Regulatory Realism from the Judicial Branch

This fall 7th U.S. Circuit Court of Appeals Chief Judge Frank Easterbrook spoke at my law school (University of Virginia), on the subject of corporate regulation.

Easterbrook had some interesting thoughts, throwing Delaware into the mix, along the lines that post-Enron federal regulations have not improved corporate governance and have predictably caused negative unintended consequences.

I would dare suggest such consequences are owing to the very nature of myopic one-size-fits-all regulatory schema crafted by purely-reactive politicians.

Add to this that they never ever bother to revisit and oversee the real results of their hodge-podge regulatory binges....until of course their mal-effects reach critical mass....prompting yet more reactive regulatory mania.

“If the mandatory rules turn out to be bad ones, investors lose. The national government, in other words, can win a race to a bottom in a way that states cannot,” Chief Judge Frank Easterbrook of the 7th U.S. Circuit Court of Appeals told a packed Caplin Pavilion on Sept. 26.

Easterbrook was the keynote speaker at a Virginia Law Review-sponsored symposium commemorating the 75th anniversary of the Securities and Exchange Commission. In a speech titled “The Race for the Bottom in Corporate Law,” Easterbrook analyzed competing theories of corporate regulation.

In the 1960s and 1970s, the conventional wisdom was that investor interests were being disregarded as state governments watered down regulations in an effort to lure companies to incorporate in their states, Easterbrook said.

“The dominant academic view in the 1970s was that Delaware had waged and won a ‘race for the bottom’ in corporate law by offering more favorable terms to corporations,” he said.

But Ralph K. Winter, now a judge on the 2nd U.S. Circuit Court of Appeals, turned that notion on its head in a 1977 article in which he concluded that investors were actually well-served by corporations that sought out the most favorable regulatory environments, Easterbrook said.

“What Judge Winter asked was ‘How could everybody be so stupid?’ If managers can exploit scattered investors by incorporating in Delaware, why doesn’t everybody know it?”

Winter was among the first to use data analysis to support his hypothesis, Easterbrook said, and his paper resulted in a dramatic shift in the perception of state regulation.

“There is a race, and Judge Winter concluded that investors are winning,” Easterbrook said.

The Sarbanes-Oxley Act passed in the wake of Enron’s collapse had a huge affect on corporate governance, the judge said. The massive and complicated act essentially did three things, he said.

First, it required equal and fair disclosure of corporate information. When taken with other SEC rules, these requirements prevent preferential disclosure of information.

“There are benefits in speedier disclosure, but this regulation makes it very hard to do,” Easterbrook said.

The act also requires that publicly traded corporations have independent governing boards and independent committees tasked with choosing auditors and setting executive compensation.

“The idea is that insiders forced to justify themselves to skeptical independents will be better servants of investors interests. Well, that may or may not be so.

“My suspicion is that independent directors might as well be relabeled ‘ignorant directors,’” Easterbrook said. “If you go there and spend enough time to understand what’s really going on at this firm, you will no longer be independent because you will be an employee of the firm.”

Even if this mode is typically the best type of governance, it’s a mistake to require that all firms use it, he said.

“Vanilla ice cream is the best for most people most of the time. It is far and away the most popular flavor. But nobody thinks that society would be better off if every other flavor were forbidden by federal law.”

Sarbanes-Oxley also required much more extensive auditing by accountants. The SEC estimated this would increase costs by about $91,000 per reporting company. The real costs, however, are more like $7.8 million per company, he said.

“Normally you’d be able to expect the government to get things right within an order of magnitude, but that just wasn’t the case.”

In general, small, tightly focused interest groups are better able to get legislation pushed through than larger groups, he said. But Sarbanes-Oxley doesn’t benefit investors, corporations or the government, he said.

“Ah, but the accounting profession and professional outside directors are something else.”

The accounting profession has learned that it can get benefits at the national level by lobbying for legislation, he said.

“The Sarbanes-Oxley act roughly doubled the amount corporations pay for accounting services. Does it surprise you that after multiple scandals reveal that the accountants haven’t caught the frauds and aren’t doing very well for investors, that Congress passes a law that requires you to spend twice as much on accounting? Why buy twice as much of a good that has been revealed to be of low quality?”

Easterbrook said the great irony of the Sarbanes-Oxley Act is that it requires corporations to be set up exactly like Enron, which had an independent board of directors and extensive outside auditing by a firm that after-the-fact examination revealed was more diligent than many of its peers.

So what is to prevent a new race to the bottom ? Easterbrook said one answer lies in the fact these regulations are not being conducted by, or for the benefit of, managers.

“The managers continue to want a good governance system. The question is, to what extent do the constraints imposed by federal regulation make it impossible?”

Firms have become much more adept at removing themselves from federal and state regulation, he said. There is also the fact that the world market is more developed than it once was, and corporations can shop outside the country for more favorable regulation.

“That may mean that if bad corporate governance pops up in the United States, it could be good for markets as a whole,” Easterbrook said.