Corporate Governance

Chairman Cox, Director Self Interest, and a Challenge to the Delaware Model

By J. Robert Brown

The Chairman of the SEC yesterday again forcefully indicated in his testimony before the House Committee on Oversight and Government Reform that "voluntary" regulation doesn't work.  As he noted:

• We have learned that voluntary regulation does not work. Whereas in 1999 the Chairman of the SEC could testify before the House on Gramm-Leach-Bliley that he "strongly supports the ability of U.S. broker-dealers to voluntarily subject their activities to supervision on a holding company basis," experience has taught that regulation must be mandatory, and it must be backed by statutory authority. It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given the statutory authority to regulate investment bank holding companies other than on a voluntary basis.

Chairman Cox has more or less taken this position before, particularly in the aftermath of the Inspector General's report on the SEC's supervision of investment banking firms (for the unredacted version of the report go here). 

That mea culpa, however, is an acknowledgement of the obvious.  Voluntary regulation resulted in the demise of the entire industry.  It's easy now to say it was a mistake. 

The place where "voluntary" regulation needs to be examined is in the area of board supervision.  This is an area left to state law, specifically the Delaware courts.  As we have noted in other posts today (keying in on Alan Greenspan's testimony), the courts have persued a model that essentially relies on director self interest to protect shareholders.  Its a form of voluntary regulation that relies on the discipline of the market rather than the strictures of the law.  In fact, as Greenspan noted, this approach has been a dismal failure.  Self interest of management has not protected the interests of shareholders.  The overriding theme, at least in the financial markets, has been enormous payouts for top management that entail risks and strategies that result in damage to the interests of shareholders. 

The Delaware courts defer to management and assume that this will be sufficient to protect shareholders.  It hasn't.  The time has come to take the SEC and strengthen its authority to protect investors and shareholders.  This will require greater regulatory authority to establish oversight standards and ensure greater accountability for directors.  The requirement for internal controls in SOX was a start but the authority needs to extend beyond the limited area of financial disclosure.  In short, it is time to replace the "voluntary" theme of the Delaware courts before self interest and lack of oversight results in the next disasterous economic crisis.

Full post as published by The Race to the Bottom on October 24, 2008 (boomark / email).