Saturday 4 October 2008

USA: "The Race for the Bottom in Corporate Law" - Frank Easterbrook

The Virginia Law Review recently held a symposium to mark the 75th anniversary of the Securities and Exchange Commission (SEC). The keynote address, titled "The Race for the Bottom in Corporate Law", was delivered by Chief Judge Frank H. Easterbrook of the United States Court of Appeals for the Seventh Circuit. Within corporate law scholarship, Judge Easterbrook is perhaps most well known for his book The Economic Structure of Corporate Law, co-authored with Daniel Fischel (considered here).  The following outline of Judge Easterbrook's speech is taken from Virginia Law Weekly (the Virginia Law School newspaper):

The primary focus of Easterbrook’s talk was the application of Judge Ralph Winter’s hypothesis regarding broad state regulation of corporations, particularly of corporate governance. Winter had argued that increased discretion in the hands of corporate managers would, in the end, enable them to design the governance measures that investors want the most. Easterbrook pointed out that economic event studies in the last 20 years or so had confirmed this: securities prices would rise and fall depending on different structures of governance, and investors could indeed move to those forms which they found most attractive.

The national government, however, has been “hampering the market of corporate control” in recent years. Easterbrook singled out the Sarbanes-Oxley Act passed in the wake of the Enron and WorldCom scandals as the major culprit, although he also targeted the recently imposed limits on short sales and changes to the tax code. Sarbanes-Oxley, Easterbrook argued, mandated corporate governance structures that often set up an “adversarial mode of corporate governance” that made little sense for the companies forced to adopt them and were, ironically, not at all what investors wanted.

Worse, Easterbrook argued, the “national government could win a race to the bottom in a way that the states cannot,” since in “moving toward a national system of corporate governance,” corporations could not simply change to another jurisdiction’s corporate law if dissatisfied with federal requirements. Easterbrook argued that in theory there are four basic models of corporate governance, and that any one could be appropriate for a corporation at a given time. “A reduction in [this] opportunity set,” the judge concluded forcefully, “makes everyone worse off, all the time—and that’s what the Sarbannes-Oxley Act has done.” As further evidence, he noted that event studies indicated that the Act actually depressed stock prices, and that Enron was, in fact, a model corporation under the governance terms of the Act.

Easterbrook had some suggestions on what might happen as a result of the “Race to the Bottom.” He noted that many firms are “opting out” of the system by becoming private and thereby removing themselves from regulation. He also argued that the international market could supply a response to Sarbanes-Oxley, the ultimate result of which may be the flow of capital to other countries with more desirable governance regulations.

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