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The Business Lawyer

Summer 2023 | Volume 78, Issue 3

Functional Federalization of Corporate Governance Since Sarbanes-Oxley

Paul Rose

Functional Federalization of Corporate Governance Since Sarbanes-Oxley

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With the passage of the Sarbanes-Oxley Act twenty years ago, scholars and practitioners expressed concern that Congress and the U.S. Securities and Exchange Commission (SEC) were “federalizing” state corporate law through federal securities regulation. Yet, while Sarbanes-Oxley may be a manifestation of the “creeping federalization of corporate law,” the Act was not the only, or even most important, federal regulation to displace state corporate governance rules in recent years. Rather than regulate corporate governance directly, much of the SEC’s recent efforts have been focused on building a shareholder-centric governance infrastructure that accomplishes indirectly what the SEC has not been able (or willing) to do directly. This article describes the rules that provide this governance infrastructure and shows how increasing shareholder power has impacted recent SEC rulemaking in, for example, the SEC’s recent climate change disclosure rules and its regulation of proxy advisors. Viewing the SEC shareholder empowerment efforts as contributing to a creeping functional federalization of corporate law may also help elucidate recent empirical findings on the diminished value of Delaware’s corporate law.

I. Introduction

The notion that state corporate law should give way to a superseding federal corporate law is nearly as old as “modern liberal corporation” law itself. A mere seven years after the passage of New Jersey’s innovative 1896 corporate law statute, a bill introduced in the House of Representatives would have required corporations to file their certificate of incorporation with the Department of Commerce and Labor, with the approval of the secretary of the department necessary for the corporation to engage in interstate commerce. The bill’s proponent, Representative Henry Palmer of Pennsylvania, argued that the bill would hold corporations “directly accountable to the sovereign power of the Federal Government rather than to any one State.” Over two dozen similar bills followed over the next three decades, but none were enacted.

Weathering these early challenges, state law has seemingly been remarkably resilient in resisting federalization in the decades since. Despite concerns with Delaware’s ascendance and dominance, epitomized by former SEC Chairman William Cary’s 1974 article decrying the “absurdity of this race for the bottom [in state corporate law], with Delaware in the lead,” there have been no serious attempts to create a statutory federal corporate law in recent years. And indeed, some scholars argued that the lack of a federal corporate law has benefitted shareholders; rather than creating a race to the bottom, competition among states for corporate charters resulted in a race to the top. Roberta Romano, for example, has argued that the fifty states have served as laboratories of corporate law, and that states are adequately incentivized to avoid offering suboptimal corporate codes. Further, she and other scholars produced evidence that Delaware’s corporate law has provided more efficient corporate governance structures, at least when assessed by share price effects.

On the other hand, some corporate law scholars have suggested that states do not really compete as producers of corporate law, either because Delaware has already won and the state faces more competition from outside the country or from the federal government, or because corporate law is simply irrelevant. Some studies suggest that state corporate law does, in fact, appear to be losing relevance, despite the lack of a federal de jure corporate law. But what if corporate law is becoming federalized not through direct corporate law rules, but rather as a result of indirect federal securities law changes?

This article interrogates that question. In the wake of Sarbanes-Oxley, Stephen Bainbridge noted the danger of a “creeping federalization of corporate law” that would eventually result in a de facto federal corporate law established through securities regulation and exchange standards controlled by federal regulators. Twenty years on, it appears that more obviously intrusive regulations such as Sarbanes-Oxley are not the only, or even most important, federal regulations impacting corporate governance. Indeed, de facto or “functional” federalization has not resulted primarily from direct rulemaking, but instead has arisen through a combination of increasing institutionalization in shareholder ownership, shareholder empowerment rulemaking by the SEC, and successful activism by shareholders taking advantage of the empowerment infrastructure created by the SEC’s rules. These factors have led to significant changes in corporate governance—a process of functional federalization—which seems to have the effect of also reducing the importance of state corporate law.

This article proceeds as follows. In Part II, the article describes recent efforts to directly impose corporate governance regulations on public corporations through the Dodd-Frank Act. Part III considers the development of indirect mechanisms of effecting corporate governance change, focusing on the SEC’s efforts to develop and foster a shareholder-centric legal infrastructure that supports institutional investor activism. In Part IV, the article provides examples of how institutional investors have been able to use this infrastructure to shape regulation through the SEC’s recent climate change disclosure rules and its regulation of proxy advisors. Part V concludes by briefly discussing implications of the functional federalization of corporate governance.

