ProfessorBainbridge.com

The ABA Domestic Surveillance Task Force

The American Bar Association is getting extensive press coverage of a white paper prepared by a bar commission on "domestic surveillance."

The American Bar Association denounced President Bush's warrantless domestic surveillance program Monday, accusing him of exceeding his powers under the Constitution. ... The nation's largest organization of lawyers adopted a policy opposing any future government use of electronic surveillance in the United States for foreign intelligence purposes without first obtaining warrants from a special court set up under the 1978 Foreign Intelligence Surveillance Act. The 400,000-member ABA said that if the president believes the FISA is inadequate to protect Americans, he should to ask Congress to amend the act.

I'm not unsympathetic to the ABA task force's position, given my general presumption in favor of limited government and civil liberties, but I'm troubled by a Federalist Society report< /a> that the task force was stacked with a number of members who are long-time contributors to Democratic politicians and/or critics of the Bush administration. It's doubtful whether a stacked commission deserves much in the way of deference. In any event, it's just one more piece of evidence for those of us who believe that the ABA has become a left-liberal special interest group rather than a nonpartisan trade association for the legal profession.

The PCAOB and the Competitive Enterprise Institute

The other day I posted on the Free Enterprise Fund's legal challenge to the constitutionality of the Public Company Accounting Oversight Board and the Sarbanes-Oxley Act that created the PCAOB. In doing so, I neglected to mention that the Fund's legal arguments were based on a white paper prepared by John Berlau and Hans Bader for the Competitive Enterprise Institute. The white paper has gobs of details on the consititutional issues at stake here. I recommend it highly to anyone interested in either corporate/securities law or separation of powers.

The effect of reputational sanctions

It is common for those who prefer markets to regulation to argue that reputational sanctions are an effective constraint on behavior. (I've made this argument more than once myself.) This is generally referred to as "shaming" in the literature. In response to a paper Hillary Sale recently presented at my seminar, however, one of my students made an interesting observation:

Sale argues that the SEC’s remedial powers, such as a bar order, can act as an incentive by shaming or dishonoring the director. She presumes that the corporate director community is small enough for a shaming sanction to work. A little research tends to undermine this argument. Sale tells of the rare private suit that led independent director Bert Roberts to owe $4.5 million as part of the Worldcom settlement. While this is in the context of a private suit, we should still expect to see the same shaming or dishonoring incentive at work. Given this result is rare, while we may not see it promote good behavior among other directors, we should at least see an impact on the corporate community’s treatment of Roberts personally. So what happened to Roberts? A Google search reveals that currently he sits on the boards of Valence Technology (traded on Nasdaq), John Hopkins University, and CaPCURE. The Valence website brags that, “he served as chairman and chief executive officer of MCI, having previously held the positions of president and chief operating officer” (hmmm, doesn’t sound like full disclosure). After Worldcom, we would not expect to see him serving on the board of another publicly traded company, though there he is. Perhaps this illustrates the lack of SEC action. Perhaps the SEC should have barred Roberts from serving as an officer and director anywhere. Perhaps Roberts has learned his lesson and is now the model independent director (I doubt it). As far as shame and dishonor, this shows that the director world maybe looks out for their own. Perhaps, the director community comprises a heard that sticks together rather than a close-knit community quick to shame those who fail in their director duties. My point is not that Sale is wrong in lobbying for more SEC action, but that relying on peer pressure will probably be insufficient. Certainly, a more comprehensive study showing the impacts of SEC and private action on directors and the corporate world’s response and later treatment of those directors could further prove me right or wrong.

Indeed, it would be instructive to collect the 10Ks for Enron, WorldCom, Adelphia, and some of the other prominent scandal firms to see what happened to their outside directors. Did their outside directors lose seats on other boards? Lose their day jobs? And so on. Of course, since post-SOX, the average number of boards on which a director sits has gone down, so you'd need to compare the scandal firm results to a control group. But this still would make an interesting law review article or student note for somebody with more patience for wading through a stack of 10Ks than I have.

Update: The Unknown Professor emails: 

I had actually started on this project, but found out it's been done - Suraj Srinivasan has a Journal of Accounting Piece titled "Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members" (May, 2005).  
He finds that "directors experience significant labor market penalties. In the three years after the restatement, director turnover is 48% for firms that restate earnings downward, 33% for a performance-matched sample, 28% for firms that restate upward, and only 18% for technical restatement firms. For firms that overstate earnings, the likelihood of director departure increases in restatement severity, particularly for audit committee directors. In addition, directors of these firms are no longer present in 25% of their positions on other boards. This loss is greater for audit committee members and for more severe restatements." 
So it appears that these directors at least get disciplined by the labor market for directors' seats.

