Corporate Law Archives – Southern California Law Review

Auditor Independence: Moving Toward Harmonization or Simplification?

June 2024June 2024Nikita Patel*

INTRODUCTION

Auditor independence has been a priority for the Securities and Exchange Commission (“SEC”) under the leadership of both the Trump Administration and the Biden Administration. In 2020, former SEC Chair, Jay Clayton, pointed out that in the United States “auditor independence rules are far-reaching and restrictive,” which could have “unintended, negative consequences.”¹ Shortly thereafter, the SEC issued new regulation that lowered auditor independence requirements and brought the SEC’s independence rules closer to the rules set forth by the Public Company Accounting Oversight Board (“PCAOB”) and American Institute of Certified Public Accountants (“AICPA”), the other two regulatory entities responsible for auditor independence.² Meanwhile, the current chair, Gary Gensler, has signaled that auditor independence remains a “perennial problem area,” indicating that a tightening of the auditor independence requirements is soon to be seen.³

While the future of auditor independence regulations remains up in the air, the problems associated with a lack of auditor independence continue. In 2019, the SEC alleged that PricewaterhouseCoopers LLP, one of the “Big Four” accounting firms, had violated auditor independence rules in connection with nineteen service engagements for fifteen publicly traded companies by providing prohibited non-audit services that could have impaired the firm’s objectivity.⁴ Non-audit services are ancillary services, such as reviews of accounting software or tax advice, that do not assist in the goal of auditing, which is reviewing the financial statements for fraud or error. The SEC also alleged that another Big Four accounting firm, Ernst & Young LLP, had violated auditor independence standards, along with one of its partners and two of its former partners.⁵ The Chief Accounting Officer for Ernst & Young’s client on this engagement was also allegedly involved with this misconduct, indicating how far-reaching auditor independence violations can be.⁶

Auditor independence is governed by a self-regulatory model, in which the SEC, in partnership with the PCAOB, the specialized non-profit corporation created by the Sarbanes-Oxley Act of 2002,⁷ provides oversight over the AICPA, which is a private industry professional organization charged with setting substantive auditor regulation. Despite the importance of auditor independence regulation in investor protection and the existence of this self-regulatory model, the regulatory framework in this area remains entangled.

While the SEC and PCAOB provide oversight over the AICPA, they also issue their own auditor independence regulation and have enforcement practices associated with auditors.⁸ Among the SEC, PCAOB, and AICPA, each standard-setter has rules that overlap with the others in the same subject-matter and some rules that defer to the rules set by the other organizations.⁹ This leads to a waterfall effect, in which all three entities have to change their regulations any time one of the other two does, in order to ensure that the rules are not in conflict.¹⁰ This effort has been called “harmonization,” and has the goal of ensuring that all regulatory frameworks in this area are made consistent with each other, to provide more certainty to the accounting firms and other stakeholders involved in audits, including public company boards of directors.¹¹ However, an alternative solution to harmonization may be “simplification,” in which instead of expending effort to harmonize the regulation of the three entities each time one of them makes a change, the existing self-regulatory model could be streamlined so that the AICPA is the primary or sole standard setter, with the SEC and PCAOB providing government oversight.

To explore whether simplification is a compelling alternative to harmonization, this paper turns to federal judicial decisions by conducting a novel case study of all auditor independence cases decided after the passage of the Sarbanes-Oxley Act of 2002. These decisions indicate that the courts largely use AICPA standards and case law requirements in assessing auditor independence, rather than SEC or PCAOB standards. This new finding suggests that simplification of the regulatory framework by relying solely on AICPA rulemaking is a viable solution, given that the federal courts already rely on AICPA rules.¹²

This paper will proceed as follows. First, Part I provides a brief summary of the business of public company audits to preview how the structure of the audit industry gives rise to unique incentivizes and pressures that may impact auditor independence. Next, Part II includes an overview of the impact of the Sarbanes-Oxley Act of 2002 on the audit industry and highlights the debate over auditor independence, including the ways that various stakeholders have argued whether auditor independence is a worthy goal, or if auditors’ role as gatekeepers is unnecessary. Thereafter, Part III provides an overview of the self-regulatory model that governs auditor regulation, as well as regulations promulgated by the SEC, PCAOB, and AICPA in the area of auditor independence, including a summary of recent efforts to harmonize the standards set by each entity. The core of the paper’s contribution to the literature on auditor independence regulation is in Part IV, which a presents a novel case study that examines which body of regulation, between the SEC, PCAOB, and AICPA, is preferred by the federal courts when determining whether there have been auditor independence violations. This leads to the key finding that, in determining whether auditor independence violations have occurred, the federal courts rely almost exclusively on AICPA standards and case law requirements developed by the courts, rather than SEC or PCAOB standards. Accordingly, the paper then briefly examines in Part V whether this finding indicates that rule-making authority should be consolidated by giving the AICPA authority to set substantive auditor independence regulation, with the SEC and PCAOB providing oversight, given that there is already a self-regulatory model in place. Put differently, the paper concludes by considering whether the three regulatory frameworks should be simplified into that of the AICPA, the standard setter that is the most comprehensive, and the one that has been most acknowledged by the courts.

I. THE BUSINESS OF PUBLIC COMPANY AUDITS

The role of auditors in public company financial reporting is to provide third-party reasonable assurance to investors that the financial statements of their client companies “are free of material misstatement, whether caused by error or fraud,” in the form of a formally issued audit opinion, which is appended to the clients’ public company SEC filings.¹³ Audit opinions state whether the auditor believes that the financial statements included in the filings are free, in all material respects, from error or fraud.

Generally, auditors are viewed as “gatekeepers,” meaning individuals who are “reputational intermediaries who provide verification and certification services to investors.”¹⁴ As gatekeepers, auditors have incentives to signal to outsiders that they are credible because their reputation of trustworthiness is what allows them to attract future clients and remain in business by giving credibility to their audit opinions.¹⁵ The reputation of auditors is also partially what enables them to provide verification services because investors recognize that auditors have fewer incentives than their clients’ management teams to mislead investors because the management teams are corporate insiders whereas auditors are objective third parties.¹⁶ A traditional understanding of the audit profession puts forth the proposition that auditors are trustworthy because they are not incentivized to risk their reputation by assisting one client with fraud, which could lose them many additional clients and destroy their reputational capital.¹⁷

Additionally, auditors have built up years of expertise that demonstrates to third parties that their services and opinions can be trusted.¹⁸ The utility of auditors extends from the fact that they have specialized technical expertise in the area of accounting. Members of accounting firms that conduct audits are generally expected to hold state licenses as Certified Public Accountants, which give them both reputational capital and technical expertise.¹⁹ Additionally, these accounting firms are typically well staffed with local and global teams to address the audit needs of multinational companies that are listed on exchanges in the United States, despite the complexity and geographical scope of the audit procedures that may be required.²⁰

It is widely known that auditing is part of an oligopoly, in which the “Big Four” accounting firms—PricewaterhouseCoopers LLP (“PwC”), Ernst & Young Global Limited (“Ernst & Young”), Deloitte Touche Tohmatsu Limited (“Deloitte”), and KPMG International Limited (“KPMG”)—dominate the market. The Big Four were responsible for the audits of 88% of SEC large accelerated filers—which are companies with a public float of larger than $700 million that are required by the SEC to submit securities filings on a shorter timeline than other filers—and 44.7% of all public companies in 2022.²¹ There are several smaller players in the market as well, including RSM US LLP, BDO USA LLP, and Grant Thornton LLP; however, the largest of these entities produces less than a third of the revenue produced by the smallest Big Four accounting firm, leaving the market substantially dominated by the Big Four accounting firms, which have offices globally.²²

Auditors for public companies are required to examine their clients’ financial statements and notes to the financial statements, which provide supplemental information. Auditors use a variety of mechanisms, including inspecting records, confirming balances with third parties, checking compliance with internal policies, and completing detailed tests of transactions to ensure the financial statements are free from material error or fraud.²³ Auditors also often test the robustness of management’s internal controls over financial reporting. Internal controls over financial reporting are policies and procedures surrounding accounting and reporting that are designed to limit the risk of fraud and error in the financial statements. All of this testing is done with an expectation of independence—that the auditors are not personally invested in the entity they are auditing, do not have conflicts of interests, and are reviewing the information with an air of “professional skepticism.”²⁴

II. THE DEBATE OVER AUDITOR INDEPENDENCE

When discussing auditor independence, much emphasis has been placed on the fact that each of the large public accounting firms have three lines of business: audit, tax, and consulting services. In the wake of the Enron scandal, debate over whether these three lines of business lead to inherent conflicts within public accounting firms that obstruct independence. Enron was a publicly traded energy company based in Texas that went bankrupt in 2001, partially as a result of a major decline in stock price after accounting irregularities were discovered at the company.²⁵ At the time, Enron was the seventh-largest company in the United States based on market capitalization, and its bankruptcy was the largest in United States history.²⁶ The accounting irregularities alleged were largely technical in nature, involving the use of (1) mark-to-market accounting, a practice that can lead to the overstatement of the value of assets by recording them at their current market value rather than their historical cost; (2) improper recognition of liabilities within “special purpose entities” that were owned by the company, which reduced the liabilities that were attributed to Enron; as well as (3) alleged improper payments to company officers, all of which were not in accordance with Generally Accepted Accounting Principles (“GAAP”) that are set by the AICPA and required to be followed by public companies.²⁷ Arthur Andersen LLP (“Arthur Andersen”), the public accounting firm responsible for Enron’s audit, did not, however, note any of these issues with GAAP in the audit opinions it issued about the accuracy of Enron’s financial statements, which led to surprise when the company collapsed.²⁸

In the wake of the Enron scandal, many stakeholders argued that one of the main contributing factors to Enron’s collapse was that the company’s auditor, Arthur Andersen, was receiving more revenue from its consulting engagement with Enron than it was from its audit engagement, to a factor of 1.08 times.²⁹ Arthur Andersen received approximately $27 million in annual non-audit fees and $25 million in annual audit fees from Enron in 2000 and expected to grow the overall fees to approximately $100 million annually, which some alleged was why Arthur Andersen did not disclose Enron’s lack of compliance with GAAP.³⁰ Arthur Andersen was exonerated of any liability; however, the court did not reach the issue of whether the firm was conflicted and what effect that may have had on the audit.³¹

Enron was used as an example of how pressure on accounting firms to maximize revenue from consulting engagements prevents accounting firms from robustly auditing financial statements. Primarily, stakeholders worried that accounting firms would fail to report material misstatements or fraud in financial statements in order to preserve relationships with management of the companies they were auditing or to sell them consulting services; in extreme cases such as Enron’s, the concern was that this failure to report could collapse the company entirely and thus completely eliminate a revenue-generating client.³²

The furor and fallout over Enron and implications on the weaknesses of accounting firms was used as a major justification for Congress’s passage of the Sarbanes-Oxley Act of 2002, given that investors lost billions upon Enron’s collapse.³³ Specifically, the social costs of the Enron collapse were high because pension funds that supported teachers, firefighters, and government employees were endangered from the losses, leading to outcries for reform.³⁴ William Donaldson, the SEC Chair during the time of the passage of Sarbanes-Oxley, testified before Congress that Enron was a major event leading to the reforms that were implemented in Sarbanes-Oxley.³⁵

Sarbanes-Oxley included sweeping regulatory changes designed, in part, to “restor[e] public confidence” in the accounting profession, emphasizing for the first time in Congressional legislation the importance of auditor independence.³⁶ The Act created the PCAOB to inspect accounting firms and set auditing regulations, departing from the prior regulatory structure in which the accounting profession was almost entirely self-regulated by the AICPA.³⁷ Sarbanes-Oxley also created a slew of additional auditor independence rules, such as requiring audit committees to pre-approve all audit and non-audit services provided by an auditor, reducing the consulting services that could be provided by an auditor, requiring that certain auditors rotate off an audit engagement on a regular schedule, requiring that independence concerns be raised to the audit committee when auditors identified them, and requiring disclosure to investors of non-audit and audit services provided by accounting firms.³⁸ The stated purpose of these reforms was not only to “restor[e] public confidence in the independence and performance of auditors of public companies’ financial statements,” but also to “enhance the integrity of the audit process and the reliability of audit reports.”³⁹

While Sarbanes-Oxley seemed to significantly reduce the opportunity for accounting firms to provide both audit services and consulting services to their clients, there exists a gray area in which accounting firms are able to provide certain “non-audit services” to their audit clients.⁴⁰ Accounting firms have found that these non-audit services can be a profitable substitute for revenue lost from consulting services, and according to a study that reviewed audit revenue as compared to non-audit revenue disclosures in annual proxy statements—which require public companies to disclose certain matters prior to their annual shareholder meetings—non-audit revenue represented 18% of the fees paid to auditors by public companies in 2021.⁴¹ These non-audit services allow public company auditors to provide a number of ancillary services to their audit clients, such as, (1) audits over accounting and information systems, including payroll software and human resources software, (2) “carve-out” audits that evaluate portions of the business that are set to be divested, (3) tax services, (4) statutory audits, which are audits that comply with local governmental audit requirements, especially in foreign countries, and (5) employee benefit plan audits, typically meaning audits over pension plans. All of these services can be provided without impairing independence under the SEC, PCAOB or AICPA rules, and several of them are repeat, annual services, making them especially lucrative and enticing to accounting firms.⁴²

The oligopoly presented by the Big Four accounting firms also puts significant cost pressure on accounting firms to lower audit costs to attract and retain clients, while still maximizing revenue and market share.⁴³ This balance is primarily struck by the accounting firms in two ways.

First, the accounting firms can look to drive efficiencies in the audit process to lower the cost of annual audits to clients.⁴⁴ This is often accomplished by retaining clients and using institutional knowledge gained over years of repeat audits to streamline audit processes and thus reduce hours and audit costs.⁴⁵ However, this has the added effect of lowering auditor independence as auditors become entrenched in relationships with their clients over a number of years.⁴⁶ For this reason, mandatory rotation of audit firms has been adopted in a number of foreign jurisdictions, including in Europe.⁴⁷ Some have also argued that mandatory audit firm rotations should be adopted in the United States, in addition to the existing United States requirement of rotation of the individuals who lead each audit project, known as audit engagement partners and who are usually equity partners in the accounting firms.⁴⁸

Alternatively, accounting firms can look to increase revenue from ancillary, non-audit services.⁴⁹ This method of increasing revenue by cross-selling non-audit services along with public company audits is seen as a positive to many because efficiencies are driven by the institutional knowledge that auditors already have as a result of their financial statement testing, lowering the costs for both the audit and the non-audit services. For example, an accounting firm that is performing both a public-company financial statement audit and a report on internal controls for the same client can use some of the testing done for the financial statement audit to satisfy testing requirements for internal controls, thus lowering the costs for the combined services.⁵⁰

Many argue that this bundling is a positive development, and given that audit services are fungible, lower transaction costs for companies in the form of reduced fees to accounting firms increase shareholder value.⁵¹ Additionally, tracking independence over each and every ancillary service would increase transaction costs without providing shareholder value, given that some of these non-audit services can be provided without impairing auditor independence, and especially because some argue that accounting firms are already conflicted by virtue of the fact that they are paid for audit services provided.⁵² Further, proponents of bundling argue that auditors are still incentivized to provide quality audits because despite the pressure to increase non-audit service revenue, auditors would not want to risk their reputational capital, which allows them to stay in business and attract other clients.⁵³

However, others argue that fee dependence on non-audit services poses the same problems as those that existed prior to Sarbanes-Oxley, in which instead of sacrificing audit quality to retain consulting revenue, firms are now sacrificing audit quality to retain other non-audit service revenue.⁵⁴ This leads to concerns that auditor independence will be impaired in a way that increases costs to investors because material misstatements are less likely to be caught, and this outweighs the costs saved from efficiencies by the same accounting firm providing both audit and non-audit services.⁵⁵

While this paper reserves judgment on these questions of how non-audit services effect auditor independence, the primary view of auditor regulation since the accountings scandals of the early-2000s and Sarbanes-Oxley has been that auditor independence is of paramount importance to the audit industry in order to protect investors from fraud or inadvertent material errors from management.⁵⁶ In the following Part, this paper will explore the existing regulation surrounding auditor independence, including identifying the many agencies and self-regulatory organizations that promulgate such regulations, and untangle the many requirements for independence as they have appeared over time.