II. Direct Federalization Efforts Post-Sarbanes-Oxley

The Sarbanes-Oxley Act of 2002 marked an important moment in state corporate law, as it created several mandatory (though perhaps minor) corporate governance mechanisms applicable to all publicly traded companies. Though not offering an extensive corporate governance framework, Sarbanes-Oxley “ushered in a new era of federal intervention” in corporate law.

Another important direct federal intervention occurred less than a decade later, with the passage of the post–Financial Crisis Dodd-Frank Act. Like Sarbanes-Oxley, Dodd-Frank intervened in state corporate law primarily through securities rulemaking. Unlike Sarbanes-Oxley, however, which favored more direct regulations such as Section 404 (requiring an internal controls report and assessment) or Section 402 (prohibiting personal loans to executives), Dodd-Frank focused on leveraging shareholder power to shape corporate governance. Yet this focus is also one of the ironies of Dodd-Frank. If the Financial Crisis was related at least in part to excessive risk-taking by financial services firms and other businesses, one might ask which parties with interest and influence over the management of a corporation have to gain through leverage and high levels of risk. Taking risks is exactly what the residual interest holders—the shareholders—want their agents to do. Creditors (including not only capital providers, but other important corporate stakeholders, such as employees and suppliers) do not benefit from high levels of risk. If excessive risk-taking lies at the heart of the governance crisis Dodd-Frank was meant to manage, increasing the power of the corporate constituents with both the motive and the opportunity to increase corporate risk-taking seems an odd policy choice. Yet Dodd-Frank explicitly sought to regulate risk by empowering shareholders.

One of the more significant corporate governance impacts of Dodd-Frank was the implementation of a say-on-pay rule. Consistent with a shareholder empowerment orientation, say-on-pay is not a direct regulation so much as an attempt to provide a mechanism for the direct exercise of shareholder power. Under Section 951 of Dodd-Frank (which created Section 14A of the Exchange Act), public companies must introduce a resolution at least once every three years seeking approval of the compensation of the company’s executives. The section also required disclosure of any “golden parachute” packages that relate to any acquisition, merger, consolidation, sale, or other disposition of all or substantially all of the assets of the issuer, and, to the extent that such agreements are not part of the executive compensation plan approved through the normal say-on-pay vote, companies must include a separate resolution on the golden parachute packages.

Say-on-pay was seen as a significant win for shareholders who believed that high executive compensation represented a major agency cost (another irony, in that high compensation rates are driven primarily by stock option and restricted stock grants, which, of course, were used to reduce agency costs by aligning executive and shareholder interests). Yet, say-on-pay was the lion that didn’t roar. As Thomas Hemphill noted in a five-year retrospective on say-on-pay implementation, “shareholder say-on-pay voting has not verified what many shareholder activists originally believed with the enactment of [Dodd-Frank], i.e., that the majority of shareholders held similar opinions about business executives being significantly overpaid for their managerial performances.” But even if Dodd-Frank’s say-on-pay provision did not meaningfully change the compensation landscape, it has certainly had an impact on compliance costs and has also siphoned away board and managerial attention. And, perversely, say-on-pay may actually have a negative impact on performance. As Jill Fisch, Darius Palia, and Steven Davidoff Solomon argue, say-on-pay is really about “say-on-performance,” and as a result, “say on pay voting may exacerbate, rather than eliminate, problems with executive pay structure” because “shareholder support for executive pay is highly correlated with an issuer’s short-term stock performance.”

III. Functional Federalization Through Shareholder Empowerment

Sarbanes-Oxley and Dodd-Frank were more visible efforts at direct corporate governance regulation by Congress, but it is not clear that they have had dramatic impacts on state corporate laws or have significantly displaced or preempted state corporate governance regulation. Meanwhile, and more significantly, the SEC has been engaged in what has been a very effective long-term strategy to empower shareholders through securities rulemaking. Ultimately, the most significant federalization of state corporate law has occurred not through direct regulation, but rather through the SEC’s development of a shareholder-centric governance infrastructure that promotes activism and has spawned a corporate governance industry in service of institutional investors. Just as Sarbanes-Oxley and Dodd-Frank were responses to a seemingly broken system of corporate governance, so too was the SEC’s effort to empower shareholders.

