Professor Bainbridge...on law, politics, religion, culture & food

Why the Problem at the NYSE is the same as the Problem at Freddie and Fannie

The Wall Street Journal editorializes today (subscription required) on Treasury Sec'y Snow's testimony yesterday on Freddie Mac and Fannie Mae:

Arguing that publicly traded companies should have only private directors, he suggested the time had come for Fan and Fred to eliminate the directors on their boards who are now appointed by the President. Good corporate governance, he crisply noted, requires that the people who are running companies serve the stockholders.

Apropos of that point, a reader writes:

My opinion is that Freddie Mac's board [mild expletive deleted] its shareholders by ordering an investigative law firm to try to pin blame on senior management (and therefore not on the Board) for an accounting scandal. The result may have covered the board's posterior, but it damaged the company both internally and externally. Is there any solution for this in terms of corporate governance? My guess is that shareholder lawsuits are a lousy tool for creating Board accountability, but is there a better tool that would not have the side effect of giving board such a strong incentive to cover itself that it hires a hit squad investigator to go after management and trash the entire company?

How does this tie into the on-going Grasso pay imbroglio? The trouble with all three entities is that they are neither fish nor fowl. Their government connections insulate them from discipline by markets and investors. The NYSE is part of a trading market oligopoly with very high barriers to entry, some of which are attributable to SEC rules. (The SEC, for example, long let the NYSE get away with listing standards making it almost impossible for a firm to de-list.) In the case of Freddie and Fannie, though, its even worse: the markets believe (with some justification) that the federal government has (implicitly) guaranteed their debts, which allows them to avoid by market discipline by borrowing at below-market rates. Moreover, because their board includes political appointees, both are further insulated from investor discipline. The solution for all three is privatization. Let them run as for-profit corporations in competitive markets, with full disclosure (none of them are very transparent as to either governance or finances).

UPDATE: Broc on Grasso:

And don't get me started about the NYSE's governance structure. True, its not a public company but it does have all the earmarkings of a poster child for bad governance. A CEO who handpicks the board - and the compensation committee. A compensation committee who approves CEO compensation arrangements that it doesn't understand. A compensation committee comprised of CEOs from companies that have inherent conflicts of interest with the CEO by virtue of him being their regulator.

Check.

UPDATE 2: Gregg Easterbrook blogs:

Turns out the compensation board that approved Grasso's grotesque bonus contained executives from big companies that had a keen interest in insuring that the NYSE did not act against stock-market manipulation. Citigroup, Morgan Stanley and Merrill Lynch--the key offenders who admitted in the recent $1.4 billion Securities and Exchange Commission settlement that they deliberately misled investors--all had seats on the committee setting Grasso's pay. So did AOL Time Warner which, during the period Grasso was being assigned the grotesque bonuses, was engaged in the most determined campaign to wipe out shareholder value in American business history. These tainted companies were in effect offering Grasso huge amounts of money if he played along and made sure the NYSE did nothing to expose them--and Grasso, a faithful water-carrier, made sure the NYSE did absolutely nothing. There's a word for all this, and the word is "corruption."

Check again.

Student Evaluations

Marginal Revolution is blogging on the question of whether student evaluations are a good idea. Tyler cites a study, which concludes (among other things) that: "Cosmetic factors such as appearance have a big influence on evaluations." This reminded me of my all-time favorite student evaluation: "Professor Bainbridge is my favorite professor. Please tell him to go on a diet, because right now he's heading for an early heart attack." I thought about that one for a while, ordered a pizza, opened a bottle of Chianti, and lit a cigar.

Kucinich for Federal Law of Corporations

Democratic presidential candidate Dennis Kucinich is advocating a federal law of corporations:

We need a new relationship between corporations and our society. Just as our founders understood the need for separation of church and state, we need to institutionalize the separation of corporations and the state. This begins with government taking the responsibility to establish the conditions under which corporations may do business in the United States, including the establishment of a federal corporate charter which describes corporate rights and responsibilities.

Federal incorporation is a perfectly legitimate idea, with a distinguished intellectual pedigree. Personally, however, I'm a competitive federalism kind of guy. In my view, the state-based system of regulating corporate governance is one of the main strengths of the U.S. capital markets -- as Professor Roberta Romano famously claimed, state regulation and the resulting regulatory competition between jurisdictions is the “genius of American corporate law.”

The basic case for federalizing corporate law rests on the so-called “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 of incorporation, 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 thereby 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 should deter states from adopting excessively pro management statutes. The empirical research bears out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

But even if you could prove that state competition is a race to the bottom, basic federalism principles would still counsel against federal preemption of 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, 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 corporations 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. (The quotations are from CTS Corp. v. Dynamics Corp., 481 U.S. 69, 91 (1987))

According to the Supreme Court’s CTS decision, the country as a whole benefits from state regulation in this area, as well. As Justice Powell explained in that case, 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. This 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 pointed out many years ago, “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 country.” (New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting)) 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, a uniform federal law would preclude experimentation with differing modes of regulation. As such, there would be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Instead, we would 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, such that exit by the regulated is no longer an option, an essential check on excessive regulation is lost.

