2002 Volume 5 Issue 3

Who’s Driving American Firms?

Who’s Driving American Firms?

Directors facing new responsibilities

Corporate boards of directors need to be very proactive and diligent in order to protect shareholder interests, the larger economy . . . and themselves.

As stock markets have evolved, the roles of various players in those markets have also evolved. The role of a director has been transformed from one in which he or she was a passive, low-compensated bystander who was rarely evaluated on his or her own performance into one in which a director is highly compensated and expected to monitor management, oversee corporate governance, and protect shareholders’ interests.[1] Yet, in the past several months, it has become clear that something is terribly wrong at far too many of our public companies in the U.S. Once well-respected companies are now better known for their corporate transgressions. Mention Enron, Arthur Andersen[2], Kmart[3], RiteAid[4], Imclone, Martha Stewart[5], Adelphia Communications[6], WorldCom[7], Global Crossing[8], Tyco[9], Qwest[10], Xerox[11], Merrill Lynch or Citibank[12] and the response is likely to be negative. Senior officials of Adelphia Communications and of ImClone have been arrested and their counterparts at Rite Aid, and Tyco International have been indicted.[13]The list of indictments is likely to grow.

The damage done is not just in the millions of dollars, but in the hundreds of millions or billions of dollars, particularly when the impact on investor confidence overall is considered. Shareholders have lost trillions of dollars in shareholder wealth.[14] Many shareholders and employees in these companies have been totally wiped out, while far too many corporate officers have walked away with huge cash payments and stock options.[15]

For example, the CEO of Global Crossing, Gary Winnick, cashed in more than $700 million in stock options as “his company careened toward bankruptcy.”[16] Now many companies are spending millions of dollars to hire outside law firms to investigate potential wrongdoing and no one knows how many more corporate scandals are yet to be uncovered.[17] Last fall, Enron became the largest corporate bankruptcy in history with assets of $63.4 billion.[18] However, the Enron bankruptcy has now been dwarfed by the $107 billion bankruptcy of WorldCom on July 22, 2002, giving WorldCom has the dubious title of the largest bankruptcy in American history.[19]

The American stock market has declined precipitously and some commentators have pointed out that these scandals have driven “the market to its worst first-half finish since 1970”[20] and that this down market may last a long time because consumers and investors have lost trust in the stock market.[21] American capitalism is under fire as never before. As one journalist put it:

“[t]he decline in stocks has meant not just a loss of billions of dollars in savings for millions of workers, but it also has exposed levels of social corruption and avarice in the U.S. that has not been seen since the Gilded Age at the end of the 19th century.”[22]

How did this happen in the United States? The American corporate model of capitalism was supposed to have so many checks and balances in place and be so highly regulated that these kinds of scandals, especially on such a massive scale, were not supposed to be able to happen here. Yet here we are, day after day, bombarded with news about corporate abuses that are almost unbelievable in their scope and audacity.[23]

Boards Neglecting Fiduciary Duties

One potential explanation for this current spate of corporate scandals is that directors at some U.S. corporations have not been keeping in mind their clear and established fiduciary duties to the corporation and the shareholders. These duties are outlined in full detail in the Corporate Director’s Guidebook, published by the American Bar Association.[24] The following is a brief review some of the responsibilities of directors of U.S. companies.

Duty of Care: The first duty, the duty of care, requires that a director discharge his duties in good faith, with the care an ordinary prudent person in a like position would exercise under similar circumstances, and in a manner he or she believes to be in the best interest of the corporation.[25] This description suggests certain expectations. That is, directors are expected to:

  • Act in good faith, act honestly, and not to act or cause the corporation to act in an unlawful way;
  • Act with care, which requires directors to pay attention to material corporate information and events, and to respond diligently and reasonably;
  • Act with common sense, practical wisdom, and informed judgment, which requires a director to become familiar with the corporation’s operations;
  • Act according to an objective standard of conduct.

To be able to meet the standard of care, a director’s personal participation is required. While it is difficult to measure the level of care displayed by a director, there are some means of determining which directors are meeting the duty. For example, directors should attend and participate in board and committee meetings. A director should request that topics be included on meeting agendas if he or she feels the topics are important. Directors should request from management any information they feel is pertinent to their decision-making process and have the right and obligation to solicit experts’ opinions when necessary.

