Speech by SEC Commissioner:
The Evolving Relationship Between the SEC and State Corporate Law
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
Annual Meeting of the American College of Business Court Judges
December 1, 2010
I am very pleased to be here tonight to speak to this esteemed group of Business Law Judges on the recent and ongoing developments in the relationship between the federal securities laws and state corporation law, and their implications for legal certainty and the U.S. business environment.
Before I continue, I need to make the standard disclaimer that my remarks this evening represent my own views, and not necessarily those of the SEC or my fellow Commissioners.
The nation and the world continue to struggle to recover from the financial crisis and the economic downturn that began in 2007, with meaningful economic expansion an elusive goal. Along with the lackluster performance of the U.S. economy, our capital markets continue to languish as banks remain reticent to lend, companies remain hesitant to borrow, expand and hire, and investors largely continue to hold their money on the sidelines.
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While there are many explanations cited for why the economy and the capital markets have been so slow to rebound, it cannot be gainsaid that uncertainty — business, legal and policy — continues to inhibit our recovery. Unfortunately, I do not think that this uncertainty is likely to abate in the near future.
Clearly, much of the current business uncertainty derives simply from economic fundamentals that accompany an economic downturn of the size and scope that we have endured. The harsh economic pullback that decimated the value of real estate, investments and other assets took a significant toll on consumer and business confidence, resulting in significantly lower demand for goods and services. It has become apparent that this confidence will return only with time, and no one can predict with certainty how quickly this confidence may be rebuilt. As a result, firms, lacking clear signals that demand for their products and services will be strong and sustained, are naturally and justifiably reticent to hire and invest in their businesses.
Yet this narrative tells only a part of the story. Of at least equal importance is the uncertainty that flows from the fundamental legal, regulatory and policy changes affecting businesses, including the government's reaction to the financial crisis and the passage of the Dodd-Frank Act in July. The Dodd-Frank Act ushers in a breathtaking amount of changes that will result in a tectonic shift in the legal, regulatory and policy landscape affecting our financial markets in a relatively short period of time. These changes touch every aspect of our financial markets, from consumer credit to proprietary trading at financial firms, from OTC derivatives markets to securitization, and from private fund registration and regulation to corporate governance at public companies.
At the SEC, we have been given substantially expanded authority, and in some cases an outright mandate, to expand the reach and focus of federal securities regulation, including into traditional state law matters.
Dodd-Frank certainly does not mark the federal government's first foray into corporate law. Clearly, the Sarbanes-Oxley Act of 2002 was a significant step in this direction — indeed, it was the most significant step by the federal government into matters affecting corporate law since 1934. For example, S-Ox:
Requires that a public company's CEO and CFO establish, design, maintain and certify the corporation's internal control over financial reporting;
Mandates that stock exchanges require each listed company to have an audit committee consisting entirely of independent directors;
Prohibits accounting firms from providing consulting services to auditing clients;
Prohibits loans by a public corporation to its officers and directors;
Requires that CEOs and CFOs forfeit bonus, incentive and equity compensation in the event of certain financial restatements; and
Requires that public companies adopt a code of ethics for their financial officers or explain why they have not done so.
Additionally, for decades prior to the enactment of Dodd-Frank, the SEC has considered mandating some form of proxy access for public companies and, in May 2009, the Commission proposed a substantive proxy access regime that would be imposed on all U.S. public companies. After Dodd-Frank explicitly granted the SEC the authority to require proxy access, the Commission adopted a highly prescriptive proxy access regime that, if upheld by the D.C. Circuit, will effectively preclude the sort private ordering in the proxy access space that was just beginning to take shape under state law.
Nor is the federal government the only regulatory entity that has occupied space traditionally left to state law in recent years: beginning in 2003, the major U.S. stock exchanges adopted listing standards requiring "majority independent" boards and other independence requirements for some board committees.1
But if, in S-Ox, Congress "upped the ante" on the bet that the federal government can effectively regulate public corporations in matters traditionally left to state law, then it "doubled down" on that bet when it passed the Dodd-Frank Act. Not only did Dodd-Frank authorize the Commission to adopt proxy access rules, it also, among many other things:
Requires that the Commission mandate a so-called "say on pay" vote for all public companies, including a vote on the companies' executive compensation and "golden parachute" arrangements;
Requires that the Commission, together with federal banking regulators, prescribe regulations on risk retention by issuers of asset-backed securities;
Requires that the Commission issue rules requiring public companies to disclose specified executive compensation information, including "pay for performance" information and the ratio of CEO pay to the average pay of the companies' employees;
Requires that the Commission, together with other regulators, consider regulations or guidelines that may impose substantive restrictions on executive incentive compensation arrangements at financial institutions;
Requires that the Commission mandate that the stock exchanges require listed companies to have compensation committees composed entirely of independent directors; and
Requires that the Commission mandate that the stock exchanges require listed companies to adopt compensation clawback policies that apply in the event of non-compliance with any financial reporting requirement.
