Delaware Law and the Responsibility for SOX

Today we will begin a series of posts that examine the responsibility of Delaware for the adoption of much of what is in SOX.  Those who criticize the Act the most vociferously are often those who also view state regulation of governance as a race to the top, an evolutionary process that results in a more efficient corporate law.  What ever the merits of the argument, it is clear that SOX was a fundamental rejection of the approach.  I have discussed these views and the congressional reaction here.  SOX effectively treated state law and it's regulation of corporate governance as a race to the bottom and overturned it in a number of respects.  Had state law fiduciary standards been more rigorous, some of the provisions in SOX would not have been adopted.

What are some examples? Section 301 of SOX requires that audit committees of listed companies have a procedure for receiving, retaining and treating complaints about accounting or auditing matters and for confidential submissions concerning questionable accounting or auditing matters. Did it really require a federally mandated listing standard to cause companies to put this type of system in place? Had the fiduciary obligation to monitor been stronger, companies likely would have had such a system, obviating the need for federal intervention.

Section 407 requires companies to disclose (in accordance with Commission rules), whether the audit committee has a financial expert. The provision stopped short of requiring financial expertise but clearly pushed companies in that direction by requiring an explanation if they did not. The provision arose because state law was not sufficiently rigorous that public companies routinely included directors on the audit committee with this type of experience.

There are plenty of other examples.  But the first that will be examined in detail are the problems that arose out of the treatment under state law of the duty of loyalty. The duty of loyalty applies to any transactions between the company and a fiduciary.  The category includes executive compensation. 

When the duty applies, the courts ordinarily apply the entire fairness analysis, a fairly rigorous standard. Delaware courts, however, exempt from this standard conflict of interest transactions that are subject to certain process.  In particular, the courts apply the business judgment rule to conflict of interest transactions approved by a majority of “independent” directors.  One problem with the standard is that in fact directors deemed independent under Delaware law are, in fact, not independent.  This topic is addressed more fully in my article here and in a prior post here. 

The other problem is that the courts allow for the interested influence to be in the decision making process.  The courts are quite clear that approval need only be by a majority of independent directors.  The interested minority can remain in the decision making process, debate the matter, and even vote, with the courts still apply the business judgment rule to the transaction.  Moreover, in apply the business judgment rule, fairness and the terms of the transaction all but become irrelevant. 

Thus, Section 402 of SOX prohibited most loans to directors and executive officers, a provision aptly titled “Enhanced Conflict of Interest Provisions.” Congress singled out loans and dealt with the lack of standards imposed under state law through a categorical prohibition. The approach did not address other types of conflicts or the fundamental problem at state law of exempting conflict of interest transactions from any kind of fairness review.  In that sense, SOX was too narrowly drawn, addressing a symptom and not the root cause.   

Tomorrow we will begin an examination of the root cause, Delaware’s approach to the duty of loyalty, starting with the poster child example of what happens when fairness becomes irrelevant to the duty of loyalty analysis.