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 200REGULATION 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 share￾holder may bring a derivative action à la the short-swing prof￾it provision under §16(b). Even when we turn from the provisions of the Act that direct￾ly 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 dis￾close whether it has adopted a code of ethics for its financial offi￾cers. 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 rea￾sons for not doing so. In addition, the corporation’s manage￾ment 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 cfocer￾tify the corporation’s financial statements effects stealth pre￾emptions 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 fur￾ther preempted by provisions requiring that the ceo and cfo report directly to the audit committee on an array of issues deal￾ing 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 rec￾ommendations, 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 long￾standing 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 con￾tested. But we can cut to the bottom line: If independent direc￾tors have utility, there should be an identifiable correlation between the presence of outsiders on the board and firm per￾formance. 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 inde￾pendence is hardly a panacea for all that ails corporate gover￾nance: 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 wis￾dom that board independence is an unalloyed good. As we have seen, the empirical evidence on the merits of board independ￾ence 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 deter￾mined by each firm’s unique culture, traditions, and compet￾itive 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. Inde￾pendent directors are not the sole mechanism by which man￾agement’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 impor￾tance 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 con￾straining 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 faith￾ful monitor than is a board having many nominally independent directors who shirk their monitoring obligations. Federal preemption The nyse’s new standards strap all list￾ed companies into a single model of corporate governance. By establishing a highly restrictive definition of director inde￾pendence 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 devel￾op the particular mix of monitoring and management that best suits its individual needs. The nyse should be especially cautious about promulgat￾ing corporate governance listing standards because such stan￾Bainbridge.Final 3/13/03 2:34 PM Page 29