The Risks to Private Enterprise from Federal Preemption of State Corporate Law

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on Friday December 18, 2009 at 9:27 am
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Editor’s Note: Peter Atkins is a Partner for Corporate and Securities Law Matters at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden client memorandum, and follows up on matters raised by Mr. Atkins in this post on the Forum regarding his article entitled Raising the Bar.

The current multi-pronged effort for U.S. federal preemption of state corporate law, particularly in the area of corporate governance, is largely predicated on the view that it is necessary to forestall excessive risk-taking in the private sector. However, the federal preemption “cure” is a carrier of its own systemic disease. Before imposing this “cure,” it is essential to make a responsible assessment of its need and consequences.

State Regulation of Public Business Corporations: A Cornerstone of Capitalism

The modern U.S economic system — variously called capitalism, free enterprise or private enterprise — is centered around the publicly traded business corporation organized under state law. It is the principal vehicle for gathering non-government capital, investing it and managing the businesses in which it is invested. Historically, the governance of these companies has been regulated by their states of incorporation, with limited exceptions. And, in general, the state law-based corporate governance model has been very respectful — indeed protective — of the core concepts of the U.S. private enterprise system: freedom, capital raising, risk-taking, experimentation, innovation and value maximization. The model recognizes that publicly traded business corporations, as key enablers of the U.S. capitalist system, should be regulated in a manner which permits these core private enterprise concepts to operate with minimal interference.

The Price of Free Enterprise Is Eternal Vigilance

Economic systems can crash and burn — as we recently almost witnessed. Fortunately, the mechanisms in place and those that were quickly added permitted a rescue operation that averted the abyss.

However, economic systems also can die due to changes imposed on them and the vitality-sapping effects of such changes over time. The U.S. private enterprise system has worked remarkably well for more than 200 years. The fundamental productivity, creativity, adaptability, growth capacity, power and global leadership of our economic system cannot be denied. Like all systems, however, America’s free enterprise economy faces the constant danger of systemic erosion due to (1) the failure of vigilance in continuing to recognize its importance and what makes it tick and (2) the desire to “improve” the system without identifying and carefully weighing the downside to the system of the improvements. Systemic erosion is a creeping phenomenon, without red flags flashing danger signals. Moreover, such erosion is susceptible to acceleration when systemic speed bumps occur (as is inevitable) and, in response, a heightened sense of the need for repair takes over (augmented, often, by political and special group agendas).

The Current Danger Zone

The U.S. appears to be in that danger zone right now. However, before examining that zone in greater detail, it needs to be noted that the thrust of this article is not a rant against government intervention in economic matters. The U.S. free enterprise system has never been perfectly free, nor should it be. Clearly there is a role for government regulation and oversight. And times of crisis can point out areas where a larger role is appropriate on a temporary basis and, in some cases, longer term.

That said, today’s reality is not about the need for federal preemption of corporate governance regulation under state law. Yet, here is what seems to be happening. In the aftermath of the financial system crisis of 2008, the publicly traded business corporation has come under siege by the federal government. The main assertion is that the near collapse of the financial system was the product of excessive risk-taking by corporate America, permitted by lax directorial oversight and incentivized by excessive compensation practices. The proposed cure is federal preemption of corporate governance by enacting in Washington a raft of uniform federal “good governance” requirements for U.S. publicly traded business corporations. What seems to be missing is adequate identification and a true appreciation of the near and longer term adverse effects that could flow from these requirements.