III. SELF-REGULATION AND THE TANGLED REGULATORY FRAMEWORK OF AUDITOR INDEPENDENCE

Modern third party audits have existed since approximately the 1920s and have varied widely in their form and requirements.⁵⁷ However, it was not until the Securities Act of 1933 that companies were required to have their financial statements certified by an independent accountant before they could register on the public markets.⁵⁸ This requirement was expanded with the passage of the Securities Exchange Act of 1934, which mandated annual and quarterly financial reporting for public companies, as well as reporting on material events, all of which were required to be certified by “independent public accountants.”⁵⁹ The Federal Trade Commission and SEC subsequently passed rulemaking that defined “independent public accountants” as those who had neither served as officers or directors of the company to be audited, nor had a “substantial financial interest” in the company, which was defined as more than one percent of the auditor’s net worth.⁶⁰

While the SEC retained statutory authority over auditor independence regulations, eventually the AICPA formed its own auditor independence requirements and in 1977 created the Public Oversight Board (“POB”) to serve as a self-regulatory organization over the accounting profession.⁶¹ The AICPA is independently funded by membership dues from members, which include individual accountants who are certified public accountants.⁶² The AICPA is governed by a council consisting of AICPA members elected by their fellow members in each state, representatives of state CPAs, and members-at-large of the AICPA, among others.⁶³ However, in the wake of the accounting scandals of the early 2000s, the SEC issued additional independence rules to move away from complete industry self-regulation by the AICPA and POB without public oversight, and these rules were then amended to coincide with the sweeping reforms passed by Congress in the Sarbanes-Oxley Act.⁶⁴ Sarbanes-Oxley required the formation of the PCAOB—a nonprofit corporation under the oversight of the SEC—but still allowed the AICPA to issue auditor independence standards.⁶⁵ The membership of the PCAOB, which consists of a five person Board, is determined by appointment from the Chair of SEC and a vote of the five SEC commissioners.⁶⁶ The PCAOB is funded by mandatory fees from public companies who are subject to audit requirements under the Exchange Act as well as fees from brokers and dealers subject to SEC regulation.⁶⁷ As a result, since 2003, when Sarbanes-Oxley took effect, the accounting profession has been governed by three primary sets of auditor independence standards, those set by the SEC, PCAOB, and the AICPA.⁶⁸ A summary of the interaction of the regulations set by the AICPA, SEC, and PCAOB is provided below and will be discussed further in the following sections:

Figure 1.

A. Self-Regulatory Models in United States Financial Regulation

The diffuse structure that contains SEC, PCAOB, and AICPA involvement in auditor independence regulation is not unheard of within United States financial services regulation. The SEC is involved in several self-regulatory models in which the SEC provides oversight to an industry organization that sets standards, and, in some cases, enforces those standards. For example, the Financial Industry Regulatory Authority (“FINRA”) sets regulation for registered broker-dealer firms and registered brokers⁶⁹ and enforces those rules.⁷⁰ The Exchange Act gives the SEC the authority to approve any rule changes made by FINRA⁷¹ as well as revoke the authority of FINRA or issue sanctions against FINRA.⁷²

The SEC is also part of self-regulatory frameworks with national securities exchanges.⁷³ The self-regulatory framework between the national securities exchanges and the SEC works much in the same way as SEC’s oversight of FINRA, in which the SEC provides oversight over and approval of the rulemaking of each securities exchange and issues sanctions for violations of the Securities Act of 1933, the Investment Advisers Act of 1940, and the Investment Company Act of 1940.⁷⁴

The SEC also has a self-regulatory model with respect to credit rating agencies.⁷⁵ Pursuant to Section 15E of the Securities and Exchange Act of 1934, each credit rating agency was required to set internal controls and policies to ensure accurate credit ratings,⁷⁶ and the SEC was required to review such policies to ensure they were robust.⁷⁷ Additionally, prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the SEC relied on credit agencies to provide a measure of credit-worthiness in SEC rules.⁷⁸ However, Section 939A of the Dodd-Frank Act required that the SEC remove such references to the credit agencies within its rules and instead create its own independent standards.⁷⁹

Although the examples above illustrate that the self-regulatory model has been widely used, the model has also been subject to debate over its merits.⁸⁰ Supporters of the model argue it is beneficial because the knowledge of industry participants enhances the usefulness of rulemaking,⁸¹ places the costs of enforcement on industry,⁸² and is more adaptive than the state-driven model because industry entities have the experience and ability to focus on specialized regulations in a way that public entities with vast oversight responsibilities may not.⁸³ However, others believe that the self-regulatory model is not as beneficial as the European state-driven model, in which public entities are the singular or primary regulators with little or no input from industry organizations, because the self-regulatory model can result in conflicts of interest in terms of funding and regulatory capture, given that individual standard setters may be members of the group facing regulation and may seek to avoid restrictions.⁸⁴ In response, proponents of self-regulation may argue that the oversight of the public entities is sufficient to mitigate these conflicts and harness the benefits of a specialized industry standard-setter working hand-in-hand with a public oversight agency, especially when safeguards such as individual term limits for regulators, or limitations on the ability of individual regulators to participate in a “revolving door” in which they rotate between industry and regulatory entity, are put in place.⁸⁵

While the self-regulatory model is not unique to auditor regulation, what is somewhat distinctive about the auditor regulation self-regulatory model is that the SEC and PCAOB not only provide oversight over the AICPA, which is the industry organization run by accountants, but the SEC and PCAOB also have concurrent jurisdiction to set independence standards and have set their own standards for auditor independence in addition to those of the AICPA.⁸⁶ While there are additional organizations that set auditor independence standards, including state boards of accountancy, state CPA societies, federal and state agencies, and the International Ethics Standards Board, the standards set by these entities are heterogeneous and are generally superseded by the SEC, PCAOB, and AICPA rules.⁸⁷ Therefore, the regulation promulgated by these entities will not be examined in this paper. In order to assess the current landscape of auditor regulation, this paper will examine the regulations passed by the SEC, PCAOB, and AICPA in Sections III.B–D.

B. SEC Independence Rules

Under the current SEC independence rules:

The [SEC] will not recognize an accountant as independent . . . if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement. In determining whether an accountant is independent, the [SEC] will consider all relevant circumstances, including all relationships between the accountant and the audit client.⁸⁸

The SEC independence rules then set forth a non-exhaustive list of instances in which an auditor would not be independent, primarily consisting of eight categories: (1) lack of financial independence, (2) client investment in the accounting firm, (3) employment by client, (4) non-audit services, (5) contingent fees,⁸⁹ (6) improper partner rotation, (7) lack of audit committee approval,⁹⁰ and (8) improper compensation.⁹¹ Perhaps the most important of these rules are those defining financial independence because without financial independence, an auditor may have conflicts of interest that prevent them from conducting a robust audit.⁹² Accordingly, a summary of these rules is given below, along with a brief summary of the independence restrictions posed by the remainder of the SEC independence rules.

1. Financial Interests

SEC Independence Rule 2-01 states that independence is impaired when (1) the accountant has a direct financial interest or material indirect financial interest in their client;⁹³ (2) the accounting firm, a covered person in the firm, or any of the covered person’s immediate family members have a direct investment in the client, in which “covered person” includes individual accountants within a firm that provide services to a client;⁹⁴ (3) any partner or employee in the firm, including their close family, has more than 5% beneficial ownership of the client’s securities or controls the client;⁹⁵ or (4) the accounting firm, a covered person in the firm, or any of the covered person’s immediate family members have loans, savings accounts, checking accounts, broker-dealer accounts, insurance products, futures commission merchant accounts, consumer loans, or financial interests in investment companies that own the client.⁹⁶

In addition to the requirements of financial independence listed above, the SEC independence rules also prohibit the audit client from investing in the accounting firm or underwriting an accounting firm’s securities.⁹⁷ Moreover, the SEC independence rules place limits on accounting firm employees from being employed at the client both during and after the audit engagement.⁹⁸

2. Audit Conduct

The SEC independence rules also mandate certain conduct during the audit. For example, auditors are not allowed to provide non-audit services that could impair their independence, such as bookkeeping services, financial information systems design and implementation, appraisal or valuation services, actuarial services, management functions, human resources, investment advising, legal services, or expert services unrelated to the audit.⁹⁹ Much of the intent behind this regulation is to reduce the types of conflicts discussed in Part II, in which auditors are incentivized to ignore errors in the audit in order to receive revenue for these non-audit services.¹⁰⁰ Additionally, audit partners are required to rotate every five years if they are the lead partner on the engagement or every seven years otherwise, to avoid forming ties with clients that may impair independence.¹⁰¹ Auditors are also not allowed to receive contingent fees or have partners compensated for any services other than audit services.¹⁰² The audit engagement, typically including fees and non-audit services, must also be approved by the client’s audit committee to ensure independence.¹⁰³

3. Enforcement and Entanglement

The SEC’s enforcement mechanism for auditor independence violations is relatively straightforward. Under the SEC independence rules, the SEC can “censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before [the SEC] in any way to any person who is found by the Commission after notice and opportunity for hearing”¹⁰⁴ to have “engaged in unethical or improper professional conduct.”¹⁰⁵ What is interesting about this mechanism is that it defers to “applicable professional standards” in determining whether there has been “unethical or improper professional conduct.”¹⁰⁶ As a result, the SEC defers the determination of the standard for violations of independence standards to the body that sets the professional standards, which has often been interpreted, both by the SEC’s Administrative Law Judges and the federal courts, to be the AICPA.¹⁰⁷ This is one instance in which the auditor independence regulations are entangled between two different standard setters—the SEC and the AICPA.

One other instance in which the auditor independence rules are entangled between regulators is that although the SEC has delegated the authority to the PCAOB to set auditor independence standards, the SEC independence rules passed in the wake of Sarbanes-Oxley in 2003 are still effective.¹⁰⁸ Aside from some minor updates to debtor-creditor relationships passed in 2019, the SEC independence rules remained largely untouched until 2020,¹⁰⁹ at which point the SEC, along with making minor updates to the independence rules, brought the PCAOB rules into harmony with the SEC rules where they conflicted, acknowledging that for several years there had been a period in which the SEC and PCAOB rules surrounding auditor independence were not consistent.¹¹⁰ This inconsistency is explored further in the sections below, including analyzing the frequency with which the courts used the SEC and PCAOB standards during this time, or the AICPA standards, which are defined in Part III.D.

C. PCAOB Standards

The PCAOB sets forth “Ethics and Independence” standards for accounting firms and their associated persons.¹¹¹

standards/ethics-independence-rules [https://perma.cc/WP6J-2LLD]. While several of these rules set forth additional requirements when compared to the SEC rules, several are similar or aligned with the SEC independence rules and AICPA standards.¹¹² First, accounting firms and their employees are required to “comply with all applicable auditing and related professional practice standards,” which implies that SEC and AICPA standards are binding.¹¹³ However, in 2003, the PCAOB released a note to PCAOB Rule 3500T, which states that the “[PCAOB’s] Interim Independence Standards do not supersede the [SEC’s] auditor independence rules” and that in situations when the SEC Rules are more or less restrictive than the PCAOB rules, the more restrictive rule is to be followed.¹¹⁴ Additionally, the PCAOB explicitly requires that accounting firms and their employees comply with AICPA Code of Professional Conduct Rules 101 and 102, including any interpretations and rulings under these rules.¹¹⁵ Further analysis of the AICPA rules will be provided in Section III.C.

The PCAOB independence rules extend beyond the SEC independence rules in three areas: (1) limiting auditors’ ability to provide audit clients with tax services,¹¹⁶ (2) requiring auditors to communicate with the client Board’s audit committee about certain independence-related matters,¹¹⁷ and (3) requiring auditors to submit a form to the PCAOB that summarizes audit hours by partner (“Form AP”).¹¹⁸

1. Tax Services

Generally, the PCAOB rules extend beyond the SEC rules by maintaining that an accounting firm is not independent of its audit client if the firm provides “marketing, planning, or opining in favor of the tax treatment of” confidential transactions or aggressive tax position transactions, or if the firm provides “tax service to a person in a financial reporting oversight role” at the client, which generally prohibits providing tax advice or preparation services to management and finance employees of the audit client.¹¹⁹

2. Audit Committee Communication

Further, the PCAOB goes beyond the SEC rules and requires accounting firms to seek audit committee pre-approval before the firms perform any permissible tax service or non-audit service related to internal controls.¹²⁰ Part of the intent of these rules is to present to the audit committee the ways that it might impair the accounting firm’s independence to provide both tax and non-audit services to the client.¹²¹ In line with this requirement, accounting firms are required to describe to the audit committees of their clients “all relationships between the registered public accounting firm . . . and the audit client or persons in financial reporting oversight roles at the potential audit client that . . . may reasonably be thought to bear on independence” both prior to beginning the audit and annually thereafter, including an annual affirmation of independence to the audit committee, which essentially requires accounting firms to disclose personal relationships that may impair independence.¹²²

3. Form AP Filing Requirements

Finally, the PCAOB requires that accounting firms file a “Form AP” with the PCAOB for each audit report it issues for a client.¹²³ The Form AP lists the lead engagement partner for the audit and notes the hours they have completed on the audit engagement, with the goal of providing users of financial statements information about the “independence of the specific individuals and firms that participate in the audit.”¹²⁴

004.pdf [https://perma.cc/U3D4-2X49] .

