The Continued Federalization of Corporate Law

Larry Ribstein has been posting on the corporate governance provisions in the financial reform legislation and has lamented the continued creeping federalization of corporate law.  Steve Bainbridge laments that the evolution of the law is increasingly a "struggle to keep the federal government from steadily encroaching on corporate governance to the point that we might as well adopt a federal corporations law."  JW Verrett is breathing a sigh of relief that, notwithstanding the other provisions in the legislation, it did not include a ban on staggered boards. 

We will have a number of posts on the governance provisions, including the sections that preempt not only state law but the authority of the stock exchange.  The legislation (at least on the Senate side) essentially gives the SEC authority over the voting of uninstructed shares by broker-dealers and the definition of independent director, at least in the context of compensation committees.

We note however, Larry's comment that while none of the provisions "is individually earth-shaking, they cumulatively touch many major aspects of corporate governance formerly left to contract and state law."  He is correct on that point but a couple of points need to be interjected into the debate. 

First, those who argue for contract and private ordering need to establish that this in fact occurs.  Thus, in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom, we show that with respect to waiver of liability companies, all of the top 100 largest companies except Pepsi had them and all of them waived liability to the furthest extent permitted by law.  In other words, the categorical rule of liability for breach of the duty of care was replaced by a categorical rule of no liability for breach of the duty of care.  There was no private ordering. 

The same is true, for example, with respect to shareholder access (a matter addressed in the legislation).  While in theory companies could use private ordering to give shareholders access to the company's proxy statement, they simply have not.  What exists is a categorical rule denying access.  When the legislation passes and the SEC acts, the new categorical rule will be in favor of access.  But it will not have any impact on private ordering in the area because there isn't any. 

Interestingly, as we will discuss in a future post, the existence of access provisions in the legislation likely came about because of threats by assorted opponents to sue the Agency under a Business Roundtable theory.  In the be careful what you wish for category, the SEC will now emerge with much clearer authority and have less incentive to adopt a rule that is less robust because of fear over legal challenges. 

As for other areas such as majority voting, there has been some private ordering with companies adopting mostly Pfizer style policies that require directors to resign if they do not get a majority of the votes cast.  These provisions are popular not because of the private ordering aspect but because they transfer authority not to shareholders but to the board.  Directors must resign but this merely gives the other directors (including the CEO) the authority to decide whether they want to keep the losing directors. 

In the two instances so far where directors have failed to get a majority and resigned (Pulte and Axcelis), the boards have declined to accept the resignations.  This will be the recurring pattern.  Shareholders typically vote against directors because of unhappiness with the financial condition of the company, something usually attributed one way or another to the actions of the CEO.  With the CEO on the board, he/she will not want to see directors forced off the board because they supported his/her policies.

As for preemption of state law, it is something Delaware has brought on itself.  The courts have relied on a concept of independent directors withough enforcing the definition.  See Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  While Caremark indicated the need for a reporting system to the board, cases like Citibank show a resolute refusal by the courts to make the reporting systems meaningful.  A more balanced approach at the state level might have been preferable to federal regulation but federal regulation is preferable to unbalanced regulation at the state level.

So on with the debate and the continued federalization of corporate law.