When Federalism Works--Why Kill It?
Federal Initiatives on Corporate and Financial Regulation
About This Event

Until very recently, corporate law and financial regulation served as prominent examples of federalism and state competition. Both regimes, however, have now come under assault. The Sarbanes-Oxley Act and regulatory initiatives by the Securities and Exchange Commission threaten to eviscerate, and perhaps to dismantle, corporations' and shareholders' choice of state charters. Similarly, proposed federal interventions on "predatory" lending would greatly expand financial market regulation, while further limiting state control over the lending practices of state-chartered financial institutions.

Is competitive federalism dead? Two panels of distinguished experts will discuss the causes, scope, and likely consequences of increased federal regulation.

Agenda

1:45 p.m.

Registration

2:00 Corporate Law: Demise of the Delaware Principle?

Panelists:

Jonathan F. Pedersen, Kirkland & Ellis

Charles Elson, University of Delaware Law School

Bruce Johnsen, George Mason University Law School

Moderator:

Peter J. Wallison, AEI

3:30

Coffee Break

3:45

Financial Regulation: Marquette and Markets or Federal Uniformity?

Panelists:

Wright Andrews, Butera & Andrews

Phil Lehman, Office of the Attorney General, North Carolina

Todd Zywicki, Federal Trade Commission

Moderator:

Michael S. Greve, AEI Federalism Project

5:30

Adjournment and Reception

Event Summary

October 2003
When Federalism Works--Why Kill It?

Until very recently, corporate law and financial regulation served as prominent examples of federalism and state competition. Both regimes, however, have now come under assault. The Sarbanes-Oxley Act and regulatory initiatives by the Securities and Exchange Commission threaten to eviscerate, and perhaps to dismantle, corporations' and shareholders' choice of state charters. Similarly, proposed federal interventions on "predatory" lending would greatly expand financial market regulation, while further limiting state control over the lending practices of state-chartered financial institutions.  Is competitive federalism dead? On October 9, two panels of distinguished experts discussed the causes, scope, and likely consequences of increased federal regulation.

Michael Greve
AEI

We tend to discuss federalism in terms of one question: should the states regulate, or should the federal government?  That vertical distribution of power, however, hardly exhausts the range of federalism options.  If you choose state regulation, two choices remain: either every state in which a company does business may regulate it, or the power to regulate may be reserved to the state in which the company has its headquarters or charter. 

That decision makes all the difference in the world.  The fifty-regulators option is really a choice of the strictest state regime, with the addition of conflicting regulations-which is why corporate officials tend to recoil in horror when federalism is mentioned.  The home-state option, on the other hand, is the heart and soul of the common market and of competitive federalism.  In Europe, this home-state principle has been sanctioned by the European Court of Justice in a decision that the European Commission is working furiously to undercut.

In the United States, the fifty-state option has taken hold, with the exception of two areas: corporate law, governed by the Delaware principle; and financial markets, governed by the Marquette principle.  In both cases, the principle of state choice is currently under fire due to corporate scandals and alleged abuses in the financial markets, so we are here today to discuss a new question: Is the home-state choice an option worth saving?

Panel I -- Corporate Law: Demise of the Delaware Principle?

Peter Wallison
AEI

In July of 2002, shortly after the disclosure of the WorldCom affair, there was a tremendous push in the Republican Congress to pass a law which has had substantial adverse effects on the rule of law in the corporate area by states: the Sarbanes-Oxley Act.   The law reflected an assumption on the part of the U.S. Congress that any serious (political or substantive) problem requires federal government action.  Since the passage of the act, the SEC has implemented the law and, in fact, gone further in proposals concerning shareholder rights. 

Charles Elson
University of Delaware

Originally, most companies were incorporated in New York, and they only arrived in Delaware after fleeing Progressive Era regulation in both New York and New Jersey.  What made Delaware particularly well-suited to the business of corporate regulation was the fact that corporate disputes were heard in the Court of Chancery (an equity court), which existed entirely for that purpose.  This dedicated court, peopled by particularly good business judges, led to the formation of a superb body of law.  It has been argued that Delaware is held captive by its corporations, and that progressive corporate reform will only take place when the regulatory power is snatched from this captive state and put into the hands of the federal government.  That plan failed in the 1970s, but all bad things reappear, and today, in response to the recent corporate scandals, we have Sarbanes-Oxley. 

In the long run, those who believe that the federalization of corporate law will lead to more "progressive procedures" are mistaken. A federal corporate law would be enforced in federal courts-in thirteen circuits that could come up with conflicting interpretations of any single law.  In addition, most federal judges lack the background and the interest to create the kind of consistency necessary for corporate regulation.  Finally, if the ultimate goals are greater shareholder democracy and avoidance of capture by managerial interest, I don't believe that federalization is the answer, as it just as susceptible to interest group politics as the states.

D. Bruce Johnsen
George Mason University Law School

The issue at hand is one of limiting the reach of error.  By placing regulatory authority in the states' hands, federalism creates a system in which errors are diversifiable and unsystematic, allowing investors the opportunity to assess risk and diversify their portfolios accordingly.  In contrast, SEC's mandatory disclosure regime has led investors down the primrose path, promising protection from everything but itself.  We will never avoid financial default entirely, but under a federal regulatory scheme, the failure would be market-wide. 

