Part II Corporate Scandals in Historical and
C. Corporate Ethics and the (Narrow) Scope of Corporate Law
The final implication of the historical evolution of American corporate governance lies in the contemporary scope of corporate law. Over the last century, the domain of American corporate law has steadily shrunk.
Antitrust, labor law, and environmental regulation—all of which are integral to corporate life—were each separated from corporate law at various points in the twentieth century.72In America, corporate law now means internal governance issues such as fiduciary duties and decision-making on fundamental transactions, and not much else. This balkanization is also reflected in the academic world, where most corporate law scholars do not specialize in areas like environmental or employment law.
70John Armour and I have developed this point in more detail elsewhere: see Armour and Skeel (2005).
71Takeovers are the subject of the EU’s Thirteenth Directive, which has been under consideration for many years. For a critical assessment of the most recent proposal, see McCahery and Renneboog (2003).
72One could add corporate reorganisation to this list, too. See, e.g., Skeel (2001) (describing the severing of corporate reorganisation from corporate and securities practice in the 1930s, and the partial reintegration in the 1980s and 1990s).
Although the narrow scope of corporate law is in many respects a historical accident, as we have seen, it has had profound implications for American corporate governance. Limiting the field of inquiry to the agency relations among shareholders, directors, and officers has reinforced the emphasis on the profit-making role of corporations.
Corporate managers can’t ignore their employees or environmental obligations, but the regulatory structure treats these concerns as peripheral to the core functions of corporate governance.
This emphasis on profits, and on shareholders as the managers’
principal constituency has a tremendous upside benefit: it provides an appropriate focus for managerial decision-making.73 But the narrow scope of corporate law may also have abetted some of the excesses of the 1990s. The prevailing ethos of the bubble years assumed that managers, directors, and shareholders were (and should be) motivated entirely by self-interest.74 Managers were encouraged to focus solely on the company’s stock price not just by the structure of corporate law, but also by compensation arrangements that relied on stock options as the principal form of executive pay. Unfortunately, the relentless appeal to self-interest—narrowly defined in terms of stock price—too often forced basic ethical considerations out.
I V. CO N CL U S I O N
What would it take to bring a healthier focus to American corporate life?
Let me conclude by offering three simple suggestions. The first is to reform the regulatory rules that contributed to the corporate scandals, as discussed earlier.75 So long as the tax code rewards companies for compensating their executives with stock options rather than cash, there will be structural pressures for managers to continue focusing narrowly on stock price. Altering the regulatory incentives that encouraged misbehaviour should therefore remain a top priority.
The second is to insist on a broader perspective on corporate law, one that looks beyond the narrow confines of shareholder, director and
73And conversely, expecting managers to focus on a broader range of constituencies could actually undermine their accountability, as noted below. As will quickly become clear, I do not share Milton Friedman’s famous view that ‘there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits [for shareholders]’ Friedman (1962: 133; 1970: 33). But I agree that managers should view the company’s shareholders as their primary constituency.
74For a postmortem critique of the assumption that ‘people are selfish, constantly calculating to their own advantage, with no thought of others,’ see Shiller (2005: A25).
75See above notes 59–61 and accompanying text.
manager relations.76 I don’t mean to suggest that directors’ fiduciary duties should encompass not only shareholders, but also employees, suppliers and other constituencies, as advocates of a ‘team production’
approach to corporate law have proposed (Blair and Stout 1999). The problem with inviting directors to abandon their focus on shareholders is that directors who are told to be loyal to many constituencies are too likely to prove loyal to none. The effect—as we saw with the ‘other constituency’ statutes enacted during the takeover wave of the 1980s—is to give the directors unfettered discretion, since nearly any decision they wish to make can be defended as benefiting one or more constituencies.77 But policy-makers and corporate scholars need to pay greater heed to areas like labor law, antitrust or campaign finance that often do not even figure in our discussions of corporate regulation. Although directors’
principal internal responsibility is to the company’s shareholders, the company’s compliance with its obligations to employees, creditors and other third parties should be central to our assessment of corporate performance.78
Third is simply integrating ethics into the existing emphasis on self-interest, starting with our law and business school classrooms and continuing into corporate life itself. There are many reasons to believe that simply announcing a policy of ethical behaviour will not by itself change the ethical tone of the company. If compensation and promotion practices are closely tied to bottom line performance measures, they will undercut the company’s code of ethics by signaling that the code is simply window dressing. Corporate ethics also requires that executives practice what they preach. ‘[I]t probably is necessary,’ as Don Langevoort puts it, ‘that senior management display in their own actions the sort of other-regarding behaviours they want to see from their agents’
(Langevoort 2002)). Only if the company’s values are reflected in the executive suite and in the expectations created throughout the firm will the recent emphasis on ethics prove more than a temporary fad.
