armour & mccahery (eds.) - after enron; improving corporate law and modernising securities regulation in europe and the us (2006)

After Enron Improving Corporate Law and Modernising Securities Regulation in Europe and the USEdited by John Armour and Joseph A McCahery Oxford and Portland, Oregon 2006... Introduction

At the end of the twentieth century, it was thought by many that theAnglo-American system of corporate governance was performing effec-tively and some observers claimed to see an international trend towardsconvergence around this model There can be no denying that the recentcorporate governance crisis in the US has caused many to question theirfaith in this view This collection of essays provides a comprehensiveattempt to answer the following questions: first, what wentwrong—when and why do markets misprice the value of firms, and whatwas wrong with the incentives set by Enron? Secondly, what has beendone in response, and how well will it work—including essays on theSarbanes-Oxley Act in the US, UK company law reform and Europeancompany law and auditor liability reform, along with a consideration ofcorporate governance reforms in historical perspective Three approachesemerge The first two share the premise that the system is fundamentallysound, but part ways over whether a regulatory response is required Thethird view, in contrast, argues that the various scandals demonstrate fun-damental weaknesses in the Anglo-American system itself, which cannothope to be repaired by the sort of reforms that have taken place.

After Enron Improving Corporate Law and Modernising Securities Regulation in Europe and the US

Edited by

John Armour and Joseph A McCahery

Oxford and Portland, Oregon

2006

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We are grateful to the authors for agreeing to contribute their material tothis collection Several of the chapters have previously been published asarticles, and where the copyright is not held by the authors, we are alsograteful to the publishers for permitting us to reproduce their material Inparticular, we acknowledge the permission of the American Bar Associa-tion (Chapters 3 and 7); Sage Publications (Chapter 4); Oxford UniversityPress (Chapters 6 and 14); the Asser Press (Chapters 9 and 15); Blackwell

Publishing (Chapter 10); Theoretical Inquiries in Law (Chapter 11); bridge University Press (Chapter 16) and the University of Pennsylvania Journal of International Economic Law (Chapter 17).

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Introduction

After Enron: Improving Corporate Law and Modernising

Securities Regulation in Europe and the US

1 The Mechanisms Of Market Efficiency Twenty Years Later: The Hindsight Bias

RONALD J GILSON and REINIER KRAAKMAN 29

2 Taming the Animal Spirits of the Stock Markets: A Behavioural Approach to Securities Regulation

Part II: Corporate Scandals in Historical and Comparative Context 127

3 Icarus and American Corporate Regulation

4 Corporate Governance after Enron: An Age of Enlightenment SIMON DEAKIN and SUZANNE J KONZELMANN 155

5 Financial Scandals and the Role of Private Enforcement:

The Parmalat Case

6 A Theory of Corporate Scandals: Why the US and Europe Differ

Part III: Evaluating Regulatory Responses: The US and UK 235

7 The Case for Shareholder Access to the Ballot

8 Rules, Principles, and the Accounting Crisis in the United States

11 The Legal Control of Directors’ Conflicts of Interest in the

United Kingdom: Non-Executive Directors Following the

Higgs Report

Part IV: Reforming EU Company Law and Securities Regulation 413

12 Enron and Corporate Governance Reform in the UK and the European Community

GÉRARD HERTIG and JOSEPH A McCAHERY 545

16 The Regulatory Process for Securities Law-Making in the EU

List of Contributors

JOHN ARMOUR is a Senior Lecturer in the Faculty of Law, and

Research Associate in the Centre for Business Research, at theUniversity of Cambridge

LUCIAN ARYE BEBCHUK is William J Friedman and Alicia

Townsend Friedman Professor of Law, Economics, and Finance,Harvard Law School

BERNARD BLACK is Haydn W Head Regents Chair for Faculty

Excellence and Professor of Law at the University of Texas LawSchool and Professor of Finance at the Red McCombs School ofBusiness, University of Texas

WILLIAM W BRATTON is Professor of Law at the Georgetown

University Law Center

BRIAN CHEFFINS is S.J Berwin Professor of Corporate Law in the

Faculty of Law at the University of Cambridge

JOHN C COFFEE, JR is Adolf A Berle Professor of Law at Columbia

University and Director of the Center on Corporate Governance atColumbia University Law School

JAMES D COX is Brainerd Currie Professor of Law at the Duke

University School of Law

PAUL DAVIES is Cassel Professor of Commercial Law at the London

School of Economics

SIMON DEAKIN is Robert Monks Professor of Corporate

Governance in the Judge Business School, Acting Director of theCentre for Business Research, and Yorke Professorial Fellow in theFaculty of Law at Cambridge University

LUCA ENRIQUES is Professor of Business Law at the University of

Bologna, Faculty of Law, and ECGI Research Associate

GUIDO FERRARINI is Professor of Law at the University of Genoa

and the Centre for Law and Finance

EILÍS FERRAN is Professor of Law in the Faculty of Law at the

University of Cambridge

RONALD J GILSON is Meyers Professor of Law and Business at

Stanford Law School and Stern Professor of Law and Business atColumbia Law School

PAOLO GIUDICI is Professor of Law at the Free University of Bozen

and Centre for Law and Finance

GÉRARD HERTIG is Professor of Law and Economics,

Eidgenössische Technische Hochschule Zürich

KLAUS J HOPT is Professor of Law and Director of the Max Planck

Institute for Foreign Private and Private International Law inHamburg

MICHAEL KLAUSNER is Professor of Law at Stanford Law School SUZANNE J KONZELMANN is Reader in Management at Birkbeck

College, University of London and Research Associate at the Centrefor Business Research, University of Cambridge

REINIER KRAAKMAN is Ezra Ripley Thayer Professor of Law at

Harvard Law School

DONALD C LANGEVOORT is Professor of Law at Georgetown

University Law Center

JOSEPH A MCCAHERY is Professor of Corporate Governance at the

University of Amsterdam Center for Law and Economics

RICHARD C NOLAN is a Fellow of St John’s College and Senior

Lecturer in Law at the University of Cambridge; he is also a Barrister

at Erskine Chambers, Lincoln’s Inn, London

DAVID A SKEEL, JR is S Samuel Arsht Professor of Corporate Law

at the University of Pennsylvania Law School

After Enron: Improving Corporate Law and Modernising Securities Regulation

in Europe and the US

DURING THE 1990s, US stocks led the world in the greatest bull

market in history On 24 March 2000, the S&P 500 Index peaked at

a record high of 1,527.47, up a dizzying 500 per cent on ten yearsearlier (Standard & Poor, 2006) For much of this period, the EnronCorporation was one of Wall Street’s darlings It was a member of an eliteclub of ‘new economy’, growth-driven firms whose stocks were at theforefront of the market’s spectacular rise Acclaimed as ‘America’s mostinnovative company’ by Fortune magazine for each of the years from

1996 to 2001, Enron is, however, best remembered for what happened

after the stock market had peaked Whilst many ‘new economy’ stocks

started to fall, Enron’s continued to rise for a while, seemingly defyinggravity (Fortune, 2001) But in the autumn of 2001, Enron tumbledspectacularly from grace Revelations of widespread accounting fraudand other misconduct by senior executives spiralled the firm into whatwas then the largest bankruptcy in history Enron’s demise was soonfollowed by scandals at a number of other ‘new economy’ stars, such asWorldcom, Tyco, Adelphia and Global Crossing This wave of accountingfraud shook investors’ faith in stock markets and by 9 October 2002, theS&P 500 had fallen by over 50 per cent from its record high Many askedwhether something was not profoundly wrong with the US system ofcorporate governance

Several things had gone wrong at Enron Its top executives had

* Faculty of Law and Centre for Business Research, Cambridge University.

Economics, and Professor of International Business Law, Tilburg University Faculty of Law.

