Two New Papers Seek to Assess the Costs of Sarbanes-Oxley

June 27, 2007

Two working papers were recently released on SSRN which seek to assess the impact of the Sarbanes-Oxley Act on smaller firms.   Both papers conclude that more study is needed. 

Ehud Kamar, Pinar Karaca-Mandic and Eric Talley have posted  Sarbanes-Oxley’s Effects on Small Firms: What is the Evidence?  The paper reviews a number of studies on the impact of Sarbanes Oxley on smaller firms.  The authors conclude that prior studies lend support to the propostion that Sarbanes-Oxley had a disproportionate impact on smaller firms, but the evidence is not conclusive. 

Christian Leuz has posted Was the Sarbanes-Oxley Act of 2002 Really this Costly? A Discussion of Evidence from Event Returns and Going-Private Decisions.  Leuz disputes the conclusions of several studies finding increased net costs for Sarbanes-Oxley.  He argues that several of these studies’ key findings may not be attributable to Sarbanes-Oxley, but may instead reflect broader market trends. Leuz concludes we do not have much SOX-related evidence that one-size-fits-all regulation imposes significant costs on firms, and that there is evidence that Sarbanes-Oxley has increased the scrutiny on firms and produced certain benefits.

Supreme Court Rules against Investors in Closely-Watched Case

June 22, 2007

The Supreme Court released its decision in Tellabs Inc. v. Makor Issues and Rights Ltd., ruling against the plaintiffs and in favor of defendant, Tellabs.  The New York Times published summary of the opinion today.

The 8-1 decision by Justice Ruth Bader Ginsburg is a slight setback for the plaintiffs’ bar in securities litigation but hardly the victory opponents of shareholder securities litigation might have hoped for.

In her majority opinion, Justice Ginsburg clarifies what kinds of allegations are sufficient to meet the Private Securities Litigation Reform Act’s (PSLRA) pleading standard of a “strong inference” of scienter (intent to deceive).  The Court rejected the 7th Circuit’s standard in the lower court opinion that a strong inference is created if a “reasonable person could infer” that the defendant acted with the required state of mind.  The court found this standard too permissive in light of the PSLRA’s intention to create a heightened pleading standard.  To qualify as “strong”, the Court held, “an inference must be more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference of non-fraudulent intent.” Because the lower courts had evaluated the plaintiffs’ complaint against an inappropriate standard, the Court remanded the case.

Importantly, however, the majority opinion also rejected the defendant’s position that plaintiffs’ failure to show any monetary gain to the individual defendant (the corporation’s CEO) negated a strong inference of scienter.  The majority also rejected the position of Justices Scalia and Alito in concurring opinions that to survive a motion to dismiss the inference of scienter must be more plausible (rather than as plausible) as any competing explanation.  

Overall, the Tellabs opinion is a welcome clarification of the pleading standard created by the PSLRA.  It is less favorable to plaintiffs’ than the 7th Circuit’s standard but much more generous than the standard sought by defendant and embraced, to some extent, by Justices Scalia and Alito. 

Robert Mikos and Cindy Kam, Do Citizens Care About Federalism? An Experimental Test

June 21, 2007

Robert Mikos (UC Davis-Law) and Cindy Kam (UC Davis-Political Science) have posted Do Citizens Care About Federalism? An Experimental Test on SSRN.  The article describes the authors’ empirical study which they say demonstrates that citizen preferences for federalism (state-centered authority and autonomy) play a role in shaping public opinion in policy debates.  Specifically, they claim that when political elites advance federalism values it can weaken public support for federal action within a sphere where citizens have a preference for state-based control.  Because issues of federalism often lie at the heart of corporate law debates, this research is relevant to corporate policy debates on the legitimacy of federal action regulating corporations.  Here is the abstract:

The ongoing debate over the political safeguards of federalism has essentially ignored the role that citizens might play in restraining federal power. Scholars have assumed that citizens care only about policy outcomes and will invariably support congressional legislation that satisfies their substantive policy preferences, no matter the cost to state powers. Scholars thus typically turn to institutions —  the courts or institutional features of the political process — to cabin congressional authority. We argue that ignoring citizens is a mistake. We propose a new theory of the political safeguards of federalism in which citizens help to safeguard state authority. We also test our theory using evidence from a nationally representative survey experiment that focuses on the timely issue of physician-assisted suicide. We find that citizens are not single-mindedly interested in policy outcomes; trust in state governments and federalism beliefs, on the urging of political elites, reduce their willingness to support a federal ban on physician-assisted suicide.

Corporate Scholars Conference – Seattle University

June 20, 2007

I am back from a productive and inspiring conference of corporate scholars hosted by Dean Kellye Testy and Seattle University School of Law last weekend.  The conference piggy-backed on Seattle Law’s annual Director Training Academy which many conference participants also attended.

