The prudent legislator is hesitant to promulgate purported reforms that may give rise to new and unforeseen abuses worse than the evil to be cured. Sarbanes-Oxley’s many so-called reforms likely to do just that. At the very least, prudence demands that Congress allow Sarbanes-Oxley to shake out and reveal its flaws before attempting further tinkering. Second, in implementing Sarbanes-Oxley, the secand other regulators must pay due respect to the principles of federalism that have governed corporation law since the New Deal. As a general rule of thumb, federal law appropriately is concerned mainly with disclosure obligations, as well as procedural and antifraud rules designed to make disclosure more effective. In contrast, regulating the substance of corporate governance standards is appropriately left to the states. Sarbanes-Oxley disrupted that balance. The sec now should set about restoring it. REGULATION SPRING 2003 31 READINGS •“A Critique of the nyse’s Director Independence Listing Standards,” by Stephen M. Bainbridge. Securities Regulation Law Journal, Vol. 30 (2002). •“Does Delaware Law Improve Firm Values?” by Robert Daines. Journal of Financial Economics, Vol. 62 (2001). •“Federalism and Corporate Law: The Race to Protect Managers from Takeovers,” by Lucian Ayre Bebchuk and Allen Ferrell. Columbia Law Review, Vol. 99 (1999). •“Law as a Product: Some Pieces of the Incorporation Puzzle,” by Roberta Romano. Journal of Legal Economics and Organization, Vol. 1 (1985). R Bainbridge.Final 3/13/03 2:34 PM Page 31