Peekaboo, the Constitution Doesn't See You

My latest TCS column

The Free Enterprise Fund, an activist think tank, has filed a law suit claiming that the Public Company Accounting Oversight Board (PCAOB, nicknamed "Peekaboo") created by the Sarbanes-Oxley Act is unconstitutional. (Read the complaint.) The gist of the complaint is that the PCAOB is vested with extensive governmental functions and powers, including a quasi-law enforcement investigatory power and a quasi-judicial power to impose substantial fines for violations of its rules.

The Fund claims that the PCAOB thus violates a number of constitutional provisions, most notably the appointments clause of the US Constitution. The potential constitutional problem is that members of the PCAOB are appointed not by the President but by the SEC.

The Appointments Clause of Article II section 2 of the US Constitution provides that:

[The President] shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

Three questions are thus presented. First, are the members of the PCAOB "Officers of the United States" and thus subject to the appointments clause? Second, if so, are the members of the PCAOB "inferior Officers" whose appointment Congress "may by Law vest" in one of the specified alternative mechanisms other than the advice and consent process? Third, if so, do the SEC Commissioners collectively qualify as a Head of Department for this purpose?

There seems to be surprisingly little guidance on these questions. But I still think there is a strong argument to be made in favor of the Fund's position. As the Fund points out, the PCAOB wields extensive governmental powers, but limited accountability:

[The PCAOB] has enormous powers to levy taxes on public companies and to regulate the accounting business. The board, a regulatory agency in all but name, is composed of five directors, no more than two of whom may have any experience as accountants or auditors.

The PCAOB, ostensibly a self-regulating organization for the auditing industry, is supported by a general power of taxation over all publicly-held companies. There are early indications that the PCAOB's independence and ability to raise its own revenue through taxation is supporting a dramatic expansion in its size and scope. Its 2004 budget was $103 million, and its staff started the year at 126 employees and ended the year with 262 employees. The PCAOB's 2005 budget is another 30 percent higher, at $136 million, and it expects to end the year with 450 employees.

PCAOB has an enormously broad Congressional mandate to create rules and enforce them under Sarbanes-Oxley. Most regulatory agencies are limited in their reach by the amount of money appropriated to them by Congress -- with its independent power to tax and raise funds as needed, there is hardly any institutional control on the power of the PCAOB.

All of which seems highly problematic under the relevant precedents. In Edmond v. United States, 520 U.S. 651 (1997), for example, the Court (per Scalia) wrote:

By vesting the President with the exclusive power to select the principal (noninferior) officers of the United States, the Appointments Clause prevents congressional encroachment upon the Executive and Judicial Branches. ... This disposition was also designed to assure a higher quality of appointments: The Framers anticipated that the President would be less vulnerable to interest-group pressure and personal favoritism than would a collective body. ... The President's power to select principal officers of the United States was not left unguarded, however, as Article II further requires the "Advice and Consent of the Senate." This serves both to curb Executive abuses of the appointment power ... and "to promote a judicious choice of [persons] for filling the offices of the union," The Federalist No. 76, at 386-387 [(M. Beloff ed. 1987) (A. Hamilton)]. By requiring the joint participation of the President and the Senate, the Appointments Clause was designed to ensure public accountability for both the making of a bad appointment and the rejection of a good one. ...

The PCAOB, by way of contrast, seems almost designed to avoid public accountability. As the W$J recently opined:

... under Sarbox, the President can neither appoint nor remove Peekaboo members. Sarbox requires that the appointed Securities and Exchange Commissioners themselves appoint the oversight Board. Similarly, only the SEC can remove Board members, and then only if they can be shown to have willfully violated federal laws. Nowhere in any of this is there a role for the elected executive.

There is also little oversight. The only way the SEC can undo any of the accounting Board's regulations is by proving that the rules are obviously inconsistent with the Sarbanes-Oxley statute -- a nearly impossible task given its vague wording. The PCAOB is even largely independent of Congressional oversight because its budget is financed from the fees it levies on the companies it regulates. The Justice Department may well argue in response that the Board simply doesn't rise to the level of a "real" agency. But that will surprise corporate America, given that the Peekaboo can fine accounting firms up to $2 million and individual accountants up to $100,000 for violations.

And, of course, familiar principles of agency capture by the industries it regulates suggest that interest group pressures and favoritism are potentially serious problems.

Likewise, the Fund can draw support from Freytag v. CIR, 501 U.S. 868, 884 -885 (1991), in which the Court opined that:

''The Framers understood . . . that by limiting the appointment power, they could ensure that those who wielded it were accountable to political force and the will of the people. . . . The Appointments Clause prevents Congress from distributing power too widely by limiting the actors in whom Congress may vest the power to appoint. The Clause reflects our Framers' conclusion that widely distributed appointment power subverts democratic government. given the inexorable presence of the administrative state, a holding that every organ in the executive Branch is a department would multiply the number of actors eligible to appoint.''

Holding that the SEC is a Department empowered to appoint the PCAOB would threaten precisely these democratic values the Appointments Clause was designed to protect.