These steps are very important in light of the business judgment rule. If a director’s decision is later determined to be unwise or unsuccessful, the director is protected under law, provided that director acted in good faith, was reasonably informed, and rationally believed the decision was in the best interest of the firm. Typically, if the court concludes that these tests are met, it will not second-guess the director’s decision and he or she is relieved from any further legal obligations related to the decision.

A Duty of Loyalty: The duty of loyalty requires directors to act in the interest of the corporation and to put the corporation’s interests ahead of their own or any other person’s or entity’s interests. Directors may find conflicts of interest arising from time to time. These conflicts are not inherently improper, but the way in which interested directors react to the conflicts may result in improper actions. A director is considered to be “interested” when he or she has a personal or financial stake in a contract or transaction in which the firm is considering engaging. To avoid violating the duty of loyalty, directors should:

  • Disclose the interest;
  • Describe and disclose to the non-interested board members all material facts related to the matter;
  • Abstain from voting on the matter and from influencing the voting of the other directors.

The duty of loyalty also requires that a director make business opportunities available to the firm before pursuing them individually. If the firm has no interest in pursuing the opportunity, the director still must seek board approval before personally engaging in the venture. State statues often prescribe additional procedures for authorizing transactions with interested directors and should be followed to avoid any conflict with the duty of loyalty.

A Duty of Candor/Disclosure: For public firms there is a well-defined, formal process for disclosing non-public information, which usually involves a spokesperson for the corporation. This process was recently refined through the adoption of regulation Fair Disclosure by the Securities and Exchange Commission (SEC). Directors are required to act in confidence in all matters involving the corporation until the general public has been informed. In private firms the process is not well defined. Nevertheless, it is typically not the directors’ responsibility or right to disclose the inside information of private firms.

Directors of public firms are obligated to ensure that the procedures for producing the corporation’s disclosure documents result in accurate and appropriate firm disclosure. This requires directors to review drafts of public documents, including annual reports, quarterly reports, proxy statements, and prospectuses.

A Duty to Account: This duty is related to a requirement to disclose all material information to the firm’s various constituencies in a timely manner. However, this duty is largely superseded by the preceding duty, which requires the directors to defer any discussion of firm-sensitive data in public and private forums to the corporation’s spokesperson. Nevertheless, the directors still have a duty to account in that they have oversight responsibilities for which they are liable and for which they are held accountable by the firm’s owners, creditors, and the courts. For example, it is particularly important that directors chosen for the audit and compensation committees of the board are qualified to carry out their responsibilities on those committees, especially since so many of the current corporate scandals involve improper accounting and outlandish executive pay.

Three Reasons American Boards May Have Failed

The following are some possible reasons why American boards may have failed, but this list is certainly not exhaustive. The first reason that American boards may not have functioned as intended is that there is a built-in problem with the process for selecting the members of the board. The CEO or some other executive typically identifies nominees for a seat on the board. Most small investors, who have little incentive to become fully informed, tend to rely on these nominations when determining their selections for new directors or reelection of incumbents. Thus, at least some of the directors may feel beholden to the nominating executive, and these directors may tend to support the management team regardless of the firm’s performance. When serious problems for the firm arise, accusations of cronyism abound.

A second reason for ineffective directors is that the “inside” directors may not be objective. Insiders are those directors who have financial ties (other than compensation for being a director) or other ties with the firm from which they derive benefit. It is common for current executives (e.g. CEO and CFO) and former executives to sit on the board. Other board members may work for firms that have a business relationship with the company and the managers whom they are supposed to be monitoring. For example, a bank or an insurance company may have representation on some of their customer’s boards. These directors may be hesitant to confront poor managers for fear of losing business, and thus will not provide the kind of monitoring and discipline the market is seeking.

A third reason for ineffective boards is a lack of information. In an ideal world, directors would receive relevant information in a timely manner. Practically speaking, directors often receive only part of the information they need to make informed decisions, and they may be hesitant to ask for additional information to enhance the process. To help overcome this deficiency, audit committees are now required to include a director who is proficient in reading financial statements and who understands the accounting process. Directors knowledgeable in accounting issues on the audit committee will be better able to both request and understand the appropriate accounting information needed to effectively understand and monitor the company’s operations.[26]

How Do You Pick an Effective Board?