While it is arguable that these most recent federal intrusions may be viewed as discreet, and thus marginal, interventions that do not pose fundamental challenges to state law primacy, I believe that they represent yet another step in a sustained push toward greater federalization of corporate matters. Notably, the corporate governance provisions that were ultimately included in Dodd-Frank were but a subset of a host of agenda items, including mandating de-staggered boards, majority voting, and split Chairman and CEO roles, that were not included in the final legislation. I have little doubt that these items will resurface as advocates of a greater federal role in corporate governance move on to future battles.
Further, these pressures toward federalization are not purely domestic. Indeed, they reflect the increasing interest of many of our international counterparts to impose corporate governance issues at the international level.
Over the past decade, most notably after the passage of S-Ox in 2002, there has been a step increase in efforts to expand and deepen dialogue among various international financial market regulators in order to minimize cross-border frictions and externalities, to identify emerging regulatory issues, and to seek more harmonized standards or common approaches to regulation. Since the onset of the financial crisis in 2007, the demonstrated interconnectedness of markets and contagion effects around the world have resulted in calls to international action by world political leaders, such as through the G-20. Coordinated international responses have been sought to identified weaknesses or deficiencies in financial regulation and regulatory oversight. Many European and other nations have chosen to adopt, or are favorably disposed towards, muscular national regulations of financial markets, including corporate governance at public companies. A consequence of these developments is that U.S. regulators increasingly are under pressure from our international counterparts to require similar policies for our capital markets and for U.S. public companies.
Contrary to the view that international regulatory cooperation in the form of uniformity in matters such as corporate governance standards is necessarily advisable and beneficial, however, I believe that international regulatory competition that allows capital to flow to companies in countries that have corporate governance policies that will maximize shareholder value will best serve the international financial markets and international investors.
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In considering the adoption of federal standards in matters long governed by state law, policymakers should consider federal solutions only if there are compelling reasons to do so, including a demonstrated need for such uniformity. I strongly believe state corporate law, and in particular the strengths of federalism, has served our capital markets extremely well. Moreover, there is little evidence, indeed, there has been little effort to show, that one-size-fits-all standards of corporate governance improve corporate performance.
As I have discussed elsewhere, I believe that federal intrusions into the regulation of corporate law are fundamentally at odds with the long-standing notions of federalism underlying the situs of corporate law in the states. This structure has served investors and our capital markets extremely well for many decades. Furthermore, this model reflects our federal system of government, which grants the federal government certain enumerated powers and reserves all other powers to the states.
The advantages of reserving authority to the states are well-chronicled. Primary among these are the ability of states to respond to the needs of the constituents affected by their laws — including the companies organized under their laws and the investors in those companies — as well as the ability of states to function as "laboratories" for innovation and experimentation.
The states are best situated to understand and respond to the needs of companies organized under their laws and to the needs of the shareholders of those companies. By and large, state corporation codes are enabling and, as such, permit "private ordering" whereby a company and its shareholders decide for themselves the corporate governance provisions that best suit the company and its shareholders. Nevertheless, state legislatures are free to restrict this private ordering for companies organized under their laws, and do so to varying degrees.
When a state chooses a private ordering approach, companies are free to adopt corporate governance provisions based on differences in their size, capital structure, investor composition, board composition, existing corporate governance policies, experiences, and a nearly endless array of other circumstances unique to those companies.
Because these companies are public, the empirical results of the decisions made by the companies and the states in which they are organized inform the future decisions of state legislatures, the boards of directors of other companies, and perhaps most importantly, investors.
When, however, Congress or the Commission adopts one-size-fits-all corporate governance provisions, they substitute their judgment for the judgment of those parties and bodies having the greatest knowledge of, and responsibility for, public companies — including state legislatures, the duly-elected directors of public companies, and even the shareholders themselves.
While the advocates for uniform federal corporate governance provisions may have many arguments for promoting these provisions, the ultimate justification for imposing such provisions is that "more" corporate governance is inherently and unarguably "good." Although people may have different notions of what is "good" in the context of public corporations, it should be uncontroversial to assert that "good" in this context is that which tends to increase, if not maximize, shareholder value.
Yet, as Yale Law Professor Roberta Romano has noted2, the empirical research available at the time S-Ox was adopted indicated that the corporate governance provisions in that Act were widely regarded to be ill-conceived, but were adopted for reasons that were characterized more by political expediency than rigorous analysis.3 Similarly, UCLA Law Professor Stephen Bainbridge noted4 that even the received wisdom that a corporation should have a majority of independent directors is not supported by empirical data — that is, the data do not support the notion that board composition improves firm profitability.