We are grateful to Brian Cheffins for helpful comments on earlier drafts The usual disclaimers apply.

engaged in aggressive accounting manipulations in an effort to boost thecompany’s stock price They were motivated, at least in part, by a desire

to maximise the value of their stock options The company’s auditors hadbeen persuaded to become complicit in earnings misstatements by thecorrosive effect of valuable consulting contracts, which were in manage-ment’s gift Moreover, analysts at several investment banks, supposedlyoffering independent advice, were tainted by conflicts of interest arisingout of their firms’ involvement in Enron’s financing As a result, Enron’sshare price was artificially inflated for a considerable period of time.Because the revelations of misconduct came on the back of a stockmarket fall, Enron’s shareholders suffered heavy losses One of theworst-hit groups—and least able to afford it—were the company’semployees, whose pension plans had been heavily invested in the firm as

an ‘incentive’ measure Particularly egregious, in many people’s eyes,was the fact that Enron executives had started to sell their shares in thecompany by mid-2001, when it was clear that trouble was unavoidable,whereas the terms of employees’ pension schemes prohibited them fromdoing so These factors gave the scandal a particularly intense politicalsalience

The US Congress responded very rapidly On 30 July 2002, less thannine months after Enron filed for bankruptcy, the Public CompanyAccounting Reform and Investor Protection Act of 2002 was passed.1Thenew legislation, known universally as the ‘Sarbanes-Oxley’ Act after itstwo sponsors, was intended to restore public confidence in stock markets

In the main, it sought to restore the integrity of the audit process bystrengthening oversight of the accounting profession However, the Actalso put in place a number of measures designed to counter failures incorporate governance These include requiring CEOs and CFOs to certify,

on pain of criminal penalties, their firms’ periodic reports and theeffectiveness of internal controls; the imposition of obligations oncorporate lawyers to report any evidence of suspected violations ofsecurities law; the prohibition of corporate loans to managers or directors;restrictions on stock sales by executives during certain ‘blackout periods;’and requiring firms to establish an audit committee comprised ofindependent directors, of which at least one member must be a ‘financialexpert.’

For a short while after the American scandals broke, European

observers might have been forgiven for experiencing a hint of fraude Continental Europeans had frequently been lectured on the virtues

schaden-of the Anglo-American ‘outsider’ model schaden-of corporate governance, and onhow the globalisation of capital and product markets would supposedlyforce the abandonment of their ‘insider’ model in order to remain

1 Sarbanes-Oxley Act of 2002, Pub L No 107-204, 116 Stat 745.

competitive (see Hansmann and Kraakman, 2001) In the immediateaftermath of Enron, some Europeans were heard to wonder whether theinsider system might not have advantages after all: at least it seemed to

be immune from stock market-driven scandals (see Enriques, 2003).Any complacency was short-lived In late 2002—little more than ayear since the Enron scandal had broken—news began to emerge thatsomething was seriously amiss at Parmalat, the Italian dairy-produceconglomerate As this and other earnings misstatement scandals—such

as those at the Dutch retail giant Ahold and the French engineering firmAlstom—unfolded over the next year, any illusion of European immunitywas shattered It did not take the European Commission long to respond.They had already, in spring 2002, asked their High-Level Company LawExpert Group to prepare a report elaborating any necessary EU legis-lation in the field of corporate governance In May 2003, the Commissionannounced a number of initiatives, including an Action Plan for themodernization of company law and plans for the reform of the statutoryaudit (European Commission, 2003a, 2003b) These proposals are findingtheir way onto the statute book at varying speeds

In the UK, Marconi, a firm that had won stock market plaudits for itsacquisition-led expansion into new economy businesses during the 1990s,suffered a dramatic fall into the hands of its creditors during the secondhalf of 2001 The UK’s corporate community held their collective breath,because memories of scandals at Polly Peck, BCCI and Maxwell in theearly 1990s were still vivid Although Marconi turned out to have been acase of management error, rather than fraud, the UK was spurred intorenewed reflection on whether its corporate governance system wasfunctioning effectively As it happened, a large-scale reform of Englishcompany law, following the independent Company Law Reviewcommissioned by the DTI, had been announced well before the Enronscandal broke (see Arden, 2003) Whilst preparations for these reformswere continuing, the government ushered in a number of corporategovernance-related initiatives, including the controversial Higgs Report

on the role and effectiveness of non-executive directors (Higgs, 2003), andthe Smith Report on audit committees (Financial Reporting Council,2003a), both of which were implemented through a revision to the UK’snon-statutory Combined Code on Corporate Governance (FinancialReporting Council, 2003b)

The series of corporate scandals on both sides of the Atlantic and theenergetic reform activity it engendered around the world provoke amultitude of questions, many of which are explored in more detail by thecontributions in this volume First, reflection is prompted about the extent

to which capital markets price stocks ‘efficiently’—that is, take intoaccount all publicly-available information about firms Some investorswere suspicious about Enron’s artificially high stock price, even before its

bubble burst (Fortune, 2001) If such investors might have viewed selling

it short as an opportunity for profit, why did it not fall more quickly?

Do capital markets behave less rationally than had previously beenimagined?

Secondly, we might investigate the ways in which, if at all, the US andEuropean scandals differed both from each other, and from othercorporate scandals that have occurred in history Are corporate scandals,and knee-jerk legislative responses to them, a cyclical process, forming

an inevitable corollary to stock market bubbles? Did the pattern ofmisconduct in Europe differ significantly from that in the US, reflectingunderlying differences in systems of corporate governance, or are all thescandals best characterised as sharing certain basic commonalities?Thirdly, and perhaps most obviously, questions arise about the legis-lative prescriptions for reform In the US context, was the Sarbanes-OxleyAct sufficient, or indeed necessary, to remedy the problems? What should

be done about issues concerning shareholder rights, accounting lation and board structure? The reforms in the European context not onlyprovoke reiterations of these questions, but also raise an additional group

regu-of issues The EU is characterised by a much greater degree regu-of bothpolitical and economic diversity than is the US This calls for examinationboth of the appropriateness of particular substantive measures as pan-European reforms, which must cater to this diversity, and of the politicalfeasibility of reform programmes The post-Enron era has seen renewedenergy in European company law and capital markets reform, which inturn prompts reflection on the degree of success with which these newmeasures have surmounted the political obstacles

Parts I-IV of this collection address these four groups of issues in turn

PA RT I: STOCK MARKETS AND I NFORMATION

Whilst it was clear that executives at Enron—and perhaps to a greaterextent, at Tyco and Worldcom—had engaged in outright manipulation oftheir accounts, many observers expressed surprise that this had not beenpicked up by the markets before the summer of 2001 This was becausethe accounts contained a number of gaps, which, it has been argued,ought to have lead seasoned investors to conclude well before then thatthere was something unnatural about the stock’s continued rise Thequest to understand why they did not do so forms the stepping-off pointfor the chapters in Part I of this collection

From the mid 1970s until the late 1990s, the orthodox view amongstfinance scholars was that capital markets priced securities ‘efficiently’.The first tenet of this view, which is known as the Efficient CapitalMarkets Hypothesis (ECMH), posits that price-sensitive information is

impounded in stock prices (Fama, 1970) Numerous ‘event studies’ haveshown empirically that companies’ stock prices do in fact react almostinstantaneously to significant events affecting their performance Thesetend to confirm the so-called ‘semi-strong’ form of the ECMH, namely

that securities prices take into account all publicly available information

about the firms issuing them (see Malkiel, 1992)

If the finance orthodoxy is correct, then what went wrong at Enron waspurely a matter of the manipulation of disclosure If markets take intoaccount all publicly available information, then it should not be sur-prising that if price-sensitive information is concealed, a company such

as Enron should have—for a limited period at least, until the marketdiscovers what is going on—an over-inflated stock price

Enron, however, provides a seeming puzzle for adherents to thefinance orthodoxy Many of the irregularities in its accounts were notconcealed, or at least not with any real efficacy The notes to thecompany’s accounts dropped very large hints about the over-engineering

of its finances The surprising thing, if the finance orthodoxy is correct, isnot that the company ultimately failed, but that this publicly-availableinformation seems to have been ignored

