Traditionally, American states have regulated the sphere of corporate governance, encompassing the relations among and between a corporation, its directors, its officers, and its stockholders. With respect to publicly-held companies, Delaware, known as the jurisdiction with an expert judiciary in company law, sound precedent and legislative flexibility, reigns supreme as the state where the greatest number of such enterprises incorporate. Statutes and court decisions focusing on shareholder agreements, duties owed by corporate directors and officers, M&A “deals”, and shareholder remedies exemplify the prevalence of state law with respect to corporate governance matters.
Today, state law is not the only source of corporate governance legal standards. With the passage of the Sarbanes-Oxley Act of 2002 (SOX) and the Dodd-Frank Act of 2010, federal law now plays an integral role in this process. Pursuant to these Acts and their implementation, for example, audit and compensation committees must be comprised entirely of independent directors, shareholders are entitled to advisory say-on-pay votes on management compensation, and companies generally may not extend loans to officers and directors. In addition, the national securities exchanges, charged with implementing several of the SOX and Dodd-Frank corporate governance directives, provide meaningful input.
Clearly, these Acts, along with the promulgation of SEC and stock exchange requirements, have further federalized corporate governance. Significantly, however, this process began in 1934 with the enactment of Section 16 of the Securities Exchange Act—requiring directors, officers, and shareholders (who beneficially own more than ten percent of a subject company’s equity securities) to disgorge their profits from purchases and sales, or sales and purchases of such equity securities that occur within a six-month period. In addition, these insiders are prohibited from engaging in short sales of the company’s equity securities. By engaging in substantive insider trading regulation—namely, conduct that otherwise would come within the purview of state law scrutiny—Congress initiated this federalization journey.
Today, a new landscape has emerged. The federalization of corporate governance—a concept that earnestly began over a century ago— is firmly entrenched.
Indeed, at the beginning of the 20th century, numerous bills were introduced in Congress seeking to require that subject companies incorporate under federal law or implement federal minimum standards regarding fiduciary conduct. The most recent such bill was sponsored in 1980 by Senator Howard Metzenbaum. Although none of these bills were enacted, they illustrate that the federalization of corporate governance is a long-standing concept.
As evidenced by the Securities Exchange Act, Congress selectively opted to federalize aspects of insider trading. Not long thereafter, the SEC engaged in this federalization process by adopting the shareholder proposal rule in 1942. Having celebrated its 75th anniversary in 2017, the rule provides a key example of SEC rulemaking to ameliorate state shortcomings. Although the parameters of shareholder voting rights remain largely a matter of state law, the SEC elected to federalize a shareholder’s entitlement to make eligible proposals to one’s fellow shareholders. The shareholder proposal rule thus serves as a vintage example of federal corporate governance.
Returning to insider trading regulation, disappointed with laxity by the states, the SEC sought to federalize insider trading far beyond the express provisions of the Securities Exchange Act. A 1961 administrative decision (In re Cady, Roberts, 40 SEC 907) partly achieved this objective. Seven years thereafter (SEC v. Texas Gulf Sulphur Co., 401 F2d 833 (2d Cir. 1968)), a major appellate court confirmed the SEC’s position by adopting a broad insider trading prohibition. Although the US Supreme Court subsequently has narrowed the scope of the insider trading proscription, importantly, improper insider trading remains firmly entrenched under federal law.
As another example, over 50 years ago, the SEC sought to affect fiduciary substantive conduct under the guise of disclosure (Franchard Corp., 42 SEC 163 (1964)). Today, by requiring disclosure to shareholders and the securities markets of executive compensation, self-dealing transactions, prior illegal conduct, and business experience, the Commission seeks to induce corporate fiduciaries to act in a more shareholder-protective manner. Although insider excesses continue with some frequency, undoubtedly, the Commission’s disclosure regime has instilled enhanced standards of normative fiduciary conduct.
In closing, two other examples are presented. Disappointed with the US Supreme Court’s decision in Santa Fe Industries (430 US 462 (1977))—holding that Section 10(b) of the Securities Exchange Act does not reach misconduct that is neither deceptive nor manipulative—the SEC promulgated a rule requiring that in a going-private transaction the subject party must disclose whether, in its view, the transaction is fair or unfair to minority shareholders and the reasons supporting that position. By focusing on disclosure, rather than substantive fiduciary conduct, the Commission complied with its rulemaking authority. Nonetheless, the impact of disclosure in this setting directly affects the manner in which valuation determinations are ascertained in such cash-out transactions.
As the last example, displeased with a Delaware Supreme Court decision (Unocal, 493 A2d 946 (1985))—holding that a target company’s directors were acting properly when authorizing the making of a discriminatory self-tender offer that excluded the hostile bidder—the SEC responded by adopting a rule prohibiting the use of such exclusionary tender offers. Thus, in practical effect, the Commission overruled the Delaware Supreme Court. In doing so, the SEC federalized an aspect of tender offer regulation that previously had been within the sole purview of state corporate governance.
Today, a new landscape has emerged. The federalization of corporate governance—a concept that earnestly began over a century ago— is firmly entrenched. In this respect, the SOX and Dodd-Frank Acts may be understood as further measures—indeed, major undertakings—in this evolutionary process.
Featured image credit:'”Wisconsin State Capitol Building,” by Pauliefred. Public Domain via Wikimedia Commons.