Inside-out corporate governance.

AuthorSkeel, David A., Jr.
  1. Introduction II. Proxy Access And Minority Directors A. Introduction B. History 1. Pre-2003 Period 2. Post-2003 Period C. The State of Play on Proxy Access 1. The SEC's Basis for Acting 2. The Ill-Fated SEC Proxy Access Rule 3. Delaware's Limited Addition to Proxy Access 4. Delaware's New Proxy Expense Rule D. Proxy Access: Current Scholarly Debate E. An Italian Alternative F. Proposals III. Third-Party Gatekeepers: Auditors And Credit Rating Agencies A. Introduction B. History of Auditing and Credit Rating. 1. History of the Auditing Industry in the United States 2. History of the Credit Rating Industry in the United States C. Recent Developments in the Regulation of Auditors and CRAs 1. Developments in the Auditing Industry 2. Current Developments in the Credit Rating Industry D. Auditing: Problems and Solutions from the Current Debate 1. The Agency Problem 2. Scholars' Solutions and Skepticism 3. The Limits of SOX 4. Scholars' Proposals for Auditing Reform a. Ex Post Litigation b. Ex Ante Reform: Restructuring the Audit Relationship E. Credit Rating Agencies: Problems and Solutions from the Current Debate 1. Introduction 2. Ratings Shopping and the Debate Whether to End "Issuer Pays" 3. Ex Ante Approaches (1): Removing the Regulatory Imprimatur 4. Ex Ante Approaches (2): Enhancing Transparency and Oversight a. Mandating Disclosure of Rating Agency Actions b. Clarifying Methodology and Symbology c. Removing the Disclosure Exemption 5. Ex Post Enforcement Proposals and Comprehensive Reform F. Insights from Italy and the European Union 1. Auditing in Italy. 2. Credit Rating Agencies in the European Union and Italy G. Where Are We After Dodd-Frank? 1. Directions for Further Audit Reform? 2. Credit Rating Reform IV. Derivatives Regulation. A. Introduction B. History of Derivatives Regulation 1. The Development of Derivatives 2. Derivatives and Regulation in the United States 3. Inside-Out Corporate Governance and Derivatives C. Derivatives Regulation in the Legal Literature D. Derivatives Regulation in the Finance Literature 1. Product-Centric View 2. Legislatively Driven Collapse 3. Human Error and the Role of Secondary Actors E. The Dodd-Frank Reforms 1. Exchange-Traded Derivatives 2. Clearinghouses 3. Collateral Requirements 4. Position Limits 5. Disclosure 6. Implications for Corporate Governance: A Concluding Note V. Conclusion I. INTRODUCTION

    In the past decade, two major corporate and financial crises have shaken the foundations of corporate governance in rapid succession. In 2001 and 2002, Enron, WorldCom, and several other major U.S. corporations collapsed after evidence of accounting fraud emerged at each company. (1) By the time lawmakers and regulators had finished dealing with the fallout from these scandals and with the Sarbanes-Oxley Act of 2002 (2) and other reforms, a new crisis emerged with the distressed sale of the largest subprime lender, Countrywide Financial, and the subsequent collapses of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, and AIG. (3)

    The earlier corporate scandals were widely viewed as a failure of corporate governance and were centered largely in the United States. (4) The 2008 crisis, however, was far more global in its scope and was closely tied to governance and regulation in the financial services industry. (5) The crisis raised grave concerns about the role of derivatives and other new financing techniques--the so-called shadow banking system--in 21st century governance. (6) Much as with securities analysts and auditors in the earlier crisis,

    the principal gatekeeper--in this case, the credit rating agencies that rated mortgage-related securitizations and other debt instruments--proved ineffectual. (7)