The highlight of the conference was the work-in-progress paper sessions where participants presented and received comments on working papers on corporate and securities law issues.   Barbara Black, Lynne Dallas, Jill Fisch, Donna Nagy, Janis Sarra, Hillary Sale and Cheryl Wade presented papers.  Other participants were Claire Moore Dickerson, Christine Hurt, Faith Kahn, Kellye Testy and Elizabeth Nowicki. 

I commented on an interesting working paper by Hillary Sale of Iowa entitled “Judicial Gatekeepers,” which argues that judges should take a more proactive role in reviewing settlements in shareholder litigation in order to help mitigate agency costs inherent in aggregate litigation (class actions and derivative actions).

What I enjoyed most about the conference was learning so much about corporate law developments in a short period of time, while getting a preview of some very good work by leading corporate scholars that will be coming down the pike soon.  Thanks to Kellye Testy, Dana Gold and Seattle University School of Law for hosting such an enjoyable and productive conference.

SEC Proxy Access Rule Taking Shape

June 13, 2007

BNA’s Corporate Counsel Weekly has an interesting report that provides insight into the likely contours of the Securities and Exchange Commission’s (SEC) anticipated new rule on Shareholder Access.  The article, SEC Proxy Access Rule Taking Shape ‘Practically Meaningless’ (subscription required), reports on the proceedings of a recent Compliance Week Conference in Washington. 

Participants predicted that the SEC would take steps to eliminate shareholders’ ability to make “precatory” non-binding proposals of the sort that currently dominate the SEC’s Rule 14a-8 shareholder proposal regime.  In “exchange,” the SEC would expand shareholders’ rights to submit binding shareholder proposals and provide a limited right to nominate board candidates on the management proxy statement. 

From the comments quoted in the article, it seems that representatives of corporate management are happy with the proposed “bargain,” while representatives of institutional investors are not.  Patrick McGurn of Institutional Shareholder Services is quoted as describing the SEC’s anticipated proxy access rule as “practically meaningless.”

Interestingly, the SEC and corporate counsel seem to favor creating “virtual annual meeting” chat rooms as a venue for shareholders to air greivances and opinions currently channeled through the Rule 14a-8 shareholder proposal process.  It is unclear to me why such a process would be appealing to corporations.  A legally mandated venue available 24/7 for any shareholder to anonymously express any opinion, view, or gripe seems problematic on a number of levels.  This seems to be a system that would defy efforts to impose order and control, which could be being more damaging to a corporation’s interests than the shareholder proposal process which has strict limitations on who can make proposals, how often and on what topics. 

Increasing shareholder power to bind management through shareholder proposals while providing shareholder activists an unfettered venue for expression of dissenting viewpoints, in “exchange” for scrapping the essentially toothless Rule 14a-8 precatory proposal regime, may indeed be a case where corporate management should be careful what it wishes for.

Scooter, Paris, Criminal Sentencing and Corporate Law

June 12, 2007

Pundits, politicians and ordinary citizens are vigorously debating whether famous defendants Scooter Libby and Paris Hilton are getting what they deserve, or whether, instead, they are unfairly being made an examples of because of their fame and notoriety.  Similar questions were raised when Martha Stewart served her sentence for obstruction of justice.

This roiling debate has led me ponder what we want from criminal sentences and how to judge whether they are fair.  Our sentencing policies and practices are expected to acheive many goals.  We want criminal sentences to deter future crimes, punish the wrongdoer, teach the criminal “a lesson”, and avenge harm to society or individual victims.  Fairness also requires that like cases be treated alike, a sentiment that seems to be driving the current popular debate.

Where one of society’s goals in sentencing is deterring future crime, we may misstep when we reflexively demand “hard time for hard crime.”  This view is advanced by scholars Paul Robinson and John Darley, who argue that, counter to common perceptions, excessively harsh penalties are not likely to deter crime.  Instead Robinson and Darley argue that to induce compliance with law, legal penalties must be consistent with citizens’ intuitions of desert.  That is, the public must believe the law is fair and reasonably enforced if they are to be expected to obey it. 

This insight from criminal law can also be applied to the corporate liability context, where the corporate officials who breach their fiduciary duties or violate securities laws can face the prospect of harsh monetary penalties.  In each instance, the financial penalty is measured by harm caused to the corporation and its investors, a figure which can easily run into hundreds of millions of dollars. 

This specter of draconian penalties for corporate law violations has led to a peculiar reality that corporate officers and directors almost never personally pay damages for their violations of law.  Instead, such penalties are averted through a number of protective legal doctrines and through insurance and indemnification provions which ensure that third parties almost always pay costs associated with defending corporate officials against charges of wrongdoing.