A. Shareholder Primacy and the Development of the Shareholder-Centric Corporate Governance Infrastructure

Given the SEC’s mandate to protect investors, it is unsurprising that the SEC has taken a variety of actions over the years to empower shareholders. The goal of these actions does not seem to have a root in a desire to dethrone Delaware through federal securities policy; while some SEC commissioners may have held that view, a simpler explanation is simply that stronger shareholders also help to augment the SEC’s bounded enforcement efforts, and promoting the interests of shareholders is viewed as principal among the three core missions of the SEC. The SEC’s mission, as currently set out by statute, is to protect investors, maintain fair, orderly, and efficient markets, and to facilitate capital formation. Sometimes the three parts of the SEC’s mission compete with one another and require hard regulatory choices. Congress has occasionally pushed the SEC to increase the attention given to the goal of capital formation in its rulemaking, such as with the JOBS Act. Investor protection always remains a key feature of SEC rulemaking, however, and the SEC has seemingly operated with the expectation that investor protection may be served both directly (through disclosure and enforcement) as well as indirectly, by providing investors with a shareholder-centric governance infrastructure that facilitates shareholder activism and enhances shareholders’ ability to protect their own interests. These shareholders, in turn, use the enabling mechanisms of state corporate law to enact corporate governance changes (such as the adoption of majority voting provisions or the elimination of poison pills) that solidify shareholder power and enhance accountability mechanisms. Such “reformed” structures further facilitate activism, including hedge fund interventions. Though not directly supplanting state corporate law, these changes represent a creep toward a standardized set of governance practices that reflect the SEC’s shareholder empowerment agenda. The SEC does not need to regulate directly if it can empower investors and proxy advisors to push for governance changes through private ordering. The development of the governance infrastructure that has made these changes possible is described in the following sections.

1. Institutionalization of U.S. Securities Markets and the Rise of the Corporate Governance Industry

The development of a shareholder-centric (and particularly, an institutional-investor-centric) governance infrastructure followed shifts in investment patterns in the 1970s and 1980s. Although mutual funds have been in existence for roughly 100 years, the SEC’s development of regulation for both investment advisers and investment companies provided a regulatory framework that fostered the growth in intermediated investment services, including through mutual funds, exchange-traded funds, hedge funds, and private equity funds. This growth accelerated dramatically in the 1970s with the creation of index funds, the creation of Keogh plans in 1962, Individual Retirement Accounts (IRAs) in the Employee Retirement Income Security Act of 1974 (ERISA), 401(k) plans in the Revenue Act of 1978, Roth IRAs in 1997, and the shift to defined contribution funds and away from defined benefit funds. Public and union pension funds, meanwhile, began to exercise their power as shareholders by introducing governance-related proposals; this activity was ostensibly designed to “raise the ocean in order to lift [the pension fund’s] boat,” in the words of former CalPERS chief counsel Richard Koppes.

Accompanying these structural changes in the investor base were parallel regulatory changes introduced by the Department of Labor and the SEC. In 1994, the Department of Labor published its seminal “Avon Letter,” which stated that “the fiduciary act of managing plan assets which are shares of corporate stock would include the voting of proxies appurtenant to those shares of stock.” The ruling created a mandatory voting regime in which managers of ERISA-covered funds were required to vote proxies even in cases in which the subject at issue was not material to the interests of the fund’s beneficiaries.

The SEC formalized a similar policy view when it adopted Rule 206(4)-6 of the Investment Advisers Act of 1940 in 2003. Rule 206(4)-6 is a relatively short and simple but powerful rule that declares that the very act of exercising (or failing to exercise) voting authority with respect to client securities is a “fraudulent, deceptive, or manipulative act, practice or course of business” unless the adviser (i) adopts and implements written policies and procedures (including procedures to address conflicts of interest) that are reasonably designed to ensure the adviser votes client securities “in the best interest of clients,” (ii) discloses to clients how they may obtain information from the adviser about how the adviser voted the securities, and (iii) describes to clients the adviser’s proxy voting policies and procedures and, upon request, furnishes a copy of the policies and procedures to the requesting client. Although the SEC’s rules do not require investment advisers to vote proxies, they expressly tie fiduciary duties (and SEC enforcement of those duties) to proxy voting, creating a regulatory risk and fostering the development of an industry designed to help manage that risk. While proxy voting and corporate governance advisors existed before 2003, the industry was given a substantial boost from the rulemaking. As the GAO noted in a 2016 review of the proxy voting industry,

[a]ccording to some industry stakeholders, based on certain interpretations of the rule and subsequent SEC staff guidance, some investment advisers determined that they could discharge their duty to vote their proxies and demonstrate that their vote was not a product of a conflict of interest if they voted based on the recommendations of a proxy advisory firm. As a result, institutional investors tended to outsource their research and voting decisions, which helped to increase the demand for proxy advisory services.