Since the mid 1990s, however, an alternative framework for standing stock markets, known as ‘behavioural finance’, has emerged(e.g Shleifer, 2000) The name reflects the way in which this view startsfrom empirical studies of investor behaviour, as opposed to axiomaticpostulates of rationality Such studies show that investor behaviour differsmarkedly from what would be ‘rational’ in a range of circumstances.However, proponents of the traditional perspective have responded with

under-a series of explunder-anunder-ations consistent with the runder-ationunder-ality under-axioms (e.g Funder-amunder-a,1998)

Part I contains two chapters that consider the extent to which thebehavioural finance view might call for a reappraisal both of claims thatcapital markets are ‘efficient’ and of perceptions about how best to regu-late them In so doing, they each consider whether investor irrationalitymight help to explain what happened at Enron Chapter 1, by RonaldGilson and Reinier Kraakman, is a reprise to an influential earlier article,

‘The Mechanisms of Market Efficiency’ by the same authors (Gilson andKraakman, 1984) The earlier paper sought to offer an account of theinstitutions that facilitate the informational efficiency of capital markets.The authors argued that arbitrageurs act as an important conduit for thereflection in stock prices of information available only to a subset ofinvestors The arbitrageurs would follow the trading activities of well-informed investors, such as corporate insiders, and any unusual activitywould thereby be rapidly picked up by the market

In Chapter 1, Gilson and Kraakman review the same terrain in light ofdevelopments in finance theory Their analysis focuses on institutional

limitations, such as regulatory and market restrictions on short selling,which make arbitrageurs less effective at transmitting negative infor-mation about corporate performance into stock prices than positiveinformation For such restrictions to impede market efficiency does notnecessitate any assumption that investors behave irrationally However,the presence of a substantial number of irrational investors (‘noisetraders’) in the marketplace compound these problems by introducing

‘noise trader risk’—that is, a risk that an arbitrageur will suffer loss on an

‘informed’ position because that information is ignored by noise traders.Moreover, where the irrationality consists of a general bias in a particulardirection, then this may generate a ‘momentum effect’—that is, a changesustained only by virtue of a previous change—for particular stocks, orfor the market in general It may become rational for arbitrageurs to trade

with, rather than against, the momentum effect—that is, if a large number

of investors are behaving irrationally by ignoring information aboutfundamentals, it becomes rational to ignore that information too Gilsonand Kraakman suggest that a sudden influx of uninformed investorswould be a good proxy for the existence of ‘bubbles’ in the market.However, such a momentum effect requires a continuous stream of newinvestors to sustain it, and at a certain point, will come to an end Thisechoes old wisdom that the time to sell investments in a bubble market isthe moment at which everyone else has entered the market, and so therewill be no fresh money to prop it up—or as Joseph Kennedy is famouslyreputed to have said: ‘when the shoe-shine guy starts giving you stocktips, it’s time to get out of the market.’

In Chapter 2, Donald Langevoort considers more directly the ways inwhich various behavioural biases might impact on the ECMH He focuses

on biases such as ‘loss aversion’—which can lead investors to sellwinning stocks too quickly (so as to avoid the risk of suffering a loss) but

to delay selling losing stocks too long (in a desire to avoid crystallising aloss), and ‘cognitive conservatism’, which leads people to change theirviews in response to new information more slowly than would beconsistent with rationality However, both effects are subject to changeunder particular circumstances Loss aversion has been shown to besignificantly reduced in the light of recent experience—that is, gamblersare more confident when ‘on a roll’ The salience, representativeness oravailability of new information may dramatically affect the way in whichpeople react to it—under certain circumstances they may overreact,rather than react conservatively The problem with many of these find-ings—as Langevoort clearly recognises—is that they are highlycontingent, making prediction difficult, and the task of a policy-maker—who must work with generalities—very complex Withouttaking a position on the question whether behavioural analysis betterpredicts market movements than traditional ‘rationality’ assumptions,

Langevoort teases out implications for a variety of different aspects ofmarket regulation—including ‘fraud on the internet’, fair disclosure andinsider trading.

Both chapters suggest that even if information was publicly able—or could readily have been extrapolated—about Enron’s trueposition, the market might have failed to respond to it as quickly as mighthave been expected, owing to irrationality on the part of investors,institutional limitations, or both This implies that what went wrong wasmore than just the manipulation of disclosure by Enron’s executives

avail-PA RT I I : CORPORATE S CANDALS I N HI S TORI CAL A ND

of Jay Cooke, who engineered the finances of the Northern PacificRailroad during the 1860s until its spectacular collapse in 1873; and that

of Samuel Insull, who built a vast empire of electricity companies in the1920s, which imploded amid allegations of fraud in 1932 Skeel arguesthat in each case, the problems were caused by a combination of a culture

in which risk-taking by executives was linked to reward, with excessivecompetition These encouraged managers to take ever-increasinggambles Each time round, some executives responded to these pressures

by manipulating the corporate form in order to inflate returns artificially

In each case, such manipulation permitted a few executives to obtainvery high returns from wrongdoing that impacted negatively on thelives of many individuals Thus when the wrongdoing came to light,scandals—popular outrage—followed As a result, there was a populistdemand for a response, which in each case took the form of legislationdesigned to ensure that the particular malpractices which had occurredwould not be repeated: the cessation of federal subsidies to railways inthe 1870s; the Securities Acts of 1933 and 1934, and the Sarbanes-OxleyAct in 2002 Skeel then reflects on the link between interest group politicsand the regulation of corporate behaviour in the US For most of thehistory of the corporate form, managers have been the dominant interestgroup: they have at their disposal corporate resources that can be used to

lobby politicians in an effective and concentrated manner Thus, on thewhole, the legal environment within which public companies operate has

a tendency to respond to managers’ preferences Yet for brief periodsfollowing the scandals that have occurred intermittently throughout thehistory of the corporate form, populist outrage compels legislatures toenact manager-constraining legislation

Skeel’s account is thus sympathetic to the widely-held view thatSarbanes-Oxley Act was a ‘knee-jerk’ response to populist pressure It isdoubtful whether this piece of legislation, passed as quickly as it was, canhave been adequately thought through It is hardly surprising, therefore,that it has drawn widespread criticism from commentators who argue,alternatively, that it is either unnecessary, or insufficient, to address the

underlying problems Precisely which reforms, if any, would lead to the

smoother functioning of market-based corporate governance is of course

a highly contentious question A troubling suggestion, exemplified bySimon Deakin and Suzanne Konzelmann’s contribution in Chapter 4, is

that Sarbanes-Oxley is merely a response to the symptoms of a deeper

malaise in a system of corporate governance that focuses too closely on

‘shareholder value’ (see also Bratton, 2002)

As is well-known, companies listed in the US and UK are said tooperate within an ‘outsider’ system of corporate governance (e.g Berglöf,1997; Bratton and McCahery, 2002) The most important distinguishingfeature is that share ownership is dispersed, with no single blockholderbeing able to exert significant control over the company The principalgoal of corporate governance is understood in terms of rendering man-agers of such companies accountable to their dispersed shareholders Thefear is that managers would otherwise tend to prefer their own interests,

to the detriment of shareholders Since the mid-1980s, an orthodox view

in Anglo-American corporate governance, based largely on the itional finance perspective, has been that the best way to render managers

trad-of public corporations accountable to stockholders has been to give themincentives to focus on the share price, for example through the threat ofhostile takeovers (Easterbrook and Fischel, 1991) If markets impound allpublicly available information about corporate performance, then themarket price will give the most reliable indicator of the extent to whichmanagers are pursuing the shareholders’ interests Thus many of themechanisms of corporate governance employed in Anglo-Americanpublic companies during the 1990s have equated shareholders’ interestswith the pursuit of higher stock prices

