Speech by SEC Commissioner:
Remarks at the 22nd Annual Tulane Corporate Law Institute
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
New Orleans, Louisiana
April 15, 2010
Thank you for the generous welcome. It is a pleasure to be in New Orleans to join you this afternoon at the Twenty-Second Annual Tulane Corporate Law Institute.
Conferences like this one enrich our collective understanding of corporate governance and financial regulation. Just as you will take away insights from the conference proceedings, as a policymaker, I too benefit from hearing the ideas and perspectives that permeate and inform your observations and analyses. Regulators are in the business of drawing regulatory lines that distinguish among conduct that is permitted, conduct that is prohibited, and conduct that is mandated. The more regulators better understand the private sector and how regulatory initiatives may impact corporate and investor behavior both for better and for worse, the more likely we are to draw regulatory lines effectively in crafting a well-calibrated regulatory regime that balances a range of diverse interests and goals.
Before I continue by sharing some of my thoughts, I must tell you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
The juxtaposition of select state corporate law developments and federal regulatory initiatives in the aftermath of the financial crisis will motivate my remarks today. My primary goal this afternoon, however, is not to comment on federalism as such, although my observations will no doubt indicate that I am skeptical of efforts that would increasingly federalize corporate law. My primary goal, instead, is to suggest concern over the extent to which federal government intervention in the economy seems poised to displace private sector decision making and to underscore the risk that the regulatory regime may become unduly restrictive at the expense of private sector innovation, entrepreneurism, and competition — ultimate drivers of economic growth.
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As someone who taught corporate law, in addition to securities regulation, before joining the Commission, I still take particular interest in state corporate law developments. Now is not the time for a detailed consideration of state corporate law, but I do want to recognize two recent developments from Delaware — one judicial and the other legislative. These developments — which include the Chancery Court's 2009 decision in the Citigroup case1 and the Delaware legislature's enactment of new sections 112 and 113 of the Delaware General Corporation Law (DGCL) — illustrate a sharp contrast between state corporate law and the federal approach to financial regulatory reform that I will turn to shortly.
Citigroup is notable primarily because of the bases the Chancery Court reasoned from in reaffirming the business judgment rule in the context of a suit against Citigroup directors and officers that centered on the collapse of the subprime housing market. The plaintiffs' Caremark claim, as characterized by the Court, asserted that Citigroup directors breached their fiduciary responsibilities by not properly monitoring and managing the firm's business risks as Citigroup became increasingly exposed to the subprime market.2
The Chancery Court dismissed the plaintiffs' claim.3 In doing so, the Court reasserted a foundational precept of Delaware corporate law. Chancellor Chandler recognized that the Delaware judiciary, notwithstanding its sophistication in corporate law matters, is not well-equipped to second guess the substantive decisions of directors4 — or senior executives, for that matter — who "must operate in the real world, with imperfect information, limited resources, and an uncertain future"5 and who, unlike judges making after-the-fact determinations, do not enjoy the ease of hindsight.6 In quoting the Caremark decision, the Court reiterated in Citigroup that judicial second-guessing by judges "would, in the long run, be injurious to investor interests."7
The Chancery Court extended its reasoning, explicitly recognizing that the value of the corporate form is rooted, in part, in the willingness of directors, along with management, to take risks. The "core" purpose of the business judgment rule, as described by the Court, is to "allow corporate managers and directors to pursue risky transactions without the specter of being held personally liable if those decisions turn out poorly," so long as the decision-making process itself was sound.8 "The essence of the business judgment of managers and directors," the Court expanded, "is deciding how the company will evaluate the trade-offs between risk and return. Businesses — and particularly financial institutions — make returns by taking on risk; a company or investor that is willing to take on more risk can earn a higher return."9 Or, as I have expressed it, just as a company can take too many risks, an enterprise can be unduly conservative.
All of this can be summarized succinctly: Even as the larger debate over regulatory reform has stressed the goal of risk reduction and proposals for more active federal government intervention in the economy have been advanced, the business judgment rule, which reflects judicial restraint and a distinctive recognition of the value of corporate risk-taking, persists. For as the Chancery Court firmly put it in Citigroup: "[T]his Court will not abandon such bedrock principles of Delaware fiduciary duty law."10
While Citigroup reflects judicial regard for allowing directors and officers room to exercise their managerial discretion in fashioning and executing the firm's business strategy, new sections 112 and 113 of the DGCL — which were adopted and enacted together in 2009 reflect a continuing legislative preference for allowing private ordering to determine the internal corporate affairs of firms.
Section 112 expressly authorizes, but does not require, bylaws granting shareholders access to the corporation's proxy materials to nominate directors. Section 113 permits a bylaw for the corporate reimbursement of shareholders soliciting proxies for the election of directors. Without access to the company's proxy materials, a shareholder still can nominate directors using its own independent proxy. Section 113 is directly responsive to the argument that shareholders are discouraged from waging a proxy contest because of the cost.