In Edmond, the court also held that:

Generally speaking, the term "inferior officer" connotes a relationship with some higher ranking officer or officers below the President: Whether one is an "inferior" officer depends on whether he has a superior. It is not enough that other officers may be identified who formally maintain a higher rank, or possess responsibilities of a greater magnitude. If that were the intention, the Constitution might have used the phrase "lesser officer." Rather, in the context of a Clause designed to p reserve political accountability relative to important Government assignments, we think it evident that "inferior officers" are officers whose work is directed and supervised at some level by others who were appointed by Presidential nomination with the advice and consent of the Senate.

Because the members of the PCAOB are not subject to such oversight except to the very limited extent they are overseen by the SEC, it would seem that the members of the PCAOB likely are not inferior officers.

The Fund thus has a very strong case that the provisions of Sarbanes-Oxley creating the PCAOB are unconstitutional. Because Congress in its rush to adopt SOX failed to include a clear severability provision, moreover, the Fund may well be able to persuade a reviewing court that the entire Sarbanes-Oxley law must be thrown out. Since both Congressman Oxley and Senator Sarbanes are set to retire this year, wouldn't that make a lovely going away present for them?

The author is Professor at the UCLA School of Law.

The Many Functions of a Corporate Board

A recent presentation at my corporate governance colloquium raised the perrenial question of whether a corporation's board of director's function of monitoring management is merely primus inter pares or is the paramount function before which all other roles must give way.

In my article, Why a Board? Group Decisionmaking in Corporate Governance, I argued for the former understanding of the board:

What then does the board produce and how does it produce it? First, and foremost, the board monitors and disciplines top management. Second, while boards rarely are involved in day-to-day operational decision making, most boards have at least some managerial functions. Broad policymaking is commonly a board prerogative, for example. Even more commonly, however, individual board members provide advice and guidance to top managers with respect to operational and/or policy decisions. Finally, the board provides access to a network of contacts that may be useful in gathering resources and/or obtaining business. Outside directors affiliated with financial institutions, for example, apparently facilitate the firm’s access to capital.

This understanding of the board's role is critical to evaluating the debate over independent directors. Since Sarbanes-Oxley and the concurrent changes in the stock exchange listing standards, which I discussed in my article A Critique of the NYSE's Director Independence Listing Standards, most public corporations have been obliged to have a majority of board members who are independent of management. In addition, audit, nominating, and compensation committees staffed by outsiders are effectively required. One concern is that this trend will lead to more adversarial relations between boards and top managers. This concern is particularly pronounced when proposals are made to further incent independent directors to monitor management, as was recommended by our colloquium speaker, who encouraged greater SEC enforcement of rules designed to force independent directors to monitor corporate disclosures.

It is doubtful whether adversarial relations between the board and management help the former with their monitoring role (it may simply encourage management to treat outside directors like mushrooms). It seems clear, however, that encouraging an adversarial relationship between activist independent directors and outsiders is counter-productive.

In theory of course, independent board members could help the board fulfill all its roles. As to networking, for example, outside directors provide both their own expertise and interlocks with diverse contact networks. As to monitoring, at least according to conventional wisdom, board independence is an important device for constraining agency costs. A new paper from two European business scholars, however, suggest that board independence (at least insofar as it results in adversarial board-CEO relations) is undesirable because it intereferes with the board's non-monitoring functions:

Abstract: This paper analyzes the consequences of the board's dual role as an advisor as well as a monitor of management. As a result of this dual role, the CEO faces a trade-off in disclosing information to the board. On the one hand, if he reveals his information, he gets better advice. On the other hand, a more informed board will monitor him more intensively. Since an independent board is a tougher monitor, the CEO may be reluctant to share information with it. Thus, our model shows that management-friendly boards can be optimal.

My bottom line is that that one size does not fit all. Firms have unique needs and should be free to develop unique accountability mechanisms carefully tailored for the firm’s special needs. Unfortunately, regulators (and a lot of academics) keep trying to squeeze firms into that one size fits all suit.

Who Owns the Corporation? Nobody

Phil Town responded a while back to one of my recent posts with this observation:

...the idea that the shareholders are not real owners is ridiculous.

Query: How do you own the a legal fiction? Ownership implies a thing capable of being owned. To be sure, we often talk about the corporation as though it were such a thing, but when we do so we engage in reification. While it may be necessary to reify the corporation for semantic convenience, it can mislead. Conceptually, the corporation is not a thing, but rather simply a set of contracts between various stakeholders pursuant to which services are provided and rights with respect to a set of assets are allocated.

Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept in nexus of contracts theory. Someone owns each input, but no one owns the totality. Instead, the corporation is an aggregation of people bound together by a complex web of contractual relationships.

As I explain in detail in my article The Board of Directors as Nexus of Contracts, the shareholders' contract with the firm has some ownership-like features, including the right to vote and the fiduciary obligations of directors and officers.