Yet, as Deakin and Konzelmann argue, giving executives powerfulincentives—both positive, in the form of lucrative remunerationpackages, and negative, in the form of threats of hostile takeover—thatare linked to a single benchmark—share price—creates a powerful andcounter-productive temptation to manipulate indicators This criticism is

complemented by the perhaps more fundamental point that the use of

‘accountability to share price’ as a proxy for ‘accountability toshareholders’ rests on the assumption that capital markets are, to a largedegree, informationally efficient To the extent that they are not, as wascontemplated by the contributions in Part I, then the share price might

not reflect shareholders’ long-term interests (Singh et al, 2005)

Con-sequently, tying managers’ conduct to share price maximization mightresult in misallocations of resources

Deakin and Konzelmann view the Enron scandal as a demonstration ofthe failure of ‘shareholder value’ as a guiding principle for business, andargue for a return to a more pluralistic view of the ambitions of corporateentities Placing less emphasis on accountability to shareholders wouldnot only reduce incentives to ‘massage’ figures, but would also make iteasier for firms to commit to ‘partnership’ arrangements with employees.What would be lost in accountability, it is argued, would be more thanmade up for through the increased effort devoted to productive activityrather than signal manipulation The characteristic feature of most of theworld’s corporate governance systems—that is, apart from the USand the UK—is that the ownership of shares in listed companies isconcentrated in the hands of blockholders Systems following this patternare said to have an ‘insider’ model of corporate governance, in contrast tothe Anglo-American ‘outsider’ model Under an insider system, thereneed be little regulatory concern about rendering managers accountable

to shareholders, as the blockholder will control the managers, who willclearly be accountable to them Hence it is possible for the corporategovernance framework explicitly to promote a pluralistic approach

A drawback with the foregoing argument is that whilst manycorporate governance systems—especially those in continentalEurope—already embrace such pluralism, Parmalat and the otherEuropean collapses have amply demonstrated that such systems enjoy nospecial immunity from scandal The Parmalat scandal, recounted byGuido Ferrarini and Paolo Giudici in Chapter 5, forcefully drove homethe point that the incentive and opportunity to commit fraud is notlimited to any particular system of governance, geographic region,industry, or size of company As is the case with many large continentalEuropean firms, Parmalat was controlled by members of its foundingfamily Its failure was a classic case of fraud carried out by thefamily-controlled managers to enrich family members and privatecompanies controlled by the family trust

There were some clear commonalities between the Enron and Parmalatscandals First, both involved self-interested executives manipulating cor-porate assets for the benefit of themselves and their associates Secondly,

as Ferrarini and Giudici explain, auditor failure appears to havecontributed materially to both scandals

Despite these similarities, there were also significant differences.Although both Enron and Parmalat involved accounting misstatements,John Coffee argues in Chapter 6 that each involved characteristicallydivergent forms of misconduct, reflecting differences in the underlyingsystems of corporate governance In outsider systems, managers are mostlikely to be tempted to inflate the share price, as happened in the variouscases of earnings misstatements in US public companies In insidersystems, on the other hand, the concern is less with manipulating theshare price, and more with the diversion of corporate assets into thehands of blockholders—as appears to have been at the heart of Parmalat’swoes One implication of Coffee’s chapter is that we should not assumethat legal reforms which are matched to the problems of outsidergovernance regimes will necessarily also work in an insider system Forexample, it might be asked how effective attempts to make boards ofdirectors more ‘independent’, recently popular in Anglo-Americancorporate governance, would be if transplanted into an ‘insider’ systemwhere top managers are in any event controlled by a blockholder.

Another important difference between corporate governance systems,which has received considerable recent attention in the economic

literature, concerns the appropriate mode of regulation That is, the ways

in which rules governing corporate behaviour are created and enforced.One provocative strand of work has focused on generic differencesbetween civil and common law countries, arguing that the common law(associated with Anglo-American systems) is more readily adaptable tochanges in market conditions, and less susceptible to harmful political

interference (e.g La Porta et al, 2000; Beck et al, 2002) Whilst a binary

division between ‘civil law’ and ‘common law’ seems overly simplistic, it

is nevertheless becoming clear that differences in the creation andenforcement of regulation may matter at least as much in corporategovernance as the content of the substantive rules themselves This point

is forcefully made in this collection by Ferrarini and Giudici (Chapter 5),who explain that the substantive rules regarding auditor liability in Italywere, at the time the misdeeds occurred at Parmalat, actually morestringent than the post Sarbanes-Oxley regime in the US Yet these rulesnevertheless failed to prevent large-scale auditor failure Ferrarini andGiudici argue that this was because of weaknesses in the rules’enforcement In Italy, as in much of continental Europe, the regulation ofcorporate governance rules relies heavily on public enforcement to renderthe substantive rules effective as a deterrent The authors contrast thiswith the US, where private enforcement plays a much more significantrole To be sure, the US system, which relies heavily on class actionlitigation, does not result in perfect deterrence (see Pritchard, 2005) ButFerrarini and Giudici’s argument is that, as a general matter, private

parties have more reliable incentives to enforce than do publicprosecutors, whose efficacy may be sidelined by rent-seeking activities.Thus, whilst auditor failure was at the heart of both the US andEuropean scandals, there were significant differences, which in turnmight require different responses—both in terms of the substance and themode of regulation—to prevent a recurrence In light of these differences,the US and European regulatory responses are considered separately,respectively in Parts III and IV of the book The UK, which shares many

of the features of the US system of corporate governance, yet is subject tothe same EU rules as continental Europe, is considered at appropriatepoints in both

PA RT I I I E VA L U AT I N G R E GU L ATORY R E S P O N S E S :

T H E U S A N D U K

The five chapters in Part III of the book consider various reforms, bothactual and proposed, that have been prescribed in the Anglo-Americancontext At the core of this discussion must necessarily be theSarbanes-Oxley Act As we have seen, it is easy to criticise the speed withwhich the US legislation was rushed through Congress A widely-heldview is that it lead to provisions that are costly and ineffective, inserted toappease populist demand rather than as genuine solutions to theunderlying problems Moreover, acting in haste may have lead Congress

to overlook more effective regulatory techniques

Those who consider that capital markets function efficiently tend tocriticise Sarbanes-Oxley as unnecessary and unjustified (Ribstein, 2005;Romano, 2005) The new rules create significant compliance costs forpublic companies, which critics claim are far greater than any counter-vailing benefits (Jain and Rezaee, 2005) The market, it is said, responded

to the misdeeds at Enron even without the new legislation Market forcespunished the company’s executives—and consequently, the auditors andanalysts who had compromised themselves—through reputational

sanctions Enron, on this account, was not an example of market failure, but of the market functioning, by removing a ‘bad apple’.

Another group of commentators criticise the recent reforms for whatwas omitted This perspective differs from the ‘efficient markets’ critique

in that its adherents have less faith in the ability of capital markets toimpound price-sensitive information, and commensurately greater belief

in the ability of regulatory intervention to improve on market outcomes

On this view, the Congressional error was largely in omitting to includeprovisions which were necessary to resolve the underlying problems: forexample, in relation to shareholder rights (Bebchuk, Chapter 7, thisvolume), accounting regulation (Cox, Chapter 9, this volume), board

structure (Kraakman, 2004), and the use of stock options to compensate

executives (Johnson et al, 2003).

