Vol. 15 No.5 (May 2005), pp.444-448

CORPORATE GOVERNANCE: LAW, THEORY AND POLICY, by Thomas W. Joo (ed).  Durham, NC:  Carolina Academic Press, 2004.  520pp.  Paper $50.00. ISBN:  0890895708.

Reviewed by Kenneth Holland, Department of Political Science, Kansas State University.  Email:  kholland@ksu.edu .

The focus of this edited volume is the law of corporate governance, including state and federal legislation and its judicial interpretation.   Rules promulgated by the federal Securities and Exchange Commission also fall within the volume’s scope.  The editor is a law professor at the University of California, Davis.  The book’s primary audience is law students and is designed to be used as a collection of supplementary readings in a course on corporate governance.  The book consists of eleven chapters, each containing between three and six abridged law review articles.   The volume is of interest to political scientists, however, because many of the readings, which appeared originally in law reviews, address the policy issues surrounding government involvement in how corporations are governed.  The topic is timely because of the scandals, involving major corporations such as Enron and WorldCom, which led to passage by Congress of the Sarbanes-Oxley Act in 2002.  As of 2005 criminal prosecutions and civil suits stemming from these scandals were in progress or pending.  Most of the articles consist of standard legal analysis of judicial decisions, laws and regulations.  Some, however, take the social science approach and rely heavily on empirical data and statistical analysis.

Until recently, the states have been the primary legislators for corporations.  Corporate law traditionally is considered private law because it governs the relationship among the officers, the board of directors and the shareholders.  Corporations exist because it is more efficient to organize production within a firm, where workers can specialize, than leaving it to autonomous individual producers.  The four basic defining elements of a corporation are indefinite life, legal personhood, limited liability, and freely transferable shares.  The basic dilemma presented by corporations is the inherent conflict of interest between the officers and shareholders due to the separation of ownership and control.  The owners, or shareholders, are not the ones who manage the enterprise.  Non-owner managers may be tempted to maximize their welfare at the expense of the corporation’s profits.   Managers serve as agents of the owners, and when they put their self-aggrandizement first they impose “agency costs” on the shareholders.  The betrayal of stockholders and employees by corporate officers is to be expected.  The actions of Enron and WorldCom’s top executives that led to the loss of billions of dollars in shareholder equity and employee pension funds only differed in scale (not in kind) from previous examples of corporate wrongdoing.  The explosion in the magnitude of executive compensation in recent years and the [*445] high turnover rate among CEOs only reinforce shareholder fear of managerial self-dealing.

A threshold question is whether law should play any role at all in regulating what is essentially a private relationship.  Legal scholars tend to adopt either a “contractarian” or “public interest” approach to this question.   Law professors who draw upon free market economic principles tend to see the corporation as a contract, a voluntary economic relationship between shareholders and management.  Those who view the relationship among managers and shareholders as a contract see little need for government regulation other than the necessity of providing a judicial forum for civil suits alleging breach of contract.  Building on common law, state legal codes find that officers owe a fiduciary duty to shareholders, a duty enforceable in civil court.   In fact, state statutes are almost silent on the duties and liabilities of officers; they have much more to say about those of members of the board of directors, the independent oversight body that represents shareholders.  Another school of legal scholars, impressed by the impact of large corporations on society, has little faith in market solutions and argues that government must force firms to behave in a manner that advances the public interest.  Analysts who emphasize corporations’ obligations to society ask how corporate behavior affects multiple stakeholders, including customers, employees, creditors, the local community, and protectors of the environment.

The stock market crash of 1929 brought the federal government into the regulation of corporate governance for the first time.  President Franklin Roosevelt believed that he had to restore public confidence in equities.  His fear was that individual investors would shy away from stocks and, by doing so, reduce the pool of capital available to fuel economic growth in the private sector.  Congress enacted the Securities Act in 1933, establishing the Securities and Exchange Commission (SEC).  It requires registration with the SEC of securities offered for public sale, outlaws fraud in the sale of securities, and offers defrauded investors means of recovering their losses.  The law is based on the assumption that issuers who are forced to disclose relevant information about a corporation will be less likely to commit fraud.  The SEC can investigate and impose sanctions on violators.  SEC enforcement is in addition to the rights of defrauded investors to sue wrongdoers in federal court.  The Securities Exchange Act of 1934 regulates stock exchanges and requires corporate officers to report their trading in securities issued by their employer.  The SEC can ask for court injunctions or request criminal prosecutions against offending exchanges or exchange members.  The SEC’s reliance on disclosure as a prophylaxis against fraud stands in sharp contrast to the approach of the states, which regulate corporations through the incorporation laws.  States have the power to revoke a corporate charter in cases of extreme malfeasance.