Even so, however, shareholders lack most of the incidents of ownership, which we might define as the rights to possess, use, and manage corporate assets, and the rights to corporate income and assets. For example, shareholders have no right to use or possess corporate property. Cf. W. Clay Jackson Enterprises, Inc. v. Greyhound Leasing and Financial Corp., 463 F. Supp. 666, 670 (D. P.R. 1979) (stating that “even a sole shareholder has no independent right which is violated by trespass upon or conversion of the corporation’s property”). Management rights, of course, are assigned by statute solely to the board of directors and those officers to whom the board properly delegates such authority. Indeed, to the extent that possessory and control rights are the indicia of a property right, the board is a better candidate for identification as the corporation’s owner than are the shareholders. As an early New York opinion put it, “the directors in the performance of their duty possess [the corporation’s property], and act in every way as if they owned it.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918).

This remains true even if a single shareholder (or cohesive group) owns a majority of the corporation's voting stock. To be sure, ownership of such a control block gives shareholders substantial de facto control by virtue of their ability to elect and remove directors, yet this still does not confer either possessory or management rights on such shareholders. Indeed, an effort by such a shareholder to exercise such rights might well constitute a breach of fiduciary duty by the controlling shareholder. In appropriate instances of such misconduct by a controlling shareholder, the board may well have a fiduciary duty to the minority to take steps to dilute the majority shareholder's control (as by issuing more stock). See, e.g., Delaware Chancellor Allen's opinion in Mendell v. Carroll, 651 A.2d 297, 306 (Del. Ch. 1994), in which he suggested that the board of directors could "deploy corporate power against the majority stockholders" to prevent "a threatened serious breach of fiduciary duty by the controlling stock." Granted, as I have observed elsewhere on this blog, "corporate law is far more tolerant of hegemony than constitutional law," but Allen's dicta would make no sense if majority voting control equalled ownership.

Let me offer another illustration. As I discuss in my article Unocal at 20, if shareholders own the corporation, the board of directors of a target corporation would have no proper role in reponding to a tender offer. The shareholders' decision to tender their shares to the bidder would no more concern the institutional responsibilities or prerogatives of the board than would the shareholders' decision to sell their shares on the open market or, for that matter, to sell their homes. Both stock and a home would be treated as species of private property freely alienable by their owners. Yet, as we all know, corporate law confers an effective gatekeeping function on the target's board of directors by allowing them to deploy potent takeover defenses.

In discussing corporations, it is easy to lose sight of the overriding fact—that firms are nothing more than groups of people. We often find ourselves using jargon like owners, monitors, team members, agent, principal, partner, manager, employee, and shareholder. We also often find ourselves engaged in a form of reification—treating firms as though they were things having an existence separate from the people who comprise them—when we say things like “General Motors did so and so.” General Motors is a firm; it is pure fiction to say General Motors did anything. Reification is often useful, or even necessary, because it permits us to utilize a form of shorthand—it is easier to say General Motors did so and so than to attempt in conversation to describe the complex process which actually may have taken place. Indeed, it is very difficult to think about large firms without reifying them. Reification, however, can be dangerous. It becomes easy to lose sight of the fact that firms aren't things, they are simply a group of people for whom the law has provided an off-the-rack relationship we call the corporation. There simply is nothing there that can be owned.

Springsteen Live

I downloaded from iTunes Bruce Springsteen's new Hammersmith Odeon, Live '75 album (a DVD version of which, of course, has been available for a while as part of the special 30th anniversary Born to Run package). Great album; great show. Very reminiscent of the show I saw at Georgetown University in the Born to Run tour. Personally, however, I very much preferred the shows I saw during the Darkness tour a couple of years later. Those shows were longer, the song list was deeper, and, thanks to the years the band had to spend touring during the Appel litigation recording hiatus, incredibly polished.

More on Lawyers and Leisure

The other day I posted some ruminations on the apparent lack of leisure time available to lawyers working for big firms, citing an Economist artic le suggesting that Americans generally are enjoying more leisure time than ever. Bruce MacEwan (of the outstanding Adam Smith, Esq., blog) replied with a very thoughtful post in which he offered a very plausible explanation:

My hypothesis is that it's the product of the nasty intersection of the billable hour with increased productivity elsewhere in the economy. ... lawyers have (a) increased their hourly productivity far more slowly than the average across the economy; and (b) remain all but universally tied to the billable hour, which creates a tremendous correlation between recorded hours worked and income.

So is the answer figuring out how to significantly boost lawyer productivity and change fee structures to some flat fee/percentage of the deal system?

See also Ted Frank's thoughtful suggestion that there is a serious collective action problem in legal practice.

