Rethinking Corporate Federalism in the Era of Corporate Reform

ABSTRACT Many commentators have criticized the Sarbanes-Oxley Act of 2002 as evidence of the "creeping federalization of corporate law."1 In this Article, I argue that a realistic threat of federalization is necessary to ensure the robust development of corporate law at the state level. Recent research suggests that Delaware enjoys a monopoly position in the market for "out-of-state" incorporations. This means that little pressure actually comes from other states which might push Delaware to shape its corporate law to increase protections for shareholders and other constituent groups. The federal government, however, can serve as a credible rival to Delaware. The Sarbanes-Oxley Act's apparent influence on Delaware corporate law suggests the potential for a dynamic relationship between state and federal regulation of corporate conduct. Recent Delaware court decisions indicate that Delaware's judiciary has begun to respond to this preemptive threat by adjusting its corporate law jurisprudence. The courts appear to be moving to more restrictive application of the business judgment rule and more vigorous enforcement of officers' and directors' fiduciary duties. This jurisprudential shift demonstrates that Congress can effectively influence state law through legislative measures that do not require complete preemption of state law. I. INTRODUCTION "If we don't fix it, Congress will, but I hope they've gone as far as they're going to have to go."2 This statement from one of our country's most respected jurists forms part of an ongoing effort to retain the state of Delaware's legitimacy and power in the realm of corporate law, in the face of recent federal encroachments on state law territory. Delaware Supreme Court Chief justice E. Norman Veasey made this statement in the wake of recent corporate scandals and Congress' subsequent adoption of the SarbanesOxley Act of 2002(3) ("Sarbanes-Oxley" or the "Act"). Chief Justice Veasey's words are an unusually blunt acknowledgment that in determining the legal rules that affect America's largest corporations, the state of Delaware is constrained most significantly by the federal government. His words suggest that standard arguments prevalent in academic literature which extol the benefits of competition among states for corporate charters are misconceived. Instead, Chief justice Veasey tacitly admits that the federal government is Delaware's main rival in the development of corporate law rules. This implied absence of state-to-state competition suggests the need to reconsider the appropriate role of the federal government as a corporate regulator. To some, Sarbanes-Oxley represents an ill-advised advance in the "creeping federalization of corporate law."4 The Act does indeed federalize some aspects of corporate law, and properly so. Because of Delaware's dominant position in the market for out-of-state incorporations, the federalization of corporate law (or at least the threat of federalization) is necessary to ensure that corporate law developed at the state level adequately addresses concerns of national scope, rather than furthering purely local interests. The longstanding academic debate about whether competition among states for corporate charters has led to a "race-to-the-bottom" or a "race-to-the-top" in corporate law,5 exaggerates the true extent of competition among states for corporate charters. Instead, recent scholarship suggests no race exists at all.6 That is, when a corporation considers a state other than its home state in which to incorporate, it almost invariably chooses Delaware.7 These same commentators have observed that other states do not actively compete with Delaware for charters.8 Neither the statutes, the court systems, nor the corporate franchise tax structures of these states appear designed to allow the states to generate additional revenue by attracting out-of-state incorporations.9 For years, scholars have argued that competition among states leads to greater innovation and experimentation in the development of corporate law rules. …