The New Federal Regulation of Corporate Governance

I. INTRODUCTION: HAS BUSINESS LAW BECOME PUBLIC LAW? Recent regulatory reforms, particularly the adoption of the Sarbanes-Oxley Act of 2002, (1) have led many commentators to argue that the federal government is improperly intruding into the traditional province of state law. Similarly, recent reforms have been criticized for imposing excessive regulatory intrusions upon the structure and organization of business relationships, a matter traditionally relegated to private contract. These complaints are both true and false. They are false in the sense that disclosure obligations, accounting standards, and financial reporting have been regulated by the federal securities laws for more than seventy years. Whether or not the United States has the most efficient level of mandatory disclosure--and whether or not mandatory disclosure is even appropriate--it is clear that uniform financial reporting standards are both necessary and appropriate for national securities markets. Securities regulation has been a species of public law since at least 1934, when Congress established the Securities and Exchange Commission to administer the operation of the capital markets "in the public interest and for the protection of investors." (2) Although securities transactions are private contracts, they take place in public markets and have effects extending far beyond the specific parties involved. Moreover, there is a general societal interest in strong capital markets. The strength of the U.S. capital markets, due in part to their relative safety and transparency, has been a fundamental component of this country's economic growth. Indeed, the U.S. capital markets are sufficiently attractive that they regularly attract listings from foreign issuers, some of whom appear to view compliance with extensive U.S. regulations as providing their securities with something like a good housekeeping seal. (3) This public nature of business law is the central focus of Sarbanes-Oxley. Similarly, it is misleading to view the auditing of publicly-traded companies as a matter of private law. When Congress initially adopted the federal securities laws, it considered bringing the auditing process explicitly into the public sector. It opted instead to provide the SEC with the authority to oversee the accounting industry and to promulgate uniform accounting principles. The SEC, in turn, has left the development of this important check on the quality of public disclosure in the private sector, with the understanding that the preparation and review of financial statements would be subject to government regulation and oversight. (4) Subsequently, despite the importance of financial disclosure to the efficiency of the public securities markets, the accounting profession was able to maintain control over the standards of disclosure and the principles of financial disclosure evaluation. (5) Nonetheless, the accounting profession was always understood to be serving a quasi-public function when it reviewed public company financial statements. In this light, the structure of an audit and the relationship between an issuer and its auditor were not really part of the issuer's internal self-governance. (6) Historically, the regulation of business has been split between corporate law and securities law. Corporate law is contractual, enabling, and administered by the states; securities law is national, mandatory, and administered by the Securities and Exchange Commission and the self-regulatory organizations. Accordingly, regulation of disclosure, the securities markets, and financial reporting are neither new nor, from a federalism perspective, particularly troubling. Sarbanes-Oxley, however, together with the increasing involvement of national regulators in the regulation of corporate governance, reflects a breakdown in this division of responsibility. (8) A similar breakdown is reflected in the enforcement actions undertaken by New York Attorney General Eliot Spitzer with respect to analyst conflicts of interest and abuses in the mutual fund industry. …