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

John Armour Joseph A. McCahery

Amsterdam Center for Law & Economics Working Paper No. 2006-07
This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at: http://ssrn.com/paper=910205 The complete Amsterdam Center for Law & Economics Working Paper Series is online at: http://ssrn.acle.nl For information on the ACLE go to: http://www.acle.nl

A F TE R E NR O N

At the end of the twentieth century, it was thought by many that the Anglo-American system of corporate governance was performing effectively and some observers claimed to see an international trend towards convergence around this model. There can be no denying that the recent corporate governance crisis in the US has caused many to question their faith in this view. This collection of essays provides a comprehensive attempt to answer the following questions: first, what went wrongwhen and why do markets misprice the value of firms, and what was wrong with the incentives set by Enron? Secondly, what has been done in response, and how well will it workincluding essays on the Sarbanes-Oxley Act in the US, UK company law reform and European company law and auditor liability reform, along with a consideration of corporate governance reforms in historical perspective. Three approaches emerge. The first two share the premise that the system is fundamentally sound, but part ways over whether a regulatory response is required. The third view, in contrast, argues that the various scandals demonstrate fundamental weaknesses in the Anglo-American system itself, which cannot hope to be repaired by the sort of reforms that have taken place.

J OHN ARMOUR AND J OS EPH A MCCAHERY I NTRODUCTI ON

Introduction After Enron: Improving Corporate Law and Modernising Securities Regulation in Europe and the US
J O H N A R M O U R * an d J OSE PH A . M cCA H E RY * *

URING 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 years earlier (Standard & Poor, 2006). For much of this period, the Enron Corporation was one of Wall Streets darlings. It was a member of an elite club of new economy, growth-driven firms whose stocks were at the forefront of the markets spectacular rise. Acclaimed as Americas most innovative 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, Enrons continued to rise for a while, seemingly defying gravity (Fortune, 2001). But in the autumn of 2001, Enron tumbled spectacularly from grace. Revelations of widespread accounting fraud and other misconduct by senior executives spiralled the firm into what was then the largest bankruptcy in history. Enrons demise was soon followed by scandals at a number of other new economy stars, such as Worldcom, Tyco, Adelphia and Global Crossing. This wave of accounting fraud shook investors faith in stock markets and by 9 October 2002, the S&P 500 had fallen by over 50 per cent from its record high. Many asked whether something was not profoundly wrong with the US system of corporate governance. Several things had gone wrong at Enron. Its top executives had
* Faculty of Law and Centre for Business Research, Cambridge University. ** Professor of Corporate Governance, University of Amsterdam Center

for Law and 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.

Introduction

engaged in aggressive accounting manipulations in an effort to boost the companys stock price. They were motivated, at least in part, by a desire to maximise the value of their stock options. The companys auditors had been persuaded to become complicit in earnings misstatements by the corrosive effect of valuable consulting contracts, which were in managements gift. Moreover, analysts at several investment banks, supposedly offering independent advice, were tainted by conflicts of interest arising out of their firms involvement in Enrons financing. As a result, Enrons share price was artificially inflated for a considerable period of time. Because the revelations of misconduct came on the back of a stock market fall, Enrons shareholders suffered heavy losses. One of the worst-hit groupsand least able to afford itwere the companys employees, whose pension plans had been heavily invested in the firm as an incentive measure. Particularly egregious, in many peoples eyes, was the fact that Enron executives had started to sell their shares in the company by mid-2001, when it was clear that trouble was unavoidable, whereas the terms of employees pension schemes prohibited them from doing so. These factors gave the scandal a particularly intense political salience. The US Congress responded very rapidly. On 30 July 2002, less than nine months after Enron filed for bankruptcy, the Public Company Accounting Reform and Investor Protection Act of 2002 was passed.1 The new legislation, known universally as the Sarbanes-Oxley Act after its two sponsors, was intended to restore public confidence in stock markets. In the main, it sought to restore the integrity of the audit process by strengthening oversight of the accounting profession. However, the Act also put in place a number of measures designed to counter failures in corporate governance. These include requiring CEOs and CFOs to certify, on pain of criminal penalties, their firms periodic reports and the effectiveness of internal controls; the imposition of obligations on corporate lawyers to report any evidence of suspected violations of securities 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 of independent directors, of which at least one member must be a financial expert. For a short while after the American scandals broke, European observers might have been forgiven for experiencing a hint of schadenfraude. Continental Europeans had frequently been lectured on the virtues of the Anglo-American outsider model of corporate governance, and on how the globalisation of capital and product markets would supposedly force the abandonment of their insider model in order to remain
1

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

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competitive (see Hansmann and Kraakman, 2001). In the immediate aftermath of Enron, some Europeans were heard to wonder whether the insider 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 2002little more than a year since the Enron scandal had brokennews began to emerge that something was seriously amiss at Parmalat, the Italian dairy-produce conglomerate. As this and other earnings misstatement scandalssuch as those at the Dutch retail giant Ahold and the French engineering firm Alstomunfolded over the next year, any illusion of European immunity was shattered. It did not take the European Commission long to respond. They had already, in spring 2002, asked their High-Level Company Law Expert Group to prepare a report elaborating any necessary EU legislation in the field of corporate governance. In May 2003, the Commission announced a number of initiatives, including an Action Plan for the modernization of company law and plans for the reform of the statutory audit (European Commission, 2003a, 2003b). These proposals are finding their way onto the statute book at varying speeds. In the UK, Marconi, a firm that had won stock market plaudits for its acquisition-led expansion into new economy businesses during the 1990s, suffered a dramatic fall into the hands of its creditors during the second half of 2001. The UKs corporate community held their collective breath, because memories of scandals at Polly Peck, BCCI and Maxwell in the early 1990s were still vivid. Although Marconi turned out to have been a case of management error, rather than fraud, the UK was spurred into renewed reflection on whether its corporate governance system was functioning effectively. As it happened, a large-scale reform of English company law, following the independent Company Law Review commissioned by the DTI, had been announced well before the Enron scandal broke (see Arden, 2003). Whilst preparations for these reforms were continuing, the government ushered in a number of corporate governance-related initiatives, including the controversial Higgs Report on the role and effectiveness of non-executive directors (Higgs, 2003), and the Smith Report on audit committees (Financial Reporting Council, 2003a), both of which were implemented through a revision to the UKs non-statutory Combined Code on Corporate Governance (Financial Reporting Council, 2003b). The series of corporate scandals on both sides of the Atlantic and the energetic reform activity it engendered around the world provoke a multitude of questions, many of which are explored in more detail by the contributions in this volume. First, reflection is prompted about the extent to which capital markets price stocks efficientlythat is, take into account all publicly-available information about firms. Some investors were suspicious about Enrons artificially high stock price, even before its

