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The elusive quest for director independence
The compliance-based approach and the integrity approach have been the mainstream responses to corporate scandals. This paper proposes that, despite each approach comprising necessary elements, neither offers a comprehensive solution. Compliance and integrity, far from being mutually exclusive, reinforce each other. Working together, in a correct relationship, they build a harmonized system that yields positive synergies and which also advocates prudence (phrónesis). It enables the generation of a culture of compliance that tends to minimize the technical and ethical errors in decision making. In order to explore an applied harmonized approach, we analyze the audit committee, a specific and broadly accepted regulatory instrument. Formed by non-executive members, regulation requires these members to be dedicated, qualified, and independent as a guarantee of efficiency. We show how the compound of those elements produces positive effects in a context of solid governance. We conclude that it is the strong relationship between efficiency and prudence, in the creation of a culture of compliance, which enables the minimization of errors.
Corporate boardroom processes and board composition have long been topics of interest and debate for both organizational researchers and practi-tioners. In recent years, however, criticism of corporate boards has increased dramatically, as evidenced by the comments of former International Tele-pbone & Telegraph chairman, Harold Geneen. According to Geneen, "the boards of directors of U.S. industry include numerous first-rate people doing what amounts to a second-rate job" (1984: 258). In defense of his position, be brought up many points, but board composition is the most central to his argument. Essentially. Geneen and other critics have argued that the designs of corporate boards restrict their members' independence and render them ineffective when it comes to monitoring top management and protecting stockholders' interests (Anshen, 1980; Drucker, 1973; Mace. 1971; Mintzberg, 1983). The reform that critics of boardroom processes most frequently offer involves increased representation by outsiders, directors who are not mem-bers of management. According to these advocates, a higher proportion of outside members strengthens a board's independence and broadens its base of power and knowledge. What is perplexing, however, is that although accepted as common knowledge and adopted in the rules and regulations of various stock exchanges and government agencies, this position remains virtually untested. Thus, despite a clear trend in U.S. firms toward greater outside representation (Heidrick & Struggles. Inc. Vance. 1983), we still do not know if organizations with greater proportions of outsiders on their boards are more effective in terms of serving stockholders tban tbose companies dominated by insiders.
This article describes how criminal liability is contingent on two sets of factors: (1) criminal law's alternatives?civil, administrative and even non-legal strategies for addressing wrongdoing, and (2) choices in how we acknowledge social influences, instrumental goals, and the social costs of punishment. Moral culpability is weighed against utilitarian concerns in decisions to impose criminal sanctions. Further, even the assessment of culpability itself is mediated by utilitarian concerns driven by criminal law's alternatives. Conduct that can be effectively addressed non-criminally seems less culpable (despite explicit coverage by criminal law), and that makes utilitarian concerns?and civil sanctions and remedies?more likely to prevail when balanced against the need for retributive judgment of wrongdoing. This dynamic arises because criminal law's long-standing twin rationales, retributivism and deterrence, sometimes conflict in the response they counsel for culpable wrongdoing. In practice, criminal liability is not explained by culpability, nor by the familiar grounds for prosecutorial discretion?state resources limits, first-offense status, or marginal resulting harm. Neither do these considerations explain the wide variance in its use across the landscape of crime, from white-collar to "street" settings. The way we actually employ criminal liability demonstrates the contingency of criminal law, and culpability itself, on civil alternatives and social costs, and this has distributive implications. We use criminal liability for "street" wrongdoing much more than we do for white-collar wrongdoing; that variation cannot be explained by distinctions in those two settings, sets of offenders, or feasible alternative remedies. Yet reasons for it explain why we have yet to move street crime policy in the productive direction that increasingly characterizes white collar policy.
