The Federalism of State Corporate Law
Historically the regulation of corporate law has been firmly within the power and authority of the states. However, over the past few decades the federal government has become increasingly active in matters of corporate governance. Typically this occurs in waves as a response to periods of scandal in specific business sectors or in the financial markets. Traditionally, when the federal government intervenes in these situations, they enact regulation either directly or indirectly by imposing upon state corporate regulations.
Specifically, the predominant method of federal regulation of corporate governance is through the enactment of mandatory terms that either reverse or preempt state laws on the same point. The most recently prominent example is the passing of the Sarbanes Oxley Act of 2002 (SOX).
Sarbanes Oxley (SOX)
SOX regulates corporate governance in five matters: (i) SOX prevents corporations from engaging the same accounting firm to provide both audit and specified non-audit services; (ii) SOX requires that audit committees of listed companies be composed entirely of independent directors and to disclose which such directors are financial experts; (iii) SOX requires that the corporation’s CEO and CFO certify that the periodic reports do not contain material misstatements or omissions and that the financial statements are accurate; (iv) SOX compels forfeiture of CEO and CFO incentive compensation in the event of an earning restatement; and (v) SOX bars corporations from making loans to executive officers.
Each of these provisions requires the corporation to govern itself accordingly, regardless of whether the board of directors deems the actions to be a useful deployment of resources and regardless of the individual facts and circumstances surrounding that corporate entity. Such provisions limit the ability of directors to negotiate, research and agree to corporate actions that solve and address the unique challenges faced by their individual organization. That is, each of these mandates directly contradicts the essence of state corporate governance.
Delaware and Model Act
State corporate law is generally based on the Delaware and Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances. The traditional fiduciary duties that govern state corporation laws include the duties of care and loyalty and are tempered by the business judgment rule.
Duty of Care
The duty of care requires that directors exercise the same level of care that would be expected from an ordinarily prudent person in the conduct of his or her own affairs. This includes making an informed decision, seeking the advice of experts when necessary and considering both the positive and negative impacts of a decision. The duty of loyalty is essentially a proscription against conflict of interest and self dealing. The business judgment rule basically says that if a director follows both his duty of loyalty and duty of care, than the decision should be deferred to.
Although the federal government may have the right motives in enacting regulations which effect corporate governance, there is always controversy when they cross “sate lines.” State regulators and judiciaries are usually the best posture to establish and enforce corporate governance regulations. It is a given that director actions that result in a fraud upon shareholders and investors is actionable under federal (and state) securities laws, however, it is still questionable as to whether the federal government is the proper regulatory authority to set forth particular mandates of director responsibility.
Delaware Corporations Act
The Delaware Corporations Act together with decisions of the Delaware Court of Chancery provides a reliable source for corporate governance matters. These state laws allow for the quick response to emerging problems in a way that the strict mandates of the federal government cannot.
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