It is not difficult to ask many questions that need to be answered before federal preemption is implemented — and the answers to these questions should have a direct bearing on whether any steps are taken in that direction and, if so, which ones. These questions include:

  • Did U.S public company boards and businesspersons really cause the financial crisis of 2008? What about all of the companies that were not part of the financial sector — were their directors and executives even involved? And what about the failure to regulate the financial markets in order to guard against “excessive risk” — was that a failure of private enterprise or of the federal government, including existing oversight agencies?
  • Is there any demonstrable correlation between any of the proposed federally-imposed corporate governance “fixes” and reining in “excessive risk-taking” — or even, for that matter, producing significantly better governance for all public companies? [1] Even if so, is such improvement necessary to avoid material systemic risk to the U.S. free enterprise system?
  • In the absence of a clear showing that it will result in the avoidance of material systemic harm, what is the justification for federal government preemption of corporate governance under state law?
  • Have the proposed “fixes” been individually critiqued for the possibility of causing harm to the private enterprise system? If so, what is the assessment? For example, what is the potential negative effect of the increased empowerment of shareholders vis-à-vis directors on the need for risk-taking by directors as an essential element of capitalism and on the willingness of directors to serve on public company boards?

The Need for and Meaning of Responsible Assessment

The basic message is this: In assessing the need for and nature of governmental intervention to effect reforms today in our economic system, the federal government (both the executive and legislative branch) has a special duty to act responsibly. Acting responsibly should mean at least the following:

  • Understanding — and placing a high priority on — the critical importance of the U.S. private enterprise system to America and all of its people.
  • Understanding — and guarding against unnecessary damage to — the core concepts on which the U.S. private enterprise system rests: freedom, capital raising, risk-taking, experimentation, innovation and value maximization over time.
  • Requiring (except for emergency actions in a time of crisis, which clearly is not present now) that every act of government intervention intended to affect the existing U.S. economic system undergo a rigorous economic impact assessment.
  • Applying in such assessments a principle of restraint in the form of a presumption against intervention unless it is shown:
    • (a) that the harm to be mitigated by the intervention is systemic and substantial,
    • (b) by credible evidence, that the intended mitigation is very likely to be achieved, and
    • (c) that the adverse effects, if any, of the intervention are not likely to have as great or greater systemic impact than the benefit to be obtained by the intervention.

A Final Word

The message from Washington to corporate America appears to be: “You have a responsibility to stay alert, make informed decisions and not put at risk the system on which we all rely.” If there was ever a time when Washington — the White House, the Senate, the House of Representatives, the Securities and Exchange Commission and other federal agencies — should heed its own advice, it is right now in relation to the attack by Washington on a cornerstone of capitalism, state regulation of public business corporations. And when Washington considers applying its medicinal powers to “cure” systemic ills, it should pay close attention to the medical aphorism, “First, do no harm.”

Endnote:

[1] These proposed “fixes” were summarized in Raising the Bar as follows:

  • greater empowerment of shareholders vis-à-vis directors (e.g., mandatory majority voting in the election of directors, requiring shareholder access to company proxy statements in the election of directors, eliminating classified boards, granting shareholders the right to call special meetings, requiring cumulative voting and mandating annual “say-on-pay” votes by shareholders);
  • increased public disclosure about directors (e.g., regarding their experience, qualifications attributes and skills), about pay practices (e.g., disclosure of specific performance targets for incentive compensation, and disclosure regarding compensation paid to the lowest and highest paid employees and related matters) and about risk-taking (e.g., discussion and analysis of risk-related overall compensation policies and practices for employees generally, if the risks arising from those policies and practices” may have” a material affect on the company, and disclosing the relationship of a company’s overall compensation practices to risk management);
  • mandating certain board structural requirements (e.g., that every board have a risk committee, and that every board separate the board chair and CEO positions, and that the chair be independent); and
  • mandating certain specific pay practices (e.g., barring severance agreements for executives terminated for poor performance, requiring that executives hold equity awards until retirement, and requiring companies to develop and disclose claw-back policies).

(go back)

  1. The preemption of state corporate law by the federal government is a necessary step to correct failures in public company governance that the states have not corrected.

    The states have shown a greater willingness to protect corporate agents and entities at the expense of the share owners. And, with the application of the ‘business judgment rule’, the states have give these agents an extraordinarily free hand to transfer share owner wealth to themselves.

    For share owners, federalization is the answer, not the problem. Of course, this post is a client memorandum and Mr. Klein can be expected to defend his clients position. He is paid to do so.

    Comment by JGP — December 18, 2009 @ 10:51 am

 

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