February 5, 2004
"Pick Your Regulator"--A Commentary by Prof. Roberta Romano
(This essay was originally published in the February 16, 2004, issue of Forbes magazine.)
Pick Your Regulator
Forget Sarbanes-Oxley. Make governments compete in the regulatory marketplace.
By Roberta Romano, Allen Duffy/Class of 1960 Professor of Law
The Sarbanes-Oxley Act is a year-and-half old, but I can safely predict it's not going to protect investors the way its proponents think. Its top-down mandates to companies--enforced by the Securities & Exchange Commission--are a one-size-fits-all approach to corporate governance. There is a more effective approach. It's called competitive federalism. Under this system there would be a free market in corporate and securities law regimes. Let companies choose their regulators from among the states, the SEC or even other nations.
Regulatory innovations would percolate from the bottom up, and investor preferences would dictate which regulations were worth their costs. If a federal Sarbanes act choked companies in paperwork while accomplishing little for investors, it might lose out to a competing law from Delaware. If Delaware caved in to mangement and left outside investors in the cold, maybe New Jersey would come to the rescue--and make the cost of capital lower for companies incorporated there.
Until Enron came along, federal securities law was built around disclosure. Federal law did not have mandates for how to run corporations; governance was left to state corporate law. Sarbanes-Oxley set off in a new direction. It provides explicit legislative directives for SEC intervention. What's wrong with that? You get rigid rules that don't work. For instance, numerous studies (11, to be precise) show no evidence that requiring that audit committees be composed of only independent directors affects companies' overall performance or reduces accounting improprieties.
Competitive federalism is already in place in many aspects of corporate law (such as how much discretion boards have in turning down merger bids). It's the reason that, for more than a century, Delaware has dominated the market as a home for corporations. Unlike other states, Delaware constantly updates its corporate statutes in response to companies' changing needs. It also has a chancery court with a judiciary that's expert in handling complex corporate litigation. For companies this guarantees a predictable, efficient environment for handling disputes.
There's no reason this model can't work for securities regulation. Securities regulation seeks to protect the same parties--investors--as does corporate law. As long as there are informed investors in the market--and today 60% of stocks are owned by institutions--the system will work. The SEC is not exactly a model for effective regulation (look at the mutual funds mess).
Competitive federalism would allow for various permutations of securities regulation. A state could experiment by having no disclosure rules for issuers of securities. Instead it could delegate that duty to the stock exchanges on which companies are listed. This is the way disclosure worked before the federal securities laws were enacted. More likely, states would adopt securities provisions that would stand as default rules that firms could tailor to their needs.
Another alternative can be borrowed from the United Kingdom, where companies must "comply or explain." They are required to disclose whether they comply with a list of so-called best corporate practices, such as having an audit committee with independent members, and to explain, when they are not in compliance.
If a corporation felt it were desirable to conform to mandates, under competitive federalism it could even opt into a top-down Sarbanes-Oxley regime by selecting the SEC as its regulator. Perhaps a company recovering from a scandal, like Tyco International, would benefit by promising its shareholders that it would go to every length to make sure its audits are independent. The point is, if investors want mandatory disclosure or corporate governance mandates, you can bet competing regulators will rush to adopt them. In this free market scheme regulators would have the incentives and the information they need to meet investor preferences. If a superior securities system emerged, then it's likely the SEC would respond by improving its regulations.
Yes, U.S. capital markets are vibrant. But that's not because the SEC has done such a wonderful job. Remember, the U.S. markets were also the largest after the first World War--before any federal regulation was enacted.