The lessons just described are not a cure-all that will end corporate misbehaviour and single-handedly usher in a new, permanent era of corporate and financial health. For better or worse, the historical cycle of periodic waves of Icarus Effect scandals followed by a federal regulatory response is part of the inevitable push and pull of American business. In
76A fascinating recent article that takes a similar perspective is Winkler (2004). Winkler argues that if we construe corporate law broadly to include the full range of regulation that comprises the ‘law of business,’ it is not nearly so narrowly focused on shareholders’ interests as is often believed.
77For an early, influential discussion of this problem, see Berle (1931).
78An important contribution of the recent book The Anatomy of Corporate Law is to reintroduce these kinds of considerations into the analysis of corporate law (Kraakmanet al 2004). As noted above, Adam Winkler (2004) has also argued for a broader conception of the
‘law of business.’
the name of flexibility and innovation corporate leaders push back against the regulatory constraints imposed in the aftermath of scandal (a process now well underway, as reflected in the continuing debates over Sarbanes-Oxley’s internal controls requirement) and technological advances create new challenges for reining in abuses that stem from the combination of risk-taking, competition, and opportunities for misuse of the corporate form. But whether the next round of corporate scandals comes later or soon depends in no small part on how fully regulators and businesses respond to what we have learned from the most recent breakdown in American corporate and financial life.
REFERENCES
Arlen, J. and Talley, E. (2003), ‘Unregulable Defenses and the Perils of Shareholder Choice’, 152U. Penn. L. Rev.577.
Armour, J. and Skeel, D. (2005), ‘Who Regulates Takeovers and Why? The Peculiar Divergence of US and UK Takeover Regulation’ (unpublished manuscript).
Armour, J., Cheffins, B., and Skeel, D.A., Jr. (2002), ‘Corporate ownership structure and the evolution of bankruptcy law: lessons from the UK’, 55Vand. L. Rev.
1699.
Bainbridge, S. (2003), ‘The Creeping Federalization of Corporate Law’, 26 Regulation(2003).
Bebchuk, L.A. (1992), ‘Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105Harv. L. Rev.1437.
Bebchuk, L.A. (2005), ‘The Case For Increasing Shareholder Power, 118Harv. L.
Rev.833.
Bebchuk, L and Fried, J. (2004),Pay Without Performance: The Unfulfilled Promise of Executive Compensation(Cambridge: HUP).
Berle, Jr., A.A. (1931), ‘Corporate Powers as Powers Held in Trust’, 44Harv. L. Rev.
1049.
Black, B.S. (1998), ‘Shareholder Activism and Corporate Governance in the United States, in 3 The New Palgrave Dictionary of Economics and the Law 459 (Peter Newman ed.)(New York: Palgrave MacMillan).
Blair, M.M. (2003), ‘Locking In Capital: What Corporate Law Achieved or Business Organizers in the Nineteenth Century’, 51UCLA L. Rev.387.
Blair, M.M. and Stout, L.A. (1999), ‘A Team Production Theory of Corporate Law’, 85Va. L. Rev.247.
Bratton, W.W. and McCahery, J.A. (2004), ‘The Content of Corporate Federalism’, ECGI Law Working Paper, 23/2004.
Cary, W.L. (1974), ‘Federalism and Corporate Law: Reflections Upon Delaware’, 83Yale L.J.663.
Coffee, J.C. (2002), ‘Understanding Enron: It’s About the Gatekeepers, Stupid’, 57 Bus. Law.1403.
Comment (1971), ‘Section 13(d) And Disclosure of Corporate Equity Ownership’, 119U. Pa. L. Rev.853.
Cools, K. (2005), Presentation at Good Governance Conference (Amsterdam, 6 Apr.).
Cunningham, L.A. (2003), ‘The Sarbanes-Oxley Act: Heavy Rhetoric, Light Reform (And It Just Might Work)’, 35U. Conn. L. Rev.915.
Davis, L.E. and North, D.C. (1971), Institutional Change and Economic Growth (Cambridge: CUP).
Donaldson, W. (2005), ‘We’ve Been Listening’,Wall St. J., 29 Mar. at A14.
Eisenberg, M. (1993), ‘The Divergence of Conduct and Standards of Review in Corporate Law’, 62Ford. L. Rev.437.
