Part II Corporate Scandals in Historical and
A. Crisis Legislation Comes with No Guarantees
The first lesson our history teaches is that crisis legislation comes with no guarantees. Each of the major waves of corporate scandal has reflected a breakdown in American corporate and financial life. The silver lining has been the overwhelming pressure on lawmakers to pass structural reform.
But the fact that Congress steps into the fray doesn’t necessarily mean that Congress will solve the problems revealed by the corporate collapse.49
The remarkable success of the New Deal reforms may have made us too optimistic in this respect. The securities acts and banking reforms of the 1930s greatly enhanced the transparency of the American securities markets and replaced the Wall Street banks with a new set of
‘watchers’—companies’ auditors and, in time, the securities analysts who covered them.
The recent Sarbanes-Oxley Act and the new stock exchange rules that accompanied it, by contrast, are more of a mixed bag. As noted earlier, many of the new rules are aimed at the accounting industry, including provisions that forbid the Big Four firms from providing consulting services to their audit clients; and others that set up a new independent oversight board for the accounting industry.50 These are the best of the new reforms, a welcome (though partial) solution to the conflicts that bedeviled the accounting industry during the 1990s.51
At the other end of the spectrum, the stock exchanges have salted their listing rules with a spate of new independence requirements, starting with the obligation that listed companies have a majority of independent directors on their boards. Most firms won’t be hurt by these requirements, and many might be helped, but the existing empirical data suggest that the changes won’t make much of a difference.52Delaware’s judges rightly complain, moreover, that these provisions run roughshod over state lawmakers’ traditional authority over internal governance issues.53 The new standards for directorial independence create a danger that boards will be subject to different definitions of independence in different
49For a much stronger version of this point, see Ribstein (2003). Unlike my analysis, which suggests that post-scandal reforms are often necessary, Ribstein argues that bubble laws frequently stifle economic growth.
50See above notes 14–20 and accompanying text.
51In my own view, Congress should have gone still further, and required that the stock exchanges rather than the companies themselves select the company’s auditor. The problem with permitting the company to select its auditor—even when a independent audit committee does the selecting—is that the auditor inevitably views the company as its client.
For a more detailed discussion, see Skeel (2005: 188–89).
52See, e.g., Romano (2005); Black (1998: 463).
53For a good statement of this concern by a corporate law scholar, see, e.g., Bainbridge (2003).
contexts—one standard for stock exchange listing, another for state fiduciary duty oversight.
By far the most controversial reform is SOA § 404, a new requirement that companies establish an internal control system.54Corporate America is complaining bitterly about the cost of putting the required controls in place, which for some companies amounts to millions of dollars a year.55 If the expense assures that accurate financial information is produced at every level of the company, the cost will be worth it. And costs are likely to decline once the compliance programs are put in place—the largest expense is the cost of getting the program up and running in the first instance. But the efficacy of the new programs remains to be seen. There is a risk that the new requirements will simply add up to more internal bureaucracy—that companies will hire a new internal compliance officer and essentially keep doing what they were doing before. There is also a risk that companies will focus narrowly on the financial compliance called for by the reform, while ignoring other kinds of potential misbehaviour within the firm.56
A major question raised by the fact that the reforms reach far into the heart of traditional corporate governance functions is whether these rules should apply to non-American companies.57The commitment to comply with American disclosure obligations has traditionally been an important benefit to European companies of listing on the American exchanges. But the new reforms mandate a ‘one size fits all’ approach on governance issues for which there is not a single, optimal approach for every firm.
The most sensible way to apply the new rules to non-US companies would be to treat them as disclosure obligations, rather than as mandatory rules. European companies should be required to disclose the independence (or not) of their directors and the nature of their internal controls. But they shouldn’t be forced to adopt a US-style structure as the price for listing shares on US markets.58
54In addition to the company’s obligation to establish and report on its ‘internal control structure and procedures...for financial reporting,’ the auditor is required to ‘attest to, and report on, the assessment made by the management of the issuer.’ SOA § 404(b). The auditor attestation requirement has dramatically increased the costs of recent audits.