Introduction

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? Are capital markets perhaps less rational than had previously been imagined? Secondly, we might investigate the ways in which, if at all, the US and European scandals differed both from each other, and from other corporate 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 of misconduct in Europe differ significantly from that in the US, reflecting underlying differences in systems of corporate governance, or are all the scandals best characterised as sharing certain basic commonalities? Thirdly, and perhaps most obviously, questions arise about the legislative prescriptions for reform. In the US context, was the Sarbanes-Oxley Act sufficient, or indeed necessary, to remedy the problems? What should be done about issues concerning shareholder rights, accounting regulation and board structure? The reforms in the European context not only provoke reiterations of these questions, but also raise an additional group of issues. The EU is characterised by a much greater degree of both political and economic diversity than is the US. This calls for examination both of the appropriateness of particular substantive measures as panEuropean reforms, which must cater to this diversity, and of the political feasibility of reform programmes. The post-Enron era has seen renewed energy in European company law and capital markets reform, which in turn prompts reflection on the degree of success with which these new measures have surmounted the political obstacles. Parts I-IV of this collection address these four groups of issues in turn.

PA RT I : S TO C K M A R K E T S A N D I N F O R M AT I O N

Whilst it was clear that executives at Enronand perhaps to a greater extent, at Tyco and Worldcomhad engaged in outright manipulation of their accounts, many observers expressed surprise that this had not been picked up by the markets before the summer of 2001. This was because the accounts contained a number of gaps, which, it has been argued, ought to have lead seasoned investors to conclude well before then that there was something unnatural about the stocks continued rise. The quest to understand why they did not do so forms the stepping-off point for the chapters in Part I of this collection. From the mid 1970s until the late 1990s, the orthodox view amongst finance scholars was that capital markets priced securities efficiently. The first tenet of this view, which is known as the Efficient Capital Markets Hypothesis (ECMH), posits that price-sensitive information is impounded in stock prices (Fama, 1970). Numerous event studies have

John Armour and Joseph A McCahery

shown empirically that companies stock prices do in fact react almost instantaneously to significant events affecting their performance. These tend 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 was purely a matter of the manipulation of disclosure. If markets take into account all publicly available information, then it should not be surprising that if price-sensitive information is concealed, a company such as Enron should havefor a limited period at least, until the market discovers what is going onan over-inflated stock price. Enron, however, provides a seeming puzzle for adherents to the finance orthodoxy. Many of the irregularities in its accounts were not concealed, or at least not with any real efficacy. The notes to the companys accounts dropped very large hints about the over-engineering of its finances. The surprising thing, if the finance orthodoxy is correct, is not that the company ultimately failed, but that this publicly-available information seems to have been ignored. Since the mid 1990s, however, an alternative framework for understanding stock markets, known as behavioural finance, has emerged (e.g. Shleifer, 2000). The name reflects the way in which this view starts from empirical studies of investor behaviour, as opposed to axiomatic postulates of rationality. Such studies show that investor behaviour differs markedly from what would be rational in a range of circumstances. However, proponents of the traditional perspective have responded with a series of explanations consistent with the rationality axioms (e.g. Fama, 1998). Part I contains two chapters that consider the extent to which the behavioural finance view might call for a reappraisal both of claims that capital markets are efficient and of perceptions about how best to regulate them. In so doing, they each consider whether investor irrationality might help to explain what happened at Enron. Chapter 1, by Ronald Gilson and Reinier Kraakman, is a reprise to an influential earlier article, The Mechanisms of Market Efficiency by the same authors (Gilson and Kraakman, 1984). The earlier paper sought to offer an account of the institutions that facilitate the informational efficiency of capital markets. The authors argued that arbitrageurs act as an important conduit for the reflection in stock prices of information available only to a subset of investors. The arbitrageurs would follow the trading activities of wellinformed investors, such as corporate insiders, and any unusual activity would thereby be rapidly picked up by the market. In Chapter 1, Gilson and Kraakman review the same terrain in light of developments in finance theory. Their analysis focuses on institutional limitations, such as regulatory and market restrictions on short selling,

Introduction

which make arbitrageurs less effective at transmitting negative information about corporate performance into stock prices than positive information. For such restrictions to impede market efficiency does not necessitate any assumption that investors behave irrationally. However, the presence of a substantial number of irrational investors (noise traders) in the marketplace compound these problems by introducing noise trader riskthat 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 particular direction, then this may generate a momentum effectthat is, a change sustained only by virtue of a previous changefor particular stocks, or for the market in general. It may become rational for arbitrageurs to trade with, rather than against, the momentum effectthat is, if a large number of investors are behaving irrationally by ignoring information about fundamentals, it becomes rational to ignore that information too. Gilson and Kraakman suggest that a sudden influx of uninformed investors would be a good proxy for the existence of bubbles in the market. However, such a momentum effect requires a continuous stream of new investors to sustain it, and at a certain point, will come to an end. This echoes old wisdom that the time to sell investments in a bubble market is the moment at which everyone else has entered the market, and so there will be no fresh money to prop it upor as Joseph Kennedy is famously reputed to have said: when the shoe-shine guy gives you stock tips, its time to get out. In Chapter 2, Donald Langevoort considers more directly the ways in which various behavioural biases might impact on the ECMH. He focuses on biases such as loss aversionwhich can lead investors to sell winning 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 a loss), and cognitive conservatism, which leads people to change their views in response to new information more slowly than would be consistent with rationality. However, both effects are subject to change under particular circumstances. Loss aversion has been shown to be significantly reduced in the light of recent experiencethat is, gamblers are more confident when on a roll. The salience, representativeness or availability of new information may dramatically affect the way in which people react to itunder certain circumstances they may overreact, rather than react conservatively. The problem with many of these findingsas Langevoort clearly recognisesis that they are highly contingent, making prediction difficult, and the task of a policymakerwho must work with generalitiesvery complex. Without taking a position on the question whether behavioural analysis better predicts market movements than traditional rationality assumptions, Langevoort teases out implications for a variety of different aspects of

John Armour and Joseph A McCahery

market regulationincluding fraud on the internet, fair disclosure and insider trading. Both chapters suggest that even if information was publicly availableor could readily have been extrapolatedabout Enrons true position, the market might have failed to respond to it as quickly as might have been expected, owing to irrationality on the part of investors, institutional limitations, or both. This implies that what went wrong was more than just the manipulation of disclosure by Enrons executives.