Fernandez, B. (2005), ‘Firms Surprised by the Cost to Keep Ledgers Honest’,Phila.
Inq., 13 Apr. at A1, A6.
Folk, E.L. (1968), ‘Some Reflections of a Corporation Law Draftsman’, 42Conn. Bar J.409.
Friedman, M. (1962)(2ndedn 1982),Capitalism and Freedom(Chicago: Univ. of Chi.
Press).
Friedman, M. (1970), ‘A Friedman Doctrine—The Social Responsibility of Business is to Increase its Profits’,N.Y. Times, 13 Sept. (Magazine) at 33.
Gapper, J. (2005), ‘Capitalist Punishment’,FT Mag., 29 Jan. at 16.
Gordon, J.S. (1988),The Scarlet Woman of Wall Street: Jay Gould, Jim Fisk, Cornelius Vanderbilt, The Erie Railway Wars, and the Birth of Wall Street (New York:
Weidenfeld & Nicolson).
Grandy, C. (1989), ‘New Jersey Corporate Chartermongering, 1875–1929’, 49J.
Econ. Hist.677.
Griffith, S. (2005), ‘Good Faith Business Judgment: A Theory of Rhetoric in Corporate Law Jursprudence’, 55Duke L.J.1.
Hacker, J.S. and Pierson, P. (2002), ‘Business Power and Social Policy: Employers and the Formation of the American Welfare State’, 30 Pol. & Soc. 277.
Horwitz, M.J. (1992),The Transformation of American Law, 1870-1960: The Crisis of Legal Orthodoxy(Oxford: OUP).
Jackall, R. (1988),Moral Mazes: The World of Corporate Managers(New York: OUP).
Johnston, A. (1980),The City Take-Over Code(Oxford: OUP).
Kahan, M. (1997), ‘Some Problems with Stock Exchange-Based Securities Regulation’, 83Va. L. Rev.1509.
Kahan, M. and Kamar, E. (2002), ‘The Myth of State Competition in Corporate Law’, 55Stan. L. Rev.679.
Kahan, M. and Rock, E. (2003), ‘Corporate Constitutionalism: Antitakeover Charter Provisions as Precommitment’, 152U. Penn. L. Rev.473.
Kahan, M. and Rock, E. (2004), ‘Our Corporate Federalism and the Shape of Corporate Law’ (Unpublished Manuscript).
Kamar, E. (1998), ‘A Regulatory Competition Theory of Indeterminacy in Corporate Law’, 98Colum. L. Rev.1908.
Khurana, R. (2002),Search for a Corporate Savior: The Irrational Quest for Charismatic CEOs(Princeton: PUP).
Kihlstrom, R.E. and Wachter, M. (2003), ‘Corporate Policy and the Coherence of Delaware Takeover Law’, 152U. Penn. L. Rev.523.
Kirk, III, W.E. (1984), ‘A Case Study In Legislative Opportunism: How Delaware Used the Federal-State System to Attain Corporate Pre-Eminence’, 10J. Corp. L.
233.
Kraakman, R.et al.(2004),The Anatomy of Corporate Law(Oxford: OUP).
Langevoort, D.C. (2002), ‘Monitoring: The Behavioural Economics of Corporate Compliance With Law’,Colum. Bus. L. Rev.71.
Mahoney, P.G. (1997), ‘The Exchange as Regulator’, 83Va. L. Rev.1453.
Marsh, H. (1966), ‘Are Directors Trustees? Conflict of Interest and Corporate Morality’, 22Bus. L.35.
McCahery, J.A. and Renneboog, L. (2003), ‘The Economics of the Proposed European Takeover Directive’ (Centre for European Policy Studies).
McCurdy, C.W. (1979), ‘TheKnight SugarCase of 1895 and the Modernization of American Corporation Law’, 53Bus. Hist. Rev.304.
Mcdonald, F. (1962),Insull(Chicago: Univ of Chi. Press).
Note (1969), ‘Cash Tender Offers’, 83Harv. L. Rev.377.
Olson, M. (1971),The Logic Of Collective Action(Cambridge: HUP).
Pinsky, D.E. (1963), ‘State Constitutional Limitations on Public Industrial Financing: An Historical and Economic Approach’, 111U. Pa. L. Rev.265.
Pozen, R. (2004), ‘How To Break Free From an American Listing’,Fin. Times, 13 Feb. at 17.
Ribstein, L.E. (2002), ‘Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002’, 28J. Corp. L.1.