In my article Law, Norms, and the Breakown of the Board I argue that a new approach is needed to enhance the legitamacy of corporate law rules and promote law compliance by corporate officials.  Moderate penalties, applied more consistently would likely fit the bill.  To be effective, such penalties must directly affect culpable actors.  We should therefore should require corporate wrongdoers to pay personally at least a portion of the penalty for the legal violation.  Requiring personal payments from culpable corporate officials can be accomplished through changes in D&O insurance policies and practices, or through reforms of the litigation settlement process.  In particular, judges can reject settlements of shareholder lawsuits that do not provide for personal payments when there is credible evidence of wrongdoing by individual defendants.

William Buzbee, Asymmetrical Regulation: Risk, Preemption, and the Floor/Ceiling Distinction

June 7, 2007

William Buzbee of Emory Law School has posted a thoughtful and interesting article on SSRN.  The article, Asymmetrical Regulation: Risk, Preemption, and the Floor/Ceiling Distinction, draws a distinction between federal preemption that creates a regulatory floor, allowing states to adopt more stringent standards and federal preemption creating a ceiling, prohibiting states from setting higher standards.  Buzbee argues that “ceiling” preemption is more problematic than “floor” preemption, an observation he views as underemphasized in the literature.

Although his article focuses on environmental, tort and health and safety regulation, Buzbee’s analysis is highly relevant to ongoing debates on the effect of federal securities laws on state regulatory power, and in particular, the wisdom of arguments favoring federal preemption of state authority to enforce their securities laws.  Here is the abstract:

If the federal government has constitutional power to address a social ill, and hence has power under the Supremacy Clause to preempt state, local, and common law regimes, is there a principled rationale for distinguishing federal standard setting that sets a federal floor or ceiling? At first blush, the two appear to be mere flip sides of the same federal power, only distinguished by their different regulatory preferences for a world of minimized risk (with floors) or higher levels of risk (with ceilings). This Article argues, however, that these two central regulatory choices are fundamentally different. Floors embrace additional and more stringent state and common law action, while ceilings actually are better labeled a “unitary federal choice” due to how they preclude any more lax or more stringent action as well as the different actors, incentives, and modalities of information elicitation and proof of common law settings. Advocates of less hindered markets respond that this is precisely the idea–regulatory certainty is enhanced with ceiling preemption, allowing producers of goods to plan with confident knowledge of the regulatory terrain, unbuffeted by an array of uncoordinated actors.

This debate was, until recently, largely hypothetical. Recently, however, in settings as diverse as product approvals, to regulation of risks posed by chemical plants, to possible legislation regarding greenhouse gases contributing to climate change, legislators and regulators have suggested or asserted such a broad, preemptive impact. The federal action, whatever it is, would be the final regulatory choice. But under what theory of regulation and legislation can one be confident that locating all decisionmaking power in one institution at one time will lead to appropriate standard setting? In fact, advocates of risk regulation, “experimentalist regulation” scholars, and, at the other end of spectrum, skeptics about the likelihood of public-regarding regulation, all call for attention to pervasive risks of regulatory failure. Agency and legislative inertia, information uncertainties and asymmetries, outdated information and actions, regulatory capture, and a host of other common regulatory risks create a substantial chance of poor or outdated regulatory choice.

Considering these pervasive risks of regulatory failure, the principled distinctions between floor and ceiling preemption become apparent. Vesting all decisionmaking power in one institution can freeze regulatory developments. Unitary federal choice ceiling preemption is an institutional arrangement that threatens to produce poorly tailored regulation and public choice distortions of the political process, whether it be before the legislature or a federal agency. Floor preemption, in contrast, constitutes a partial displacement of state choice in setting a minimum level of protection, but leaves room for other actors and additional regulatory action. Floors anticipate and benefit from the institutional diversity they permit. This Article closes by showing how the institutional diversity engendered by retaining multiple layers of law and regulatory actors creates conditions conducive to reassessment and adjustment of often rigid or outdated regulation.

Matteo Migheli, Trust, Gender and Social Capital: Experimental Evidence from Three Western European Countries

June 6, 2007

Still more on the link between gender and trust and its potential implications for board governance.  Matteo Migheli (University of Turin and Catholic University of Leuven) has posted an article to SSRN entitled, Trust, Gender and Social Capital: Experimental Evidence from Three Western European Countries.  His study looks at differences between men and women in trusting and investment in social capital.  He seeks to determine if lower levels of trusting by women can be attributed to a lower investment in social capital (i.e., networking).  The study conducted in three different European countries finds that women invest less in social capital, but the lower levels of social capital do not fully explain gender differences in trust.  Here is the abstract:

