July 06, 2005
Leo Strine on SOX
Posted by Gordon Smith

Steve Bainbridge has an excellent post on Vice-Chancellor Leo Strine's recent speech on the Sarbannes-Oxley Act (SOX), which was discussed in the Financial Times here. Here are a couple additional thoughts.

First, the FT article states, "An influential US judge launched a ferocious attack on the Sarbanes-Oxley legislation on Tuesday and warned federal legislators to "stay in [their] lane" and leave corporation law to individual states." (emphasis added) I cannot imagine that Leo warned Congress in the manner implied here. That is, he almost surely didn't threaten Congress: stay in your lane or else! I suspect, however, that he said something like this: the U.S. is better off if corporate law remains in Delaware's hands.

Second, Leo attacks the cult of independence embraced by SOX and by the New York Stock Exchange and Nasdaq listing standards:

The emerging model is a board comprised of one insider - the CEO - who knows everything about the corporation and who has a keen interest in its future, and 10 independent directors selected precisely because they have no affiliation with or, interest in, the business or its fate. That is an odd group to help develop a business strategy and seems likely to function largely as a monitor, with strategy being left to the CEO and subordinates outside the board's presence.

Indeed, this is an odd model if you want the board to do something other than monitoring senior executives. Steve agrees with Leo's implicit condemnation of the monitoring model, arguing that good boards do much more than monitoring, including policy making, acting as a sounding board for managers, and providing networks of useful contacts.

The modern U.S. board of directors described by Leo seems to me to replicate quite closely the German model of corporate governance, with a supervisory board of independent directors and a management board of employee directors. (Kraakman et al also make this point in Anatomy of Corporate Law.) In my view, the main problem with this model is not that the (supervisory) board is ineffective at non-monitoring functions, but that they are impaired in their ability to monitor. They are dependent upon managers for information about the company, and when only one manager (the CEO) is on the board, they may get a skewed view of things. Having multiple senior managers on the board of directors improves the quality of information provided to the independent directors, thus enhancing their ability to monitor.

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