The list of the SEC's current and past errors is not a brief one.   Mandatory disclosure, the emphasis on accounting procedures, the executive salary cap and the resulting shift to payment in stock options-none of these regulations have ended up benefiting the investor, and, in fact, I believe that they will lead to financial default.  The SEC and the federal regulators have erred, and that kind of regulatory error is inevitable.  The question is, do we want this to happen on small sporadic scales?  Or do we want to experience a system-wide, market-wide failure?

Jonathan F. Pederson
Kirkland & Ellis

For most of the last fifteen years, I worked as a corporate financial lawyer in Asia, where companies have the freedom to chose their regulatory regime.  The main question on the table was how to raise capital, and the companies had a menu of options: the regional regulatory market, which was respectable but characterized by speculation and insider trading; the European regulatory market, which was almost always available as a sort of general bet on growth in Asian markets; the 144a (institutional) market in the U.S., with high standards and significant disclosure but some flexibility; or the SEC public offering market, characterized by high standards, high legal risks, and significant disclosure.

Asian corporations did not just go for the lowest possible disclosure requirement-in fact, they often opted into very imperfect, high-standard regimes at great expense to themselves.  Certainly the companies were interested in U.S. capital, but money is often mobile, and it was not always necessary to submit to U.S. regulation in order to acquire it.  Reputational benefits were clearly taken into account, as well as were the anticipated effects of regulation on internal improvements.  The truth is that regulatory choice and competition do not always lead companies to the lowest common denominator, and in fact, sometimes lower disclosure and regulatory standards are as attractive to investors as they are to corporations.  Certainly, in defense of the SEC, nobody does it better-they are serious, dedicated, and they are not corrupt-but some of their rules are very hard to justify to foreign corporations.

Panel II -- Financial Regulation: Marquette and Markets or Federal Uniformity?

Todd Zywicki
Federal Trade Commission

Federalism does two things: Madison referred to it as an "auxiliary protection" of individual liberty; and the Brandeisian view employed the term to cover variation, experimentation, and regulation in solving collective action problems.  I would argue that our dual-regulatory banking system effectuates the two policy goals of federalism-in fact, where a traditional federalism argument says, "If you don't like it, you can move," this system operates on the principle, "If you don't like it, you can go to another bank." 

Anti-predatory lending regulations essentially act like usury laws, and usury laws generally have three effects: the intended effect (bans on certain behaviors); term repricing (shifting of costs from regulated terms to unregulated terms); and credit rationing.  The result in this case is that if you attack "predatory" lending practices, the intended effect will occur, but the industry will shift to term repricing and credit rationing.

But this all begs the question-under the dual system, in theory, consumers could choose the state bank that outlaws predatory practices or the federal bank that did not.  If these anti-predatory laws are so desirable and attractive, wouldn't the state-chartered bank have a competitive advantage over nationally-chartered banks?

Phil Lehman
Office of the Attorney General, North Carolina

Preemption has caused those of us in the state law enforcement community a lot of heartburn over the past year.  The OCC has proposed rules on preemption in their recent order preempting the Georgia lending law, and we have filed comments in opposition-in a nutshell, we don't like it at all.

This is a very difficult time for states' rights.  We have traditional authority in a lot of areas that is now being challenged, and it appears that the pendulum is swinging very fast and very hard to a regime of exclusive federal control.  We agree that there should be some federal preemption-states and the federal government have coexisted and cooperated in this kind of regulation for a long time.  But if we are going to share the regulatory authority, we need to share the same goals: the protection of the marketplace, and the protection of the consumer.  Instead, we are being pushed off of the playing field. 

In terms of North Carolina's predatory lending law (the first in the country), federal preemption is misguided.  We have acted as a laboratory of innovation.  In early 1999, a federal task force attempted to put together a comparable lending law and found only gridlock.  But North Carolina's goal was cooperation and compromise.  We collaborated with representatives from community banks, national banks, state mortgage brokers, mortgage bankers, and consumer advocates, and what emerged was a law based on bright line standards that has worked very well.  Now the federal government wants to preempt it.

Wright Andrews
Butera & Andrews

This is not an argument about whether or not regulation is necessary.  The clients that I represent-sub-prime lenders-feel very strongly that federal legislation is needed.  Congress clearly left some large holes in HOEPA, and I don't blame North Carolina or any state for trying to plug those gaps, but the solution has to come from the federal level.

Homeownership is part of the American dream, and home equity has helped to sustain our economy during recent difficult times.  In fact, the people who do not have perfect credit and cannot qualify for prime loans, have a special need for equity support.  For that and other reasons, the characterization of sub-prime lending has been unfair.  If you listen to the popular perception, you would think that these loans go out only to elderly minorities with extremely low incomes; but in reality, the average sub-prime borrower is a non-minority person in his or her forties or fifties, making $50,000-60,000.  The average sub-prime rate is only two points higher than the prime rate.

But these loans are easily disrupted.  Roughly forty states and localities have passed some sort of predatory lending law, and every one of them is different-a different mousetrap, but not a better one.  These laws prevent companies from working in standardized ways, and smaller companies are unable to keep up with the multiple demands.  Georgia has already seen disaster, and New Jersey is headed in that direction.  The situation in one state has ramifications in others.  State governments should be involved in enforcement, but federal preemption must bring order to this havoc.

AEI Research Assistant Kate Rick prepared this summary.

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