55See, e.g., Fernandez (2005).
56Congress also indulged its penchant for moralistic criminal legislation by adding a slew of new corporate crimes to the criminal code, and ratcheting up the penalties for others. I have criticised these provisions elsewhere. Skeel and Stuntz (2006).
57The SEC has delayed implementation of § 404 for foreign companies, as well as small- and mid-sized American firms. But as of this writing, the Commission takes the position that foreign companies eventually will be required to fully comply. See, e.g., Donaldson (2005:
A14).
58Many foreign companies that are currently listed on US exchanges are considering delisting in order to avoid the new mandates. Under the securities laws, companies are required to continue complying unless they have less than three hundred US shareholders.
For an argument that this requirement should be relaxed if the company makes a reasonable buyout offer to its US shareholders, see Pozen (2004: 17).
Much more troublesome than the reforms that Congress passed were the ones it did not. Congress did almost nothing to address two of the most obvious problems highlighted by the corporate scandals. The first is runaway compensation, and in particular, the perverse incentives created by injecting huge amounts of stock options into executives’ pay.59Options are a one way ratchet, with an unlimited upside but little downside for executives who pump the company’s stock price.60 Second is the risk to employees whose retirement plans are now invested in the stock market.
At the least, employees should be required to diversify their investment, to prevent a reprise of the financial devastation suffered by Enron and WorldCom employees whose retirement accounts were loaded with company stock. Lawmakers also need to give more serious thought to the need to provide at least limited protection for the funds that investors have in market-based pension plans.61
In Delaware, the principal legacy of the scandals seems to be the newly emerging good faith duty and the possibility that Delaware will subject directorial compensation to closer scrutiny in the future. It is important to note that this response to the scandals has come in Delaware’s courts, rather than through a statutory reform effort. This is significant for at least two related reasons. First, because the judicial process takes time, even in Delaware, the principal cases are being decided long after the initial outrage at the scandals has passed. As a result, there is much less pressure for a radical response now.62 Secondly, Delaware’s fiduciary duty jurisprudence has a self-correcting quality. It is open-ended enough so that the courts can incorporate new concerns without dramatically altering its precedent.63
In short, in the 2000s, as in the 1930s, the most dramatic reforms have come from Congress because Congress faces intense public pressure to address breakdowns in corporate America. The shortcomings of the
59For more detailed discussion of the compensation problem, see, e.g., Skeel (2005: 152–54);
Bebchuk and Fried (2004). A new study by Kees Cools (2005) found that the best predictors of whether a company was likely to be required to restate its financials in the 1990s were the amount of options-based compensation it provided its executives, the amount of media attention the company received, and the percentage increase in its average earnings targets.
60Under an Internal Revenue Code provision put in place in 1993—ironically, in an effort to curb managerial compensation—companies are permitted to deduct a maximum of one million dollars per year of compensation for each executive as a business expense. The deduction is lost for amounts in excess of one million dollars. But Congress excluded stock and stock options from the ceiling, which encourages companies to use these forms of compensation rather than cash.
61Several possible insurance strategies are discussed in Skeel (2005: 212–14).
62The waning sense of outrage may be part of the explanation for the Delaware Chancery Court’s recent decision in theDisney case, which found no liability despite an almost complete lack of oversight of CEO Michael Eisner’s decision to give Michael Ovitz $140 million in termination benefits.In re Walt Disney Shareholder Litigation(Del. Ch. 9 Aug. 2005).
63For an extended analysis of this attribute of Delaware corporate law, see Kahan and Rock (2004). SeealsoGriffith (2005).
recent reforms vividly illustrate the point made at the outset of this section—that the pressure Congress faces to act after a scandal does not guarantee that the reforms that are passed will be ideal. But each of the great corporate scandals has reflected a breakdown in corporate oversight, which suggests, at the least, that Congress is likely to be aiming at the right target when it steps in. As a result, scandal reforms generally will make things better rather than worse overall, which is a fair assessment of the recent reform efforts.