How I square all of this with my earlier post on Spitzer will be the subject of a future post, tentatively entitled "Can you Be a Competitive Federalist and Still Want Spitzer to Shut the %!*# Up?" Stay tuned.

Corporate Governance and Presidential Politics

Being a corporate law kind of guy, I decided to check whether the main presidential candidates had said anything about corporate governance in their web sites. As far as I can tell, so far only Kucinich (see above) and John Edwards have done so. Edward's position paper has a lot more detail than did Kucinich's, with more action items. Kucinich was also easier, because competitive federalism is something I've written a lot about, so there was plenty of stuff in the file to adapt for that post. I'll get back to you on Edwards, probably over the weekend.

In the interests of equal time, I should note that Bush's official site apparently doesn't have a position paper on corporate governance issues either. Nor, for that matter, do any of the California recall gubernatorial candidates. (Does Bustamante have a campaign web site? I couldn't find one for the recall campaign -- just his official state site and Lt. Gov. campaign site, the latter of which seemed to be down.)

Anyway, blogging about presidential candidates should generate some hate mail, if nothing else does. (I don't plan on blogging about "you know who" though. I don't need that much hate mail.)

New Article on Sarbanes-Oxley Section 307

The Social Science Research Network is a site for legal, economic, management, and accounting scholars to post working papers before they are formally published in a professional journal. All of my articles since 1998 are collected there, along with most of the ones published before that date. SSRN just released to its data base my newest article, co-written with UCLA grad Christina Johnson, entitled "Managerialism, Legal Ethics, and Sarbanes-Oxley Section 307. This article was prepared for a conference on the Sarbanes-Oxley Act (a.k.a. the 'Public Company Accounting Reform and Investor Protection Act' of 2002), this Article focuses on the professional responsibility rules promulgated by the Securities and Exchange Commission under Section 307 of the Act. According to the theoretical model of corporate governance espoused by all business corporation statutes, a corporation is to be run by its board of directors for the benefit of its shareholders. In practice, however, corporations frequently are run by their top managers for the benefit of those managers.

A number of recent trends have empowered boards of directors vis-a-vis management. As this Article's review of the statutory text and its legislative history demonstrates, Congress intended the Sarbanes-Oxley Act to further that trend. We further demonstrate that Section 307 should be understood as part of the Act's overall anti-managerialist intent. Congress sought to enlist legal counsel in strengthening the board. Specifically, Congress directed the SEC to create an up the ladder reporting requirement pursuant to which a firm's legal counsel would report evidence of misconduct to the board of directors, thereby redressing one of the information asymmetries between boards and managers.

This Article argues that, as a normative matter, Sarbanes-Oxley Section 307 was well-intentioned. As a practical matter, however, Section 307 seems unlikely to effect significant changes in corporate governance. In our view, the nature of legal practice, the largely unchanged relationship between lawyers and managers, and the problematic approach taken by the SEC to implementing Section 307 suggest that the new legal regime is unlikely to result in significantly better information flows within the corporate hierarchy.

You can download the full paper HERE.

Sarbanes-Oxley Ethics Codes

Kansas city corporate attorney Arthur Chaykin sends along the following observations:

I had been hopeful that the Sarbanes-Oxley Act would have one saving virtue: I thought, perhaps, that CEO's would do what they could to improve business decision making in their companies if only to avoid immediate disclosure through anonymous "hotline" directly to the Board. I reasoned that such calls could, at the very least, become an annoyance for CEO's and, at worst, could give the Board the impression that the CEO did not know how to run the company. Therefore, I thought it was at least possible that CEO's would "pump up" corporate ethics codes and programs in an earnest attempt to reduce the number of "bad acts" within the company.

However, on further reflection, I am concerned that the Sarbanes-Oxley Act may have the exact opposite impact. As you know, the Act requires an ethics code, at least for financial officers, or an explanation as to why no ethics code is presented (and no company will want to explain that). Furthermore, the Act requires a company to explain any "deviation" from its ethics code. As I read it, that means that anytime a company decides to make a reasonable exception to a conflict of interest policy, it has to do a public filing. In order to avoid that, I am sure companies will try to (a) obfuscate their codes so that it will be hard to know whether a violation has occurred or not (thus defeating the entire purpose) or (b) attempt to reserve discretion in some body within the corporation so that they do not have to report the exception as a deviation (but it is not clear that will work). So, I expect a lot of companies to select (a). I have had one general counsel indicate that she had just written the new code and made sure that it only did the bare minimum because she did not want to incur additional disclosure obligations.