    Even more than its predecessor, the recent crisis spurred a pervasive restructuring of corporate regulation. Once fully implemented, Congress's handiwork--the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) (8)--will dramatically rework three crucial areas: internal corporate decision making, third-party gatekeepers, and financial derivatives. With internal corporate governance, lawmakers focused on increasing minority shareholders' ability to propose their own directorial candidates by authorizing the Securities and Exchange Commission (SEC) and other regulators to promulgate "proxy access" rules. (9) The SEC quickly acted on this invitation--too quickly, it appears, as the SEC's initial rule was struck down on procedural grounds. (10) Dodd--Frank homed in on third-party gatekeepers by imposing new directorial independence requirements on credit rating agencies and instructing regulators to remove the provisions in banking regulation that give pride of place to the three dominant rating agencies: Standard & Poor's, Moody's, and Fitch. (11) For financial derivatives--contracts whose value is based on changes in interest rates, currency values, stock prices, or nearly anything else, or the occurrence of a specified event, such as a default on a company's debt--Dodd-Frank fills an almost complete regulatory vacuum. It does so by requiring that most derivatives be both cleared by a clearinghouse that guarantees the performance of both parties, and traded on an exchange, rather than negotiated privately by the two parties. (12)

    Although the three sets of reforms seem entirely unrelated--both as initially enacted and as regulators have fleshed out the new regime--we argue in this Article that the regulation in each area embraces, wrestles with, and attempts to shape a new corporate governance paradigm we call "inside-out" corporate governance. This new inside-out governance model has profound implications for corporate regulation, as well as the respective roles of federal and state legislation. Much as the principal regulatory challenge of the 1980s and 1990s was takeovers, the central question for the current era will be, we believe, how to effectively manage the new inside-out paradigm.

    For much of the 20th century, corporate governance consisted of internal corporate governance--that is, decision making by the principal inside constituencies of the firm--together with outside oversight by regulators, auditors and credit rating agencies, and markets. (13) With the advent of the takeover movement, most visibly in the 1980s,14 the distinction between inside and outside governance began to erode. Although the "raiders" of the 1980s were outsiders, they relied on the internal mechanisms of corporate governance--such as proxy contests--when incumbent managers thwarted their bids with poison pills and other defenses. (15) More recently, hedge funds and other "outside" investors have used the tools of corporate governance to seek representation on the board of directors or to influence corporate decision making in other ways. (16) As a result of these developments, inside and outside governance are now intertwined in ways that echo the emergence of shadow banking in finance, (17) and draw on many of the same innovations. (18)

    Throughout the Article, we pursue two main objectives. First, having identified the new inside-out governance paradigm, we show how it is reflected in the new regulatory landscape. Second, using inside-out governance as our lens, we assess its implications for proxy access, auditing and credit rating, and derivatives, and offer suggestions for further reform in each area.

    At several key points in the Article, we draw on new developments in Italian and E.U. corporate governance. Italy may seem an odd place to look for revealing insights for the united States. The united Kingdom is usually viewed as a more logical choice, given the historical links between the united States and united Kingdom and the similarities in their approach to corporate governance. (19) In both the United States and the United Kingdom, corporate stockholding is far more dispersed than elsewhere in the world, and both countries have a comparatively market-oriented stance toward corporate

    controlled either by a family or by a corporate group. (21) unlike in the united States, where corporate governance experts worry primarily about the conflict of interest between managers and shareholders, the principal conflict in Italian corporations pits the control block against minority shareholders. (22)

    While the contrasts are indeed stark, they make the Italian comparison far more revealing for our purposes. With both minority shareholder representation and credit rating agencies, Italy has intervened in ways that echo proposals or actual reforms in the United States and which are designed to foster inside-out governance. By teasing out the reasons for the similarities and differences--do the divergences reflect a difference in the governance context, for instance, or might they offer insights of direct relevance for the United States?--we can offer new insights into these issues and inside-out governance more generally.

    The Article begins, in Part II, with the issue of proxy access and minority shareholder representation on the board of directors. A central theme in this Part is the distinction between U.S. reform, which focuses on shareholder voting power, and the Italian emphasis on minority shareholder representation. U.S. regulators worry more about the process, or "means," whereas Italy has been more concerned with the results, or "ends." We argue that the distinction can be traced to the different shareholding patterns in the two countries, but that the two approaches also have very different implications for corporate governance and raise different concerns. We also show that the SEC has pursued an internally incoherent (though not politically incoherent) path on proxy access. Although proxy access is best seen as bringing outsiders such as hedge funds more fully into internal corporate governance--and thus as facilitating inside-out governance--the rule's prerequisites--most importantly, a three year holding...

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