The SEC solidified the role of proxy advisors in no-action letters to Egan-Jones Proxy Services (May 27, 2004) and Institutional Shareholder Services, Inc. (Sept. 15, 2004). In those letters, the SEC affirmed that “a proxy voting firm could be an independent third party for purposes of making proxy voting recommendations for an investment adviser's clients, even though the firm receives compensation from an issuer … for providing advice on corporate governance issues.”

Proxy advisors play a key role in corporate governance for a variety of reasons, despite a lack of solid evidence that the information they produce and the recommendations they make are associated with better firm performance. First, they serve as data aggregators, and play a useful function in collecting and systematizing data. Investment advisers may be faced with the daunting task of reviewing thousands of proxy statements, most of which arrive within a relatively compressed timeframe. Proxy advisors simplify the process of managing this data load and are useful in executing votes on routine matters such as a typical auditor ratification. Second, as Larry Ribstein noted, institutional investors may use proxy advisors not merely as a means to manage the regulatory risks associated with compliance with the SEC’s nebulous fiduciary duty standards with respect to proxy voting, but also as a form of “criticism insurance.” For a price—the subscription costs to ISS or Glass Lewis, the two major proxy advisory firms, serving as a form of premium payment—fund managers buy the ability to say that they have relied on “good governance” experts who have examined the proxy statements and evaluated the various matters up for shareholder vote. Note that there is no guarantee that the fund managers are receiving quality governance advice. And, in fact, some scholars have argued that institutional investors may actually prefer a low-quality, “noisy” signal because “low-quality ratings make it harder to hold them accountable for poor decision making or poor outcomes associated with those investment decisions.”

Finally, some institutional investors might value certain governance changes even if they have no proven positive effect on corporate performance; corporate governance changes that increase managerial accountability, even if not associated with stronger firm performance, may be useful to these institutional investors because they may more easily exercise power and influence over corporate policies that are meaningful to them. To this point, Matsusaka and Shu argue that as cost- and return-focused investors like index funds are unwilling to pay for high-quality advice, proxy advisory firm recommendations are more likely to be aligned with the preferences of “socially responsible” investment funds that are not necessarily focused on wealth maximization, even if such funds “comprise only a small fraction of investors.”

The rise of the proxy advisory industry has had a powerful impact on corporate governance. As noted by BlackRock, the world’s largest asset manager, “proxy advisors can have significant influence over the outcome of both management and shareholder proposals.” Nadya Melenko and Yao Shen find, for example, that a negative ISS recommendation on a say-on-pay proposal leads to a 25 percent reduction in support for the proposal. Further, some asset managers seemingly outsource their voting obligations entirely to proxy advisors. In 2020, for instance, 114 asset managers managing over $5 trillion in assets voted in lockstep with ISS, the largest proxy advisor, on 99.5 percent of ISS’ recommendations.

2. Shareholder Proposals and Rule 14a-8

Another major component of the SEC’s empowerment infrastructure is the shareholder voting rules under Rule 14a-8, which were promulgated to foster a “functional ‘corporate democracy.’” In its early management of the shareholder proposal process, the SEC took the view that an inappropriate use of the proxy process included proposals “for the purpose of promoting general economic, political, racial, religious, social or similar causes.” The SEC attempted to focus shareholder participation by allowing companies to exclude proposals that related to the “ordinary business” of the corporation and to proposals that had been submitted in prior years but had not received significant support from other shareholders. Some “gadfly” investors made use of the rule in the 1940s, 1950s, and 1960s, and in the 1970s they were joined by “social investors” that sought to shift corporate practices on a wide variety of social issues, including environmental issues, nuclear weapons, animal welfare, and important political questions. In more recent years, institutional investors, including public pension funds and hedge funds, have made use of shareholder proposals to enhance accountability mechanisms, as well as to eliminate governance structures that serve as barriers to shareholder influence, such as poison pills, classified boards of directors, and supermajority vote provisions.

