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http://ssrn.com/abstract_id=332681

2 Market vs. Regulatory Responses to Corporate Fraud 2002
MARKET VS. REGULATORY RESPONSES TO CORPORATE FRAUD: A

CRITIQUE OF THE SARBANES-OXLEY ACT OF 2002
Larry E. Ribstein*
Draft of September 20, 2002
Abstract
The crashes and frauds of Enron, WorldCom and other companies have
reinvigorated the debate over regulating corporate governance. Many pundits have
called for corporate regulation to restore confidence in the securities markets. These
recommendations appear to be supported by the fact that neither the contracting devices
that were supposed to control managers, nor efficient securities markets, worked to
prevent or spot the problems. Congress responded with the Sarbanes-Oxley Act of
2002. But this article shows that, given the limited effectiveness of new regulation, its
potential costs, and the power of markets to self-correct, new regulation of fraud in
general, and Sarbanes-Oxley in particular, is unlikely to do a better job than markets.
* Corman Professor, University of Illinois College of Law. Prepared for 2002 Conference on
Regulatory Competition and Economic Integration within the European Union: Company, Securities,
Insolvency and Tax Law, Tilburg University, September 5-6, 2002. Valuable comments were provided
by Jill Fisch and Richard Painter and participants at the Conference.
Table of Contents
I. THE PROBLEM OF CORPORATE FRAUD 6

A. AN OVERVIEW OF ENRON AND OTHER CORPORATE FRAUDS 6
B. THE CASE FOR MARKET FAILURE 9
II. REGULATORY RESPONSES TO CORPORATE FRAUD 13

A. INDEPENDENT DIRECTORS 14
B. OTHER GOVERNANCE PROTECTIONS AGAINST FRAUD 15
C. AUDITOR OVERSIGHT AND INCENTIVES 16
D. EXECUTIVE COMPENSATION 18
E. INCREASING DISCLOSURES 19
F. FRAUD LIABILITY 19
G. SECURITIES ANALYSTS 20
III. PROBLEMS WITH THE REGULATORY APPROACH 21

A. EXPLAINING THE FRAUDS 21
1. Insiders’ incentives and heuristics 22
2. Investor heuristics 25
3. Trust 27
B. EFFECTIVENESS OF REGULATORY PROPOSALS 29

1. Independent directors as watchdogs 29
2. Auditors and other detectives 34
3. Increased disclosure 37
4. The marginal deterrence effects of liability 37
C. COSTS OF INCREASED LIABILITY AND REGULATION 40

1. Agency costs 40
2. Resource allocation 43
3. Information costs 45
4. Distrust 46
5. Inducing cover-ups 48
6. Collateral organizational effects 48
7. Indeterminacy and mandatory rules 50
D. POLITICS OF REFORM 50
IV. MARKET RESPONSES TO CORPORATE FRAUD 52

A. MARKET SCRUTINY 53
B. SIGNALING 59
C. SHAREHOLDER MONITORING AND TAKEOVERS 60
D. THE MARKET FOR REGULATION 63
V. CONCLUDING REMARKS 68
APPENDIX: OVERVIEW OF THE SARBANES-OXLEY ACT 69
The latter part of the 20th century saw a debate about the appropriate approach
to regulating the corporation. The traditional view was that governance of the large
corporation was and should be largely determined by government regulation. This
approach seemed justified by the lack of an effective means by which the shareholders
could exert control over their ownership interests or the firm’s governance terms.
Under this view, as espoused by influential commentators such as the Columbian cartel
(Adolf Berle,1 William Cary2 and John Coffee3), the owners’ powerlessness left
managers with the ability to use their corporate positions to maximize their personal
wealth and power. The pro-regulatory position has proven quite nimble, shifting from
standard economic arguments favoring regulation to arguments that law is necessary to
back the creation and maintenance of norms of trust and fairness.4
Other commentators, notably including Henry Manne, Frank Easterbrook, and

Daniel Fischel, building on basic theoretical work by, among others, Ronald Coase,
Armen Alchian & Harold Demsetz, argue that the corporation was appropriately viewed
as fundamentally the product of private contractual relationships, and should be entitled
to the same presumption of efficiency as contracts generally.5 The twin pillars of this
1
See Adolf Berle & Gardiner Means, THE MODERN CORPORATION AND PRIVATE
PROPERTY (1932).
2
See William Cary, Federalism and Corporate Law: Reflections upon Delaware, 83 YALE L.J.
663 (1974).
3
See, e.g., John C. Coffee, Jr., No Exit?: Opting Out, The Contractual Theory of the
Corporation, and the Special Case of Remedies, 53 BROOK. L. REV. 919 (1988).
4 For a review of this literature, see Larry E. Ribstein, Law v. Trust, 81 B. U. L. REV. 553
(2001).
5
See Frank H. Easterbrook & Daniel Fischel, THE ECONOMIC STRUCTURE OF
CORPORATE LAW; Armen Alchian & Harold Demsetz, Production, Information Costs, and Economic
view are that aspects of corporate governance that might seem suspect, including the
separation of ownership and control, actually make economic sense; and that public
corporate governance arrangements are disciplined in efficient securities markets.
The spectacular crashes and frauds of Enron, WorldCom and other companies,
including Sunbeam, Waste Management, Adelphia, Xerox, and Global Crossing, have
reinvigorated this debate. The most public phase of the scandals began with Enron,
which was at one time the seventh largest firm based on market capitalization, but in the
fall of 2001 was suddenly shown to be an empty shell created by financial
manipulation. WorldCom, which owns among other things the second largest long
distance telephone carrier, disclosed in the summer of 2002 that it had created billions
in earnings by capitalizing expenses as needed. These firms’ managers have become
poster boys for the problems of separation of ownership and control. The frauds
occurred despite several levels of monitoring by, among others, directors, prominent
accounting and law firms, institutional shareholders, debt rating agencies, and securities
analysts. Supposedly efficient securities markets adhered to overly optimistic
assumptions about firms’ business plans in the face of mounting evidence to the
contrary.
Some argue that, because of the unreliability of corporate managers, monitors

and the market in these cases, government regulators need to restore confidence in the
securities markets.6 The most important legal response was the Sarbanes-Oxley Act of
2002, summarized in the Appendix.7 This Act is the most sweeping federal law
concerning corporate governance since the adoption of the initial federal securities laws
in 1933 and 1934.8
This Article argues that, despite all the appearances of market failure, the recent
corporate frauds do not justify a new era of corporate regulation. Indeed, the fact that
the frauds occurred after 70 years of securities regulation shows that more regulation is
Organization, 62 AM. ECON. REV. 777 (1972); Henry N. Butler & Larry E. Ribstein, Opting Out of the
Corporate Contract: A Response to the Anti-Contractarians, 65 WASH. L. REV. 1 (1990); Ronald H.
Coase, The Nature of the Firm, 4 ECONOMICA 386 (1937); Henry G. Manne, The “Higher Criticism”
of the Modern Corporation, 62 COLUM. L. REV. 399 (1962).
6 In addition to countless newspaper articles and editorials, academic articles include William
W. Bratton, Enron and the Dark Side of Shareholder Value, __TUL. L. REV. __ (2002) (available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=301475); Jeffrey N. Gordon, What Enron Means for
the Management and Control of the Modern Business Corporation: Some Initial Reflections, 69 U. CHI.
L. REV. 1233 (2002).
7 See PL 107-204 (HR 3763) (July 30, 2002). Title 8 of the Act is the Corporate and Criminal
Fraud Accountability Act of 2002; Title 9 is White Collar Crime Penalty Enhancements Act of 2002;
Title 11 is the Corporate Fraud and Accountability Act of 2002.
8 President Bush described the Act as “the most far-reaching reforms of American business
practices since the time of Franklin Delano Roosevelt. Signing Statement of George W. Bush, July 30,
2002, available at www.whitehouse.gov/news/releases/2002.
not the answer.9 Rather, with all their imperfections, contract and market-based
approaches are more likely than regulation to reach efficient results. Post-Enron
reforms, including Sarbanes-Oxley, rely on increased monitoring by independent
directors, auditors and regulators, who have both weak incentives and low-level access
to information. This monitoring has not been, and cannot be, an effective way to deal
with fraud by highly motivated insiders. Moreover, the laws are likely to have
significant costs, including perverse incentives of managers, increasing distrust and
bureaucracy in firms and impeding information flows. The only effective antidotes to
fraud are active and vigilant markets and professionals with strong incentives to
investigate corporate managers and dig up corporate information.
Part I states the case for reform that emerges from the recent corporate frauds.
Part II discusses regulatory reform proposals, focusing on the Sarbanes-Oxley Act. Part
III discusses the costs of reform, while Part IV discusses the potential for market-based
reforms. Part V has conclusions and implications.
I. THE PROBLEM OF CORPORATE FRAUD

This Part discusses the problems revealed by Enron and other frauds. Subpart A
briefly reviews the relevant facts of Enron and other recent corporate frauds. Subpart B
discusses the case for a regulatory response based on the apparent scale of deception
and the fact that it escaped detection by several layers of seemingly sophisticated
monitors. In general, while this discussion reveals flaws in market and contractual
devices designed to catch fraud, it also sets the stage for the discussion later in the
article of the likely ineffectiveness of regulatory responses to Enron.
A. AN OVERVIEW OF ENRON AND OTHER CORPORATE FRAUDS
The Enron story has been recounted many times, probably most clearly and
succinctly by William Bratton,10 and most exhaustively in the report of the Enron
board’s Special Committee.11 I will briefly summarize here. Enron was initially
9 See Lawrence A. Cunningham, Sharing Accounting’s Burden: Business Lawyers in Enron’s

Dark Shadows, Boston College Working Paper (April, 2002), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=307978 (noting that “it is hard to see what new
regulations are possible. After all, regulate what? Accountants? Auditors? Executives? Boards?
Politicians? Regulations are all in place. There are also criminal laws relating to accounting, auditing, and
disclosure that landed in jail top executives at companies rocked by recent accounting scandals, along
with hefty civil penalties for associated professionals”).
10 See Bratton, supra note 6. For another useful account, see Paul M. Healy & Krishna Palepu,
Governance and Intermediation Problems in Capital Markets: Evidence from the Fall of Enron, Harvard
Negotiation, Organizations and Markets Working Paper No. 02-27 (August 15, 2002), available at
http://papers.ssrn.com/paper.taf?abstract_id=325440.
11
See William C. Powers, Jr., Raymond S. Troub & Herbert S. Winokur, Jr., REPORT OF
INVESTIGATION BY THE SPECIAL INVESTIGATIVE COMMITTEE OF THE BOARD OF
DIRECTORS OF ENRON CORP., 2002 WL 198018 (February 1, 2002).
successful in creating an energy market that eliminated the need for utility companies to
engage in potentially costly vertical integration. It later applied this innovation to other
markets, such as fiber optic cable. Enron gave the impression of ever-increasing
earnings and stable finances through extensive derivatives trading and profitable
transactions with special purpose entities (SPEs), which also yielded substantial gains
for Enron insiders. In fact, the apparent profits were illusory. Among other things,
Enron apparently used “marking to market” to book as revenue speculative predictions
of years of future sales, and outside investors loaned money to Enron in transactions
disguised as revenue from prepay commodities contracts.12
The worst problems centered on Enron’s hiding risks through SPEs created for
the purpose of keeping debts off of its balance sheet. Enron’s disclosure of its error in
the fall of 2001 began the collapse that quickly led to litigation and bankruptcy. The
seeds were sown when Enron formed an initial entity, Chewco, to take over Calpers’
investment in its JEDI joint venture with Enron. In order to ensure that Enron would not
have to report Chewco’s debt on its balance sheet, Chewco needed to be under
independent control and have a minimum 3% outside equity. But Chewco probably was
controlled by an Enron employee, Michael Kopper, as general manager of Chewco’s
general partner, which was in turn owned by Kopper’s domestic partner, William
Dodson. Also, although Barclays provided an outside investment, the loan was secured
by a cash reserve account that Chewco itself funded. When Andrew Fastow, Enron’s
chief financial officer, presented this to the Enron board in November, 1997 he did not
clarify the nature of the “outside” equity.
Enron’s network of SPEs soon became larger and more complex. Fastow and
Enron set up LJM I (initials based on the names of Fastow’s wife and children) in June,
1999, which Fastow controlled as the manager of the LLC that served as the entity’s
general partner. Enron then formed LJM II to syndicate investments to outside
investors. In May, 2000, Enron began establishing the Raptor entities, purportedly to
hedge against declines in Enron investments so Enron could continue to provide the
market that was central to its business plan. The “hedge” consisted of a put pursuant to
which Enron could sell its stock back to the Raptor if it declined. Thus, the “hedge”
was really a bet that securities markets would keep running up Enron’s stock price
despite its losing investments in the SPEs. Enron was not hedged, but was really
speculating on derivatives, including the put on its own stock.13 The Enron Finance
Committee had recognized the risk, but nevertheless signed off, relying on Andersen’s
willingness to do so.
Enron collapsed quickly after restating its earnings and debts in October, 2001
to reflect a $618 million third quarter loss and $1.2 billion write-off. The Raptors could
no longer cover investment losses as Enron’s stock fell from its high in the 80’s in
January, 2001 to the 30’s in October. The collapse was hastened by the fact that Enron’s
12See Jathon Sapsford & Paul Beckett, Citigroup Deals Helped Enron Disguise Its Debts as
Trades, Wall. St. J., July 22, 2002 at A1.
13 See Frank Partnoy, Enron & Derivatives, available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=302332.
basic business depended on its customers trusting its ability to bear market risks, which
the falling stock price called into doubt.
In addition to hiding its risks and losses, Enron and its insiders profited from
churning of financial assets between Enron and its SPE’s, booking gains at both ends
that did not reflect the real value of the assets. Although the Enron board understood the
problem with potential insider transactions stemming from Fastow’s position with the
SPEs, it relied on arm’s length negotiations between Fastow and the relevant Enron
divisions to protect Enron’s interests, as well as on a set of special review procedures.
However, the Special Committee concluded that the board inadequately probed the
transactions given Fastow’s involvement, and that the very need for exhaustive controls
should have suggested to the board the dubiousness of the transactions. The Special
Committee also criticized Enron’s failure to disclose the nature and extent of the insider
transactions and Fastow’s gains.
The blame for Enron’s failure has been widespread. The Enron board’s Special
Committee noted failures at all levels of monitoring within the company: senior
management, including Lay, Enron’s chief executive officer at the beginning of its rapid
rise, Skilling, the chief operating officer who became chief executive officer, Causey,
the chief accountant, and Buy, the senior risk officer; the board, particularly including
the audit committee; Andersen, which was aware of much of the detail but did not insist
on clear disclosure; and Enron’s main outside counsel, Vinson & Elkins, which helped
in structuring SPE transactions and drafting disclosures and, in August, 2001,
investigated the famous Sherron Watkins memo and concluded that Andersen’s
accounting for the Raptor entities was not technically inappropriate. There were also
failures in the securities markets. Securities analysts continued to give buy
recommendations, and all of the major debt rating agencies rated Enron’s debt as
investment grade, right up until shortly before bankruptcy. CalPers, the huge
institutional investor that has long portrayed itself as the shareholders’ champion, seems
to have looked the other way at the conflicted entities that bought its JEDI investment.
Arthur Andersen, has been virtually shut down by its conviction for Enron-related
obstruction of justice, Andrew Fastow has been indicted for securities fraud, and
Michael Kopper has pleaded guilty to fraud.
Although Enron has been the most publicized of the corporate frauds, it is not
the only one.14 In June, 2001, Waste Management settled SEC charges arising out of a
restatement of $1.42 billion in earnings relating to 1993-1997 financial statements
involving a variety of improper accounting techniques, including improper
capitalization of expenses, failure to amortize, and improper use of reserves.15 Waste
Management’s auditor (again, Arthur Andersen), continued to give unqualified audits
despite its early recognition that Waste Management was a "high risk client" that
"actively managed reported results," had a "history of making significant fourth quarter
14 For a useful summary of some recent pre-Enron frauds, see Richard C. Sauer, Financial
Statement Fraud: The Boundaries of Liability under the Federal Securities Laws, 57 BUS LAW. 955
(2002).
15 See SEC Releases 1405 and 1410 (June 19, 2001).

adjustments" to its financial statements, and was in an industry that required "highly
judgmental accounting estimates or measurements," and although Waste Management
failed to comply with Andersen’s plan for the firm to get its books in order – a plan that
was not communicated to Waste Management’s audit committee.16
Sunbeam was another precursor of Enron. In June, 1998, a Barrons article

revealed that Sunbeam had manipulated its financial statements by, among other things,
excessive write-downs in a “big bath” restructuring, booking phony sales and rebates,
and not accounting for accounting and other advertising expenses.17 These irregularities
explained most or all of Sunbeam’s seemingly remarkable turnaround following
“Chainsaw Al” Dunlap’s 1996 restructuring. The irregularities were not spotted by
Sunbeam’s auditor (again, Arthur Andersen), or by Sunbeam’s independent directors.
Other accounting shenanigans in public corporations include Xerox’s

accelerating revenues from long-term equipment leases,18 Qwest’s and Global
Crossing’s manipulation of revenues and expenses on sales and swaps of fiber optic
capacity,19 and apparently rampant looting by the family controlling Adelphia. Most
recently, news appeared that WorldCom may have misstated billions in current
expenses (fees the company paid to use transmission networks) as capital expenditures.
Like the other problems noted above, these irregularities were not uncovered by the
firm’s board, its initial auditor (again, Arthur Andersen), or by telecom analysts who
had long followed WorldCom and continued until virtually the moment before the
public disclosure to give it “buy” ratings.20
B. THE CASE FOR MARKET FAILURE
Modern regulatory theories of corporate governance begin with Berle &

Means,21 who argued in the wake of the 1929 crash that owners of publicly held
corporations could not effectively control their corporations. This effectively involves
two problems. First, as Adam Smith observed, corporate managers do not watch over
“other people’s money” with the “anxious vigilance with which the partners in a private
16 See SEC Release No. AE - 1405, 2001 WL 687561 (June 19, 2001).
17 See Jonathan R. Laing, Dangerous Games: Did "Chainsaw Al" Dunlap manufacture
Sunbeam's earnings last year? BARRONS, June 8, 1998 at 17.
18 See Mark Maremont, Leading the News: Xerox Overstated Pretax Income By $1.41 Billion,
Filing Reveals, Wall St. J., July 1, 2002 at C1.
19 See Deborah Solomon & Susan Pulliam, SEC Adopts Tougher Position
On Qwest Accounting Methods, Wall St. J., June 26, 2002.
20See Robin Sidel, Sorry, Wrong Number: Some Untimely Analyst Advice on WorldCom Raises
Eyebrows, Wall St. J., June 27, 2002 at A12.
21 See Berle & Means, supra note 1.

copartnery frequently watch over their own.”22 In other words, public corporations
involve agency costs. Second, agency costs are high because it is impractical for
shareholders with small, dispersed interests to invest much time and money in
monitoring managers.
The anti-regulatory response to Berle & Means is essentially that shareholders

cannot be as vulnerable to misappropriation as the regulatory model would suggest
because no one can force them to invest in firms that will squander their money. The
capital markets therefore can be expected to develop devices that overcome the
problems Berle & Means discussed. These devices include hostile takeovers and other
devices that aggregate shareholder voting power and facilitate shareholder monitoring;
alignment of managers’ and shareholders’ interests through incentive compensation;
and monitors such as independent directors and large accounting and law firms.
Efficient securities markets, in turn, provide both an effective valuation device

to enable these devices to operate and a mechanism for pricing and testing the efficacy
of the devices. The takeover market functions because the price of a sub-optimally
managed firm drops enough to make it worthwhile for better managers to buy the stock
and replace the incumbents. Stock compensation is an efficient incentive because it
aligns managers’ interests with shareholder welfare. A company’s stock price can be
viewed as measuring the value of its bundle of contracts. Even if the market cannot
know the evil that lies within managers’ hearts, it can observe the contracts that tend to
keep them honest. Investment dollars will tend to flow to the firms with the most
efficient governance devices.
Enron and other recent scandals seem to threaten the viability of the anti-
regulatory model because all of these contracts and markets apparently failed. Enron,
for example, had prestigious outside directors, law and accounting firms who might
have been expected to care more about their reputations than about letting Enron
insiders get away with shady deals. Enron’s stock price failed to reflect even obvious
problems until it was too late. Enron’s 2000 Annual Report showed large affiliate
investments and liabilities.23 Although these disclosures did not clarify that Enron’s
income essentially depended on derivatives trading and that Enron was not actually
hedged, the disclosures were disconcerting enough to lead an adequately inquisitive
market to check further and get to the facts. Even more striking is the fact that Enron’s
$90 share price in 2000 could be justified only by some very unrealistic assumptions,
such as a 25% return on equity forever, revenues of $700 billion within ten years and an
22 See Adam Smith, 1 WEALTH OF NATIONS, Vol 2, p. 741 (Glasgow ed. 1976) (“directors . .
. being the managers rather of other people’s money than of their own, it cannot well be expected that
they should watch over it with the same anxious vigilance with which the partners in a private copartnery
frequently watch over their own”).
23 See Enron 2000 Annual report, discussed in Bratton, supra note 6 (22.6% of its assets, or $5.3
billion, were investments in “unconsolidated equity affiliates” with $4.7 billion current liabilities, $9.7
billion long term debt, and $6.148 billion of “other noncurrent liabilities.”).
increase thereafter of 10% per year, more than twice U.S. public firms’ historical rate.24
And apparently few people stopped to wonder whether Enron’s not paying federal taxes
for four of the five tax years through 2001 indicated that it was really not making any
money.25
To be sure, Enron’s stock price dropped from 80 to 40 in the first eight months
of 2001 in the face of rising earnings, indicating that Enron’s problems may have been
seeping into its price.26 But Enron’s trading for $30-$40/share when it was probably
worthless suggests that the market had spotted only a small piece of its problems.
Moreover, most institutional investors failed to sell Enron until October, 2001.27 This
raises serious questions concerning the extent to which the market can be relied on to
ferret out facts and to make efficient judgments about appropriate governance devices.
Enron and other accounting frauds may indicate a new category of problems that
calls for new regulation. Enron insiders seem to be a new breed of corporate executives
who are unconstrained by the traditional devices.28 These executives are hyper-
motivated survivors of a highly competitive tournament (that Enron called “rank and
yank”) who have proven their ability to make money while putting on a veneer of
loyalty to the firm. They are Machiavellian, narcissistic, prevaricating, pathologically
optimistic, free from self-doubt and moral distractions, willing to take great risk as the
company moves up and to lie when things turn bad, and nurtured by a corporate culture
that instills loyalty to insiders, obsession with short-term stock price and intense distrust
of outsiders.
Even these new-breed executives would not present a problem if effective

monitors watched them. The companies in which major frauds occurred had directors
who were not members of senior management and high-priced auditors who missed
24 See Healy & Palepu, supra note 10 at 24.
25 See Victor Fleischer, Enron’s Dirty Little Secret: Waiting for the Other Shoe to Drop, Tax
Notes 1045 (Feb. 25, 2002). But see Gary A. McGill & Edmund Outslay, Did Enron Pay Taxes?: Using
Accounting Information to Decipher Tax Status, 96 TAX NOTES, No. 8, (August 19, 2002) (noting
difficulty in estimating tax liability from firm’s public income tax disclosures).
26 See Gordon, supra note 6 at 9, n. 11. It is not clear whether Enron was dropping on a market-
adjusted basis, since the market generally was falling during this time. However, questions about Enron
had surfaced in the press in May and June, 2001. See Peter Behr & April Witt, THE FALL OF ENRON:
Coming Storms Visionary's Dream Led to Risky Business, WASH. POST, July 28, 2002 at A1.
28 See Donald C Langevoort, Enron and the Organizational Psychology of Hyper-Competition:

