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Scrapping Sarbox

Modern CEOs always worry about the state regulation of their corporations. Unfortunately, these regulatory schemes have be come more intrusive …

Modern CEOs always worry about the state regulation of their corporations. Unfortunately, these regulatory schemes have be come more intrusive and less useful in recent years, because our legislators and judges often fail to understand how and why the public company reached its dominant position as a vehicle for large business enterprises. Quite simply, the winning formula rests on a one – two punch. 

First, large corporate ventures depend on a rule of limited liability that restricts the liability of each shareholder to the amount that they have contributed to the corporation, thereby allowing them to shield their other assets from the vicissitudes of any given corporate business. At first blush, this critical legal decision looks as though it allows corporations to engage in dangerous activities, while dumping the costs of their misdeeds on outside individuals who will have no recourse against the firm. 

Yet that criticism is wrong in three vital ways. First, it ignores how the corporate form allows the aggregation of large amounts of capital that could never be assembled without the shield of limited liability, for few wealthy individuals will put their entire fortunes on the line for a business in which they take only a passive role. Hence, the well endowed corporation provides stronger protection to injured third parties than the thinly capitalized unincorporated ventures that would otherwise undertake those risky ventures. Second, limited liability makes it possible for investors to gain greater protection against market risks by diversifying holdings while retaining their desired passive positions. Third, any attack on limited liability does not prevent the state from requiring special forms of liability insurance that could be reached only by innocent persons should some harmful event occur. The public protection of strangers can thus be achieved, leaving all voluntary creditors to negotiate whatever terms and conditions they deem appropriate to protect their claims against the firm. 

The second piece of the corporate puzzle is as important as the first. It assumes that, at the time of formation, company founders will seek to maximize their profits by offering the first round of investments that mix the levels of flexibility and protection to satisfy potential investors. This simple statement is meant to highlight a trade-off well known to all CEOs, namely the need to balance the demand for speed with the need to protect passive outside investors against the various forms of abuse and neglect that insiders could practice against them. 

There is no conflict of interest between these corporate founders and their new investors, for both want the optimal rules for doing business within the firm. Therefore, the appropriate tactic is first to settle on the ideal corporate form. This usually imposes duties of loyalty and care, subject to a broad business judgment rule that insulates the CEO and the chief management team from liability for most adverse business consequences. Those rules allow investors to get the managers they want. The less-than absolute legal protection thus raises the price at which new shares can be sold and works to keep the value of shares high in the secondary market. 

The major defect in modern capital markets is that our legislators do not understand that the chief role of government is to enforce the voluntary mechanisms that corporate founders put into place and not to superimpose upon them huge regulatory schemes with high compliance costs and reduced flexibility. One major misguided move in that direction is the 2002 Sarbanes-Oxley Act (SOX) imposed in the aftermath of the Enron, Tyco and WorldCom scams. A substantial miscalculation in SOX was the assumption that the breakdown of internal safeguards in a handful of corporations signaled a vast breakdown in all. The new guidelines represented a massive form of overkill that was endorsed by virtually every member of both political parties. 

The upshot is an onerous regime that requires CEOs to certify the accuracy of key financial statements, whose validity depends on thousands of internal accounting decisions that no single human being could oversee, let alone review. It also demands independent auditors who must meet formal qualifications that knock out some of the ablest people with unconventional backgrounds, thereby complicating the CEO’s recruiting tasks. 

The decisive objection to all these regulations is one that had no traction with Congress. If these particular items were cost-effective, firms would voluntarily adopt them and raise their stock price in the bargain. That has not happened. Instead, we have high compliance costs that systematically disadvantage smaller firms. We also have new potential for busywork and liability that leads able people to decline taking high profile positions in all firms, large and small. And we have officers and boards worrying more about compliance and self-protection than performance. 

A simple test shows SOX’s Achilles’ heel. The implicit assumption behind Sarbox is that it provides a level of protection against fraud and misappropriation that companies are unable to secure by their own voluntary devices. If that claim were correct, we should expect more small firms to go public on U.S. exchanges to take advantage of protection that is not available elsewhere. But the response has been exactly the opposite. Prudent CEOs now are more reluctant to take private firms public and more eager to take public corporations private. The former reduces the rate at which aggressive entrepreneurs can redeploy their capital toward risky ventures. The latter reduces the opportunities available to public investors. The unmistakable pattern is a rise of activity in foreign markets and through domestic private equity firms, both of which operate outside of SOX’s regulatory framework. 

One of the constant themes in modern corporate law is that the state should provide protection for investors unable to protect themselves. That argument may have made sense years ago when capital markets were far less developed than they are at present. But it makes little sense today when a host of responsible intermediaries-mutual funds and financial advisers-can be hired for pennies on the dollar to provide small investors with sound and effective representation. With these intermediaries available, why must Congress supply legal protection that sophisticated market monitors neither need nor desire? Intervention in capital markets should take a direction that is diametrically opposed to today’s conventional wisdom. 

Any government rules should be geared to sophisticated investors only. Governmental regulators and firm members should state that point loudly and clearly, so that amateurs will know that they participate in markets at their own risk unless they hire professionals to run interference for them. The social gain comes from reduced regulatory burden on corporations, which frees the CEO and the key management team from worrying about complying with trapdoor rules, and allows them to spend their energies on worthwhile business ventures. 

SOX needs major renovation, which goes far beyond the welcome but insufficient proposals to reduce the accounting requirements for smaller corporations. Rather, this entire edifice should be scrapped. Don’t look only at the countless serious studies of Sarbox that have reported the migration of firms away from public ex changes in the U.S. Also try this test: If compliance with SOX were optional, what corporation would sign up? Don’t trust CEOs to make that decision unilaterally, but open the matter to a shareholder vote. If that vote is affirmative, the regulations gain new legitimacy. But a negative vote supplies ample evidence of regulatory overkill. The American regulation of internal corporate affairs has taken such an unfortunate for precisely because firm-by-firm elections are not allowed. The same arguments carry over to state regulation of buying and selling in various securities markets. 

Richard A. Epstein, the James Parker Hall Distinguished Service Professor of Law and the Peter and Kirsten Bedford Senior Fellow at The Hoover Institution, is the author of Free Markets Under Siege: Cartels, Politics and Social Welfare.

About richard a. epstein

Richard A. Epstein is the Laurence A. Tisch Professor of Law, New York University, the Peter and Kirsten Senior Fellow, The Hoover Institution, and a senior lecturer and the James Parker Hall Distinguished Service Professor of Law Emeritus at the University of Chicago. He is a recipient of the 2011 Bradley Prize. He writes extensively on topics of business and labor, property rights, health care, and liability.