Assembling an effective board is a difficult task that requires the election of individuals with varied backgrounds, training, experience, and management philosophies. In achieving the goal of an effective board, there are a few tried and true commonalities.

First, the board should be comprised primarily of outside directors. Academic studies indicate that boards dominated by outsiders (where 60% of the board are outsiders) are significantly more likely to replace ineffective CEOs, that they replace ineffective CEOs sooner, that new CEOs are more likely to be outsiders themselves, and that firms with independent boards significantly outperform firms with insider dominated boards in terms of return on invested capital.Taken together, this evidence supports the notion that a board comprised of outsiders does a much better job of protecting shareholders’ interests.[27]

Second, committee heads, especially the heads of the audit and compensation committees should be outside directors, and a majority, if not all, of the members of these committees should be outside directors. This will help ameliorate any biases or conflicts of interest introduced by consultants hired to assist in the decision and evaluation processes. This problem is acute when it comes to compensation. “Any other kind of consultant you can think of is brought in to try to cut costs. The basic goal of compensation consultants is to justify whatever it is the CEO wants to make. After all, who’s going to recommend these consultants to other CEOs? Not the little old lady in Dubuque with her 100 shares, that’s for sure.”[28]

Third, organization of the board is important. To reduce any potential conflicts of interest, the CEO should not be the chairman of the board of directors, and in addition, the chairman should be an outside director. Fourth, retired executives of the firm should not stay on as directors. This can and does impede the new management team from asserting itself and taking the firm in new directions.

Finally, there is a push by concerned investors to have directors compensated with the firm’s shares that could not be sold for the duration of their terms. Thus, directors might be more inclined to “blow the whistle on management when necessary without fear of the short-term price declines that may follow.”[29] The intent is to heighten the awareness and focus the attention of directors by putting the directors’ wealth at risk along with that of the shareholders.

Taken together, these recommendations won’t guarantee an effective board, but they will take the board much closer to where shareholders and lenders would like the board to be in relation to the management team.

What U.S. Boards are Likely to Face in the Future

Shareholder Activism: Because of the number and magnitude of recent corporate scandals, more sShareholders are likely to exercise a greater voice in corporate governance than they have in the past. This is especially true because the composition of stockholders in American companies has changed markedly over the past twenty years. Today, a relatively small number of huge institutional shareholders control over half of the stock in the U.S. stock market.[30] In recent years and months, several of these huge institutional investors have demonstrated a penchant for demanding both corporate governance and accounting reforms.

In the wake of recent corporate scandals, there has been a resurgence of shareholder activism and shareholders have been winning some victories over company managements. For example, shareholders of EMC Corp and Mentor Graphics Corp. approved shareholder resolutions opposed by management, and it is believed that this might be a continuing trend.[31] While shareholder resolutions are non-binding, large institutional investors can often get management’s immediate attention since they have the power to sell large blocks of shares. Some active institutional investors, such as CALPERS and LENS have created target lists of underperforming firms and have pressured managers and boards to adopt high value-producing strategies or step down. In addition, the financial press has also been shining a spotlight on ineffective boards by creating lists of the worst performing boards and management teams. Anecdotal evidence on board composition and performance has also appeared in many financial publications.

Potential Reforms and Enforcement Actions: Because of the scale of the ethical problems currently being discovered and the trillions of dollars of lost shareholder wealth involved, it is highly likely that this decade will see more corporate regulatory reforms than at any other time since the passage of the securities laws in the 1930s.[32] James Flanigan, a columnist with the Los Angeles Times succinctly summed up the reason why. According to Mr. Flanigan, some Wall Street money managers in the 1920s figured out a way to pool investor funds, used these funds to drive up stock prices, and sold these inflated shares to the small investors. When stock prices later plummeted, these small investors who were left “holding the bag.” In the 1990s, Mr. Flanigan observed that investment bankers and corporate managers used initial public offerings in much the same way, resulting in huge profits for themselves and extraordinary losses for the investing public.[33] Since nearly half of all Americans are invested in the stock market today, the economic pain of today’s market plunge is felt by a much larger number of people. Added to this is the fact that the baby boom generation is nearing retirement and far too many of them are likely to have their retirement dreams at worst destroyed, or at best, significantly delayed.

