How Not to Prevent another Enron

Wednesday, April 30, 2003

Major reform of corporate law in the United States is rarely the outgrowth of a rational and serious debate. All too often, a series of local crises creates a huge public consensus for somebody doing something about a problem quickly. The result is a predictably ineffective process: We enact legislation in haste and then litigate at leisure. Rapid and precipitous behavior in the political arena is followed by years of complicated administrative and judicial maneuvering.

Consider the brave new world of corporate liability and corporate responsibility ushered in by the Sarbanes-Oxley Act, which sailed through Congress in July 2001. This complex legislation represents a side of the Bush administration that shows, to say the least, a shortage of respect for the self-corrective power of markets in business affairs.

It is instructive to remember that Sarbanes-Oxley was brought on by a half-dozen corporate bankruptcies—Enron, Tyco, and WorldCom among them. Each case was a distinctive breakdown, yet, in the concern over these high-visibility cases, it is easy to forget that 99 percent of public corporations have done nothing that merits reproach. Most have behaved properly over the long haul: They make good products that generate profits for shareholders and jobs for employees. But the commonplace becomes inconspicuous when a zealous Congress seeks to “prevent the next Enron” by introducing elaborate safeguards and sanctions. Similar refrains have been sounded after previous frauds, from Teapot Dome to the almost forgotten Salad Oil and Equity Funding scandals. Yet that naive optimism ignores the central truth of any large and diverse economy: Things will go wrong no matter how sound the legal regime.

The grand conceit is that we can “fix” such problems once and for all by anticipatory regulation. Even the most clever, adroit, and skillful legislature cannot achieve zero risk in human affairs. Any sensible legal system has to rely in part on sanctions brought to bear after people have stolen property or looted corporations. We do not possess a laser precise enough to target in advance only thieves. Any regulatory scheme sweeps into the net the good corporations along with the bad. The effort to slow down abuse in poorly run corporations often makes it more difficult for well-run corporations to remain that way. Compliance with external standards could easily undermine internal safeguards, formal and informal, against fraud and abuse.

Federalization Is Not the Answer

Sarbanes-Oxley marks, almost by default, an enormous shift in the locus of government power over corporate affairs. From 1933 until 2002, the stock exchanges were generally regulated as national institutions by the Securities and Exchange Commission (SEC). These laws covered the registration of new stock issues, insider trading, and the like. But internal matters of corporate governance were generally left to regulation under state law, an allocation that makes sense. The organizers of any corporation will choose to incorporate in the state that offers the most attractive home. The state laws that supply the best mix of flexibility and shareholder protection will win in the long run. Competition between states thus generates decent rules on corporate governance through trial and error. Delaware has turned out to be a big winner in this derby, largely because its legislators and judges have supplied a superior and consistent product.

The Bush administration, although generally solicitous of states’ rights, found itself subject to such intense political pressures that it took the lead in federalizing large chunks of the law of corporate governance. This shift in the center of gravity gratuitously eliminates the beneficial competition on corporate governance now in place at the state level. Even worse, it puts the federal regulatory eggs all in the wrong basket. The SEC is now in sad disarray after the tumultuous leadership of Harvey Pitt, and the Accounting Standards Board is leaderless and rudderless after the precipitous departure of William Webster. The Republicans in Congress, led by Michael Oxley himself, have had second thoughts about the potential reach of the act, so that the entire administrative process has become mired in delay that stretches forward to the time of this writing in April 2003.

Rules that Make Sense

Over the long haul, of course, it’s not solely a question of who is running this show but what are the legal rules that have been chosen. We must ask what Sarbanes-Oxley does to resolve the great dilemma of corporate governance. On the one hand, it is critical to hold people who misbehave accountable for their misdeeds. But, on the other hand, it is imperative to allow directors and officers to make tough decisions without being hammered in litigation when things turn out badly for their corporations. No one will take up corporate office if he or she is required to pay back the corporation for its losses but does not receive any additional reward for its successes. A corporate officer cannot be expected to guarantee the success of the business venture that he or she oversees.

The business challenge is to devise rules that induce people to serve while still holding them appropriately accountable. The basic compromise that virtually all states have adopted is the so-called business judgment rule (BJR), which is based on the reality that all personal businesses have bumps and turns and that corporate ventures are not immune to parallel risks. Shareholders gain not by having guaranteed risk-free investments but by gaining expertise and diversification of wealth with the help of a professional management team. As long as a director tries to make the right calculations and acts honestly and in good faith, then the shareholders are along for the ride—up or down. If they don’t like the team at the helm, they can sell their shares and invest elsewhere. Cases of fraud, illegal conduct, and (most critically) conflict of interest fall outside the protection of this rule. Fraud and illegal conduct have no defense, and conflict of interest is judged under a higher standard of “entire fairness,” both procedural and substantive. Procedurally, self-dealing directors have to show that the appropriate steps were taken to ensure that the shareholders are represented only by individuals who are looking out for shareholder interests. Substantively, they have to show that the set of terms is beneficial for shareholders at the time it was made.

