The new federalism of the American corporate governance system: preliminary reflections of two residents of one small state.

• Author: Chandler, III, William B.
• Position: Symposium: Corporate Control Transactions

At the beginning of a new century, the American system of corporate governance finds itself in tumult. Propelled by genuine outrage at abuses within companies like Enron, Worldcom, Tyco, Global Crossing, and Adelphia, and by fear of being held accountable for previous inaction, the federal government (through the Sarbanes-Oxley Act of 2002) (1) and the nation's two largest Stock Exchanges (2) (through committee reports that will, subject to Securities and Exchange Commission approval, generate new listing requirements) (3) have adopted important new initiatives designed to improve the integrity of corporate America--what we will call the 2002 Reforms.

Notably, the 2002 Reforms do not target only the core problems that gave rise to some of the more publicized scandals, but instead concentrate more generally on the manner in which public corporations should be governed. Indeed, one senses that it was easier for Congress and the Stock Exchanges to gain consensus on this broader corporate governance agenda than on measures that would (it can be argued) more specifically redress some of the incentives that gave rise to the past years' abuses. These include an obvious perception that fast-and-loose accounting and expenditure practices would not be easily detected nor prosecuted by federal and state governmental authorities, weak accounting principles that gave corporations leeway to engage in risky practices, and human greed tempted by perverse accounting and tax rules that encouraged questionable compensation arrangements. It is remarkable that neither Congress nor the Exchanges took action to rectify the perverse accounting incentives that now exist for executive and director compensation. (4) Currently, for example, a public corporation that desires to grant its executives restricted stock or stock options tied to genuine measures of performance must reflect a current balance sheet charge, but one that simply chooses to give its executives at-the-money options need not. (5)

Likewise, the political branches of the federal government have hesitated to give the SEC all the resources it has sought to enforce the many existing laws that were arguably violated in the various scandals now under investigation. (6) Even some at the SEC have expressed reluctance to have the agency play a more full-bodied role in the regulation of the accounting industry. (7)

With debate continuing about issues like these, Congress and the Exchanges chose instead to proceed more aggressively on other fronts. In particular, they adopted a wide array of corporate governance requirements that embody into law, in Congress's case, and into contract, in the case of the Exchanges, recommendations for good corporate governance that have been advocated for many years by commentators like Martin Lipton, Ira Millstein, former Delaware Chancellor William Allen, and Delaware Chief Justice E. Norman Veasey. (8) These distinguished commentators have long stressed the obligations of corporate directors to be vigilant in their oversight responsibilities and the integrity-assuring benefits of genuinely independent directors whose ability to choose and oversee top management impartially could not be questioned. In aid of their shared vision, these commentators articulated useful techniques (e.g., a majority of independent directors, the identification of a "lead" independent director, director oversight of legal compliance systems, and regular meetings of the independent directors outside of the presence of the management directors) that would facilitate effective monitoring by independent directors and that would limit room for abuse by insiders.

The 2002 Reforms embrace their vision in a substantial manner. Taken together, the Sarbanes-Oxley Act and the proposed Stock Exchange Rules change an aspirational agenda for best corporate practices into a largely invariable model that must be followed by any listed company domiciled in the United States. (9)

As members of a Delaware judiciary that has voiced strong support for many of the "best practices" that are now embodied in the 2002 Reforms, it would smack of hypocrisy for us to fail to acknowledge the substantial integrity-generating potential of these initiatives. In many respects, the 2002 Reforms reflect a recognition that useful practices that have been encouraged by the more tentative and contextually-specific teachings of the common law of corporations are sufficiently workable and valuable to merit system-wide implementation.

Still, Delaware judges also anticipate being among the first governmental decision makers to confront real-world disputes influenced by the 2002 Reforms. These Reforms purport to mandate a wide range of actions by directors of Delaware corporations. Thus, it is unavoidable that the Delaware judges charged with adjudicating directorial compliance with legal and equitable duties will confront cases in which the mandates of the 2002 Reforms make their legal debut. Appropriate candor, therefore, requires us to acknowledge our concerns regarding some aspects of the 2002 Reforms.