Sections 112 and 113 are most notable, to my mind, in that both recognize the benefits of permitting variation across firms, allowing boards and shareholders flexibility to strike what they deem to be the proper governance balance. Not only do the sections authorize an "opt in" to access and reimbursement, but the code provisions expressly state that access and reimbursement rights, if afforded, may be subject to any limitations that are lawful.
Although regulation by mandate often is warranted, drawing hard-and-fast regulatory lines runs a heightened risk of being counterproductive when dictates are imposed uniformly across an expanse of diverse and evolving relationships, practices, transactions, and interests. The tradition of state corporate law — and sections 112 and 113 are no exception — has been not to regulate by mandate for this very reason. To the contrary, in regulating the internal affairs of corporations, states, such as Delaware, historically have adhered to an "enabling" approach to corporate law as opposed to a "mandatory" approach.
Mandatory corporate law forces a universal governance scheme on all firms without permitting an enterprise to adapt its approach to governance and corporate accountability to its distinct circumstances. Recognizing that one-size-fits-all mandates are inappropriate for many businesses, the enabling approach defers to private ordering, spurred on by market discipline and competition, to determine how each firm should be organized to advance its interests most effectively. The enabling approach permits the internal affairs of each corporation to be tailored to its own attributes and qualities, including the company's personnel, culture, maturity as a business, and governance practices.
The virtue of private ordering, in sum, is that it does not force all corporations into the same governance box. Instead, in yielding to the unique features of different companies, enabling corporate law expects firms to follow different paths to achieve the best results for the enterprise.
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With this in mind, let me turn to three current developments at the federal level: the SEC's proxy access proposal; corporate governance initiatives forwarded in Congress; and the regulation of systemic risk.
In May of 2009, shortly after the Delaware legislature adopted new sections 112 and 113, the SEC took a significant step in realigning the balance of corporate control at the federal level.11 The Commission proposed new Exchange Act Rule 14a-11, which creates a direct right of access for shareholders to the company's proxy materials for nominating board members. Whereas section 112 (as well as section 113) of the Delaware corporation code is enabling, proposed SEC Rule 14a-11 is mandatory, denying shareholders the ability to opt out of the Rule 14a-11 access regime, even if shareholders want to. The Commission also proposed amending Exchange Act Rule 14a-8 to allow shareholders to include in the company's proxy materials a proposal to amend the company's bylaws to provide shareholders with a more generous access regime than Rule 14a-11 but not one with more restrictions, even if those restrictions are legally permissible under state law.
The immutability of Rule 14a-11 in imposing upon shareholders a minimum proxy access right — notwithstanding that shareholders may prefer a more limited right of access or no proxy access at all — is emblematic of a mandatory approach to corporate law where government decision making displaces private ordering. More to the point, the immutability of Rule 14a-11 risks negating the importance of a shareholder vote and is in tension with the disclosure philosophy that animates the federal securities laws.
The essence of the disclosure philosophy of securities regulation is that, when armed with information, shareholders are well-positioned to evaluate companies and, as each shareholder sees fit, can agitate for change or reallocate its investments. By ensuring that investors have the information they need to make informed decisions, mandatory disclosure leverages market discipline as a means of corporate accountability that stands in contrast to more substantive government regulation of the business affairs of firms. Yet the mandatory nature of Rule 14a-11 cuts in a different direction, dictating a central aspect of firm governance, thereby frustrating the kind of shareholder choice that disclosure seeks to empower.
To flesh this out, let me offer one reason why shareholders may not prefer a regime of ready access to nominate directors. Disagreement at the highest levels of a firm can be important to ensuring that there is a full airing of issues and robust deliberation. However, too much conflict can generate distrust and disharmony that undercuts the ability of the board and management to run the business productively. Mediating the tipping point requires careful balancing. It is important to recognize that the enterprise and its stakeholders may be disserved by the additional dissension and disruption that could result if certain shareholder nominees run and are elected. Proxy access could be particularly costly if so-called "special interest" directors were to wield untoward influence, as the concern has been expressed that special interest directors may have goals that compete with maximizing firm value, putting such directors at odds with the best interests of shareholders.12
In that they too are mandatory, legislative initiatives in Congress that seek to regulate governance and promote corporate accountability are in the mold of proposed Rule 14a-11. By way of illustration, the second Dodd bill in the Senate, released in March of 2010,13 would in effect mandate that public company shareholders have a non-binding "say on pay";14 that board compensation committees be independent;15 that executive compensation be "clawed back" if a company has to restate its financials;16 and that public company directors be elected by a majority vote.17
Although there is much that could be said, I will comment on these congressional initiatives en masse simply by reasserting what I have already indicated — namely, that such a mandatory set of legislative proposals, if enacted, would deny each company the flexibility to adapt its governance structure and practices to fit its particular needs. Accordingly, provisions such as those in the Dodd bill deny firms and their stakeholders the value of private ordering. This is consequential. One readily can foresee that an approach to corporate governance that is right for a struggling Midwest industrial manufacturer may not best suit a small-cap biotechnology company in Silicon Valley, and that both the manufacturer and the biotech firm may face different governance challenges than a dominant financial firm in New York.
