Securities Fraud as Corporate Governance: Reflections Upon Federalism

Federal securities law and enforcement via securities fraud class actions today has become the most visible presence in regulating corporate governance. State law, long at center stage in discussions of corporate governance, continues to provide the legal skeleton for the corporate form and state fiduciary duty litigation continues as a frequent means to monitor managers. Yet, in today's world, state law does so almost entirely in the specific contexts of decisions about acquisitions or in self-dealing transactions. The empirical evidence in this Article illustrates that corporate governance outside of these areas has passed to federal law and in particular to shareholder litigation under Rule 10b-5. The Sarbanes-Oxley Act of 2002, passed by Congress in the wake of the current corporate accountability scandals, provides new evidence of the expanded role of federal law. But, the move to federal corporate governance is broader than that law and has a longer history than the current scandals. The ascendancy of federal law in corporate governance reflects at least three factors. First, disclosure has become the most important method to regulate corporate managers and disclosure has been predominantly a federal, not a state, methodology. Second, state law has focused largely on the duties and liabilities of directors, and not officers, and federal law has increasingly occupied the space defining the duties and liabilities of officers. Officers have become the fulcrum of governance in today's corporations. Third, federal shareholder litigation based on securities fraud has several practical advantages over state shareholder litigation based on fiduciary duty that have contributed to the greater use of the federal forum. As a result of these trends, federal law now occupies the largest part of the legal corporate governance infrastructure in the 21st century. The outpouring of suggested reforms that have followed in the wake of Enron and WorldCom have focused on federal law and on the conduct of officers and directors, rather than state law, which in practice, focuses mainly on directors. Indeed, the discussions about reforms have excluded state law almost entirely. In this article, we develop the idea of federal law as corporate governance in three parts organized around history, empirical data, and analysis. In Part I, we begin with the traditional legal template. State corporate law is the focus and federal securities law plays a supporting role. In Part II, we present empirical data on the use of both federal and state litigation to regulate corporate governance. We begin with a data set we have developed of securities fraud class action complaints filed in 1999. Our analysis of those complaints shows that securities fraud class action litigation is being used mostly in areas that relate to the managers' operation of the business. Not surprisingly, for example, many of the complaints raise concerns about the ways in which managers have recognized revenues or engaged in some form of accounting manipulation. From that base, we expand the story using data developed by others on securities fraud class actions more generally. Then, we compare transactions that give rise to securities fraud claims to another data set that covers all corporate cases filed in the Delaware Chancery Court for that same year. The result is a surprisingly narrow focus for state litigation and a much broader one for federal suits, revealing a gap in the standard learning about corporate governance. In Part III, we address how the federal securities fraud picture we provide might fit with state shareholder litigation in a current theory of corporate governance.