It is probably too soon to reach a final conclusion as to which of theforegoing positions is closer to the truth, as the answer depends in partupon the view taken about the efficiency of capital markets—itself anarea in which, as the essays in Part I evidence, no settled positioncurrently exists In reaching an answer, however, it is necessary tounderstand not just the weaknesses of the legislation that was passed, butalso the relative merits of various proposals that have been offered bycritics in the second camp To this end, the five chapters that comprisePart III consider three regulatory mechanisms that are at the core of thepost-Enron reform debate: (i) strengthening shareholder rights; (ii) thereform of accounting regulation and (iii) increasing the role played bynon-executive (or ‘outside’) directors Some, but not all, of these weresignificantly reformed by Sarbanes-Oxley, and each has featuredprominently in policy debates about corporate governance since Enron

on both sides of the Atlantic Considering the actual or potential merits ofthese various mechanisms provokes thought about the extent to which, if

at all, regulatory intervention may be capable of remedying the problemsexemplified by Enron

A Strengthening Shareholder Rights

In ‘outsider’ systems of corporate governance, the notion of ‘shareholderrights’ is often used to refer to the extent to which shareholders, if theyare so minded, are able to exercise ‘voice’ within the firm to keepmanagers in check—sometimes referred to as ‘antidirector rights’ (see La

Porta et al, 1997, 1998) It encompasses not only positive entitlements by

shareholders to elect (or remove) the board, veto (or authorise) certaintypes of transaction and the like, but also correlative restrictions onmanagement’s ability to entrench themselves against shareholderdecisions (for example, through defences capable of blocking a takeoverbid) A number of recent empirical studies have reported correlationsbetween various indices of ‘shareholder rights’ and share prices

(Gompers et al, 2001; Bebchuk et al, 2004; Larcker et al, 2005) Of particular

significance is a link between mechanisms by which managers are able toentrench themselves—for example, through takeover defences, staggeredboards and the like—and weaker corporate performance

In the US, most of corporate law is formulated at the state, rather thanthe federal, level The Sarbanes-Oxley Act, being federal, is an importantexception US corporations are free to select their state-level governinglaw by changing their state of incorporation, something which Sarbanes-Oxley did nothing to change ILucian Bebchuk has argued that because

share ownership in US listed companies is widely dispersed, managers oflisted companies have too much influence over decisions to reincorporate(Bebchuk, 2005; 2006) He claims that as a result, firms will tend to besteered towards legal regimes that entrench managers and disenfranchiseshareholders, which the empirical evidence suggests may, over time, have

a negative impact upon firm values In Chapter 7, Bebchuk proposes apartial solution: federal rules facilitating shareholder access to the ballotbox for board elections, which would limit the extent to which managerscould entrench themselves

The problem of managerial entrenchment is one that is peculiar to

‘outsider’ systems of corporate governance This is because where listedfirms are controlled by blockholders, the problem becomes one ofblockholder, rather than managerial, entrenchment It is thereforeinteresting to contrast the case of the US with that of the UK, the onlyother country in which share ownership is typically widely dispersed.Perhaps surprisingly, there are considerable differences in the extent towhich the two countries permit managerial entrenchment: the UK issignificantly more restrictive than the US UK directors are mandatorilysubject to the threat of dismissal by a simple majority of the shareholders

in general meeting.2 Strong pre-emption rights and market hostility todual class voting stock disable managers from using such structures toperpetuate their control (Ferran, 2003) Moreover, the UK’s City Code,written and implemented by the self-regulatory Panel on Takeovers andMergers, gives much greater control to shareholders over the conduct oftakeover bids than they enjoy under the more manager-friendly doctrinesunder Delaware law (Armour and Skeel, 2005)

One possible explanation for this divergence in outcomes is that therelatively weaker position of US shareholders results from a ‘race to thebottom’ in US corporate law The UK’s corporate law, based in a unitaryjurisdiction, has for most of its history not faced any pressure fromregulatory competition, a force which in Bebchuk’s view has beenresponsible for degrading shareholder rights in the US However, thisexplanation provokes further questions, suggesting that it may only bepart of the story Much of the UK’s regulatory regime for publiccompanies has developed out of self-regulatory or ‘soft law’ codespromulgated by stock market institutions, as opposed to legislation PaulDavies (Chapter 12), argues that the use of ‘soft law’ has been useful tothe UK government in overcoming managerial lobbying, because the

(unexercised) threat to resort to legislation Such techniques have alsobeen used in the US: for example, in response to Enron, both the NewYork Stock Exchange and NASDAQ have recently introduced new rules

2 UK Companies Act 1985 s 303.

regarding board structure Regulatory competition does not explain whysuch codes have historically not been more extensively deployed in the

US to reinforce shareholder rights Rather, this may be because the federalsecurities acts of the 1930s—a populist response to an earlier set ofcorporate scandals—pre-empted self-regulation by mandating the SEC toapprove stock exchange listing rules (Armour and Skeel, 2005).3 Ofcourse, shareholder enfranchisement may still be advanced, within thisframework, through changes to SEC rules, and it is a proposal of thisvariety that is made by Bebchuk in Chapter 7

B The Reform of Accounting Regulation

Arguably the most fundamental of the Sarbanes-Oxley reforms has beenthe tightening of controls on auditors The basic problem, to which theAct responds, is that of managerial influence over auditors Whilst aconcern with reputation would supposedly encourage auditors not to betoo soft on management, such effects have been considerably under-mined in recent years by the growth in the provision of non-auditservices by accountants to their audit clients These have provided thelarge accountancy firms with an ever-increasing share of their revenues,and in so doing have given their corporate clients a powerful, and notreadily visible, lever with which to encourage the auditor to agree withmanagement’s own preferred statement of the company’s position Inextreme cases, this may provide enough of an incentive to auditors tosign off where not just aggressive accounting, but downright fraud, hasbeen taking place (Coffee, 2002, 2004)

In response, the Sarbanes-Oxley Act has mandated the creation of anew accounting regulator, the Public Companies Accounting OversightBoard, with whom firms auditing US-listed public companies mustregister The Act has also required public companies to channel auditorappointment and oversight through an audit committee, comprised ofindependent directors; required CEOs and CFOs, on pain of criminalpenalties, to certify the veracity of financial statements; mandated quin-quennial rotation of audit partners at accounting firms; and prohibitedthe offering by audit firms of a range of specified nonaudit services.However, some argue that the problems with US audit practices godeeper, and consequently are not remedied by the Act Chapters 8 and 9consider two such claimed problems: the heavy reliance on rules, ratherthan principles, in US accounting practice, and the oligopolistic structure

of the US accounting industry

3 Recently, the trend in the UK has been away from self-regulation, as with the Financial Services Authority taking control of the Listing Rules from the London Stock Exchange in 2000.

It has been argued by some that one of the factors that facilitatedEnron’s balance sheet manipulation was the ‘rules-based’ structure of USGAAP (generally accepted accounting principles) The US GAAP is oftencontrasted with ‘principles-based’ systems such as UK GAAP or theIASB’s guidelines, which involve more generally-worded, open-endednorms, the application of which, it is said, requires a greater level ofprofessional judgement by accountants The criticism levelled at USGAAP is that a system in which accounts are audited primarily forcompliance with a body of rules, depends for its integrity on thecomprehensiveness of the rulebook employed Any body of accountingrules will have loopholes, which in a rules-based system then lendthemselves to exploitation by companies seeking to manipulate theirearnings On the other hand, it is argued that a principles-based system,which requires professionals to exercise their judgement more frequentlyinstead of passively standing behind the rule book, would lead to less ofthis sort of ‘gaming’ behaviour.