D. AICPA Standards

The AICPA promulgates what is the most rigorous standard of independence requirements for auditors, when compared to the SEC and PCOAB. The AICPA Code of Professional Conduct begins by setting forth a single independence rule: “A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by [the AICPA Governing] Council.”¹²⁵ Stemming from this rule, the AICPA has then set forth hundreds of interpretations,¹²⁶ which are binding on accounting firms and accountants performing “attest engagements,” which are any services to a client requiring independence from the client, including audits.¹²⁷

Given the complexity of the interpretations to the independence rule and the many scenarios effecting independence that they address, it would be impractical to describe all interpretations within this paper. However, to summarize, the interpretations to the independence rule cover a variety of situations regarding the independence of individual accountants, such as how to handle the employment of a family member at an audit client¹²⁸ and how to address whether an individual accountant’s financial investments in a client’s securities impair their independence.¹²⁹ The interpretations also cover more complex situations regarding the independence of accounting firms as a whole, such as how to maintain independence in situations in which a nonclient acquires a current client¹³⁰ or how “network firms” with multiple offices should each remain independent of each other’s clients.¹³¹

In the absence of any relevant interpretation, accounting firms and accountants are expected to apply the AICPA’s “Conceptual Framework for Independence.”¹³² The Conceptual Framework for Independence requires that accountants evaluate whether a particular “relationship or circumstance” would lead a reasonable person “to conclude that there is a threat to . . . independence . . . that is not at an acceptable level.”¹³³ The Conceptual Framework then lists potential “threats” to independence, such as holding an adverse interest from the client, advocating for the client, familiarity with the client, auditor participation in management of the client, self-interest, self-review, and undue influence by the client or a third party.¹³⁴ Following the potential threats, the Conceptual Framework identifies “safeguards” which can reduce threats to an acceptable level that will ensure independence, such as external review, competency requirements for professional licensing, analysis of an accounting firm’s revenue dependence on one client, and accounting firm policies for engagement quality control, such as external review.¹³⁵ By ensuring threats are low or nonexistent or by balancing them with safeguards, accounting firms and accountants can ensure compliance with independence standards under the Conceptual Framework in situations in which there is no authoritative interpretation set forth by the AICPA.¹³⁶

The AICPA also has a senior committee, the Auditing Standards Board, that sets forth Generally Accepted Auditing Standards (“GAAS”).¹³⁷ GAAS sets forth specific testing requirements and procedures for auditors as they undertake audit engagements for clients.¹³⁸ In addition to these audit testing requirements—which are largely technical in nature and outside of the scope of this paper—GAAS also sets for ethical requirements relating to audits of financial statements, stating that an “auditor must be independent of [a client] when performing an engagement in accordance with GAAS.”¹³⁹ GAAS then defers to the Code of Professional Conduct’s Conceptual Framework, which was discussed previously.¹⁴⁰ GAAS is often referenced more frequently than the Code of Professional Conduct, as will be discussed in Part IV, because GAAS includes not only ethical requirements for auditors, but substantive guidance for how audits are to be conducted in practice.¹⁴¹

Overall, there is significant overlap between the regulations set forth by the AICPA and the SEC and PCAOB.¹⁴² The AICPA standards set forth detailed guidance for accounting firms to ensure they comply with the broader standards set forth by the SEC and PCAOB. For example, while the SEC and PCAOB rules prevent auditors from receiving contingent fees from their clients, the AICPA rules state that same proposition and provide guidance that states contingent fees include finder’s fees, fees based on cost-savings achieved by the client, and exclude fees based on the results of judicial proceedings in tax matters.¹⁴³ This level of detailed guidance means that practitioners often consult the AICPA standards, as they set forth a more restrictive set of guidelines and also a more informative set of interpretations that can be applied to specific circumstances. This delegation of substantive regulation to the private industry organization—AICPA—is also consistent with other self-regulatory models.

E. Harmonization Efforts

In October 2020, the SEC issued updates to the auditor independence rules set forth in SEC Independence Rule 2-01.¹⁴⁴ These updates covered a variety of miscellaneous matters in the SEC independence rules, including refining the definition of affiliates of audit clients, amending the definition of an “audit and professional engagement period,” excluding some student loans from causing independence violations, and addressing inadvertent violations of the independence rules due to mergers and acquisitions, among other matters.¹⁴⁵

As a result, stakeholders raised concerns that the PCAOB rules, particularly those related to affiliates of audit clients, such as subsidiaries, were no longer consistent with the SEC independence rules.¹⁴⁶ In response, and to “provide greater regulatory certainty,” the PCAOB amended its rules to align with the SEC independence rule changes.¹⁴⁷ Additionally, several of the PCAOB rules that needed realignment with the new SEC rules were those that the PCAOB adopted directly from the AICPA or had interpreted based on the AICPA rules.¹⁴⁸ As a result, the AICPA issued a temporary policy statement as a stop-gap measure that stated to accounting firms and accountants that they would be considered in compliance with the AICPA Code of Professional Conduct if they complied with the updated SEC independence rules.¹⁴⁹ Soon thereafter, the AICPA put forth a proposal to change its rules and definitions to align with the SEC and PCAOB changes.¹⁵⁰ This proposal has not been adopted as of the time of this paper, but it seems likely that the AICPA will bring its standards into alignment with the current SEC and PCAOB independence rules.

Overall, this amendment waterfall that began with the SEC proposing changes in October 2020 that were then adopted by the PCAOB, and which still have not been adopted by the AICPA two years later, shows that the regulatory framework for auditor independence remains entangled. This entanglement may be occurring because the Sarbanes-Oxley Act created the PCAOB, which is allowed to pass audit regulations subject to the oversight of the SEC; and the Sarbanes-Oxley Act also allowed the SEC to become more involved in rule-setting for auditors, which had previously been handled entirely by the AICPA.¹⁵¹ While some argue that harmonization between these three entities is a worthy goal to disentangle regulations that are not consistent between the three entities,¹⁵² one might also consider whether harmonization is the answer, or rather whether simplification is a better goal, to avoid having to involve three regulatory agencies in rule changes, in order to ensure clear standards for accounting firms, clients, and stakeholders in the market. The following section of the paper will explore whether one regulatory entity is dominant over the others, and whether this agency should be favored for simplification that centers around focusing auditor independence on this agency and its rules exclusively, rather than the standards set across all three entities.

IV. CASE STUDY

As discussed, the following case study will assess published federal court opinions in which auditor independence was at issue in a civil litigation to determine whether SEC, PCAOB, or AICPA standards were used in the courts’ reasoning.¹⁵³ While a study of administrative law decisions from the SEC was considered, federal court decisions were deemed to be a more relevant indicator of which body of regulation is used in deciding civil matters because SEC administrative law decisions rely almost exclusively on a single, broad rule, SEC Rule 102(e)(1)(ii), which “censure[s] a person . . . after finding that a person engaged in improper professional conduct.”¹⁵⁴

There were fifteen cases decided by federal courts in which auditor independence was at issue in civil litigation, and which were used to comprise the population for this case study.¹⁵⁵ The population of cases includes only cases in which auditors were performing financial statement audits, and therefore excludes government and internal audit services, as these non-financial statement audits are typically not part of the debate over auditor independence because they involve different monetary incentives, risks for auditors and investors, and different auditing standards. Additionally, cases were only observed after May 6, 2003, which was the effective date of the Sarbanes-Oxley legislation, given that Sarbanes Oxley completely changed the landscape of auditor independence, giving the SEC broad authority to issue rulemaking in this area and effectively creating the PCAOB.¹⁵⁶ Finally, cases that relied on state regulations over auditor licensing and independence were excluded, as they do not address the relevant issue of federal regulatory structure.¹⁵⁷

This case study aims to examine which body of regulatory law federal courts rely on in making determinations over whether auditors have breached their independence obligations. Each of the AICPA, SEC, and PCAOB have their own enforcement mechanisms to sanction auditors who do not adhere to independence requirements, and each enforcement division uses their own regulation as well as occasionally relies on the regulation of the other entities to sanction auditors.¹⁵⁸ However, the civil courts do not have a requirement to adhere to the regulations of any particular standard-setter under the requirements of Sarbanes-Oxley or the Securities and Exchange Act of 1934. Given this lack of constraints, the standard used by the federal courts in determining independence violations has not been examined and is ripe for analysis to determine whether one set of standards (that is, those of the AICPA, SEC, or PCAOB) is preferred over the others. Therefore, this study will examine all fifteen federal court decisions to determine what standards have been used by the courts in the area of auditor independence as well as whether the result was in favor of the auditor or against the auditor in each scenario.

There are three major areas in which auditor independence has been examined by the federal courts. First, individuals who have been sanctioned by the SEC for violations of auditor independence standards can appeal to the federal courts for a review of the SEC’s decisions under a broad “abuse of discretion” standard to argue that the agency acted arbitrarily and capriciously in a way that requires the SEC’s decision to be overturned under 5 U.S.C. 706(2)(A).¹⁵⁹

Next, auditor independence is frequently at issue in Securities and Exchange Act Section 10(b) and SEC Rule 10b-5 claims, which are often brought as class-actions.¹⁶⁰ To prevail on these claims, plaintiffs must prove scienter, meaning that the defendant employed a “device, scheme, or artifice to defraud,” in addition to proving the elements of a material misstatement or omission, on which the plaintiff relied, and was the proximate cause of the plaintiff’s loss.¹⁶¹ Plaintiffs often allege that auditors’ violations of independence rules are evidence of scienter for purposes of satisfying this element to bring a successful 10(b) or 10b-5 claim.¹⁶² However, this practice has been complicated by the heightened pleading requirements for Section 10(b) and Rule 10b-5 claims established in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which was passed in part to reduce the number of non-meritorious securities class action claims raised by plaintiffs and requires that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁶³ The PSLRA has resulted in different pleading standards for scienter among and within circuits, however, many courts find “scienter [is] plead with particularity by facts supporting a ‘motive or opportunity’ to commit fraud.” ¹⁶⁴ As will be discussed in Section IV.B, this heightened pleading standard has reduced the circumstances in which courts have viewed violations of auditor independence rules to be sufficient to show scienter.

Finally, plaintiffs also bring state law claims—including negligent misrepresentation, professional negligence, and fraud suits—against auditors who have violated auditor independence standards, using the alleged violations of these standards as de facto evidence of a breach of duty.¹⁶⁵ In one instance, a plaintiff also attempted to bring a state law breach of fiduciary duty claim against an auditor who allegedly did not comply with auditor independence standards.¹⁶⁶

Given the heterogeneity of the claims within these cases, this paper examines the cases within these three groups—reviews of SEC administrative decisions, federal securities law claims, and state law tort claims—to identify developments in the case law regarding auditor independence and to examine when courts apply SEC, PCAOB, or AICPA standards in determining whether there has been an independence violation sufficient to warrant a judgment against auditors.

A. Appeals of SEC Administrative Decisions

In Ponce v. SEC, the Ninth Circuit reviewed an appeal from a decision that the SEC made to bar a plaintiff accountant from practice, and the court acknowledged that as part of the SEC’s decision, the accountant had been held in violation of SEC Independence Rule 102(e)(1)(ii), which means he engaged in “improper professional conduct.”¹⁶⁷ In order to determine whether there was truly “improper professional conduct,” the court turned to AICPA standards and ruled that the auditor failed to maintain his independence because he allowed his clients to run up a substantial balance of unpaid fees, which under AICPA guidance, resulted in a presumed lack of independence because the AICPA standards set forth that “independence is considered to be impaired if fees for all professional services rendered for prior years are not collected before the issuance of the member’s report for the current year.”¹⁶⁸

Similarly, in Dearlove v. SEC, the Court of Appeals for the District of Columbia Circuit used the same approach as Ponce, albeit six years after the decision¹⁶⁹ and six years after the implementation of Sarbanes-Oxley, including its resulting reform of SEC independence rules and the formation of the PCAOB. In Dearlove, the court concluded that “the appropriate standard of care . . . is supplied by . . . GAAS” when reviewing whether the SEC had abused its discretion in determining that an accountant violated SEC Independence Rule 102(e)(1)(ii) by failing to maintain independence from their audit client.¹⁷⁰

Ponce and Dearlove are indicators of how the federal courts have given credibility to the AICPA standards, including GAAS, in determining whether there has been a violation of auditor independence. The court’s opinion in Dearlove references SEC Independence Rule 102(e)(1)(ii), but it does so only to note that the SEC rule states “improper professional conduct” will warrant sanctions, before deferring to the AICPA GAAS standards to assess what improper conduct is.¹⁷¹ The court also stated that “the SEC need not establish a standard of care separate from the GAAS in order to give meaning to” what SEC Independence Rule 102(e)(1)(iv)(B)(2) describes as “unreasonable conduct,” showing further deference to AICPA standards.¹⁷² The fact that this decision came more than six years after the implementation of Sarbanes-Oxley, when the court had the ability to reference the updated SEC independence rules or PCAOB rules, but chose not to, shows even more significant reliance on the standards set by the AICPA.

B. Determinations of Scienter in Securities Claims

Similarly, in In re WorldCom, Inc. Securities Litigation, defendants moved for summary judgment on the matter of whether Arthur Andersen, the auditors at the helm of both the Enron, and in this case, WorldCom accounting scandals, had the requisite scienter to be in violation of Section 10(b) of the Securities and Exchange Act and SEC Rule 10b-5 because they allegedly recklessly issued false audit opinions.¹⁷³ The plaintiff alleged that violations of the AICPA’s GAAS were sufficient to prove scienter, even under the heightened pleading standards required by the PSLRA, which required the plaintiffs to plead recklessness in order to avoid their claim being dismissed.¹⁷⁴ The court recognized the importance of violations of GAAS in proving scienter, but ultimately denied summary judgment due to conflicting expert reports on whether GAAS was violated.¹⁷⁵ Although the claim survived the motion for summary judgment due to unresolved questions of fact, this case was another high profile example of the federal courts giving credence to AICPA standards in determining whether there was auditor wrongdoing.¹⁷⁶

In re WorldCom, Inc. Securities Litigation also included a Securities Act claim, in which the plaintiffs alleged that Arthur Andersen was in violation of Section 11 of the Securities Act, which states that a “preparing or certifying accountant . . . may be liable ‘if any part of the registration statement . . . contained an untrue statement of a material fact.’ ”¹⁷⁷ Arthur Andersen attempted to assert a due diligence defense, in which it claimed that it “had, after reasonable investigation, reasonable ground to believe and did believe, at the time . . . the registration statement became effective, that the statements therein were true,” and then moved for summary judgment.¹⁷⁸ In deciding whether summary judgment was appropriate on this issue, the court issued an even stronger affirmance of the relevance of AICPA standards, concluding that a “reasonable investigation” that would support a due diligence defense, like that raised by Arthur Andersen, must be a “GAAS-compliant audit.”¹⁷⁹ Because the plaintiff presented sufficient evidence to rebut the argument that the audit was “GAAS-compliant,” Arthur Andersen’s motion for summary judgment was denied. While this second issue is not directly related to auditor independence rules, it shows the courts’ general deference to the AICPA’s GAAS.

