Katrina and Sarbanes-Oxley

Dean Levmore asserts that post-Katrina (and, for the most part, post-9/11), "states are neither here nor there." On the issue of natural and human-caused disasters, one might start from John Adams's assertion that "government turns every contingency into an excuse for enhancing power in itself," and then ask why, if true, the locus of power accumulation is primarily federal and not state. Aren’t the state (and local) governments captured by Adams's postulate? At one level, one might think that state (and local) governments would be more likely to aggrandize power in the wake of these events since they are closer to the situation and thus the citizenry, and are more likely to reap long-term benefits from an increased profile. After all, it is unlikely that Iowa congressional elections in 3 years will focus on Katrina, but we can be sure that the Louisiana local races will. Corporate law is another area that might help us think through the puzzle.

One can think of the recent spate of corporate bankruptcies and frauds as a similarly disruptive event for corporate America. Crudely, Enron = Katrina. Here too we see primarily a federal response. Within months of the Enron bankruptcy, Congress passed the Sarbanes-Oxley Act of 2002, which federalized many important corporate law issues that had heretofore been governed by the states. For example, section 404 of the Act mandates comprehensive (read: expensive and not sure to work) internal controls requirements without regard to differences in size and scope across firms and without regard to the substantial case law in states such as Delaware on the subject. (On the former part, one might have expected a state-law solution to internal controls to be more flexible to the needs of various firms through an enabling default rule approach as opposed to the federal, command and control approach.) A similar intrusion into state law can be seen on a range of issues from board composition to executive liability for financial reports. 

The federal reaction is not surprising -- it is the same reaction we saw seven decades earlier when Congress responded to the stock market crash of 1929 (the other recent corporate Katrina) with the most far reaching business reforms in American history -- the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940, which created from whole cloth our modern system of securities regulation and replaced a patchwork system of state “blue sky” laws.

What is somewhat surprising is the lack of a coherent state response to Enron and its aftermath. Delaware, to take the most important corporate law state, did virtually nothing, despite the direct attack on their turf by the federal government. Why?

One explanation is that they were powerless in the face of federal action. If true, this would necessitate a corollary to Adams's observation -- self-enhancement increases as the relative size of the government body increases. This should worry us, as it portends a fundamental shift in power -- over time and across many legal areas -- as more "Katrinas" happen. Federalists and libertarians should not be the only ones that ask tough questions about this evolutionary arc of our government.

Another possible explanation is that Delaware is not as concerned about the federal-state power dynamic as it is about its power vis-à-vis other states. After all, Delaware is competing for corporate charters with California and New York, not Washington. (At least not yet!) Here again we see a collective action problem of sorts that keeps the various states from a coordinated and unitary response that is needed when an emergency is "national." In this world, Delaware can be expected to spring into action only when the federal government intrudes to an extent that makes state corporate charters -- and the fees, prestige, and so on they bring -- irrelevant. Even then, it isn't clear what power the Small Wonder would have in the face of a federalization of corporate law.

Whether the explanation is one of these or some other possibility, the fact remains that federal power seems to consistently take the opportunities for enhancement that we give it. This is not good or bad in itself. There are likely to be salutary effects from the Sarbanes-Oxley reforms over the long term, not to mention the arguable impact that the legislation had on consumer and investor confidence in the immediate aftermath of Enron. But even when taken in the best possible light, the fact that the reforms here and in other areas of law were (must have been?) federal is cause for concern for those who believe there is wisdom in dispersion of government power.

Comments

[Scott Scheule]

I'm going to like this blog.

[saul levmore]

Yes, I agree with Professor Henderson, crises stimulate federal law. Or at least I recently argued something like this for corporate law (2005 Illinois Law Review 195). In theory the force can move a state in either direction. Knowing that a crisis like Enron is apt to generate federal law, Delaware might "preempt" the feds by enacting protective legislation in advance. If a crisis is 5% likely, so to speak, Delaware might find it worthwhile to lower this probability to 3% (at least for "its" corporations), even if this requires legislation that is on average inefficient or otherwise undesirable. On the other hand, if Delaware is worried more about competition with other states than with the federal government, then it might welcome federal intrusions because federal law might occupy the terrain that would otherwise prove fertile for other states as competitors. In that article, I suggested that one way or the other, and for better or worse, we ought to expect more federal law over time.

[ToddHenderson]

Riffing off of the Dean's comment, would Delaware really fear other states' innovations? Michael Abramowicz (visting here at Chicago this term) has argued that given the ease by which Delaware could mimic any innovation by another state -- say, Nevada -- the threat is simply not credible. A possible solution is some property right -- call it intellectual property for laws -- in corporate law innovations by states. Of course this raises a host of big hairy questions, but it might help foster the federalist dream of the states as laboratories of democracy. On the corporate side of the ledger, there just doesn't seem to be much innovating at the state level. It may be, as Richard Epstein argued to me today, that the innovation is largely done, but the question is likely an open one in need of more data/analysis. Certainly the feds (Congress, SEC, SROs) are innovating, and the states, namely Delaware, are sitting on the sidelines. Even the recent Delaware decision in the Disney-Ovitz compensation case was fairly mushy about Delaware standards for these cases going forward. Just as Fukuyama was wrong that history was not over, I think the view that corporate law cannot be improved at a fundamental level is misplaced. What should be the locus of innovation and how should it be encouraged, if at all, are tough questions.

[Bob Griffin]

Forgive my ignorance, but where in the U.S. Constitution does it allow the Federal Government to intrude in any way into the jurisdictions of any one of the States for any other reasons than those listed in Article I, Section 8? Are not all rights not explicitly given to the Federal Government to remain with the soverign states? If a state stands by when an ecomomic disater occurs, does it automatically surrender it's jurisdiction to the Feds? I think not.

And don't quote anything from the first sentence of the Constitution, because that was only an introduction to the document. That sentence did NOT allocate any powers to the Federal Government. Please! No general welfare garbage. Any layman can read and understand that that was not the intent. Only lawyers can distort something that simple into the rediculous belief that the Federal Government is all-powerful and can do anything it likes in the name of the "general welfare".

Ditto for the whole "Declaration of Independence", as this document isn't even a legal document. It is merely a statement.