PA RT I I : C O R P O R AT E S C A N D A L S I N H I S TO R I C A L A N D C O M PA R AT I V E CO N T E X T

The chapters in Part II draw on experiences of corporate scandals from both history and different financial systems. In Chapter 3, David A Skeel, Jr suggests lessons that might be learned from history about the causesand consequencesof corporate scandals. The compensation packages granted to Enrons top executives gave them extremely high-powered incentives to focus on the share price. This contributed to their willingness to misstate the financial affairs of the company so as to please analysts and investors. Skeel compares this with the behaviour of errant executives in two previous rounds of corporate scandalsthat of Jay Cooke, who engineered the finances of the Northern Pacific Railroad during the 1860s until its spectacular collapse in 1873; and that of Samuel Insull, who built a vast empire of electricity companies in the 1920s, which imploded amid allegations of fraud in 1932. Skeel argues that in each case, the problems were caused by a combination of a culture in which risk-taking by executives was linked to reward with excessive competition. These encouraged managers to take ever-increasing gambles. 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 obtain very high returns from wrongdoing that impacted negatively on the lives of many individuals. Thus when the wrongdoing came to light, scandalspopular outragefollowed. As a result, there was a populist demand for a response, which in each case took the form of legislation designed to ensure that the particular malpractices which had occurred would not be repeated: the cessation of federal subsidies to railways in the 1870s; the Securities Acts of 1933 and 1934, and the Sarbanes-Oxley Act in 2002. Skeel then reflects on the link between interest group politics and the regulation of corporate behaviour in the US. For most of the history of the corporate form, managers have been the dominant interest group: they have at their disposal corporate resources that can be used to lobby politicians in an effective and concentrated manner. Thus, on the

Introduction

whole, the legal environment within which public companies operate has a tendency to respond to managers preferences. Yet for brief periods following the scandals that have occurred intermittently throughout the history of the corporate form, populist outrage compels legislatures to enact manager-constraining legislation. Skeels account is thus sympathetic to the widely-held view that Sarbanes-Oxley Act was a knee-jerk response to populist pressure. It is doubtful whether this piece of legislation, passed as quickly as it was, can have 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 by Simon Deakin and Suzanne Konzelmanns 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 to operate within an outsider system of corporate governance (e.g. Berglf, 1997; Bratton and McCahery, 2002). The most important distinguishing feature is that share ownership is dispersed, with no single blockholder being able to exert significant control over the company. The principal goal of corporate governance is understood in terms of rendering managers of such companies accountable to their dispersed shareholders. The fear 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 traditional finance perspective, has been that the best way to render managers of public corporations accountable to stockholders has been to give them incentives to focus on the share price, for example through the threat of hostile takeovers (Easterbrook and Fischel, 1991). If markets impound all publicly available information about corporate performance, then the market price will give the most reliable indicator of the extent to which managers are pursuing the shareholders interests. Thus many of the mechanisms of corporate governance employed in Anglo-American public companies during the 1990s have equated shareholders interests with the pursuit of higher stock prices. Yet, as Deakin and Konzelmann argue, giving executives powerful incentivesboth positive, in the form of lucrative remuneration packages, and negative, in the form of threats of hostile takeoverthat are linked to a single benchmarkshare pricecreates a powerful and counter-productive temptation to manipulate indicators. This criticism is complemented by the perhaps more fundamental point that the use of

John Armour and Joseph A McCahery

accountability to share price as a proxy for accountability to shareholders rests on the assumption that capital markets are, to a large degree, informationally efficient. To the extent that they are not, as was contemplated by the contributions in Part I, then the share price might not reflect shareholders long-term interests (Singh et al, 2005). Consequently, tying managers conduct to share price maximization might result in misallocations of resources. Deakin and Konzelmann view the Enron scandal as a demonstration of the failure of shareholder value as a guiding principle for business, and argue for a return to a more pluralistic view of the ambitions of corporate entities. Placing less emphasis on accountability to shareholders would not only reduce incentives to massage figures, but would also make it easier for firms to commit to partnership arrangements with employees. What would be lost in accountability, it is argued, would be more than made up for through the increased effort devoted to productive activity rather than signal manipulation. The characteristic feature of most of the worlds corporate governance systemsthat is, apart from the US and the UKis that the ownership of shares in listed companies is concentrated in the hands of blockholders. Systems following this pattern are said to have an insider model of corporate governance, in contrast to the Anglo-American outsider model. Under an insider system, there need be little regulatory concern about rendering managers accountable to shareholders, as the blockholder will control the managers, who will clearly be accountable to them. Hence it is possible for the corporate governance framework explicitly to promote a pluralistic approach. A drawback with the foregoing argument is that many corporate governance systemsespecially those in continental Europealready embrace such pluralism, yet Parmalat and the other European collapses have amply demonstrated that such systems enjoy no special immunity from scandal. The Parmalat scandal, recounted by Guido Ferrarini and Paulo Giudici in Chapter 5, forcefully drove home the point that the incentive and opportunity to commit fraud is not limited to any particular system of governance, geographic region, industry, or size of company. As is the case with many large continental European firms, Parmalat was controlled by members of its founding family. Its failure was a classic case of fraud carried out by the family-controlled managers to enrich family members and private companies controlled by the family trust. There were some clear commonalities between the Enron and Parmalat scandals. First, both involved self-interested executives manipulating corporate assets for the benefit of themselves and their associates. Secondly, as Ferrarini and Giudici explain, auditor failure appears to have contributed materially to both scandals. And thirdly, both raise questions about the efficiency with which stock markets price securitiesfor just as

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Introduction

Enrons accounts contained a number of warning signals that the market did not heed, Parmalats ownership structure transparently left outside investors exposed to the risk of opportunism by insiders, yet the stock price was not discounted to reflect this. 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 characteristically divergent forms of misconduct, reflecting differences in the underlying systems of corporate governance. In outsider systems, managers are most likely to be tempted to inflate the share price, as happened in the various cases of earnings misstatements in US public companies. In insider systems, on the other hand, the concern is less with manipulating the share price, and more with the diversion of corporate assets into the hands of blockholdersas appears to have been at the heart of Parmalats woes. One implication of Coffees chapter is that we should not assume that legal reforms which are matched to the problems of outsider governance regimes will necessarily also work in an insider system. For example, it might be asked how effective attempts to make boards of directors more independent, recently popular in Anglo-American corporate governance, would be if transplanted into an insider system where 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 differences between civil and common law countries, arguing that the common law (associated with Anglo-American systems) is more readily adaptable to changes 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 and enforcement of regulation may matter at least as much in corporate governance 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 Italy were, at the time the misdeeds occurred at Parmalat, actually more stringent than the post Sarbanes-Oxley regime in the US. Yet these rules nevertheless failed to prevent large-scale auditor failure. Ferrarini and Giudici argue that this was because of weaknesses in the rules enforcement. In Italy, as in much of continental Europe, the regulation of corporate governance rules relies heavily on public enforcement to render the substantive rules effective as a deterrent. The authors contrast this with the US, where private enforcement plays a much more significant

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11

role. To be sure, the US system, which relies heavily on class action litigation, does not result in perfect deterrence (see Pritchard, 2005). But Ferrarini and Giudicis argument is that, as a general matter, private parties have more reliable incentives to enforce than do public prosecutors, whose efficacy may be sidelined by rent-seeking activities. Thus, whilst auditor failure was at the heart of both the US and European scandals, there were significant differences, which in turn might require different responsesboth in terms of the substance and the mode of regulationto 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 to the same EU rules as continental Europe, is considered at appropriate points in both.