Joseph Phelps Ovation Chardonnay (Napa Valley) 2002

An exceptional white wine. A limpid pool of yellow gold. Gala apples, orange blossom, and vanilla. A creamy texture, but enough acidity to make it very food friendly (we served it with a roasted garlic and rosemary chicken for which it was a spectacular match). A perfect amount of oak - vanilla, honey, butter, and a just the right touch of wood. This is a highly sophisticated and refined American chardonnay that can credibly compete with anything out of Burgundy. Very, very highly recommended, although it's a very low volume product that is hard to find if you aren't on the winery's mailing list. About $40. (See the Phelps winemaker's note .) Grade: A

Lawyers, Guns Leisure, and Money

There was an iconoclastic article in last week's Economist, which strikes at the coventional wisdom about the balance between work and lesiure:

A pair of economists have looked closely at how Americans actually spend their time. Mark Aguiar (at the Federal Reserve Bank of Boston) and Erik Hurst (at the University of Chicago's Graduate School of Business) constructed four different measures of leisure.* The narrowest includes only activities that nearly everyone considers relaxing or fun; the broadest counts anything that is not related to a paying job, housework or errands as “leisure”. No matter how the two economists slice the data, Americans seem to have much more free time than before.

Over the past four decades, depending on which of their measures one uses, the amount of time that working-age Americans are devoting to leisure activities has risen by 4-8 hours a week. (For somebody working 40 hours a week, that is equivalent to 5-10 weeks of extra holiday a year.) Nearly every category of American has more spare time: single or married, with or without children, both men and women. The only twist is that less educated (and thus poorer) Americans have done relatively better than more educated ones (see chart). And that is not just because unemployed high-school drop-outs have more free time on their hands. Less educated Americans with jobs—the overstretched middle class of political lore—do very well.

If what my ex-students tell me is true, however, lawyers haven't seen much growth in leisure time. To the contrary, it seems as though lawyers are working as harder or harder than ever, if we are to believe a Chicago Lawyer survey:

A full 80 percent of respondents said they work 40 hours or more a week. About 33 perent work 50 to 59 hours a week, and 10 percent said they work 60 or more hours a week.

About 73 percent of respondents said they worked on weekends, with 7 percent reporting they worked more than seven hours on the average weekend. About 72 percent said they worked from home after normal work hours each week.

They're not all happy to be working that much. Nearly three-fourths of respondents who have a spouse or children said that work cuts into family time ''somewhat more'' or ''far more'' than they'd like. More than half of all respondents -- about 54 percent -- said they would reduce the number of hours they work, with a corresponding cut in pay, if they had the option.

The study cited by the Economist would suggest that lawyers should not have seen as much growth in leisure as people who work in professions requiring less education, but it seems lawyers are actually losing lesiure time? Why? The CL survey shows a definite link between working hours and pay:

The survey showed that how much money a lawyer makes corresponds almost exactly with how much work reduces family time. In the open-ended responses, lawyers said over and over again that achieving a high level of success in the profession simply demands putting in long hours.

But if lawyers can (and do) make more money by working more, why isn't that equally true of other professions whose practitioners seem to be enjoying more leisure? And why hasn't the market made available options for lawyers who would be willing to take a cut in pay to work fewer hours? Very curious.

Thanks to the SF Chronicle (HT: Caron), I now know that I am not among the 2277 highest paid employees of the University of California system, but 21 of my colleagues are.

In other news, according to Brian Leiter, I'm ranked third among all law school faculty by SSRN downloads. Hmmm.... I think maybe I'll start taking Fridays off.

Replying to Bruce Kesler and Tom Smith re Corporate Management and Social Responsibility

In a comment on my latest TCS column on the shareholder wealth maximization norm, Bruce Kesler writes:

I’ve written many times about the matter of imposing restraints on U.S. hi-tech companies selling Internet technology to China, Vietnam, and MidEast states that use it to repress free speech and dissent. Aside from my concern for human rights generally, my emphasis is that:
* This behavior undermines U.S. foreign policy to encourage the growth of democracy abroad for a more benign environment;
* This behavior goes beyond undermining the general U.S. foreign policy, but abets campaigns against the U.S. and the West, often incited by these buying states – such as the current “cartoon” intifada -- by furthering one-sided information being available to their populace; and
* The resentments bred among future leaders abroad may well undermine the long-range economic success of these firms.

...

I do not argue for changing the “basic rules of corporate governance,” heaven forbid. I do argue that there are rare times when there are other “basic rules,” like not undermining U.S. foreign policy, that must come into play. This is one of those times.

There are basically two ways for a democratic capitalist society to regulating corporate behavior. First, you can do so directly by taxing or regulating corporate behavior you don't like. Second, you can authorize corporate managers to be "socially responsible." Under current law, while management has a lot of discretion as to means, the end goal of corporate governance must be the maximization of shareholder wealth within the constraints of law. Some folks, however, want to give management an open-ended authorization (and, in some cases, a mandate) to go out and be socially resposible.

