TCS Daily


The SEC and the Election

By Stephen Bainbridge - November 5, 2004 12:00 AM

With Bush having won a decisive majority of the popular vote and the GOP having gained seats in both the Senate and House of Representatives, 2005 should be a very good year for the conservative agenda. The markets certainly seem to be in a celebratory mood. As of 10 AM PST on the day after the election, all of the major market indices were up.

"Clearly, we're seeing a Bush victory rally," said Michael Sheldon, chief market strategist at Spencer Clarke. (Link)

But what does this decisive Bush victory mean for regulation of the capital markets? It's hard to say with any confidence, because President Bush did not campaign on issues of corporate governance or securities regulation. If the President is now looking for suggestions, however, here are two top priorities to which he should give prompt attention:

1. Fire Securities and Exchange Commission Chairman William Donaldson. Chairman Donaldson was brought in to pour oil on the troubled waters stirred up by his well-meaning but politically incompetent predecessor Harvey Pitt. Donaldson did that task reasonably well. Although at one point it looked like Enron and the other corporate scandals could dent President Bush's image, Donaldson's tenure at the SEC saw those issues disappear from the front pages.

Yet, even though Donaldson has several years left on his term, it is rumored that he is contemplating stepping down after the election. If so, Bush should encourage him; if not, Bush should give him a shove out the door. Although nominally a Republican, Donaldson has consistently sided with the two Democrats on the Commission rather than fellow Republican Commissioners Atkins and Glassman in a series of highly contentious 3-2 votes, all of which significantly increased the regulatory burden on securities firms and markets.

In particular, Donaldson has let Democrat Commissioner Harvey Goldschmid wield an unusual degree of influence for a minority member. Goldschmid is a very smart guy and a highly experienced securities lawyer and academic, but he is also highly partisan with a strongly pro-regulatory outlook. Goldschmid has been a driving force behind a number of the SEC's most controversial regulatory efforts. The next SEC Chairman must be somebody who can relegate Goldschmid to the usual nonentity status of minority Commissioners.

2. Get a replacement for Donaldson on board in time to block the SEC from adopting its shareholder access proposal. As I've explained in my TCS columns Does the SEC Know When Enough Is Enough?, and The SEC: From Bad to Worse?, this proposal to let selected shareholders nominate directors under certain circumstances is fundamentally inconsistent with both federalism and sound corporate governance.

The federalism implications are particularly significant, because the SEC proposal would mark a substantial intrusion of the federal government into an area of corporate law traditionally reserved for the states. The corporation is a creature of the state, "whose very existence and attributes are a product of state law." States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, a state has a legitimate "interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs."[1] In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.

According to the Supreme Court's decision in CTS Corp. v. Dynamics Corp., the country as a whole benefits from state regulation in this area, as well. As Justice Powell explained in that case, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, "It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country."[2] So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead leads to more efficient corporate law rules.

Federal preemption cuts off that process of experimentation. Congress and the SEC rarely revisit their rules, leaving many controversial provisions carved in stone. By blocking the SEC's shareholder access proposal, President Bush would draw a line in the sand in defense of competitive federalism and state rights.



[1] CTS Corp. v. Dynamics Corp., 481 U.S. 69, 91 (1987).

[2] New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).


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