PA RT I I I . E VA L U AT I N G R E GU L ATO RY R E S P O N S E S : THE US AND UK

The five chapters in Part III of the book consider various reforms, both actual and proposed, that have been prescribed in the Anglo-American context. At the core of this discussion must necessarily be the Sarbanes-Oxley Act. As we have seen, it is easy to criticise the speed with which the US legislation was rushed through Congress. A widely-held view is that it lead to provisions that are costly and ineffective, inserted to appease populist demand rather than as genuine solutions to the underlying problems. Moreover, acting in haste may have lead Congress to overlook more effective regulatory techniques. Those who consider that capital markets function efficiently tend to criticise Sarbanes-Oxley as unnecessary and unjustified (Ribstein, 2005; Romano, 2005). The new rules create significant compliance costs for public companies, which critics claim are far greater than any countervailing benefits (Jain and Rezaee, 2005). The market, it is said, responded to the misdeeds at Enron even without the new legislation. Market forces punished the companys executivesand consequently, the auditors and analysts who had compromised themselvesthrough 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 what was omitted. This perspective differs from the efficient markets critique in that its adherents have less faith in the ability of capital markets to impound 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 include

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Introduction

provisions which were necessary to resolve the underlying problems: for example, in relation to shareholder rights (Bebchuk, Chapter 7, this volume), 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 the foregoing positions is closer to the truth, as the answer depends in part upon the view taken about the efficiency of capital marketsitself an area in which, as the essays in Part I evidence, no settled position currently exists. In reaching an answer, however, it is necessary to understand not just the weaknesses of the legislation that was passed, but also the relative merits of various proposals that have been offered by critics in the second camp. To this end, the five chapters that comprise Part III consider three regulatory mechanisms that are at the core of the post-Enron reform debate: (i) strengthening shareholder rights; (ii) the reform of accounting regulation and (iii) increasing the role played by non-executive (or outside) directors. Some, but not all, of these were significantly reformed by Sarbanes-Oxley, and each has featured prominently in policy debates about corporate governance since Enron on both sides of the Atlantic. Considering the actual or potential merits of these various mechanisms provokes thought about the extent to which, if at all, regulatory intervention may be capable of remedying the problems exemplified by Enron.

A. Strengthening Shareholder Rights In outsider systems of corporate governance, the notion of shareholder rights is often used to refer to the extent to which shareholders, if they are so minded, are able to exercise voice within the firm to keep managers in checksometimes 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) certain types of transaction and the like, but also correlative restrictions on managements ability to entrench themselves against shareholder decisions (for example, through defences capable of blocking a takeover bid). A number of recent empirical studies have reported correlations between 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 to entrench themselvesfor example, through takeover defences, staggered boards and the likeand weaker corporate performance. In the US, most of corporate law is formulated at the state, rather than the federal, level. The Sarbanes-Oxley Act, being federal, is an important

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exception. US corporations are free to select their state-level governing law by changing their state of incorporation, something which SarbanesOxley did nothing to change. In Chapter 7, Lucian Bebchuk argues that because share ownership in US listed companies is widely dispersed, managers of listed companies have too much influence over decisions to reincorporate. He argues that as a result, firms will tend to be steered towards legal regimes that entrench managers and disenfranchise shareholders, which the empirical evidence suggests may, over time, have a negative impact upon firm values. The solution, Bebchuk suggests, is federal legislation restricting the extent to which shareholders can be disenfranchised. The problem of managerial entrenchment is one that is peculiar to outsider systems of corporate governance. This is because where listed firms are controlled by blockholders, then the problem is one of blockholder, rather than managerial, entrenchment. It is therefore interesting to contrast the case of the US with that of the UK, the only other country in which share ownership is typically widely dispersed. Perhaps surprisingly, there are considerable differences in the extent to which the two countries permit managerial entrenchment: the UK is significantly more restrictive than the US. UK directors are mandatorily subject to the threat of dismissal by a simple majority of the shareholders in general meeting.2 Strong pre-emption rights and market hostility to dual class voting stock disable managers from using such structures to perpetuate their control (Ferran, 2003). Moreover, the UKs City Code, written and implemented by the self-regulatory Panel on Takeovers and Mergers, gives much greater control to shareholders over the conduct of takeover bids than they enjoy under the more manager-friendly doctrines under Delaware law (Armour and Skeel, 2005). One explanation for this divergence in outcomes, which emerges from Bebchuks contribution, is that the relatively weaker position of US shareholders results from a race to the bottom in US corporate law. The UKs corporate law, based in a unitary jurisdiction, has for most of its history not faced any pressure from regulatory competition, which in Bebchuks view has been responsible for degrading shareholder rights in the US. However, this explanation provokes further questions, suggesting that it may only be part of the story. Much of the UKs regulatory regime for public companies has developed out of self-regulatory or soft law codes promulgated by stock market institutions, as opposed to legislation. Paul Davies (Chapter 12), argues that the use of soft law has been useful to the UK government in overcoming managerial lobbying, because the government retains thinly-veiled bargaining power from the (unexercised) threat to resort to legislation. Such techniques have also
2

UK Companies Act 1985 s 303.