The gist of my TCS column is that the former is preferable, as Bruce recognized in an update to his post. As I explained in a comment to an earlier blog post:

The question is NOT whether "business can or should be charged with some level of effort to repay that contribution society has made." Of course business can. And business is so charged. It's called taxes. And regulation. My argument is that so long as management operates within the bounds of law, both business AND society are well served by a regime in which the legal fiduciary duties of directors require them to maximize shareholder wealth. You want business to internalize certain costs, then pass a law. But don't change the rules governing whose interests management pursues.

There are two problems with pursuing social policy through a general mandate to management to be "socially responsible." First, as I explained in the TCS column, managers who are responsible to every social interest end up being accountable to none:

... absent the clear standard provided by the shareholder wealth maximization norm, the board of directors will be tempted to allow their personal self-interest to dominate their decision making. Put another way, directors who are allowed to consider everybody's interests end up being accountable to no one.

Second, relying on managers to be socially responsible is risky. It only works if managers share your definition of social responsibly behavior. Despite the criticism most liberals direct at corporate elites, my guess is that on a host of social issues management elite views of what is socially responsible would be closer to those of Hillary Clinton than that of Bruce or myself.

Consider, for example, what I wrote about John Kerry and Warren Buffett back in May 2004:

John Kerry is wooing corporate CEOs (whom he was calling Benedict Arnolds not so long ago, albeit while taking their money) and with some success:

Mr. Kerry disclosed that he has launched a major push to enlist corporate supporters and touted two stars he has landed so far: investment sage Warren Buffett and technology executive Steve Jobs, both of whom will be advisers, the senator said.

Why does this not surprise me? Consider what Christopher Lasch had to say about elites, including business elites like Buffett and Jobs:

[T]he new elites, the professional classes in particular, regard the masses with mingled scorn and apprehension. In the United States, “Middle America”—a term that has both geographical and social implications—has come to symbolize everything that stands in the way of progress: “family values,” mindless patriotism, religious fundamentalism, racism, homophobia, retrograde views of women. (The Revolt of the Elites: And the Betrayal of Democracy at 28.)

As far as the elites are concerned, Middle America and the Republican Party are synonymous. Given the trend for religious voters to lean Republican, while secular voters lean Democrat, moreover, Lasch's comments about elite attitudes toward religion are particularly telling:

A skeptical, iconoclastic state of mind is one of the distinguishing characteristics of the knowledge classes. ... The elites’ attitude to religion ranges from indifference to active hostility. (Id. at 215.)

What I'd like for folks - like my friend Tom Smith - who think that "A corporation is no more entitled than you or I to do something wicked, just because it is necessary to maximize profits" would operationalize that claim while also preventing management from using social responsibility arguments as a camoflauge for self-interested behavior and ensuring that management's definition of socially responsible conduct reflects majoritarian values. Until somebody does so, and no one has to date, I'll stick with shareholder wealth maximization.

Lawyers Behaving Badly

Lawyer David Boies has made a career going after corporate abuses of power (see, e.g., his service as a special counsel for the Justice Department's suit against Microsoft and his role in the Tyco litigation). Tom Kirkendall has the scoop on some apparent questionable conflicts of interest on Boies' part. The Law Blog also has some additional details.

Securities lawyer Mel Lifshitz is under investigation for, essentially, owning his own plaintiff:

Since 2003, a charitable trust funded and administered by Lifshitz's family has donated money to various causes, most of them orthodox Jewish organizations. Another recipient of the charity's money, however, has been a limited partnership that was a plaintiff in more than a dozen class-action lawsuits filed by Lifshitz's firm over the past four years, a review of documents shows. ... Moreover, in five filings with the Securities and Exchange Commission, Lifshitz is listed as a "beneficial owner" of the Colbart Birnet partnership -- a circumstance Lifshitz says is plain wrong and attributes to "human error."

If true, Lifshitz would seem to have discovered that you don't need to chase ambulances if you own the ambulance company.

Challenging SOX

The Free Enterprise Fund has filed a law suit claiming that the Public Company Accounting Oversight Board created by the Sarbanes-Oxley Act is unconstitutional. (Read the complaint.) The gist of the complaint is that the PCAOB is vested with extensive governmental functions and powers, including a quasi-law enforcement investigatory power and a quasi-judicial power to impose substantial fines for violations of its rules.

The Fund claims that the PCAOB thus violates a number of constitutional provisions, most notably the appointments clause of the US Constitution. The potential constitutional problem is that members of the PCAOB are appointed not by the President but by the SEC.

The Appointments Clause of Article II section 2 of the US Constitution provides that:

[The President] shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

Three questions are thus presented. First, are the members of the PCAOB "Officers of the United States" and thus subject to the appointments clause? Second, if so, are the members of the PCAOB "inferior Officers" whose appointment Congress "may by Law vest" in one of the specified alternative mechanisms other than the advice and consent process? Third, if so, do the SEC Commsissioners collectively qualify as a Head of Department for this purpose?