An Essay for Larry Mitchell, 70 Geo. Wash. L. Rev. ___ (forthcoming 2002). See also Donald C.
Langevoort, Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market
Investors (and Cause other Social Harms), 146 U. PA. L. REV. 101 (1997) (noting that corporate
information flows are affected by managerial optimism, and other problems of managerial heuristics,
including cognitive conservatism, decision simplification, and self-serving beliefs).
fundamental problems for a long time. Arthur Andersen was deeply involved in
structuring the Enron transactions and cannot plausibly claim lack of expertise. But
Andersen had a strong incentive to hang on to a major buyer of both audit and non-audit
services, and the partner in its Houston office principally responsible for Enron, David
Duncan, derived a significant amount of compensation from selling these services to
Enron. There were similar facts regarding Andersen’s and its partners’ relationship
with Waste Management.29
The accounting profession seems not to have adjusted to the transition from
professional to profit-maximization norms.30 Like other auditing firms Andersen
pressed the business side, exhorting its partners to sell non-audit services to audit clients
and tying partner compensation to business production. In other words, auditing firms
have used their auditing services, which firms must buy, as “loss leaders” to sell non-
auditing services.31 Auditors’ loss of independence in effect may have made them part
of the management team in some cases.32 Years of working for the same client, with
prospects of joining the client’s management and participating in its success, may have
made auditors subject to the same pathologies that affected client management,
including excessive optimism and loyalty, and reduced their concern for their auditing
firm’s reputation.33 Moreover, as the same people worked for the same clients from
year to year, they may have found themselves bound to defend errors from earlier
audits.34
Executives, directors, monitors and the stock markets all arguably were
hamstrung in recent cases by the challenges new business methods created for securities
valuation. Historical price-earnings multiples did not constrain valuations in the face of
arguments that novel business methods created sky-high potential for future earnings.
This was certainly true for Enron, which Fortune ranked the most innovative company
in America for six straight years, whose chief executive, Jeff Skilling, was named
second best in the country (after Microsoft’s Steve Ballmer) as recently as April, 2001,
and which had been the subject of admiring business school studies.35 A more skeptical
29 See SEC Release 1405 (June 19, 2001).
30 See Gordon, supra note 6.
31 See SEC Rel. 33-7919 at 83; Bratton, supra note 6; 251; John C. Coffee, Jr., Understanding
Enron: It’s About the Gatekeepers, Stupid, Colum. Law & Economics W.P. No. 207 at 15 (July 30,
2002), avail.at http://papers.ssrn.com/paper.taf?abstract_id=325240.
32 See, e.g., SEC Release 1405 (June 19, 2001) (noting the number of Andersen employees who
became senior executives at Waste Management).
33 See supra text accompanying note 28; Donald C. Langevoort, Seeking Sunlight In Santa Fe’s
Shadow: The SEC’s Pursuit of Managerial Accountability, 79 Wash. U. L.Q. 449 (2001).
34 Id. This clearly happened in Waste Management. See SEC Release 1405 (June 19, 2001).
35 See, e.g., Samuel E. Bodily, et al, Enron Corporation's Weather Derivatives (A) & (B),
market, with a more precise metric for measuring the success of “new economy” firms,
might have looked more closely at Enron’s numbers. This valuation problem was, of
course, common in a bubble market that was willing to assume that every new Internet
business would produce limitless profits by increasing demand to infinity and reducing
costs to zero. Many of these firms were honest failures that made their risks clear to
investors. Enron showed how firms could capitalize even more spectacularly on the
market’s gullibility by inflating earnings and hiding risks.
The recent frauds cannot, however, entirely be attributed to new ways of doing
business. Sunbeam and Waste Management were old-economy companies, and the
problems in WorldCom and other telecoms apparently involved straightforward
mischaracterizations of revenues and expenses. This suggests that the accounting frauds
resulted more from fundamental incentive problems than from new business methods.
Whatever the cause, the costs of corporate fraud potentially go beyond owners,
employees and others associated with defrauding firms. If the market cannot distinguish
efficient from inefficient firms, investors may, at least at first, put too many resources in
the inefficient firms, and ultimately may stay out of what they see as a “lemons” market
altogether,36 with the result that the economy becomes less productive. This suggests
that if markets have failed, government must step in.
II. REGULATORY RESPONSES TO CORPORATE FRAUD

Highly publicized corporate frauds engendered a blizzard of reform proposals,
mostly in Congress.37 Although current federal securities law does not permit direct
federal regulation of corporate governance,38 Congress can change those laws.
Moreover, even under the current general disclosure-oriented approach Congress, and
the SEC on its own, can regulate corporate governance indirectly through disclosure
laws. The securities exchanges also can regulate corporate governance through their
listing requirements. This Part briefly reviews some of the reforms in the Sarbanes-
Oxley Act and other responses to recent corporate frauds, and discusses how these
reforms purportedly respond to the problems discussed in Part I.39 Part III analyzes the
Darden Case Nos.: UVA-F-1299-M-SSRN and UVA-F-1300-M-SSRN (2000), available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=274195 (co-authored by an Enron employee).
Authors of this study were able to put their Enron expertise to further use in a different vein two years
later. See Samuel E. Bodily & Robert F. Bruner, Enron, 1986-2001, (2002), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=302155 (presenting Enron as a case study in business
failure).
36 See George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market
Mechanism, 84 Q.J. ECON. 488 (1970).
37 For a discussion of state/federal issues in corporate reform, see infra subpart III(D).
38 See Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990); Santa Fe Industries v.
Green, 430 U.S. 462 (1977); Langevoort, supra note 33.
39 The Appendix briefly summarizes some of the Act’s more important provisions discussed
benefits and costs of these reforms.
A. INDEPENDENT DIRECTORS
One of the favorite projects of corporate reformers has been the creation of the
so-called “monitoring” board. The basic theory is that the corporation’s main decision-
making body should include a majority of “independent” directors who do not work
full-time for the corporation and therefore theoretically are in a position to watch over
the insiders, with wholly independent “audit” and “nominating” committees that work
with the company’s auditing firm and control election of directors.40
The monitoring board model has come into standard usage by large public
corporations pursuant to recommendations over the last twenty years by, among others,
the American Bar Association’s Committee on Corporate Law of the Section of
Corporation, Banking & Business Law,41 the SEC,42 the New York Stock Exchange,43
and the American Law Institute’s Principles of Corporate Governance.44 In 1999, the
SEC adopted a rule requiring corporate proxy statements to disclose whether the firm’s
audit committee has discussed the audited financial statements with management and
accounting policies with the auditors, received the auditors assurances of its
independence, and recommended to the full board that it include audited financial
statements in the company’s annual report; any written charter the board has adopted
for the audit committee; and information concerning audit committee members’
independence.45
Suggestions and requirements of greater board independence and more board

monitoring are predictable responses to Enron and other corporate frauds. Recent
events indicate large public companies’ managers may need more watching regarding
such matters as insider transactions, compensation, and selection and supervision of
auditors. Henry Paulson, chief executive officer of Goldman Sachs, suggested requiring
below.
40 See generally, Melvin Eisenberg, THE STRUCTURE OF THE MODERN CORPORATION

(1976).
41
See Corporate Directors’ Guidebook, 33 BUS. LAW. 1595, 1607–10 (1978); 1994 Edition,
49 BUS. LAW. 1243 (1994).
42
See Lewis Solomon, Restructuring the Board of Directors: Fond Hope–Faint Promise? 76
MICH. L. REV. 581 (1978).
43
See NYSE Guide, CCH Fed. Sec. L. Rep. ¶ 2501 (1988) (requiring listed companies to have
audit committees of outside directors).
44See Section 3.03 (suggesting a legislative requirement of an independent audit committee for
large public companies and recommending independent nominating and compensation committees for
large public companies and audit committees for smaller firms).
45 See SEC Release No. 34-42266 (Dec. 22, 1999).

firms to have a majority of independent directors with wholly independent audit and
compensation committees. Also, the New York Stock Exchange Board of Directors has
adopted and submitted to the SEC new listing standards requiring a majority of the
board to have no material relationships with the firm, and lengthening to five years the
“cooling off” period for board service by former employees of the issuer or its auditor; a
requirement that directors meet without management; requiring wholly independent
nominating and compensation committees in addition to the independent audit
committee; requiring the chair of the audit committee to have accounting or financial
management expertise; requiring the audit committee to have sole responsibility for
hiring the auditing firm; and prohibiting compensation of audit committee members
apart from directors’ fees. In addition to increasing board monitoring, the new NYSE
rules require ethics and conduct codes and prompt disclosure of waivers; shareholder
approval of all equity-based compensation rather than only such compensation to
officers or directors as under the prior rules; certification by the chief executive officer
of procedures and compliance with those procedures regarding accuracy of information;
a program for education of board members; and a provision for public reprimand by the
NYSE for violation of its rules.46
Section 301 of the Sarbanes-Oxley Act directs securities exchanges and

securities associations to prohibit the listing of any security of an issuer that does not
have an audit committee responsible for hiring and oversight of auditors and that is
wholly independent. Section 407 requires disclosure concerning the audit committee’s
financial expert.
B. OTHER GOVERNANCE PROTECTIONS AGAINST FRAUD
Corporate responsibility theoretically is enhanced if senior full-time managers

have appropriate incentives not to engage in wrongdoing and to ensure that their
underlings are not engaging in wrongdoing. A significant problem in Enron,
WorldCom and other cases was that senior managers apparently were involved in the
frauds, making them exceptionally difficult to uncover. Also, managers and monitors
need to be able to get information about possible fraud from their underlings.
Establishment of control systems within the firm and protecting whistleblowers helps
ensure the flow of information within the company.
Sarbanes-Oxley addresses these concerns by requiring executive certification of

reports and of internal controls (§302), providing for SEC rules prohibiting fraudulently
influencing or misleading auditors (§303), requiring attorney reporting of evidence of
fraud (§307), requiring disclosures concerning the firm’s internal control structure and
code of ethics for financial officers (§§404, 406), and protecting whistleblowers (§806)
46 See Corporate Governance Rule Proposals Reflecting Recommendations from the NYSE
Corporate Accountability and Listing Standards Committee as Approved by the NYSE Board of Directors
August 1, 2002, available at http://www.nyse.com/pdfs/corp_gov_pro_b.pdf.
C. AUDITOR OVERSIGHT AND INCENTIVES
Enron and other recent fiascos pointed up weaknesses in the auditing of

corporate books. In general, the problems have involved some combination of
excessive ties between auditing firms and the companies they are supposed to be
scrutinizing; inadequate review of the accounting firm’s work by corporate audit
committees, discussed in the preceding subsection; inadequate industry or government
scrutiny of accounting firms’ work; and excessively lax accounting standards.
There has been much attention focused on tightening standards regarding

auditors’ non-auditing work for audit clients and other aspects auditors’ relationships
with clients that compromises auditors’ independence. Auditors theoretically are
independent because the highly concentrated structure of the auditing industry means
that auditing firms do not depend heavily on audit revenues from particular clients.
Moreover, large accounting firms have invested over many years in valuable
reputations. They have a strong incentive not to forfeit these “reputational bonds.”47
But accounting firms and their members clearly are subject to countervailing
pressures. Even the largest accounting firm may have an incentive to overlook
misconduct from a client from which it makes significant fees for consulting and other
non-audit work. The auditor may believe that her conclusions are honest, but only
because her judgment is affected by a “self-serving” bias to view behavior that serves
her interests in the most favorable light.48 Moreover, auditors have incentives to
maximize their own income within the firm, which may not match the incentives of the
firm as a whole to guard its reputation.49 For example, David Duncan in the Enron case
derived most of his compensation from Enron.
In response to concerns about auditor independence, after extensive deliberation

the SEC in late 2000 adopted rules that reflect a compromise between those who
believed that substantial reform was necessary and those who believed that major
reform would be costly and unnecessary.50 In general, the rules forbid several types of
non-audit services for audit clients, requires proxy disclosures by firms of aggregate
audit and non-audit fees, and whether the audit committee "has considered whether the
provision of non-audit services is compatible with maintaining the principal
47Cf. Larry E. Ribstein, Ethical Rules, Agency Costs and Law Firm Structure, 84 VA. L. REV.
1707 (1998) (discussing the role of reputational capital in explaining large law firms).
48
See generally, Max H. Bazerman, et al, The Impossibility of Auditor Independence, SLOAN
MANAGEMENT REVIEW at 91 (Summer 1997).
49 The individual partners’ incentive structure is, of course, set by the firm, so that this
phenomenon may ultimately reflect the firm’s interest in maximizing short-term revenues over long-term
reputation.
50 See Securities and Exchange Commission, Final Rule: Revision of the Commission's Auditor
Independence Requirements, 17 CFR Parts 210 and 240, Release Nos. 33-7919; 34-43602; 35-27279; IC-
24744; IA-1911; FR-56; (effective February 5, 2001).
accountant's independence.”
Sarbanes-Oxley overtakes the SEC in this regard by barring auditors from non-
audit work for audit clients (§201), requiring rotation of audit partners after five years
(§203), requiring corporate audit committees to select auditors (§202), and restricting
auditing of a firm a member of whose senior management was previously employed by
the auditor (§206).
Part of the problem regarding laxity of accounting arguably has to do with issuer
board oversight of auditors’ work. This is addressed by the audit committee
requirements discussed in subpart B. Sarbanes-Oxley also requires more detailed
reporting by auditors to boards (§204), and helps ensure that the audit committee has
adequate expertise to perform its oversight function by requiring disclosure concerning
the audit committee’s financial expert (§407).
The problems with auditor independence and laxity of auditors’ work in

uncovering accounting frauds arguably indicate that it may be time to abandon the
current model of regulating the public accounting profession. The fact that reputational
bonds posted by national accounting firms may no longer be enough to ensure quality
work arguably suggests that regulation of the accounting industry should move closer to
the model that has applied to the more fragmented securities industry. The current
system of peer review within the AICPA obviously has not filled in the gaps, as
indicated by the recent corporate frauds themselves, and by the fact that no major
accounting firm has failed a peer review.
The SEC proposed a rule providing for an independent agency dominated by

people who are not accounting professionals that would, among other things, exercise
oversight, annually review large accounting firms for independence, objectivity,
performance and methodology, and set standards for audits and quality control.51 This
proposal now has been superseded by the Sarbanes-Oxley requirements for a Public
Company Accounting Oversight Board (§§101-109), with oversight by SEC, to register,
inspect and investigate public accounting firms, directed by five members of which only
two have industry ties in the sense of being or having been licensed certified public
accountants, and none can be currently working for a major accounting firm.
Finally, the problems in some cases may have been at least partly attributable to
accounting standards for how items must be reported rather than to auditors’ non-
compliance with these standards. In particular, Enron would not have been required to
place the debts of its special purpose entities on its own balance sheet had it been able
to find just a 3% outside equity investor. Although the fall, 2001 restatements that
seemingly triggered the company’s downfall were necessitated by the company’s
noncompliance even with this lax standard, it is not clear why the difference between a
minimal and no outside equity should justify significant differences in reporting of
debts.52 Also, current standards relating to so called “pro forma” earnings that exclude
51 See SEC Release 33-8109 (June 26, 2002).
52 The Financial Accounting Standards Board is considering raising the standard to 10% outside
“extraordinary” events give firms significant room to manipulate earnings. Sarbanes-

Oxley addresses problems by imposing conditions on the structure of the organization
that approves accounting standards the SEC deems “generally accepted” (§108).
D. EXECUTIVE COMPENSATION
The corporate frauds relate in two ways to insider compensation. First, some of
the frauds, including most notoriously Fastow and others’ suspect SPE deals in Enron,
Adelphia’s dealings with its controlling Rigas family, who have been arrested for
looting the company of a billion dollars, and WorldCom’s $366 million in loans to its
longtime leader Bernard Ebbers, appear to have involved actual or borderline looting.
High levels of executive compensation, though short of outright looting, also may
constitute transfers of wealth from outside shareholders to executives.53
Second, there is a concern that stock-based compensation, particularly
compensation based on short-term options, gives insiders incentives to manipulate
operations, or earnings alone, to reap large short-run payoffs, and then sell before the
market adjusts.
Third, inadequate disclosure of the compensation or its effects on earnings may

compound these problems. A salient issue in this respect is not requiring firms to record
the difference between the market and option price of stock options as an expense just
like most other forms of compensation. Lobbyists defeated a proposal to require
expensing of stock options in Sarbanes-Oxley.54 Ironically, Congress threatened to strip
the Financial Accounting Standards Board of its power to set standards for public
companies when the Board proposed requiring expensing in 1993. Now the FASB is
considering the issue again, and the International Accounting Standards Board recently
proposed expensing.55
The NYSE proposal would address some concerns with employee compensation
by requiring shareholder approval of all equity-based compensation, thereby expanding
its prior rule, which required approval only of stock-based compensation to officers or
directors.56 Sarbanes-Oxley deals with the compensation issue mainly by prohibiting
insider loans (§402). The Act also addresses compensation as a way of penalizing fraud,
by requiring return of incentive based compensation, as well as profits from stock sales,
following accounting restatements resulting from “the material noncompliance of the
equity. See Cassell Bryan-Low and Ken Brown, And Now, the Question Is: Where's the Next Enron?,
Wall St. J., June 18, 2002, at C1.
53 See Lucian Arye Bebchuk, et al, Managerial Power and Rent Extraction in the Design of
Executive Compensation, Harvard Law & Economics Discussion Paper No. 366 (June 2002), available at
54 See infra text accompanying note 197.
55 See Jackie Spinner, Board Takes Up Options Issue, WASH. POST, July 27, 2002, at E1.
56 See NYSE Report, supra note 46.

issuer, as a result of misconduct, with any financial reporting requirement under the
securities laws” (§304).
E. INCREASING DISCLOSURES
The corporate frauds entailed firms’ inadequate disclosure to shareholders of

data relating to the quality of earnings, corporate debts and risks, and insider
transactions. The firms themselves are the cheapest sources of this information, but
their insiders may lack adequate incentives to be forthcoming, particularly where the
disclosures would uncover their own wrongdoing.
The securities laws, of course, already require substantial disclosure, including

reporting of important corporate events and extensive quarterly and yearly filings.
However, the recent corporate frauds arguably have altered the sorts of things investors
would be concerned about. Thus, Sarbanes-Oxley requires the SEC to issue rules
requiring, among other things, enhanced disclosure regarding off-balance-sheet
transactions and pro forma earnings (§401) and clear and immediate disclosure of
material changes in financial condition (§409).
The recent corporate frauds may have related less to problems with existing
disclosure requirements than to firms’ failure adequately to comply with these
requirements. This arguably could be remedied by increasing penalties for disclosure
failures. Some proposals would focus the penalty on chief executives. The SEC has
issued an order requiring executives of certain large firms to certify financial
disclosures on penalty of personal liability57 and the NYSE is considering requiring
listed firms’ chief executive officers to certify their firms’ procedures regarding
accuracy of information and compliance with those procedures.58 Sarbanes-Oxley
requires chief executives and chief financial officers to certify financial statements
(§302), with criminal penalties for reckless certification (§906). Increased civil and
criminal liability for fraud is discussed in the next subpart.
Finally, corporate fraud theoretically can be reduced by increasing SEC

surveillance. The SEC traditionally has lacked the resources to do intensive review of
corporate disclosures. Sarbanes-Oxley addresses this by requiring increased SEC
review of public company filings (§408) and increasing the SEC’s funding (§601).
F. FRAUD LIABILITY
Recent corporate frauds occurred following 1990’s laws scaling back potential
liability for corporate fraud, the Supreme Court’s 1994 decision in Central Bank
eliminating aiding and abetting liability under the 1934 Act’s general anti-fraud
57 See SEC File No. 4-460, Order Requiring the Filing of Sworn Statements Pursuant to Section
21(a)(1) of the Securities Exchange Act of 1934 (June 27, 2002).
58 See NYSE Report, supra note 46.

provision,59 Congress’ scaling back of securities class actions in the Private Securities
Litigation Reform Act (PSLRA),60 and state limited liability partnership (LLP) laws
eliminating vicarious liability of members in accounting and other partnerships. These
laws reduced the exposure of gatekeepers such as Arthur Andersen, as well as of non-
disclosing corporations and their insiders. The reduced liability risk may have
encouraged fraudulent or shirking behavior in marginal situations where defrauding
insiders or lax auditors had persuaded themselves that the likelihood of detection was
low. This argues for reversing some aspects of the PSLRA.
Sarbanes-Oxley makes several moves toward increasing penalties for corporate

fraud, including increased criminal penalties (§§807, 903, 904-06, 1106), reducing the
standard for officer-director bars (§1105), increasing the statute of limitations for fraud
claims (§804) and providing for bars on professional practice before the SEC (§602). It
also indirectly penalizes fraud by requiring return of incentive based compensation or
profits from stock sales following accounting restatements resulting from “misconduct,”
whether or not by the executive whose compensation or profits had to be returned
(§304).
G. SECURITIES ANALYSTS
The markets did a bad job of uncovering fraud at least partly because securities
analysts and other market professionals were not assiduous in finding and reporting
problems with firms they were covering. The underlying problem was analysts’
increased involvement in the sale of securities, particularly following the deregulation
of commissions made it harder for securities firms to compensate analysts for
research.61 Analysts’ research function came to be compromised by their own
investments and their ties to the investment banking arms of their securities firms.62
These problems were addressed in part by recent NASD rules approved by the SEC that
regulate and require disclosure of ties between analyst research and investment banking
activities of analysts’ employers and analysts’ ownership of recommended stocks.63
Sarbanes-Oxley addresses these conflicts by ordering significant new regulation of
securities analysts, particularly including rules ensuring that analysts are not subject to
pressure on account of their firms’ investment banking activities (§501).
59 See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994).
60 Some relevant provisions of the Act are summarized infra text accompanying notes 140-143.
62 For a review of the analyst self-interest problem, see Jill E. Fisch & Hillary A Sale, The
Securities Analyst as Agent: Rethinking the Regulation of Analysts (ms. 2002).
63See Research Analyst Conflicts of Interest, 67 Fed. Reg. ¶34,968, at p. 34,969 (approved by
SEC, May 10, 2002).
III. PROBLEMS WITH THE REGULATORY APPROACH