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Introduction

been used in the US: for example, in response to Enron, both the New York Stock Exchange and NASDAQ have recently introduced new rules regarding board structure. Regulatory competition does not explain why such codes have historically not been more extensively deployed in the US to reinforce shareholder rights. Rather, this may be because the federal securities acts of the 1930sa populist response to an earlier set of corporate scandalspre-empted self-regulation by mandating the SEC to approve stock exchange listing rules (Armour and Skeel, 2005). 3

B. The Reform of Accounting Regulation Arguably the most fundamental of the Sarbanes-Oxley reforms has been the tightening of controls on auditors. The basic problem, to which the Act responds, is that of managerial influence over auditors. Whilst a concern with reputation would supposedly encourage auditors not to be too soft on management, such effects have been considerably undermined in recent years by the growth in the provision of non-audit services by accountants to their audit clients. These have provided the large accountancy firms with an ever-increasing share of their revenues, and in so doing have given their corporate clients a powerful, and not readily visible, lever with which to encourage the auditor to agree with managements own preferred statement of the companys position. In extreme cases, this may provide enough of an incentive to auditors to sign off where not just aggressive accounting, but downright fraud, has been taking placeas was undoubtedly part of the problem at Enron (Coffee, 2002, 2004). In response, the Sarbanes-Oxley Act has mandated the creation of a new accounting regulator, the Public Companies Accounting Oversight Board, with whom firms auditing US-listed public companies must register. The Act has also required public companies to channel auditor appointment and oversight through an audit committee, comprised of independent directors, required CEOs and CFOs, on pain of criminal penalties, to certify the veracity of financial statements, mandated quinquennial rotation of audit partners at accounting firms, and prohibited the offering by audit firms of a range of specified nonaudit services. However, some argue that the problems with US audit practices go deeper, and are not remedied by the Act. Chapters 8 and 9 consider two such claimed problems: the heavy reliance on rules, rather than principles, in US accounting practice, and the oligopolistic nature of US the 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.

John Armour and Joseph A McCahery

15

It has been argued by some that one of the factors that facilitated Enrons balance sheet manipulation was the rules-based structure of US GAAP (generally accepted accounting principles). The US GAAP is often contrasted with principles-based systems such as UK GAAP or the IASBs guidelines, which involve more generally-worded, open-ended norms, the application of which, it is said, requires a greater level of professional judgement by accountants. The criticism levelled at US GAAP is that a system in which accounts are audited primarily for compliance with a body of rules, depends for its integrity on the comprehensiveness of the rulebook employed. Any body of accounting rules will have loopholes, which in a rules-based system then lend themselves to exploitation by companies seeking to manipulate their earnings. On the other hand, it is argued that a principles-based system, which requires professionals to exercise their judgement more frequently instead of passively standing behind the rule book, would lead to less of this sort of gaming behaviour. William Bratton disputes this argument in Chapter 8. In Brattons view, Enron was really a case of old-fashioned fraud, rather than sophisticated, aggressive accounting. Moreover, he suggests that US GAAP is in reality more principles-based than many of the proponents of principles seem to realise. In practice, the demand for rules appears to have been fuelled not by companies wishing to be assured of loopholes to exploit, but rather by accountants facing competitive pressures, because rules foster certainty and help to lower the fees auditors need to charge to insure themselves. In Chapter 9, James Cox argues that the highly concentrated structure of the accounting industry allows firms to coordinate on price and strategy, and contributed to the professions weaknesses. Such concentration may have facilitated the development of the accounting firms consultancy businesses, and the conflicts of interest with audit to which these gave rise. Moreover, he suggests that the industrys concentration is also likely to undermine the effectiveness of the Sarbanes-Oxley reforms. He reports preliminary findings on the Acts operation, which do not suggest that it has made a significant difference. Because the accounting profession 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 directors have been amongst the most important areas of reform. In the US, the Sarbanes-Oxley Act has mandated the creation of audit committees by public companies. These must be staffed by independent directors, at

16

Introduction

least one of who must be a financial expert. In addition, new NYSE and NASDAQ 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 central part of the governance of listed companies since the introduction of the Cadbury Code in 1992, following scandals in the early 1990s. Post-Enron, the UKs 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-executive directors may be able to act as a champion of shareholders interests, and a check on egregious fraud, by ensuring that proper procedural steps are taken. However, there is considerable debate about the best way to give such directors appropriate incentives to perform their function. One oft-cited mechanism for encouraging attentiveness is the threat of legal liability. However, liability risk may have side-effects that actually outweigh any benefits generated by deterrence. Fear of too much liability, leading directors to behave in an excessively risk-averse fashion, may be just as likely to compromise directorial judgement as lack of independence. 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 across countries, depending on the mechanics of civil procedure and the structure of the legal profession, Black, Cheffins and Klausner show that this picture is misleading. Rather, a range of other factors affect both the likelihood of a lawsuit being brought and the amount which a director who was found liable might need to pay from his or her own pocket. For example, in systems where the frequency of lawsuits against directors is high, so too is the incidence of directors and officers (D&O) insurance. Once these various factors are taken into account, it appears that independent directors around the world face a very similarand uniformly lowlevel of real liability risk. One interpretation of this finding might be that high, real levels of liability exposure are counterproductive, and consequently parties contract out by using insurance in systems 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 the company. However, a director with a significant shareholding, whilst having strong incentives, may not be as independent as an individual wholly without ties. This in turn provokes thought about the proper scope of non-executives role. Some suggest that non-executives should be viewed as capable of playing an active part in the formulation of business strategy, by bringing outside experience to strengthen the

John Armour and Joseph A McCahery

17

boards capabilities, and a valuable network of contacts. Others see non-executives as performing a role akin to board-level auditors of decision-making processesasking questions, and putting a check on any misconduct by executives. Whilst these two functions are not necessarily mutually exclusive, they may sometimes be in tension, and their implications for the desirability of director share ownership may cut in different directions. In resolving the foregoing issue, the Sarbanes-Oxley Act strongly prioritises independence, at least for audit committee members (Chandler and Strine, 2003). The Act prohibits them from receiving any compensation 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 who holds (either alone or in concert with others) a controlling stake in the company. Control is determined by a factual test, although there is a safe harbour provision that ownership of less than 10 per cent of any class of voting equity securities will not count as control. In contrast to the mandatory rules used in the Sarbanes-Oxley Act, the UKs Combined Code regulates these issues using a comply or explain mechanism. That is, listed firms are required either to comply with the Codes requirements, or to explain to investors why they have not done so. In Chapter 11, Richard Nolan reviews the UK position, and describes the changes that were implemented following the Higgs Review of the Role of Non-Executive Directors (Higgs, 2003). The Higgs Review sought to reconcile both lines of thinking about non-executives role, a compromise that Nolan criticises. In Nolans view, the Reviews recommendations, which were subsequently incorporated into the UKs Combined Code, would have been clearer and more effective had they focused solely on the goal of ensuring the independence of nonexecutives. This would avoid any possibility of conflict of interest, and incentives to monitor effectively could be generated not only by the threat of legal liability, but also by reputational concerns. The latter might in turn be strengthened by drawing such directors from pools of professionals which have strong reputational bonds for independence anyway. It seems plausible that one model of non-executives role might not be appropriate for all types of company. Interestingly, one empirical study (Lasfer, 2002) finds that compliance with the UK Combined Codes provisions in respect of independent non-executive directors is positively associated with stock price performance for companies in mature industries, but is actually negatively associated with performance for smaller, high-growth companies. His interpretation is that for highgrowth companies, strategic guidance and networking functions associated with non-independent directorsare relatively more valuable inputs from the board, whereas in mature industries, it is relatively more

18

Introduction

useful to have genuine outsiders who will ask searching questions of managers, particularly about what will be done with free cash flow. The foregoing suggests thatas Nolan argueswhat seems most appropriate is perhaps not mandatory legislation on board structure, but rather a framework which promotes reflection upon the use of outside directors and disclosure of the practices which have been adopted. To this end, the UK Combined Codes comply or explain framework seems preferable to the mandatory rules adopted in the US.