There seems to be surprisingly little guidance on these questions. But I still think there is a strong argument to be made in favor of the Fund's position. As the Fund points out, the PCAOB wields extensive governmental powers, but limited accountability:

[The PCAOB] has enormous powers to levy taxes on public companies and to regulate the accounting business. The board, a regulatory agency in all but name, is composed of five directors, no more than two of whom may have any experience as accountants or auditors.

The PCAOB, ostensibly a self-regulating organization for the auditing industry, is supported by a general power of taxation over all publicly-held companies. As Senator Phil Gramm, R-Texas, explained on the Senate Floor, ?The board is going to have massive, unchecked power, by design.? There are early indications that the PCAOB?s independence and ability to raise its own revenue through taxation is supporting a dramatic expansion in its size and scope. Its 2004 budget was $103 million, and its staff started the year at 126 employees and ended the year with 262 employees. The PCAOB?s 2005 budget is another 30 percent higher, at $136 million, and it expects to end the year with 450 employees.

PCAOB has an enormously broad Congressional mandate to create rules and enforce them under Sarbanes-Oxley. Most regulatory agencies are limited in their reach by the amount of money appropriated to them by Congress?with its independent power to tax and raise funds as needed, there is hardly any institutional control on the power of the PCAOB.

All of which seems highly problematic under the relevant precedents. In Edmond v. United States, 520 U.S. 651 (1997), for example, the Court (per Scalia) wrote:

By vesting the President with the exclusive power to select the principal (noninferior) officers of the United States, the Appointments Clause prevents congressional encroachment upon the Executive and Judicial Branches. . . . This disposition was also designed to assure a higher quality of appointments: The Framers anticipated that the President would be less vulnerable to interest-group pressure and personal favoritism than would a collective body. . . . The President's power to select principal officers of the United States was not left unguarded, however, as Article II further requires the "Advice and Consent of the Senate." This serves both to curb Executive abuses of the appointment power, . . . and "to promote a judicious choice of [persons] for filling the offices of the union," The Federalist No. 76, at 386-387 [(M. Beloff ed. 1987) (A. Hamilton)]. By requiring the joint participation of the President and the Senate, the Appointments Clause was designed to ensure public accountability for both the making of a bad appointment and the rejection of a good one. . . .

The PCAOB, by way of contrast, seems almost designed to avoid public accountability. As the W$J opined:

... under Sarbox, the President can neither appoint nor remove Peekaboo members. Sarbox requires that the appointed Securities and Exchange Commissioners themselves appoint the oversight Board. Similarly, only the SEC can remove Board members, and then only if they can be shown to have willfully violated federal laws. Nowhere in any of this is there a role for the elected executive.

There is also little oversight. The only way the SEC can undo any of the accounting Board's regulations is by proving that the rules are obviously inconsistent with the Sarbanes-Oxley statute -- a nearly impossible task given its vague wording. The PCAOB is even largely independent of Congressional oversight because its budget is financed from the fees it levies on the companies it regulates. The Justice Department may well argue in response that the Board simply doesn't rise to the level of a "real" agency. But that will surprise corporate America, given that the Peekaboo can fine accounting firms up to $2 million and individual accountants up to $100,000 for violations.

And, of course, familiar principles of agency capture by the industries it regulates suggest that interest group pressures and favoritism are potentially serious problems.

Likewise, the Fund can draw support from Freytag v. CIR, 501 U.S. 868, 884 -885 (1991), in which the Court opined that:

''The Framers understood . . . that by limiting the appointment power, they could ensure that those who wielded it were accountable to political force and the will of the people. . . . The Appointments Clause prevents Congress from distributing power too widely by limiting the actors in whom Congress may vest the power to appoint. The Clause reflects our Framers' conclusion that widely distributed appointment power subverts democratic government. given the inexorable presence of the administrative state, a holding that every organ in the executive Branch is a department would multiply the number of actors eligible to appoint.''

Holding that the SEC is a Department empowered to appoint the PCAOB would threaten precisely these democratic values the Appointments Clause was designed to protect.

In Edmond, the court also held that:

Generally speaking, the term "inferior officer" connotes a relationship with some higher ranking officer or officers below the President: Whether one is an "inferior" officer depends on whether he has a superior. It is not enough that other officers may be identified who formally maintain a higher rank, or possess responsibilities of a greater magnitude. If that were the intention, the Constitution might have used the phrase "lesser officer." Rather, in the context of a Clause designed to preserve political accountability relative to important Government assignments, we think it evident that "inferior officers" are officers whose work is directed and supervised at some level by others who were appointed by Presidential nomination with the advice and consent of the Senate.

Because the members of the PCAOB are not subject to such oversight except to the very limited extent they are overseen by the SEC, it would seem that the members of the PCAOB likely are not inferior officers.

