The pendulum swings: federalization of corporate law and its effects on the American capital markets.

• Author: Fliss, Adam M.

1. INTRODUCTION

   Publicly traded firms, in the wake of the Enron and WorldCom collapses, face increased scrutiny from the Department of Justice, the SEC, state attorneys general, an active plaintiff's bar, stock exchanges, and the 2002 Sarbanes-Oxley Act (Sarbanes). (1) Firms increasingly face shareholder challenges demanding increased power over executive compensation, merger and acquisition decisions, and directorial elections. (2) While substantive state law traditionally governed the internal workings of corporations, since 2002 Congress, federal courts, and the SEC have deliberately--and sometimes with good reason--intruded into these state law areas. (3) The resulting increase in compliance costs, coupled with expanding areas of liability for directors, and uncertainty over the federal government's often ad hoc rulemaking is forcing an increasing number of executives and public firms to explore the benefits of going private, and simultaneously pricing some private firms out of the United States' public markets altogether. (4) Unprecedentedly diffuse ownership in today's public capital markets makes those markets' retention of firms and top executives critical to America's long-term economic health. (5)

   Federal courts have aided Sarbanes' intrusions into state corporate law by creating, enforcing, and broadly interpreting new rules that effectively supplant well-established state corporate law. (6) Though SEC officials recognize that state law theoretically controls corporate governance, its leadership recently suggested that the SEC "empower investors" by creating new federally-mandated directorial duties beyond substantive fiduciary duties developed over centuries of state common-law evolution. (7) Despite recognizing the excruciatingly high costs of compliance for small firms, SEC officials seem intent on creating duties based on social benefits and a "culture of compliance" among public companies. (8) Federal courts, however, at times check the SEC when it overreaches and fails to consider the economic consequences of its actions while acting in the name of corporate governance. (9) Indeed, Stoneridge Investment Partners, L.L.C. v. Scientific-Atlanta, Inc. (10) suggests that the Supreme Court will not give in to political and institutional advocates of far-reaching reforms where Congress has not expressly authorized such regulation. (11)

   Perhaps no issue in the corporate governance debate is more headline-grabbing than executive compensation. (12) The discourse in this area is fiercely political and engenders emotional complaints to investor advocacy groups and the SEC. (13) While reducing executive compensation is a popular item on political agendas, even the SEC is uncertain of the effectiveness or necessity of proposed disclosure rules. (14) Increased disclosure requirements coupled with heightened personal liability can drive high-quality executives away from public company management and boards of directors and into private firms. (15) Firms may be likely to follow. (16)

   Traditionally, state corporate law controls elections for boards of directors, with Delaware being the most influential state. (17) Generally, state law provides minimum default rules for director elections, which firms can voluntarily adopt in their articles so long as they do not conflict with state-promulgated minimums. (18) Some firms and a minority of state legislatures favor majority voting schemes, to the approval of shareholder advocates. (19) Through enhanced SEC rulemaking, including Rule 14-a(8)'s private right of action and narrow interpretation of the "election exclusion," federal authorities circumvent state law and provide shareholders with greater control over the companies in which they invest. (20)

   While firms have long embraced "going private" as a defensive measure, an increasing number of firms are currently seeking long-term growth elsewhere by opting out of U.S. public markets. (21) Going private refers to a publicly traded firm exiting public markets through its acquisition by a private investment group, individual, or company. (22) Reasons for going private include expense mitigation, avoidance of shareholder disputes, increased executive liability, compliance with Sarbanes, hostile-takeover defense, and long-term growth opportunities. (23) While the number of firms abstaining from entering the public securities markets for these reasons is unknown, the trend in public firms going private is unquestionably increasing. (24) Although some commentators suggest that this trend is limited to small firms, in recent years an increasing amount of mid--and even large sized--firms left American public markets. (25) While large firms are better positioned to absorb compliance costs, all firms suffer significant losses in opportunity costs. (26) These disincentives--in addition to promoting a going-private trend--push some firms overseas. (27)