This Part shows that the case for additional regulation in response to Enron and
related scandals is weaker than might appear from the litany of market failures
discussed in Parts I and II. As discussed in subpart A, corporate fraud has deep-seated
causes, including the regulatory environment itself, and is accordingly not amenable to
simple regulatory solutions.
Subpart B discusses the inherent limitations on what the new regulation can
accomplish. The basic problem is that post-Enron reforms hope to reduce fraud mainly
by making outside monitors more independent. But independence reduces access to
information, and therefore is not likely to be an effective counter to the high-powered
incentives of the perpetrators.
Even if increasing the level of regulation reduces the risk of future fraud, subpart
C shows that the costs of increased truthfulness may outweigh the benefits, including
deterring beneficial transactions, increasing the adversarial nature of corporate
governance, reducing executives’ incentives to increase firm value, and diverting
executive talent to closely held firms. In general, as Alan Greenspan warned, “[w]e
have to be careful . . . not to look to a significant expansion of regulation as the solution
to current problems, especially as price/earnings ratios increasingly reflect the market's
perception of the quality of accounting.”64
Most of this Part discusses inherent limitations on what government is able to

accomplish. Beyond these limitations, political considerations usually cause regulation
to fall short of its theoretical potential. As discussed in subpart D, this is particularly
true of Sarbanes-Oxley, which was passed in a hectic environment in which politicians
played on public misperceptions of risk and eschewed careful balancing of costs and
benefits.
A. EXPLAINING THE FRAUDS
Before trying to make the markets safer, it is necessary to consider why the
latest frauds occurred and to place them in historical context. This is not the first time
that widespread financial chicanery has occurred in the context of rampant market
speculation. For example, some of the speculation preceding the 1929 Crash has a
familiar ring. J.K. Galbraith recounts Goldman Sachs’ launching of a series of
“exiguous” trading companies whose assets consisted largely of their own stock, rose
sharply with their own value and fell just as fast.65 After 70 years of regulation, Enron
did much the same thing. Indeed, almost 300 years ago the South Sea Bubble lured
investors with false promises of sky-high riches from the new world, the high-tech of its
64 See Greg Ip, Greenspan Warns Against Too Much Regulation, Wall St. J., March 27, 2002 at
A3. Ironically, one of the few reforms Greenspan recommended in this speech was expensing of stock
options, one of the few regulatory moves Congress ultimately did not make.
65 J.K. Galbraith, THE GREAT CRASH, 1929, 60-65 (50th anniversary ed., 1979).
day, only to collapse amid recriminations against directors and “stock-jobbers.”66 This
history raises at least preliminary questions as to whether new regulation will work any
better to prevent tomorrow’s frauds than yesterday’s regulation did to prevent those of
today.
This subpart discusses some of the conditions that may have given rise to the
corporate frauds. It also shows that regulation itself may have contributed to creating
conditions that are conducive to fraud. This discussion indicates the difficulty and
danger that await regulators who attempt to eradicate fraud.
1. Insiders’ incentives and heuristics
In order to fix the markets, it is necessary to understand why the insiders who
pulled accounting scams at major public corporations thought they could get away with
them in efficient and regulated securities markets. A thorough understanding of the
perpetrators’ motives would seem to be essential in designing regulation that has a
significant chance of preventing future frauds. It is too simplistic to ascribe these frauds
to “greed” without accounting for the risk of detection. Notably, in contrast to
notorious crooks such as Robert Vesco, none of the main characters in the recent
scandals has absconded with the loot, beyond buying houses in Florida. Moreover, the
alleged perpetrators were not shady criminals but seemingly responsible business
people who had earned the trust of their even more respectable monitors. For example,
Scott Sullivan, who is accused of manipulating WorldCom’s books in order to meet
earnings targets, was regarded as “one of the best chief financial officers around” and
“the key to WorldCom Inc.'s financial credibility.”67 How could such a man have
engaged in blatant financial manipulation, if this is proved to be the case? Similar
questions arise regarding the seemingly more blatant behavior of some Enron insiders,
particularly including Andrew Fastow. Indeed, the insiders’ conduct seems particularly
puzzling, at least at first glance, given agents’ usual incentives. Since agents bear
severe penalties in firms if they fail, including loss of job and reputation, but normally
do not get the full benefit of success, it follows that they would tend to be more cautious
than their employers would want them to be, rather than the reverse.
To begin with, there is a large literature on judgment biases that lead at least
some people to tend to be more optimistic about the future, and more confident in their
judgment and ability to control future events, than would an actor who objectively
processed the relevant data.68 For example, traders generally to overestimate their
ability to judge the true value of the company – i.e., the value of their private
66
See Charles Mackay, EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS
OF CROWDS, 46-88 (1852).
67See Shawn Young & Evan Perez, Finance Chief of WorldCom Got High Marks on Wall
Street, Wall St. J., June 27, 2002 at B1.
68For reviews of this literature and its application to insider motivations, see Langevoort, supra
note 28; Langevoort, supra note 33. For a popular account, see Holman W. Jenkins, Jr., How Could They
Have Done It? Wall St. J., August 28, 2002 at A15.
information.69 These biases may be bolstered over time by the self-esteem-maximizing

device of emphasizing positive returns as an indication of ability and downplaying
trading losses as irrelevant.70 Moreover, even rational people arguably would be more
likely than a third party observer to attribute their own failures to luck and their own
successes to skill given the fact that people are more likely to have initially selected
actions where they overestimate than where they underestimate the likelihood of
success.71
Actors’ judgment biases may depend somewhat on their self-esteem, in the

sense that those with the highest self-esteem are the most likely to misjudge their
control and skill. But managers’ attributes in this respect are not randomly distributed.
Donald Langevoort argues that successful firms tend to reward and promote a particular
type of individual – one who is highly, perhaps unrealistically, optimistic about the
firm’s prospects, confident in his abilities,72 seemingly loyal to the firm and its senior
management, and distrustful of outsiders.73
These judgment biases and miscalculations might be enhanced by external cues.

In particular, legal rules hold that managers are better able to judge the value of their
companies than markets. This view emerges most clearly in cases involving takeovers
or sale of the company, in which courts have given managers the power to defend
against above-market-value takeovers.74 The courts’ acceptance of managers’
arguments that market prices are systematically too low is particularly striking given
managers’ power to release positive information and ability to delay the release of
negative information. The law’s disregard of markets may have helped confirmed
managers’ beliefs that their actions were benefiting the firm whatever markets, or
earnings, might be saying at the moment.
The above story seems to fit some recent corporate frauds. New methods of
69 See Brad Barber & Terrance Odean, Trading is Hazardous to Your Wealth: The Common
Stock Investment Performance of Individual Investors, 55 J. FIN. 773 (2000) (discussing study of on-line
traders).
70 See Donald C. Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral
Approach to Securities Regulation, 96 _NW. U. L. REV.__ (2002), available at
71See Eric Van Den Steen, Skill or Luck? Biases of Rational Agents, MIT Sloan Working Paper
No. 4255-02 (June 2002), available at http://papers.ssrn.com/paper.taf?abstract_id=319972.
72 See Malcolm Gladwell, The Talent Myth, The New Yorker, July 22, 2002 at 28 (describing
culture of “talent” at Enron, which emphasized innate belief talent over organization).
73 See Langevoort articles, supra notes 28 and 33. For an application to the Enron context, see
Bratton, supra note 6.
74 See generally, Bernard Black & Reinier Kraakman, Delaware's Takeover Law: The Uncertain
Search for Hidden Value, 96 NW U. L. REV. 521 (2002).
doing business such as the provision of alternative markets (Enron), consolidation of

long distance telephone service (WorldCom), or the power of downsizing (Sunbeam)
produced initial successes and high market valuations based on optimistic estimates of
future earnings. Stock prices built on hope were highly susceptible to negative earnings
shocks, providing an incentive to prevent these shocks at all costs. Hyper-motivated
and super-optimistic insiders might be able to persuade themselves that any setbacks
were temporary, so that cover-ups need only work for a little while to be successful.
They might conclude that markets that spiked in defiance of modest, or no, earnings
confirmed their firms’ high inherent value, and therefore the validity of their business
plans. On the other hand, stocks that fell on bad earnings numbers did not reflect even
publicly available information about the firms’ abiding value. Thus, hyper-optimistic
insiders might be able to convince themselves that earnings manipulations “corrected”
misimpressions such earnings might convey.
But even these misjudgments and do not seem fully to explain why insiders
would risk jail and loss of all of their wealth and future business prospects by engaging
in fraud that a rational person would surely realize was likely to be detected, all without
apparently having a Vesco-type end game strategy. It has been argued that, once having
begun their conduct, insiders managed to deceive themselves that their actions were
right.75 But surely at some point insiders would realize that the probability discounted
cost of severe sanctions outweighed the potential benefit. Indeed, it would seem that, if
investors did act in disregard of the risk because they were convinced they were right,
they were behaving altruistically rather than greedily.
The solution to the puzzle may lie in the shift of agent incentives that occurs at
the point at which they perceive the risk that they may lose everything. This point
probably occurs before the agents have committed any wrongdoing, which helps
explain why they would engage in wrongdoing in the first place. Insiders faced
punishment in the form of job and reputation loss even for lawful conduct that failed to
meet investor expectations – that is, for their firm’s failure to meet investors’ earnings
expectations.76 At this point insiders may enter a final period in which they are no
longer susceptible to potential discipline by their firms or the employment market
because failure to distort earnings also will result in loss of their job and reputation.77
Since insiders are convinced that they are doing the right thing in defending their
company’s value from destruction by misguided markets, they are also not subject to a
75 See Donald C. Langevoort, Monitoring: The Behavioral Economics of Inducing Agents'

Compliance with Legal Rules (June 26, 2001). available at
76 See Donald C. Langevoort, Managing the “Expectations Gap” in Investor Protection: The
SEC and the Post-Enron Reform Agenda (ms. 2002).
77For discussions of the effect of the final period problem on insiders’ incentives to commit
wrongdoing, see Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities
Markets: Theory and Evidence, 1992 U. ILL. L. REV. 691; Mitu Gulati, When Corporate Managers
Fear a Good Thing is Coming to an End: The Case of Interim Nondisclosure, 46 UCLA L. REV. 675
(1999).
significant moral constraint.
As soon as insiders begin engaging in fraud, this results in additional alterations

of insider incentives. At this point, insiders risk loss of wealth and even personal
freedom unless they continue the cover-up. Indeed, the consequences of discovery may
be so severe that even a small chance of success might lead a rational actor to cover up.
This calculus may be reinforced by a psychological tendency to prefer risk when
choosing whether to take a present loss or take a chance on avoidance or on future
loss.78
This brief summary should be enough to indicate that strong measures may be
necessary significantly to reduce the risk of future fraud. Insiders who think that are
doing the right thing may be harder to detect and deter than those who were simply
greedy. Deterrence that is effective also may be very costly. Moreover, given the shift
in incentives discussed above when the end seems near, increasing punishment may
actually increase the risk of a cover-up, even as it has little effect on the fraud itself. All
of this suggests significant uncertainty about how best to craft the law to prevent future
frauds.
2. Investor heuristics
Why did not securities markets reflect skepticism about the companies’ numbers
and basic business plans even after public signs of problems emerged?79 For example,
no one seems to have considered the implications of WorldCom’s meeting earnings
projections by small fractions of a penny per share, or why Enron did not owe any
taxes.80 These phenomena are at least partly attributable to investor judgment biases
that lead them to underestimate the risk that bad things will occur. Investors, like others,
may be over-optimistic in the sense of discounting risks, including the risk of fraud.81
This optimism may have been exacerbated in the present circumstances by a
confirmation or conservatism bias that tended to discount evidence contrary to the long-
78 See Richard W. Painter, Lawyers’ Rules, Auditors’ Rules and the Psychology of Concealment,
84 MINN. L. REV. 1399 (2000); Jeffrey J. Rachlinski, Gains, Losses, and the Psychology of Litigation,
70 CAL. L. REV. 113 (1996).
79 See supra text accompanying notes 23-25 (discussing signs of Enron’s flaws that were
apparent long before its crash). See also infra text accompanying note 199 (discussing analysts’ early
discovery of these problems).
80 See supra text accompanying note 25.
81 See Robert Prentice, Whither Securities Regulation? Some Behavioral Observations

Regarding Proposals for its Future, 51 DUKE L.J. 1397, 1457-59 (2002) (discussing general problem of
investor over-optimism as a reason for not deregulating securities sales). For a good example of the over-
optimism problem in another context, see Lynn A. Baker & Robert E. Emery, When Every Relationship
Is Above Average: Perceptions and Expectations of Divorce at the Time of Marriage, 17 LAW & HUM.
BEHAV. 439 (1993) (finding that few married couples believe that they will divorce despite their
knowledge of high general risk of divorce).
running bubble market.82
Assuming these observations are accurate, their implications are ambiguous.

Given investor biases, perhaps stock prices do not efficiently reflect inherent value,
thereby increasing investors’ need for disclosure.83 On the other hand, even if factors
other than inherent value influence stock prices, this should not matter to investors
unless they can consistently outguess the market.84 There is little, if any, evidence that
they can.
Moreover, even if investors are irrational, it is not clear what disclosure law can
or should do about it. Why would investors want more information about inherent value
if their more emotional colleagues will ignore this evidence and take the price in a
different direction? Indeed, critics of market efficiency argue that even well-financed
arbitrageurs would not want to bear the risk of investing contrary to investor
momentum, and for this reason do not move the market toward efficiency.85 More
information cannot cure investors of the judgment biases that supposedly lead them to
misuse the information.
Perhaps clear disclosures of risks would provide the sort of salient warnings
necessary to break through investors’ excessive optimism or conservatism bias. But
requiring such disclosures carries the cost of forcing firms to make characterizations
that are not necessarily supported by the available facts. This could make stock prices
more volatile and expose firms and insiders to liability. Moreover, mandatory
disclosure designed in light of investors’ judgment biases may present different
problems in bear and in bull markets. As discussed below in subpart IV(A), in a bear
market investors may be overly skeptical, suggesting that in this context firms need to
be more concerned about clarity regarding positive than about negative information. It
is not clear how a single set of rules can deal with both problems without presenting
firms with considerable uncertainty.
In short, regulation that simply ensures that markets will have more accurate
82 Although there is evidence of such a bias in lags in investor adjustments to earnings reversals,
there is contradictory evidence in investor over-reaction to evidence of earnings trends. See Nicholas
Barbaris, et. al, A Model of Investor Sentiment, 49 J. FIN. 307 (1997) (presenting model of efficient
market anomalies in which investors assume earnings are mean reverting and so do not rapidly adjust for
earnings reversals or assume trends and engage in momentum trading). Barbaris, et al, reconcile these
findings by classifying events to which investors react according to their strength and weight. This
relates to the availability heuristic discussed infra text accompanying note 191.
83There is a large literature on the implications of behavior theory for market efficiency, and of
course on market efficiency in general. For a recent review of some of the literature see Langevoort,
supra note 70.
84See Daniel Fischel, Efficient Capital Markets, The Crash, and the Fraud on the Market
Theory, 74 CORNELL L. REV. 907 (1989).
85 See Andrei Shleifer & Robert Vishny, The Limits of Arbitrage, 52 J. FIN. 35 (1997).
information will not solve the problem of corporate fraud if, as many commentators
suggest, investors do not know what to do with the information when they get it. A
more promising approach is encouraging investors to be more skeptical of firms’
disclosures and more alert to fraud than they seem to have been in the recent corporate
frauds. Yet, as discussed in the next section, regulation may actually contribute to these
problems.
3. Trust
A few individuals probably could not alone have perpetrated and sustained
frauds in large corporations in an atmosphere of skepticism and distrust. Large-scale,
successful frauds may require collusion among employees and others.86 There have
been reports that lower level WorldCom employees knew of the accounting
manipulations years before they were disclosed,87 and that banks colluded with Enron.88
Investor complacency in the face of signals of insider fraud could be explained
simply as investor trust in insiders’ honesty based either on altruistic motives or on a
realistic assessment of insiders’ basic honesty rather than on judgment biases as
discussed in Section 2. At least some of the defrauding firms seem to have been helped
by a high level of employee loyalty. This may be why, for example, Enron’s workers
kept their retirement funds invested in the company’s stock when they could have
diversified, even after problems started appearing, and before the company had locked
down the retirement funds. One WorldCom worker was quoted as saying after the
earnings debacle, “I have never worked for a better company.”89 Of course the loyalty
may have been instilled in part by fear of reprisals within the firm or loss of pensions or
stock investments if the firm went under. But some of the loyalty may have been
attributable to firms’ efforts, in response to arguments by corporate commentators and
reformers, to eschew short-term profit-maximization in dealing with various corporate
constituencies in order to instill a corporate “culture” of loyalty in workers and others.90
This provides, among other things, a rationale for managerial opposition to takeovers
that would threaten the carefully developed relationship between workers and
incumbent managers.91
86 See AICPA Auditing Standards Board, Exposure Draft: Consideration of Fraud in a

Financial Statement Audit, 20 (February 28, 2002).
87 See Yochi J. Dreasen & Deborah Solomon, Andersen Ignored Warnings

On WorldCom, Memos Show, www.wsj.com, July 15, 2002.
89 See Kelly Greene & Rick Brooks, Sorry, Wrong Number: WorldCom Staff Now Are Saying
'Just Like Enron', Wall St. J., June 27, 2002 at A9.
90 For a review and critique of the literature, see generally, Ribstein, supra note 4.
91 See Bruce Chapman, Trust, Economic Rationality and the Fiduciary Obligation, 43 U.
The recent frauds reveal a potential dark side to corporate trust. Good corporate
governance may require distrustful employees to watch over insiders for the same
reason that it needs distrustful auditors, outside board members, securities analysts and
others. This is not to suggest that employee trust is bad. As discussed below, too much
monitoring may be counterproductive precisely because it instills distrust.92 Moreover,
the recent corporate scandals indicate that monitoring alone cannot prevent fraud and
that fraud can be instilled by an atmosphere of hyper-competition.93 Thus, Enron may
have succumbed to a conflict between, or combination of, trust and competition.94
Reducing the level of trust might have either reduced the risk of fraud by adding more
monitoring to the mix, or increased the risk of fraud by exacerbating the culture of
competition. The only clear lesson is that the incentives and heuristics of corporate
actors are highly complex and not yet well enough understood that they provide a clear
basis for any particular regulatory regime.
Investor trust in insiders may be even more complex. It seems unlikely that
investors would have the same sort of altruistic motives for trust that workers would
have. Rather, investor trust more likely resulted from a calculation that, given high
levels of regulation of securities markets, insiders were unlikely to lie or steal.95 Instead
of using “trust” to describe both of these disparate phenomena, it would seem clearer to
refer to the second phenomenon as investor reliance on or belief in the efficacy of
regulation.96 The possibility of such reliance suggests the difficulty not only of defining
trust, but also of distinguishing judgment biases from reasonable, but ultimately
frustrated, expectations. Investors might assume that widespread fraud could not be
occurring because the corporate governance framework so highly touted by corporate
reformers -- a vigilant SEC, public corporations’ “monitoring” boards and audit
committees, and public accounting firms – was effectively guarding against fraud. This
assumption might have been reasonable given what investors had been told, or might
have resulted from a potent mix of facts with the confirmation bias discussed above.97
This view of investor complacency suggests a possible cost of regulation in
TORONTO L.J. 547 (1993) (arguing that managers need to be the sort of people who simply are
trustworthy and whom employees will trust).
92 See infra §III(C)(4).
94
See Margaret M. Blair, Post-Enron Reflections on Comparative Corporate Governance,
Georgetown University Law Center 2002 Working Paper Series in Business, Economics, and Regulatory
Law, Working Paper No. 316663, available at http://papers.ssrn.com/paper.taf?abstract_id=316663.
95 See Lynn A. Stout, The Investor Confidence Game,

http://papers.ssrn.com/paper.taf?abstract_id=322301, UCLA School of Law, Research Paper No. 02-18.
96 See Ribstein, supra note 4 at 571-76 (distinguishing “weak form reliance” from other forms of
trust).

addition to those discussed below in subpart C. The market may have been misled not
only by defrauding insiders, but by years of exaggerated claims by regulators and
reformers about the efficacy of regulation. In other words, regulation sends a signal to
investors that helps shape their behavior, and specifically that may mislead them into
inaction.98 If this hypothesis is correct, then additional regulation, accompanied by new
exaggerated claims for its efficacy, might inhibit markets from self-adjusting to fraud
by giving investors a reason for continued complacency.99 For example, Sarbanes-
Oxley provisions calling for increased SEC review of corporate filings and a
significantly increased SEC budget (§§408 and 601) may give investors the impression
that the SEC is effectively guarding against fraud. This is an additional reason for being
concerned about the actual effectiveness of these and other proposed regulatory
responses to corporate fraud, discussed in more detail in the next subpart.
B. EFFECTIVENESS OF REGULATORY PROPOSALS
As discussed in subpart A, the executives and other insiders who perpetrated the
frauds apparently acted because of acute judgment biases as well as strong incentives to
protect themselves and colleagues from exposure. In other words, these were probably
not cases of simple calculating greed. Some may argue that these circumstances support
stronger forms of regulation.100 But this subpart shows that past approaches to
regulation, monitoring and liability are seriously flawed. This suggests that intensifying
regulation is unlikely to be effective.101
1. Independent directors as watchdogs
As discussed in subpart II(A), corporate reformers have emphasized independent

directors as a way to curb insider abuse. However, the emphasis on the monitoring
board over the last thirty years has demonstrated the inherent limitations on independent
directors’ effectiveness. Myles Mace, in his famous 1971 study of directors,
98 Cf. Robert W. Hahn & Patrick M. Dudley, The Disconnect Between Law and Policy Analysis:
A Case Study of Drivers and Cell Phones, AEI-Brookings Joint Center Working Paper 02-7 (May 2002),
available at http://papers.ssrn.com/paper.taf?abstract_id=315781 at 52 (after discussing evidence that
banning use of hand-held but not hands-free cell phones while driving would not reduce overall risk,
observing that such a ban “could convince consumers that hands-free devices are safe, thereby
encouraging their use. Since hands-free devices do represent some risk, this might very well decrease
overall safety.”).
99 This can be viewed as an additional problem with relying on “trust” as a justification for
increased regulation. See Ribstein, supra note 4 (discussing other problems with “trust”-based arguments
for regulation).
100 See Langevoort, supra note 33.
101 This proposition is more broadly supported by the observation that corporate law does not
fundamentally protect against agency cost, as indicated by the fact that the level of corporate law
protection does not explain differences across countries in the separation of ownership and control. See
Mark J. Roe, Corporate Law’s Limits, 31 J. LEG. STUD. 233 (2002).
summarized these limitations as constraints on time, information and inclination to

participate effectively in management.102 Outside directors lack the time to do more
than review, rather than make, business decisions. They also must depend on insiders
for critical information. With respect to inclination, independent directors traditionally
are nominated by insiders, and in any event generally are selected from the business
community to ensure that they will have adequate expertise, and therefore usually will
be unwilling to second-guess managers.
Not surprisingly, board independence has done little to prevent past

mismanagement and fraud. For example, thirty years ago the SEC cast much of the
blame for the collapse of the Penn Central Company on the passive non-management
directors.103 No corporate board could be much more independent than those of
Amtrak, which have managed that company into chronic failure and government
dependence. Enron had a fully functional audit committee operating under the SEC’s
expanded rules on audit committee disclosure.104
The substantial data on boards of directors that has been compiled over the last
twenty years offers little basis for relying on regulation of board composition as the
solution to corporate fraud.105 The evidence shows that there is no overall positive
relationship between various measures of firm welfare, including earnings, Tobin’s q
and stock price, and the degree of independence of corporate boards.106 While there is
evidence that independent boards may be better at some tasks, such as removing poorly
performing managers or reviewing their compensation,107 there is also evidence that
independent directors are correlated with worse corporate performance.108 This
evidence indicates that insiders may have some value on boards, perhaps in adding
102 See Myles Mace, DIRECTORS: MYTH AND REALITY (1971).
103 See Staff Report, The Financial Collapse of the Penn Central Company, 157–72 (1972).
105 For a critique of the New York Stock Exchange director independence rules, discussed text
accompanying supra note 46, in light of the evidence noted in this paragraph, see Stephen Mark
Bainbridge, A Critique of the NYSE's Director Independence Listing Standards, UCLA School of Law,
Research Paper No. 02-15 (2002), available at http://papers.ssrn.com/paper.taf?abstract_id=317121.
106See Sanjai Bhagat & Bernard Black, The Non-Correlation Between Board Independence and
Long-Term Firm Performance, 27 J. CORP. L. 231 (2002); Sanjai Bhagat & Bernard Black, The
Uncertain Relationship Between Board Composition and Firm Performance, 54 BUS. LAW 921 (1999);
Sanjhai Bhagat & Roberta Romano, Event Studies and the Law: Part II: Empirical Studies of Corporate
Law, 4 AM. L. & ECON. REV. 380, 402-03 (2002).
107See, e.g., Morck, Shleifer & Vishny, Management Ownership and Market Valuation: An
Empirical Analysis, 20 J. FIN. ECON. 293 (1988); Weisbach, Outside Directors and CEO Turnover, 20
J. FIN. ECON. 431 (1988).
108 See Bhagat & Black articles, supra note 106.