Corporate scholars rely on traditional theories of the firm to analyze corporate organization and corporate contracting. However, traditional theories of the firm, as the authors argue, are incomplete in that they neglect the role that knowledge plays in shaping the internal structure of a firm. The article proceeds to address this gap by focusing on knowledge resources as a key influence on internal corporate governance structures. First the authors introduce a new typology that explains firm internal governance structure based on the types of knowledge used in the production process. Then they analyze the interaction of law and knowledge management. They go on to show how certain legal mechanisms, such as patents, trade secrets, and private contracting (e.g. covenants not to compete) emerged as tools for binding knowledge to the firm. They propose a principle of efficient knowledge allocation, positing that organizational structures must maximize the use of knowledge resources against the background of specific hazards that affect transactions involving knowledge inputs. Applying these theoretical constructs, the authors show how the management of knowledge resources required in mass production, high tech and law firms differentially affect the decisional hierarchies of these types of firms and also their compensation and ownership structure in certain instances. More specifically, the authors argue (1) that a shift in knowledge requirements drove the changes in the organizational structure of mass production firms from the C-form to the M-form, affecting decision-making powers; (2) that the adoption of stock option plans in high-tech firms controls knowledge hazards (stock options prevent leakage by retaining individual knowledge and discouraging hoarding of knowledge); (3) that profit splitting and the partners-associate hierarchy in law firms reflects the need to maximize the use of knowledge resources and that changing knowledge requirements are affecting law firm organization; and finally, (4) that certain business transactions like mergers, joint ventures and licensing contracts are shaped by knowledge inputs. The authors conclude that knowledge considerations provide policy makers with a positive explanation for firm structure and a normative perspective counseling greater attention to the effects of regulation on knowledge allocation within firms.
In this Article I provide an economic analysis of criminal law as a preference-shaping policy. I argue that in addition to creating disincentives for criminal activity, criminal punishment is intended to promote various social norms of individual behavior by shaping the preferences of criminals and the population at large. By taking into account this preference-shaping function, I explain many of the characteristics of criminal law that have heretofore escaped the logic of the economic model. It is also the preference-shaping function and the prerequisite ordering of preferences that distinguish criminal law from tort law. My analysis suggests that society will make an activity a crime whenever the social benefits of changing individual preferences through criminal punishment outweigh the social costs. However, since this weighing of social costs and benefits is conducted through a political process on the basis of ethical and moral standards and requires estimates of the costs of changing opportunities and preferences, I conclude that other disciplines can usefully inform the economic model of criminal law.
Recent articles by Romano of Yale, Clark of Harvard, and Ribstein of Illinois have all surveyed the empirical academic literature and found Sarbanes-Oxley (SOX) wanting, Romano terming four of its key provisions "quack corporate governance." Using a slightly wider lens and considering an avalanche of more recent work, this article demonstrates that the current dominant view that SOX is wholly unsupported by the academic literature is simply wrong. Rather, that literature gives substantial reason to view some of SOX's most important provisions with a measure of hope.
The enactment of the Sarbanes-Oxley Act of 2002 and the recent adoption of new corporate governance listing standards by the major American securities markets have resulted in a number of prescriptions that influence the selection of directors of U.S. public companies. These requirements are in some respects inconsistent with the traditional agency role of the monitoring board and, more important, may conflict with optimal functioning of the board as a group. The authors survey the literature on the role of the board and board dynamics, examine the new constraints and their impact on director qualification and selection, and offer ten practical suggestions for director selection that will help nominating and governance committees of public companies to assemble boards of directors that will effectively perform their critical monitoring functions in the new regulatory environment.
The ability to protect mergers is important to both targets and acquirors. A series of recent Chancery Court decisions, however, challenges the validity of deal protection provisions in merger agreements and threatens the stability of Delaware's established change of control paradigm. This article argues that last period concerns animate the Chancery Court's decisions and finds, in the last period problem, a theoretical principle capable of harmonizing these decisions with existing jurisprudence and providing a coherent approach to the practical problems raised by deal protection provisions.
Corporations are governed by a textured fabric of enabling legislation, private ordering, independent directors, good counseling, and judge-made fiduciary dudes. The tension in corporate governance today is between judicial deference to directors' decisions and the scope of judicial review. That tension is often denned by the nature of the issue: whether it is an enterprise, ownership, or oversight issue. There are some common threads and some analytical differences between the interests of investors in enhancing corporate performance and the focus of courts in liability adjudication. Yet, consistent, good corporate governance practices and the emphasis on the independence of directors is clearly a common denominator. This Article explores the defining tension and the interplay of the aspirations of sound corporate governance practices with the reality of the court's examination of directorial conduct in adjudicative settings.