Ribstein, L.E. (2003), ‘Bubble Laws’, 40Houston L. Rev.77.
Rock, E.B. (1997), ‘Saints and Sinners: How Does Delaware Corporate Law Work?’, 44Ucla L. Rev. 1009.
Roe, M.J. (1994),Strong Managers, Weak Owners(Princeton: Princeton University Press).
Roe, M.J. (2003), ‘Delaware’s Competition’, 117Harv. L. Rev.588.
Romano, R. (1993),The Genius of American Corporate Law(Washington: ALI Press).
Romano, R. (2005), ‘The Sarbanes-Oxley Act and the Making of Quack Corporate Governance’, 114Yale L.J.1521.
Roosevelt, F.D. (1938), ‘New Conditions Impose New Requirements Upon Government and Those Who Conduct Government’, inThe Public Papers and Addresses of Franklin D. Roosevelt(Samuel I. Rosenman ed.) (New York: Random House).
Seligman, J. (1982),The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance(Boston: Houghton Mifflin).
Shiller, R.J. (2005), ‘How Wall Street Learns to Look the Other Way’,N.Y. Times, Feb. 8, at A25.
Skeel, D.A. (1997a), ‘Public Choice and the Future Of Public Choice-Influenced Legal Scholarship’, 50Vand. L. Rev. 647.
Skeel, D.A. (1997b), ‘The Unanimity Norm in Delaware Corporate Law’, 83Va. L.
Rev.127.
Skeel, D.A. (2001), Debt’s Dominion: A History of Bankruptcy Law in America (Princeton: Princeton University Press).
Skeel, D.A. (2005), Icarus In The Boardroom: The Fundamental Flaws In Corporate America And Where They Came From(New York: OUP).
Skeel, D. and Stuntz, W. (2006), ‘Christianity and the (Modest) Rule of Law’, U. Penn. J. Const. L.(Forthcoming).
Steffins, L. (1905), ‘New Jersey: A Traitor State’, 25McClure’s Magazine, May.
Thompson, R.B. and Sale, H.A. (2003), ‘Securities Fraud as Corporate Governance:
Reflections upon Federalism’, 56Vand. L. Rev.859.
Veasy, N. (2003), ‘What’s Wrong With Executive Compensation’,Harv. Bus. Rev., Jan. , at 5 (Veasy Remarks at Roundtable)
Weiss, E.J. and White, L.J. (2005), ‘File Early, Then Free Ride: How Delaware Law (Mis)Shapes Shareholder Class Action’, 57Vand. L. Rev.1797.
Winkler, A. (2004), ‘Corporate Law or the Law of Business?: Stakeholders and Corporate Governance at the End of History’, 67L. & Contemp. Probl.109.
4
Corporate Governance after Enron: An Age of Enlightenment?
SIMON DEAKIN* AND S UZANNE J KONZELMANN* *
THE FALL OF Enron has again focused attention on the failure of mechanisms of corporate governance to protect investor interests.
However, financial scandals of this kind are nothing new, particularly in periods of ‘correction’ following stock market bubbles.
Moreover, there is no consensus on the wider implications of the Enron affair. Three distinct positions might be taken. According to the first, Enron’s collapse simply tells us that the existing corporate governance system is working. As theEconomistput it (2002a), the unraveling of the corporate scandals ‘might actually be a reason to be more confident about corporate America.’ Enron’s share price nose-dived once news of its earnings restatements surfaced: ‘what is interesting about Enron is not the fact that the energy giant collapsed, but how fast the market brought it down’ (Benefits Canada 2002). Market sanctions, in the form of reputational damage to its senior managerial team and to its auditors, Arthur Andersen, served as an effective disciplinary device. Enron’s bankruptcy offers an appropriate lesson: ‘in the drama of capitalism, bankruptcy plays an essential part’ (Economist2001). On this basis, there is nothing to be gained and much to be lost from wider reforms to the corporate governance system.
The second point of view is more sceptical. It acknowledges that the company’s corporate governance exhibited serious failures of monitoring, which can be traced back to conflicts of interest on the part of board members and its auditors. Changes are needed: ‘if corporate America cannot deliver better governance as well as better audit, it will
†This chapter was previously published in (2003) 10 Organization 583–587. The permission of Sage Publications to republish is gratefully acknowledged.
*Faculty of Law and Centre for Business Research, University of Cambridge.