   Industry may be ready to battle back and begin pushing the pendulum the other way. (28) Courts might hesitate before opening the floodgates to any and all shareholders who may disagree with directors or management. (29) Perhaps most significantly, the Supreme Court recently expressed skepticism regarding trends in the federal securities regulatory regime and noted its concern that federal expansion into corporate law has potentially severe consequences on American public markets. (30)

   This Note explores the ways in which courts, the SEC, and Congress have made being public--or working for a public company--less attractive to firms of all sizes. (31) Part II discusses the motivations for federal corporate reform with a particular focus on the role of institutional investors. (32) Part III examines the roles of the federal and state systems in regulating corporate reform as well as the deficiencies in private enforcement mechanisms. (33) Part IV describes the recent trend of firms and executives abandoning, or never entering, public markets. (34) Part V begins by analyzing the reasons firms and executives are leaving public markets, considers the effect of federal mandates on state corporate law, and observes a growing recognition on the part of courts that the federalization of substantive corporate law comes at a tremendous cost to society. (35) Part VI recommends that Congress, courts, and agencies reexamine their increasingly ad hoc process of legislating drastic changes to a largely successful corporate model and consider the long-term consequences on American public capital markets. (36)

2. SARBANES, POST-2002 CORPORATE REFORMS, AND THEIR MOTIVATIONS

   Greed, self-interest, and loose lending practices have plagued America's businesses and markets throughout history. (37) Congress constructed a securities regulation regime to deal with such abuses. (38) Despite instances of scandal, the state-law driven American corporate model has proven remarkably successful over time. (39) The more than 88 million Americans representing 51% of U.S. households that invest in public markets--numbers significantly greater than at any other time in American history--cause some to argue that recent scandals demonstrate that society can no longer rely on the market to fix its own problems. (40) If American markets have experienced overall gains over the last twenty years, however, it is unclear why diffuse ownership makes regulatory solutions more favorable than market-based reforms that helped to solve previous market failures. (41)

   A major factor in recent corporate scandals was "irrational exuberance" on the part of market institutions, which are the very institutions the market relies upon to provide at least some protection against large-scale fraud. (42) Misplaced exuberance rendered these actors complicit in the greed overtaking some of the nation's largest public companies. (43) Managers saved themselves while many workers and pension holders absorbed staggering losses. (44) Scandals at other companies assumed similar characteristics. (45) Some observers have questioned whether state corporate law was to blame for failing to constrain the type of self-dealing underlying these scandals. (46)

   1. A "Culture of Compliance" (47)

      In response to Enron and other corporate scandals, in 2002 Congress passed the Sarbanes-Oxley Act to protect investors. (48) Sarbanes amended the Securities Exchange Act to enhance federal regulation of corporate governance. (49) These modifications include, for example, mandating changes to internal corporate governance structures, specifying requirements for the composition and conduct of audit boards, and requiring officer certification of financial statements. (50) The corresponding costs of Sarbanes compliance effectively force even honest businesses to consider leaving, or never entering, American public markets. (51) Furthermore, Sarbanes' strict imposition of personal liability on officers and directors drives some executives away from public companies. (52)

      Sarbanes and other reforms passed in the wake of financial scandals at several large companies--including Enron, Worldcom, Tyco, and Adelphia--together comprise a major federal remedial system, which is somewhat random as a result of their rapid enactment. (53) As a result, Sarbanes deals only tangentially with the root causes of corporate scandal, while directly addressing larger political views of corporate governance. (54) In addition, within a year of Sarbanes' enactment, the SEC contributed to a rapid increase in federal oversight of corporate law by promulgating several sets of regulations under the auspice of restoring investor confidence. (55)

      In many ways, these recent federal reforms supersede areas of corporate law traditionally left to state courts and legislatures. (56) For example, Sarbanes bans all corporate loans to officers and directors, specifies new requirements for audit committees, more stringently defines directorial independence than does Delaware common law, strengthens...