William Bratton disputes this argument in Chapter 8 In Bratton’s view,Enron was really a case of ‘old-fashioned fraud’, rather than sophis-ticated, aggressive accounting Moreover, he suggests that US GAAP is inreality more principles-based than many of the proponents of ‘principles’seem to realise In practice, the demand for rules appears to have beenfuelled not by companies wishing to be assured of loopholes to exploit,but rather by accountants facing competitive pressures, because rulesfoster certainty and help to lower the fees auditors need to charge toinsure themselves

In Chapter 9, James Cox argues that the highly concentrated structure

of the US accounting industry allows firms to coordinate on price andstrategy, and contributed to the profession’s weaknesses Such concen-tration may have facilitated the development of the accounting firms’consultancy businesses, and the conflicts of interest with audit to whichthese gave rise Moreover, he suggests that the industry’s concentration isalso likely to undermine the effectiveness of the Sarbanes-Oxley reforms

He reports preliminary findings on the Act’s operation, which do notsuggest that it has made a significant difference Because the accountingprofession around the world is dominated by the same ‘Big Four’ firms,the implications of Cox’ argument are not limited to the US

C The Board of Directors

Corporate boards and the closely-related role of independent directorshave been amongst the most important areas of reform In the US, theSarbanes-Oxley Act has mandated the creation of audit committees bypublic companies These must be staffed by independent directors, at

least one of who must be a ‘financial expert’ In addition, new NYSE andNASDAQ rules require that public company boards comprise a majority

of independent directors These developments mirror those in the UK,where the use of independent non-executive directors has been a centralpart of the governance of listed companies since the introduction of theCadbury Code in 1992, following scandals in the early 1990s Post-Enron,the UK’s Higgs Review (Higgs, 2003) has seen a further, ‘incremental’,strengthening of the rules relating to non-executives, (Davies, Chapter 12,this collection)

The thinking behind these reforms is that independent non-executivedirectors may be able to act as champions of shareholders’ interests, and acheck on egregious fraud, by ensuring that proper procedural steps aretaken However, there is considerable debate about the best way to givesuch directors appropriate incentives to perform their function Oneoft-cited mechanism for encouraging attentiveness is the threat of legalliability However, liability risk may have side-effects that actuallyoutweigh any benefits generated by deterrence Fear of too much liability,leading directors to behave in an excessively risk-averse fashion, may bejust as likely to compromise directorial judgement as lack of indepen-dence

In Chapter 10, Bernard Black, Brian Cheffins and Michael Klausner

focus on the actual, rather than perceived, risk of outside director liability.

While it is often assumed that the liability risk for directors varies acrosscountries, depending on the mechanics of civil procedure and thestructure of the legal profession, Black, Cheffins and Klausner show thatthis picture is misleading Rather, a range of other factors affect both thelikelihood of a lawsuit being brought and the amount which a directorwho was found liable might need to pay from his or her own pocket Forexample, in systems where the frequency of lawsuits against directors ishigh, so too is the incidence of directors and officers’ (D&O) insurance.Once these various factors are taken into account, it appears thatindependent directors around the world face a very similar—anduniformly low—level of real liability risk One interpretation of thisfinding might be that high, real levels of liability exposure are counter-productive, and consequently parties ‘contract out’ by using insurance insystems where such risks would otherwise be run

Another way to incentivise non-executive directors would be for them

to be, or be appointed by, the holder of a significant block of shares in thecompany However, a director with a significant shareholding, whilsthaving strong incentives, may not be as independent as an individualwholly without ties This in turn provokes thought about the properscope of non-executives’ role Some suggest that non-executives should

be viewed as capable of playing an active part in the formulation ofbusiness strategy, by bringing outside experience to strengthen the

board’s capabilities, and a valuable network of contacts Others seenon-executives as performing a role akin to board-level auditors ofdecision-making processes—asking questions, and putting a check onany misconduct by executives Whilst these two functions are notnecessarily mutually exclusive, they may sometimes be in tension, andtheir implications for the desirability of director share ownership may cut

in different directions

In resolving the foregoing issue, the Sarbanes-Oxley Act stronglyprioritises independence, at least for audit committee members(Chandler and Strine, 2003) The Act prohibits them from receiving anycompensation from the company on whose audit committee they serve,other than in their capacity as a board or committee member Moreover,they may not hold a controlling stake, or be appointed by a person whoholds (either alone or in concert with others) a controlling stake in thecompany ‘Control’ is determined by a factual test, although there is a

‘safe harbour’ provision that ownership of less than 10 per cent of anyclass of voting equity securities will not count as control

In contrast to the mandatory rules used in the Sarbanes-Oxley Act, theUK’s Combined Code regulates these issues using a ‘comply or explain’mechanism That is, listed firms are required either to comply with theCode’s requirements, or to explain to investors why they have not done

so In Chapter 11, Richard Nolan reviews the UK position, and describesthe changes that were implemented following the Higgs Review of theRole of Non-Executive Directors (Higgs, 2003) The Higgs Reviewsought to reconcile both lines of thinking about non-executives’ role, acompromise that Nolan criticises In Nolan’s view, the Review’srecommendations, which were subsequently incorporated into the UK’sCombined Code, would have been clearer and more effective had theyfocused solely on the goal of ensuring the independence of non-executives This would avoid any possibility of conflict of interest, andincentives to monitor effectively could be generated not only by the threat

of legal liability, but also by reputational concerns The latter might inturn be strengthened by drawing such directors from pools of profes-sionals which have strong reputational bonds for independence anyway

It seems plausible that one ‘model’ of non-executives’ role might not beappropriate for all types of company Interestingly, one empirical study(Lasfer, 2002) finds that compliance with the UK Combined Code’sprovisions in respect of independent non-executive directors is positivelyassociated with stock price performance for companies in mature

industries, but is actually negatively associated with performance for

smaller, growth companies His interpretation is that for growth companies, strategic guidance and networking functions—associated with non-independent directors—are relatively more valuableinputs from the board, whereas in mature industries, it is relatively more

high-useful to have genuine outsiders who will ask searching questions ofmanagers, particularly about what will be done with free cash flow Theforegoing suggests that—as Nolan argues—what seems most appropriate

is perhaps not mandatory legislation on board structure, but rather aframework which promotes reflection upon the use of outside directorsand disclosure of the practices which have been adopted To this end, the

UK Combined Code’s ‘comply or explain’ framework seems preferable tothe mandatory rules adopted in the US

PA RT IV REFORMING EU COMPANY L AW AND

SECURITIES REGULATION

Part IV of the collection considers the particular issues raised by ising company law and securities regulation in Europe In addition todifficulties generated by the issues that have proved controversial in the

modern-US, the European reform agenda faces several unique challenges Themost fundamental stems from the fact that the EU encompasses adiversity of systems of corporate governance Most obviously, there is adivide between the UK’s ‘outsider’ share ownership and the ‘insider’share ownership of continental Europe, with a corresponding difference

in the emphasis of regulation between rendering management able and keeping blockholders under control Member states also differsystematically in the way in which their regulation is designed andenforced Furthermore, following enlargement in 2004, the EU nowcontains several Eastern European economies in varying stages of tran-sition As a result, not only might the appropriate regulatory measuresdiffer from state to state, but there are also likely to be severe politicalobstacles to wide-ranging European legislative reform

account-A The European Reforms

Given the foregoing, the scale and speed of the European-level response

to Enron may seem surprising In the spring of 2002, even before anyproblems had surfaced at Parmalat, the European Commission askedtheir High-Level Company Law Expert Group to prepare a report elabor-ating any necessary EU legislation in the field of corporate governance InMay 2003, the Commission were able to announce a number of initiatives,including an Action Plan for the modernisation of company law(European Commission, 2003a), the goal of which was to increase thetransparency of intra-group relations and transactions with relatedparties and to improve disclosures about corporate practices TheCommission also launched plans for the reform of the statutory audit

(European Commission, 2003b) Then, in the wake of the Parmalatscandal, the Commission proposed additional measures mandatingcollective board responsibility for financial statements and regulatingdisclosure of related party transactions, including those between acompany and controlling shareholders or top executives (EuropeanCommission, 2004).