The contours of the rule have changed repeatedly over the years through both SEC action and judicial intervention, with shareholder rights under the rule waxing and waning over time, generally in rhythm with the political composition of the Commission. However, as markets have become increasingly institutionalized and shareholder power has become increasingly concentrated, the SEC’s efforts have correspondingly tended toward facilitating shareholder voice, even on matters that state law traditionally reserved to the management of the board of directors. The SEC staff recognized this escalating tension in 2007, noting that under “state corporate law and current practice … shareholders have the right to adopt shareholder resolutions to ratify board actions or to request the board to take certain actions. But they may not involve themselves in the management of the corporation.” Reflecting the surge in shareholder activism in the prior decades, the staff also noted that “this basic arrangement has come into question in recent years,” with some believing that the shareholders, as “owners of the company,” should be empowered to exercise more oversight and control over matters of corporate governance. Others, the SEC notes, believe that increasing shareholder power is “already adversely affecting the board’s and management’s ability to manage the corporation, thereby ultimately harming the shareholders of the corporation.”

The staff goes on to explain that when Congress empowered the SEC to regulate the proxy process for public companies, it created “a federal role in vindicating shareholders’ state law rights,” an odd reading of the statutory role of the SEC in that it suggests that Congress had made a determination that state corporate laws did not provide adequate mechanisms for shareholders to use and protect existing rights, a role not expressed in the legislative history of the Securities Act or the Exchange Act. Indeed, one of the drafters of the Securities Acts, Department of Commerce Ollie Butler, stated in a Senate hearing that “no attempt in drafting this bill was made to amend corporate law. The only aim of this bill was to control the sale of securities.” While current SEC practices do not amend state corporate law, they do serve to amplify shareholder voice so that shareholders themselves are better able to make use of the proxy process to shift governance practices.

Under the Biden administration, shareholder voice has been further strengthened through a clarification of the “ordinary business” exclusion, “realigning” the rule with the standard “initially articulated in 1976, which provided an exception for certain proposals that raise significant social policy issues” (but, of course, taking the rule out of alignment with the earlier intention of allowing companies to exclude social proposals). Under the SEC’s revised guidance, SEC staff will not focus on any particular nexus between a given policy issue and the company’s business, but will consider “whether the proposal raises issues with a broad societal impact, such that they transcend the ordinary business of the company.” Rules proposed in July 2022 will also limit the availability and scope of certain existing exclusions, including for proposals that the company has already substantially implemented, that duplicate other proposals submitted by the company or other shareholder proponents, and for proposals that have been submitted in prior years. Rule 14a-8 seems positioned to remain the “principal tool” of the SEC to “effectuate a form of ‘corporate democracy’ through its proxy rules.”

B. Shareholder Power and Shifts in Corporate Governance

The SEC’s path to corporate democracy has not always been smooth and straight. When the SEC has attempted to shape its rules in ways that directly federalize corporate governance without a clear congressional mandate, reactions from business leaders have been swift and fierce, and courts have often sided with business leaders in these cases. For example, the SEC attempted to intervene in corporate elections through the introduction of Rule 14A-11, which provides shareholders a limited ability to place nominees on the corporation’s proxy statement. The rulemaking was later vacated by the D.C. Circuit in Business Roundtable v. SEC in a “triumph of federalism over federalization.” Yet, notwithstanding the ruling, functional federalization occurred as shareholders made use of the channels of shareholder influence described in this article to accomplish what the SEC could not.

Shareholders have engaged in numerous successful initiatives, primarily through proxy activism, to shift corporate governance practices. In the case of proxy access, the SEC had tried (and failed) to impose a mandatory proxy access rule. Under the SEC’s proposed rule, shareholders would have the ability to include their director nominees on the company’s proxy statement if the shareholders had continuously held “at least 3% of the voting power of the company's securities entitled to be voted” for at least three years prior to the date the nominating shareholder intended to use the rule. Following a suit by the Business Roundtable, the D.C. Circuit ultimately struck down the proxy access rule, concluding that the SEC “acted arbitrarily and capriciously for having failed once again … [to] adequately to assess the economic effects of a new rule.” The SEC, the court wrote, had “inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.” But ultimately, while the Business Roundtable won the battle in the D.C. Circuit, it lost the war over proxy access. By 2019, about 76 percent of S&P 500 companies had adopted a form of proxy access in their bylaws. This trend was recently strengthened by the SEC’s recently adopted rules allowing for shareholders to vote on their “preferred mix” of candidates in contested elections—the so-called “universal proxy” rules.