PA RT I V. RE F O R M I N G E U C O M PA N Y L AW A N D C O R P O R AT E GO V E R N A N C E

Part IV of the collection considers the particular issues raised by modernising company law and securities regulation in Europe. In addition to difficulties generated by the issues that have proved controversial in the US, the European reform agenda faces several unique challenges. The most fundamental stems from the fact that the EU encompasses a diversity of systems of corporate governance. Most obviously, there is a divide between the UKs outsider share ownership and the insider share ownership of continental Europe, with a corresponding difference in the emphasis of regulation between rendering management accountable and keeping blockholders under control. Member states also differ systematically in the way in which their regulation is designed and enforced. Furthermore, following enlargement in 2004, the EU now contains several Eastern European economies in varying stages of transition. As a result, not only might the appropriate regulatory measures differ from state to state, but there are also likely to be severe political obstacles to wide-ranging European legislative reform.

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 any problems had surfaced at Parmalat, the European Commission asked their High-Level Company Law Expert Group to prepare a report elaborating any necessary EU legislation in the field of corporate governance. In May 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 the transparency of intra-group relations and transactions with related parties and to improve disclosures about corporate practices. The Commission also launched plans for the reform of the statutory audit

John Armour and Joseph A McCahery

19

(European Commission, 2003b). Then, in the wake of the Parmalat scandal, the Commission proposed additional measures mandating collective board responsibility for financial statements and regulating disclosure of related party transactions, including those between a company and controlling shareholders or top executives (European Commission, 2004). In Chapter 12, Paul Davies offers an explanation for the speed of the response in Europe, and in the UK in particular. He argues that the breaking of the Enron scandal had the effect of neutralising a range of opposition to pre-existing reform initiatives, which were simply re-characterized (and in some cases extended) by advocates of the post-Enron measures. Although there are echoes of Skeels account (Chapter 3) of how populist pressure generated by corporate scandals can upset the ordinary balance of power between interest groups. Several other factors contributed to the rapid progress of the reforms. First, the EU was in 2002 engaged in difficult negotiations with the US over the proposed extraterritorial reach of the Sarbanes-Oxley Act. Crucial to the success of these negotiations was the existence of a set of safeguards for European investors that could credibly be said to be equivalent to those in the US. The alternative to EU reform was the extra-territorial imposition by the US of its reforms on EU companies that listed in the US. Secondly, the imminent accession to the EU of 10 new countries leant a now or never quality to proposals. And thirdly, the stirring for the first time within the EU of regulatory competition in company law, following the ECJs landmark 1999 ruling in Centros,4 may have added further pressure towards the achievement of consensus at the European level over minimum standards, at least in the eyes of those who fear that unbounded regulatory competition may lead to a race to the bottom. The blueprint for the Commissions Company Law Action Plan was the report delivered by the Commissions High Level Expert Group in December 2002. In Chapter 13, Klaus Hopt, a leading member of the Expert Group, explains how the Group approached its task and the thinking behind its conclusions. The Group were much exercised by the problems of ensuring that the reforms would be appropriate for both the diversity of corporate ownership structures and regulatory enforcement techniques that are employed throughout the EU. The essence of their response, 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 coreor common denominatorrules which, in the Groups view, would be necessary to ensure good governance in any of the member states, regardless of national diversity. At the same time, much attention was also paid to
4

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

20

Introduction

ensuring that appropriate regulatory instruments were chosen. Together, this produced a package of reforms intended to comprise the minimum necessary 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 by the Group. Shareholder rightsin particular, rights to vote on executives remuneration packages, and to block defensive tactics in the face of a takeover bidwere seen as core features of the reform programme.5 It is worth noting that such rules are essentially antidirector in character, and may therefore be thought to be of less significance for systems in which insider ownership is common. In such systems, a majority shareholder would of course control the vote. This is reflected in the way in which these issues were ultimately implementedvoting on directors remuneration took the form of a non-binding Commission Recommendation, and the ban on defensive tactics, implemented as part of the Takeover Directive, contains an opt-out provision for member states (or individual companies). Turning to the role of auditors, the Group focused in particular on the usefulness of having an audit committee comprised of independent directors to channel communications between the company and its auditors as a key strategy for overcoming potential conflicts of interest between audit and non-audit work. As Davies explains in Chapter 12, the Commissions reforms in this area, which have now yielded a proposed Directive (European Commission, 2004) have also included a number of changes clearly inspired by Sarbanes-Oxley, including mandating collective responsibility of the board for financial statements; mandatory rotation of audit partners or audit firms; the barring of business relationships between audit firm and customer which might compromise the auditors independence, and the strengthening of disclosure rules relating to auditors. A particularly important issue for the High-Level Group concerned the role and structure of the board of directors, the relevant proposals for which have now been incorporated into a Commission Recommendation.6 Hopt explains in Chapter 13 that their proposals for independent directors were designed to be capable of complementing both UK-style
5 Both proposals have since been taken forward. The Commission Recommendation on 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 companys 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 . 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).

John Armour and Joseph A McCahery

21

unitary boards, and German-style two-tier boards with employee codetermination: monitoring functions can be carried out by non-executive shareholder appointees or by employee representatives respectively. Moreover, independent directors are viewed as having a role to play in both outsider and insider owned companies, as safeguards against self-serving conduct by, respectively, managers and blockholders.

B. Developments in Regulatory Techniques The Expert Group/Action Plans philosophy of focusing legislative energies on core issues for which consensus might be achieved, and the greater use of non-binding Recommendations, can be seen as part of an emerging trend. European policymakers are becoming both more sensitive to the different capabilities of various regulatory techniques both to overcome political obstacles and to achieve regulatory goals. The last four contributions to the collection consider three examples of this new thinking in operation, followed by a pessimistic assessment of the impact of more traditional harmonization techniques. The ECJs jurisprudence in Centros and subsequent cases has opened up, for the first time, a degree of regulatory competition in European company law.7 In Chapter 14, John Armour considers the possibilities for harnessing regulatory competition as a means of mutual learning by regulators, whilst nevertheless permitting continued diversity of national company law regimes. This would be appropriate in fields where no European consensus has emerged. Whilst regulatory competition has traditionally been feared in Europe as leading to a race to the bottom, Armour argues that this need not be the case, provided that sufficient safeguards are in place to ensure that relevant constituencies are able to participate in a firms decision to reincorporate, protections he suggests will 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 to companies have concerned takeovers and securities markets. As well as being of enormous substantive significance for the development of European corporate governance, the processes by which these reforms have been effected evince two distinct further regulatory techniques. The
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 it 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.