important expertise.109 In general, firms seem to be making the right decisions as to how
much board independence is appropriate, except that evidence of a negative correlation
between corporate performance and board independence may indicate that even prior to
the post-Enron regulation corporations were being forced to err on the side of
independence.110
This data does not necessarily mean that board independence is irrelevant to
corporate fraud. First, independent directors arguably are better at certain types of
decisions, perhaps including supervising their firms’ financial disclosures and
relationships with auditors. Enron and related scandals arguably make the data cited
above obsolete because they uncovered pervasive fraud that increases the need for this
type of supervision. Second, although the overall proportion of independent directors
may not affect corporate performance, the independence of certain “trustee” committees
such as audit, nominating and compensation committees, may be particularly
important.111 Third, post-Enron regulation might usefully tweak the definition of
independence so that it precludes at least some directors, particularly those on sensitive
“trustee” board committees, from receiving favors such as donations to pet charities
with which insiders can buy director loyalty.112 For example, Ross Johnson at RJR-
Nabisco sought to buy board member Juanita Kreps by endowing two chairs at her
school, Duke, one of them named after herself.113 On the other hand, it seems unlikely
that a relatively minor donation could influence a director with a strong reputation to
protect.
Even given these caveats, more independence is not necessarily correlated with
better monitoring. In order to avoid suspect relationships and connections, corporations
may have to appoint more directors from outside the business community. Board
members such as law professors,114 with little hands-on business experience and no
109 See Bhagat & Romano, supra note 106 at 403.
110See id; Klein, supra note 106. Firms may select directors because of their political rather
than monitoring attributes where their business involves dealings with the government. See Anup
Agrawal & Charles R. Knoeber, Do Some Outside Directors Play a Political Role? 44 J. L. & Econ. 179
(2001). Bhagat & Black alternatively hypothesize that less profitable firms have a greater need for
independent directors to counteract insiders’ tendency to excessively retain cash not needed for growth.
111 See Gordon, supra note 6.
112 See, e.g., H.R. 3745, the Corporate Charitable Disclosure Act, introduced by Rep. Paul E.
Gillmor (increasing disclosure of corporate charitable contributions, in part to aid in scrutiny of conflicts
of interest).
113 See Burrough & Helyar, BARBARIANS AT THE GATE: THE FALL OF RJR NABISCO
97 (1990).
114
Examples include Judith Areen, dean of the Georgetown Law Center, who was on the
WorldCom board at the time of its earnings debacle (see Jared Sandberg & Joann S. Lublin, Questioning
the Books: WorldCom's Travails Could Affect Its Directors, Wall St. J., June 28, 2002 at A9); and
formal connection with a company may not be sophisticated enough to spot problems,
or able or willing to stand up to a powerful executive. Moreover, there are significant
limits on what even the best audit committee can do if, as is typically the case, it meets
only a few times a year.115
These problems of board independence may be exacerbated by other proposals

to reform the board, particularly including proposals to have directors represent multiple
constituencies in the company, such as workers, rather than the shareholders
exclusively.116 Encouraging or requiring directors to focus on goals other than financial
performance increases the risk that directors will miss signs of misbehavior, if only
because of the limitations on directors’ time discussed above. Directors who are
specifically selected to represent particular constituencies may be useless in protecting
against insider fraud because of their lack of business sophistication or their interest
only in looking after a particular constituency.117 To be sure, firms might minimize
these problems by delegating financial monitoring to a specific audit committee that is
focused on this task. But even in this situation a multi-constituency board might
interfere with monitoring by nominating financially unsophisticated directors, or by
impeding full disclosure to and discussion by the full board.118
One might argue that, other things equal, independent directors would be more
attentive to corporate interests if they held stock in their companies.119 Indeed, there is
evidence that firms with independent boards that get incentive compensation are more
likely to fire bad managers.120 On the other hand, the WorldCom directors were heavy
Charles Elson, who was appointed by Al Dunlap to the Sunbeam board (see Joann S. Lublin, Sunbeam's
Chief Picks Holder Activist and Close Friend as Outside Director, Wall St. J., September 26, 1996 at B9)
and was on that board at the time of its earnings misstatement, after a Barron’s reporter had spotted the
problem (see Laing, supra note 17).
115 See Healy & Palepu, supra note 10 at 17-18 (detailing the Enron audit committee’s daunting
agenda at one 85-minute meeting).
116 See, e.g., Margaret M. Blair & Lynn A. Stout. Director Accountability and the Mediating
Role of the Corporate Board, 79 WASH. U. L.Q. 403 (2001) (arguing that board should be “mediating
hierarchs” who balance conflicting claims of various constituencies).
117 See Alfred Conard, Reflections on Public Interest Directors, 75 Mich. L. Rev. 941 (1977).
118 See John C. Coffee, Jr., Beyond the Shut-Eyed Sentry: Toward a Theoretical View of
Corporate Misconduct and an Effective Legal Response, 63 Va. L. Rev. 1099, 1145 (1977). This also
exacerbates the problem of distrust that arises from monitoring directors. See infra §III(C)(4).
119 See Charles M. Elson, Director Compensation and the Management-Capital Board: The
History of a Symptom and a Cure, 50 SMU L. REV. 127 (1996). See also Charles M. Elson and Robert
B. Thompson, Van Gorkom’s Legacy: The Limits of Judicially Enforced Constraints And The Promise
Of Proprietary Incentives, 96 NW. U. L. REV. 579 (2002) (arguing that such stock ownership should be
taken into account in the directors’ favor in breach of fiduciary actions).
120 See Tod Perry, Incentive Compensation for Outside Directors and CEO Turnover (June
investors in WorldCom, having received both their stock and board memberships in
WorldCom’s earlier acquisitions of MCI and other companies.
Perhaps the problem with board independence is not the specific links between
board members and their companies but how they are selected and monitored. Thus,
commentators have suggested that corporations should have professional directors who
serve on several boards at the instance, and subject to the supervision, of institutional
shareholders.121 Although this idea has gained little ground in the more than ten years
since its publication, perhaps Enron will make the time ripe. Similarly, perhaps the
world is ready for outside directors who are not only more independent more active in
their firms’ affairs.122 The question is whether these ideas will prove to be more
successful than the basic principle of the monitoring board.
Finally, it is important to keep in mind that all of the proposals for better board
incentives and greater independence can do no more than improve the prospects for the
board’s hiring of specialists, particularly including the auditors, to catch fraud. Thus,
the discussion of auditors’ capabilities in the next section is critical. The board itself, as
a part-time supervisory body, is inherently unsuited to reviewing the minutiae of
corporate transactions closely enough to spot fraud by committed and astute insiders.
This problem was noted more than eighty years ago by Justice Holmes in holding that
outside directors could not be held liable for failing to stop a cashier from taking
essentially the entire assets of a bank by drawing checks on the bank and falsely
charging the checks to various accounts, including the president’s.123 Although the
outside directors accepted the cashier’s statement of liabilities without inspecting the
deposit ledger, the Court said that these directors could trust the cashier because his
work had been validated “by the semi-annual examinations by the government
examiner” and by the president “whose responsibility, as executive officer; interest, as
large stockholder and depositor; and knowledge from long daily presence in the bank,
were greater than theirs.” Accordingly, the court concluded that the outside directors
“were not bound by virtue of the office gratuitously assumed by them to call in the
passbooks and compare them with the ledger, and until the event showed the possibility
they hardly could have seen that their failure to look at the ledger opened a way to
fraud.” This seems similar to the Enron directors’ failure to see through a complex
maze of SPEs, hedging and derivatives, and the WorldCom directors’ failure to see that
trusted insiders were turning expenses into assets.124
2000), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=236033.
121 Ronald Gilson & Renier Kraakman, Reinventing the Outside Director: An Agenda for
Institutional Investors, 43 STAN. L. REV. 863 (1991).
122 See Ira Millstein & Paul MacAvoy, The Active Board of Directors and Performance of the
Large Publicly Traded Corporation, 98 COLUM. L. REV. 1283 (1998).
123 Bates v. Dresser, 251 U.S. 524 (1920).
124 It has been suggested that cases like Bates no longer are good law in light of more recent
recognition of the board’s need to establish internal monitoring systems discussed infra text
accompanying note 251. See Cunningham, supra note 9. However, as the Enron Special Committee
2. Auditors and other detectives
Public accountants undoubtedly contributed to the recent corporate frauds by

certifying financial statements that ultimately proved to be fraudulent or at least
defective. Lax accounting standards, as in the case of the 3% equity rule for moving
liabilities to off balance sheet entities, arguably contributed to the problem. These rules
could be tightened, but this might lead to excess conservatism that cause as many
problems, including misleading the market and inviting evasion, as excessively lax
standards.125 In any event, standards could not have been the whole problem because, as
long as the basic transactions are recorded, the market ultimately can see through how
the transactions are reported. This was certainly the case in Sunbeam, where most of
the bad accounting was uncovered by a Barron’s reporter based almost entirely on the
company’s own disclosures,126 and to some extent was the case even in Enron.127
The main problem in many cases was that outside auditors did not discover (e.g.,
WorldCom) or report (e.g., Enron and Waste Management) the fraud. Auditors’ failure
to report problems that they discover would seem to be amenable to changes in
auditors’ incentives and to more intensive monitoring of the profession. As discussed
above,128 auditors’ independence arguably has been compromised by, among other
things, their dependence on non-audit work for audit clients. The current system of self-
regulation proved insufficient to counteract these strong economic motives.
Accordingly, a strong system of regulation, including prohibition on certain types of
arrangements, monitoring by non-industry-dominated agency and more independent
corporate audit committees, would seem necessary and appropriate. The need for
strong measures is indicated by the fact that auditing firms have proven willing to cast
aside valuable reputation129 for short-term profits. Notably, a $7 million fine levied
against Andersen because of its mishandling of Waste Management a few months
before the Enron scandal broke130 did not provoke Andersen to significantly change its
ways.
Report recognized, the board is limited in its ability to anticipate new types of fraud, through internal
controls or otherwise, just as it was at the time of Bates, and the later case of Graham v. Allis-Chalmers
Mfg Co., 188 A.2d 125 (Del. 1963).
125 See Healy & Palepu, supra note 10 at 31 (discussing accounting standard-setters’ choice
between rigid and flexible rules).
126 See Laing, supra note 17.
127 See infra text accompanying note 199.
128 See supra subpart II(B).
130 See SEC Release No. AE-1410, 2001 WL 687562 (June 19, 2001).
Even if the sale of non-audit services affected auditors’ reporting of fraud,131 it

is not clear that restricting accounting firms’ sale of such services, as under Sarbanes-
Oxley, will solve the problem. Such a restriction, standing alone, probably cannot
reverse the strong profit-oriented culture that now seems to pervade accounting firms.132
In any event, the restriction is porous. Although the Act forbids the sale of non-audit
services “contemporaneously” with audit services by the same accounting firm, clients
may still have some leverage over auditors that hope to sell non-audit services to them
in the future, or to others with whom clients have contractual or ownership ties.133
For present purposes, the more serious issue is whether even strong regulation
will change auditors’ practical ability to find corporate fraud when determined corporate
insiders want to hide it. In the wake of the WorldCom disclosure, an accounting expert
pointed out that accountants do not do “forensic audits” designed to uncover
wrongdoing, but rather only sampling audits that may entirely miss the problem.134 The
AICPA draft standard on auditing for fraud observes that “[i]dentifying individuals with
the requisite attitude to commit fraud, or recognizing the likelihood that management or
other employees will rationalize to justify committing the fraud, is difficult.”135 The
draft notes that:
Characteristics of fraud include concealment through (a) collusion by both

internal and third parties; (b) withheld, misrepresented, or falsified
documentation; and (c) the ability of management to override or instruct others
to override what otherwise appear to be effective controls.136
To be sure, there is much auditors can do to spot fraud, including developing

cross-check procedures and identifying risky situations, as is made clear by the
extensive discussion in the AICPA’s Exposure Draft.137 However, requiring auditors to
131 For evidence that it did not, see Rick Antle, et al., The Joint Determination of Audit Fees,
Non-Audit Fees, and Abnormal Accruals, Yale School of Management Working Paper No. AC-15 (June
14, 2002), available at http://papers.ssrn.com/paper.taf?abstract_id=318943 (UK study showing that audit
firms’ provision of non-audit services did not affect the incidence of abnormal accruals).
132 See Healy & Palepu, supra note 10 at 21 (noting pressures on auditors to be entrepreneurial).
133 This is analogous to the boundaries-of-the-firm issues presented by the prohibition on multi-
disciplinary law firms. See Larry E. Ribstein, Ethical Rules, Law Firm Structure and Choice of Law, 69
U. Cin. L. Rev. 1161, 1172-74 (2001).
134 See Deborah Solomon & Dennis Berman, Questioning the Books: Experts Say WorldCom
Auditors Should Have Found Hidden Costs, Wall St. J., June 28, 2002 at A9 (quoting Roman Weil).
135 See AICPA Exposure Draft, supra note 86 at 19-20.
136 Id. at 21.
137 In fact, the Draft’s overall tenor is to show how much auditors can do to spot fraud. This
suggests that qualifying language like that quoted in the Text is intended mainly for use at later trials to
do significantly more than they are doing may involve more than just changing their
incentives and making them more independent, but also changing the basic scope of
what they do. The marginal benefits of increased auditing may not exceed the
significantly increased costs.
If investors cannot rely on auditors to find fraud, it is even less realistic for them
to rely on government regulators, particularly including the SEC,138 as Sarbanes-Oxley
hopes to do by instructing the SEC to increase its review of financial statements and
increasing its budget (§§408 and 601). The SEC is charged with a wide range of tasks in
addition to spotting fraud in financial statements, including oversight of securities firms,
exchanges, investment advisors and mutual funds, and of market trading, including
insider trading. Its staff is perennially too small for these mammoth tasks.139
Sarbanes-Oxley hopes to enlist others to help in the fight against fraud. Lawyers
will now be required to report “evidence of a material violation of securities law or
breach of fiduciary duty or similar violation by the company or any agent” to executives
and possibly to the board (§307). The Act also includes strong protection for
whistleblowers (§806). As discussed below in subpart C, these rules may be costly
because they inhibit efficient information flows within the firm and perversely affect the
relationship between corporations and their lawyers. The main point for present
purposes is that these rules are also ineffective for purposes of uncovering fraud. Those
involved in a fraudulent scheme are unlikely to discuss it with non-participants. The
new rules will simply inhibit more routine and innocuous conversations that might have
helped indirectly in uncovering frauds, as by revealing unusual procedures or suspicious
information that could have been handled more circumspectly before Sarbanes-Oxley
made such conversations fodder for federal litigation and investigations.
Sarbanes-Oxley also includes provisions designed to make executives more

vigilant. Section 302 provides for new SEC rules requiring executive certification of
facts in firms’ securities filings, and §304 requires chief executives and senior financial
officers to return their incentive or equity-based compensation or profits from stock
sales during a year following the issuance of a financial document that had to be
restated due to “misconduct,” whether or not they were personally involved in the
deflect liability from accountants. See James Freeman, Who Will Audit the Regulators?, Wall St. J., July
8, 2002 at A22 (noting that this use of auditing standards is an important issue in whether the auditing
industry should continue to control drafting of the standards). The potential perverse effects of excessive
liability are discussed infra §III(C)(1).
138 See Michael Schroeder and Greg Ip, SEC Faces Hurdles Beyond Low Budget in Stopping
Fraud, Wall St. J., July 19, 2002 at A1, col. 6.
139 See Michael Schroeder, SEC Gives Broad Interpretation of Rules for Accounting Statute,
Wall St. J., August 28, 2002 at C4 (noting that SEC will review reports on a “spot basis” and “rely on
investors and the media for information about companies that fail to comply”); Michael Schroeder, SEC
Gets a Raise, but Will It Be Enough?, Wall St. J., August 12, 2002 at C1 (noting that while annual
exchange trading volume has increased nearly sixfold between 1993 and 2001, the SEC's enforcement
staff has been increased only 15%, mostly to police Internet fraud unit, and that its enforcement division
has grown to 981 from about 400 since 1972 while trading increased more than 100 times).
misconduct. As discussed below in Section 4, at least the latter provision may be a

significant change in insider liability. As discussed below in subpart C, the benefits of
any such increase in liability must be weighed against potential costs of holding
executives responsible for subordinates’ acts.
3. Increased disclosure
The recent corporate frauds were attributable less to firms’ silence or misleading
than to the falsity of what they disclosed. Thus, it is not clear how much difference the
Sarbanes-Oxley requirements concerning disclosure of off-balance-sheet transactions,
pro forma earnings and material changes in financial condition will make in preventing
future fraud. To be sure, burying information in financial statements can make it
difficult for individual investors to determine a firm’s financial condition. But
misleading legions of analysts, reporters and others in an active market requires greater
opacity. In any event, these provisions deal with yesterday’s problem. Recent events
have cast so much light on these specific matters that additional wattage is unlikely to
make any difference in these particular areas. The next great fraud probably will occur
elsewhere.
4. The marginal deterrence effects of liability
As discussed above in subpart II(G), pundits and politicians have suggested that
Enron and other frauds occurred because of rules restricting securities class actions in
the Private Securities Litigation Reform Act (PSLRA) and the Supreme Court’s Central
Bank case. This suggests that reinstituting stronger liability will prevent future Enrons.
The basic problem with this argument is that the marginal deterrence effect of pre-
PSLRA rules or post-Enron reforms on corporate actors’ conduct, as compared with
corporate actors’ incentives under current law, is unlikely to be significant.
First, there is no indication that the above law changes significantly reduced
federal securities law liability. To begin with, both the number of suits and the size of
settlements have increased since the enactment of the PSLRA.140 This is consistent with
the incremental nature of the law’s changes. The PSLRA clarified the standard for
pleading scienter by requiring the complaint to “state with particularity the facts giving
140 The average number of suits/year from 1991 to 1995 is 190 as compared with 237/year from
1996 through 2001. In 2001, 488 suits were filed, as compared with 214 in 2000. As of August 28, 2002
181 suits were filed in 2002, projecting to 271 for the year. Settlements have risen dramatically, from an
average of $7.8 million prior to the PSLRA to $24.9 million after the Act, or $14.4 million excluding an
outlier. The data and related documents are collected at http://securities.stanford.edu. Settlements are
analyzed in http://securities.stanford.edu/Settlements/REVIEW_1995-2001/Settlements.pdf. While the
increase in the number of suits may reflect the end of the bull market, the rise in settlements suggests that
the PSLRA is having the intended effect of reducing nuisance rather than legitimate suits. For a more
extensive analysis of the effect of the PSLRA, drawing data from a number of sources, see Richard
Painter, et al., Private Securities Litigation Reform Act: A Post-Enron Analysis, available at
http://www.fed-soc.org/pdf/PSLRAFINALII.PDF.
rise to a strong inference that the defendant acted with the required state of mind.''141
These pleading standards did not affect liability for fraud, were the same as that
previously adopted in the Second Circuit,142 and nowhere significantly affected
plaintiffs’ ability to bring claims in the cases of blatant misstatements that have
attracted recent attention. The Act also modified joint and several liability by providing
that parties who do not ``knowingly'' violate the securities laws in most cases can be
held liable for the portion of the judgment that cannot be collected from other
defendants only up to 50% of the party's proportionate share of the total damages.143
But this leaves the threat of considerable liability in cases like Enron where the damages
potentially are in the billions. Central Bank clarified that there was no civil liability for
“aiding and abetting” under §10(b), but this liability was unclear before Central Bank,
and the clarification leaves the coast clear for liability for misstatements, including
accountant certifications.
Second, any harmful effects of reducing securities liability must be considered

in the context of the whole set of incentives and constraints facing corporate actors.
Even without securities liability, accountants and corporate insiders still face state law
liability for fraud and breach of contract. For example, although state law privity rules
may block direct investor suits against auditors, a shareholder or bankruptcy trustee can
sue a corporation’s auditors for missing a corporate that eventually brought the firm
down. Although there is authority for letting the auditors off the hook where the insiders
lied to them,144 auditor liability in this situation has been recognized where the firm
suffered from the misleading certification.145 Moreover, with or without criminal or
civil liability, accusations of fraud could ruin insiders’ or gatekeepers’ reputations.146
Third, any increased likelihood of fraud from reducing securities law liability
must be compared with the costs of liability, including those of placing the risks of
141 Securities Exchange Act of 1934, §21D(b)(2).
142 See the legislative history of the Securities Litigation Uniform Standards Act of 1998, Pub.
L. No. 105-353, 112 Stat. 3227 (1998) (providing that the PSLRA is intended to adopt the Second Circuit
standard); Stern v. Leucadia National Corp., 844 F.2d 997 (2d Cir. 1988) (plaintiff must allege specific
facts that give rise to a ``strong inference'' that the defendants possessed the requisite fraudulent intent).
143 Id. §21D(f)(4).
144 See Cenco, Inc. v. Seidman & Seidman 686 F. 2d 449 (7th Cir.1982), cert. denied, 459 U.S.
880 (1982).
145 See Holland v. Arthur Andersen & Co., 469 N.E.2d 419 (Ill. App. 1984) (auditors not
entitled to dismissal of claim by bankruptcy trustee of insurance holding company).
146 See Sanjai Bhagat & Roberta Romano, Event Studies and the Law: Part I: Technique and
Corporate Litigation, 4 AM. L. & ECON. REV. 141 (2001) (finding that markets imposed penalties on
firms that were higher than criminal sanctions). See generally, Ribstein, supra note 47 (discussing
reputational bonding in law firms).
doing business on corporate agents.147 The market’s assessment of these costs may have
contributed to the positive stock price effects of the enactment of the PSLRA.148
To be sure, some may question the wisdom of leaving sanctions to state law or
extra-legal devices. In particular, some commentators are skeptical of the power of
reputational sanctions,149 and the threat of such sanctions obviously did not prevent the
recent corporate frauds. But it is important to keep in mind that the issue under
consideration is not whether federal liability for securities violations should be reduced,
but whether it should be increased from present levels. The recent corporate frauds do
not demonstrate that more penalties are appropriate, but rather that corporate insiders
may be willing to proceed in the face of potential reputational or other injury because
they were driven by strong impulses of loyalty, greed or fear, and failed realistically to
assess the risks of their conduct.150 It is unclear how more liability would have
succeeded where other constraints failed.
Whatever changes in liability might have been effective to stop future frauds, it
is unlikely that the marginal changes in Sarbanes-Oxley will accomplish this.
Lengthening the statute of limitations (§804) may open the door to a few good cases
that otherwise would have been blocked, but may also permit prosecution of suits that
should not have been brought because of stale evidence. For business people who were
not deterred from willful fraud by the thought of substantial jail sentences or fines
available under prior law, increasing jail terms or fines for mail, wire or securities fraud
(§§807, 903 and 1106) and imposing penalties for knowingly certifying false reports
(§906) do not seem to hold much promise.
The requirement of executive certification of issuers’ reports in §302 of the Act,

