Volume 96 - Virginia Law Review

Placebo Ethics

ENACTED in response to abuses that led to Enron’s fall, Section 406 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley” or “SOX”) effectively requires every public company to disclose its code of ethics, and also to disclose immediately, via website or SEC filing, any waivers from the code that the company grants to its top three executives. These waivers offer a unique window not only into the ethical practices of public U.S. companies, but also into how disclosure works “on the ground”—whether companies are actually complying with disclosure rules.

Out of 200 randomly selected firms, we found only one waiver filed over five years disclosed pursuant to Section 406. By exploiting an overlap in disclosure regulations, we were able to crosscheck our sample companies’ waiver disclosures. We identified 33 instances in which companies appear to have violated Section 406, and another 70 instances in which companies evaded illegality by watering down their codes to such a degree that they no longer forbid the very En-ron-style conflicts of interest that led to the adoption of Section 406.

Finally, we studied all Section 406 waivers filed with the SEC in the six years following SOX’s passage—and found only 36 total. Event studies revealed that the market generally did not react to these transactions, suggesting that companies use waivers only to disclose innocuous, immaterial information, and disclose more problematic information, if at all, in more covert ways.

We draw two conclusions from our research. First, the current regime is unhelpful and inefficient, long on costly and burdensome disclosures, and short on demonstrable benefit. Section 406’s disclosure requirement is not functioning as intended. Either by mistake, manipulation, or indifference, companies are evading its requirements. We suggest eliminating the currently unenforced code-of ethics waiver disclosure mandate, and instead requiring immediate disclosure of related-party transactions involving the company’s CEO, CFO, or CAO, regardless of the firm’s internal ethics rules. Second, our study highlights the limited utility of regulation by mandated disclosure alone and the inadequacies of website disclosure for securities regulation.

Of Punitive Damages, Tax Deductions, and Tax-Aware Juries: A Response to Polsky and Markel

IN “Taxing Punitive Damages,” Gregg D. Polsky and Dan Markel argue that defendants paying punitive damages are under-punished relative to juries’ intentions, because tax-unaware juries do not take into account the fact that the deductibility of punitive damages significantly reduces defendants’ after-tax costs. They note that the Obama administration has proposed addressing the under-punishment problem by amending the Internal Revenue Code to disallow deductions for punitive damages (and for settlements paid on account of punitive damage claims) They conclude, however, that the proposal would be ineffective because defendants could avoid its impact by disguising nondeductible punitive damage settlements as deductible compensatory damage settlements. They argue that a superior approach would be to leave federal tax law unchanged and to change jury instructions in punitive damage cases instead. If juries were explicitly told that punitive damages were deductible, they could “gross up” the awards to impose the desired level of after-tax punishment on defendants. In contrast with the Obama administration’s proposal, this non-tax, non-federal solution to the under-punishment problem would not be undermined by pre-trial settlements: “Gross ups, in addition to increasing jury verdicts, would increase settlement values because litigants determine these values in the shadow of what a jury would be expected to award.”

Their argument is powerful and original. It may have dramatic real-world effects, if it inspires plaintiffs’ lawyers across the nation to request the jury instructions required to produce tax-aware juries, and if courts grant those requests. In this brief Response, however, I raise two possible objections to their analysis. The first objection is that they do not consider the alternative of a nondeductibility rule applicable to punitive damages but not to settlements of punitive damage claims. This narrower nondeductibility rule is arguably superior to both broader nondeductibility and tax-aware juries. The second objection is that they do not consider how their analysis would change if deterrence, rather than punishment, were viewed as the primary function of punitive damages. Although these are considerably more than quibbles, they do not detract from my view of their article as a major contribution to the scholarly literature on the intersection of torts and taxes, with the potential for significant real-world impact. The Response closes with a brief observation on the relationship between the article, plaintiffs’ attorneys, and ten dollar bills on sidewalks.

State Judicial Elections and the Limits of Calibrating Access to the Federal Courts

ALMOST all state court judges are subject to some sort of popular election to attain or retain office. In some states, judges are selected by competitive elections (some partisan, some nonpartisan), much like those for other public offices. In other states, judges are initially appointed, putatively by merit selection, and then undergo periodic retention elections, where they run against themselves and must obtain a majority (or more) of the votes cast to retain their seat. In a few states, some judges are appointed for terms and do not face retention elections. There is substantial evidence that, for a variety of reasons, both competitive and retention elections, especially at the state supreme court level, have since the 1980s become more contentious, expensive, and salient to voters and interest groups. These changes have attracted considerable and mostly critical attention, both nationwide and within certain states, from the federal and state judiciary, bar associations, and academics. Over the same time period, there has been a seemingly unrelated development at the United States Supreme Court. Throughout much of the twentieth century, the Court decided well over 100 cases on the merits each Term. As late as the 1970s and 1980s, the Court was deciding up to 150 cases each year. In the early 1990s, that figure began to decline sharply to about 100, and since about 2000 has declined even further, to about 70 to 80 cases a year. Only about ten cases a year are appeals from state courts.

In their timely and provocative article, Amanda Frost and Stefanie Lindquist do not argue that there is a causal connection between these phenomena. But they do argue that it is useful to consider the significance of these developments together. In short, they contend that the high-profile nature of state judicial elections is not a good thing, since it presents the “majoritarian problem” found in their title: nominally impartial state judges, in place to check the other branches of government, will be prone to bend to public opinion as expressed in elections. On this account, it is particularly a problem when state judges must enforce counter-majoritarian rights. But as Frost and Lindquist observe, “[l]ike it or not, elected judges are here to stay.” To deal with the majoritarian problem, they argue that life-tenured federal judges can adjust the gate-keeping criteria by which they review state court decisions. The authors suggest that the federal Supreme Court more often review decisions of courts from states with competitive election systems, and that lower federal courts take into account the same factors when collaterally reviewing state criminal decisions via habeas corpus. They further argue that federal courts should explicitly state that they are taking these criteria into account.

In this response, I will briefly review Frost and Lindquist’s arguments and their empirical study that indicates that the Supreme Court more often reviews decisions from elective states than appointive states. In my critique, I focus mainly on their remedy, that federal courts should candidly announce that they are taking into account the mode of state judicial election when reviewing, or deciding to review, decisions from a particular state. Among the issues I will address are whether such a blunt remedy is necessary in light of (1) existing empirical evidence about judicial elections, and on how state courts in general apply federal law; (2) assumptions about the presumed need or ability to ensure uniformity in federal law; (3) whether federal courts will be as candid as suggested by Frost and Lindquist; and (4) how such a remedy, if adopted, might affect decision-making in state courts.

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