22

Introduction

Takeover Directive,8 following a lengthy political roadblock, was eventually passed in a form that permits member states, and individual firms, to opt into or out of key provisions. In Chapter 15, Grard Hertig and Joseph McCahery argue that this menu of legal options approach can overcome many of the difficulties of fitting a single legislative rule to diverse systems, and suggest that it might be used as a blueprint for future reforms. The beneficial effects may also include the development of a richer set of regulatory arrangements, offering the potential for mutual learning by firms and regulators and thereby leading to improvements in the quality of investor protection. By contrast, the comitology technique used in the new regulatory frameworks for the European securities market, considered by Eils Ferran in Chapter 16, involves the delegation of legislative power to a committee of technocrats. In relation to securities markets, this is known as the Lamfalussy process, after the chairman of the committee of experts who recommended the current structure. Ferrans account concentrates on the mechanics of the process, discussing the cooperation between the Commission, Council and Parliament in the process, as well as the new Committees created under Lamfalussy, the consultation process and implementation of the new regime. Comitology, too, could provide a blueprint for future reform activity, seemingly permitting contentious issues to be placed outside the realm of political discussion by delegation to experts. The three foregoing mechanismstransforming political choices into market choices through regulatory arbitrage; preserving political choices through options in European legislation; and disguising political choices through devolution to a technocratic committee, each represent possible futures, and part of the probable future, of European company and securities law-making. They stand in stark contrast to the attempts at harmonization 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 all significant issues. This meant that, even in the early days of the European project, the body of EC company law which was made through traditional harmonizing directives, which require member states to implement a particular regime or set of minimum standards, was only capable of proceeding by focusing on issues that were essentially trivial. It is to be hoped that the new techniques described above may yield greater success in the future.

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

John Armour and Joseph A McCahery

CONCLUSION

23

An issue at the centre of this collection concerns the extent to which the differences between Anglo-American and continental European systems of corporate governanceoutsider and insider systems respectively have lead to differences in the nature of, and susceptibility to, corporate governance failures. The fact that failings have exposed in both types of system has tended to weaken the force of accounts that view Enron solely as a symptom of weaknesses of the Anglo-American system of corporate governance. At the same time, it has tended to strengthen the conviction of those who call for generalised regulatory solutions without regard to the underlying corporate governance context. Yet whilst some common weaknesses did indeed existin particular, the universal failure of auditors to function effectivelyfor which the same solutions may be appropriate, it is dangerous to regard the systems as otherwise equivalent, because both the causes of, and appropriate solutions for, recent failures are different. So far as the US is concerned, it seems unlikely that a hastily-prepared populist measure such as Sarbanes-Oxley will break with history by definitively putting an end to corporate scandals. Even the relatively uncontentious measures concerning audit regulation seem to have been less successful than may have been hoped. And the corporate governance measures, which have drawn widespread criticism for the costs they impose on US public companies, betray a lack of thought on issues concerning board structure and shareholder rights. What is less clear, however, is the appropriate way forward on these issues. It seems plausible that for different firms, different constellations of board structure and shareholder rights may be appropriate. If that is the case, then US policymakers might do well to rethink their recent fondness for mandatory federal rules regarding corporate governance, and to consider some of the more flexible regulatory strategies that have been employed in the EU. In Europe, the scandals have provided the impetus for surmounting political obstacles to the reform of corporate and securities law at the EU level. In rolling out their responses, European policy-makers faced the need to regulate a diversity of systems, and also a means of minimising the political cost of implementation. In response, they have begun to experiment with a range of new regulatory techniques, few, if any, of which rely upon traditional mandatory rules at the federal level. These include a mixture of non-binding recommendations, opt-in rules, delegation to committees of experts and the selective use of regulatory competition (coupled with procedural safeguards contained in federal rules). Whilst a considerable amount has been achieved, it remains to be seen how the highly complex regulatory architecture that has resulted will actually function.

24

Introduction

By March 2006, the S&P 500 Index had crept back up to more than 1,300, little more than 10 per cent short of its peak in 2000. Some may view this as evidence that the crisis precipitated by Enron has been resolved. A reader of this collection should rightly view such an interpretation as simplistic. Our understanding of stock markets is actually rather less secure than had previously been imagined. Moreover, corporate scandals have tended to repeat themselves in history, following the bursting of market bubbles and provoking populist legislation which has failed to prevent future cycles of scandal. It is wise to regard current conclusions as no more than preliminary, and appropriate for prescriptions to be advanced with humility.

REFERENCES Arden, Rt Hon Lady Justice Mary (2003), UK Corporate Governance After Enron 3 Journal of Corporate Law Studies 269. Armour, J. and Skeel, D.A., Jr (2005), Who Writes the Rules for Hostile Takeovers? The Peculiar Divergence of the US and the UK, Working Paper, University of Cambridge Faculty of Law/University of Pennsylvania Law School. Bebchuk, L.A., Cohen, A., and Ferrell, A. (2004), What Matters in Corporate Governance, Harvard Law School John M. Olin Discussion Paper No 491, available on www.ssrn.com . Beck, T., Demirg-Kunt, A., and Levine, R. (2003), Law and Finance: Why Does Legal Origin Matter? 4 Journal of Comparative Economics 653. Berglf, E. (1997), A Note on the Typology of Financial Systems in K.J. Hopt and E. Wymeersch, Comparative Corporate Governance: Essays and Materials (Berlin: Walter de Gruyter), 151. Bratton, W.W. (2003), Enron and the Dark Side of Shareholder Value 76 Tulane Law Review 1275. Bratton, W.W. and McCahery, J.A. (2002), Comparative Corporate Governance and Barriers to Global Cross Reference, in J.A. McCahery et al (eds), Corporate Governance Regimes: Convergence and Diversity (Oxford: OUP), 23. Chandler, W.B. and Strine, L.E., Jr (2003), The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State 152 University of Pennsylvania Law Review 953. Coffee, J.C. (2002), Understanding Enron: Its About the Gatekeepers, Stupid 57 Business Lawyer 1403. (2004), What Caused Enron? A Capsule Social and Economic History of the 1990s 89 Cornell Law Review 269. Easterbrook, F.H. and Fischel, D.R. (1991), The Economic Structure of Corporate Law (Cambridge: MA, Harvard University Press). Enriques, L. (2003), Bad Apples, Bad Oranges: A Comment From Old Europe on Post-Enron Corporate Governance Reforms 38 Wake Forest Law Review 911. European Commission (2003a), Modernising Company Law and Enhancing Corporate Governance in the European UnionA Plan to Move Forward, COM(2003) 284 final 21 May 2003.