Can you believe it?

Yes, I can believe it. Arthur is exactly right that no company in its right mind will want to explain the absence of an ethics code (in the trade we call this therapeutic disclosure, about which I will be posting soon). He's also exactly right that no company will want to be put in the position of disclosing deviations from the code. Hence, we're going to get bare bones ethics codes, which is exactly what seems to be happening.

A Review of “The Company”

The Company: A Short History of a Revolutionary Idea. John Micklethwait & Adrian Wooldridge. New York, The Modern Library, 2003. Although I recommend this text to generalist readers seeking a (remarkably) concise introduction to history of the business corporation, personally I came away somewhat disappointed. There is little doubt Micklethwait and Wooldridge are correct in their claim that the corporation is now the key economic institution in Western nations. Yet, it did not have to turn out that way. As Micklethwait and Wooldridge usefully remind us, two centuries ago, leading business and economic thinkers (including the great Adam Smith) derided the joint stock company. What explains the relatively rapid development in the mid-19th century of a recognizably modern corporation and, in turn, that entity's emergence as the dominant form of economic organization?

Micklethwait and Wooldridge offer a fairly conventional answer to that question, based largely on new technologies -- especially the railroad -- requiring vast amounts of capital, the advantages such large firms derived from economies of scale, the emergence of limited liability that made it practicable to raise large sums from numerous passive investors, and the rise of professional management. Readers familiar with the work of business historian Alfred Chandler will find relatively little new in this part of the story, although Micklethwait and Woolridge's treatment has the advantage for generalist readers of being considerably more accessible than is most of Chandler's work. Instead of offering any novel historical analysis, Micklethwait and Wooldridge's principal potential contribution (albeit one they failed adequately to realize) is the normative thesis to be derived from the historical account.

In their introduction, Micklethwait and Wooldridge lay out a claim that will be familiar to readers of Michael Novak's work (surprisingly, however, they seem unaware of his seminal work). Like Novak, Micklethwait and Wooldridge argue not only that the corporation is one of the West's great competitive advantages, but also that the number of private-sector corporations a country boasts is a relatively good guide to the degree of political freedom it provides its citizens. Unfortunately, this insight goes nowhere.

The normative claim is entirely plausible. The rise of modern corporations did more than just expand the economic pie. The legal system that facilitated their rise necessarily allowed individuals freedom to pursue the accumulation of wealth. Economic liberty, in turn, proved a necessary concomitant of personal liberty -- the two have almost always marched hand in hand. 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 livelihood depends 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 has observed, private property and freedom of contract were indispensable if private business corporations were to come into existence. In turn, the corporation gave liberty economic substance over and against the state. Regrettably, after laying it out, Micklethwait and Wooldridge fail to pursue this thesis. Instead, their book lapses into mere narrative history.

Having said that, however, it is exceptional narrative history. As journalists for the Economist, which I regard as the best-written magazine around, they write clearly yet powerfully. There are numerous insights, cleverly turned phrases, and interesting anecdotes. All of which makes for a compelling read, if not a compelling normative argument.

Donaldson tells Congress action on shareholder access to proxy coming soon

Reuters is reporting that:

U.S. Securities and Exchange Commission Chairman William Donaldson told lawmakers on Tuesday that the agency will consider, as early as this month, proposals to give shareholders access to proxy statements. The commission has been moving toward adopting a rule to allow shareholders to nominate some company directors using the corporate proxy statement, a pamphlet distributed to shareholders annually.

Mike O'Sullivan has been blogging at Corp Law Blog about why this is such a bad idea. I tend to agree with him on the merits, and will post later explaining why.

Tonight I'm commenting solely on whether the SEC has authority to adopt this rule. I am leaning towards concluding (albeit reluctantly) that the SEC probably has authority to do most of what they are talking about. In particular, consider the distinction the Business Roundtable court drew between rule 19c-4 and rule 14a-4(b)(2)'s requirement that proxies give shareholders an opportunity to withhold authority to vote for individual director nominees. Business Roundtable v. SEC, 905 F.2d 406 (DC Cir. 1990). In the court's view, the latter "bars a kind of electoral tying arrangement, and thus may be supportable as a control over management's power to set the voting agenda, or, slightly more broadly, voting procedures," while "Rule 19c-4 much more directly interferes with the substance of what shareholders may enact." In an article I wrote on 19c-4, I concluded that the shareholder proposal rule would pass muster under the Business Roundtable approach. Absent rule 14a-8, shareholders have no practical means of initiating action in the voting process or otherwise affecting the agenda. As such, rule 14a-8 presumably is supportable "as a control over management's power to set the voting agenda." Director nomination rules would seem to fall into that category as well.