Roosevelt’s decision to place publicly traded corporations and stock exchanges under federal supervision begs the question whether it is wise public policy to encourage average citizens to entrust their savings to corporate managers.  Should the law not steer members of the body politic toward placing their money [*446] in safe harbors such as bank savings accounts or treasury bonds?  The temptation that managers have to maximize their welfare at the expense of shareholders makes stocks riskier than other forms of investment.  Scholars who question the wisdom of middle-class investment in the stock market have much to say that is relevant to the current debate over President George W. Bush’s proposal to privatize social security, another FDR legacy.  Both of Roosevelt’s program experiments have been wildly successful.  Millions of Americans own shares of stock, primarily through their 401(k) retirement account investments in mutual funds.  The value of these accounts varies according to the vagaries of the business cycle and global events.  At the same time, millions of retired Americans rely on monthly checks issued by the Social Security Administration, which guarantees monthly benefits at a predetermined magnitude.  Loss of investor confidence in the stock market due to corporate scandals and the aging of the population represent significant threats to these two pillars of the New Deal—protection of small investors and income security for the retired.

An established theme in political science is the phenomenon whereby an interest group gains control over the government agency established by Congress to regulate it.  The contributors to Joo’s volume disagree over whether the stock exchanges have “captured” the SEC.  Critics of the SEC point to its efforts to build investor trust in the exchanges by making the trading of stocks as transparent as possible.  Others see the alliance between the agency and the exchanges as necessary to strengthen its influence over the issuance and trading of shares.

Major policy themes addressed by the contributors are the growth in federal regulation of corporations at the expense of the states and the federal criminalization of behavior by corporate officers that previously exposed them only to civil liability in state courts.  One of the most interesting dimensions of the collection is the debate between those who take a contractual, as opposed to a public interest, approach to corporate governance.  Libertarians, for example, point to the desire of corporate officers to maintain a good reputation as a deterrent to dishonest conduct.  If they mismanage a firm, they may lose their jobs due to hostile takeovers or mergers.  Another reason why government regulation is unnecessary, they argue, is because the board of directors acts as an internal control over errant managers.  Enforcement is another major topic.  The authors debate the relative merits of civil litigation brought by private parties, lawsuits filed by the SEC, criminal prosecution by the Department of Justice, and leaving sanctions to the market as means of protecting the public interest.   Shareholders can always withdraw their investment from a dishonestly managed enterprise, conclude the advocates of a market approach.

As a result of the revelations of accounting and financial misconduct in the Enron and WorldCom scandals, Congress enacted the Accounting Reform and Investor Protection Act of 2002, or Sarbanes-Oxley Act.  WorldCom lied about its earnings, and when the fabrications were exposed, the company went bankrupt, costing [*447] investors more than $200 billion.  The legislation was based on the assumption underlying the Securities and Exchange Act that full disclosure will prevent fraud.  It sought to ensure full disclosure of information in firms’ financial statements.  Investors had relied on an accounting firm’s independent audit, which in fact overlooked adverse information.  The law established an oversight board for accounting practices and augmented the SEC’s resources and expanded its supervisory responsibilities.  The statute contains new threats of criminal prosecution against managers.

An interesting topic developed in the volume is of particular interest to political scientists who study judicial policymaking.  Courts lead by exhortation as well as by fiat.  Most of the major state court decisions involving corporate governance are issued by the Delaware Chancery Court, due to the large number of major corporations incorporated in Delaware.  Attorneys for these corporations follow the Delaware court’s judgments carefully and communicate the judges’ holdings to their superiors, the corporate managers.  The Delaware Chancery Court shapes the behavior of corporate officers through what are termed “corporate law sermons.”  In the Twenty-First Century, federal securities law and enforcement by means of class action lawsuits filed in federal court by shareholders against managers, however, have supplanted state law as the most visible means of regulating corporations.  The federalization of corporate governance law is perhaps best illustrated by the provision of the Sarbanes-Oxley law that bans corporate loans to directors and executive officers, a matter long dominated by state law.  The shareholder class action, however, has produced its own social problem—a large increase in the number of frivolous lawsuits.  Attorneys have a strong incentive to file these suits whenever a corporation’s share price drops significantly over a short period of time.  The drop in price is prima facie evidence of wrongdoing, especially withholding of negative information from shareholders.  Corporate defendants typically follow their insurance carrier’s advice and settle such suits out of court rather than face the uncertainty and cost of a trial.  The lawyers for the plaintiffs receive substantial attorneys’ fees while the shareholders receive very little compensation.  In the 1980s, the U. S. Supreme Court began to address this threat to corporate welfare through such measures as shortening the statute of limitations applicable to such claims and the imposition of other restraints.  A hallmark of the Court associated with Chief Justice William Rehnquist is its restrictive approach to private securities claims.  The greatest blow to class action corporate suits, however, was struck by the Ninth Circuit Court of Appeals in SILICON GRAPHICS (1999).  In 1995 Congress also addressed the issue of frivolous class actions by enacting the Private Securities Litigation Reform Act (PSLRA).  The Ninth Circuit interpreted the act in the way most likely to deter abusive suits by holding that the statute required plaintiffs to allege facts that would show that defendants were “deliberately reckless” in making representations to shareholders that gave rise to the charge of fraud.   This case is an excellent example of judicial lawmaking by means of interpretation. [*448]

CASE REFERENCE:

IN RE SILICON GRAPHICS INC., 183 F. 3d 970 (9TH Cir. 1999).

*************************************************

© Copyright 2005 by the author, Kenneth Holland.