INTRODUCTION :: By all accounts, the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) represented a significant intrusion by the federal government into the substantive regulation of corporate governance of U.S. public companies, an area long considered to be the province of state corporate law. Among other things, Sarbanes-Oxley and the accompanying rules of the Securities and Exchange Commission (SEC) and self-regulatory organizations (SROs) like the New York Stock Exchange (NYSE) instructed boards of directors how to monitor senior executives of their companies and imposed new duties and restrictions upon those executives. This kind of substantive, even paternalistic, regulation of a public firm’s corporate governance brings to mind the federal banking agencies’ regulation of national and state banks and bank and financial holding companies. Bank regulators screen proposed executives and directors of a new bank and may not allow the bank to begin operations if they disapprove of some or all of these individuals. They set standards of conduct for bank officers and directors and continue, through regular examinations, to monitor them and their performances. Moreover, bank regulators have considerable informal and formal enforcement powers; they can even remove executives and directors, temporarily or permanently, from a financial institution or from the entire banking industry. Indeed, in Sarbanes-Oxley Congress borrowed part of its regulation of public company management from banking law.
In this Article, I contend that Sarbanes-Oxley represents a significant step in the ongoing development of a paternalistic federal regulation of public firm management that is in certain respects comparable to the regulation of bank and bank holding company management by federal banking agencies. However, I argue that the regulation of public firm management, as it has occurred, is too oriented towards the punishment of directors and officers. Federal regulation of bank management is all-encompassing, covering bank officers and directors from the time a bank begins its operations onward. The pervasive regulatory guidance and constant interaction, both informal and formal, between bank managers and regulators give the managers notice of the regulators’ expectations for their behavior and an early warning of regulators’ concerns and problems with it. The prescreening and ongoing monitoring thus justify the serious penalties that can be assessed against a bank officer or director by a bank regulator, whether through administrative proceedings or the courts, or by a U.S. attorney in a criminal prosecution.
By contrast, neither the SEC nor any SRO screens officers or directors of public companies. At the direction of Congress, the SEC and the SROs increasingly specify standards of conduct for these officers and directors. However, they do not monitor officers’ and directors’ compliance with the standards, inspect the firms or interact with them formally (or even informally) outside of enforcement and prosecutions. Despite this approach, which reflects the SEC’s jurisdictional limitation to the regulation of company disclosure, the SEC’s disciplinary powers over public firm management have grown, as has criminal liability for officers and directors. Those powers more and more parallel the powers of bank regulators over (and the criminal liability of) bank officers and directors. Officers and directors of public firms can be punished harshly even though they do not have the kind of ongoing, close relationship with the SEC and the SROs that their bank counterparts have with bank regulators.
This state of affairs leads to a quandary. As a theoretical and practical matter, the SEC and the SROs cannot replicate the prescreening, setting of standards and oversight of management provided by bank regulators. Public companies are in diverse industries and, in many cases, are exceedingly complex organizations. Thus, it would be difficult to find regulators and examiners who could competently prescreen public company officers and directors, set appropriate behavior standards for them, and then evaluate their performances. Indeed, bank regulators acknowledge the difficulty of standard-setting and monitoring for the management of the largest banking organizations; as a result, they are relying more on organizations’ self- regulation and even advocating the use of a disclosed, market-based monitoring of these organizations, especially as they become financial and even commercial conglomerates. Moreover, the all-encompassing bank regulation has itself not always deterred bank management scandals, and arguments can be made that the costs of this regulation do not justify its benefits.
Yet current corporate governance in public companies-i.e., the supervision and monitoring of executives by boards of directors-is unsatisfactory. Despite improvements to the boards’ abilities to govern over the last decades, including those derived from Sarbanes-Oxley, and despite the activism of institutional shareholders, directors often do a poor job of monitoring executives. Current corporate governance has been particularly ineffective in countering the excessively self-interested behavior of executives, as shown by the corporate scandals of the early 2000s. Boards of public firms often failed in their monitoring, although not because the directors’ motivations to perform well were inadequate or because there were technical, but easily resolvable, problems in governance arrangements. Rather, the failure often was due to the formation in public firms of a destructively cohesive group of senior executives, corporate advisors such as bankers, accountants and lawyers, and even some board members, led by the CEO. Influenced by a group mentality, an “inner circle” operated a firm for its own benefit. Social psychologists explain why these groups form and identify their typical failings, in particular their resistance and hostility to anything and anyone contradicting their views and behavior.