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(2003b), Reinforcing the statutory audit in the EU, COM(2003) 286 final, [2003] Official Journal C236/2. (2004), Proposal for a Directive of the European Parliament and of the Council amending Council Directives 78/660/EEC and 83/349/EEC concerning the annual accounts of certain companies and consolidated accounts, COM(2004) 725 final, 27 October 2004. Fama, E.F. (1970), Efficient Capital Markets: A Review of Theory and Empirical Work 25 Journal of Finance 383. (1998), Market Efficiency, Long-term Returns, and Behavioural Finance 49 Journal of Financial Economics 283. Ferran, E. (2003), Legal Capital Rules and Modern Securities Marketsthe Case for Reform, as Illustrated by the UK Equity Markets in K. Hopt and E. Wymeersch (eds), Capital Markets and Company Law (Oxford: OUP), 115. Financial Reporting Council (2003a), Audit CommitteesCombined Code Guidance: A Report and Proposed Guidance by an FRC-Appointed Group Chaired by Sir Robert Smith (London: FRC). (2003b), The Combined Code on Corporate Governance (London: FRC), available online at: http://www.frc.org.uk/combined.cfm. Fortune (2001), Is Enron Overpriced?, Fortune, 5 March 2001. Gilson, R. J. and Kraakman, R. (1984). The Mechanisms of Market Efficiency 70 Virginia Law Review 549. Gompers, P., Ishii, J., Metrick, A. (2001), Corporate Governance and Equity Prices, 118 Quarterly Journal of Economics 107. Hansmann, H.B. and Kraakman, R. (2001), The End of History for Corporate Law 89 Georgetown Law Journal 439. Higgs, D. (2003), Review of the Role and Effectiveness of Non-Executive Directors (London: DTI). Jain, P.K. and Rezaee, Z. (2005), The Sarbanes-Oxley Act of 2002 and Security Market Behavior: Early Evidence, Working Paper May 2005, available at: www.ssrn.com. Johnson, S.A., Ryan, H.E., and Tian, Y.S. (2003), Executive Compensation and Corporate Fraud, Economics Working Paper, Louisiana State University, April 2003, available at: www.ssrn.com. Kraakman, R. (2004), Disclosure and Corporate Governance: An Overview Essay, in G. Ferrarini, K.J. Hopt, J. Winter and E. Wymeersch (eds), Reforming Company and Takeover Law in Europe (Oxford: OUP). La Porta R., Lopez-de-Silanes F., Shleifer A. and Vishny R. (2000) Investor Protection and Corporate Governance 58 Journal of Financial Economics 3. Larcker, D.F., Richardson, S.F., and Tuna, A.I. (2005), How Important is Corporate Governance?, Working Paper, Stanford Graduate School of Business/ Wharton School, available at www.ssrn.com . Lasfer, M. (2002), Board Structure and Agency Costs, EFMA 2002 London Meetings, available on www.ssrn.com. Malkiel, B.G. (1992), Efficient Markets Hypothesis, in P. Newman et al (eds), The New Palgrave Dictionary of Money and Finance Markets, Vol 1 (London: Macmillan), 739. Pritchard, A. (2005), Should Congress Repeal Securities Class Action Reform in

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W. Niskanen (ed.), After Enron: Lessons for Public Policy (New York: Rowman and Littlefield), 125. Ribstein, L. (2005), Sarbanes-Oxley After Three Years, [2005] New Zealand Law Review 365. Romano, R. (2005), Sarbanes-Oxley and the Making of Quack Corporate Governance, 114 Yale Law Journal 1521. Shleifer, A. (2000), Inefficient Markets: A Guide to Behavioural Finance (Oxford: Clarendon Press). Singh, A., Glen, J., Zammit, A., Singh, A. and Weisse, B. (2005), Shareholder Value Maximisation, Stock Market and New Technology: Should the US Corporate Model be the Universal Standard?, University of Cambridge CBR Working Paper No 315, September 2005. Standard & Poor (2006), S&P 500 Price Index data, www.standardandpoor.com (checked 14 April, 2006).

Contents
Acknowledgements List of Contributors Table of Cases Table of Legislation Introduction After Enron: Improving Corporate Law and Modernising Securities Regulation in Europe and the US JOHN ARMOUR and JOSEPH A McCAHERY Part I 27 5

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 DONALD C LANGEVOORT 65 Part II 3 Icarus and American Corporate Regulation DAVID A SKEEL, JR 4 Corporate Governance after Enron: An Age of Enlightenment SIMON DEAKIN and SUZANNE J KONZELMANN 5 Financial Scandals and the Role of Private Enforcement: The Parmalat Case GUIDO FERRARINI and PAOLO GIUDICI 6 A Theory of Corporate Scandals: Why US and Europe Differ JOHN C COFFEE, JR 103

129

131

157

217

vii

viii Part III 7 The Case for Shareholder Access to the Ballot LUCIAN ARYE BEBCHUK 235

237

8 Rules, Principles, and the Accounting Crisis in the United States WILLIAM W BRATTON 265 9 The Oligopolistic Gatekeeper: The US Accounting Profession JAMES D COX

295

10 The Liability Risk for Outside Directors: A Cross-Border Analysis BERNARD BLACK, BRIAN CHEFFINS and MICHAEL KLAUSNER 343 11 The Legal Control of Directors Conflicts of Interest in the United Kingdom: Non-Executive Directors Following the Higgs Report RICHARD C NOLAN 12 Enron and Corporate Governance Reform in the UK and the European Community PAUL DAVIES 13 Modern Company and Capital Market Problems: Improving European Corporate Governance After Enron KLAUS J HOPT 14 Who Should Make Corporate Law? EC Legislation versus Regulatory Competition JOHN H ARMOUR 15 Company and Takeover Law Reforms in Europe: Misguided Harmonization Efforts or Regulatory Competition? GRARD HERTIG and JOSEPH A McCAHERY 16 The Regulatory Process for Securities Law-Making in the EU EILS FERRAN 17 EC Company Law Directives and Regulations: How Trivial Are They? LUCA ENRIQUES Index

367

413

4443

495

543

573

635