This chapter focuses on an alternative explanation for the wave of accounting and financial reporting irregularities that surfaced in 2001- 2002: namely, that the gatekeepers failed. That is, the professionals who serve investors by preparing, verifying, or certifying corporate disclosures to the securities markets that acquiesced in managerial fraud; not in all cases, to be sure, but at a markedly higher rate than during the immediately preceding period. While the gatekeeper concept will be discussed and refined later, this term certainly includes the auditors, securities analysts, and securities attorneys who prepare, review, or analyse disclosure documents. Part II of the chapter develops competing, but complementary, explanations for gatekeeper failure. Part III maps out the range of strategies available to regulators. Part IV proposes alternative reforms intended to make gatekeepers more responsive to the interests of investors.
This article reports on the first quantitative perceptual deterrence study of corporate (rather than individual) deterrence. The study is based on interviews with 410 chief executives of small organizations and their officially recorded compliance with regulatory standards. We find partial support for the certainty of detection as a predictor of both self-reported and officially recorded compliance but no support for the certainty or severity of sanctioning. The narrow range of sanctions available in the particular regulatory domain studied (regulation of nursing home quality) has enabled a fuller specification than was possible in previous studies of an expected utility model for all available sanctions. Managers' expected corporate disutility from all sanctions fails to explain compliance. Deterrence does not work significantly more effectively for chief executives (a) of for-profit versus nonprofit organizations, (b) who are owners compared with those who are not owners, (c) who say they think about sanctions more (sanction salience), (d) who may better fit the rational choice model in that they are low on emotionality, (e) who have a weaker belief in the law. Nor is deterrence more effective when compliance costs are low.
Numerous observers have argued that the addition of independent directors to corporate boards would solve the problem of corporate social responsibility without incurring the costs of external regulation. In this Article, Professor Brudney examines the past performance of independent directors in order to assess the likelihood of their success in this new role. He begins by analyzing the obstacles independent directors have encountered in policing managerial conflicts of interest and in monitoring the maximization of shareholder wealth. Based on this analysis, Professor Brudney concludes that it is unrealistic to suggest that independent directors can perform the still more difficult task of fostering social responsibility well enough to justify eliminating or diluting regulatory controls on corporate behavior.
A strong theory has emerged that the quality of corporate law in protecting distant shareholders primarily determines whether ownership and control separate. The theory helps to convincingly explain why separation is weak in transition and developing nations. But in several rich nations, although legal structures as measured protect shareholders well, separation is shallow. Something else has impeded separation. Separation should be narrow if shareholders face high managerial agency costs if ownership diffused. But most managerial agency costs are not corporate law's focus. Judicial doctrine attacks self‐dealing, not business decisions that hurt stockholders. Indeed, the business judgment rule puts beyond direct legal inquiry most key agency costs—such as overexpansion, overinvestment, and reluctance to take on profitable but uncomfortable risks. Even if a nation's core corporate law is perfect, it directly eliminates self‐dealing, not most managerial mistake or most misalignment with shareholders. If the risk of managerial misalignment varies widely from nation to nation, or from firm to firm, ownership structures should also vary widely, even if conventional corporate law tightly protected shareholders everywhere from insider machinations. I show why this variation in managerial alignment is likely to have been deep.
In this paper we use a survey concerning a hypothetical taxpayer to analyze how certain features of the enforcement of the tax laws shape perceptions of the risks of detection and penalties for tax non-compliance. We also examine the effects of these perceptions on intended noncompliance behavior. Our findings provide strong support for various hypotheses concerning the effect of the enforcement process on perceptions. We also find, in contrast to prior results, that the perceived risk of criminal prosecution appears to act as a powerful deterrent to noncompliance. We explain why earlier studies might have failed to detect a deterrent role for the severity of punishment.
This Article argues that Delaware mis-formulates and mis-uses the business judgment rule. Properly understood, the business judgment rule's function in corporate law is quite modest. It is a narrowly-drawn judicial policy of nonreview which, in duty of care cases, shields the merits of board decisions from judicial scrutiny. The Article contends that the business judgment rule, therefore, should be de-emphasized as an analytical construct in the law of director fiduciary duties and should be sharply differentiated from the broader-gauged duty of due care. Doing so will pave the way for Delaware courts to rethink the importance of articulating a robust, generally applicable—but concisely formulated—director duty of care.