**School of Management and Organisational Psychology, Birbeck University of London, and Centre for Business Research, Cambridge.
have only itself to blame when the public backlash becomes both fierce and unpleasant’ (Economist 2002b). This is the agenda that shaped the Sarbanes-Oxley Act which was passed by the US Congress in the summer of 2002. As a result, audit partners (although not audit firms) must now be rotated every five years and audit firms may not supply services to a company whose CEO and chief accounting officers were employed by the auditor and took part in an audit of the issuer within the preceding year.
In addition, the Act imposes tighter standards on the certification of annual and quarterly reports by CEO and other leading officers; requires the reimbursement of gains from stock options if earnings are retrospectively restated; prohibits share sales by top officers during
‘pension blackouts’ of the kind which locked in the Enron workforce as its shares collapsed; prohibits loans to top corporate officers; imposes a duty to disclose ‘on a rapid and current basis’ additional information
‘concerning material changes in the financial condition or operations of the issuer, in plain English’ [sic]; and introduces a tighter definition of non-executive director independence. Thanks to its extra-territorial reach, the Act applies to overseas companies with a US stock exchange listing or holding US corporate debt.
The third view offers a radically different explanation for Enron’s fall.
It holds that Enron’s business model exemplifies the pathology of the
‘shareholder value’ system which became dominant in Britain and America in the 1980s and 1990s (Bratton 2002). The company’s focus on short-term stock price appreciation, in part the result of the share options granted to senior management, was the cause of its downfall. It was this which led to the use of ‘special purpose entities’ to conceal debts and artificially inflate the value of the company’s stock. In pursuing an ‘asset light’ strategy at the expense of long-term growth, the company placed itself at risk of implosion once the business cycle turned down, as happened in the course of 2001. From this perspective, the fate of Enron is less important than the future of the business model which it came to represent. Unless the regulatory framework is adjusted to make this model unattractive, it will only be a matter of time before the same approach is tried again.
We believe that this third interpretation of events goes to the heart of the matter, and explains why the Enron case, more than any of the other corporate scandals, has given rise to concern. If we are to take this view seriously, nothing less than a fundamental rethinking of corporate governance practices and procedures is required. Above all, corporate governance must no longer confine its analysis to the relationship between managers, boards and shareholders. The narrowness of this focus is a major contributing factor to the present round of corporate scandals of which Enron is the most emblematic.
The case for shareholder value as the lodestar of corporate governance was made by financial economists in the early 1980s as a means of
minimizing agency costs arising from the separation of ownership and control. Contrary to what is often supposed, it did not derive from legal conceptualizations of the duties of company directors. These tend (still) to be framed in open-ended terms which provide management with considerable discretion in balancing the interests of different stakeholder groups. However, a norm of shareholder primacy gained ground in the 1980s in the American and British systems, principally as a result of the rise of the hostile takeover as the basis of the ‘market for corporate control.’ In the 1990s, this was reinforced by the growing influence and power of institutional investors (principally the pension funds). Novel accounting metrics, measuring corporate performance by reference to
‘economic value added’ and ‘return on capital employed’, expressed the new philosophy very clearly, as did the linking of managerial pay to stock price movements through the use of share options. The composition of the senior managerial class itself began to change, as companies increasingly prized financial skills and deal-making above organizational ability and applied professional knowledge.
The implications for employees were far-reaching: restructuring and downsizing, once thought to be a sign of corporate weakness, became instead the source of share price gains. How far these gains were made as a result of improved efficiency in the use of productive resources, and how far they represent the effects of particular accounting conventions, remains hotly debated. What is not in dispute is that these changes put the post-war ‘social contract’ between labour and management under unprecedented strain.
Enron simply took the logic of shareholder value to its extreme. Its aggressive approach to mergers and acquisitions, the unique ‘rank and yank’ system of employee appraisal, and the sheer scale of the stock options granted to senior managers, may have marked it out from its rivals. But in its essential respects, the path followed by Enron was no different from that being pursued by many other apparently successful companies during this period. This explains the wider, negative stock market response to the revelation that Enron’s strategy was built on sand.
If Enron’s fall was the inevitable consequence of its rise, the question of what comes next is a pressing one. Tinkering with rules on conflicts of interests is unlikely to be the answer. There is already a substantial body of regulation on this issue, but Enron shows that it does not prevent serious corporate collapses. It is now clear that Enron’s senior managers committed various legal wrongs even before the point at which its shares began to decline as part of the general response, during 2001, to the end of the dot com boom. However, although the contracts made with the special purpose entities involved ‘self-dealing’ of the kind which is closely scrutinized by corporate and securities law, these arrangements may well have passed tests of adequate disclosure. While board members