which probably has received more publicity than any other provision, seems to provide
an important incentive given its potential effect in triggering civil liability for
misstatements made with the requisite scienter. But even under prior law chief
executives and chief financial officers had to sign the annual 10-K and the latter had to
sign the quarterly 10-Q, with potential direct liability based on scienter.151 Thus, the
rule’s main innovation is requiring certification of, and therefore creating a basis of
liability for, not only financial information, but regarding the firm’s internal controls,
and the executives’ candor with the firm’s auditors and audit committee.152
147 See infra subpart III(C).
148 See Bhagat & Romano, supra note 106 at 400 (summarizing studies).
149 Ted Schneyer, Reputational Bonding, Ethics Rules, and Law Firm Structure: The Economist
as Story Teller, 84 VA. L. REV. 1777 (1998).
150 See supra subpart III(A).
151 See Howard v. Everex Corp., 228 F.3d 1057 (9th Cir. 2000).
152 Along the same lines, §303 provides for an SEC rule prohibiting fraudulently influencing or
misleading an auditor for purpose of rendering financial statements misleading. However, even before
Section 304 includes a kind of vicarious liability provision by requiring

executives to return compensation or stock profits following a misconduct-induced
accounting restatement. Notably, although the provision requires a showing of
“misconduct,” it does not require that the reimbursing executive have participated in the
misconduct, or that the amounts reimbursed relate to the accounting misstatement.
Although damages are limited to stock profits or compensation, this does not negate the
penalty aspect of the reimbursement. Thus, Section 304 expands executive liability.
The next subpart considers whether the costs of greater agent liability exceed the
benefits.
C. COSTS OF INCREASED LIABILITY AND REGULATION
Even if the regulatory moves discussed in Part II are more effective than might
be expected from the analysis in subpart B, it is important to consider the potential costs
of increased liability and regulation, including increasing agency costs by skewing
executives’ incentives to engage in value-maximizing transactions; encouraging
executives to move to less monitored firms and activities; increasing firms’ costs of
obtaining information about executives’ fraudulent activities; and increasing friction in
the organization by reducing trust.
1. Agency costs
Contracts in firms are designed to a significant extent to maximize the benefits

and minimize the costs of hiring non-owner agents. In order to operate efficiently, large
firms must separate capital-raising and control functions. The tradeoff is that non-owner
agents who control property have incentives to use their control to benefit themselves
rather than the owners. This generates what have been referred to as “agency costs,”
which include the owner’s costs of monitoring the agent, the agent’s cost of posting a
bond to protect the owner, and residual losses that agents impose on owners despite
monitoring and bonding.153 Optimal contracting in the firm involves minimizing these
costs without unduly reducing the benefits of using non-owner agents. Agents might be
made to behave just like owners – that is, residual costs would equal zero – but total
agency costs, including monitoring and bonding costs, might be quite high. Agency
costs could be reduced to zero by making the agents owners, but this would involve
sacrificing the benefits of specializing functions.
Designing firms’ contracts to maximize the net benefits of employing agents

obviously is a complex, multi-dimensional task that requires consideration of each
firm’s characteristics and that regulation can affect in unpredictable ways. This is
apparent from understanding the role of increased liability and regulation in the general
context of agents’ incentives.
A main benefit of hiring non-owner agents and thereby specializing ownership
the Act, SEC Rule 13b2-2 prohibit officer or director misstatements to auditors.
153
See Michael Jensen & William Meckling, Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976).
and management functions is to permit passive owners to invest in diversified

portfolios. Diversified owners can tolerate risks associated with specific firms, and care
only about the risks of their whole portfolios, which if adequately diversified are similar
to those of the market as a whole. Thus, a diversified investor should not be concerned
about the prospects of his umbrella investment in a dry year because that investor also
owns a bathing suit firm. This investor accordingly would not want his agent to be too
concerned about firm-specific risks. In other words, agency costs can be associated with
agent behavior that is too cautious as well as with behavior that is too risky from the
principal’s perspective. On the other hand, non-owner agents who do not bear even the
small burden of failure that is borne by diversified owners might have an incentive to
invest the firm’s assets in projects with poor expected returns. Optimal agency contract
design involves encouraging the agent to take the owners’ interests into account, but not
forcing the agent to bear so much of the firm’s risks that she is more cautious than the
owners would want her to be.
This general discussion suggests a potential problem with Sarbanes-Oxley

provisions that encourage executives to police their firm’s fraud, including §302 forcing
chief executives to vouch for their firms’ financial statements and internal controls, and
§304 requiring reimbursement of compensation and stock profits following accounting
misstatements. The former provision may permit liability on the basis of a court’s ex
post judgment that the executive certified controls that proved to be inadequate. The
latter explicitly provides for liability up to the amount of compensation or stock profits
for misconduct by others in the organization regardless of scienter, and indeed even if
the executives exercised all reasonable care in monitoring and instituting controls. The
provisions therefore require executives to bear some of the risk of fraud formerly borne
more cheaply by diversified investors. This may increase rather than reduce agency
costs in the sense of causing agents to act more conservatively than owners would
prefer.
Executives may respond in various ways to increased liability. They can bear the
risk themselves or insure it and seek compensation for the risk itself or the insurance
from the company. If the executives are protected and reimbursed in full, the liability
may have little effect on their incentives. On the other hand, even fully reimbursed
executives may act overly cautiously because of the risk of reputational harm.
Moreover, even if the executives’ incentives remain the same, the risk shifting may be
an extra cost to the firm to the extent that the executives or their insurers are less
efficient risk bearers than the diversified investors. That will probably be true for the
executives, and may even be true of the insurers if the firm itself would be better able
than the insurer to monitor its own executives. Thus, it is not surprising that directors’
and officers’ liability insurance is becoming significantly more expensive and less
available in the wake of Enron and WorldCom.154
154 See Tamara Loomis, D&O Insurance Not a Sure Thing, New York Law Journal, August 30,
2002, available on www.law.com; Christopher Oster, Directors' Insurance Fees Get Fatter, Wall St. J.,
July 12, 2002 at C1; Christopher Oster, Insurers Expected to Try to Deny WorldCom Officers' Coverage,
Wall St. J., July 1, 2002 at C14 (noting that “the recent rash of earnings restatements and accounting
problems has driven up rates for D&O policies”)
Laws that impose extra risks on executives who are not in a position readily to
spot fraud may cause executives to respond in several ways to reduce their risks of
liability.155 First, they may manage the firm to reduce the potential for liability. One
possible approach is to reduce the variance in its expected returns, thereby reducing the
chance of an earnings “surprise” that could trigger massive liability. The liability also
may affect the categories of transactions executives seek to engage in on behalf of the
firm. Because monitors and courts cannot determine with certainty whether a
transaction or the corporation’s monitoring and approval procedures are efficient, they
must rely on signals or proxies that may not be completely accurate. For example,
derivatives, insider transactions, SPEs and incentive compensation, may have been
abused in Enron but may serve valuable purposes in other settings.
Second, liability may perversely affect the disclosure policies executives set for
the firm. The general agency problem is that, while executives do not get the benefits of
minimizing disclosure costs or of extra clarity of disclosure, they bear the costs of
failing to disclose fraud. For example, executives may under-report earnings on the
theory that they are less likely to be held liable for overly conservative than for
exaggerated earnings reports,156 cover themselves by inundating investors with
information, or surround disclosures with obfuscating hedges and qualifiers. These
options would not necessarily better serve investors’ interests than managerial
inattention to fraud. And apart from the information that is actually disclosed,
executives may institute very costly information-getting procedures in the firm that
produce less value for investors than they do in protecting executives from the risk of
fraud liability.
The perverse effects of increased agent liability are exacerbated by regulation of

agent compensation. Stock-based compensation may have the positive effect of
aligning agents’ and shareholders’ incentives. Thus, researchers have found positive
share-price effects associated with the adoption of stock-based compensation.157
Conversely, regulating such compensation could cause corporate executives to behave
more like bureaucrats and less like entrepreneurs by reducing their benefits from risky
decisions that pay off for the firm158 and their incentive to work hard to produce
155 Increased liability may have analogous effects on audit firms. See Healy, supra note 10 at
37.
156 See E.S. Browning, Dow Industrials Decline After Soaring on Friday, www.wsj.com, July 9,
2002 (explaining market drop in part by noting that “some investors worry that new Securities and
Exchange Commission rules, requiring chief executives at the nation's largest companies to personally
endorse the company's financial filings and face punishment if the filings are false, could make some
companies file unexpectedly conservative numbers”). It is not clear why the market would fall if it
thought that accounting numbers were misleadingly low. The real problem is greater market risk from
less reliable information.
157 See Bhagat & Romano, supra note 106 at 409 (reviewing studies).
158 This effect of deterring entrepreneurialism in corporate management is enhanced by

increased procedural requirements for director decision-making under state law. See Jonathan R. Macey,
profits.159 Executive compensation always has been a tempting target for regulators
because concerns about harm to shareholders combine with populist antipathy to wealth
disparities.160 This concern was muted when markets were rising, but is emphasized in
falling markets when people seek to assign blame. For example, there have been calls
for increased scrutiny and regulation of executive stock options, and particularly for
requiring firms to account for these as expenses, like other compensation.161 Also,
Sarbanes-Oxley bans certain loans to executives, including loans for buying the
company’s stock. On the other hand, enabling insiders to share in the upside without
taking downside risk could help align their interests with those of the shareholders.
Excessive risk-aversion is always a problem with agents because, unlike shareholders,
agents invest their non-diversifiable human capital in the firm.162 It is especially a
problem now in light of executives’ increased liability risks discussed above in this
section.
2. Resource allocation
Increased liability and regulation may not only increase agency costs, but also
may affect the flow of resources to particular firms. Firms whose earnings are more
variable, that are in lines of business where the accounting standards are more
uncertain, or that use now-suspect business practices such as hedging and derivatives,
are all subject to increased liability risk. This effect is exacerbated by the possibility of
increased securities law and other liability for insiders, auditors and outside directors of
Smith v. Van Gorkom: Insights about C.E.O.s, Corporate Law Rules, and the Jurisdictional Competition
for Corporate Charters, 96 NW. U. L. REV. 607, 621 (2002) (noting that these rules deter
entrepreneurial-type individuals from serving on corporate boards).
159 This is particularly a problem regarding outside directors, who must take on new governance
responsibilities while facing new restrictions on compensation. See Robin Sidell, More Board Effort, But
Concern about Regulating Board Compensation, Wall St. J., August 30, 2002 at C1.
160 See Donald C. Langevoort, Rereading Cady, Roberts: The Ideology and Practice of Insider
Trading Regulation, 99 COLUM. L. REV. 1319, 1329 (1999) (noting that “envy and frustration at the
wealth and power of economic elites, and resulting mistrust . . . play a role” in insider trading regulation).
This is only one of many manifestations of envy and related emotions in public policy. See, e.g.,
HELMUT SCHOECK, ENVY: A THEORY OF SOCIAL BEHAVIOR (Michael Henry & Betty Ross
trans., Harcourt, Brace 1969); Mark J. Roe, Backlash, 98 COLUM. L. REV. 217 (1999).
161 See supra text accompanying note 54. Recording the expense of options is not entirely
straightforward, and arguably is more confusing than simply disclosing the amount of options in
footnotes to financial statements. See Robert L. Bartley, The Options-Accounting Sideshow, Wall St. J.
July 29, 2002 at A15; Don Clark, Discussion at Intel: the Two Theories of Stock Options, Wall St. J.,
August 8, 2002 at B1. As long as firms report the basic facts of the options, it would seem that efficient
securities markets should be able to discount the options’ dilution and other effects in stock price. But if
the disclosure rules are unduly complex or unclear, firms might face a risk of securities fraud liability,
which could discourage use of options.
162
See David Haddock, et al, Property Rights in Assets and Resistance to Tender Offers, 73 VA.
L. REV. 701 (1987).
firms whose disclosures are now subject to greater scrutiny. Other things being equal,
increased liability and regulation will reduce “suspect” firms’ value and ability to attract
financial and human capital. This is inefficient to the extent that these firms do not, in
fact, pose a significantly higher risk of fraud.
Increased liability risk may have two types of effects on the flow of human
capital. First, if reward remains constant while the risk increases, the affected jobs will
attract less risk-averse parties for whom the cost of risk is lower than the incumbents.
Second, the best executives who now head large firms may be enticed to companies that
can offer greater risk-adjusted rewards because they are not subject to full-fledged
disclosure regulation. This may inefficiently allocate to non-public firms managerial
talent that is best used in larger, more specialized firms. Also, firms in riskier industries,
with higher likelihood of liability, may be less able to attract managers.
Increased securities law liability risk also might affect firm structure. Sarbanes-
Oxley’s enhanced disclosure and other requirements in effect impose a tax on public
ownership of stock. Firms can avoid this tax by buying their shares and “going private,”
thereby freeing themselves of 1934 Act reporting requirements. Currently depressed
share prices make such transactions even more attractive. If the costs of being private
would outweigh benefits for a particular firm but for the liability risk, these can be
considered deadweight costs of the liability rules.163 Moreover, a trend toward going
private transactions could reduce market-wide liquidity in the sense of the available
choices of investment options. The effect might be exacerbated if going private
transactions were concentrated in particular industries that will have particularly high
liability and auditing costs under Sarbanes-Oxley. This effect would be ironic in light of
the law’s intent to lure investors back into the market.
Increased liability and regulation also might have significant effects on auditing
firms, with indirect effects on their clients. Forcing accounting firms to stop using audit
services to sell non-audit services to clients might increase the price publicly traded
firms must pay for audit services. Some might respond by hiring small firms, including
audit-only subsidiaries of traditional accounting firms, whose prices are lower because
they do not internalize the full cost of liability. This might lower overall auditing
standards, unless the new oversight of auditing firms required by Sarbanes-Oxley really
is effective. Also, new liability and regulatory constraints might make it harder for
auditing firms to attract the best people from jobs in investment banking, consulting and
other fields that pay more for the same skills.164 Reinstituting vicarious partner liability
for firm debts would help ensure auditor responsibility but would exacerbate the
potential brain drain from the auditing profession.165
163
Cf. Larry E. Ribstein, The Deregulation of Limited Liability and the Death of Partnership, 70
Washington Univ. Law Quarterly 417, 456-67 (1992) (discussing the costs of tax classification rules).
164 The SEC responded to this point in part by blaming firms for portraying auditing as less
exciting than other things accounting firms do. See Auditor Independence Requirements, supra note 50 at
__ . This ignores the real issue concerning financial incentives.
165 See Ianthe Jean Dugan, As Andersen Sinks, Staffers Find Job Prospects Are Scarce, Wall St.
3. Information costs
Post-Enron regulation has two kinds of effects on information costs. On the one
hand, the regulation directly increases firms’ costs in part by requiring them to spend
more to get information. In particular, new auditor regulation significantly increases
firms’ audit fees as well as their costs of dealing with and producing information for
auditors.166 Although firms may get more and better information, the question is
whether the increased benefits outweigh the costs.
The regulation also may indirectly increase firms’ costs of obtaining the same
quantity and quality of information by prohibiting business practices that, in effect,
subsidized information gathering and disclosure. The moves toward auditor and outside
director independence are intended to reduce job-preservation incentives for fraud by
severing other links between monitors and the monitored firm, as by prohibiting
consulting work by auditors or revolving doors between auditing and client firms,
requiring periodic change of auditors, or forbidding independent directors from having
other associations with or receiving other benefits from the company. The problem is
that monitors’ other links with firms increased their access to information. If the fully
independent monitor can duplicate the connected monitor’s information, requiring
greater independence just increases the firm’s cost of obtaining information. Regulation
and liability that impose higher standards of investigation on public firms forces these
firms and their investors to incur the cost. In that case, whether investors are better off
depends on whether higher investigation costs exceed the benefits of better monitor
incentives. In other cases, prohibiting some links between monitors and firms, such as
the performance of non-audit services, may block “knowledge spillovers” that give
monitors access to valuable information.167 Also, insiders might have less incentive to
shade the truth when dealing with consultants who help them do their jobs than when
dealing with auditors whose sole function is disclosure.168
There may be similar effects at the director level. The closer the relationship
between the director and the particular firm or industry, the more insight the director is
likely to have into the firm’s problems and the quality of the information the board is
receiving. This relates to the board’s ability not only to advise managers, but also to
uncover fraud. For example, directors with inside knowledge of the company may be
J., June 18, 2002 at C1 (discussing accountant who joined Andersen only after LLP statutes ensured
liability protection).
166
See Calmetta Coleman & Cassell Bryan-Low, Audit Fees Rise, and Investors May Pay Price,
WALL ST. J., August 12, 2002 at C1.
167See Antle, et al, supra note 131 (discussing and providing evidence of knowledge spillovers
between auditing and non-auditing services).
168 The SEC dismissed these concerns in its auditor independence release, arguing that these
points overlook the misincentives from non-audit work and that not all information from non-audit work
is used in audit work. See Auditor Independence, supra note 50 at __. But, as discussed in the Text, the
question is whether the increased information costs resulting from auditor independence outweigh the
benefits of increased auditor independence.
better able than more “independent” directors to see through ambiguous, opaque or
misleading financial statements because they have enough background to understand
the kinds of tricks insiders might be playing.
The costs and benefits of independence may vary from one situation to another.
First, some types of independence may have higher net benefits than others. Monitors
may have better or cheaper access to information if they perform other tasks for the
company, but not if they simply receive more compensation. Second, the amount of
information provided by monitors’ other links with firms may vary according to the
complexity or uniqueness of the firm’s business. Third, the cost-benefit tradeoff may
depend on how many levels of monitors the firm has. For example, it may make sense
to require complete independence at the auditor or director level, but the total costs of
independence may exceed the benefits if it is required at both levels. Thus, a fully
independent audit committee might provide the optimal mix of independence and
access without prohibiting non-audit services.169 These variables and uncertainties
support a flexible and contractual approach to regulation,170 including requiring
disclosure of but not otherwise regulating auditor independence.171
4. Distrust
The level of trust among those working in a firm can significantly affect the
firm’s operating costs by, among other things, increasing the flow of information among
personnel and the extent to which people in the firm are willing to rely on informal
assurances of reciprocal fair play rather than insisting on costly regulatory and
contractual protection.172 As discussed above,173 high levels of trust may disarm
monitors. On the other hand, mandating complete independence of monitors risks
creating an adversarial relationship between insiders and outsiders that may reduce both
the efficiency of day-to-day management and the monitors’ access to information.
First, requiring staffing of boards of directors by people with no other ties to the
169 The SEC rejected relying on audit committees rather than mandating auditor independence
because the purpose of audit committees “is not to set the independence standards for the profession.” See
id. at __. But rather than assuming that there should be a single professional standard of independence,
the question is whether the degree of independence suits the needs of individual audited firms. Moreover,
the SEC at least considered the tradeoff in not outlawing all combination non-audit services for audit
clients. Sarbanes-Oxley takes that next step.
170 See infra §III(C)(7) and subpart IV(D).
171 The SEC rejected a disclosure-only approach in favor of prohibiting combination of audit
and non-audit services “to the extent necessary to protect the integrity and independence of the audit
function.” See Auditor Independence, supra note 50 at __. Again, as discussed in supra note 169, the
relevant question is whether the benefits of independence outweigh the costs for the particular firm.
172 See generally Ribstein, supra note 4.
173 See supra §III(B)(2).

company may remove insiders who can assure executives that they will actually receive
the rewards the firm explicitly and implicitly promises them.174 Insiders confronted by
adversarial, outsider-dominated boards may insist on upfront, non-performance-oriented
compensation or move to insider-dominated firms. Also, executives who work for
outsider-dominated boards may spend time on self-promotion and political activities in
order to curry favor that they otherwise would spend more productively.175
Second, more monitoring and liability may work counter to their intended goals
by inhibiting detection and reporting of fraud. Discovering fraud depends on
communication among various levels of the organization which, in turn, depends to
some extent on trust. For example, a worker whose conduct was at least arguably
innocent or defensible in the light of applicable rules but nevertheless hurt the firm
might reasonably fear punishment by overly zealous monitors or whistle-blowers and
therefore may be reluctant to communicate with them.176
Third, insiders who are closely monitored may become less trustworthy, thereby
increasing the need for costly legal sanctions and constraints. Legal sanctions may
“crowd out” parties’ motivations to engage in trustworthy or benevolent behavior in the
absence of such sanctions.177 More monitoring and penalties also may change the
“social meaning” of behavior, with a similar result of making insiders less trustworthy
and increasing the need to rely on legal sanctions.178 For example, forcing insiders to
deal with adversarial outsiders might induce them to see their jobs as a kind of game, or
Dilbert comic strip, in which they must outwit clueless outsider directors, courts and
overly scrupulous auditors. On the other hand, fostering cooperation between insiders
and outsiders alters the connotation of behavior such as shading accounting numbers
from succeeding at a game to impeding the attainment of the firm’s legitimate
objectives. Finally, establishing stringent liabilities and close monitoring by outsiders
174 See generally, Donald C. Langevoort, The Human Nature of Corporate Boards: Law, Norms,
and the Unintended Consequences of Independence and Accountability, 89 GEO. L. J. 797 (2001)
(explaining why the board has insiders, since their expertise could be hired).
175 Id.
176 The next subsection discusses other costs of whistle-blowing and attorney reporting
obligations.
177 See Bruno S. Frey, NOT JUST FOR THE MONEY, 7-8 (1997); Iris Bohnet, et al., More
Order With Less Law: On Contract Enforcement, Trust, and Crowding (John F. Kennedy School of
Gov't, Harv. U., Fac. Res. Working Papers Series No. 00-009, 2000), available at http://
papers.ssrn.com/paper.taf?abstract_id=236476 (discussing experimental evidence showing that, if people
are allowed to interact in a low-enforcement environment, they became more trustworthy); Langevoort,
supra note 75 at 22-23; Ribstein, supra note 4 at 581.
178
See Lawrence Lessig, Social Meaning and Social Norms, 144 U. PA. L. Rev. 2181 (1996);
Lawrence Lessig, The Regulation of Social Meaning, 62 U. Chi. L. Rev. 943 (1995); Ribstein, supra note
4 at 582.
may deter trustworthy behavior by signaling that others are not trustworthy.179
To be sure, less trust may have the converse effect of increasing information.180
As with the other problems discussed in this subpart, finding the right balance between
trust and distrust in the firm is a complex, multidimensional problem that is unlikely to
be achieved by hasty, crisis-oriented, top-down regulation.
5. Inducing cover-ups
Insiders’ incentives may change once they have committed acts that can trigger
liability.181 At this point they enter a final term in which they are no longer motivated
by the firm’s long-term interests, or by their own interests in maintaining their careers
and reputations. Whether or not significant liability deters fraud, once agents have
committed the fraud the liability’s main effect may be increasing insiders’ incentives to
cover it up. This may be because either the risk-adjusted benefit of the cover-up exceeds
the risk-adjusted cost, or because agents embrace risk in a loss-avoidance context.182
6. Collateral organizational effects
At least two provisions of Sarbanes-Oxley may have significant costs within

firms apart from the effects discussed above that are remote from the concerns with
agency costs and fraud that are the focus of the Act and of this Article. First, the strong
protection afforded whistle-blowers (§806) in effect creates a new subtopic in
employment law. Workers who have been demoted or terminated for any reason now
have an incentive to “cause information to be provided” concerning a securities
violation to the SEC, Congress or “a person with supervisory authority over the
employee,” and those who are concerned about a potential demotion or termination
have an incentive to threaten such action. Litigation is likely over whether the employee
“reasonably believes,” the information shows a securities law violation and whether the
action against the employee was because of the whistle-blowing. But whatever courts
do, the new law obviously can give significant leverage to employees, including in
cases where the firm has good reason to take action against the employee. It is an open
question whether the benefits of exposing fraud will outweigh the disruptive effects of
179 See Margaret Blair & Lynn Stout, Trust, Trustworthiness, and the Behavioral Foundations of
Corporate Law, 149 U. PA. L. REV. 1735 (2001); Ernst Fehr & Simon Gächter, Reciprocity and
Economics: The Economic Implications of Homo Reciprocans, 42 EUR. ECON. REV. 845, 855 (1998);
Dan M. Kahan, Social Influence, Social Meaning, and Deterrence, 83 VA. L. REV. 349, 356 (1997)
(showing the effect of expectation that others will engage in criminal behavior); Peter H. Huang & Ho-
Mou Wu, More Order without More Law: A Theory of Social Norms and Organizational Cultures, 10 J.
L. ECON. & ORG. 390, 403 (1994) (showing how the expectation of corrupt behavior by others can
influence one’s own behavior); Langevoort, supra note 75 at 22; Ribstein, supra note 4 at 583.
180 See supra §III(A)(3).