However, not all courts have agreed with the Southern District of New York’s decision in WorldCom, which may be in part due to differing interpretations of the heightened pleading requirements of the PSLRA. In In re Cardinal Health, Inc. Securities Litigations, the Southern District Court of Ohio ruled that Ernst & Young’s failure to adhere to the AICPA’s GAAS requirements for auditor independence did not establish the requisite scienter for a plaintiff’s claim to survive Ernst & Young’s motion to dismiss on a Rule 10b-5 claim.¹⁸⁰ The Court reasoned that while recklessness is generally sufficient to meet the pleading standard under the PSLRA, claims brought against auditors were subject to the even more heightened pleading standard of “a mental state ‘so culpable that it approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company,’ ” which was not met in this case based merely on the alleged failure of Ernst & Young to adhere to AICPA GAAS requirements.¹⁸¹

Further, the court opined that an auditor’s past sanctions in SEC administrative proceedings were insufficient to prove scienter.¹⁸² In this case, the court also noted that SEC administrative decisions were not dispositive in determining scienter for Rule 10b-5 claims, perhaps suggesting that judicial interpretation of independence violations supersedes determinations by regulatory bodies.¹⁸³ This is in line with existing administrative law doctrines that do not require federal courts to defer to the SEC’s interpretations of the Exchange Act.¹⁸⁴

Similarly, in In re Royal Ahold N.V. Securities and ERISA Litigation, the United States District Court for the District of Maryland ruled that alleged violations of AICPA’s GAAS standards on independence—in which the only allegations from the plaintiff were that auditor independence was impaired due to the auditor providing audit and non-audit services—were not sufficient to establish scienter for a Rule 10b-5 claim against an auditor.¹⁸⁵ However, the court did note that violations of AICPA’s GAAS can be sufficient to plead scienter when they are coupled with allegations that show that “the nature of the violations of those violations was such that scienter is properly inferred.”¹⁸⁶ Likewise, in New Jersey v. Sprint Corp., a group of class action plaintiffs brought Rule 10b-5 claims against Sprint Corporation and Ernst & Young for filing false and misleading registration statements, prospectus supplements, and proxy statements that did not disclose that the company had considered dismissing their auditor, Ernst & Young, and that there were conflicts between executives at the company and the auditor, which resulted in auditor independence violations under AICPA’s GAAS.¹⁸⁷ The court relied on the AICPA’s GAAS to assess independence, noting that the plaintiffs did not plead sufficient facts to show that Ernst & Young lacked the independence in “mental attitude” required by GAAS, and even if sufficient facts were pled to show that Ernst & Young violated GAAS, this would not be sufficient under the PSLRA to establish scienter because the standard for scienter is recklessness, that is “so obvious that the defendant must have been aware of it” which goes beyond a mere violation of GAAS. ¹⁸⁸ Therefore, the motion to dismiss was granted in favor of Ernst & Young.¹⁸⁹

While the varied interpretations in different jurisdictions over whether violations of the AICPA’s GAAS standards is sufficient to plead scienter persists, some courts have ruled that merely “articulating violations of GAAS and GAAP alone is insufficient” to satisfy the element of scienter under the PSLRA’s heightened pleading requirements and instead imposed additional requirements to plead scienter through case law.¹⁹⁰ For example, the court in Grand Lodge of Pennsylvania v. Peters determined that in order to prove scienter, violations of GAAS must be accompanied by “red flags” that would put a reasonable auditor on notice that their client was committing fraud.¹⁹¹ Therefore, the plaintiff’s allegations in this case that the auditor was conflicted by providing consulting services to the client in violation of GAAS were insufficient to establish scienter for a Rule 10b-5 claim.¹⁹² Additionally, the court in In re Williams Securities Litigation ruled that “GAAS violations must be coupled with evidence that the violations were the result of the auditor’s fraudulent intent to mislead investors,” in order to have a sufficient pleading of scienter.¹⁹³ This supports the idea that some courts grant credibility to the AICPA standards, however, they impose additional burdens on plaintiffs that are developed through case law.

This case law has developed in the years since the passage of the PSLRA. The Ninth Circuit Court of Appeals summarized the development of the additional requirements to prove scienter, other than GAAS violations, in New Mexico State Investment Council v. Ernst & Young LLP.¹⁹⁴ The court ruled that failing to “maintain independence in mental attitude during an audit,” in violation of GAAS and PCAOB standards, is not sufficient to prove scienter.¹⁹⁵ Rather, there should be “red flags” that a reasonable auditor would have investigated as well as a showing that there were violations that amount to more than “alleging a poor audit.”¹⁹⁶ New Mexico State Investment Council indicates how the courts’ reliance solely on AICPA standards has lessened slightly over the years, as the burden to meet additional case law requirements for scienter has increased due to the passage of the PSLRA and its heighted pleading requirements, which require that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁹⁷

While the discussion above indicates that courts have largely relied on violations of AICPA’s GAAS and case law requirements in determining whether auditor independence violations are sufficient to show scienter, other courts have discussed Sarbanes-Oxley in determining whether an auditor independence violation is sufficient to show scienter as an element of a Rule 10b-5 violation.¹⁹⁸ In Brody v. Stone Webster, Inc., the First Circuit Court of Appeals examined whether scienter could be presumed on the part of PwC in connection with a 10b-5 claim because PwC allegedly turned a blind eye toward accounting irregularities to protect its accounting and consulting revenue from a client.¹⁹⁹ The court determined that “turn[ing] a bind [sic] eye” to misleading accounting for a “profit motive” may have been a rationale for the passage of Sarbanes Oxley, but it is not enough in itself to prove scienter sufficient for a valid Rule 10b-5 claim under the PSLRA without specific allegations that the auditor ignored “red-flags” that were signs of fraud.²⁰⁰

Courts have also been reluctant to find that scienter has been sufficiently pled in accordance with the PSLRA when plaintiffs allege auditor independence violations on the basis of general policy arguments against auditors depending on fees from clients.²⁰¹ In In re ArthoCare Corporation Securities Litigation, plaintiffs alleged that PwC was not independent in its audit because the firm had a longstanding relationship with its client and was dependent on the client’s audit fees.²⁰² The United States District Court for the Western District of Texas found that general allegations based on a perceived lack of independence or violations of GAAS due to fee dependence or long-standing relationships, which are allegedly against public policy, are not sufficient to establish scienter on the part of auditors under the PSLRA.²⁰³ Similarly, in Ley v. Visteon Corporation, the Sixth Circuit determined that an allegation that Ernst & Young was not independent during an audit because it sought to preserve revenue from a client by not pointing out the client’s alleged accounting irregularities was not sufficient to plead scienter on the part of the auditors under the PSLRA’s requirements because it was merely an allegation of a “motive.”²⁰⁴

On the whole, these cases show a broad trend of the courts giving credibility to the AICPA’s standards, as compared to SEC or PCAOB standards. As the case law has developed, violation of AICPA standards has been shown as one of the avenues plaintiffs can use to establish scienter for Securities and Exchange Act Section 10(b) and SEC Rule 10b-5 claims, when additional case law requirements are met. Notably, neither violations of the PCAOB independence rules nor the SEC independence rules have been used by the federal courts to assess whether there has been scienter for the purposes of a Section 10(b) or Rule 10b-5 claim that has been sufficiently pled in accordance with the PSLRA. Instead, the courts have relied on the AICPA rules as one factor for establishing scienter, and then have developed additional case law standards, such as finding “red flags” and alleging more than a poor audit, in order for plaintiffs to prevail on Section 10(b) and Rule 10b-5 claims against auditors. This focus on the AICPA rules is aligned with the deference given by the courts to AICPA standards in appeals of SEC enforcement decisions, discussed in Section IV.A.

C. Fraud, Negligence, and Other State Law Causes of Action

In state law actions for fraud, courts have required a heightened standard for liability that extends beyond a violation of the AICPA’s GAAS independence standards in order to hold auditors liable. For example, in In re Parmalat Securities Litigation, plaintiffs pled that Deloitte aided an audit client with common law fraud.²⁰⁵ Given that this was a state law cause of action, the court applied the New York common law requirements for fraud, requiring the plaintiff to prove “that the defendant (1) made a material, false statement; (2) knowing that the representation was false; (3) acting with intent to defraud; and that plaintiff (4) reasonably relied on the false representation; and (5) suffered damage proximately caused by the defendant’s actions.”²⁰⁶ The court focused primarily on the intent to defraud and ruled that an auditor’s violation of GAAS does not by itself show intent, however “an auditor’s decision to take on non-audit work that threatens to compromise its duty of independence gives rise to a strong inference of . . . [fraudulent] intent . . . when . . . the auditor has a ‘direct stake’ in the alleged fraud.”²⁰⁷ This heightened standard to show the intent element for common law fraud in New York, which includes not only a GAAS violation but also an auditor’s direct stake in the fraud, is in some ways analogous to the heightened standard to prove scienter on the part of auditors, as discussed in Section IV.B, because in both instances the courts have recognized a violation of the AICPA’s GAAS standards as helpful in showing intent, in addition to adding case law requirements to plead a valid claim.

However, some courts have not found it necessary to analyze auditor independence regulation when determining whether auditors were negligent in their review of their clients’ financial statements. In a consolidated action, insurance companies brought state law claims against Enron, Enron management, and Enron’s auditors, Arthur Andersen, in the wake of the Enron accounting scandal and resulting collapse.²⁰⁸ The plaintiffs specifically alleged that Arthur Andersen made negligent misrepresentations to investors and committed common law fraud in violation of Texas law.²⁰⁹ In connection with the negligent misrepresentation claim, the plaintiffs were required to show (1) the defendant provided information (2) that was false, (3) the defendant did not exercise reasonable care or competence in obtaining or communicating the information, (4) the plaintiff justifiably relied on the information, and (5) the plaintiff suffered loss by justifiably relying on the information.²¹⁰ In connection with the common law fraud claim under Texas law, the plaintiffs were required to show “(1) a material representation was made; (2) the representation was false; (3) when the representation was made, the speaker knew it was false or made it recklessly . . . (4) the representation was made with the intention that it be acted upon by the other party; (5) the party actually and justifiably acted in reliance upon the representation; and (6) the party suffered injury.”²¹¹ While the plaintiffs alleged that Arthur Andersen’s violations of AICPA’s GAAS standards showed the firm lacked independence, which they claimed was sufficient to show that Arthur Andersen did not meet the standard of care and competence as required by the negligent misrepresentation claim,²¹² and that the violation of GAAS showed that Arthur Andersen made false representations about its independence sufficient for a common law fraud claim,²¹³ the court did not reach these issues, instead dismissing both claims because the plaintiffs could not show they relied on Arthur Andersen’s representations.²¹⁴

Another area in which courts have assessed whether auditor independence gives rise to liability is in the area of state law claims for breach of fiduciary duties. In In re SmarTalk Teleservices, Inc. Securities Litigation, a trustee argued that PwC exceeded its normal role as an independent auditor, as defined by the AICPA’s GAAS, and therefore PwC owed a trustee fiduciary duties that the firm then breached by providing inadequate accounting and audit services.²¹⁵ While the court did not reach the issue of whether there was a valid cause of action for breach of fiduciary duty, the court determined that whether PwC violated GAAS standards for independence was a genuine issue of material fact and denied the auditor’s motion for summary judgment on the breach of fiduciary duty claim, providing yet another example of the federal courts giving credence to the AICPA standards in determining auditor liability.²¹⁶

V. IMPLICATIONS OF STUDY ON HARMONIZATION OR SIMPLIFICATION OBJECTIVES

In all three areas of the law covered by the case study, including appeals of SEC enforcement decisions, federal securities claims, and state law claims, the federal courts have preferred to use the AICPA standards, including GAAS, in their decision-making over auditor independence. In many instances when AICPA standards were used in federal securities actions, case law requirements were also supplied to determine whether there was sufficient evidence presented to plead scienter. But, notably, there were no cases found that apply PCAOB or SEC auditor independence rules.

On the whole, this paper does not aim to provide a normative proposal for auditor independence regulation. However, the case study presented in Part IV can shed light on the process of harmonization, which, as discussed in Section III.E, involves the SEC, PCAOB, and AICPA each having to change their rules regarding auditor independence each time one of the other entities changes their independence rules, in order to ensure that the rules are not in conflict. Given that the case study indicates that AICPA standards are preferred by the federal courts, along with case law, in determining whether auditor independence has been violated, there is an argument to be made that the power to regulate auditor independence should be simplified into one regulatory framework run by a single entity—the AICPA. Under this proposal of “simplification,” the regulations set by each entity would not need to be harmonized each time one entity makes a change in auditor independence rules. Rather, given that the federal courts rely on AICPA standards, the substantive rule-making authority would be given to the AICPA alone. This is because the current framework has two entities, the SEC and PCAOB, whose frameworks are rarely applied in the federal courts or outside of internal enforcement actions and investigations.

As discussed in Part III, the AICPA, PCAOB, and SEC are involved in a self-regulatory model, in which the SEC provides oversight over the PCAOB, and the SEC and PCAOB have concurrent jurisdiction to set auditor independence standards as a federal regulatory agency and as a non-profit corporation subject to the oversight of the SEC, respectively. In this self-regulatory model, the SEC also provides oversight over the AICPA, which is a private industry organization run by accountants and which sets substantive auditor independence regulation. This self-regulatory model could be simplified to reflect other self-regulatory structures in United States financial services regulation so that rule-making authority is deferred entirely to the AICPA, with oversight by the SEC, in order to simplify the regulatory framework and reduce conflicts between the independence rules set by the AICPA, SEC, and PCAOB. This would be similar to the model between the SEC and FINRA, in which the SEC allows FINRA to set rules for national securities exchanges and provides oversight over that rulemaking, rather than having the SEC set its own detailed regulation over exchanges. Given that the AICPA sets forth the most comprehensive rulemaking and interpretations of auditor independence standards, and the federal courts rely on these standards, simplifying the regulatory framework for auditor independence by deferring to the AICPA seems like a possible solution.

Overall, the relative costs and benefits of self-regulation and the outsourcing of rulemaking to private industry are beyond the scope of this paper; however, the following arguments are meant to provide a brief summary of why simplification of rule-making authority regarding auditor independence regulations by giving authority to the AICPA and oversight to the SEC may or may not be beneficial.

There are valid reasons to argue against simplification that comes in the form of allowing the AICPA to be the only standard-setter in the area of auditor independence. Several critics have pointed out that self-regulation was one of the issues at the forefront of the Enron collapse and resulting scandal, and that the accounting profession needs an external regulator.²¹⁷ However, others have argued that it was not self-regulation, but market failures and misaligned incentives over reputational costs that caused the accounting scandals during the early 2000s.²¹⁸ Further, self-regulatory organizations, such as FINRA, have successfully provided guidance to their respective stakeholders, with some oversight from the SEC, indicating that self-regulatory organizations with some administrative oversight can be successful.²¹⁹

Additionally, critics may argue that the AICPA relies on the SEC and PCAOB enforcement practices in addition to running its own enforcement program,²²⁰ and to split up the enforcement and regulation practices could pose problems. However, given that the current system splits the enforcement burden between the SEC, PCAOB, and AICPA, and each uses violations of the other’s regulations to bring sanctions, consolidating the regulations into one body would not have to change this framework.

CONCLUSION

This paper reserves judgment on the relative merits of self-regulation and instead notes that the current regulatory harmonization effort is not the only solution to disentangle the regulatory framework for auditor independence. Instead, this paper poses a new potential solution—simplification—to the problem of unwinding the tangled regulatory framework of auditor independence to promote efficiency in rulemaking and clarity for stakeholder accounting firms, regulators, and clients.

Given that the courts frequently defer to AICPA auditor independence standards—along with case law requirements for pleading federal securities law violations—rather than SEC and PCAOB standards, and having three regulatory frameworks that need to be continuously updated to align with each other is complex and costly, simplification is a worthy goal. However, it is just one solution of many. As the SEC, PCAOB, and AICPA continue to pursue harmonization,²²¹ it is worth considering whether other alternative approaches to auditor independence regulation, such as simplification, exist.

