In one of his characteristically thoughtful blog postings (available here), Ed Fallone argues that market regulation follows the Second Law of Thermodynamics, which states (to paraphrase) that in any closed system, disorder will reign over time. Ed argues that this principle holds true for federal securities regulation, where technological and market changes have made the comprehensive statutory scheme of market regulation obsolete. With respect to non-financial institutions, he proposes (consistent with the Obama administration’s proposal) replacing our current scheme of detailed disclosure rules with regulation that focuses on the consumer (the investor), and the consumer’s need for multiple products to choose from as well as information to make product comparisons.
It does seem to make sense to consider the needs of investors in creating legislation aimed at protecting investors. But in my view, any new regulatory scheme aimed at protecting investors should leave to the states the regulation over business organizations’ internal affairs.
The following excerpt from Ed’s post aptly describes the purpose of federal securities laws:
“Federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities. The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision. Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.”
The Securities and Exchange Commission (SEC) oversees the implementation and enforcement of federal securities laws. It does this by interpreting federal securities laws as well as through rule-making. In fact the SEC has promulgated an extensive body of interpretive releases and rules that detail what information must be disclosed, how that must be presented and when and how it must be reported to investors, all with the objective of enabling investors to receive sufficient information on which to make investment decisions.
States, in contrast, have traditionally regulated the internal affairs of business entities organized in that state. Internal affairs refer to the relationships between and among the various constituents of a business entity. For example, in the case of a corporation, the corporation’s state of incorporation would regulate the rights and responsibilities of the corporation’s stockholders, directors and officers vis-a-vis one another. (Viewed more broadly, a corporation’s constituents also include its employees, creditors, suppliers, customers, and communities where it operates.)
States typically regulate internal affairs through a combination of statutory codes and common law. State codes typically provide a system of “default” rules governing an entity’s internal affairs. That means a business entity can modify these rules and opt for a different arrangement. (The codes also state who has the right to alter the default rules and how.) While most state codes do set forth some “mandatory” rules which may not be altered, by and large the internal affairs of business entities are regulated by a set of rules that function much like a private contract.
State common law supplements these codes, not only by offering judicial interpretation of the codes, but also by addressing matters that are not covered by the codes (often also as “default” rules). Importantly, in some states (including Delaware), the imposition of fiduciary duties on managers is almost exclusively a matter of common law.
There seem to be a number of benefits to state regulation over internal affairs. For one, the judicial promulgation of judicial standards on fiduciary duties provides a mechanism to flexibly apply those duties in light of relevant facts and circumstances. It also enables courts to modify fiduciary standards so that they reflect evolving business norms and mores. Moreover, the legislative and judicial use of default rules for most matters of internal affairs reflects the fact that no two businesses are alike, and allows for customization of internal affairs in a way that reflects the unique nature of each business. It also allows for the creation of innovative business structures.
In addition, having the states regulate internal affairs may lead to competition among states for charters. As some would argue, this competition leads to a “race to the top” because entrepreneurs and managers opt for the most efficient set of rules. Often that means choosing a jurisdiction where the “default” rules most closely approximate the desired internal affair structure to minimize costs of having to contract around those rules. Still, some would argue that having states compete for charters leads to a “race to the bottom”. That is because entrepreneurs and managers organize (or re-organize) entities in jurisdictions with rules that are the most protective of their rights and impose on them the fewest duties, to the detriment of other constituents such as the equity holders. While those default rules can be altered, it is often impractical to do so either because the constituent wishing to alter them (typically equity holders) doesn’t have the right to initiate that type of change, or because it is simply impractical to alter them. While each argument has its merits, there has yet to be a conclusive finding on the consequences of the competition between states for charters.
In any case, if the federal government were to regulate internal affairs, we would likely lose many of the benefits of state regulation that I identified above. That is because federal regulation would likely mean a set of mandatory rules over internal affairs (much like existing market regulation and disclosure rules) that do not permit for flexible structuring or private ordering. Nor would these rules likely be updated on a regular basis to reflect changing norms. As a closed system, federal regulations over internal affairs would inevitably become obsolete in the face of a constantly changing business environment and the need for innovative business structures.
This is not merely a theoretical concern, for Congress is currently considering “say on pay” legislation. Under this law, shareholders of all public companies would have a non-binding, advisory vote on the compensation of top executive officers. The proposed law is mandatory in nature in that it cannot be contracted around. Moreover, it is inflexible because it does not consider whether a shareholder vote on pay is sensible for a particular company. For instance, a company may have other, more effective checks on the decision as to what to pay executive officers than asking investors, who do not typically give input on board decisions (nor have a fiduciary duty to consider the best interest of the company or other shareholders in doing so), to vote on a matter as to which they may have only limited information.
While I concede that there is a problem at some companies with executive over-compensation, I don’t think that a mandatory, one-size fits all federal solution is ideal. Rather, state law with its flexible standards and circumstance-driven duties that evolve to reflect changing norms seems to be a much more appropriate place to address this type of internal affair concern.