this new form of job protection.
The provision for a rule requiring lawyers to “report evidence of a material

violation of securities law or breach of fiduciary duty or similar violation by the
company or any agent thereof” (§307) raises even more serious questions. The rule
obviously inhibits conversations between lawyers and the firm’s agents at all levels. In
this respect, as discussed in the preceding section, there is a tradeoff between the need
to encourage the flow of information among the firm’s agents and the need to ensure
that the information flows to the right place.
The rule also imposes new risks on lawyers, with further consequences for legal
representation of corporations. The rule requires the lawyer to report “evidence” of
wrongdoing, whether or not the lawyer concludes that such wrongdoing has occurred.
It also reaches beyond securities law violations to fiduciary breaches and “similar”
violations, whatever that means. Lawyers concerned about losing their privilege to
practice before the SEC, and thereby their livelihoods, will be inclined to interpret these
requirements liberally. The potential breadth of the requirement increases the risks, and
therefore the costs, of corporate legal representation. Moreover, in order to determine
whether they are looking at suspect “evidence,” lawyers may have to learn more about
the general context of the representation. This makes harder for firms to use boutique
firms for particular specialties, or divide work among major firms as Enron did in going
to Kirkland & Ellis to set up specific related entities. It also makes it harder for firms to
defer to accounting or other specialties, as Vinson & Elkins did in relying on
Andersen’s accounting. To be sure, in some cases the division of responsibilities may
have allowed fraud to escape through the cracks. But in other cases such division is
cost-justified.183
It is instructive to compare §307 with the more restrictive approach of Rule

1.13(b)-(c) of the Model Rules of Professional Conduct. Rule 1.13(b) requires
disclosure within the organization only where the act relates to that organization and the
lawyer “knows” of a potential act that “is likely to result in substantial injury to the
organization,” and requires the lawyer to “proceed as is reasonably necessary in the best
interest of the organization” giving “due consideration to the seriousness of the
violation and its consequences, the scope and nature of the lawyer’s representation, the
responsibility in the organization and the apparent motivation of the person involved,
the policies of the organization concerning such matters and any other relevant
considerations. Any measures taken shall be designed to minimize disruption of the
organization and the risk of revealing information relating to the representation to
persons outside the organization.” This language requires lawyers to exercise
professional judgment about reporting facts. Moreover, rather than simply being
required to report the act to a senior officer or director as under §307, the lawyer can
consider “asking reconsideration of the matter” or “advising that a separate legal
opinion on the matter be sought for presentation to appropriate authority in the
183 The new attorney disclosure rule may have the unexpected side effect of encouraging the
development and acceptance of multi-disciplinary law firms. Although the malfeasance of lawyers’
would-be accounting partners might seem to have made such firms less attractive, requiring lawyers to
have in-house accounting and financial expertise arguably also makes such firms more necessary.
organization.”
This rule was the product of a long debate within the bar, and survived a further
debate in the current round of revisions.184 When a group of 40 law professors wrote the
SEC in the spring of 2002 urging adoption of an attorney duty to report illegal conduct
to the board, the SEC rejected the move.185 Sarbanes-Oxley went further not only than
the ABA’s rule, but even than the rule proposed by the law professors, by requiring
report of “evidence” of misconduct that is not necessarily illegal. Thus, in the heat of a
market and regulatory panic, Sarbanes-Oxley leapt over both the ABA and the SEC in
radically reshaping the relationship between lawyers and their corporate clients.
7. Indeterminacy and mandatory rules
The above discussion does not establish that the Sarbanes-Oxley reforms are
wrong, but rather that there are significant questions concerning whether their benefits
outweigh their costs, including those of encouraging cover-ups, improperly allocating
risks within firms, requiring complete independence of multiple levels of monitors, and
instilling distrust. Also, the effects of many of the rules depend on firms’ size, business
needs and governance structure. These observations imply that regulation should be at
the state, rather than federal, level.186 Assuming the rules are federal, they might be
default rules subject to variation by individual firms. Thus, for example, the initial form
of the attorney disclosure rule proposed by its main advocate would have permitted
firms to elect alternative approaches.187
D. POLITICS OF REFORM
Sarbanes-Oxley emerged under circumstances that virtually ensure against the

sensitive cost-benefit tradeoff that the above analysis shows is necessary. First, those
who see corporate fraud as a wedge to push a broader regulatory agenda applied
significant pressure in favor of regulation. Corporate fraud helps Democrats by
discrediting Republican deregulatory and anti-tax policies and the pro-business Bush
administration on the eve of the November, 2002 Congressional elections. Republicans,
for their part, risked compromising their broader agenda by appearing to side with
corporate criminals.188
184 The Model Rules of Professional Conduct were revised in 2002. See
http://www.abanet.org/cpr/e2k-rule113.html.
185 The letter to Chairman Pitt of March 7, 2002 and ensuing correspondence are available at
http://www.abanet.org/buslaw/corporateresponsibility/responsibility_relatedmat.html.
186 See infra subpart IV(D).
187 See Richard W. Painter & Jennifer E. Duggan, Lawyer Disclosure of Corporate Fraud:
Establishing a Firm Foundation, 50 SMU L. REV. 225, 263, 266-72 (1996).
188 See, e.g., Jim VandeHei & David S. Hilzenrath, Corporate Crime Bill Sent to Bush, WASH.
Second, the political parties’ general goals mesh to some extent with those of
specific interest groups. For example, large, established issuers, law and accounting
firms will tend to find it easier to comply with new regulations than smaller or newer
firms. Some parties gain from corporate frauds, including the “monitoring” industry of
large law firms and others who are hired to investigate corporate frauds and defend the
accused.189
Third, public perceptions contribute to this political environment. Revelations of

corporate fraud coincided with public anxiety over the economy, and populist
sentiments condemning the insiders who took great wealth out of now-fallen
companies. More importantly, just as judgment biases supposedly can make investors
tend to underestimate risks in a rising or bubble market,190 so can they lead investors
and the public generally to overestimate risks and the need for regulation in a falling
market. Thus, the same problems that arise in promulgation of safety and health
regulation191 are also relevant to regulation of corporate fraud. For example, the
“availability heuristic,” where saliency of a story in the news media can lead the public
to exaggerate the risk, can apply to stories about corporate fraud just as they can to
stories about nuclear power accidents. Also, public opinion about the need for
regulation might be shaped by “cascade effects” in which others are observed
expressing the same opinion, “reputation effects” in which people are reluctant to
express minority opinions, and by an emotional response to risk.192 These effects are
exacerbated by the media’s profit incentive to sell the story of corporate fraud as a
continuing saga of wrongdoing that readers or viewers follow everyday rather than as
discrete events.
Public perceptions of risk may have played a particularly potent role in

enactment of Sarbanes-Oxley. The political arguments for regulation in Congress
apparently echoed in the precipitous July 20% drop in stock prices on record-setting
volume prior to enactment.193 This is arguably confirmed by the short-term recovery
POST, July 25, 2002 at __ (noting that “Republicans, who as recently as yesterday were provided private
polling data showing that business scandals are eroding some of their support, have pushed hard for quick
votes on legislation cracking down on corporations, especially as Democrats are trying to make the issue
a central theme for this fall's House and Senate elections”).
189 See Richard B. Schmitt, Lawyers' Growth Industry: Corporate Probes, Wall St. J., June 28,
2002 at B1.
190 See supra text accompanying notes 81-82.
191See generally, Cass R. Sunstein, Cognition and Cost-Benefit Analysis, 29 J. LEG. STUD.
1059 (2000); Cass R. Sunstein, Availability Cascades and Risk Regulation, 51 STAN. L. REV. 683
(1999).
192See id. See also, Hahn & Dudley, supra note 98 (describing similar phenomena relating to
public demand for regulation of cell phone use by automobile drivers).
193 This would not be the first time that a credible case could be made for a politically induced
stock market crash. Enactment of the Smoot-Hawley trade tariff may have contributed to the October,
following enactment.194 To be sure, regulated entities such as auditors or executives

may have enough clout to defeat significant increases in liability or regulation of
compensation,195 including by disseminating information as to costs and benefits.196 For
example, requiring expensing of stock options was defeated in the Senate after heavy
corporate pressure against it.197 But these forces may not be enough to prevent over-
regulation. Some firms may favor regulation that confers competitive advantage,198 and
entire industries may support regulation to appease public passions that can lead to even
stricter regulation.
Finally, the hasty adoption of Sarbanes-Oxley in the midst of a stock market

crash was even less conducive than the circumstances surrounding typical legislation to
careful weighing of costs and benefits. By contrast, the original federal securities laws
were enacted years after the 1929 Crash, following extensive hearings. Sarbanes-Oxley,
among other things, reversed decisions made in more deliberative settings on such
important issues as auditor independence and attorney reporting of fraud.
IV. MARKET RESPONSES TO CORPORATE FRAUD

The above discussion shows that potential regulatory responses to corporate
fraud, including those which have been suggested so far, are unlikely to do much good
and may do harm. At the same time, it seems clear that the frauds have increased the
general level of market risk and accordingly reduced market valuations, other things,
including corporate earnings, remaining constant. Since markets seem to have failed,
regulation might seem to be worth trying even if it is unlikely to help.
1929 crash. See Note, Jason Luong, Forcing Constraint: The Case for Amending the International
Emergency Economic Powers Act, 78 TEX. L. REV. 1181, 1189 (2000); Editorial, Not What the World
Needs, Wall St. J., Feb. 2, 1999, at A22, available in 1999 WL 5439181. Also, plans to eliminate
deductibility of interest on takeover-related loans may have sparked the October, 1987 crash. See Mark L.
Mitchell & Jeffrey M. Netter, Triggering the 1987 Stock Market Crash: Antitakeover Provisions in the
Proposed House Ways and Means Tax Bill?, 24 J. FIN. ECON. 37 (1989); Roberta Romano, A Guide to
Takeovers: Theory, Evidence and Regulation, 9 YALE J. ON REG. 119, 173 n.214 (1992).
194 If so, this signals the additional problem that the Act will mislead investors into
complacency. See supra text accompanying note 98.
195 See Gary S. Becker, A Theory of Competition Among Pressure Groups for Political
Influence, 98 Q. J. ECON. 371 (1983); Gary S. Becker, Public Policies, Pressure Groups, and Dead
Weight Costs, 28 J. PUB. ECON. 329 (1985).
196 See Gary S. Becker, A Comment on the Conference on Cost-Benefit Analysis, 29 J. LEG.
STUD. 1149 (2000); John M.P. De Figueiredo, Lobbying and Information in Politics, Harvard Law and
Economics Discussion Paper No. 369 (June, 2002), available at
197 See Helen Dewar and David S. Hilzenrath, McCain Accounting Proposal Scuttled
Senate Rejects Listing of Stock Options as a Corporate Expense, Wash. Post, July 12, 2002 at A1.

But before adopting regulatory solutions it is necessary to consider the

feasibility of market-based responses. This Part shows that market-based approaches
have high prospects of success now that the risks of defective accounting have become
as obvious to market participants as they have become to politicians and regulators.
Indeed, it was markets and not regulators that uncovered the problems and adjusted the
share prices of offending companies, while years of regulation of securities disclosures
and of the membership of boards of directors failed to prevent the frauds. In other
words, dishonest insiders were able to outrun the kinds of monitors that regulators
favor, but not, ultimately, the markets.
If markets can react, there are significant benefits to allowing them to do so.
Market actors are likely to be better informed and motivated than regulators. Markets
also lead to a variety of competing solutions. As long as these solutions are evaluated in
liquid securities markets, the most efficient solutions are likely to dominate, and firms
can pick the approaches that best suit their particular circumstances. A political or
regulatory approach will pick a particular approach that may not be the most efficient
overall for the reasons discussed in subpart III(D), and may be unsuitable for many
firms.
Although market responses are likely to be imperfect, it is necessary to compare

market with regulatory imperfections, rather than unrealistically assuming that only
markets are flawed. Moreover, it is important to keep in mind that markets have been
constrained by past regulation, particularly including of takeovers and of insider
trading. Although repeal of this regulation may be politically infeasible amid calls for
more regulation of the securities markets, it is worth reflecting on the contribution of
past regulation to current problems when considering whether additional regulation is
appropriate.
This Part discusses several potential market-type responses to corporate fraud:

relying on newly alerted markets to police corporate frauds (subpart A); signaling by
honest firms to differentiate themselves from dishonest competitors for capital (subpart
B); more shareholder policing of firms (subpart C); and competition by multiple
regulators, including states and securities exchanges (subpart D).
A. MARKET SCRUTINY
Most of the corporate frauds that have been exposed so far left tracks in the
public record that observant market watchers noticed before they caught the public’s
eye. For example, in February, 2001, long before the disclosures of fall, 2001, a hedge
fund manager named Jim Chanos, had figured out that Enron had become a derivatives
speculator with unhedged investments.199 Fundamental risks of Enron’s business,
particularly including its susceptibility to competition in the various markets it was
entering, and the implausibility of the assumptions underlying its market valuation,200
199 See Jonathan R. Laing, The Bear That Roared: How short-seller Jim Chanos helped expose
Enron, available at http://online.wsj.com/barrons/article/0,4298,SB101191069416063240.djm,00.html.

were obvious to astute observers. Moreover, footnotes to financial statements disclosed

the basic facts, if not the details, of its potential exposure to debts incurred by special
purpose entities.201
This discussion indicates that the market can significantly reduce its
vulnerability to fraud simply by paying closer attention to warning signs. This might
include watching for discrepancies in firms’ figures, reading fine print such as financial
statement footnotes, and relying on “harder” numbers such as free cash flow that are not
affected by firms’ decisions on capitalizing and amortizing expenses. Markets also can
observe firms’ vulnerability to and methods of monitoring fraud, such as relationships
with auditors. For example, a recent study showed not only that firms have a greater
tendency to “manage” earnings the more non-audit services they bought from their audit
firms, but also that investors tended to devalue firms that disclosed unexpected
purchases of non-audit services.202 Market skepticism is more likely now that investor
biases have moved from over-optimism203 to excessive pessimism.204 In the current
environment, firms, analysts, auditors and others have a strong incentive to signal their
integrity and independence, as discussed below in subpart B.
Although market scrutiny of corporate conduct can increase without changes in

the law, the level of market scrutiny is affected by past regulation. Regulation’s
perverse effects in this regard counsel caution about the desirability of additional
regulation. An example is Regulation FD, which the SEC promulgated in August,
2000.205 This rule requires firms that disclose material nonpublic information to
securities analysts to publicly disclose the same information simultaneously or
promptly. The strongest argument for the Regulation is that it reduces the chance of
analyst complicity in corporate fraud. The SEC argued in its proposing release that the
rule would reduce firms' incentive to “delay general public disclosure so that they can
selectively disclose the information to curry favor or bolster credibility with particular
analysts or institutional investors,” and analysts' incentive "to slant reports in order to
maintain access" to disclosing firms' information.206 Moreover, the Regulation
technically leaves corporate insiders free to disclose material information broadly to the
market, and to continue private discussions with analysts as long as they do not disclose
material non-public information. In any event, the Regulation might seem to have no
effect on disclosure of corporate fraud, which insiders would have no incentive to
201 See Bratton, supra note 6 at __.
202 See Richard M. Frankel, et al, The Relation Between Auditors' Fees for Non-Audit Services
and Earnings Quality, MIT Sloan Working Paper No. 4330-02 (January 2002), available at
205 Securities Act Rel. No.7881, Aug. 15, 2000.
206 See SEC Release No. 33-7787, 71 SEC Docket 732 (Dec. 20, 1999).
disclose voluntarily to analysts.
The actual effect of the Regulation, however, may be to reduce analysts’ ability
to uncover fraud.207 First, selective disclosure of material information is an important
tool for disclosure of general information about firms that even honest firms would not
disclose more broadly. Firms can disclose valuable intellectual property to trusted
analysts without concern that the analysts will reveal the information to competitors.
They can also disclose pieces of information that individually are subject to
misinterpretation but together, in the hands of an analyst who follows the company
closely, reveal a complete and accurate picture, or “mosaic.” Commissioner Laura
Unger’s Special Study on Regulation FD208 noted that firms’ concern about the limits of
materiality under the Regulation and of making a mistake that could trigger at least an
SEC enforcement action has caused them to shift oversight of disclosure from pro-
disclosure investor relations departments to more conservative legal departments. This
may have kept out of analysts’ hands information that would have enabled them to
piece together more complete pictures of the business prospects of the firms they are
covering. Indeed, the Unger study summarized analyst surveys generally concluding
that Regulation FD has reduced the flow of information.
Second, private disclosure to analysts encourages them to formulate and ask

follow-up questions that they would not ask in public calls because it would reveal their
research to competitors. Thus, even if the Regulation did not affect what companies
were willing to disclose to analysts, it may have limited analysts’ ability to process the
information.
Third, Regulation FD may have increased insiders’ ability to hide from inquiring
analysts. Before the Regulation, failure to confront an analyst who was following the
company might have triggered negative inferences about what was happening in the
company. The Regulation gave insiders a legitimate excuse for avoiding analysts,
thereby making it easier for firms to hide accounting and other problems. The
Regulation was promulgated in August, 2000, just as the bull market was ending and
firms started to have strong incentives to manipulate their accounting in order to
maintain their earnings increases and the high stock prices that depended on those
increases. Thirty years ago, Ray Dirks broke the notorious Equity Funding scandal with
information he obtained from a corporate insider because of his position as a leading
insurance company analyst – a disclosure that the Supreme Court ultimately decided did
207 For generally skeptical accounts of Regulation FD, see Stephen J. Choi, Selective
Disclosures in the Public Capital Markets, 35 U. C. DAVIS L. REV. 533 (2002); Larry E. Ribstein,
Enron and Regulation FD, 5 SECURITIES REGULATION UPDATE, issue 13 at 1, July 8, 2002; Larry
E. Ribstein, SEC "Fair Disclosure" Rule is Constitutionally Suspect, 10 WASHINGTON LEGAL
FOUNDATION LEGAL OPINION LETTER no. 17 (October 6, 2000). For more favorable accounts,
see Fisch & Sale, supra note 62; Langevoort, supra note 70 at __ (emphasizing the problem of analyst
conflicts and doubts about the quality of analysts’ work).
208 SEC Special Study on Regulation FD (December, 2001).

not violate the securities laws,209 but that may now violate Regulation FD. Someone
like Jim Chanos210 might well have served a similar function in revealing the Enron
fraud. Even analysts who had once tied their fortunes to Enron eventually might have
come to see that independence would serve them better, as they do now in the wake of
Enron’s collapse.
In general, therefore, Regulation FD may inhibit analysts from being part of the
solution to the problem of inadequately informed securities markets. The alternative of
liability and disclosure rules that seek to force the information out of insiders has its
own costs.211 To be sure, the Regulation addresses a real problem of analyst conflicts of
interests by reducing corporate insiders’ ability to “buy” analyst support. But it is not
clear that the rule’s benefits outweigh its costs for all firms to which the rule applies.
Thus, this may be another respect in which the rule should be left to firm-specific
contracts.212
Regulation FD can be seen as part of a misguided SEC strategy of insider

trading regulation that has hobbled markets’ ability to scrutinize corporate misconduct.
From the earliest days of SEC regulation of insider trading, the Commission has sought
“fairness” in the securities markets.213 Chairman Arthur Levitt justified Regulation FD
partly by the need to "bring all investors, regardless of the size of their holdings, into
the information loop" – that is, to promote fair disclosure, consistent with the rule’s
initials. This links with the SEC’s pursuit of parity of information in its rationale for
substantially expanding insider trading liability in its Cady, Roberts administrative
proceeding,214 the Texas Gulf Sulphur litigation215 and in its arguments in the Supreme
Court cases culminating most recently in O’Hagan.216 The search for parity of
information in securities markets is Quixotic. If some group, such as insiders or
analysts, loses priority, another inevitably steps to the head of the line.217 More
209 See Dirks v. SEC, 463 U.S. 646 (1983).
211 See supra subpart III(C).
212 See supra §III(C)(7).
213 See Langevoort, supra note 160.
214 40 SEC 907 (1961).
215 SEC v Texas Gulf Sulphur Co., 401 F2d 833 (2d Cir 1968) (en banc).
216See U.S. v. O’Hagan, 117 S Ct 2199 (1997); Dirks v. SEC 463 US 646 (1983); Chiarella v.
U.S, 445 US 222 (1980).
217 See David D. Haddock & Jonathan R. Macey, A Coasian Model of Insider Trading, 80 NW.
U. L. REV. 1449 (1986).
importantly for present purposes, forcing sharing of information necessarily weakens

incentives to gather and create the information.218 The best hope for countering insiders’
strong incentives to hide their misconduct is unleashing well-motivated information-
suppliers who can profit from uncovering it.
Parity-of-information regulation reflects a still broader, and equally misguided,

regulatory philosophy of protecting and encouraging active securities trading. The
SEC’s main current justification for promoting “fairness” is that market makers increase
bid-ask spreads in the presence of information asymmetries, thereby increasing the cost
and reducing the amount of outsider trading.219 Under this theory, insider trading
regulation is not aimed at protecting outsiders, since they are paid through the bid-ask
spread for any increased risk they are taking in trading with outsiders. This specifically
applies to Regulation FD, since there is evidence that bid-ask spreads increase during
firms’ closed analyst calls.220 However, the social welfare implications of any additional
trading encouraged by insider trading regulation are unclear. While additional liquidity
adds more traders’ judgments to the mix, these judgments probably contribute more
noise than information,221 particularly in the bubble market that culminated in 2000.
Thus, the benefit of parity-of-information regulation aimed at increasing outsider
trading may not be worth the costs in reduced information production. Indeed, this
policy may have helped create the conditions that allowed fraud to flourish by
encouraging uninformed and unsophisticated investors to trade on speculation and
overconfidence in their own acuity.222 In short, Regulation FD is more likely to be
explained by the SEC’s interest in seeking broad public support for its work than by any
social welfare benefit.
Regulation may have perversely affected market scrutiny in another way, by

creating accounting techniques that were ripe for abuse. Forcing competition in
218 See generally, Frank H. Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges
and the Production of Information, 1981 S Ct Rev 309. Misappropriation liability, as in O’Hagan,
arguably protects these property rights. But protection and creation involves sensitive balancing, better
left to contracts enforced by state law.
219 See Larry E. Ribstein, Federalism and Insider Trading, 6 SUP. CT. ECON. REV. 123 (1998)
(discussing the SEC’s use of this theory in O’Hagan).
220 See Shyam V. Sunder, Investor Access to Conference Call Disclosures: Impact of Regulation
Fair Disclosure on Information Asymmetry (May, 2001), available at
221 See Hayne E. Leland, Insider Trading: Should it Be Prohibited, 100 J. POL. ECON. 859
(1992).
222See Langevoort, supra note 70 at __ (discussing “myth” of desirability of encouraging