APPENDIX

Appendix
	Case Name and Citation	Procedural Posture	Body of Law Applied	Result in Favor of Auditor?
1	Ponce v. SEC, 345 F.3d 722 (9th Cir. 2003).	Appeal of Administrative Decision	AICPA and SEC	No
2	Dearlove v. SEC, 573 F.3d 801 (D.C. Cir. 2009).	Appeal of Administrative Decision	AICPA and SEC	No
3	New Jersey v. Sprint Corp., 314 F. Supp. 2d 1119 (D. Kan. 2004).	Motion to Dismiss	AICPA	Yes
4	Newby v. Enron Corp. (In re Enron Corp. Secs., Derivative & ERISA Litig.), 762 F. Supp. 2d 942 (S.D. Tex. 2010).	Motion to Dismiss	AICPA^a	Yes
5	In re WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472 (S.D.N.Y. 2005).	Motion for Summary Judgment	AICPA and SEC	No, on Securities Act Claim. Yes, on SEC Rule 10b-5 claim.
6	In re Cardinal Health, Inc. Sec. Litigs., 426 F. Supp. 2d 688 (S.D. Ohio 2006).	Motion to Dismiss	AICPA	Yes
7	In re Royal Ahold N.V. Sec. & ERISA Litig., 351 F. Supp. 2d 334 (D. Md. 2004).	Motion to Dismiss	AICPA	Yes
8	Brody v. Stone & Webster, Inc. (In re Stone & Webster, Inc., Sec. Litig.), 414 F.3d 187 (1st Cir. 2005).	Motion to Dismiss	Sarbanes-Oxley	Yes
9	Ley v. Visteon Corp., 543 F.3d 801 (6th Cir. 2008).	Motion to Dismiss	AICPA	Yes
10	Grand Lodge of PA v. Peters, 550 F. Supp. 2d 1363 (M.D. Fla. 2008).	Motion to Dismiss	AICPA	Yes
11	In re Williams Sec. Litig., 496 F. Supp. 2d 1195 (N.D. Okla. 2007).	Motion for Summary Judgment	AICPA	Yes
12	N.M. State Inv. Council v. Ernst & Young LLP, 641 F.3d 1089 (9th Cir. 2011).	Motion for Summary Judgment	AICPA	Yes
13	In re Parmalat Sec. Litig., 501 F. Supp. 2d 560 (S.D.N.Y. 2007).	Motion to Dismiss	AICPA	Yes
14	In re ArthroCare Corp. Secs. Litig., 726 F. Supp. 2d 696 (W.D. Tex. 2010).	Motion to Dismiss	AICPA	Yes
15	In re SmarTalk Teleservices, Inc. Secs. Litig., 487 F. Supp. 2d 928 (S.D. Ohio 2007).	Motion for Summary Judgment	AICPA	No
Note: The plaintiffs pled a violation of AICPA standards, but the court did not reach the issue in this case before making its final determination.

97 S. Cal. L. Rev. 495

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Nikita Patel*

* Executive Articles Editor, Southern California Law Review, Volume 97; J.D. Candidate, University of Southern California Gould School of Law, 2024; B.S., B.A., Boston College, 2017. Many thanks to Professor Jonathan Barnett for his feedback and guidance, as well as to the editors of the Southern California Law Review for their thoughtful suggestions. All mistakes are my own.

Adventure Capital

April 2024April 2024Elizabeth Pollman*

This symposium Article traces the history and rise of venture capital and venture-backed startups in the United States from a business law perspective and explores the current big questions in the field. This examination highlights that after lawmakers shaped the enabling environment for venture capital to flourish, corporate and securities law has responded to the rise of venture-backed startups incrementally but with profound effect. Although business law has not always fit easily with the distinctive features of venture-backed startups, it has provided an enormous space in the private realm for them to order their governance and maneuver with relative freedom. This private realm is a good fit for the needs of startups that drive economic growth and innovation, but their activity can also create lingering issues of social costs and policy that are difficult to address. Grappling with this reality is essential to continuing to foster a vibrant venture capital ecosystem while also developing a coherent business law response to the current wild era of “adventure capital.”

Venture capital has fueled the rise of some of largest businesses in the world.¹ This relatively small asset class produces huge social and economic impact. By one measure, venture capital funds less than one percent of companies started in the United States each year, yet accounts for the backing of nearly half of the companies that enter the public markets.² Among U.S. public companies founded since 1968, venture-backed companies account for 77% of total U.S. market capitalization, 41% of total employees, and 92% of research and development spending.³ Further, the impact of venture capital is not only evidenced in public markets, but also spans the footprint of disruptive startups operating in the private realm and the technology that they generate. From the personal computer you use to access the internet to the search engine by which you navigate it, the innovation fueled by venture capital touches everyday life in innumerable ways.⁴

The industry that produces such outsized social and economic impact is notably of relatively recent vintage and the result of both business and legal transformation. Some of today’s venture capital resembles aspects of the risk-sharing ventures of centuries ago from Genoese merchants to American whalers, but the modern industry began in earnest in the mid-twentieth century—originally coined “adventure capital.”⁵ It was not, however, until the 1980s when venture capital really took off. In 1979, the Department of Labor changed an Employment Retirement Income Security Act (“ERISA”) rule that freed pension fund managers to take portfolio diversification into account in fulfilling their “prudence” standard.⁶ With this change, pension fund managers could allocate a portion of their funds to venture capital even if companies in the venture fund’s portfolio were relatively illiquid or failed.⁷ With a greater influx of investment dollars, the venture capital sector grew quickly,⁸ and in less than half a century has become “the dominant source of financing for high-potential startups commercializing risky new ideas and technologies.”⁹

Although a significant and growing body of scholarly literature examines venture-backed startups, many questions remain open and legal scholars do not often step back to examine the broader landscape of business and legal transformation in this area. How has business law facilitated and responded to the rise of venture capital? What is the social welfare impact of venture capital? Should the law do more to shape the direction of entrepreneurial finance or startup governance? This Article takes aim at stimulating discussion and research about these important questions.

First, the Article traces the history and rise of venture capital in the United States and highlights that venture capital contracting has largely settled upon an established set of practices that create distinctive governance features in startups and the types of companies funded.¹⁰ This discussion illuminates how the rise of the modern venture capital industry evolved to rely on laws that enable private business entities and private markets.

Second, it argues that after lawmakers shaped the enabling environment for venture capital to flourish, in subsequent decades, corporate and securities law has responded to the rise of venture-backed startups incrementally and with some challenges or tensions with the distinctive features of venture capital and startups. The big picture, however, is that the enabling nature of corporate law and the deregulatory trend of securities law have facilitated an enormous space in the private realm for venture-backed startups to order their governance and maneuver with relative freedom. This private realm is highly useful for cultivating startups that drive valuable innovation and create outsized economic impact.

Notably, venture-backed startups also create lingering issues of social costs that have prompted rising concerns in recent years. Therefore, the Article concludes by highlighting two promising avenues for developing a deeper understanding of whether a business law response is warranted: a more systematic study of impacts on stakeholders such as employees and customers or users, and further inquiry into whether and when any governance intervention would be optimal using a realistic understanding of a startup’s timeline in the venture cycle. Building a solid foundation of understanding of these issues in the current era would advance a measured approach to the future of business law, while continuing to promote a vibrant ecosystem of startups and venture capital.

The Article proceeds as follows. Part I traces the rise of venture capital and the distinctive features of venture-backed startups. Following on this background, Part II examines how corporate and securities law has facilitated and responded to venture capital and venture-backed startups. Finally, Part III identifies and starts a conversation about the big questions that the current regime raises.

I. THE RISE OF VENTURE CAPITAL AND DISTINCTIVE FEATURES OF VENTURE-BACKED STARTUPS

Entrepreneurs have long sought financing for risky ventures.¹¹ The venture capital industry emerged in the United States in the mid-twentieth century with its own unique history, and subsequent decades have witnessed its meteoric rise and establishment as a key driver of innovation and economic growth in society. This Part provides an overview of the origins and development of venture capital, as well as an examination of the special characteristics and governance of the startup companies they fund. Although the venture capital industry continually changes, and startup governance varies by individual company, certain patterns have taken shape that can be described by their distinctive features.¹²

A. A Brief History of Venture Capital

Throughout the history of entrepreneurship in the United States, wealthy individuals and family offices have served as notable sources of funding when commercial banks and Wall Street financiers have been unwilling to invest or lend to risky new enterprises.¹³ It was not until the period after World War II, however, that formalized organizational structures started to emerge to provide high-risk, innovative new firms with financing.¹⁴ Startup capital before that time was relatively scarce—representing what many perceived as a funding gap or market failure.¹⁵

Historians pinpoint several key institutions, individuals, and policies that played an important role in catalyzing the modern venture capital industry. A few highlights are worth discussing here to capture how government policy as well as trial and error from enterprising individuals and firms were required before hitting upon the modern formulation of venture capital investing.

Some start the story with one of the most serious early experiments—American Research & Development Corporation (“ARD”).¹⁶ The Boston-based firm made high-risk investments in companies working on technology developed for World War II.¹⁷ The firm, established in 1946 by Harvard Business School professor Georges Doriot and MIT President Karl Compton, was structured as a publicly traded closed-end fund and imbued with public-service motives.¹⁸ It did not ultimately serve as a model organization for later venture investors as the public structure ensnared it in regulation that restricted its ability to invest fresh capital into portfolio companies, calculate the value of its investments, and grant employee stock options.¹⁹ Further, the firm’s public-service ethos that disdained financial incentives disappointed staff and investors, and prevented the firm from productively abandoning underperforming portfolio companies.²⁰

Nonetheless, ARD provided proof of concept of a couple of key ingredients for venture investing. First, a single investment—Digital Equipment Corporation—accounted for the lion’s share of all the gains that ARD generated over a quarter century.²¹ This represented an early demonstration of what later became known as the “power law”²² or “long-tail investing”²³ business model that attracted the attention of others interested in financing technological innovation. A small number of big “hits” can drive a fund’s success despite numerous other failures. Second, the leader of ARD and a key figure in risk capital during this era,²⁴ Doriot, was deeply involved in providing managerial counsel as well as capital to his portfolio companies.²⁵ In his view, founders were the visionary stars and venture capitalists’ role was to provide wisdom and guidance.²⁶

Another important development of the era was the passage in 1958 of the Small Business Investment Company (“SBIC”) Act, which reflected the U.S. government’s effort to respond to the perceived funding gap for entrepreneurial finance.²⁷ Under the SBIC Act, a privately-owned investment fund aimed at making investments in qualifying small businesses would be eligible for favorable tax treatment and a government loan at nominal rates.²⁸ The program engendered debate between advocates of government subsidy to encourage small business formation and those who believed in market-based solutions.²⁹ Neither side received total vindication as the government intervention made clear impact, but it was market players who ultimately pioneered what became the venture capital industry.

Practically speaking, the limitations on SBICs proved too restrictive for pioneering investors in the nascent venture capital industry who sought to finance startups—highly risky innovative ventures with the potential for outsized returns.³⁰ Most SBICs were small and undercapitalized.³¹ SBICs could not exceed a fund size of $450,000 to qualify for maximum assistance, and “could not compensate their investment staff with stock options, nor could they invest more than $60,000 into a portfolio company . . . .”³² SEC registration rules were burdensome and costly, and SBICs and their shareholders were subject to double taxation.³³ In sum, these rules were poorly suited for enabling venture capitalists to provide adequate capital to high-growth, innovative companies, and to compensate the investors for their efforts. Despite these drawbacks, or perhaps thanks to the lessons they generated, the program shed light on the legal policies and financial institutions that would clear the way for venture capital and startup entrepreneurship to thrive.³⁴

The year before the SBIC Act’s passage, and before ARD had financed Digital Equipment, one of the most significant events occurred in the history of venture capital—a tremor that became an earthquake that eventually opened a new landscape in the orange groves around Stanford University. A group of eight young Ph.D. graduates had been recruited by the renowned inventor William Shockley to work at Shockley Semiconductor Laboratory on developing new semiconductor devices at Fred Terman’s new research park.³⁵ These “Traitorous Eight” young engineers quickly became “fed up” with “suffering” under Shockley, the famous Nobel Prize winning “father of the semiconductor,” who acted as a “tyrant.”³⁶ One of the group members, Eugene Kleiner, had a connection through his father to a New York investment firm.³⁷ He wrote and asked if perhaps a financier could find an employer willing to hire all eight as a team.³⁸ Their “act of defection” in 1957 “created the magic culture of the Valley,”³⁹ and it was made possible by an equally visionary young banker, Arthur Rock, who was given the letter by Kleiner’s father.⁴⁰ Rock had already immersed himself in the emerging semiconductor industry and was intrigued by the request from an elite team so he flew out to San Francisco to meet with them. Rock proposed a possibility they had not even imagined: striking out on their own as founders of a new company that he would help finance.⁴¹

Rock’s vision was radical at the time.⁴² And, after trying to raise capital from numerous backers without avail, just one wealthy individual willing to fund the Shockley rebels emerged from Rock’s search—Sherman Fairchild.⁴³ But Fairchild cut a hard bargain—the eight co-founders put up a small amount of cash in return for 100 shares each, the budding venture capitalist bought 225 shares at the same price, 300 shares were set aside for recruiting managers, and Fairchild put in $1.4 million in the form of a loan that came with control via a voting trust and an option to purchase all of the company for $3 million down the line.⁴⁴ The startup, Fairchild Semiconductor, was wildly successful—within two years, each of the Traitorous Eight and Rock received six hundred times what they had invested, but Fairchild, the passive financier, did even better.⁴⁵

Beyond the obvious riches, one important takeaway from the Fairchild Semiconductor adventure was that without dedicated pools of money looking to finance startups, the investors held the bargaining power and the innovators got short shrift. In the 1960s, after a taste of success, Rock moved out to California, and, with a like-minded partner, started to raise a venture fund with a limited partnership structure in which the two general partners would seed the fund with some of their own capital.⁴⁶ By eschewing SBIC loans and public market money, they raised over $3 million from thirty “limited partners”—wealthy individuals who served as passive investors—and avoided the regulatory restrictions that had held back SBICs and ARD.⁴⁷ They had enough money to supply risky yet promising startups with the capital needed to grow aggressively, and they incentivized entrepreneurs and key employees with equity.⁴⁸ After fund raising, they made concentrated bets on a dozen or so companies, respectfully exercised a measure of governance control with the aim of helping the entrepreneurs succeed, and returned a handsome share of profits to limited partners on a set timeline by identifying and nurturing hits that could find an exit by going public or being acquired.⁴⁹

A winning formula for financing risky technology startups was finally found—it involved private business entities and private markets. Venture capitalists in the subsequent period built upon these early lessons, fine-tuning investment and governance practices, and pushing for favorable government policies. By the 1970s, several pioneering venture capital firms emerged alongside the early players—including Sequoia and Kleiner Perkins, among others.⁵⁰ They funded some of the big hits of the era, including Intel, Apple Computer, and Genentech.⁵¹ In this period, the importance of deal flow, repeat entrepreneurship, incentive compensation, and governance support were solidified.⁵² Venture capitalists learned to lower their risk by actively guiding founders and staging financings, with each capital infusion calculated to encourage the company to hit an agreed milestone and leaving open the possibility of abandoning underperforming startups.⁵³ Silicon Valley became an ecosystem of early-stage finance and entrepreneurship with universities, a pool of potential founders, specialized investors, large tech companies and employees, lawyers with dealmaking savvy, and more.⁵⁴

Further, the National Venture Capital Association, a trade association of venture capitalists founded in 1973, lobbied heavily for the legislative change that freed pension funds from previous restrictions in allocating a portion of their capital to venture funds.⁵⁵ Pension funds joined university endowments, insurance companies, and a handful of wealthy individuals in this nascent asset class.⁵⁶ With a supply side boost of capital thanks to supportive policymakers, the venture capital industry rapidly grew in the 1980s.⁵⁷

Over time it became clear that the venture capital industry and the tech firms they financed were subject to boom and bust cycles.⁵⁸ Further, it remained difficult to systematically generate outsized returns from “long-tail” portfolios.⁵⁹ The top-quartile funds have typically outperformed the bottom quartile by a wide margin.⁶⁰ But the overall trendline was one of continued growth and maturation of the industry and the Silicon Valley ecosystem.⁶¹ By the 1980s and 1990s, a set of practices around venture capital investing took shape which fostered a distinctive set of features for venture-backed startups that remain today.