Independence and Its Limitations

Sarbanes-Oxley does not alter these rules directly, but it does change the balance of power because it contains many specific directives, thereby reducing the area of discretion to which the BJR applies. In addition, it comes up with a universal fix for all corporate problems that is only likely to make matters worse. The new hero in American corporate law is the independent director, which, roughly speaking, refers to those directors who are not part of the management team. Of course we need independent directors, but how many and under what circumstances? Independent directors do help counteract conflict-of-interest problems, but so did special prosecutors before they ran amok.

Other downsides to independent directors are ignorance, if the outsiders don’t have close connections to the business; incomprehension, if they don’t understand its traditions and rhythms; or indifference, if they don’t have a visceral determination to make the business prosper. A board with all independent directors may easily founder without insiders to keep them in line. After all, independent directors have other commitments that could easily come first.

In the end we must talk about marginal benefits and marginal costs—the trade-offs at the margin that vary from business to business. It is critical to know something about the mix of shareholders, the character of the CEO, and the nature and quality of the firm before making any judgment as to the ratio of insiders to outsiders. Yet what Sarbanes-Oxley says in effect is that “we don’t know anything about any company in particular, so we will decree something for every public company. We therefore decree that boards are to be dominated by independent directors, and audit committees will have only independent members.” If this course of action were sound, you would expect to see strong empirical evidence on how independent directors magically improve corporate returns, and you would also expect to see strong market gravitation to that result. But the evidence is rather weak because the trade-offs are close. Nothing whatsoever suggests that a full slate of independent directors is going to create the ideal board.

Especially controversial are the exacting requirements for audit committees to operate independently from the board of directors: Only the audit committee can appoint and review the work of the outside auditors to the firm. It is easy to see how such independence can lead to a genuine impasse within the firm whenever the audit committee is at loggerheads with the board. At that point, does the board have any real control over the budget of the audit committee, can it reject the committee’s recommendations, or can it change the committee’s membership? Disputes over these issues may well take two sets of warring lawyers within the same organization to resolve. The creation of a potential fifth column within the organization makes the duties of members of the audit committee far more onerous than before, with no relief in sight.

The upshot of all this is that independent directors face heavier duties and greater potential liabilities than ever before. The fiendish irony is that heaping these new obligations on board members is likely to undercut the independent directors. The only “independent” directors who can do the job are those who devote a huge chunk of time to the business of the company, to which they are necessarily beholden. No longer can the independent director function like a moth that moves from flame to flame. The number of boards on which an independent director can prudently serve will shrink. The number of people who are willing to serve on these boards will shrink as well, given the financial risks associated with service. I have been told that currently only one in nine individuals approached to serve on boards will accept, as compared to one in three before Sarbanes-Oxley. Search fees for directors have increased by about a third, and the compensation paid to outside directors has started to increase as well—these are inescapable costs to the shareholders. In the end, the caliber of people in the business may be reduced by Sarbanes-Oxley. Indeed the requirements could prove to be so onerous that many small listed corporations will decide that it makes no sense to remain public. And other private corporations will choose to remain private. Those decisions involve real costs to the economy, for the willingness to begin new ventures depends on the ability to sell out once they have reached some level of financial stability. Thus the final irony is that Sarbanes-Oxley may interfere with the operation of capital markets, to the detriment of the very investors it is trying to protect.

The Power of Contracts

The basic principles that should be used to judge the soundness of Sarbanes-Oxley (and other reforms of corporate law) are the same great libertarian principles that should inform any evaluation of the role of government in the regulation of the economy. A corporation is primarily an elaborate network among shareholders, directors, and officers. There are really no third-party interests that will be unrepresented at the table.

As a general rule, only one legal system can successfully bring together large numbers of heterogeneous individuals from all walks of life—people who have some imperfect concordance of beliefs and objectives. That legal system is contract law. No single contract can do the job; what is needed is a complex set of sequential arrangements that govern multiple parties. That edifice may break down from time to time, but it is not appropriate to compare the breakdown rate of a sensible system of contracts tested over time with an idealized system of federal regulation whose breakdowns are often excused by the good intentions and laudable purposes of federal intervention.

Sarbanes-Oxley marks a loss of freedom and flexibility in running corporations. This short-term political fix will have consequences that promise to extend into the indefinite future.