Institutional investors have had similar success with majority voting provisions. Twenty years ago, most corporations had rules allowing for directors to be elected by a plurality of shareholders; if only 70 percent of a corporation’s shareholders voted, and only 60 percent of those shareholders favored a particular director, the director would still be elected with just 42 percent of the total votes of the shareholders in favor of her election. But after considerable efforts by activist investors, majority vote provisions were put in place at nearly 90 percent of S&P 500 companies. Although corporations use several different forms of majority voting rules, the common denominator for these provisions is that directors receiving only a plurality of the vote are not allowed to be seated as directors. A Commission rule requiring majority voting would likely have suffered a fate similar to the proxy access rule; because shareholders have been so successful in pressing companies to make changes to their director election rules, such an effort is unnecessary.

These are just two of many successes. Shareholders at large companies—where institutional ownership is more concentrated—have successfully shifted numerous corporate governance practices, such as reducing the use of permanent poison pills, reducing the prevalence of classified boards of directors, and reducing the use of supermajority requirements to amend the charter.

IV. Recent Regulatory Efforts Reflecting Shareholder Power

The SEC’s rulemaking has not only helped empower shareholders within their portfolio companies, but recursively has also allowed shareholders to shape SEC rules that apply to all firms. Some of the SEC’s recent rulemaking actions reflect the use of this infrastructure, including the SEC’s recent climate change disclosure rules and its regulation of proxy advisors.

A. Climate Change

The SEC’s climate change rules are, like Dodd-Frank and Sarbanes-Oxley, rules that may dramatically shape corporate governance, and indeed are designed to impact the governance of not only public corporations, but private corporations that supply public corporations with goods and services. The proposed rules accomplish this by requiring disclosure of Scope 3 emissions (with certain limitations), among the more controversial aspects of the proposed disclosure rules.

The climate change rules are notable for their strong emphasis on demand for climate change regulation, and specifically for disclosures about “how climate conditions may impact their investments.” They cite a series of shareholder-led initiatives pressing for “better information” on climate risk, and urging governments and companies to take steps to reduce investors’ exposure to climate risks,” including the Global Investor Statement to Governments on Climate Change, Investor Agenda’s 2021 Global Investor Statement to Governments on the Climate Crisis, the U.N. Principles for Responsible Investment (a longstanding initiative that currently has over 4,000 signatories), the Net Zero Asset Managers Initiative, the Climate Action 100+, and the Glasgow Financial Alliance for Net Zero. In the proposed rules, the SEC avers that “[e]ach of these investor initiatives has emphasized the need for improved disclosure by companies regarding climate-related impacts,” and that each initiative has “advocated for mandatory climate risk disclosure requirements aligned with the recommendations of the Task Force on Climate-Related Financial Disclosures (“;TCFD”) so that disclosures are consistent, comparable, and reliable.” While the rules may have come about without a push from shareholders, shareholders undoubtedly shaped the scope and content of the rules.

B. The Proxy Advisor Rules

Shareholder power is also reflected in the SEC’s recent decision to walk back regulation of proxy advisors. The SEC’s proxy advisor rules were developed after nearly a decade of work across Republican and Democratic-controlled commissions. The ultimate result was relatively modest: enhanced disclosure and conflict-of-interest rules, a rule providing companies the right to respond to proxy advice (including advice based on erroneous information), and the codification of the SEC staff ’s decades-longstanding position that proxy advisors were subject to the antifraud rule of 14a-9. Taking lessons from earlier failures such as Rule 14a-11, the proxy advisor rules seem more carefully crafted to meet the stringent demands of the Administrative Procedures Act, with extensive research, lengthy notice-and-comment periods, and incorporation of commenter feedback in the final rules. Yet, with no real explanation for a shift in policy, SEC Chair Gary Gensler directed the staff to reconsider the application of a rule that it had already considered for a decade. The implicit explanation for the shift is that the rule serves to potentially weaken some of the power of proxy advisors and the institutional investors who use proxy advisors as their megaphone, muffling the SEC’s efforts to amplify shareholder voice through the proxy process generally. Chair Gensler’s position likely does not reflect the views of all institutional investors, but it certainly reflects the views of many large investors, including public pension funds, the core advocates for proxy advisors. Proxy advisors, in turn, magnify the pension funds’ views on corporate governance matters, even though these views may not reflect the investment policies of all institutional investors.

