The Federalization of Corporate Governance

In my recently published book, The Federalization of Corporate Governance (Oxford University Press 2018) (ISBN 978-0-19-993454-6), I explore this process of federalization in the United States from 1903 to the present. Clearly, the states, particularly Delaware, traditionally have been and continue as principal regulators of the sphere of corporate governance. Nonetheless, to an increasing degree, the federal government, the SEC, and the national stock exchanges impact corporate governance standards. The book views this federalization as an evolutionary process that commenced at the beginning of the twentieth century. Going through periods of activism, gradual transition, and stagnation, the process intensified with the enactment of the Sarbanes-Oxley and Dodd-Frank Acts.

To view these Acts as representing a revolutionary transformation with respect to federal oversight of corporate governance is an exaggeration. Rather, they symbolize a period of enhanced activism whereby this federalization process was accentuated. From a historical perspective, between 1903 and 1914, 24 bills were introduced in Congress which sought to require federal chartering and/or the implementation of federal minimum substantive standards. During that era, both Presidents Roosevelt and Taft favored federal incorporation. Between 1914 and 1930, another seven bills were introduced in Congress seeking to effectuate similar objectives—with one such bill requiring that the Federal Trade Commission approve executive officer remuneration. Interestingly, the next significant legislative effort occurred 50 years thereafter with the Metzenbaum Bill of 1980 which prescribed federal minimum standards that largely focused on adherence to fiduciary duties, including with respect to related-party transactions. Although hearings were held through the years, none of these bills were enacted.

This effort to implement federal minimum standards was not confined to the legislative arena. Indeed, for years, attempts were made to achieve such federalization through judicial construction of the federal securities laws, particularly Section 10(b) and SEC Rule 10b-5. Although achieving some fleeting success, the U.S. Supreme Court in Santa Fe Industries (430 U.S. 462 (1977)) thoroughly rejected this effort—holding that a disclosure deficiency must be present to implicate these federal provisions. The substantive fairness of fiduciary conduct, the Court reasoned, is a matter of state corporate law.

Although not becoming law, these legislative and judicial efforts have modern day relevance. For example, many of the bills introduced early in the twentieth century sought to exclude corporate insiders from serving as directors or officers at competing companies. With certain exceptions, this prohibition was codified in the Clayton Antitrust Act of 1914. A number of other bills mandated that a subject company’s independent auditor certify such company’s financial statements as a requisite for the issuance of a federal charter. Today, audited financial statements, CEO and CFO certifications, and independent audit committees are firmly established. And, as mentioned above, one such bill required federal regulatory approval of officer compensation. Although this mandate has not been enacted, today we have extensive disclosure with respect to executive remuneration, the prohibition on loans to officers and directors, and shareholder advisory votes on executive compensation (say-on-pay).

Perhaps surprising to some observers, the initial implementation of federal corporate governance standards occurred with the Securities Exchange Act of 1934. Although not its primary focus, that Act prohibited short-selling by insiders as well as requiring, based on strict liability, that short-swing profits (made from purchases and sales or sales and purchases of an equity security within a six-month period) be disgorged. Seven years later, the SEC took its first significant foray in this sphere by promulgating the shareholder proposal rule. As stated by the author, “The SEC shareholder proposal rule represents an early ‘intrusion’ by the Commission—dating back to 1942—with respect to federalizing an area traditionally within the purview of state company law. Today, the Rule is well entrenched as an accepted facilitator of shareholder activism and of dialogue between management and institutional shareholders.” (Federalization of Corporate Governance at page 190).

Also stunning in this context is the federalization of insider trading which commenced in 1961 with the SEC’s administrative decision in In re Cady, Roberts (40 SEC 907 (1961)). Displeased with state court refusal to rectify this perceived misconduct, SEC Chairman William Cary made this subject a key item of his agenda. Seven years thereafter, the Second Circuit in Texas Gulf Sulphur (401 F.2d 833 (2d Cir. 1968) (en banc)) reinforced that the insider trading prohibition is a matter of federal corporate governance. Although subsequent U.S. Supreme Court decisions have confined the scope of Texas Gulf Sulphur, nonetheless federal law continues to govern this area of substantive fiduciary conduct.