In Chapter 12, Paul Davies offers an explanation for the speed of theresponse in Europe, and in the UK in particular He argues that thebreaking of the Enron scandal had the effect of neutralising a range ofopposition to pre-existing reform initiatives, which were simplyre-characterized (and in some cases extended) by advocates of thepost-Enron measures Although there are echoes of Skeel’s account(Chapter 3) of how populist pressure generated by corporate scandals canupset the ordinary balance of power between interest groups, severalother factors contributed to the rapid progress of the reforms First, the

EU was in 2002 engaged in difficult negotiations with the US over theproposed extraterritorial reach of the Sarbanes-Oxley Act Crucial to thestrength of the EU’s position was the existence of a set of safeguards forEuropean investors that could credibly be said to be equivalent to those inthe US Secondly, the imminent accession to the EU of 10 new countriesleant a ‘now or never’ quality to proposals And thirdly, the stirring forthe first time within the EU of regulatory competition in company law,

following the ECJ’s landmark 1999 ruling in Centros,4 may have addedfurther pressure towards the achievement of consensus at the Europeanlevel over minimum standards, at least in the eyes of those who fear thatunbounded regulatory competition may lead to a ‘race to the bottom’.The blueprint for the Commission’s Company Law Action Plan wasthe report delivered by the Commission’s High Level Expert Group inDecember 2002 In Chapter 13, Klaus Hopt, a leading member of theExpert Group, explains how the Group approached its task and thethinking behind its conclusions The Group were much exercised by theproblems of ensuring that the reforms would be appropriate for both thediversity of corporate ownership structures and regulatory enforcementtechniques that are employed throughout the EU The essence of theirresponse, as Hopt explains, was to focus on identifying those reforms for

which a European-level (as opposed to member state level) rule was

strictly necessary and appropriate These were the core—or commondenominator—rules which, in the Group’s view, would be necessary toensure good governance in any of the member states, regardless ofnational diversity At the same time, much attention was also paid toensuring that appropriate regulatory instruments were chosen Together,

4Case C-212/97, Centros Ltd v Erhvervs-og Selskabssyrelsen [1999] ECR I-1459, [2000] Ch 446.

this produced a package of reforms intended to comprise the ‘minimumnecessary’ for European legislation.

Perhaps unsurprisingly, a number of similar issues to those discussed

in Part III, in the Anglo-American context, were identified as priorities bythe Group Shareholder rights—in particular, rights to vote on executives’remuneration packages, and to block defensive tactics in the face of atakeover bid—were seen as core features of the reform programme.5It isworth noting that such rules are essentially ‘antidirector’ in character, andmay therefore be thought to be of less significance for systems in whichinsider ownership is common In such systems, a majority shareholderwould of course control the vote This is reflected in the way in whichthese issues were ultimately implemented—voting on directors’ remun-eration took the form of a non-binding Commission Recommendation,and the ban on defensive tactics, implemented as part of the TakeoverDirective, contains an opt-out provision for member states (or individualcompanies)

Turning to the role of auditors, the Group focused in particular onthe usefulness of having an audit committee comprised of independentdirectors to channel communications between the company and itsauditors as a key strategy for overcoming potential conflicts of interestbetween audit and non-audit work As Davies explains in Chapter 12, theCommission’s reforms in this area, which have now yielded a proposedDirective (European Commission, 2004) have also included a number

of changes clearly inspired by Sarbanes-Oxley, including mandatingcollective responsibility of the board for financial statements; mandatoryrotation of audit partners or audit firms; the barring of ‘business relation-ships’ between audit firm and customer which ‘might compromise’the auditor’s independence, and the strengthening of disclosure rulesrelating to auditors

A particularly important issue for the High-Level Group concerned therole and structure of the board of directors, the relevant proposals forwhich have now been incorporated into a Commission Recommend-ation.6Hopt explains in Chapter 13 that their proposals for independentdirectors were designed to be capable of complementing both UK-styleunitary boards, and German-style two-tier boards with employee co-

fostering an appropriate regime for the remuneration of directors of listed companies (2004/913/EC, [2004] OJ L 385/55) indicates that shareholders should be given a say in the performance-related aspects of directors’ pay, and the Takeover Directive (2004/25/EC, [2004]

OJ L 142/12) includes a rule prohibiting target management from taking any action which may frustrate an actual or potential bid without the approval of the company’s shareholders However, the impact of this latter provision is significantly diluted by the availability of a national opt-out: see Chapter 15, discussed below, text to n 8.

6 Commission Recommendation on the role of non-executive or supervisory directors of listed companies and on the committees of the (supervisory) board (2005/162/EC, [2005] OJ L 52/51).

determination: monitoring functions can be carried out by non-executiveshareholder appointees or by employee representatives respectively.Moreover, independent directors are viewed as having a role to play inboth outsider and insider owned companies, as safeguards againstself-serving conduct by, respectively, managers and blockholders.

B Developments in Regulatory Techniques

The Expert Group/Action Plan’s philosophy of focusing legislativeenergies on core issues for which consensus might be achieved, and thegreater use of non-binding Recommendations, can be seen as part of anemerging trend European policymakers are becoming both moresensitive to the different capabilities of various regulatory techniquesboth to overcome political obstacles and to achieve regulatory goals Thelast four contributions to the collection consider three examples of thisnew thinking in operation, followed by a pessimistic assessment of theimpact of more traditional harmonization techniques

The ECJ’s jurisprudence in Centros and subsequent cases has opened

up, for the first time, a degree of regulatory competition in Europeancompany law.7In Chapter 14, John Armour considers the possibilities forharnessing regulatory competition as a means of mutual learning byregulators, whilst nevertheless permitting continued diversity of nationalcompany law regimes This would be appropriate in fields where noEuropean consensus has emerged Whilst regulatory competition hastraditionally been feared in Europe as leading to a ‘race to the bottom’,Armour argues that this need not be the case, provided that sufficientsafeguards are in place to ensure that relevant constituencies are able toparticipate in a firm’s decision to reincorporate, protections he suggestsmay be better catered for in the EU context than has hitherto been the case

in the US

Two other major areas of recent European reform in relation tocompanies have concerned takeovers and securities markets As well asbeing of enormous substantive significance for the development ofEuropean corporate governance, the processes by which these reformshave been effected evince two distinct further regulatory techniques TheTakeover Directive,8 following a lengthy political roadblock, was

7 To date, this has only been with regard to incorporations However, remaining barriers to competition for reincorporations appear to be falling swiftly with the advent of the Tenth Directive on Cross-Border Mergers (Parliament and Council Directive 2005/56/EC on cross-border mergers of limited liability companies, [2005] OJ L 310/1), and the recent

extension by the ECJ of its Centros jurisprudence to mergers (C-411/03, Reference for a

Preliminary ruling from the Landgericht Koblenz in proceedings against SEVIC Sytems AG[2006] OJ

C 36/5) Together these will permit companies to change their registered office by the expedient of a cross-border merger into a shell company.

eventually passed in a form that permits member states, and individualfirms, to opt into or out of key provisions In Chapter 15, Gérard Hertigand Joseph McCahery argue that this ‘menu of legal options’ approachcan overcome many of the difficulties of fitting a single legislative rule todiverse systems, and suggest that it might be used as a blueprint forfuture reforms The beneficial effects may also include the development

of a richer set of regulatory arrangements, offering the potential formutual learning by firms and regulators and thereby leading toimprovements in the quality of investor protection

By contrast, the ‘comitology’ technique used in the new regulatoryframeworks for the European securities market, considered by EilísFerran in Chapter 16, involves the delegation of legislative power to acommittee of technocrats In relation to securities markets, this is known

as the ‘Lamfalussy process’, after the chairman of the committee ofexperts who recommended the current structure Ferran’s accountconcentrates on the mechanics of the process, discussing the cooperationbetween the Commission, Council and Parliament in the process, as well

as the new Committees created under Lamfalussy, the consultationprocess and implementation of the new regime Comitology, too, couldprovide a blueprint for future reform activity, seemingly permittingcontentious issues to be placed outside the realm of political discussion

by delegation to experts

The three foregoing mechanisms—transforming political choices intomarket choices through regulatory arbitrage; preserving political choicesthrough options in European legislation; and disguising political choicesthrough devolution to a technocratic committee, each represent possiblefutures, and part of the probable future, of European company andsecurities law-making They stand in stark contrast to the attempts atharmonization which were in vogue in previous decades In Chapter 17,Luca Enriques examines the weaknesses of this mode of law-making,arguing that it has tended to fall foul of political opposition on allsignificant issues This meant that, even in the early days of the Europeanproject, the body of EC company law which was made throughtraditional ‘harmonizing’ directives, which require member states toimplement a particular regime or set of minimum standards, was onlycapable of proceeding by focusing on issues that were essentially trivial