trading by the retail investor). For other criticisms of policies encouraging trading by unsophisticated
investors see Henry T.C. Hu, Faith and Magic: Investor Beliefs and Government Neutrality, 78 TEX. L.
REV. 777 (2000); Lynn Stout, Are Stock Markets Costly Casinos?:Disagreement, Market Failure and
Securities Regulation, 81 VA. L. REV. 611 (1995).
telecommunications meant having incumbent carriers provide access to their markets

for non-market-driven costs.223 This reliance on regulatory rather than market-
determined costs invited the use of opaque accounting methods. If markets had been
left to provide the relevant metrics, the playing field would have been clearer and
success and failure easier to determine.
Finally, it is important to be wary of regulation based on the need to restore

investor “confidence.”224 In the short run this claim seems to be supported mainly by
the apparent panic at the time of the passage of Sarbanes-Oxley. Yet this panic itself
might have had a political origin.225 More importantly, over the longer run, the investor
confidence rationale depends on complex judgments about perceived compared to
actual market risk, the effect of various regulatory approaches, the benefits of additional
investor confidence, and the costs of the law’s requirements and liabilities.226
Moreover, even if lack of confidence is keeping investors out of the market, it is

not clear that regulation should bring them back in unless it actually justifies greater
confidence. Sarbanes-Oxley may justify little confidence because it makes only
incremental changes in prior law.227 Corporate frauds arguably were facilitated because
there was too much investor confidence, as indicated by investors’ willingness to ignore
what the market knew about questionable accounting and to question firms’ extravagant
claims about unproven business plans.228 Overselling regulation might perpetuate this
misjudgment and mislead investors back into the same complacency that contributed to
the recent frauds.229
By contrast, a new stress on market risks and investor education could

encourage the development of a more sophisticated market.230 Rather than betting their
223 See Peter Huber, Washington Created WorldCom, Wall St. J., July 1, 2002 at A14.
224 See, e.g., Stout, supra note 95.
225 See supra text accompanying 193.
227 See supra subpart III(B).
229 This problem has been noted even by those favoring Enron-related regulation. See
Langevoort, supra note 76 at 35 (observing that the SEC must try “to persuade investors that the issuers
are honest enough to justify broad and confident public participation without committing its own version
of a fraud on the market”); Stout, supra note 95, at __, n. 61 (noting but deferring discussion of the
potential problem of excessive investor trust).
230 For an example of the kind of investor education efforts that might supplement or replace
direct regulation, see Securities and Exchange Commission, Analyzing Analyst Recommendations (June
20, 2002), available at http://www.sec.gov/investor/pubs/analysts.htm.
savings and retirement funds on single stocks, particularly including their employers in
which they had already invested their careers, investors are better off diversifying their
investments, as they seem increasingly to be doing.231 The market crash also might
encourage investors to seek investment advice in various forms, including managed, as
distinguished from index, mutual funds rather than speculating based on fads or the
pronouncements of the latest hot analysts. A more sophisticated market will provide
less fertile ground for future corporate frauds.
B. SIGNALING
Advocates of more regulation would argue that the securities market is now one
for “lemons” that investors would tend to avoid because they cannot distinguish the
quality products from the defective ones. This is a reference to the theory of George
Akerlof, who shared the 2001 Nobel Prize for Economics.232 Notably, however, the
Prize also was awarded to Michael Spence and Joseph Stiglitz for work concerning
market responses to this problem, particularly including signaling by potential sellers to
avoid being classed with lemons.233 In securities markets, issuers have strong incentives
to demonstrate to investors, consumers, creditors, potential employees234 and others that
they are not like Enron and WorldCom. This is particularly the case for firms using
now-suspect devices such as derivatives and special purpose entities. Firms can signal,
among other ways, by maintaining a high level of voluntary disclosure,235 including
through meetings with and disclosures to securities analysts and the media,236 or by
voluntarily adopting reforms such as expensing stock options, as several companies
have done.237
Auditors also can signal the objectivity and care of their services by, for
example, clearly separating audit and non-audit services or getting out of the non-audit
231 See Jane J. Kim, Investors Heeding Planners’ Advice to Diversify, Wall St. J., July 3, 2002 at
D2.
232 See Akerlof, supra note 36.
233
See, e.g., A. Michael Spence, MARKET SIGNALING: INFORMATIONAL TRANSFER IN
HIRING AND RELATED PROCESSES (Harvard 1974).
234 See Joann S. Lublin & Carol Hymowitz, No Thanks: Fearing Scandals, Executives Spurn
CEO Job Offers, Wall St. J., June 27, 2002 at A1 (noting that companies have to compete for credibility
in executive recruitment market and that CEO candidates are hiring due diligence experts).
235 Firms can bond the quality of their disclosure by choosing to be subject to regulatory regimes
that require high levels of disclosure. See infra note 276 and accompanying text.
236See Holman W. Jenkins, Jr,, One CEO’s War for “Investor Confidence, Wall St. J., July 3,
2002, at A11 (discussing actions of firm accused of misleading accounting in dispelling market doubts).
237 For a current list, see http://online.wsj.com/documents/opting_in.htm (subscription required).

business. Alternatively, issuers can compete in the way they purchase audit and non-
audit services. Issuers can signal the markets about the honesty of their books by, for
example, not buying non-audit services from the same firms that audit their books and
periodically switching audit firms. Notably, they will do this not just because they are
ordered to do so by independent audit committees, but because the securities markets
demand it.
Insurance can be an important method of signaling, in which the size of the

premium reliably indicates the extent of the insured risk. Insurance is a particularly
useful signal because of insurers’ strong incentives to be accurate in setting premia, and
because firms have non-signaling incentives to buy insurance. There is evidence that the
premium a company pays for directors’ and officers’ liability insurance accurately
indicates the quality of a firm’s governance arrangements.238 Premia in the so-called
“credit-default-swap” market, in which debt-holders effectively insure against default,
recently have appeared reliably to indicate increasing risks associated with debtors.239
Issuers also might signal honesty by buying “financial statement insurance,” where the
insurance carrier hires the auditor and provides the signal.240
The potential for signaling may not only reduce the benefits of regulation, but
also may increase its cost. Mandatory governance rules reduce firms’ ability to signal
quality by choosing governance forms, auditors, disclosure methods and so forth. If
these mechanisms have significant benefits for investors in all companies, and if firms
have inadequate incentive to signal, then the costs of allowing opting out might exceed
the benefits of effectuating signaling. But if firms have incentives to signal quality and
regulation is excessively burdensome for some firms, then the availability of signaling
is an argument against regulation.
C. SHAREHOLDER MONITORING AND TAKEOVERS
Firms are subject to scrutiny not only by various capital and other markets, but
also by their own shareholders. Shareholders do not need to wait for corporate managers
or regulators to decide that firms need protection from fraud. First, institutional
shareholders can press for these changes through direct communication with managers,
as TIAA-CREF has done regarding expensing of stock options, and through shareholder
238 See John E. Core, The Directors' and Officers' Insurance Premium: An Outside Assessment
of the Quality of Corporate Governance, 16 J. L. ECON. & ORG. 449 (2000) (showing significant
association between D & O premia and proxies for the quality of firms' governance structures, confirmed
by positive correlation between firms’ insurance premia and excess CEO compensation). It arguably
follows that U.S. firms should be required to disclose D & O insurance premia, like the Canadian firms in
the foregoing study. Yet Treasury Secretary O'Neill initially set out in precisely the opposite direction, in
suggesting that executives not be permitted to insure against securities liability. See Bob Davis, O’Neill
Wants Stiffer Penalties for CEOs, Wall St. J., February 4, 2002 at A2.
239 See Henny Sender, The Early-Warning Signal for Stock Trouble, Wall. St. J., July 17, 2002
at C1, col. 2.
240 See Julius Cheney, et al, Financial Statement Insurance, (March 2002).
proposals through which the shareholder can gather support from other shareholders.
Even if private institutions do not gain enough from such moves to invest significant
resources in them, managers of public funds have political incentives to do so.241 In
light of the political salience of the issue, firms’ managers likely would respond
positively to high-visibility institutional holders like TIAA-CREF and to shareholder
proposals receiving significant, even if minority, votes. The proposals could serve as
firm-by-firm referenda testing the level of shareholder acceptance of various
alternatives, by contrast with federal laws or SEC rules imposed on all firms.
Aggregation of shares in institutional holders may increase because of the declining
confidence of amateur investors discussed in subpart A.
Second, and more importantly, there is a theoretical potential for monitoring by

outside bidders for control. Bidders have the sort of high-powered, profit-driven
incentives that independent directors, auditors and analysts may lack. Even insiders in
firms that are never subject to hostile bids may be less likely to take excessive
compensation or to engage in fraud if they know potential hostile bidders are watching
them.242 Among other things, bidders for control could buy firms that have hired low-
quality auditors, directors or managers, fire the monitors and hire new ones, and pocket
the resulting difference in the share price.
A problem with relying on hostile takeovers for monitoring is that takeover

regulation has eased the threat of such takeovers. Indeed, this regulation may help
account for the recent corporate frauds.243 Extensive regulation began in 1968 with the
Williams Act, which imposed disclosure requirements on bidders and required them to
structure their bids to give incumbent directors time to defend. This reduced potential
gains from risky hostile bids, and therefore takeovers’ effectiveness as a monitoring
device.244 Despite the Williams Act, there was a takeover boom in the 1980’s facilitated
by Michael Milken’s ability to quickly assemble massive financing and to count on the
241 See Roberta Romano, Public Pension Fund Activism in Corporate Governance
Reconsidered, 93 COLUM. L. REV. 795 (1993); Randall S. Thomas & Kenneth J. Martin, Should Labor
Be Allowed to Make Shareholder Proposals? 73 WASH. L. REV. 41 (1998).
242 Firms like WorldCom were subject to a different sort of scrutiny in that they used their
shares to make acquisitions and so were investigated by owners and managers of acquired firms. For
example, Ronald Perelman, who owned a company (Coleman) that Sunbeam acquired with its stock, led
shareholder litigation against Sunbeam. However, these shareholders may not have enough power to do
anything about mismanagement and therefore may have little incentive to discover and report fraud. For
example, the WorldCom board consisted mainly of directors and executives from acquired firms,
including MCI, who proved to be ineffective in spotting the accounting fraud or disciplining the
mismanagement.
243 See Henry G. Manne, Bring Back the Hostile Takeover, Wall. St. J. June 26, 2002 at A18.
244 See Daniel R. Fischel, Efficient Capital Market Theory, The Market for Corporate Control
and the Regulation of Cash Tender Offers, 57 TEX. L. REV. 1 (1978); Henry G. Manne, Cash Tender
Offers for Shares—A Reply to Chairman Cohen, 1967 DUKE L. J. 231.
support of arbitrageurs, notably including Ivan Boesky.245 Formation of these networks

may have depended to some extent on Milken’s being able to share information about
his moves with others. This detour around the Williams Act was closed with
prosecution of Milken for a technical violation of the Williams Act, and with adoption
of SEC Rule 14e-3, which covered disclosures of information about impending
acquisitions.246 State regulation of takeovers further limited their effectiveness, mainly
by authorizing directors to adopt very effective poison pill-type defenses without
shareholder approval.247
Takeover regulation therefore has substantially diluted firms’ agency-cost-

control arsenal, forcing them to resort to second-best incentive devices and control
mechanisms.248 The increased profit orientation that arose from the 1980’s takeover
boom collided with the lack of market discipline brought on by the takeover regulation
of the late 1980’s and early 1990’s. The greater efficiencies created by, among other
things, corporate downsizing and the increasing use of technology, together with the
hype of the dotcom boom, initially produced enough profits, or at least high enough
stock prices, to cover any weakened discipline. But as the boom ended, the effects of
weakened discipline started to show through.
The cure would seem to be to resurrect takeovers as a viable monitoring

mechanism. While this is probably politically infeasible in the current environment, this
discussion teaches a lesson about regulating corporate governance that suggests caution
in responding to the recent corporate frauds. Takeover regulation was supposed to be
the solution to the last problem of excessive job insecurity for managers and workers.
But tinkering with corporate governance in response to this problem may have helped
create the conditions for the next crisis of corporate fraud. The lesson is that additional
market regulation may have unforeseeable perverse effects and should be approached
with caution rather than embraced in panic.
245 See Connie Bruck, THE PREDATORS’ BALL (1988).
246 17 CFR § 240.14e-3. The Court in O’Hagan expressly left open whether that rule exceeded
the SEC’s authority to the extent that it barred trading on takeover-related information that was
authorized by the bidder. See 117 S. Ct. at 2217 n 17.
247 With respect to shareholder authorization, see generally Larry E. Ribstein, Takeover
Defenses and the Corporate Contract, 78 GEO. L. J. 71 (1989). The current issue in this respect is
whether shareholders should be able to amend the bylaws on their own initiative to eliminate poison pills.
See International Brotherhood of Teamsters v. Fleming Companies, 1999 WL 35227 (Okla., Jan. 26,
1999); Lawrence A. Hamermesh, Corporate Democracy and Stockholder-Adopted By-Laws: Taking Back
the Street? 73 TULANE L. REV. 409 (1998).
248 It has been argued that these mechanisms reduce the harm from takeover defenses. See
Marcel Kahan, How I Learned to Stop Worrying and Love the Pill: Adaptive Responses to Takeover
Law, 69 U. CHI. L. REV. 871 (2002). However, they are unlikely to be perfect substitutes in all, or even
many, firms.
D. THE MARKET FOR REGULATION
Even if regulation may be appropriate notwithstanding regulatory costs and the

availability of market-based remedies, there is a further question concerning the level at
which this regulation should be imposed. Capital markets provide a mechanism for
competition among various bodies of regulation as well as among corporations and
individual corporate contracts. A firm’s decision to be subject to a particular body or
regulation is subject to capital market evaluation as part of its general bundle of
governance terms.249
These “contractual” approaches currently dominate regulation of corporate

governance. The governance of U.S. corporations is largely determined by the law of
the state in which each firm has chosen to incorporate. State legislatures can mandate
particular forms of governance, such as independent directors, and state courts can
impose standards of conduct, as in Smith v. Van Gorkom250 and In re Caremark
International Inc. Derivative Litigation.251 Stock exchange listing agreements252 also
can be considered a form of contractual governance given firms’ ability to choose the
exchange or exchanges on which they are listed.253 The NYSE, for example, has an
incentive in competing with NASDAQ and other exchanges to encourage firms to pay
higher listing fees in exchange for a lower cost of capital by assuring investors in those
firms that the NYSE is actively monitoring them. The same principle could apply to
competition among professional associations of auditors.254
Sarbanes-Oxley changes course from this contractual approach to corporate

regulation. Its provisions relating to, among other things, the composition of board audit
committees, the activities of corporate counsel, protecting whistleblowers, regulating
249 With respect to choice of incorporating state, see Roberta Romano, Law as Product: Some
Pieces of the Incorporation Puzzle, 1 J.L. ECON. & ORG. 225 (1985); Daniel R. Fischel, The "Race to
the Bottom" Revisited: Reflections on Recent Developments in Delaware’s Corporation Law, 76 NW. U.
L. REV. 913 (1982); Ralph Winter, State Law, Shareholder Protection, and the Theory of the
Corporation, 6 J. LEGAL STUD. 251 (1977).
250 488 A.2d 858 (Del. 1985) (imposing liability on directors for breaching duty of care in
recommending corporate merger).
251 698 A.2d 959 (Del. Ch. 1996) (discussing directors’ duty to supervise and institute internal
control systems).
252 See supra text accompanying notes 43 and 46.
253 See generally, Paul Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453 (1997).
254 See Paul V. Dunmore and Haim Falk, Economic Competition between Professional Bodies:
The Case of Auditing, 3 AM. L. ECON. REV. 302, 302 (2001) (showing that competition between
professional auditing associations can effectively replace most government regulation of auditors).
loans to officers,255 requiring reimbursement of bonuses and stock profits, mandating

disclosures regarding particular types of transactions and of the issuer’s code of ethics
for senior financial officers,256 fixing responsibility on officers for corporate
disclosures, and increasing the SEC’s power to bar people from serving as officers and
directors, all involve insertions of federal regulators into corporate governance.257 The
Act thus sides with corporate reformers who argue for a federal corporation law on the
ground that corporate managers’ ability to influence the firm’s incorporating decision
disables state law as a constraint on insider misconduct.258
Federalizing corporate governance should be approached with caution. The

state-based system of regulating corporate governance can be considered one of the
main strengths of the U.S. capital markets.259 Moreover, there is significant evidence
supporting the view that firms’ incorporation decisions are efficient.260 The occurrence
255This regulation, under §402 of the Sarbanes-Oxley Act, poses particular problems of
defining precisely what type of credit is covered. Under pressure of litigation, the provision may become
unexpectedly broad regulation of executive compensation, now primarily regulated under state corporate
law.
256 Even such rules merely requiring disclosure can have the effect of substantive regulation.
For example, Section 406 of Sarbanes-Oxley concerning disclosure of firms’ codes of ethics for financial
officers, requires firms to balance the costs and benefits of relatively rigid codes that necessitate many
waivers, which firms must immediately disclose, and excessively loose standards that accomplish little.
The effect may be the evolution of a uniform boilerplate ethics code that may be unsuitable for many
firms.
257
One problem of federalization is that the new federal law of corporations will have to be
meshed with existing state law on such issues as the rules for enforcing the new federal duties on
compensation through state derivative actions.
258See Cary, supra note 2. For more recent versions of this theory, see Lucian Arye Bebchuk &
Allen Ferrell, Federalism and Takeover Law: The Race to Protect Managers from Takeovers, 99
COLUM.L. REV. 1168 (1999); Lucian Arye Bebchuk, Federalism and the Corporation: The Desirable
Limits on State Competition in Corporate Law, 105 HARV. L. REV. 1435 (1992). See also, Alan Murray,
Bush Should Take 3 Steps to Support Corporate Ethics, Wall St. J., July 9, 2002, at A9 (suggesting that
the solution to the problem of corporate fraud lies in federalizing corporate law).
259 See generally, Roberta Romano, THE GENIUS OF AMERICAN CORPORATE LAW
(1993).
260 See Bhagat & Romano, supra note 106 at 382-94 (reviewing studies relating to state
competition debate); Peter Dodd and Richard Leftwich, The Market for Corporate Charters: Unhealthy
Competition versus Federal Regulation, 53 J. BUS. 259 (1980); Roberta Romano, The Need for
Competition in International Securities Regulation, 2 THEO. INQUIRIES IN LAW 387, 495-97 (2001)
(reviewing eight studies finding positive abnormal stock returns from changing incorporation state). This
evidence has been challenged, primarily on the ground that it does not take adequate account of the fact
that reincorporations are not random events, so that their effects may be determined by the characteristics
of particular corporations and transactions.
of recent corporate frauds is as much an indictment of existing federal regulation of

disclosure as of state regulation of governance. Even if some reform is appropriate, as
discussed throughout this Part, any reform involves complex cost-benefit tradeoffs.
Moreover, governance rules should be designed to suit the particular circumstances of
each firm, as indicated by the evidence that there is no optimal level of board
independence.261 These considerations suggest that these issues are best resolved in a
market for regulation that would permit experimentation and flexibility.
Nor do the recent corporate frauds indicate a specific problem with Delaware
law, which currently dominates state competition. Interestingly, at least two of the main
culprits, Enron and WorldCom, were not Delaware corporations, but rather incorporated
in Oregon and Georgia, respectively. These firms’ choice of state law may have been
based on an expectation of favorable state regulatory treatment, or better protection
against takeovers than in Delaware.262 The recent corporate frauds may encourage firms
to consider more carefully how well the incorporating state protects shareholders
against managerial agency costs, and may encourage Delaware to sharpen its
corporation law to compete in this altered market.263 In other words, Delaware is more
likely to be part of the solution than to have been part of the problem.
One possible qualification of the pro-state-law position concerns state anti-

takeover law.264 It has been argued that state competition is inefficient to the extent that
it involves the rules managers care most about, namely protection against takeovers.265
261 See supra note 106 and accompanying text.
262 This particularly applies to Georgia law, which led the country in adoption of a particularly
effective “dead-hand” poison pill. See Invacare Corporation v. Healthdyne Technologies, Inc., 968 F.
Supp. 1578 (N.D. Ga. 1997). See John C. Coates, IV, Measuring the Domain of Mediating Hierarchy:
How Contestable Are U.S Public Corporations?, 24 J. CORP. L. 837, 853, n. 92 (1999) (noting that
poison pills are generally not very effective against takeovers because they permit proxy contests, but
distinguishing “dead-hand” pills). By contrast, Delaware has a relatively weak anti-takeover statute,
which, in contrast to many other state-anti-takeover statutes, did not significantly affect the stock prices
of Delaware corporations when adopted. See Jonathan M. Karpoff & Paul H. Malatesta, The Wealth
Effects of Second Generation Takeover Legislation, 25 J. FIN. ECON. 291 (1989). Also, Delaware has
ruled against the sort of “dead-hand” provision upheld in Georgia. See Quickturn Design Sys. v. Mentor
Graphics Corp., 721 A.2d 1281 (Del. 1998); Carmody v. Toll Bros. Inc., 723 A.2d 1180 (Del. Ch. 1998).
263Delaware courts are well-suited to responding quickly to the regulatory challenge presented
by corporate fraud. See Jill E. Fisch, The Peculiar Role of the Delaware Courts in the Competition for
Corporate Charters, 68 U. CIN. L. REV. 1061 (2000).
264 See Bhagat & Romano, supra note 106 at 391 (noting that the evidence on negative share
price effects of adoptions of state antitakeover statutes “are the strongest (and sole) empirical evidence
against the efficacy of state competition for charters”).
265 See Bebchuk & Ferrell, supra note 258 (arguing that firms should be permitted to opt into a
federal takeover regime, and required to allow shareholders rather than managers to exercise the opt-in
right); Lucian Bebchuk & Alma Cohen, Firms' Decisions Where to Incorporate, NBER Working Paper
This argument is significant given takeovers’ significance as a potential market-based

constraint on managerial agency costs.266 On the other hand, it is not clear that state
takeover defenses either are effective267 or reduce shareholder wealth.268 Thus, even if
firms tend to be attracted to states that have stronger anti-takeover laws, this may either
not harm shareholders, or may increase shareholder wealth because the benefits of such
protections for particular types of firms (for example, in encouraging managers to make
firm-specific investments of human capital in their firms269) outweigh any increase in
other agency costs. Moreover, it is significant that the leading incorporation state
(Delaware), has a relatively weak statute.270 As suggested above, the new focus on
agency costs in the wake of the recent corporate frauds may increase the benefits of
takeovers, and thus may cause firms to move from very protective states to Delaware.
A federal corporation law would eliminate such choices. Indeed, federal anti-takeover
law may be more of a problem than state law, in part because the former applies equally
to all firms regardless of firm-specific characteristics.
Not only are there arguments against federalizing corporate governance law, but
there are strong arguments favoring extending jurisdictional competition from internal
governance rules into the area of disclosure rules. Some commentators propose
permitting issuers to choose their disclosure regime.271 Even under current law, firms
can to some extent choose their disclosure regime. Foreign issuers have significant
N. W9107 (Aug. 2002), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=324049