This case study of the Enron directors' role in the scandal aims to serve as a story that allows students to see how honest, smart individuals can succumb to cognitive biases prevailing in corporate cultures. More importantly, perhaps students and lawyers will use this case study as a parable to tell themselves and their clients to avoid these behavioral defects in the first place.
This article argues that the corporate governance paradigm for boards of directors is inverted: shareholder-owners should be in the majority and independent directors should be in the minority. The Sarbanes-Oxley Act gives short shrift to the role and efficacy of inde-pendent directors by focusing on the independence of auditors and internal controls. In reviewing the history of boards of directors, the authors suggest that boards represent an intermediary process to buffer corporate managers from the shareholder-owners to whom they are supposedly accountable. The authors researched 254 public companies across 50 industries and found, consistent with other significant econo-metric research in the area, inconclusive evidence that boards dominated by independent directors increase financial performance for shareholders. Consequently, the authors propose three reforms to Sarbanes-Oxley that would facilitate the participation of larger, longstanding owners, oversight shareholders, serving on boards of directors and include safe harbors for insider trading liability and controlling party liability. Additionally, the authors propose that Sarbanes-Oxley be amended to facilitate the ability of these oversight shareholders to call shareholder meetings, which would serve as the most effective check and balance on management.
Recent empirical work has puzzled over the lack of a positive correlation between the presence of a majority of outside directors on a corporate board and measures of firm performance. Drawing on work in social psychology and group behavior, this paper extends previous work to offer plausible explanations for the value-enhancing contributions of a "balanced" board. These possibilities include insider countering of outsider biases, the promotion of internal middle management interests, and the reduction in CEO influence activities that distort communications and interfere with trust. The paper then turns to use these same (and related) insights to point out some unintended behavioral consequences of recent efforts to increase the liability exposure of directors and make them more accountable. The paper concludes by addressing the connection between its analysis and the current "law versus norms" debate in corporate and securities law.
In the wake of recent scandals and the economic meltdown, there is nearly universal support for the notion that corporations must have independent directors. Conventional wisdom insists that independent directors can more effectively monitor the corporation and prevent or otherwise better detect wrongdoing. As the movement to increase director independence has gained traction, inside directors have become an endangered species, relegated to holding a minimal number of seats on the corporate board. This Article questions the popular trend away from inside directors by critiquing the rationales in favor of director independence, and assessing the potential advantages of inside directors. This Article argues that the value of independent directors has been overstated, while the value of inside directors has been under-appreciated and under-examined. This argument rests on three critical points. First, independent directors are constrained in their ability to perform their monitoring functions, and many of these constraints may be insurmountable – particularly as we increase independent directors’ responsibilities. Second, inside directors can make valuable, and often overlooked, contributions to board governance. Third, reliance on independent directors as a substitute for external regulation is inappropriate and potentially costly. To this end, this Article suggests that inside directors may serve an important signaling function, underscoring the need for enhanced regulation, while ensuring that corporate monitors are subject to appropriate liability and therefore have increased incentives to perform their responsibilities.To be sure, the case for the inside director is not an easy one, particularly given that any benefits such directors bring to the board come with costs, including the potential for self-dealing and overreaching. However, before we render inside directors extinct, we first should determine whether their costs are outweighed by their benefits.
This Article adds to the emerging literature on rewards to promote effective capital market gatekeeping. Capital market gatekeeping theory traditionally relies heavily on threats of legal liability for failure to perform legally mandated functions (along with a presumed constraint imposed by reputation effects). The ineffectiveness of many gatekeepers in the past decade revealed limitations of the liability strategy and yet reforms continue to emphasize legal duties and liability for gatekeepers. This emphasis also has the negative side-effect of discouraging gatekeepers from willingness to perform desired functions - such as to detect for fraud. Using rewards can induce gatekeepers to perform desired functions and add positive incentives to encourage them to be more effective in vetting enterprises seeking access to capital.