B. Venture-Backed Startup Features and Governance

As the discussion so far has highlighted, the rise of the venture capital industry reflected a historically contingent confluence of business and legal transformation. Pioneers of the industry experimented with a variety of arrangements and then settled on a model that uses the limited partnership form to raise and deploy pools of risk capital over a set period of time. Further, the industry matured through the development of contracting and governance mechanisms aimed at addressing the particular challenges involved in financing and nurturing high-risk and potential high-reward innovative, young companies. The discussion will now turn to those practices and their implications for the kinds of businesses that get funding, and their governance.

It is worth emphasizing at the outset that the most fundamental aspect driving venture capital investing is the “power law.” As noted above, this is not a true law in any sense. Rather it is a phenomenon or understanding that a very small subset of deals typically generates the bulk of the returns for a successful venture capital fund.⁶² As one well-known venture capitalist, Peter Thiel of Founders Fund, has explained, “This is a scary rule, because it eliminates the vast majority of possible investments.”⁶³ Why? As no one knows with certainty in advance which companies will succeed, and as innovative startups are highly risky, many will fail or have mediocre returns. For this reason, “every single company in a good venture portfolio must have the potential to succeed at vast scale.”⁶⁴ Downside risk is limited to the total investment 1x while upside gain could be 100x or more within a relatively short amount of time.⁶⁵ Venture capitalists are therefore not just looking for startups with the possibility of becoming profitable—they are aiming at investing only in startups that have the potential to utterly disrupt or create industries with large addressable markets.⁶⁶ Crystallizing this point, Bill Gurley of Benchmark Capital has remarked, “Venture capital is not even a home run business. It’s a grand slam business.”⁶⁷

Further, the power law operates within an assumption that often goes unarticulated—not only must venture capitalists aim to invest only in potential grand slams, but they also need startups to find an exit within a timeframe that roughly corresponds with the term of their fund. There are just two main paths to a successful exit: sell the company or go public.⁶⁸ As venture capitalists typically use a 10–12 year term for their fund,⁶⁹ this dynamic shapes the type of companies they invest in and the way that they govern them.⁷⁰ One venture capitalist put it succinctly, “I sell jet fuel.”⁷¹ Venture-backed startups must grow fast to succeed.⁷²

This dual reality of power law returns and the need for exit on a relatively short timeframe distinguishes venture capital and the types of startups they invest in from other businesses or stages of a business life cycle. For example, private equity portfolios typically aim to optimize each portfolio company’s performance and leverage the gains.⁷³ They often target existing, underperforming businesses rather than help build new, innovative companies that have a large risk of failure.⁷⁴ Other private businesses include traditional closely held enterprises that range from small mom-and-pop businesses to virtual behemoths such as Cargill and Koch Industries.⁷⁵ These companies often begin as sole proprietorships, partnerships, or family businesses, and organically grow over time without a particular aim at exit.⁷⁶

In turn, because venture capitalists are specialized intermediaries uniquely tailored to financing innovative startups, they have developed contracting and governance mechanisms aimed at addressing the particular constellation of issues that these companies pose: uncertainty, information asymmetry, agency costs, and incomplete contracting.⁷⁷ In the early stages of a startup, its success is highly uncertain—more so even than the usual new business because startups are typically innovative, not replicative.⁷⁸ Entrepreneurs often have more information than investors and their interests are not fully aligned.⁷⁹ Contracts between entrepreneurs and venture capitalists will inevitably be incomplete because of the participants’ bounded rationality and their inability to foresee and resolve all potential contingencies.⁸⁰

These were the challenges faced by the pioneers of venture capital, from Georges Doriot to Arthur Rock. And, since the maturation of the venture industry in the 1980s and 90s, a set of contracting practices for venture capital funds and startup investing has become the norm, creating an “interrelated bundle of incentives and protections” that facilitates the flow of funds to entrepreneurs.⁸¹

Venture capital firms raise capital from passive limited partners, organized in funds with 10–12 year terms, charging an annual management fee and a percentage of profits.⁸² Acting as general partner of the fund, venture capitalists make and monitor investments in a portfolio of startups.⁸³ Startup founders and employees will typically have an incentive-based ownership stake that vests over time and takes the form of common stock or options.⁸⁴ Venture capitalists invest in syndicated, staged financing rounds for convertible preferred stock that come with liquidation preferences and other protections for downside risk and the ability to convert into common on the upside.⁸⁵ Notably, venture contracts separate cash flow ownership from voting and other control rights. Venture capitalists typically participate in board governance and bargain for shareholder voting rights and the right to veto certain major management decisions.⁸⁶ Over the life cycle of a venture-backed startup, as it increases the number of participants with varied interests and claims, the vertical and horizontal tensions among and between common and preferred shareholders tend to multiply.⁸⁷ Ultimately, if a venture-backed startup survives past its early stage, governance complexity increases and pressure builds for the startup to find a liquidity event.⁸⁸

These basic contours of venture capital investing and governance are well understood. Naturally, much more could be said about industry trends and entrepreneurial finance. The point here is to highlight that the basic practices of venture capital in the United States have been established for over four decades now—and have become sticky—fostering a distinctive set of companies and governance in the business world.⁸⁹

With this foundation set, the next Part can take up the big picture view of how business law has enabled and responded to the rise of venture capital and startups, with subsequent discussion to explore the lingering issues of social costs and policy they raise.

II. BUSINESS LAW’S CREATION AND RESPONSE TO THE RISE OF VENTURE CAPITAL AND VENTURE-BACKED STARTUPS

As the previous Part has highlighted, the rise of the modern venture capital industry developed to take advantage of laws that enable private business entities and private markets. Both state business law and federal securities laws facilitated this combination.⁹⁰

Traditionally, business entity formation and governance have been a matter of state law. Under enabling state laws, venture capitalists can form limited partnerships for the purpose of raising and operating venture funds, and founders can form corporations through which to engage in startup entrepreneurship. The internal affairs doctrine provides that the law of a firm’s state of incorporation governs the relationships among the firm, its investors, and managers.⁹¹ Venture capitalists and startup entrepreneurs have predominantly chosen Delaware as their preferred state for formation of limited partnerships and corporations.⁹²

Federal securities law, under the architecture of the Securities Act of 1933 and the Exchange Act of 1934, has partitioned issuers, securities, and offerings into two realms—public and private—with each side bearing distinct privileges and burdens.⁹³ Public company stock, once registered, can be freely issued and traded, but the issuing companies are subject to extensive mandatory disclosure as well as active enforcement mechanisms.⁹⁴ Conversely, the issuance and trading of private company stock must conform to restrictions of registration exemptions, but regulation of private firms is otherwise light.⁹⁵ Investment funds are subject to an analogous public-private divide.⁹⁶ Since Rock started his first fund in the 1960s, venture capital firms have organized their activity to fall on the private side in both the arrangement of their own funds and the portfolio companies in which they invest.

Given the importance of business law to venture capital and venture-backed startups, this Part takes up the question of how the law has responded to the developments traced thus far and describes the big picture of the growth of the private realm and the wild (and sometimes questionable) adventures of startups in it.

A. The Evolution of Corporate and Securities Law in an Age of Venture Capital and Startups

Corporate and securities law have taken vastly different approaches to the rise of venture capital since the industry began to solidify, grow, and mature in the 1980s. They have in common one high-level response: neither creates a legally defined category for venture-backed startups.⁹⁷

While the key corporate law state for startups—Delaware—has been generally enabling and highly regarded, its case law has not been particularly favorable for startup participants as it is not crafted for the distinctive characteristics of these companies and is instead often made in the context of very different public corporations. Despite these tensions, for the most part, startups are able to take advantage of the enabling nature of Delaware corporate law through venture contracting practices and can avoid ex post litigation, so state corporate law ultimately creates an environment for highly flexible governance practices and a stable backstop, albeit sometimes problematic, for the rare disputes that go to court.

By contrast, securities laws have responded to the rise of venture capital and venture-backed startups with enormously favorable provisions and a deregulatory trend that has facilitated a radical transformation of private markets over the past several decades. The combination of these relevant state corporate and federal securities laws, which are discussed further below, work in tandem to foster a growing public-private divide and startup governance challenges that characterize the present era and raise big questions for the role of business law in the future.

1. Corporate Law and Venture-Backed Startups

Delaware famously makes and applies one general corporate law.⁹⁸ Thus, the same statute and case law generally apply whether the corporation at hand is one of the world’s largest public corporations or a brand-new private startup. The rise of venture capital and venture-backed startups has therefore posed interesting and challenging issues of fit between corporate law and startup participants’ interests and needs.

As permitted under Delaware corporate law, venture-backed startups customize their governance arrangements through the organic documents of the corporation (charter and bylaws) and extensive shareholder agreements, typically re-bargaining these arrangements in each round of venture financing.⁹⁹ Delaware’s enabling approach is a boon in this regard. For example, it is mandatory to have a board of directors, but Delaware corporate law requires only one director, allows for different sizes and compositions, and does not impose requirements of independence, qualifications, committees, or the like.¹⁰⁰ When disputes arise, however, Delaware case law takes a highly fact-specific approach and often imposes its most rigorous standard of scrutiny—entire fairness—when venture-backed startups are involved because they generally lack disinterested and independent boards and shareholders.¹⁰¹

Over time, this divergent dynamic between public and private corporations and fiduciary litigation has become more pronounced as federal securities law has added a layer of corporate governance requirements on public companies, requiring majority independent boards.¹⁰² In addition, Delaware corporate law doctrine has developed more pathways to lighter review under the deferential business judgment rule if certain process protections are followed with disinterested and independent board members and/or shareholders.¹⁰³ This means that absent specific conflicts or the like, most public company boards would receive deferential review if their decisions are challenged and could likely dispose of litigation in early motion practice, whereas startup boards would not often be so lucky and might be encouraged to incur costly procedures such as banker fairness opinions or special committees that are not otherwise a fit for the norms or circumstances.¹⁰⁴

Furthermore, some venture-backed startup cases involving fiduciary litigation under the strenuous entire fairness standard have provoked controversy. Most notably, in a case involving a conflict between the interests of the common and preferred shareholders in an M&A exit, In re Trados, the Delaware Court of Chancery declared that directors owe a fiduciary duty to maximize value for the common shareholders as residual claimants.¹⁰⁵ Corporate law scholars have pointed out that this approach can give rise to inefficient outcomes that fail to maximize aggregate welfare.¹⁰⁶ Similarly in cases involving venture capital contracts and the status of preferred shareholder rights, Delaware courts have taken a strict construction approach that has elicited criticism given its potential to disrupt expectations and allocated risks.¹⁰⁷

None of these doctrinal tensions have been insurmountable impediments.¹⁰⁸ On balance, venture-backed startups and their participants have largely learned to take advantage of the freedom for private ordering and to generally avoid litigation. This latter point is likely a matter of practicality—given that failure or economic realities often make litigation less relevant for startups¹⁰⁹—as well as norms in an ecosystem of repeat players and reputational concerns.¹¹⁰ Further, a community of knowledgeable and experienced lawyers has flourished over decades, playing an important role as dealmakers and guides providing counsel to venture-backed startups through contracting practices, conflicts, fiduciary duties, and more.¹¹¹

2. Securities Law and Venture-Backed Startups

While corporate law’s response has been a mix of enabling rules with certain doctrinal tensions in application, securities law has provided a veritable windfall to the venture capital industry. The legal transformation to securities laws regulating private markets and companies has occurred incrementally over many years. In the aggregate, this deregulatory shift has been sufficiently dramatic to raise existential questions about the coherence of the securities law framework and its approach to venture capital and venture-backed startups.

First, in 1988, during a period of rapid growth in funds allocated to venture capital, the Securities and Exchange Commission (“SEC”) adopted Rule 701, permitting private companies to issue equity-based compensation to employees and service providers, in limited amounts, without registering the offering or providing extensive disclosures.¹¹² As the history of venture capital illuminates, equity-based compensation for founders and entrepreneurs has long been understood as a key ingredient for attracting and retaining talent in risky enterprises, and the SEC’s rule added important clarity for startups to offer equity compensation to prospective employees lacking sophistication or high net worth.¹¹³ At the time of adoption, the SEC had come under considerable pressure from scholars, industry representatives, and lawyers to create this special exemption.¹¹⁴ And, under continued lobbying pressure from industry players, the SEC has periodically, across decades, increasingly relaxed various aspects of the remaining Rule 701 restrictions, “turning [a] small exemption into a significant channel of securities offerings to household investors.”¹¹⁵

Second, a long trajectory of additional deregulatory actions since the early 2000s has opened the floodgates to private markets and loosened restrictions.¹¹⁶ The result is larger, more complex private markets and a regulatory environment in which two firms that are virtually identical in value, number of employees and shareholders, access to capital, and size and footprint of operations can be subject to vastly different regulatory obligations and oversight.¹¹⁷ The implicit bargain that venture-backed startups faced through the 1990s of becoming a public company subject to an extensive federal regulatory regime in order to access large and liquid pools of capital has been replaced by a new set of options.

After the dot-com bust and financial accounting scandals of the early 2000s, Congress passed the Sarbanes-Oxley Act of 2002, setting in motion a narrative of “over-regulation” amid a deepening decline in IPO activity.¹¹⁸ While the costs and obligations on public companies concerning governance arrangements, internal controls, and disclosures indeed ratcheted up, a set of market forces including increased M&A activity and greater availability of private capital also took effect.¹¹⁹ The number of IPOs and U.S. publicly traded companies significantly dropped.¹²⁰ Shortly after Congress passed the Dodd-Frank Act of 2010 in the wake of the global financial crisis, further increasing regulatory burdens on public corporations, it passed the JOBS Act of 2012, which deregulated major aspects of the rules concerning venture financings and easing startups’ exit pathway with a new IPO on-ramp.¹²¹ The venture capital industry, startups, and exchanges that stood to gain from the changes lobbied heavily in favor of them.¹²² As the “SEC continued to prioritize the deregulation of the private markets in the name of public capital formation,”¹²³ the tables began to turn—going public changed from a rite of passage that successful startups would go through after a few years in the venture cycle to an idiosyncratic, firm-specific choice that could be significantly delayed.¹²⁴ The pathway to exit via M&A became much more common than IPO.¹²⁵

With massive inflows of private capital and new investors to private markets, the SEC’s rationale for its deregulatory trend took an ironic twist away from capital formation to “democratizing” access to private markets.¹²⁶ Delayed timelines to venture-backed startup exits had effectively allowed startups to grow larger and for much of their growth to occur on the private side of the divide.¹²⁷ “Unicorn” companies that raised venture financing at a private valuation of $1 billion or more exploded.¹²⁸ In 2020, the SEC adopted extensive rule amendments to permit larger and more frequent private offerings to be offered more widely to the general public.¹²⁹

In hindsight, it became evident that a slow-motion series of piecemeal securities law developments transformed the public-private divide and the environment in which startups go through the venture cycle.