V. Implications and Conclusions

The SEC’s support of shareholder empowerment and its creation of activism channels seems to be a boon for good corporate governance and a solution to the problem of the separation of ownership and control identified by Berle and Means nearly one hundred years ago. The assumption underlying this view is that institutional investors are successfully limiting or eliminating managerial agency costs through their efforts to shape modern corporate governance.

A view that institutional investor power is inherently good for corporate governance seems to rest on an understanding that shareholders have similar interests in value maximization, and that although shareholders may have minor variations in risk preferences, a fundamental capitalist logic drives the markets. And, as George Dent has argued, even if some shareholders might hold non-wealth-maximizing positions, ‘[r]arely do such investors own more than a small fraction of a company’s shares.” Furthermore, the particular, peculiar agendas of these shareholders tend to “cancel out one another.” And, as a general matter, a shift away from a managerialist model and toward a “monitoring model,” as explained by James Cox and Randall Thomas, supports occasional shareholder interventions as an “error correction” mechanism that ultimately produces shareholder value.

Other scholars have pointed to a variety of potential conflicts of interest that may lead to the pursuit of ends that ultimately harm other shareholders. As Iman Anabtawi and Lynn Stout note, activist investors may use their shareholder status “to push for favorable treatment in their other dealings with the firm.” Shareholders may have conflicting interests due to their use of derivative instruments that separate economic interests from voting rights, or through their ownership in other companies’ securities. Shareholders may also be investors in other parts of a corporation’s capital structure, thereby facing (and sometimes exploiting) potential conflicts of interest with respect to their risk preferences. Stephen Bainbridge summarizes these concerns by noting that “institutional investor activism does not solve the principal-agent problem but rather merely relocates its locus.” Indeed, within the typical function of corporations, and assuming there is no evidence of managerial opportunism, the parties most likely to make use of corporate influence channels would more likely be those having interests conflicting with wealth-maximization. The end result of the SEC’s shareholder empowerment efforts, then, may have (and arguably already seems to have) the effect of empowering institutional investors in ways that exacerbate the principal-agent costs these investors impose on their beneficial-owner retail investors.

A further implication of the functional federalization of corporate law is a diminution of the value of state corporate law. To put it in terms more positive to shareholder empowerment, functional federalization creates a baseline set of governance standards that will provide broad benefits for all shareholders. But, of course, more homogenized, functional corporate governance standards also reduce the incentives of states to compete for incorporations and re-incorporations. We would thus expect to see a decrease in the value of Delaware incorporation over time. And indeed, while analyses by Daniel Fischel (1982), Roberta Romano (1985), and Robert Daines (2001) found evidence for a premium for Delaware companies, Subramanian’s 2004 study found that the effect was fading. Still later work has called into question whether there is still any premium in Delaware’s corporate law. Robert Anderson and Jeffrey Manns’ 2014 article The Delaware Delusion, for example, provides an analysis of merger incorporation decisions and finds that “Delaware law does not add to or subtract significant value from publicly traded companies.” Robert Rhee’s 2023 article The Irrelevance of Delaware Corporate Law, which conducts a longitudinal study of Fortune 500 company valuations, likewise finds that “Delaware corporations are not valued more than the companies chartered in other states. There is no actionable Delaware premium.” These results are consistent with a creeping, functional federalization of corporate law, under which state-level differences become decreasingly meaningful to the point of irrelevance.

In sum, to the extent “federalization” has occurred, it is not primarily the result of direct regulation either in the form of federal corporate law or securities regulations that operate like a federal corporate law, but instead through the effects of securities regulation that shift power to institutional investor and proxy advisors, who then use this power to impose standardized governance structures that increasingly operate like a functional federal corporate law. Whether this is ultimately a benefit or a detriment to shareholders and society at large is a question that will undoubtedly be investigated by corporate law scholarship for years to come.

The author thanks Miriam Baer, Stephen Bainbridge, Alina Ball, Carlos Berdejo, Jim Cox, Alex Lee, Jim Park, Urska Velikonja, and Andrew Verstein for helpful comments and discussion.