NYSE: The New York Stock Exchange has already announced a proposed plan, which if approved, would boost the independence and authority of boardroom directors who are the ones responsible for overseeing top corporate executives.[34] Under this plan, companies that wanted to be listed on this exchange must have a board composed of a majority of independent — “outside” — directors, and all of the directors of both the audit and compensation committees must be independent shareholders who have the power to vote on all company stock-compensation plans. Further, all CEOs would be required to personally sign off on the accuracy of their company’s financial statements.[35] In addition, the SEC has proposed a new oversight body for the accounting industry, ending the program of voluntary oversight of the accounting profession that has existed up until this time.[36]

Other proposals under discussion include requiring companies to account on their income statements for the cost of stock options granted to employees, officers and directors. As of late July, 2002, three of the Standard & Poor’s 500 largest companies were doing this – Boeing, Winn-Dixie Stores, Inc. and Coca-Cola Co.[37] Coca-Cola executives, who just announced this is July, hope that they will be able to bolster investor confidence in the company’s stock by agreeing to do this voluntarily. In addition, some proposals will require companies to disclose insider trades within two days; will punish wayward corporate executives by requiring those who profit from financial irregularities to pay back any profits they receive in the form of bonuses and stock options, and will prohibit accounting companies from providing both auditing and consulting services to the same clients.[38]

New Law: On July 24, 2002, Congress passed the most sweeping corporate reforms since the 1930s, and the President is expected to sign it quickly. Key provisions in this new bill include:

(1) the creation of an independent board to oversee the accounting profession, by establishing auditing and ethical standards and to discipline auditors;

(2) a requirement that top executives certify financial results;

(3) stiffer penalties for corporate fraud;

(4) a requirement that lawyers report fraud and other corporate misconduct by managers.[39]

Insurance Problems: Directors’ errors and omissions insurance policies are of paramount importance because directors are personally liable for breaches of their fiduciary duties. Early this year, two large insurance companies that wrote the officers’ and directors’ insurance coverage for Enron filed court papers refusing to provide coverage saying that Enron had made “material misrepresentations” when purchasing their insurance coverage.[40] If successful, this argument could send shock waves through the directors’ community which may find itself exposed to liability with no insurance protection at all. At a minimum, with the current rash of civil and criminal lawsuits, insurance premiums for such coverage are likely to skyrocket and coverage will only be given to those companies deemed to be good risks because they have acceptable corporate governance in place.[41]


As the former Chairman of the SEC, Arthur Levitt so aptly said in a recent speech, blame for these corporate scandals cannot be laid only at the feet of the directors. It is rather the “almost total failure of all of corporate behavior.” The truth is, that whether corporate reforms are accomplished by force of law or through shareholder pressure, they must be accomplished – and quickly.[42] Only then will investors have trust in the fairness and soundness of American capital markets. Without ethical rules of conduct that are enforced and obeyed, there can be no trust. Without trust, people will continue to be hesitant to invest, stock prices will fall further and capital will become scarce. Without capital to fuel the engine of economic growth, the U.S. economy will stall. An essential ingredient for restoring investor confidence in U.S. companies is for the boards of directors to diligently carry out their fiduciary duties and responsibilities.


[1] For example, Tyco International paid a director $10 million and gave $10 million to the director’s favorite charity for the his help on an acquisition, see Byrne, J. A., Lavelle, Byrnes, L. N., Vickers, M., Borrus, a. “How to Fix Corporate Governance,” BUSINESS WEEK, May 6, 2002, p. 71. That is exceptional by any standard, and involved more than normal board responsibilities. Nevertheless, most board members are well paid for the time spent. According to The Conference Board, in 2001 median total compensation for outside directors, including stock grants and options, was $51,000 in the manufacturing sector, $48,000 in the service sector, and $40,250 in the financial services sectors. These numbers are down from the previous year when they were $68,000, $57,000 and $41,000 respectively. The drop is due largely to the decline in the value of the stock and options. The data are based on a survey of 660 companies. News Release #4682A. (link no longer accessible)

[2] Enron: The CFO has been accused of pocketing millions of dollars from off-balance sheet partnerships. Enron’s senior executives were paid millions of dollars in compensation and stock while many employees and shareholders lost virtually everything. The SEC is currently investigating accounting irregularities and more criminal indictments are likely to follow, since it’s auditor, Arthur Andersen, was criminally convicted of obstruction of justice. Arthur Andersen has notified regulators that it will cease auditing public companies on August 31, 2002.