(presenting evidence of incorporations among all states indicating that states that offer more takeover
protection attract the most incorporations). For criticism of Bebchuk & Ferrell’s proposal, see Stephen J.
Choi & Andrew T. Guzman, Choice And Federal Intervention in Corporate Law, 87 VA. L. REV. 961
(2001). For a rebuttal, see Lucian Arye Bebchuk & Allen Ferrell, Federal Intervention to Enhance
Shareholder Choice, 87 VA. L. REV. 993 (2001).
267 See Coates, supra note 262.
268 See John C. Coates, IV, Takeover Defenses in the Shadow of the Pill: A Critique of the
Scientific Evidence, 79 TEX. L. REV. 271 (2000) (discussing evidence of negative wealth effects from
adoption of takeover defenses and showing that these studies ignore “shadow” poison pills in place in
every firm, and evidence that pre-bid poison pill adoptions do not affect outcomes).
269 See Haddock, et al, supra note 162.
270 See Bhagat & Romano, supra note 106 at 391 (noting that “[t]he nonnegative [share price]
impact of the Delaware takeover statute is a fact of itself favorable to an assessment of state
competition”).
271 See Stephan J. Choi & Andrew T. Guzman, Portable Reciprocity: Rethinking the
International Reach of Securities Regulation, 71 S. CAL. L. REV. 903 (1998); Roberta Romano,
Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359 (1998). For
criticisms of these proposals, see James D. Cox, Regulatory Duopoly in U.S. Securities Markets, 99
COLUM. L. REV. 1200 (1999); Merritt Fox, Securities Disclosure in a Globalizing Market: Who Should
Regulate Whom, 95 MICH. L. REV. 2498 (1997); Prentice, supra note 81.
ability to avoid U.S. regulation,272 and have provoked exemptions and rule changes in
the U.S. aimed at encouraging foreign issuers to raise capital here.273 Securities
exchanges can be effective in promoting jurisdictional competition.274 Despite some
commentators’ fears of a race-to-the-bottom in securities regulation,275 there is
substantial evidence that issuers have chosen to bond their integrity by deliberately
choosing regimes with more rigorous regulation.276
272 For example, U.S. federal courts generally have enforced Lloyd’s contract provisions
providing for English law and forum and thereby circumventing U.S. securities laws. See, e.g., Richards
v. Lloyd's of London, 135 F.3d 1289 (9th Cir. 1998); Haynsworth v. Corporation, 121 F.3d 956 (5th Cir.
1997); Allen v. Lloyd's of London, 94 F.3d 923 (4th Cir. 1996); Shell v. R.W. Sturge, Ltd., 55 F.3d 1227
(6th Cir. 1995); Bonny v. Society of Lloyd's, 3 F.3d 156 (7th Cir. 1993), cert. denied, 510 U.S. 1113
(1994); Roby v. Corporation of Lloyd's, 996 F.2d 1353 (2d Cir. 1993), cert. denied, 510 U.S. 945 (1993);
Riley v. Kingsley Underwriting Agencies, Ltd., 969 F.2d 953 (10th Cir. 1992), cert. denied, 506 U.S.
1021 (1992).
273 William J. Carney, Jurisdictional Choice in Securities Regulation. 41 VA. J. INT’L L. 717
(2001); John C. Coffee, Jr., Racing Towards the Top?: The Impact of Cross-Listings and Stock Market
Competition on International Corporate Governance, Columbia Law and Economics Working Paper No.
205 (May 30, 2002), available at http://papers.ssrn.com/paper.taf?abstract_id=315840 (discussing
exemption of foreign-regulated issuers from U.S. exchange listing requirements); Merritt B. Fox,
Regulation FD and Foreign Issuers: Globalization's Strains and Opportunities, 41 VA. J. INT'L L. 653
(2001) (discussing exemption of foreign firms from Regulation FD).pact of Cross-Listings and Stock
Market Competition on International Corporate Governance, Columbia Law and Economics Working
Paper No. 205 (May 30, 2002), available at http://papers.ssrn.com/paper.taf?abstract_id=315840
(discussing exemption of foreign-regulated issuers from U.S. exchange listing requirements); Merritt B.
Fox, Regulation FD and Foreign Issuers: Globalization's Strains and Opportunities, 41 VA. J. INT'L L.
653 (2001) (discussing exemption of foreign firms from Regulation FD). Notably, the Sarbanes-Oxley
Act does not exempt foreign issuers. This may cause significant problems. In particular, the audit
committee requirements in §301 of the Act may be incompatible with the structure of German GMBH’s,
which have a lower-tier insider board and an upper-tier board 50% composed of employees. Regulators
face the hard choice of exempting these firms and opening a significant gap in coverage, or not
exempting and driving foreign firms out of the U.S. market. For example, the Act has caused Porsche not
to list on the N.Y.S.E.
274 See Amir N. Licht, Stock Exchange Mobility, Unilateral Recognition, and the Privatization
of Securities Regulation, 41 VA. J. INT’L L. 583 (2001).
275 See Prentice, supra note 81 at 1434-43.
276 See Stephen J. Choi, Assessing the Cost of Regulatory Protections: Evidence on the Decision
to Sell Securities Outside the United States (Yale Law & Economics Research Paper No. 253, UC
Berkeley Public Law Research Paper No. 51 2001) available at
http://papers.ssrn.com/sol3/paper.cfm?abstract_id=267506 (showing that firms that had been sued under
the securities laws and investigated by the Securities and Exchange Commission tend to make U.S.-
regulated securities offerings rather than foreign offerings, indicating that they are using U.S. federal
securities laws to allay investor mistrust); Howell E. Jackson & Eric J. Pan, Regulatory Competition in
International Securities Markets: Evidence from Europe in 1999—Part I, 56 Bus. Law. 653, 691 (2001)
(finding that the market demanded more securities disclosures than required by the minimum standards in
For present purposes, it is unnecessary to go all the way to competition of

disclosure rules. The question at hand is simply whether to increase regulation in the
light of recent corporate frauds, including by reducing the amount of jurisdictional
competition that already exists, assuming this would be feasible. The serious questions
about the costs and benefits of proposed regulation support subjecting these proposals to
the discipline of jurisdictional competition.
V. CONCLUDING REMARKS
In Enron and other notorious cases arising out of the rubble of the bubble market
many levels of market and monitoring devices simultaneously failed. Pro-regulatory
theorists argue that this demonstrates that securities markets cannot be trusted to work
on their own without strong regulatory support and that new regulation was needed to
restore investor confidence. However, this Article has shown that the case for
significantly increased regulation has not been made. While Enron exposed gaps in the
existing monitoring structure, the benefits of eliminating those gaps are not as clear as
they might seem to be. The substantial existing regulatory framework was breached by
aggressive outsiders who seemed determined to ignore the risks of their actions,
including their personal exposure to punishment. Promoting more independent monitors
with lower-powered incentives to scrutinize the actions of highly informed and
motivated insiders cannot solve this problem.
Moreover, the costs of increased regulation could be significant. On the one
hand, the Act may reduce the incentives of both insiders and monitors to increase
shareholder value. Even if the Act is ineffective, as this Article suggests may be the
case, the Act could cause harm simply by misleading the market that regulation can
solve its problems.277 In fact, as history has often shown, from the South Sea Bubble,278
to the Great Crash,279 defrauders manage to say one step ahead of the regulators. The
endless cycle of boom-bust-regulation accomplishes little in the long run. Finally, even
if some highly sophisticated and nuanced regulation theoretically could increase social
welfare, it is not likely that this type of reform will arise out of the present highly
charged political environment.
E.U. directives, and noting that "market developments in European capital markets to date do not offer
support to critics of regulatory competition who claim that the issuer choice proposals would prompt a
race to the bottom in international securities regulation."); Ian Gerard MacNeil, Competition and
Convergence in Corporate Regulation: The Case of Overseas Listed Companies (August 1, 2001),
available at http://papers.ssrn.com/paper.taf?abstract_id=278508; Edward B. Rock, Coming to America?
Venture Capital, Corporate Identity and U.S. Securities Law, U of Penn, Inst for Law & Econ Research
Paper 02-07 (April, 2002), available at http://papers.ssrn.com/paper.taf?abstract_id=313419 (showing that
Israeli technology firms advertise quality to investors by voluntarily listing in America and subjecting
themselves to U.S. regulation).
278 See Mackay, supra note 66.
279 See generally, Galbraith, supra note 65.

Markets are capable of responding more quickly and precisely than regulation to
corporate fraud, as long as regulation does not impede or mislead them. Although
markets will remain imperfect, the potential for a market response, combined with the
likely costs of regulation, make the case for additional regulation dubious.
APPENDIX: OVERVIEW OF THE SARBANES-OXLEY ACT

Section 101: Creation of Public Company Accounting Oversight Board, a
District of Columbia nonprofit corporation whose duties include registering public
accounting firms, adopting auditing, quality control, ethics, independence, and other
standards for issuers’ audit reports; conducting inspections and investigations of public
accounting firms and imposing sanctions. The Board consists of five members, two who
are or have been CPAs, although the chair cannot have practiced public accountancy
within five years of appointment. The members serve full time for five-year staggered
terms.
Section 102: Beginning six months after the Board is established, only firms
registered by the board may audit issuers. The registration must disclose, among other
things, the names of issuers being audited by the firm, annual fees from each, the firm’s
quality control policies, names and licensing information of all of the firm’s auditors,
criminal, civil, or administrative actions or disciplinary proceedings pending against the
firm or any of its associated persons in connection with any audit report, and copies of
any of the issuers filed disclosures during the past year that disclose accounting
disagreements between the issuer and the auditing firm. The auditing firm must consent
in connection with registration to cooperate and comply with Board orders for
testimony and documents.
Section 103: Provides for adoption of auditing, quality control and

independence standards and rules, including rules promulgated by other associations.
These must include seven-year retention of work papers, peer review of audits,
disclosure of auditors’ testing of issuers’ internal controls, monitoring of ethics and
independence, consultation within auditing firms, supervision, hiring, acceptance of
engagements and internal inspection.
Section 104: Provides for inspections of auditing firms annually for firms doing
more than 100 audits per year and every three years for other firms, including
inspection of selected engagements and the firm’s quality control system.
Section 105: Provides for investigations, including requiring testimony and

documents; suspension and revocation of registrations of firms or their associated
persons who do not cooperate; and sanctions for firm and individual violations and for
failures to supervise.
Section 107: Gives the SEC oversight of the Board, including its rules and
disciplinary actions.
Section 108: Requires as a condition of SEC recognition of accounting

standards as “generally accepted” that these standards be promulgated by an
organization funded as set forth in the next section and a majority of whose members
have not been associated with an accounting firm for two years.
Section 109: Provides for funding of the Board from auditing fees.
Section 201: Adds subsection 10A(g) of the 1934 Act, dealing with audits of
financial statements required by the securities laws, prohibiting audit firms from also
providing non-audit services to audit clients, including bookkeeping, financial
information systems design, appraisal, valuation, or fairness reports; actuarial services;
internal audit outsourcing services; management functions or human resources; broker
or dealer, investment adviser, or investment banking services; legal services and expert
services unrelated to the audit.
Section 202: Adds §10A(i) requiring preapproval by the issuer’s audit

committee of both audit and permitted non-audit services.
Section 203: Adds §10A(j) requiring client rotation of audit and reviewing
partners after five years.
Section 204: Adds §10A(k) requiring reports by audit firms to issuers’ audit
committees of critical accounting policies and practices, alternative treatments of
financial information within generally accepted accounting principles that have been
discussed with management officials of the issuer, ramifications of the use of such
alternative disclosures and treatments and the treatment the accounting firm prefers, and
other material written communications between the registered public accounting firm
and the management of the issuer.
Section 206: Adds §10A(l) prohibiting audit services to an issuer whose chief
executive officer or senior accounting officers were employed by the auditing firm and
participated in an audit of the issuer during the preceding year.
Section 301: Adds §10A(m) requiring securities exchanges and associations to

amend listing standards to require issuers’ audit committees be responsible for hiring
and supervising the firm’s auditor and restricting members from receiving fees from or
being affiliated persons of the issuer.
Section 302: Provides that SEC rules shall require that reporting firms’ principal
executive and financial officers certify in each 1934 Act annual or quarterly report280
facts including the following: that they have reviewed the report; based on their
knowledge, the report does not contain any untrue statement of a material fact or omit to
state a material fact necessary in order to make the statements made, in light of the
circumstances under which such statements were made, not misleading; fairly presents
in all material respects the issuer’s financial condition and results of operations; the
officers are responsible for establishing and maintaining internal controls and have
designed such to ensure that material information is reported to them; and the officers
280 Securities Act Release No. 33-8124 (August 26, 2002) provides that this requirement applies
only to “periodic” reports, and not to “current” reports such as that on Form 8-K.
have disclosed to the issuer's auditors and the audit committee significant deficiencies in
the design or operation of internal controls and any fraud by management or other
employees who have a significant role in the issuer's internal controls.
Section 303: Provides for SEC rule prohibiting fraudulently influencing or

misleading an auditor for purpose of rendering financial statements misleading.
Section 304: Provides that an issuer’s chief executive officer and senior
financial officer shall reimburse any incentive or equity-based compensation or profits
from stock sales during a year following the issuance of a financial document that had
to be restated due to misconduct.
Section 305: Changes officer bars under §21(d)(2) of the 1934 Act from
requiring “substantial unfitness” to requiring mere “unfitness.” Section 21(d)(5) revised
to permit SEC to get equitable relief for securities law violations.
Section 306: Prohibits director or executive officer selling shares he acquired in

connection with his job during a pension blackout period, and requires disgorgement of
profits from such sale, and provides for other regulations regarding blackouts.
Section 307: Requires the SEC within 180 days to issue rules “setting forth
minimum standards of professional conduct for attorneys appearing and practicing
before the Commission in any way in the representation of issuers,” including a rule
“requiring an attorney to report evidence of a material violation of securities law or
breach of fiduciary duty or similar violation by the company or any agent thereof” to
the chief legal counsel or chief executive officer, and to the audit committee, other
independent directors, or the board, if the legal counsel or officer do not appropriately
respond.
Section 308: Provides that civil penalties shall be added to disgorgement funds.
Section 401: Requires disclosures pursuant to rules to be promulgated by the

SEC concerning off-balance-sheet transactions and pro forma figures.
Section 402: Adds subsection 13(k) to the Securities and Exchange Act of 1934
prohibiting issuer loans to executive officers or directors.
Section 403: Changes time of disclosures of insider transactions under §16 of

the 1934 Act from 40 to two days.
Section 404: Requires annual report disclosures stating management’s

responsibilities for establishing and maintaining an adequate internal control structure
and procedures for financial reporting and an assessment of the effectiveness of the
structure, attested to by the firm’s auditor.
Section 406: Requires disclosure pursuant to SEC rules of the issuer’s code of
ethics for senior financial officers, or explaining why the issuer does not have one, and
immediate disclosure of changes or waivers.
Section 407: Requires disclosure pursuant to SEC rules concerning the audit
committee’s financial expert.
Section 408: Provides for regular and systematic SEC review of nationally
listed issuers at least every three years and more often based on several listed factors,
including past reporting history, earnings volatility, and significance of the issuer’s
operation to the economy.
Section 409: Adds subsection §13(l) to the 1934 Act requiring issuers to
“disclose to the public on a rapid and current basis such additional information
concerning material changes in the financial condition or operations of the issuer, in
plain English, which may include trend and qualitative information and graphic
presentations” per SEC rule.
Section 501: Adds §15D to the 1934 Act providing for adoption by the SEC,
NASD or national securities exchange of rules dealing with analyst conflicts, including
rules restricting prepublication clearance or approval of research reports by broker-
dealer firm’s investment banking arm; limiting the supervision and compensatory
evaluation of securities analysts to officials employed by the broker or dealer who are
not engaged in investment banking activities; prohibiting broker-dealer and its
investment banking personnel from retaliating or threatening to retaliate against its
analysts for negative reports on investment banking clients; defining periods during
which broker-dealer’s participating as underwriters or dealers in public offerings may
not distribute research reports; establishing safeguards within broker-dealer firms to
ensure that securities analysts are separated by appropriate informational partitions
within the firm from pressures from the investment banking arm of the firm; and
requiring disclosure of specified analyst conflicts in public appearances and research
reports.
Section 601: Substantially increases funds allocated to the SEC.
Section 602: Provides for censure or bar from practice before the SEC of
persons, including on the basis of improper professional conduct, which as to a public
accounting firm may include one instance of highly unreasonable conduct.
Section 802: Provides for a penalty of twenty years for destruction, alteration, or
falsification of records in Federal investigations and bankruptcy; requirement of
maintaining all audit or review workpapers for five years; SEC rules for retention of
audit papers; and ten years for violating rules regarding retention.
Section 803: Adds paragraph 19 to 11 U.S.C. §523(a) providing for non-

dischargeability in bankruptcy of debts incurred in violation of securities fraud laws.
Section 804: Adds subsection (b) to 28 U.S.C. §1658 changing the statute of
limitations for securities fraud actions to two years after the discovery of the facts
constituting the violation or five years after the violation, as to proceedings commenced
on or after enactment.281
Section 806: Prohibits 1934 Act a reporting company or its employees or agents
from taking adverse employment actions against employees who lawfully “provide
information, cause information to be provided, or otherwise assist in an investigation
regarding any conduct which the employee reasonably believes constitutes” a securities
law violation when the information is provided to or the investigation is conducted by a
federal agency, Congress, or “a person with supervisory authority over the employee;”
or files or otherwise assists in a securities law proceeding. The affected employee may
file a complaint with the Labor Department and, if no action within 180 days, a legal
action, for relief including compensation and reinstatement.282
Section 807: Increases criminal penalty for knowing securities fraud, including
imprisonment for up to 25 years.283
Section 903: Increases imprisonment for mail and wire fraud from 5 to 20
years.
Section 904: Increases penalties for ERISA violations.
Section 906: Requires issuers’ 1934 Act filings of financial reports to be

accompanied by chief executive and chief financial officer written certification of
compliance with §§13(a) and 15(d) of the Act and that the information contained in the
periodic report fairly presents, in all material respects, the financial condition and
results of operations of the issuer. An officer who certifies knowing that report does not
comport with requirements is subject to fine up to $1,000,000 or imprisonment of up to
ten years or both, or $5,000,000 and 20 years if he “willfully” certifies.284
Section 1102: Provides that obstructing a proceeding, including by tampering

with documents, is subject to imprisonment up to 20 years.
Section 1103: Provides for SEC authority to freeze firms’ extraordinary

payments.
281 For a discussion of questions concerning the scope of this provision, including its application
to anti-fraud claims under Rule 10b-5, see Michael Perino, Statutes of Limitations under the Newly
Passed Sarbanes-Oxley Act, N.Y.L.J., August 2, 2002 at p.4.
282 18 USC §1514A. See also §1107 of the Sarbanes-Oxley Act, adding 18 U.S.C. §1513(e),
providing that one who “knowingly, with the intent to retaliate, takes any action harmful to any person,
including interference with the lawful employment or livelihood of any person, for providing to a law
enforcement officer any truthful information relating to the commission or possible commission of any
Federal offense, shall be fined under this title or imprisoned not more than 10 years, or both.”
283 18 U.S.C. §1348.
284 This provision is to be codified at 18 U.S.C. §1350(a)-(b).

Section 1105: Adds §8A(f) of the Securities Act of 1933 and §21C(f) of the
Securities Exchange Act of 1934285 providing for SEC power to prohibit person who
has violated anti-fraud provisions from acting as an officer or director of publicly
reporting issuer if the conduct demonstrates unfitness to serve as such, as distinguished
from “substantial unfitness” under the prior standard.
Section 1106: Increases criminal penalties under §32 of 1934 Act.286
285 15 U.S.C. §77h-1; 15 U.S.C. 78u-3.
286 15 U.S.C. §78ff(a).

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MARKET VS. REGULATORY RESPONSES TO CORPORATE FRAUD: A

Draft of September 20, 2002

I. THE PROBLEM OF CORPORATE FRAUD 6

B. THE CASE FOR MARKET FAILURE 9

II. REGULATORY RESPONSES TO CORPORATE FRAUD 13

B. OTHER GOVERNANCE PROTECTIONS AGAINST FRAUD 15

C. AUDITOR OVERSIGHT AND INCENTIVES 16

III. PROBLEMS WITH THE REGULATORY APPROACH 21

B. EFFECTIVENESS OF REGULATORY PROPOSALS 29

C. COSTS OF INCREASED LIABILITY AND REGULATION 40

IV. MARKET RESPONSES TO CORPORATE FRAUD 52

C. SHAREHOLDER MONITORING AND TAKEOVERS 60

D. THE MARKET FOR REGULATION 63

APPENDIX: OVERVIEW OF THE SARBANES-OXLEY ACT 69

Other commentators, notably including Henry Manne, Frank Easterbrook, and

Some argue that, because of the unreliability of corporate managers, monitors

I. THE PROBLEM OF CORPORATE FRAUD

A. AN OVERVIEW OF ENRON AND OTHER CORPORATE FRAUDS

9 See Lawrence A. Cunningham, Sharing Accounting’s Burden: Business Lawyers in Enron’s

13 See Frank Partnoy, Enron & Derivatives, available at

15 See SEC Releases 1405 and 1410 (June 19, 2001).

Sunbeam was another precursor of Enron. In June, 1998, a Barrons article

Other accounting shenanigans in public corporations include Xerox’s

B. THE CASE FOR MARKET FAILURE

Modern regulatory theories of corporate governance begin with Berle &

21 See Berle & Means, supra note 1.

The anti-regulatory response to Berle & Means is essentially that shareholders

Efficient securities markets, in turn, provide both an effective valuation device

Even these new-breed executives would not present a problem if effective

24 See Healy & Palepu, supra note 10 at 24.

27 See Healy & Palepu, supra note 10 at 23.

28 See Donald C Langevoort, Enron and the Organizational Psychology of Hyper-Competition:

29 See SEC Release 1405 (June 19, 2001).

30 See Gordon, supra note 6.

II. REGULATORY RESPONSES TO CORPORATE FRAUD

Darden Case Nos.: UVA-F-1299-M-SSRN and UVA-F-1300-M-SSRN (2000), available at

benefits and costs of these reforms.

Suggestions and requirements of greater board independence and more board

40 See generally, Melvin Eisenberg, THE STRUCTURE OF THE MODERN CORPORATION

45 See SEC Release No. 34-42266 (Dec. 22, 1999).

Section 301 of the Sarbanes-Oxley Act directs securities exchanges and

B. OTHER GOVERNANCE PROTECTIONS AGAINST FRAUD

Corporate responsibility theoretically is enhanced if senior full-time managers

Sarbanes-Oxley addresses these concerns by requiring executive certification of

C. AUDITOR OVERSIGHT AND INCENTIVES

Enron and other recent fiascos pointed up weaknesses in the auditing of

There has been much attention focused on tightening standards regarding

In response to concerns about auditor independence, after extensive deliberation

The problems with auditor independence and laxity of auditors’ work in

The SEC proposed a rule providing for an independent agency dominated by

51 See SEC Release 33-8109 (June 26, 2002).

“extraordinary” events give firms significant room to manipulate earnings. Sarbanes-

Third, inadequate disclosure of the compensation or its effects on earnings may

54 See infra text accompanying note 197.

56 See NYSE Report, supra note 46.

The corporate frauds entailed firms’ inadequate disclosure to shareholders of

The securities laws, of course, already require substantial disclosure, including

Finally, corporate fraud theoretically can be reduced by increasing SEC

58 See NYSE Report, supra note 46.

Sarbanes-Oxley makes several moves toward increasing penalties for corporate

61 See Healy & Palepu, supra note 10 at 28.

III. PROBLEMS WITH THE REGULATORY APPROACH