Building on the success of prediction markets at forecasting political elections and other matters of public interest, firms have made increasing use of prediction markets to help make business decisions. This Article explores the implications of prediction markets for corporate governance. Prediction markets can increase the flow of information, encourage truth telling by internal and external firm monitors, and create incentives for agents to act in the interest of their principals. The markets can thus serve as potentially efficient alternatives to other approaches to providing information, such as the Sarbanes-Oxley Act's internal controls provisions. Prediction markets can also produce an avenue for insiders to profit on and thus reveal inside information while maintaining a level playing field in the market for a firm's securities. This creates a harmless way around existing insider trading laws, undercutting the argument for the repeal of these laws. In addition, prediction markets can reduce agency costs by providing direct assessments of corporate policies, thus serving as an alternative or complement to shareholder voting as a means of disciplining corporate boards and managers. Prediction markets may thus be particularly useful for issues where agency costs are greatest, such as executive compensation. Deployment of these markets, whether voluntarily or perhaps someday as a result of legal mandates, could improve alignment between shareholders and managers on these issues better than other proposed reforms. These markets might also displace the business judgment rule because they can furnish contemporaneous and relatively objective benchmarks for courts to evaluate business decisions.
Using event history analysis, we examine the recidivism patterns of a sample of 38 corporations charged with one or more serious antitrust violations between 1928 and 1981 to see whether sanction experience decreases the likelihood of a firm's reoffending. Specifically, we analyze the effects of procedure type (e.g., civil, criminal, and administrative redress) and proxy measures of corporate deterrence while controlling for changes in antitrust law and the economic conditions of the firm, industry, and general economy. Though not robust, there is some evidence that past guilty verdicts and changes in penalties for lawbreaking from misdemeanors to felonies inhibit recidivism. We note, however, that industry characteristics are stronger by far in their effects on future illegality than formal sanction risk or consequence. The implications of these findings for organizational deterrence and corporate crime control are discussed.
This paper is an overview of the philosophy of evolution - past, present, and future - to be published in The Blackwell Guide to the Philosophy of Science , edited by P.K. Machamer and M. Silberstein. It surveys the following topics: the neutralist/selectionist debate, the adapationist programme and its challenges, sociobiology, contingency, laws of biology, the species category problem, the species taxon problem, the tautology problem, fitness, units of selection.
Positioned in a lively current debate concerning how to design auditor incentives to optimize financial statement auditing, this Article presents the more ambitious financial statement insurance alternative. This breaks from the existing securities regulation framework to draw directly on insurance markets and law. Based on upon an evaluation of major structural and policy-related features of the concept, the assessment prescribes a framework to permit companies, on an experimental-basis and with investor approval, to use financial statement insurance as an optional alternative to the existing model of financial statement auditing backed by auditor liability. The financial statement insurance concept, pioneered by New York University Accounting Professor Joshua Ronen, promises considerable advantages compared to traditional financial statement auditing. As with any proposal, however, it presents challenges. This Article expands the model first sketched by Dr. Ronen, extending and interpreting it to examine its efficacy, attempting to show how certain limitations can be overcome. A chief challenge is relating state insurance law, the default applicable to insurance policies including FSI, to federal securities regulation. A general method is to develop for financial statement insurance the functional equivalent of the U.S. Trust Indenture Act of 1939 applicable to contracts governing public debt securities. This would allow substantial freedom of contract in policy terms, governed by state law, while mandating certain specific terms and establishing minimum federal parameters for others. Most other hurdles arising from the interplay between state insurance law and federal securities regulation can be overcome using disclosure, while more uncertain are issues associated with preserving insurer solvency if financial statement insurance is placed at the center of the public-company financial reporting system.
If private securities class actions alleging fraudulent behavior by officers or directors of a company are meritorious, directors and officers should pay a reputational penalty when they sit on a board of a company whose officers and directors are accused of fraud. I find little evidence of a negative effect associated with allegations of fraud. Using various definitions of board positions as a proxy for the reputation of directors who are accused of fraud, I find that the net number of board positions is consistently increased. Only in shareholder class actions in the top quartile of settlements or in which the Securities and Exchange Commission has initiated a case do directors appear to suffer a reputational penalty when a board they serve on is accused of fraud. The results call into question the merits of private securities class actions.