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SECURITIES & EXCHANGE

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

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 of loss- 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 further loss 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 WorldCom, along with the varying On top of the continuing retrenchment of the economy fol- degrees of fraud uncovered at too many other companies, rein- Tlowing the late ’90s bubble, concerns over terrorism and 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 WorldCom are merely the most notorious; a high pro- markets. As Congress and market regulators began implement- file investigation by New York’s 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 on. — federalization of corporate governance law. The nyse’s new In such an environment, it was inevitable that Congress and listing standards regulating director independence are one exam- the Securities and Exchange Commission would step in to ease ple of that phenomenon. Other examples appeared to little pub- investors’ fears. But how quickly we forget Ronald Reagan’s lic debate in the sweeping Sarbanes-Oxley legislation. Taken indi- adage: “The nine most terrifying words in the English language vidually, each of Sarbanes-Oxley’s provisions constitutes a are: ‘I’m from the government and I’m here to help.’” significant preemption of state corporate law. Taken together, they In responding to the Enron and WorldCom 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, to 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 one of 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 constitutional law but rather of prudence and federalism. [email protected]. Until the New Deal, corporate law was exclusively a matter

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ers 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 Con- gress chose not to act. Yet, the Supreme Court nevertheless has rou- tinely rejected regulato- ry efforts to preempt state law and create a de facto federal law of cor- porations. As the Court noted in its 1987 deci- sion in CTS Corp. v. Dynamics Corp., “State regulation of corporate governance is regula- tion 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

MORGAN BALLARD that are acquired by purchasing their for the states. Around the beginning of the last century, howev- 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 the rights of share- given to creating a federal law of corporations. holders. State law thus 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 Act’s 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) actions 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- For instance, in its 1979 decision in Burks v. Lasker, the Court

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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, for example. 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 right to cumulative voting in the election of directors, whether law governing the appointment, removal, and compensation the corporation’s directors 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 a number of pro- “aggressive” in rooting out corporate fraud. Hence, it was visions that do so indirectly. First, in the event a corporation is entirely predictable that the shenanigans at Enron, WorldCom, 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, or equity-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 — for making “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 coming from a former state governor with a track record of ■ It preempts the board’s power over executive com- stated respect for basic federalism principles. pensation.

■ SARBANES-OXLEY AND CORPORATIONS 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 for the Enron ■ It requires reimbursement even if others committed and WorldCom 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 the board of directors of public corporations. For example, 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 directly or indi- tee and that that 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 minor exceptions. 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 new regulation. At the very least, however, they con- by a majority of the disinterested directors or the shareholders. firm and endorse 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 the sweeping language of the Act’s prohibition on insider loans, with being “directly responsible for the appointment, com- some observers believe it 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 to preclude 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, 401(k) and other stock-based pension plans are forbidden from

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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 may bring a derivative action à 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 nyseand Sarbanes-Oxley are premised on the conventional wis- concept here is so-called “therapeutic disclosure.” In other dom that board independence is an unalloyed good. As we have words, the Act uses disclosure requirements to effect changes seen, the empirical evidence on the merits of board independ- in substantive behavior. For example, the corporation must dis- ence is mixed, at best. Indeed, the clearest take-home lesson to close whether it 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 for managerial 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 firm’s 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 Even the widely touted requirement that the ceoand cfocer- sort of manager dominates the corporate culture have less need tify the corporation’s financial statements effects stealth pre- for outside accountability mechanisms. emptions of state law. Under that provision, the ceoand cfoare On the other side of the equation, firms have a wide range made responsible for the establishment, design, and maintenance of accountability mechanisms from which to choose. Inde- of the corporation’s internal 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 alone to omit such controls). work together to constrain management’s incentive to shirk: the State law governing the board’s oversight responsibilities is fur- capital and product markets within which the firm functions, ther 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. For example, managers of the nyseaegis, 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 panel’s rec- those of a firm with no takeover defenses. The former needs a ommendations, the nyseadopted 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 corporation’s board of directors. The new optimal levels of accountability also will vary depending 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 nominally independent 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- 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 among firms. The nyse between the presence of outsiders on the board and firm per- and Congress therefore should have allowed each firm to devel- 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- ing corporate governance listing standards because such stan-

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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 major event stud- virtue of the sec’s considerable influence over the exchanges, ies confirm, there is a positive stock price effect upon reincor- the expansion of exchange listing standards in the corporate poration in Delaware. governance area permits a backdoor power grab by the sec The event study findings are buttressed by Robert Daines’ over matters that Congress and the courts have left to the states. study comparing the Tobin’s Q of Delaware and non-Delaware By virtue of the unique relationship between the sec and the corporations. (Tobin’s Q is the ratio of 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 sec’s “raised 1996 had a higher Tobin’s 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’s initiatives, the exchanges role in corporate governance er wealth. Although subsequent research suggests that the — and, hence, the sec’s 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” codes by John Coates confirms that the Delaware statute is the make policy sense? 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 to the race to the bottom theory, because it 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 were 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 too excessively to management. corporate takeovers appears to be an exception to the rule that 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. Competition for corporate charters thus should deter tionship between federalism and liberty. In other words, 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 a crea- of state competition, suggesting that efficient solutions to cor- ture of the state “whose very existence and attributes are a 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- their 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- it charters, as well as in ensuring that investors in such corpo-

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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 Court’s CTSdecision, 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- erful incentive 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 their businesses. 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 their incorporation. 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 for experimentation 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 chief virtue 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, if its 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 risk of conflicting rules 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 governance stan- 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 restoring it. R ment. Competitive federalism promotes liberty as well as share- holder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes imprac- 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- READINGS mization necessarily must allow individuals freedom to pursue the accumulation of wealth. Economic liberty, in turn, is a nec- •“A Critique of the nyse’s Director Independence Listing essary concomitant of personal liberty — the two have almost Standards,” by Stephen M. Bainbridge. Securities Regulation Law always marched hand in hand. The pursuit of wealth has been Journal, Vol. 30 (2002). 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. Journal 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 of living 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- Ferrell. Columbia Law Review, Vol. 99 (1999). 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 ends. Vol. 1 (1985). In turn, the modern public corporation has turned out to

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