[3] Kmart: The SEC is investigating alleged corporate accounting irregularities. Kmart posted a $2.42 billion loss for 2001, the largest in its 103 year history and has filed for bankruptcy. Just prior to the bankruptcy filing, millions of dollars of company money was loaned to Kmart executives. These loans are also being investigate

[4] RiteAid: Three former executives have been indicted for a massive criminal accounting fraud

[5] Imclone: The CEO has been indicted for insider trading and his close friend Martha Stewart is currently being investigated for both insider trading and possible obstruction of justice. Imclone is currently being investigated by the Justice Department and the SEC to determine whether it might have misled its investors regarding its cancer drug, Erbitux.

[6] Adelphia Communications: Allegations have been made of criminal self-dealing on a massive scale, including over $3 billion in loans to a partnership controlled by the CEO and his family that was used primarily by them to purchase company stock. The company is likely to have to add $1.6 billion in debt to its balance sheet and has filed for bankruptcy protection. The SEC and the U.S. Attorney’s office are probing possible accounting irregularities. The founder, John J. Rigas, and his sons, as well two other former company officials, have been arrested and charged with fraud.

[7] Worldcom: Worldcom first announced approximately $4 billion in “accounting errors.” It has since filed for bankruptcy, the largest in U. S. history. Two large pension funds have announced that they have lost $1 billion because of the decline in the value of Worldcom stock. The SEC has filed federal fraud charges against the top managers of the company. The board directors of Worldcom approved a loan of more than $400 million to the CEO at a very low interest rate to enable him to purchase company stock.

[8] Global Crossing: This company has filed for bankruptcy and is being investigated by the SEC and the FBI to determine whether some transactions were shams to boost revenue. In addition, the SEC is investigating stock sales by Global Crossing officers. Millions of dollars were paid to executives, consultants and companies that had personal ties to Global Crossing executives, including the former CEO.

[9] Tyco International: New York prosecutors are investigating whether company funds were used to purchase personal property for its officers. The former CEO has been indicted for tax evasion and the company has filed lawsuits against a former General Counsel, and a director, for payments of tens of millions of dollars that they may have received in secret from the former CEO.

[10] Qwest: The SEC is currently investigating its accounting practices and reviewing insider stock sales. The CEO has resigned and may face further investigations regarding possible conflicts of interest in which he may have placed his own interests above the corporation.

[11] Xerox: Earlier this year, Xerox paid a $10 million fine to the SEC for an estimated $3 billion accounting error. Xerox has just disclosed that, in fact, it has improperly recorded an astounding $6.4 billion in revenue over a five year period.

[12] Merrill Lynch: The investment banker paid a $100 million fine to settle charges by the State of New York that its analysts were simultaneously promoting stocks to the public that they were privately disparaging in their emails. It is alleged by some that some Citibank transactions with Enron helped hide debt at Enron and that Citibank knew, or should have known, this.

[13] “Former CEO cuffed”, (2002). Los Angeles Daily News, July 25, 2002, Business-1; Girion, L. An arresting symbol, in handcuffs,” Los Angeles Times, July 25, 2002, p. A1.

[14] Morgenson, G. (2002). Market reflects investors doubts”, Los Angeles Daily News, July 21, 2002, p. 20.

[15] Hymowitz, C. (2002). Does rank have too much privilege? Wall Street Journal, Feb. 26, 2002 p.B1.

[16] Gunther, M. (2002). Investors of the world, unite! Fortune, June 24, 2002 p. 78.

[17] High profiles in hot water. Wall Street Journal, June 28, 2002 p. B1.

[18] Granelli, J.and Douglass, E. (2002). “WorldCom files for record bankruptcy”, Los Angeles Times, July 22, 2002, p. 1.

[19] Romero, S., Atlas, R. D. (2002). WorldCom Bankrupt. Los Angeles Daily News, July 22, 2002, p. 1. (from NY Times)

[20] Times Staff and Wire Reports, (2002). Scandals help push market to its worst first half since 1970. Los Angeles Times, June 29, 2002 p. C1.

[21] Gosselin, P. (2002). Scandals may delay recovery. Los Angeles Times, June 30, 02 p. A1.

[22] Balzar, J. (2002). The business of America is out of control, Los Angeles Times, June 5, 2002 p. B13.