The economic literature has discussed the links between trust and gender, and trust and social capital. Given that some empirical evidence shows also that gender and trust are somehow related and specifically women tend to trust less than men, I try to investigate the effect of social capital on generalized trust, controlling also for the “gender effect”. This latter could be due to the fact that women are less prone to invest in social capital than men, as the literature highlights. Using the tools of experimental economy, I performed the same experiment in Oslo, Leuven and Torino, in order to obtain a mixed Western European sample. In this one I included Scandinavia, Central and Mediterranean Europe. My measure of social capital is more complete than the usual one: I add informal networks (such as phone conversations, time spent with friends, etc.) to formal ones (basically voluntary associations). Analysing the obtained results through both comparisons of conditional means and econometrics, I find out some influence of social capital on trust. Furthermore, also after controlling for social capital, gender differences persist still. Thus I can conclude that behavioural differences due to gender are not a mere reflex of different investments in social capital. I also found evidence that some kinds of formal and informal networks exert positive influence on generalized trust.

Erica Beecher-Monas, Marrying Diversity and Independence in the Boardroom: Just How Far Have You Come, Baby?

June 5, 2007

Following up on last week’s post on Joan Heminway’s recent article Sex, Trust and Corporate Boards, Erica Beecher-Monas also has an article on SSRN that explores the potential impact of diversity and independence on board decisionmaking.  The article is titled Marrying Diversity and Independence in the Boardroom: Just How Far Have You Come, Baby?  Here is the abstract:

Corporate governance reform, with its focus on agency costs, and corporate diversity, with its emphasis on social equity, would appear to have little common ground, other than the corporate setting. Both strands of reform, however, share an important goal: improved functioning of the corporation through more active decisionmaking by its board. The spectacle of boards asleep at the wheels of governance jarred Congress into action in the wake of the multibillion dollar Enron/Worldcom string of debacles. Despite massive regulatory changes in corporate governance mandated by Sarbanes-Oxley, however, skyrocketing executive compensation, backdating of options, and mis-reporting of financial statements continue to command the news. This article examines the theoretical and empirical basis for independence as a solution to director dereliction of monitoring duties, and posits that the lack of empirical support for independence may be due to a definitional quandary, and that defining independence as mere absence of financial conflicts rather than diversity of opinion may be the root of the problem.

This article takes an interdisciplinary approach to accountability of large publicly held corporations, using economics and cognitive insights into human rationality to assess the role of law in structuring human interactions – in this case focusing on the decision making processes of directors of large publicly held corporations. In particular, this article examines the Sarbanes-Oxley Act’s corporate governance solution of emphasizing the role of independent directors in the firm. This article further explores the psychology of small group dynamics, examines the inherent problems of homogeneous groups, and suggests ways in which diversity of opinion mitigates the effects of small group dynamics. My article recognizes that the trust fostered by homogeneity has the dark side of quashing dissent, and suggests ways to overcome resistance to diversity. This article concludes that nourishing a culture of dissent is the foundation for the kind of decisionmaking that leads to effective monitoring, and that while gender and ethnic diversity are no guarantors of diverse viewpoints, they are a good place to start in creating the kind of board culture that will begin to take its monitoring duties seriously.

Has the Justice Department Achieved what the PSLRA Could Not?

June 1, 2007

Today’s New York Times reports that famed securities plaintiffs attorney Bill Lerach may leave the firm he founded three years ago.  Lerach is the lead attorney in the ongoing Enron securities litigation and has already recovered $7.3 billion for shareholders in the case. Here is the story: Top Lawyer, Under Fire, May Depart.

The Times reports that Lerach’s expected departure may be part of a deal to spare his firm an indictment in connection with an ongoing investigation into allegations of kickbacks paid to securities class action plaintiffs.  Lerach’s former firm, Milberg Weiss, and two of its former partners are currently under indictment in connection with the alleged scheme.

If the Times reports are true, there is a certain irony in the trajectory of Lerach’s career since Congress adopted the Private Securities Litigation Reform Act of 1995 (PSLRA), a bill said to be designed to put Lerach out of business.  Instead, the PSLRA only served to strengthen Lerach’s position as the top securities litigator in the country. 

More ironic is the fact that the PSLRA’s lead plaintiff provisions should have eliminated any temptation to “bribe” individual shareholders to serve as class action plaintiffs.  Under the lead plaintiff provisions, institutional investors with the largest stake in shareholder suits became the most attractive potential clients.  Many such investors are willing to pay plaintiffs firms to monitor their portfolios and, due to their significant stakes in the corporations, should need little inducement to serves as lead plaintiffs in securities litigation.

So, the PSLRA which was designed to destroy Lerach did not, and the practice of relying on “professional plaintiffs” that the PSLRA was designed to eliminate may yet lead to his downfall.


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