The Importance of the Shareholder Wealth Maximization Standard

My latest TCS column:

There has been a fair bit of ruminating about corporate cowardice lately. Several technology firms have been criticized lately for agreeing to cooperate with authorities in China. Google's decision to censor its Chinese search engine, for example, elicited widespread criticism in the blogosphere (although it also prompted some to speak out in its defense; see here for example). Blogger Mark Kleiman has spotted what he thinks is another example and invites me to reply:

"The weekend Financial Times (behind a paywall; just below the fold on page two of the December 4/5 edition) reports that Nestlé has been swift to advise the Islamic bigots boycotting Danish products that Nestlé is Swiss, not Danish. A rumor had spread in Saudi Arabia that some Nestlé products were of Danish origin. 'We took the trouble to rectify the situation — to give the correct information to consumers,' said a Nestlé spokescoward.

"The implication, of course, is that Danish origin is something to be ashamed of. And the result is to help focus the boycott on the Danes, and thus to increase the pressure on the Danish government to back off from its support of a free press.

"No doubt, if this had been the 1930s, Nestlé would have been equally swift to assure the Nazis that its products were of strictly Aryan origin.

"I'm still waiting for Professor Bainbridge to tell us whether he's prepared to stand behind his theory that the sole duty of corporate managers is to make money for the shareholders when it comes to cases such as this one. Assume, for the moment, what is probably correct: that Nestlé had good reason to think that selling out the Danes would help its bottom line. Is that really any excuse?"

First, the duty of directors is not solely to make money for the shareholders, but rather to do so within the bounds of law. Second, it should be apparent that the duty of directors is not so much to make money as it is to maximize share value. The two are different, because the value of a share of stock is the present discounted value of the stream of dividends the stock will pay in the future. Hence, directorial actions that are inconsistent with short term profit maximization but are consistent with increasing the present discounted value of the future stream of dividends are perfectly appropriate. Suppose, for example, that Nestle management thought confusion over the national origin of its products might endanger employees working in predominately Muslim countries. If so, it would seem both ethical (preservation of life) and profitable (enhanced employee morale) to safeguard the lives and property of those employees through statements such as the ones about which Mark complains.

In some cases, of course, long-term corporate viability may require the entity to take controversial political positions. In particular, as I argued in my paper Catholic Social Teaching and the Corporation, good corporate managers have a very strong stake in supporting democratic capitalism:

"The corporation has proven to be a powerful engine for focusing the efforts of individuals to maintain the requisite sphere of economic liberty. Those whose livelihood depends on corporate enterprise cannot be neutral about political systems. Only democratic capitalist societies permit voluntary formation of private corporations and allot them a sphere of economic liberty within which to function, which gives those who value such enterprises a powerful incentive to resist both statism and socialism. Because tyranny is far more likely to come from the public sector than the private, those who for selfish reasons strive to maintain both a democratic capitalist society and, of particular relevance to the present argument, a substantial sphere of economic liberty therein serve the public interest."

Both society and their shareholders would have been well-served if German corporate managers had nipped Hitler's rise in the bud instead of facilitating it, for example.

But does all of this mean that corporate fiduciary duty law should require -- or, at least, allow -- corporate directors and officers to behave in ways Kleiman deems brave or responsible when doing so would be inconsistent with shareholder wealth maximization? I think not.

In the first place, requiring directors to maximize shareholder wealth provides the board of directors with a determinate metric for making business decisions. I often use the following example to explain what I mean by that: Suppose Acme's board of directors is considering closing an obsolete plant. The board is advised that closing the plant will cost many long-time workers their job and be devastating for the local community. On the other hand, the board's advisors confirm that closing the existing plant will benefit Acme's shareholders, new employees hired to work at a more modern plant to which the work previously performed at the old plant will be transferred, and the local communities around the modern plant. Assume that the latter groups cannot gain except at the former groups' expense. By what standard should the board make the decision?

Shareholder wealth maximization provides a clear answer -- close the plant. Once the directors are allowed to deviate from shareholder wealth maximization, however, they must inevitably turn to indeterminate balancing standards. Such standards deprive directors of the critical ability to determine ex ante whether their behavior comports with the law's demands, raising the transaction costs of corporate governance.

Worse yet, absent the clear standard provided by the shareholder wealth maximization norm, the board of directors will be tempted to allow their personal self-interest to dominate their decision making. Put another way, directors who are allowed to consider everybody's interests end up being accountable to no one.

In the plant closing example, if the board's interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant's workers and the local community. In contrast, if the board of directors' interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm's shareholders, creditors, and other benefited constituencies.

In sum, if you don't like corporate cowardice, the answer is to work for changes that make corporate courage profitable. If you thought Nestle's decision was deplorable, buy American-made Scharfenberger. But don't try changing the basic rules of corporate governance.

The author is Professor at the UCLA School of Law.