Inside-Out Corporate Governance

I. INTRODUCTION In the past decade, two major corporate and financial crises have shaken the foundations of corporate governance in rapid succession. In 2001 and 2002, Enron, WorldCom, and several other major U.S. corporations collapsed after evidence of accounting fraud emerged at each company.1 By the time lawmakers and regulators had finished dealing with the fallout from these scandals and with the Sarbanes-Oxley Act of 20022 and other reforms, a new crisis emerged with the distressed sale of the largest subprime lender, Countrywide Financial, and the subsequent collapses of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, and AIG.3 The earlier corporate scandals were widely viewed as a failure of corporate governance and were centered largely in the United States.4 The 2008 crisis, however, was far more global in its scope and was closely tied to governance and regulation in the financial services industry.5 The crisis raised grave concerns about the role of derivatives and other new financing techniques-the so-called shadow banking system-in 21st century governance.6 Much as with securities analysts and auditors in the earlier crisis, the principal gatekeeper-in this case, the credit rating agencies that rated mortgage-related securitizations and other debt instruments-proved ineffectual.7 Even more than its predecessor, the recent crisis spurred a pervasive restructuring of corporate regulation. Once fully implemented, Congress's handiwork-the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)8-will dramatically rework three crucial areas: internal corporate decision making, third-party gatekeepers, and financial derivatives. With internal corporate governance, lawmakers focused on increasing minority shareholders' ability to propose their own directorial candidates by authorizing the Securities and Exchange Commission (SEC) and other regulators to promulgate "proxy access" rules.9 The SEC quickly acted on this invitation-too quickly, it appears, as the SEC's initial rule was struck down on procedural grounds.10 Dodd-Frank homed in on third-party gatekeepers by imposing new directorial independence requirements on credit rating agencies and instructing regulators to remove the provisions in banking regulation that give pride of place to the three dominant rating agencies: Standard & Poor's, Moody's, and Fitch.11 For financial derivatives-contracts whose value is based on changes in interest rates, currency values, stock prices, or nearly anything else, or the occurrence of a specified event, such as a default on a company's debt-Dodd-Frank fills an almost complete regulatory vacuum. It does so by requiring that most derivatives be both cleared by a clearinghouse that guarantees the performance of both parties, and traded on an exchange, rather than negotiated privately by the two parties.12 Although the three sets of reforms seem entirely unrelated-both as initially enacted and as regulators have fleshed out the new regime-we argue in this Article that the regulation in each area embraces, wrestles with, and attempts to shape a new corporate governance paradigm we call "inside-out" corporate governance. This new inside-out governance model has profound implications for corporate regulation, as well as the respective roles of federal and state legislation. Much as the principal regulatory challenge of the 1980s and 1990s was takeovers, the central question for the current era will be, we believe, how to effectively manage the new inside-out paradigm. For much of the 20th century, corporate governance consisted of internal corporate governance-that is, decision making by the principal inside constituencies of the firm-together with outside oversight by regulators, auditors and credit rating agencies, and markets.13 With the advent of the takeover movement, most visibly in the 1980s,14 the distinction between inside and outside governance began to erode. …