The Missing Link in Sarbanes-Oxley: Enactment of the 'Change of Control Board' Concept, or Extension of the Audit Committee Provisions to Mergers and Acquisitions

Abstract

This paper builds upon on my 2000 article, Change of Control Board: Federal Preemption of the Law Governing a Target's Directors (2000 COCB Article). In that article I propose that Congress address the conflicts of interest that can arise in the acquisition of a publicly held target corporation in various types of hostile and consensual merger and acquisition (M&A) transactions by requiring the independent appointment of a disinterested Change of Control Board. Under this proposal, unless the shareholders elect-out, once a public corporation becomes a target of a bona fide M&A offer, a federal Change of Control Official would appoint for the target a three-person Change of Control Board, which would have complete authority over the acquisition process. This concept would override all state takeover laws, and because of the obvious independence of the Change of Control Board, a Federal uniform standard of review, the business judgment rule, would apply in determining if the board acted properly. Thus, this concept would eliminate the several confusing standards of review applicable to the actions of a target's directors in M&A transactions under Delaware law. Many features of the Change of Control Board concept are similar to those provided for audit committees in the Sarbanes-Oxley Act of 2002 (SOX). The audit committee is directly responsible for dealing with the firm's CPA, each member of the audit committee must be independent, and the audit committee has the authority to hire its own advisors. Also, the U.S. stock exchanges have promulgated rules requiring that the boards of directors of each listed company consist of a majority of independent directors.

Although these independence requirements move in the right direction, they do not properly address issues that can arise when a publicly held corporation engages in a M&A transaction. The continuing problem with the acquisition of publicly held targets is illustrated most recently in two 2007 cases in the Delaware Chancery Court: Caremark and Netsmart, and the problem with acquirors is illustrated in the 2006 decision of this Court in J.P. Morgan Chase.

This article first explains how the audit committee provisions of SOX and the independent director requirement of the exchanges build upon a previous proposal for federalization of certain aspects of corporate law. The article then discusses (1) the manner in which current state law deals inadequately with various types of conflicts of interest that can arise in mergers and acquisitions, and (2) the bizarre structure of state anti-takeover law under which some states provide boards with virtually unlimited power to block a hostile acquisition. After explaining why the Change of Control Board concept should also apply to major acquisitions made by acquiring corporations, the article then elaborates on the essential features of the concept. Finally, the article discusses how many of the principles could be implemented by the SEC through its rulemaking authority under the audit committee provisions of SOX.

Keywords: Anti-takeover, Audit Committee, Change of Control, Corporate law, Merger and acquisition, Sarbanes-Oxley, Securities regulation

JEL Classification: G34, G38, M49, K22