The Dodd Debacle

Eight summers ago Congress decided to respond to a financial panic with a political panic. It was called the Sarbanes-Oxley Act, and it consisted of a sort of regulatory Christmas tree ornamented with half-baked ideas waiting for a so-called crisis to get enacted. Henry Butler and I wrote a book, The Sarbanes-Oxley Debacle, detailing the act's large direct compliance costs, as well as its even larger indirect costs in deterring legitimate business activity and subverting the vibrant state market for business law. We hoped that the book would at least stand as a warning for the next time.

Well, the next time is here, and financial "reform" is again before Congress. Unlike the last time, when Congress could at least point to a plummeting stock market, this time Congress and the SEC had to manufacture a crisis out of Goldman to move the legislation. It's another debacle in the making, as Professor B has already warned.

The concerns, of course, start with the financial provisions, whose effects go far beyond the large banks that were in the middle of the crisis. As the NYT discusses this morning (via Dealbook), the Act could, among other things, affect the price of candy, motorcycles and student loans and throw a monkey wrench on PayPal's ability to move Internet commerce.

Like Professor B, I'm concerned mainly with the corporate governance provisions. As with SOX, the Dodd bill plays host to a lot of tired ideas about corporate governance, including:

• Mandatory majority voting.
• Forcing firms to justify their decision not to separate the CEO and board chair jobs.
• Mandating ill-defined risk committees (which did little good for Citigroup and other firms in the financial meltdown).
• Forcing pay-performance disclosures, thereby increasing benchmarking and decreasing firms' ability to design incentives to fit their diverse needs.
• Require shareholders to vote on executive pay.

These reforms have much more to do with shoring up flagging union clout than with financial reform.

Scholars are just beginning to study the effect of these ideas. Consider the very recent Gox, Imhof and Kunz, 'Say on Pay' and its Repercussion on CEO Investment Incentives, Compensation, and Firm Profit, which tests the effects of various shareholder say-on-pay rights and finds, among other things, that "unconditionally binding voting rights reduce both firm profit and executive compensation significantly," and that even merely advisory shareholder voting rights can increase executive compensation, and "have only limited impact on firm profit and executive compensation." In general, the authors'

results suggest that regulators should carefully evaluate dysfunctional economic consequences of shareholder voting rights before they are introduced or before existing rules are tightened.

Apart from the costs and risks of say on pay and other governance proposals, their policy foundations are murky. Under the approach that has been in place in this country since the beginning of securities regulation, substantive corporate governance regulation has basically been the province of enabling state law, with the federal law limited to disclosure regulation. As financial markets have become far deeper and more competitive since the 30s, it makes little sense for regulators to actually trust them less. Moreover, if there is a basis for questioning shareholder choice of governance rules, then it would seem to make little sense to give shareholders more power over so complex a matter as corporate pay. If we're going to give shareholders say over pay, why not also say over SOX?

Although these provisions are woefully misguided, at least they relate to the big corporations that were caught up in the crisis. Other provisions of the law reach the firms that were more solutions than causes of the crisis – hedge funds who saw it coming and bet accordingly will now have to register with the SEC, undoubtedly a precursor to collaring them with more regulation; fewer investors will be able to participate in unregistered offerings; and small offerings will be burdened with the uncertainty and delay of SEC review. The ridiculousness of burdening growth of small firms in a still-struggling economy because some big firms messed up is too obvious to deserve discussion.

I suspect the Dodd bill will pass. It would be fitting if it did so the same day the Supreme Court strikes down Sarbanes-Oxley.

Comments

[Joseph Marchelewski]

What makes you think the Supreme Court will strike down Sarbanes-Oxley?

[Tweetrific]

"fewer investors will be able to participate in unregistered offerings"

Estimates I've seen say a good 75% of accredited investors wouldn't qualify under the rules required by Dodd's bill. That's no mere burden to small offerings, that's a disaster. I presume that's the point, push those investors to public offerings where the major Wall Street houses can profit.

"small offerings will be burdened with the uncertainty and delay of SEC review"

It's much, much worse than that. Dodd's bill removes the Regulation D preemption of state securities law. Florida's regulator says he's happy he's only approved one offering in 17 years. Texas and California are other notoriously strict securities regimes. The disclosure regime of federal law is tolerable, if much too strict, especially regarding publicity. State securities laws are much worse, tending to have affirmative rules about what an acceptable offering looks like. If you or your investors want something different, too bad. Your presumably quite wealthy investors are too stupid to know what's good for them, thankfully the state regulator knows better. If you want to offer in multiple states, your problems are multiplied exponentially, especially since what is permissible in state A may be impermissible in state B. A boon for securities lawyers seeking big fees, but a bad thing for startup formation.