The Creeping Federalization of Corporate Law: The Saroanes-Oxley Act Extends Washington's Oversight of Corporate Governance Practices but Offers Questionable Benefits to Investors. (Securities & Exchange)

Article excerpt

THE NEW MILLENNIUM HAS NOT BEEN kind to Wall Street. In 2000-'01, the stock market recorded back-to-back years of losses for the first time since 1973-74. With a further loss in 2002, the market fell for three consecutive years for the first time since the Great Depression.

On top of the continuing retrenchment of the economy following the late '90s bubble, concerns over terrorism and the Middle East, and uncertainty over oil, investor confidence remains shaky in the wake of last year's corporate governance revelations. We all know the litany: repeated accounting scandals, of which Enron and WorldCom are merely the most notorious; a high profile investigation by New York's attorney general calling into question the integrity of stock market analysts; and so on.

In such an environment, it was inevitable that Congress and the Securities and Exchange Commission would step in to ease investors' fears. But how quickly we forget Ronald Reagan's adage: "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help."'

In responding to the Enron and WorldCom scandals, Congress and the regulators have implemented a set of reforms that are deeply flawed. They have adopted policies that have no empirical support or economic justification. Worse yet, in doing so, they have eviscerated basic federalism rules that have long served us well.

For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states. To be sure, over the years, there have been countless proposals to federalize corporate law. To date, however, none have succeeded.

The collapse of Enron and WorldCom, along with the varying degrees of fraud uncovered at too many other companies, reinvigorated the debate over state regulation of corporate governance. Many politicans and pundits called for federal regulation not just of securities but also of internal corporate governance, claiming it would restore investor confidence in the securities markets. As Congress and market regulators began implementing some of those ideas, there has been a creeping--but steady -- federalization of corporate governance law. The NYSE's new listing standards regulating director independence are one example of that phenomenon. Other examples appeared to little public debate in the sweeping Sarabanes-Oxley legislation. Taken individually, each of Sarabanes-Oxley's provisions constitutes a significant preemption of state corporate law. Taken together, they constitute the most dramatic expansion of federal regulatory power over corporate governance since the New Deal.

WHO REGULATES CORPORATIONS?

No one seriously doubts that Congress has the power under the Commerce Clause, especially as it is interpreted these days, to create a federal law of corporations if it chooses. The question of who gets to regulate public corporations thus is not one of constitutional law but rather of prudence and federalism.

Until the New Deal, corporate law was exclusively a matter for the states. Around the beginning of the last century, however, economic progressives began arguing for federal preemption -- frequently in response to various corporate scandals of the day. After the Great Crash of 1929, serious consideration was given to creating a federal law of corporations.

The New Dealers' initial response to the Crash, of course, consisted of the now familiar federal securities laws. The key statute here is the Securities Exchange Act of 1934, which critics claimed was a federal attempt to usurp corporate governance powers. On its face, however, the Exchange Act says nothing about regulation of corporate governance. Instead, the Act's basic focus is trading of securities and securities pricing. Virtually all of its provisions are addressed to such matters as the production and distribution of information about issuers and their securities, the flow of funds in the market, and the basic structure of the market. …