The shareholder proposal rule and In re Cady, Roberts are two early examples of the SEC’s activism impacting the federalization of corporate governance. This activism has continued with frequency, such as: (1) with respect to insider trading, adopting Rules 10b5-2 and 14e-3 as well as Regulation FD; (2) seeking to mitigate the impact of the U.S. Supreme Court’s decision in Santa Fe by promulgating Rule 13e-3 that requires a subject party to disclose whether it has a reasonable belief that the going-private transaction is fair or unfair to unaffiliated shareholders and the reasons supporting that belief; (3) adopting the all holders rule prohibiting exclusionary tender offers, thereby, in practical effect, abrogating the Delaware Supreme Court’s decision in Unocal (493 A.2d 945 (Del. 1985)), that upheld the use of selective tender offers; (4) seeking to deter fiduciary self-dealing through the guise of disclosure (In re Franchard Corporation (42 SEC 163 (1964)); (5) levying officer and director bars against miscreant fiduciaries; (6) ordering Undertakings in Commission enforcement actions (including such expansive measures as the appointment of independent directors, retention of special counsel, appointment of independent consultants, and retention of independent monitors— see, e.g., In re Occidental Petroleum Corporation, Securities Exchange Act Release No. 16950 (1980)); and (7) bringing disciplinary proceedings against gatekeepers, including attorneys, for engaging in allegedly unethical conduct, thereby declining to relegate this area solely to state bar associations. These actions exemplify that the Commission is an active participant in the federalization of corporate governance process.

From this perspective, the Sarbanes-Oxley and Dodd-Frank Acts reflect a continuation on this federalization path. Focusing on such subjects as independent directors, the composition, roles and functions of board committees (such as the audit and compensation committees), codes of conduct, and say-on-pay advisory shareholder votes, these Acts meaningfully impact normative conduct. These Acts reinforce that federal corporate governance is a strong presence. They also serve as a reminder to the states that lax regulation may induce the passage of federal legislation, particularly during times of crisis.

Lastly, the national stock exchanges play a prominent role in this federalization process. Indeed, at the SEC’s behest, the New York Stock Exchange in 1977 adopted a rule requiring that the members of a listed company’s audit committee be comprised solely of independent directors. Several of the provisions contained in the Sarbanes-Oxley and Dodd-Frank Acts condition the eligibility of a subject company to list on a national stock exchange by requiring that the subject company adhere to the Acts’ mandates. Through this process of government mandates and SEC “persuasion,” the Exchanges have facilitated the effectuation of this federalization process.

With respect to suggestions for further federalization of corporate governance, several measures should be considered. One is that offensive and defensive tactics undertaken in M&A deals should be within the purview of federal law. How a state like Delaware should be the determiner in M&A deals involving global companies and affecting national policy is baffling. Second, our law of insider trading should be revised by the passage of all-encompassing federal statutes. The judge-made law of insider trading, layered by SEC pronouncements, has resulted in an arbitrary and vague framework. Third, the federal courts’ deference to state law, at times, to determine the parameters of the federal securities laws no longer is warranted in view of the current reality of the enhanced federalization of corporate governance. And, as a last example, the SEC should more rigorously utilize the enforcement measures that Congress already has provided, such as the control person provision which the Commission declined to invoke in its enforcement actions in the aftermath of the financial crisis.

In conclusion, federal law today impacts the governance of publicly-held corporations to a greater extent than ever before in our country’s history. My book The Federalization of Corporate Governance (at page 24) “discusses the evolution and development of corporate governance from a federal law perspective from the commencement of the twentieth century to the present. It examines the tension between state company law and federal law, analyzes the federal historical developments, explains the ramifications of the federal legislation enacted during the past two decades, and recommends corrective measures that should be implemented.”