It is to be hoped that the new techniques described above may yieldgreater success in the future

8 2004/25/EC, [2004] OJ L 142/12.

as a symptom of weaknesses of the Anglo-American system of corporategovernance At the same time, it has tended to strengthen the conviction

of those who call for generalised regulatory solutions without regard tothe underlying corporate governance context Yet whilst some commonweaknesses did indeed exist—in particular, the universal failure ofauditors to function effectively—for which the same solutions may beappropriate, it is dangerous to regard the systems as otherwise equiv-alent, because both the causes of, and appropriate solutions for, recentfailures are different

So far as the US is concerned, it seems unlikely that a hastily-preparedpopulist measure such as Sarbanes-Oxley will break with history bydefinitively putting an end to corporate scandals Even the relativelyuncontentious measures concerning audit regulation seem to have beenless successful than may have been hoped And the corporate governancemeasures, which have drawn widespread criticism for the costs theyimpose on US public companies, betray a lack of thought on issuesconcerning board structure and shareholder rights What is less clear,however, is the appropriate way forward on these issues It seemsplausible that for different firms, different constellations of boardstructure and shareholder rights may be appropriate If that is the case,then US policymakers might do well to rethink their recent fondness formandatory federal rules regarding corporate governance, and to considersome of the more flexible regulatory strategies that have been employed

in the EU

In Europe, the scandals have provided the impetus for surmountingpolitical obstacles to the reform of corporate and securities law at the EUlevel In rolling out their responses, European policy-makers faced theneed to regulate a diversity of systems, and also a means of minimisingthe political cost of implementation In response, they have begun toexperiment with a range of new regulatory techniques, few, if any, ofwhich rely upon traditional mandatory rules at the federal level Theseinclude a mixture of non-binding recommendations, opt-in rules,delegation to committees of experts and the selective use of regulatorycompetition (coupled with procedural safeguards contained in federalrules) Whilst a considerable amount has been achieved, it remains to beseen how the highly complex regulatory architecture that has resultedwill actually function

By March 2006, the S&P 500 Index had crept back up to more than1,300, little more than 10 per cent short of its peak in 2000 Some mayview this as evidence that the crisis precipitated by Enron has been resol-ved A reader of this collection should rightly view such an interpretation

as simplistic Our understanding of stock markets is actually rather lesssecure than had previously been imagined Moreover, corporate scandalshave tended to repeat themselves in history, following the bursting ofmarket bubbles and provoking populist legislation which has failed toprevent future cycles of scandal It is wise to regard current conclusions

as no more than preliminary, and appropriate for prescriptions to beadvanced with humility

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Stock Markets and Information

THIS IS A propitious time to revisit The Mechanisms of Market

Efficiency (MOME) (Gilsen and Kraakman 1984).1 We began thatproject some twenty years ago, as newly-minted corporate lawacademics2 trying to understand what to make of a large empiricalliterature proclaiming the efficiency of the U.S stock market In anobservation then offered as a simple description of the state of play,Michael Jensen (1978: 95) announced that ‘there is no other proposition ineconomics which has more solid empirical evidence supporting it thanthe Efficient Market Hypothesis’ (EMH) But if this were so, it seemed to

us that it could not be because market efficiency was a physical property

of the universe arising, like gravity, in the milliseconds following the big

maternal feelings.

2 Gilson had joined the Stanford Law School faculty in 1979; Kraakman had joined the Yale Law School faculty in 1980 The project began while Gilson was a visiting professor at Yale Law School in 1982.

* Meyers Professor of Law and Business, Stanford Law School, and Stern Professor of Law and Business, Columbia Law School.

** Ezra Ripley Thayer Professor of Law, Harvard Law School.

This chapter was previously published, as part of a symposium on the Mechanics of Market

Efficiency, in (2003) 28 Journal of Corporation Law 715–742 We are grateful to Donald Langevoort and Hillary Sale for suggesting this symposium, and to the Journal of Corporation

Law, the University of Iowa School of Law, and the Sloan Foundation for their support for the

event Participants at the symposium and a Columbia Law School corporate faculty workshop, as well as Bernard Black, Allen Ferrell, Jeffrey Gordon, Zohar Goshen, Samuel Issacharoff, and Michael Klausner provided perceptive comments on an early version of this chapter The chapter is better for their contributions; the remaining failings belong to the authors This chapter originated in a lecture given at the symposium and maintains some of the informality of that format

bang Rather, the prompt reflection of publicly-available information in asecurity’s price had to be the outcome of institutional and marketinteractions whose proper functioning necessarily depended on thecharacter of those institutions.3Thus, MOME represented the efforts oftwo young scholars to understand the institutional underpinnings of theempirical phenomenon called market efficiency.

We concluded that the level of market efficiency with respect to aparticular fact is dependent on which of a number of mechanisms—universally-informed trading, professionally-informed trading, deriv-atively-informed trading, and uninformed trading—operated to causethat fact to be reflected in market price Which mechanism was operative,

in turn, depended on the breadth of the fact’s distribution, which in turndepended on the cost structure of the market for information The lowerthe cost of information, the wider its distribution, the more effective theoperative efficiency mechanism and, finally, the more efficient themarket

Revisiting this framework is particularly appropriate because we arenow experiencing the early stages of a quite different framework forevaluating the efficiency of the stock market, also supported by a

3 We should be clear at the outset that we are addressing here, and addressed in MOME, the phenomenon of informational efficiency It is now commonplace to distinguish fundamental efficiency—that market price represents the best current estimate of the present value of the future cash flow associated with an asset—from informational efficiency, that is, the absence

of a profitable trading strategy based on publicly available information Although this is a longer discussion than is appropriate here, we remain sceptical of the analytical foundations

of the distinction A stock price is efficient with respect to a particular information set The assertion that fundamental value differs from an informationally efficient market price must mean one of two things Either the market is inaccurately assessing currently available information, in which case a profitable trading opportunity in fact exists (unless there is a breakdown in the arbitrage mechanism, see below text accompanying notes 24-34), or someone has additional, non-public, information (including a better asset pricing model) that demonstrates the inaccuracy of the current stock price—a circumstance that plainly does not call into question the market’s semi-strong form efficiency Operationally, the distinction is posed in terms of whether there is an institution other than the market whose estimates of current value we believe are systematically better than the market’s (assuming private information is divulged) For example, do we imagine that an investment banker’s fairness opinion is likely to be a better predictor? Compare the Delaware Supreme Court’s unexamined commitment to the discoverability of fundamental value if one only asks an

investment banker in Smith v van Gorkom, 488 A.2d 858 (Del 1985) (failure of board to secure a

fairness opinion was compelling evidence of violation of duty of care) with the Chancery

Court’s scepticism of investment bankers’ valuation opinions in Paramount Communications,

Inc v Time Inc., Fed Sec L Rep (CCH) P 94,514 (Del Ch 1989, aff’d 571 A.2d 1140 (Del 1990))

(investment banker opinion reflecting ‘a range that a Texan might feel at home on’) Or that a judge’s estimate following evaluation of duelling expert reports is likely to be more accurate?

If no existing institution will systematically better predict the fundamental value of a security

on the available information, the distinction between informational efficiency and fundamental efficiency smacks of the Nirvana fallacy Professor Allen (2003) advises that this analysis identifies us as ‘epistemological materialists’ If we were choosing a label to dignify our effort, we’d lean toward calling it a pragmatic rejection of a Platonic form of fundamental value, but we appreciate Professor Allen’s effort on our behalf.