[23] Ibid., and Granelli and Douglass, op. cit. p. 1

[24] Corporate Director’s Guidebook, 2nd edition, American Bar Association, 1994.

[25] Ibid., p 9.

[26] For more on the importance of having informed directors, see B. Zehner, “What Directors Need to Know,” Graziadio Business Review, Summer 2000.

[27] Borokhovich, K A., Parrino, R. and Trapani, T. (1996). Outside directors and CEO selection. Journal of Financial and Quantitative Analysis, 31, September, pp. 337-355; Warner, J.B., Watts, R. L. and Wruck, K. H. (1988) Stock prices and top management changes,” Journal of Financial Economics, 20, pp. 461-492; Weisbach, M. Outside directors and CEO turnover,” Journal of Financial Economics, 20, 1988, pp. 431-460.

[28] “This stuff is wrong,” (2001) Fortune, June 24, pages 73-84.

[29] Byrne, J. A., Lavelle, l. Byrnes, N., Vickers, M. & Borrus, A. (2002). How to fix corporate governance’, Business Week, May 6, p. 78.

[30] Flanigan, J. (2002). Reforms coming to remedy ’90s abuses, Los Angeles Times, Apr. 1, p. C1.

[31] Jerry Guidera, Shareholder Activists Win Two Big Ones, Wall Street Journal, May 9, 2002, p. C1; Josh Friedman, Shareholders Spurn Execs in Proxy Votes, Los Angeles Times, May 30, 2002 p. C1.

[32] Flanigan, op cit.

[33] Ibid..

[34] Shell, A. (2002). NYSE calls for more independence on boards, USA Today, June 7, 2002, p. 1B.

[35] Ibid.

[36] Bryan-Low, C., Schroeder, M. (2002). Audit cleanup: New oversight is proposed by blue-chip firms, Wall Street Journal, Mar. 29, p. C1.

[37] Pham, A. (2002). Coca-Cola to treat options as expenses”, Los Angeles Times, July 15, 2002, p. C1.

[38] Weber, J., Byrnes, N., McNamee, M., Cohn, L., Woellert, L. (2002), The CFOs weigh in on reform, Business Week, Mar. 11, p. 30; Borrus, A. Woellert, L. (2002), Guess who’s going after Wall Street?, Business Week, Mar. 18, p. 86; McNamee, M. and Miller, R. (2002). How Bush would hold CEOs’ feet to the fire. Business Week, Mar. 18, p. 58.

[39] Simon, R. (2002). Congress in accord on business reform bill”, Los Angeles Times, July 25, p. A1; Peltz, J. F. and Vrana, D. (2002). Looking to corporate America to change from within”, Los Angeles Times, July 25, p. A16; Schmitt, R. B. (2002). Lawyers pressed to report fraud under the new law”, Wall Street Journal, July 25, p. B1.

[40] Glater, J. D., and Brick, M. (2002). Two insurers seek to void Enron policies, Feb. 21, 2002, http://www.nytimes.com/2002/02/21/business/21INSU.html%20

[41] Kahn, J. (2002). Desperately seeking suit protection. Fortune, Apr. 1, p. 38.

[42] Flanigan, op cit.

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Authors of the article
Steven R. Ferraro, CFA, PhD
Steven R. Ferraro, CFA, PhD, is an Associate Professor of Finance at Pepperdine’s Graziadio School of Business and Management where he teaches corporate finance, valuation and corporate combinations, and investments. His current research interests include corporate restructuring, event-driven investing, and real estate investment trusts. Dr. Ferraro is managing director of the Center for Valuation Studies and principal of Ferraro Capital Management. He holds a PhD from Louisiana State University and is a Chartered Financial Analyst (CFA). He is also a recent recipient of the Howard A. White teaching award.
Linnea B. McCord, JD, MBA
Linnea B. McCord, JD, MBA, Associate Professor of Business Law at the Graziadio School of Business and Management, Pepperdine University. Dr. McCord started teaching business law and ethics more than 30 years ago, first as an in-house corporate counsel and later as the General Counsel of a division that was part of a high-tech Fortune 500 multinational corporation, headquartered in New York and Paris. Her area of expertise is the critical role Rule of Law plays in the long-term success of economies and countries and why American Rule of Law is unique in the world.
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