(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Corporate Governance Principles Emerge in Environment of "Competitive Federalism"

A tension exists with regard to corporate governance between state and federal authority, stated E. Norman Veasey, chief justice of the state of Delaware. Professor John Coffee of the Columbia University Law School described " a new kind of regulatory competition" with regard to corporate affairs that could lead to a regulatory "Balkanization", while Joel Seligman, dean and professor of law at Washington University, described how the two dynamic systems of regulation will be a positive force for investor protection. The remarks were made in a panel discussion at the annual Securities Regulation Institute hosted by Northwestern University's law school.

Delaware Law

Chief Justice Veasey, referring to his earlier remarks at the National Association of Corporate Directors, noted that there are differing roles for at least 10 different actors in corporate governance matters. These are 1) stockholders, 2) directors, 3) management, 4) Congress, 5) the SEC, 6) the Justice Department, 7) self-regulatory organizations, 8) federal courts, 9) state courts and 10) state legislatures. Even though the roles of these entities are different, the chief justice asserted that they should all share the same goal of promoting good corporate governance, transparency, integrity, investor protection and prudent business risk-taking.

The chief justice described how it is important to distinguish between two related yet different sets of standards. The first is the standard of conduct for directors, while the second is the standard of review for liability arising from the failure to meet those standards. Chief Justice Veasey described the first standard as "aspirational" and evolve over time. With regard to liability considerations, the chief justice stated that "what happens in cases that come before our courts may be an aberration, as such a case is almost certainly an autopsy."

He cited two cases in Delaware as evidence of what he described as an evolutionary approach to corporate governance in the state's courts. The first was In re Caremark, decided in 1996, in which the chancellor indicated that the sustained inattention of directors to an "utter failure" to institute compliance programs could be a violation of the directors' fiduciary duty of good faith. Now, said the chief justice, compliance programs are expected.

The second case was the ongoing derivative litigation involving the Walt Disney Co. The case arose from the Disney board's approval of an extraordinary $140 million severance package for a short-term senior officer. In a May 2003 opinion, the chancellor wrote that "these facts, if true, do more than portray directors who, in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance to their corporation." Continuing, the chancellor added that "the facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a we don't care about the risks attitude concerning a material corporate decision." The chancellor concluded that "[k]nowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company." Such misconduct, stated the chancellor, could fall outside the protection of the business judgment rule.

The chief justice stated that this opinion reflected the "evolving expectations" of director conduct under Delaware law. While he could not comment on the specifics of the case because of the ongoing litigation, he stated that the chancellor's opinion " should be respected as presumptively correct."

He also noted as a matter of "prudent counseling" that under Delaware law, the issue of good faith may be measured against the backdrop of Sarbanes-Oxley Act legislation and accompanying SEC and SRO rulemaking as well as Delaware common law. Even if no private right of action may exist under a particular provision, adherence to the federal reforms "may be relevant and would be advisable," he stated.

Regulatory Competition

Professor Coffee stated that the new kind of regulatory competition could be summed up in a single question, "where was the SEC?" With regard to several major scandals, including the Wall Street analyst matter and the recently-disclosed mutual fund abuses, Prof. Coffee noted that the regulatory energy came from the state level rather than from the SEC.

While the Commission and the academic community may have been aware of conflicts of interest within major brokerage and investment banking firms, Prof. Coffee described both as unresponsive and "blase'." Similarly, he stated that investors knew that mutual funds could be arbitraged, and the industry knew this too. He added that the SEC knew of stale price arbitrage practices, but didn't "push" regulatory responses.

Today, though, the professor described a "changed political landscape." Led by New York Attorney General Eliot Spitzer, he said that states are after "big game." As a result, noted the professor, the next whistleblower may likely go to state authorities rather than to the SEC.

With regard to corporate governance and management questions, the professor observed that historically, regulatory competition has been between the states, with Delaware setting the tone for the competitive environment. In light of recent trends, stated the professor, regulatory competition has shifted from the state level to that of a contest between state and federal authority.

Initially, he noted that increased competition may have a positive effect. The SEC has become more responsive to a wide range of investor protection issues, he observed. Vigorous state regulation may also fill in the gaps when the SEC is unable or unwilling to address a particular matter. He did grant that the overwhelming manpower demands of such major cases as Enron and WorldCom may have precluded effective SEC review of the mutual fund scandals.

He cited the recent decision by the state of Oklahoma to indict WorldCom and its former CEO, as an example of the problems with increased state activity. In so doing, noted the professor, the state created a major problem for federal prosecutors, as they may not be able to offer effective plea bargains if the prospect of state prosecution remains. Federal agencies and prosecutors may also be pressured to rush their cases to court rather than to carefully develop them through the investigatory process so that they do not appear to be lagging behind the states.

Market efficiency might also be harmed by such regulatory "Balkanization," he stated. Efficiency would be impaired if every state could impose unique rules. Single jurisdictions could effectively overrule the SEC's national market oversight system.

To address this problem, the professor suggested expanding SEC authority. According to Prof. Coffee, the agency should have the authority to block or unwind state actions. Such authority could be crafted to limit limit the time period in which the SEC could act, such as 90 days from an adverse state action. He also urged that such authority be limited to the SEC, and not expanded to private parties.

Investor Protection Professor

Seligman disagreed with both the chief justice and Professor Coffee. He saw not tension or competition, but "co-variance." In both the state and federal systems, he saw a return to proper governmental emphasis on investor protection. The federal courts are more responsive to this notion, as are the active state regulators and enforcement authorities.

He cited the recent decision of the U.S. Supreme Court in SEC v. Edwards (¶92,656). In that case, the high court unanimously held that an investment scheme promising a fixed rate of return could be an investment contract and thus a security subject to the federal securities law. The court reversed and remanded a decision of the 11th U.S. Circuit Court of Appeals (2002 CCH Dec. ¶91,951) that concluded that an investment in a pay telephone program did not fall within the definition of a security because investors had a contractual entitlement to a fixed 14 percent return.

According to Prof. Seligman, even though the opinion was "casually written," it is the mode of analysis that is significant. The opinion deals less with the particular wording of the statute and emphasizes the overall purpose of the securities laws. A similar approach may be seen in the recent Enron litigation, in which the court (SD Tex) appeared to take an expansive reading of a primary violator and declined to dismiss private actions against attorneys, accountants and investment bankers as aiding and abetting.