Social psychologists suggest that one way to prevent the formation of these perverse groups, or to break apart existing ones, is to involve in the monitoring of the groups an outsider who is loyal to an organization other than the groups and who, as a result, can resist the attraction of the groups’ circles. For public companies, this person would have to be someone not from the public company, nor from a professional firm providing services to it. One logical outsider is an employee or a representative of a government regulator like the SEC that is already involved in the regulation of public companies. This leads back to the issue of the substantive oversight of public company management, with the problem that the SEC is ill-suited to offer a complete paternalistic regulation.
The bank regulatory model could offer a solution to the problem of public company management regulation, even if the entirety of this model is not practical or desirable. One possibility is that the SEC could appoint a corporate governance monitor for certain public firms who would have a role like that of an examiner of a large bank or financial holding company. The SEC would hire, train, and oversee the performance of these monitors, who would be supervised by that part of the SEC’s Division of Corporation Finance responsible for their firms and industry. Among other things, a monitor would promote the development of professional standards in a board, assist the board in reviewing any conflicts of interest, look for “red flags” of serious management problems, and convey to directors and executives, on an ongoing and informal basis, any SEC concerns about their conduct. Interaction with the monitor would give executives and directors an opportunity to address any problems in their behavior before the SEC instituted formal enforcement proceedings or the Department of Justice began criminal action. The presence of the monitors “on the ground” in public companies would also enable the SEC to receive valuable information about companies and industries, which could improve overall company disclosure as the SEC becomes aware of, and demands corrections to, inadequacies in current disclosure.
This significant extension of SEC paternalistic regulation of public company management would be controversial and could be seen as a throwback to governance procedures in state-owned firms. The backlash against Sarbanes-Oxley is in full swing, and it is unrealistic to believe that any reform intrusive upon public company management would succeed in the present political climate. All aspects of the proposal should be debated and variations on it are imaginable, such as requiring only certain public firms to have monitors or allowing most firms to opt out of a monitor requirement. Even if the immediate success of the proposal is unlikely, it is important that proposals on public company governance be put forward, and kept alive if they are deserving, particularly since it can be argued that recent governance reforms, rather than going too far, did not go far enough in controlling public company management. The reform will have the added advantage of bringing into the open the paternalistic regulation that already is occurring through the SEC’s enhanced enforcement powers over public firm management and the increasing criminalization of management’s behavior, and of balancing this enforcement with guidance so that SEC regulation does not just punish firm executives without offering them any accompanying benefits.
This Article proceeds as follows. Part II offers a broad but brief overview of the history and current regulation of bank management under federal banking laws. It explains how all-encompassing it is: Bank regulators screen officers and directors, set standards of conduct for management, and monitor managers on an ongoing basis and exercise considerable informal and formal powers over them, including the power to ban an officer or director from the banking industry for life. Again from a broad perspective, Part III contrasts this comprehensive bank regulation of management with the limited regulation of public firm management authorized to the SEC by the federal securities laws. The SEC does little gatekeeping of public company officers and directors and sets few standards for their conduct. Since the late 1990s, however, as a result of waves of corporate scandals, there has been major growth in SEC and SRO regulation of public firm management. The SEC and SROs, along with federal prosecutors, have received significant powers to discipline and punish officers and directors. This Part also emphasizes how Sarbanes-Oxley, the SEC’s implementing regulations, and SRO rules pursuant to these regulations continue this process, and it discusses the reasons for the focus on enforcement. Part IV first argues that an SEC regulation that emphasizes enforcement with little gatekeeping, standard-setting, or ongoing relationships with firm management, is inappropriate and unfair. It then discusses the theoretical and practical reasons why the SEC cannot take on a complete regulatory role toward public firm officers and directors comparable to that of bank regulators to bank management. The next Part describes, from a social psychological perspective, the problem of the formation of inner circles in public firm management and the possible solution of an outside monitor. It sets forth a proposal (as well as possible modifications to it) that there be established corporate governance monitors in certain public companies, using the model of bank examiners in large complex banking organizations, and presents a few examples of existing monitors. Part V concludes the discussion.
April 2014, Vol. 66, No. 2
Sergio J. Campos, Class Actions and Justiciability
Andrew Guthrie Ferguson, Constitutional Culpability: Questioning the New Exclusionary Rules
Alberto R. Gonzales & Amy L. Moore, No Right at All: Putting Consular Notification in its Rightful Place After Medellin
Kevin J. Lynch, The Lock-in Effect of Preliminary Injunctions
Anne R. Traum, Using Outcomes to Reframe Guilty Plea Adjudication
Stephen E. Ludovici, Rule 60(b)(4): When the Courts of Limited Jurisdiction Yield to Finality