Draft: December 20, 2005 AN ANALYSIS OF ENABLING VS. MANDATORY CORPORATE GOVERNANCE STRUCTURES POST SARBANES-OXLEY Anita Indira Anand∗∗ ∗∗ Visiting Olin Scholar in Law and Economics and Visiting Lecturer in Law, Yale Law School; Associate Professor, Faculty of Law, Queen’s University, Kingston, Ontario, Canada, e-mail: [email protected]. Thanks to Bernard Black, Kim Brooks, Doug Harris, Edward Iacobucci, Lewis Johnson, John Knowlton, Kate Litvak, Niamh Maloney, Marc Paulez, Jessie Penley, Larry Ribstein, Arthur Sweetman and Michael Trebilcock for their very helpful comments as well as to the Social Sciences and Humanities Research Council of Canada for providing comments of an anonymous reviewer. Deep thanks also to Jessie Penley, Ryan Sheahan and Nicole Stephenson for their excellent research assistance. Thanks to participants in the Queen’s Law and Economics Discussion Group, the annual conference of the Canadian Law and Economics Association (2004), and the annual meeting of Law and Society (Canada) for their helpful comments. I extend my appreciation to the Queen’s University Advisory Research Council, the Foundation for Legal Research, and the Social Sciences and Humanities Research Council of Canada for assistance in funding research underlying this project.ABSTRACT I argue that firms have incentives to adopt corporate governance practices in the absence of a legal requirement to do so. I further contend that a partially enabling governance regime, and particularly one coupled with mandatory disclosure of a firm’s governance practices, is likely to yield a high level of compliance at lower direct costs to the issuer than a wholly mandatory regime. While a wholly mandatory structure may yield slightly better compliance, its other benefits are uncertain and its costs are likely much higher. I seek to push the boundaries of existing comparative corporate governance scholarship by arguing that the enabling/mandatory dichotomy informs analyses of corporate governance regimes across countries.3I. Introduction In the United States, certain aspects of corporate governance have become the subject of mandatory regulation under the Sarbanes-Oxley Act.1 Other major common law jurisdictions, such as the United Kingdom, Australia and Canada, have rejected mandatory corporate governance legislation of this nature. These countries have instead opted for an enabling, or partially enabling, regime under which companies can choose the governance practices they will adopt but they must make disclosure regarding these choices. The question that arises is whether an enabling structure gives rise to the benefits of a mandatory governance regime but at less cost. Free marketers of course dismiss the notion of a mandatory corporate governance regime, arguing that if enhanced corporate governance practices were beneficial and desired by investors, firms competing for scarce capital would implement them voluntarily. On the other hand, investor advocates argue that an enabling regime is insufficient, since there is no guarantee that all firms will implement the reforms necessary to provide investors with adequate checks on agency problems. On this view, mandatory corporate governance is necessary -- just like rules prohibiting insider trading -- to protect investors. 1 The Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 15 U.S.C. and 18 U.S.C.) [“Sarbanes- Oxley” or “SOX”].4These extreme positions do not capture the complexities inherent in a choice between enabling and mandatory governance regimes. In this paper, I argue that firms have incentives to adopt corporate governance practices in the absence of a legal requirement to do so. I further contend that an enabling governance regime coupled with mandatory disclosure of a firm’s governance practices is likely to yield a high level of compliance at lower cost than a wholly mandatory regime. While a wholly mandatory structure may yield slightly better compliance, its costs (particularly direct costs) are likely much higher. I do not seek to slot entire governance regimes into either the mandatory or the enabling category: most regimes exhibit characteristics of both. In particular, in the United States, corporate law as a whole is largely enabling at the state level, providing default rules to which corporations must adhere if they do not choose an alternative arrangement that will govern them.2 Despite the enabling character of state corporate law, most would agree that Sarbanes-Oxley cannot be characterized as enabling legislation.3 Thus, in this paper, I address the conspicuous aspect of US corporate 2 On the enabling characteristic of U.S. corporate law, see e.g., Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law (Cambridge, Mass.: Harvard University Press, 1996) [Easterbrook & Fischel, Economic Structure of Corporate Law]; Jeffrey N. Gordon, “The Mandatory Structure of Corporate Law” (1989) 89 COLUM. L. REV. 1549; Roberta Romano, “Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws” (1989) 89 COLUM. L. REV. 1599; Bernard Black, “Is Corporate Law Trivial?: A Political and Economic Analysis” (1990) 84 N. W. U. L. REV. 542; Lucian Ayre Bebchuk & Assaf Hamdani, “Optimal Defaults for Corporate Law Evolution” (2002) 96 N. W. U. L. Rev. 489. 3 See e.g. Ronald J. Gilson & Curtis J. Milhaupt, “Choice as Regulatory Reform: The Case of Japanese Corporate Governance” Columbia Corp. Gov. Project Working Paper No. 251 (2004) at 29, who state, “The most recent cycle of US corporate governance reform…both through Sarbanes-Oxley and the5governance regulation that is mandatory under Sarbanes-Oxley, conspicuous because of the enabling character of state corporate law and because other principal common law jurisdictions have not adopted a similar approach. While the US regime under SOX is largely mandatory,4 other jurisdictions have adopted a different governance model. Canada’s regime dates back to 1995 when the Toronto Stock Exchange (TSX) issued a list of best practices that Canadian listed firms may but are not obliged to follow.5 Disclosure regarding the extent of a firm’s compliance with the best practices was required in the firm’s proxy circular or annual report.6 Provincial securities commissions now bear the responsibility for formulating and administering the