First, many appear to have been taken off the shelf and put into the mix, not so much because they would have helped to prevent the recent scandals, but because they filled the perceived need for far-reaching reform and were less controversial than other measures more clearly aimed at preventing similar scandals. This is not to say that the asserted motivations behind the 2002 Reforms were not sincere. Rather, it recognizes the reality that this year's scandals gave advocates who had long desired certain aspects of the Reforms an opening to actually obtain serious consideration and adoption of their proposals, regardless of the lack of a clear connection between those proposals and the conduct that caused the scandals. And, unsurprisingly, the 2002 Reforms also have a somewhat random quality, which reveals the desire of many in the political and corporate governance worlds to leave some imprint on the resulting product.

All of this is to say that the 2002 Reforms are typical of major remedial measures that result from our political process. Though the Reforms contain much that is likely to be of enduring value, they also suffer from the rapidity of their enactment and a tendency to deal with many issues somewhat superficially and sporadically, rather than with one or two issues deeply and coherently. Overall, however, the 2002 Reforms promise benefits to the nation's investors, so long as they are implemented with sensitivity by policymakers who are open-minded about the need to tailor the Reforms when necessary to ensure workability.

As a modest contribution to the early stages of that process, this Article seeks to anticipate some of the more interesting potential implications of the 2002 Reforms for substantive state corporation law. Although it is difficult to predict the full ramifications of the 2002 Reforms for state law, what is clear is that the Reforms represent a marked increase in federal government and Exchange regulation of the corporate boardroom. As will be shown, the 2002 Reforms prescribe a host of specific procedures and mechanisms that corporate boards must employ in the governance of their firms. These prescriptions impinge on the managerial freedom permitted to directors by state corporation law and will fuel a new round of dialogue among the three sources of corporate governance policy that predominate in the American system: the federal government (principally through the SEC), state governments (through their corporate codes and the common law of corporations), and the Stock Exchanges (through their rules and listing requirements). (10)

The dialogue among these policymakers is, of course, not novel. For most of the last century, these policymakers have influenced each other and have intruded on each other's principal domains in the overall American system of corporate governance. That said, the 2002 Reforms appear to be a relatively aggressive move by the federal government and the Exchanges into the realm of board decision making and composition, an area where, traditionally, the states have been predominant. (11) As we will show, the Reforms generate creative friction with some state law concepts, which may result in adaptations in state law or in amendments to the Reforms themselves.

In this Article, we do not seek to predict the outcome of this upcoming dialogue. Rather, we limit ourselves largely to identifying areas that are likely to generate policy intersection in the litigation process and to advancing some tentative perspectives on the resulting possibilities (pro and con) for the American corporate governance system. Our goal is not to be exhaustive, but to concentrate on a few subjects where some level of policy conflict or evolution might reasonably be expected. (12) We use the law of our own state, Delaware, as being generally representative of state corporate laws to help make our discussion more concrete.

In order to rationally pursue this objective, we begin Part I with a brief overview of those aspects of the 2002 Reforms that address areas of corporate responsibility that are traditionally the primary focus of state law. We move from there to address specific policy consequences that we perceive as resulting from these Reforms.

Specifically, in Part I, we note the overall discord between the prescriptive quality of the 2002 Reforms--particularly the proposed Exchange Rules--and the enabling approach to corporate regulation taken by the Delaware General Corporation Law. Under the Delaware approach, boards are given wide authority to pursue lawful goals unhampered by numerous procedural mandates, but with the constraints of fiduciary duty and targeted statutory requirements (such as mandates for stockholder votes on key transactions) as the primary safeguards. By contrast, the 2002 Reforms require that corporate boards establish an array of specific...