Like S-Ox, the Dodd-Frank Act was passed in reaction to dramatic market events, crisis and scandal. Indeed, such interventions are most likely to occur under these circumstances. What cannot be said, however, is that these interventions are narrowly tailored to address — or for that matter are even tangentially related to — the crisis or scandal at hand. Most public companies were not implicated in the financial crisis but, rather, were harmed in the crisis in many cases just as investors were harmed. Yet, the governance reforms affect all public companies, not merely those large financial institutions whose risk-taking activities have been the primary focus of concern.
Nevertheless, because the arguments extolling the purported benefits of uniform corporate governance provisions have, heretofore, been largely impervious to analytical rigor, they are readily adopted under the uncritical assumption that they are "good." The corporate governance provisions in Dodd-Frank, like those adopted under S-Ox, were adopted in this fashion, in the absence of any empirical evidence that these measures realistically could have prevented scandals or mitigated the crisis, nor even any assurance that these measures will ensure better performance in the future.
Because the benefits of uniform corporate governance provisions are unproven at best, and the advantages of the federalist structure that has long characterized corporate law are so great, I remain unconvinced that the adoption of uniform federal standards will be beneficial to our capital markets or the broader economy.
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Setting aside the comparative merits of federalism versus federal mandates and the merits of individual provisions of the Dodd-Frank Act, there can be little doubt that the sheer volume and breadth of the federal expansion in Dodd-Frank will usher in dramatic changes that remain largely undefined, as that Act delegated to regulators, including the SEC, the responsibility to implement broad principles. Moreover, even after federal regulators issue all of the regulations necessary to implement the Act — a process that will take 18 months or more — the implementation of those regulations will take years. Furthermore, the full implications of the statute and the related regulations on our financial markets will likely not be known for many years, so it will likely take a decade or more for the financial markets to settle into a "new normal" in a post-Dodd-Frank world. While this process unfolds, public companies and companies considering going public will face substantial legal and regulatory uncertainty that threaten to hamper for the foreseeable future the dynamism of U.S. firms that drives the growth and resiliency of our markets and our economy as a whole.
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Perhaps the least noticed — but potentially most significant and long-lasting — source of uncertainty that attends the federalization of corporate law is the loss of predictability and legal certainty in corporate law matters that has developed in the states.
A historical strength of our capital markets that is derived from placing responsibility for corporate law with the states — particularly states with a highly developed set of corporate law principles such as Delaware — is the subject matter expertise, developed over decades, among the state legislatures, bars and courts, and the resulting predictability for companies organized in these states.
Certainly, as business law judges, the members of this audience recognize the importance of legal certainty to decision-making by firms.
Rapidly expanding federal preemption of corporate law matters significantly diminishes this predictability. Not only does federal preemption of corporate law matters upend the balance achieved through multiple iterations of state legislation, adjustment by firms, and development of the applicable common law in state courts, but the entire approach to these matters will be different where federal law steps in. For instance:
rather than taking the form of an enabling statute, these provisions are prescriptive, and
these matters will no longer be argued by an expert state corporate law bar before state law courts with extensive subject matter experience and expertise.
Policymakers have expressed concern about the effect of increasing policy and political risk on U.S. IPOs, and the potential suffocation of innovation and growth in our economy. I fear that the rapidly expanding federalization of corporate law — with its implications for predictability for U.S. public companies — provides further reason for significant concern.
In 2009, before joining the SEC as an Attorney Fellow in the Division of Corporation Finance, and before Congress passed and the President signed the Dodd-Frank Act, our colleague, then-professor Lawrence Hamermesh, examined5 the risks to Delaware's position as the preeminent jurisdiction in corporate law posed by federal initiatives that "might limit the scope and effectiveness of the advantages of Delaware incorporation." Larry concluded that the greatest concern is "whether federal initiatives will make our nation's capital markets more or less attractive to businesses seeking capital and to investors who supply it." I could not agree with him more. Furthermore, these concerns are clearly not confined to Delaware's borders, but rather apply to the U.S. capital markets and economy as a whole.
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As the U.S. capital markets and economy struggle to recover from the recent global financial crisis, firms face many uncertainties. As with any economic downturn, they face uncertainty with respect to when demand for their goods and services will justify raising capital, making capital improvements, and hiring additional workers. Added to these "ordinary" uncertainties are the uncertainties that flow from the dramatic, and not fully understood, changes to the legal and regulatory environment, such as those resulting from the passage of Dodd-Frank. The sheer size and scope of these uncertainties forebode a long-lived adjustment period for firms, markets and the economy.
Yet, the most dangerous uncertainty to our capital markets and to the U.S. economy may not be simply that Dodd-Frank is "big." Instead, I believe the greatest uncertainty now facing public companies is that Dodd-Frank continues and drastically accelerates a trend towards the federalization of matters traditionally left to states, particularly corporate law. In an already highly uncertain business environment and market, this expansion adds to the risks faced by U.S. public companies and other companies considering going public in the United States.