B. The Wild Adventures and Misadventures of Venture-Backed Startups in the Private Realm

With an understanding of the business and legal history that has brought about and transformed venture capital, startups, and the regulatory environment that they enjoy, the discussion can now explore the implications of these developments and what the role of business law might be in the future.

The heart of the matter concerns the enormous space that business law creates for venture-backed startups to operate for long periods without significant governance or disclosure requirements. Accountability mechanisms beyond the internal participants’ private ordering are also vastly limited in comparison with those in the public company context.¹³⁰ Private startups are generally free from securities class actions, short sellers, quarterly earnings pressures, public stock prices, and the like. Further, regulators at different levels from federal to local, in different areas of subject matter expertise, face challenging dynamics responding to innovative startups—their activity might fall into unmapped territory, legal gray areas, or regulatory blind spots until egregious circumstances develop.¹³¹ With limited resources, regulators might prioritize oversight and enforcement of large established companies.

This environment of relative freedom to push the envelope fits the needs of venture capital and startups, which are fundamentally “a machine for running experiments.”¹³² Moreover, given the power law, these startup experiments are typically not seeking to hit a single or double—they aim at “disrupting entrenched corporate power” in lucrative markets that could be grand slams.¹³³ As we have seen, venture capitalists are looking for “radical departures from the past.”¹³⁴ Room for maneuvering without disclosures that would prematurely share information with competitors or potential competitors is important for incubating innovative products and services. Longer timelines for staying private enable startups to try moonshots that might take significant time to develop or find product-market fit.

Recent years have witnessed venture-backed startup activity that has increasingly raised concern about the growing public-private divide and startup governance, however. The private space and relative freedom that are embraced by startup entrepreneurs and venture capitalists have given rise to scandals from Theranos to FTX, governance fiascos such as WeWork, and controversial products and services such as Juul’s vaping technology and Uber and Lyft’s ride sharing services. With a massive influx of private capital over the past decade, venture capital has spread sectorially to startups aimed at widespread industries from health to transportation.¹³⁵ And with this long timeline and large footprint have come concerns about harms to customers, employees, and other stakeholders, as well as questions about how society is impacted more generally by venture capital.¹³⁶

A vivid example of this complex dynamic of startups in the private realm comes from the burgeoning artificial intelligence (“AI”) industry. AI is posed to deliver some of the biggest financial hits of the current generation of startups and it threatens to destabilize countless industries and impact social and economic activity globally in unpredictable ways. Sam Altman, the CEO-founder of OpenAI, which has developed ChatGPT, currently valued at $29 billion, has declared that it is better to continue running the company privately so that his decisions are not limited.¹³⁷ Altman remarked, “When we develop superintelligence, we’re likely to make some decisions that public market investors would view very strangely.”¹³⁸

Notably, however, Altman made these statements about staying private while on a world tour of meetings with governments in which he warned them of the existential threat posed by AI. He testified to the U.S. Congress: “I think if this technology goes wrong, it can go quite wrong.”¹³⁹ And although he originally expressed a desire for his company to work with governments on responsibly regulating AI, he threatened that OpenAI would leave Europe in response to new European Union regulations.¹⁴⁰ He later backtracked after EU lawmaker pushback,¹⁴¹ but he could not unring the proverbial bell that raised questions about the dangers of the technology being developed and the sincerity of its stewards’ statements about embracing regulation.

As regulators’ ability to rein in the harms posed by venture-backed startups is often limited as a practical matter, and the protections of public markets are absent, focus has shifted to startup governance and the failures of private ordering to create checks and balances. For over a decade, with more private capital available in a low-interest rate environment and intense competition for venture deals, many venture capitalists adopted “founder-friendly” stances.¹⁴² Some founders have been allowed to act as “monarchs” with “unchecked power.”¹⁴³ Critics have expressed concern that venture capitalists have turned into “hype” people exercising little managerial oversight—“a money-hungry mob” pushing for “hyper growth” instead of the prudent “midwives to innovation” they had been in the past.¹⁴⁴

In some instances, utterly disastrous startup governance has come to light. One example is the collapse of FTX, one of the largest cryptocurrency exchanges, once privately valued at $40 billion.¹⁴⁵ The CEO-founder was “the paragon of crypto,” and vaulted to celebrity status as he led the startup through rocket-ship growth.¹⁴⁶ After troubling reports came to light about potential leverage and solvency concerns, customers attempted to pull out of FTX, precipitating the company’s downfall. Prosecutors and regulators quickly closed in on the CEO-founder, asserting that FTX had been illegally using clients’ deposits.¹⁴⁷ Shortly after, the CEO-founder resigned and the company filed for bankruptcy. One of the biggest unicorns crumbled within days.

In the aftermath, FTX installed a new CEO to handle the bankruptcy—the same person who had handled the cleanup of the massive accounting and audit scandal at Enron that had prompted the passage of the Sarbanes-Oxley Act in 2002.¹⁴⁸ After taking the helm at FTX, he said: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”¹⁴⁹ The company had no board of directors—none of the well-known venture firms that had financed FTX had taken seats.¹⁵⁰ According to media reports, “control was in the hands of ‘a very small group of inexperienced, unsophisticated and potentially compromised individuals.’ ”¹⁵¹ Company financials were not tracked.¹⁵² Software was reportedly used to conceal the misuse of client money.¹⁵³ The CEO-founder was arrested and charged with multiple criminal counts, and other top executives pleaded guilty and admitted that they knew what they did at the startup was wrong.¹⁵⁴ Potentially billions of dollars in customer funds went missing.¹⁵⁵

Apart from governance scandals is the separate concern that with venture capitalists raising and deploying dramatically larger funds, they might end up funding money-losing companies that are creating “disruption without social benefit.”¹⁵⁶ In some cases, startups might in fact be “destroying social value” and crowding out the development of superior technologies.¹⁵⁷ Venture capital goes to a narrow slice of potential innovators and not necessarily those that would produce the most social value or positive innovation.¹⁵⁸ Even venture capitalists themselves have raised this concern, for example noting, “We wanted flying cars, instead we got 140 characters.”¹⁵⁹ And while the social value that Twitter produced is certainly debatable, it compares favorably to many other startup inventions including robotic pizza makers and “Juicero” juicers.¹⁶⁰ Commentators have also raised concerns that only a relatively small number of venture capital investors shape the direction of a substantial amount of the capital that is financing radical technological change.¹⁶¹

A number of proposals for reform have been offered. These have tended to be somewhat narrowly focused on particular aspects of problematic facets of the public-private divide and startup governance. For example, proposals from scholars and regulators include special disclosure regimes for unicorns,¹⁶² enhanced disclosures for startup employees,¹⁶³ expanded anti-fraud enforcement efforts,¹⁶⁴ facilitating private company stock trading for price accuracy,¹⁶⁵ and reforming the “shareholders of record” trigger for public company status.¹⁶⁶

Without a more systematic approach to these issues, however, it is difficult to know if there is a problem with venture-backed startups and the private realm, and whether private ordering, new lawmaking, or enforcement could provide a solution. The next Part takes up some of the larger issues and promising avenues for future research.

III. THE BIG QUESTIONS

It might be impossible to accurately calculate the social welfare impact of venture capital, but researchers have begun to ask this question.¹⁶⁷ For most industry players, researchers, and others who are involved in some way in startups and venture capital, the answer is intuitively positive—despite drawbacks and harms, the gain is incalculably large as it is a key economic driver of growth and innovation that changes millions of lives.¹⁶⁸ The vibrant U.S. venture capital ecosystem is a jewel of the economy that countries around the world seek to emulate. Innovation is not automatically good for society,¹⁶⁹ but “in the long run, innovation is essential to productivity gains and economic growth.”¹⁷⁰

As one researcher explained: “Venture capitalists generate private value in the form of fund-level returns, but the social value they create surely exceeds that. That social value is equivalent to private value plus all other returns realized from the technological change that venture financing enables.”¹⁷¹ And on the latter point, “[n]umerous innovations developed by VC-backed firms, from memory chips to recombinant insulin . . . have moved society forward—and in turn, stimulated additional waves of technological development with immense collective impact.”¹⁷²

At the same time, even those who have a rosy or optimistic view about the aggregate social value that venture capital produces might be uncomfortable with the lingering impacts on stakeholders that arise in the context of venture-backed startups. Further, the rise of founders with unchecked power and the decline in active corporate governance by venture capitalists is concerning to many observers.

This Article offers two promising avenues for further inquiry for legal scholars and policymakers. Although the social welfare impact of venture capital may be somewhat intractable in the abstract, there are concrete related questions that would benefit from additional legal study and debate.

First, researchers can usefully focus attention on studying which persons impacted by venture-backed startups, if any, are systematically suffering harm. Key areas for additional investigation include startup employees and customers or users.

A number of researchers have raised concerns about startup employees developing incorrect expectations about the value of their equity compensation or suffering losses by exercising vested options and incurring tax consequences.¹⁷³ Assessing the value of startup equity compensation is challenging because of the lack of liquidity and a clear market price.¹⁷⁴ Further, as discussed above, startups rely on Rule 701 to avoid registering compensatory offerings with the SEC, and have limited disclosure obligations.¹⁷⁵ Complex and often opaque capital structures add to the challenges for startup employees to evaluate their equity compensation.¹⁷⁶ Venture capitalists typically receive preferred stock, which comes with contractual protections such as liquidation preferences, and is considerably more valuable than the common stock for which employees are typically granted stock options.¹⁷⁷ In short, an illiquid market, incomplete information, and complex capital structures often make it difficult for startup employees to make informed decisions about their equity compensation.¹⁷⁸ A more systematic study of the issue offers a concrete path for legal reform that could temper some of the harms of startup governance failures or fraud as other startup participants—venture capitalists, founders, and executives—are often better situated to bear the risk or avoid creating the harm in the first place.

Another group of individuals impacted by startups that deserves deeper inquiry are customers or users.¹⁷⁹ Some salient examples of startups that have harmed users in recent times have included the blood-testing company Theranos, vaping pioneer Juul, and the crypto exchange FTX.¹⁸⁰ Determining whether startups pose distinctive risks to customers is difficult, however. Corporate harms and externalities are certainly not unique to startups—closely held and publicly traded companies are involved in a range of pressing social issues from the opioid crisis to environmental pollution and catastrophes. Nonetheless, one could imagine that startups more frequently pose risks, or uncertain impacts, to customers or users stemming from the innovation or technology that is at the heart of venture-backed experiments. And yet, attempting to regulate the harms from innovation through corporate and securities laws may be inefficient or worse. Further work could be done to bring together relevant research across silos of business law, technology and innovation law, and regulatory and enforcement approaches.

Second, a worthy area of legal focus is whether and when a governance intervention is optimal on a startup’s timeline in the venture cycle. Many observers have bemoaned bad startup governance and even blamed it for major scandals, yet little work has been done to examine how the venture contracting and governance model could change to incentivize active monitoring or whether regulatory mandates are necessary.¹⁸¹

For example, would additional disclosure, due diligence, independent directors, audited financials, or some other mechanism improve startup governance? Is there a bargaining or market failure that prevents such a governance mechanism from being used in most startups? As many startups fail, particularly in their early stages, increasing governance or compliance costs may be unwise and impinge on the valuable space for maneuvering in the private realm that fosters a thriving startup ecosystem. Further, as startups mature, they are often navigating increasing potential tensions among a larger number of participants and greater costs of bargaining, while trying to find a path to a successful exit.¹⁸² Therefore, it may be relatively easy to point to startup governance failures as a problem in the abstract, but difficult to find an ideal moment in the timeline to introduce mandatory obligations and to know which solutions, if any, are optimal. As the topic of startup governance garners more attention, it is important to bolster the empirical and theoretical foundations for understanding whether any legal reform is due.

In sum, while the U.S. venture capital ecosystem is a jewel of the economy and a key driver of innovation, it has also catalyzed concerns about social costs which are worthy of further examination. Further inquiry into two key areas—whether any stakeholders systematically experience negative impacts and potential improvements to the venture contracting and governance model—could help illuminate a path for the future of business law in this area.

CONCLUSION

Technology and innovation in the digital era have profoundly transformed business and society. This Article has investigated how law, particularly corporate and securities law, has facilitated and responded to the rise of venture capital that has been the key financial driver of this transformation.

The discussion has explored in particular how, after lawmakers shaped the enabling environment for venture capital to flourish, corporate and securities law has responded to the rise of venture-backed startups incrementally but with profound effect. Although business law has not always fit easily with the distinctive features of venture capital and startups, it has provided an enormous space in the private realm for venture capital and startups to maneuver with relative freedom. This private realm is a good fit for the needs of innovative companies, but their activity creates lingering issues of social costs and policy. Important and promising areas of future research lie ahead to develop a coherent business law response to the current wild era of adventure capital..

96 S. Cal. L. Rev. 1341

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Elizabeth Pollman*

* Professor of Law, University of Pennsylvania Carey Law School. Special thanks to Danny Sokol and the participants and editors involved in the 2023 Symposium of the Southern California Law Review. Additional thanks for helpful comments and valuable discussion to Brian Broughman, Elisabeth de Fontenay, and workshop participants at Seoul National University School of Law, the Center for Advanced Studies on the Foundations of Law and Finance at Goethe University Frankfurt, and Bocconi University.

For Whom Corporate Leaders Bargain

March 2022March 2022Lucian A. Bebchuk, Kobi Kastiel & Roberto Tallarita

At the center of a fundamental and heated debate about corporate purpose, an increasingly influential view (which we refer to as “stakeholderism”) advocates giving corporate leaders increased discretionary power to serve all stakeholders and not just shareholders. Supporters of stakeholderism argue that its application would address growing concerns about the impact of corporations on society and the environment. By contrast, critics of stakeholderism argue that corporate leaders should not be expected to use expanded discretion to benefit stakeholders. This Article presents novel empirical evidence that can contribute to resolving this key debate.

Following a stakeholderist framework, the constituency statutes adopted by more than thirty U.S. states authorize corporate leaders to give weight to stakeholder interests when considering a sale of their company. Using hand-collected data, we study how corporate leaders in fact used their stakeholderist discretion in transactions governed by such statutes in the past two decades. In particular, we provide a detailed analysis of more than one hundred transactions governed by such statutes in which corporate leaders negotiated a company sale to a private equity buyer.

We find that corporate leaders used their discretion to obtain gains for shareholders, executives, and directors. However, despite the clear risks that private equity acquisitions often posed for stakeholders, corporate leaders generally did not use their discretion to negotiate for any stakeholder protections. Indeed, in the small minority of cases in which some stakeholder protections were formally included, they were generally cosmetic and practically inconsequential.