Simply put, the countless characteristics that differentiate thousands of public companies in the U.S. from each other suggest that a one-size-fits-all approach to corporate governance is ill-advised.
Systemic risk regulation is the third federal-level development I want to mention. The topic of systemic risk regulation is afield of my focus to this point on traditional aspects of corporate governance and accountability, but the regulatory reform debate over the regulation of systemic risk nonetheless is instructive. This is so particularly insofar as proposals to regulate systemic risk would afford the federal government a great deal of latitude to determine the business and affairs of financial firms in the name of minimizing risk to the financial system.
The financial overhaul bills moving through Congress contemplate a demanding regulatory regime to empower the government in identifying and rooting out systemic risk. Among other things, the federal government — whether it is through the Federal Reserve, a new council of regulators, or otherwise — would have expansive authority not only to set stringent prudential standards for systemically-significant firms, including more restrictive capital, leverage, liquidity, and concentration requirements, but also to require a systemically-significant firm to break itself up or to curtail or terminate certain activities.
Without question, systemic risk presents regulatory difficulties. Individuals in the private sector tend to emphasize the personal costs and benefits of their actions without necessarily taking full account of the broader social impacts that may follow from their conduct. Profit-and-loss considerations — as compared to, say, ensuring the financial system's stability — primarily determine a financial firm's decisions regarding its leverage, liquidity, and trading. There is, therefore, a central role for the government in ensuring a sound, well-functioning financial system — a "public good."
That said, I have elsewhere expressed my concerns with certain legislative proposals for regulating systemic risk.18 This afternoon, let me emphasize just one matter that troubles me — that is, I am troubled that the systemic risk regulator will be too precautionary in regulating risks that may pose a threat to the financial system. Systemic risk regulation contemplates an anticipatory approach to regulation. At core, the systemic risk regulator will be charged with spotting and responding to risks earlier to avoid infirmities that threaten the system. To this point, the various legislative initiatives talk in terms of "emerging risks" and "potential threats" and of dangers that "could" jeopardize the financial system. When given this charge, the natural tendency may be to act increasingly quickly and aggressively to minimize systemic risk. Consequently, in my estimation, the regulator inevitably will identify risks that turn out to be benign, or at least not worth the cost of regulating. The trouble with such "false positives" is that they can precondition the stage for overregulation.
Exacerbating the prospect of overregulation, the systemic risk regulator may overemphasize the downside — as its mission is to prevent the buildup and adverse results of risk — without giving appropriate due to the potential benefits of the conduct and practices presenting the worry. Indeed, a singular focus on reducing systemic risk may crowd out an appropriate consideration of the economic benefits that flow when the regulatory regime affords financial companies room to innovate and compete. Once a risk is spotted, there may be a bias to avoid it, notwithstanding the cost of doing so if the financial sector is unduly burdened and the flow of capital unduly impeded.
A more focused approach to systemic risk oversight than the bills in Congress have advanced would be to hone in on refashioning capital requirements and introducing liquidity standards, which themselves might be a function of a financial firm's size, activities, and interconnectedness with the rest of the financial system. This more targeted approach would afford a financial firm discretion in managing its business and operations to meet the needs of our dynamic economy, so long as the firm satisfies established capital and liquidity parameters that would position the firm to withstand a shock or period of particular strain. Although fixing capital requirements and liquidity standards is itself complicated, the task would seem to be less complicated than the task envisioned for the systemic risk regulator, which would need considerable expertise about particular firms and their operations, role in the economy, and competitiveness.
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The overarching takeaway from these remarks is this: Even in the aftermath of the financial crisis, when the failures of the market seem apparent and the benefits of regulation seem self-evident, it is essential for government to retain a healthy respect for the role of markets in our economy, and we must appreciate that there are limits to what we can and should expect from regulation. We must recognize that just because markets operate imperfectly, it does not follow that the government has effective answers. As I noted earlier, the Delaware Chancery Court observed in the Citigroup opinion that "[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and an uncertain future."19 So too must regulators. Pointing out the failures of the marketplace, therefore, does not alone justify displacing private sector decision making with government regulation. Rather, one also must assess the realistic ability of the government to fashion and administer a proper regulatory response that accounts for both the costs and benefits of government intervention.
Indeed, even as the goal of avoiding and managing risk has become a driving focal point of regulatory reform, we must recognize that risk is the price we pay in exchange for the benefits of a regulatory regime that is flexible enough to permit established enterprises and upstart entrepreneurs the room they need to innovate and compete in meeting the shifting demands of a global marketplace. Some risks simply are worth it if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled at the expense of economic growth.
Drawing regulatory lines that strike the proper balance is not easy, but it is fundamental if regulation after the financial crisis is to do more good than harm.