Beyond the implications of our findings for the long-standing debate on constituency statutes, these findings also provide important lessons for the ongoing debate on stakeholderism. At a minimum, stakeholderists should identify the causes for constituency statutes’ failure to deliver stakeholder benefits in the analyzed transactions and examine whether embracing stakeholderism would not similarly fail to produce such benefits. After examining alternative explanations for our findings, we conclude that the most plausible explanation lies in corporate leaders’ incentives not to protect stakeholders beyond what would serve shareholder value. Our findings thus indicate that stakeholderism cannot be relied on to produce its purported benefits for stakeholders. Stakeholderism therefore should not be supported as an effective way for protecting stakeholder interests, even by those who deeply care about stakeholders.

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Tracing the Diverse History of Corporate Residual Claimants

January 2022February 2024Sung Eun (“Summer”) Kim

Postscript | Corporate Law
Tracing the Diverse History of Corporate Residual Claimants
by Sung Eun (“Summer”) Kim*

Vol. 95, Postscript (Jan 2022)
95 S. Cal. L. Rev. Postscript 43 (2022)

Keywords: Corporate Law, Residual Rights

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The conventional understanding in corporate law is that shareholders are the residual claimants of corporations because they own the residual right to profits. Based on this understanding, shareholders are entitled to a host of corporate law rights and protections—including the right to vote and fiduciary duty protections. However, a review of the origin and history of residual claimant theory shows that the theory originally envisaged a broad conception of the residual claim that goes beyond profits, leading to a diverse array of stakeholders being the residual claimants of corporations over time. Depending on which of the theories of rent, interest, wages, or profit was adopted, each of the landlord, capitalist, laborer, and entrepreneur has been considered the residual claimant of the corporation. This history shows that the prevailing view of shareholders as the exclusive residual claimants of the corporation is a relatively recent understanding and that the historical record supports a more diverse conception of the residual claimant. In that sense, residual claimant analysis is better understood as a theory for the stakeholder model of the firm than the shareholder primacy model, as it is presently understood.

* Professor of Law, University of California, Irvine School of Law. I am grateful to Mehrsa Baradaran, Joshua Blank, Jill Fisch, Vic Fleischer, Jonathan Glater, Alex Lee, Jennifer Koh Lee, Stephen Lee, Christopher Leslie, Omri Marian, L. Song Richardson, and Arden Rowell for reading prior versions of this Article and providing helpful comments. I also benefitted from the opportunity to present and receive feedback on this project at the Trans-Pacific Business Law Dialogue (September 2020) and the University of Florida Business Law Conference (November 2020). Tianmei Ann Huang and Nick Nikols provided extraordinary research assistance, and Vivian Liu, Mindy Vo, Elizabeth Bell, and Jessica Block of the Southern California Law Review Postscript team, Deborah Choi, and Matthew Perez provided superb editorial assistance. Any errors are my own.

The Corporate Purpose of Social License by Hilary A. Sale*

October 2021March 2022Southern California Law Review Admin

Article | Corporate Law
The Corporate Purpose of Social License
by Hillary A. Sale*

94 S. Cal. L. Rev. 789 (2021)

Keywords: Corporate Law, CSR, Social License

This Article deploys the sociological theory of social license, or the acceptance of a business or organization by the relevant communities and stakeholders, in the context of the board of directors and corporate governance. Corporations are generally treated as “private” actors and thus are regulated by “private” corporate law. This construct allows for considerable latitude. Corporate actors are not, however, solely “private.” They are the beneficiaries of economic and political power, and the decisions they make have impacts that extend well beyond the boundaries of the entities they represent.

Using Wells Fargo and Uber as case studies, this Article explores how the failure to account for the public nature of corporate actions, regardless of whether a “legal” license exists, can result in the loss of “social” license. This loss occurs through publicness, which is the interplay between inside corporate governance players and outside actors who report on, recapitulate, reframe and, in some cases, control the company’s information and public perception. The theory of social license is that businesses and other entities exist with permission from the communities in which they are located, as well as permission from the greater community and outside stakeholders. In this sense, businesses are social, not just economic, institutions and, thus, they are subject to public accountability and, at times, public control. Social license derives not from legally granted permission, but instead from the development of legitimacy, credibility, and trust within the relevant communities and stakeholders. It can prevent demonstrations,

boycotts, shutdowns, negative publicity, and the increases in regulation that are a hallmark of publicness—but social license must be earned with consistent, trustworthy behavior. Thus, social license is bilateral, not unilateral, and should be part of corporate strategy and a tool for risk management and managing publicness more generally.

By focusing on and deploying social license and publicness in the context of board decision-making, this Article adds to the discussions in the literature from other disciplines, such as the economic theory on reputational capital, and provides boards with a set of standards with which to engage and address the publicness of the companies they represent. Discussing, weighing, and developing social license is not just in the zone of what boards can do, but is something they should do, making it a part of strategic, proactive cost-benefit decision-making. Indeed, the failure to do so can have dramatic business consequences.

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*. Associate Dean for Strategy, Agnes Williams Sesquicentennial Professor of Law, and Professor of Management at Georgetown University. Thanks go to Olivia Brown, Hollie Chenault, Claire Creighton, Samantha Glazer, and Jing Xu at Georgetown and Kelsey Bolin and Colin Pajda from Washington University for their invaluable research assistance, and to Brian Tamanaha, Bob Thompson, Don Langevoort, Michael Diamond, Urska Velikonja, Saul Levmore, David Hyman, Bob Rasmussen, Cynthia Williams, Bill Buzbee, Marty Lipton, Elizabeth Pollman, Andrew Tuch and the Georgetown and Michigan Law Faculties.

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The Giant Shadow of Corporate Gadflies by Kobi Kastiel and Yaron Nili

September 2021March 2022Southern California Law Review Admin

Article | Corporate Governance
The Giant Shadow of Corporate Gadflies

by Kobi Kastiel* and Yaron Nili†

From Vol. 94, No. 3
94 S. Cal. L. Rev. 569 (2021)

Keywords: Corporate Law, Shareholders, Corporate Social Responsibility

Modern-day shareholders influence corporate America more than ever before. From demanding greater accountability of executives, to lobbying for a variety of social and environmental policies, shareholders today have the power to alter how American companies are run. Amazingly, a small group of individual shareholders wields unprecedented power to set corporate agendas and stands at the epicenter of our contemporary corporate governance ecosystem. In fact, the power of these individuals, known as “corporate gadflies,” continues to rise.
Corporate gadflies present a puzzling reality. Although public corporations in the United States are increasingly owned by large institutional investors, much of their corporate governance agenda has been and is still dominated by a handful of individuals who own tiny slivers of most large companies. How does an economy with corporate equity in the trillions of dollars cede so much governance power to corporate gadflies? More importantly, should it? Surprisingly, scholars have paid little attention to the role of corporate gadflies in this ever-changing governance landscape.
This Article is the first to address the giant shadow that corporate gadflies cast on the corporate governance landscape in the United States. The Article makes three contributions to the literature. First, using a comprehensive dataset of all shareholder proposals submitted to the S&P 1500 companies from 2005 to 2018, it offers a detailed empirical account of both the growing power and influence that corporate gadflies wield over major corporate issues and of gadflies’ power to set governance agendas. Second, the Article uses the context of corporate gadflies to elucidate a key governance debate over the role of large institutional investors in corporate governance. Specifically, the Article underscores the potential concerns raised by the activity of corporate gadflies and questions the current deference of institutional investors to these gadflies regarding the submission of shareholder proposals. Finally, the Article proposes policy reforms aimed at reframing the current discourse on shareholder proposals and potentially sparking a new line of inquiry regarding the role of investors in corporate governance.

*. Assistant Professor of Law, Tel Aviv University; Research Fellow and Lecturer on Law, Harvard Law School Program on Corporate Governance.

†. Associate Professor of Law, University of Wisconsin Law School and Smith-Rowe Faculty Fellow in Business Law. For helpful comments and suggestions, the Authors would like to thank Albert Choi, Asaf Eckstein, Yuval Feldman, Jesse Fried, Eric Goodwin, Zohar Goshen, Assaf Hamdani, Sharon Hannes, Cathy Hwang, Rob Jackson, Adi Libson, Amir Licht, Ehud Kamar, Kate Litvak, Dorothy Lund, James McRitchie, Gideon Parchomovsky, Ed Rock, Sarath Sanga, Bernard Sharfman, Eric Talley and the participants of the Rethinking the Shareholder Franchise Conference at the University of Wisconsin, the 2020 National Business Law Scholars Conference, the 2020 Annual Meeting of the Israeli Private Law Association, the Faculty Lunch Seminar at Tel Aviv University, the law and economics and empirical studies workshops at Bar Ilan University, the Securities and Exchange Commission, the Missouri Law School Faculty Colloquium, the BYU Law 2020 Winter Deals Conference, the University of Florida 2020 Business Law Conference, and the Soshnick Colloquium on Law and Economics at Northwestern Pritzker School of Law. Maya Ashkenazi, Katie Gresham, Gabrielle Kiefer, James Kardatzke, Chris Kardatzke, Tom Shifter, Maayan Weisman, and Gretchen Winkel provided valuable research assistance.

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How the States Can Tax Shifted Corporate Profits: An Application of Strategic Conformity by Darien Shanske

August 2021March 2022Southern California Law Review Admin

Article | Tax Law
How The States Can Tax Shifted Corporate Profits: An Application of Strategic Conformity
by Darien Shanske*

From Vol. 94, No. 2
94 S. Cal. L. Rev. 251 (2021)

Keywords: Tax Law, Corporate Law, State Law

The combination of pandemic, recession and federal dysfunction has put severe fiscal strain on the states. Given the scale of the crisis and the essential nature of the services now being cut, it would be reasonable for states to contemplate inefficient—and even regressive—revenue-raising measures. Yet surely they should not start with such measures. They should start with making the efficient and progressive improvements to their revenue systems that they should have made anyway.

Improving the taxation of the profits of multinational corporations—the topic of this Article—represents a reform that would be efficient, progressive, and relatively straightforward to administer. Not only would such a reform thus represent good tax policy, but it would also raise significant revenue. And, if substantial revenue, efficiency, progressivity and administrability are not sufficiently motivating, then I will also add that it would be particularly appropriate to make these changes during the pandemic so as to raise revenue from those best able to pay during the current crisis.

To be sure, the argument that states can and should tax multinational corporations more has the whiff of paradox. After all, there is general consensus that no nation-state is currently taxing multinational corporations very effectively and, further, that subnational governments are in an even worse position to do so. This is because multinational corporations can exploit the mobility of capital even more easily between parts of the same country. Nevertheless, I will argue that the American states find themselves in a particularly strong position to do better at taxing multinational corporations and this is in part precisely because of the missteps made at the federal level.

The Tax Cuts and Jobs Act (“TCJA”), passed in December 2017, contained several provisions, including rules concerning Global Intangible Low-Taxed Income (or “GILTI”), that were meant to combat income stripping. The GILTI provision identifies foreign income likely to have been shifted out of the United States and subjects it to U.S. tax.

In this Article, I argue that the states should and can tax GILTI income. The basic policy argument is simple: states should not miss a chance to protect their corporate tax bases. The amount of revenue at stake is not trivial; it could be as high as $15 billion per year for the states as a whole or the equivalent of a 30% boost in corporate tax collections.

The basic legal argument is also simple: it cannot be the case—and it is not the case—that states need to take corporations at their word as to where their income is earned. If the states can make a reasonable argument that nominally foreign income has in fact been shifted out of the United States, then their choices as to their tax system should be respected.

This Article makes several other core arguments. First, the Article argues that returning to mandatory worldwide combination as a complete alternative to GILTI conformity would be preferable to GILTI conformity alone. Second, the Article argues that offering taxpayers a choice between GILTI conformity and worldwide combination is preferable to GILTI conformity alone.

Finally, this Article places all these issues in a larger framework of strategic conformity. As with GILTI, the states should look for other opportunities where they can take advantage of federal miscues while also advancing sound tax policy.

* Professor, UC Davis School of Law. Many thanks to audiences at the Association of Mid- Career Tax Professors, the NorCal Tax Roundtable, the University of Minnesota Law School Perspective on Taxation Lecture Series and to Eric Allen, Revuen Avi-Yonah, Kimberly Clausing, Steven Dean, Peter Enrich, Michael Fatale, David Gamage, Mark Gergen, Kristen Hickman, Ken Levinson, Michael Mazerov, Amy Monahan, Susie Morse, Michael Simkovic and Adam Thimmesch. I am particularly grateful to David Gamage who coauthored some shorter pieces on which this Article is based. All opinions and mistakes are my own.

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Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance by Michal Barzuza, Quinn Curtis & David H. Webber

February 2021February 2021Southern California Law Review Admin

Article | Corporate Law
Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance

by Michal Barzuza,* Quinn Curtis† & David H. Webber‡

Vol. 93, No.6 (February 2021)
93 S. Cal. L. Rev. 1243 (2020)

Keywords: ESG Activism, Index Fund, Corporate Governance

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Abstract

Major index fund operators have been criticized as ineffective stewards of the firms in which they are now the largest shareholders. While scholars debate whether this passivity is a serious problem, index funds’ generally docile approach to ownership is broadly acknowledged. However, this Article argues that the notion that index funds are passive owners overlooks an important dimension in which index funds have demonstrated outspoken, confrontational, and effective stewardship. Specifically, we document that index funds have taken a leading role in challenging management and voting against directors in order to advance board diversity and corporate sustainability. We show that index funds have engaged in a pattern of competitive escalation in their policies on environmental, social, and governance (“ESG”) issues. Index funds’ confrontational and competitive activism on ESG issues is hard to square with their passive approach to more conventional corporate governance questions.

To explain this dichotomy in approaches, we argue that index funds are locked in a fierce contest to win the soon-to-accumulate assets of the millennial generation, who place a significant premium on social issues in their economic lives. With fee competition exhausted and returns irrelevant for index investors, signaling a commitment to social issues is one of the few dimensions on which index funds can differentiate themselves and avoid commoditization. For index funds, the threat of millennial migration to another fund is more significant than the threat of management retaliation. Furthermore, managers themselves, we argue, face intense pressure from their millennial employees and customers to respond to their social preferences. This three-dimensional millennial effect—as investors, customers, and employees—we argue, is an important development with the potential to provide a counterweight to the wealth-maximization paradigm of corporate governance.

We marshal evidence for this new dynamic, situate it within the existing literature, and consider the implications for the debate over index funds as shareholders and corporate law generally.

____________________

*. Professor of Law, University of Virginia School of Law. For useful comments and suggestions, we are grateful to Steve Bainbridge, Ryan Bubb, Emiliano Catan, George Geis, Scott Hirst, Kate Judge, Dorothy Lund, Alma Oliar, Ariel Porat, Adriana Robertson, Mark Roe, Leo Strine, Andrew Tuch, and participants at the Association of American Law Schools Annual Meeting—Business Associations Section, the UVA/UCLA Corporate & Securities Law Conference, Tel Aviv Corporate Governance Seminar, Tel Aviv Law & Economics Workshop, Tulane Corporate & Securities Law Round Table, University of Chicago Law School Faculty Workshop, and Corporate Law Academic Webinar Series. The authors wish to acknowledge excellent research assistance from Brianna Isaacson and Jordan Voccola.

†. Professor of Law, University of Virginia School of Law.

‡. Associate Dean for Intellectual Life and Professor of Law, Boston University School of Law.