Perspectives

March 2004

The Sarbanes-Oxley Act and Evolution of Corporate Governance

By Jorge E. Guerra

The use and abuse of high-yield junk bonds, derivative instruments, and insider information characterized the 1980s’ scandal cycle. The leveraged buyout craze and savings and loans debacle, coupled with the stock market crashes of 1987 and 1989, set the stage for the scandal cycle of the 1990s. And today, we once again face a crisis of investor confidence in the financial markets. Obviously, we did not learn the lessons of the past.

The critical question today is: Can we now finally fix the problem? The answer depends on how we define and implement the solution. First, we must determine what went wrong and identify the transgressors. Second, we must get to the root of the problem and define why a crisis reoccurred. Third, we must develop an action plan that corrects—once and for all—not only the manifestations of the problem, but also its roots.

What Went Wrong?

In “Corporate Governance” (McGraw-Hill Executive MBA Series, New York, 2003, p. 229), the authors provide a comprehensive list of the most common transgressions to existing corporate governance rules:

• Executive compensation grossly disproportionate to corporate results;
• Stock promotion, such as initial public offerings (IPO), that has gone to an extreme in the creation of very questionable or unproven business concepts;
• Misuse of corporate funds;
• Trading on insider information, particularly by managers exercising stock options that have rewarded short-term thinking;
• Misrepresentation of the true earnings and financial condition of too many companies; and
• Obstruction of justice by concealing activities or destroying evidence.

Who Were the Transgressors?

• Passive, nonindependent, and rubber-stamping boards of directors;
• Nonaccountable CEOs and senior management involved in serious conflicts of interest;
• Transaction-driven investment bankers and market-makers, and biased and nonindependent investment analysts;
• Nonindependent public accounting firms; and
• Regulators paying more attention to the manifestations of the problem than to the systemic conflicts of interest at the core of poor governance practices.

Why Did This Happen Again?

The current crisis of investor confidence occurred because of flawed corporate governance processes. The core of the problem is a breach of fiduciary duty by the trustees of the investors’ interests: the board of directors and management. A passive, nonindependent, and rubber-stamping board of directors made up of members selected by the CEO or chairman of the board is not a guarantee of effective oversight of management actions and conduct.

On the other hand, management teams that place their personal interests above investor demand for value creation when conducting the affairs of the corporation incur a systemic conflict of interest. Breaches of fiduciary duty by management and boards of directors were condoned by nonindependent auditors with limited capability and authority to challenge management.

These problems were further exacerbated by investment bankers and market-makers focused exclusively on increasing their profits by enticing investors to invest in companies with unproven business models, giving rise to the tech bubble that burst in March 2000.

What Needs to Be Done Now?

Regulators must take the following actions:

• Strictly enforce new rules issued as directed by the Sarbanes-Oxley Act aimed at transparent financial reporting and effective internal controls;
• Monitor and take necessary action to avoid the negative impact of unintended consequences from the application of Sarbanes-Oxley dispositions;
• Actively enforce laws and regulations relating to board of director and auditor independence from management;
• In rule-making activities, prioritize the shareholder’s ability to monitor the board of directors’ structure, operation, and performance;
• Ensure that the financial markets’ self-regulatory organizations (SRO) adopt strict governance listing requirements; and
• Effect the necessary changes in the operation of the financial markets to guarantee a market free of the conflicts of interest now widespread.

Boards of directors must take the following actions:

• Restructure the board of directors and the audit committee to effectively undertake the new responsibilities assigned by the Sarbanes-Oxley Act;
• Review the structure and operation of the nominating and compensation committees to eliminate even the appearance of conflicts of interest;
• Review existing corporate governance policies to ensure the inclusion of corporate governance “best practices”;
• Eliminate even the appearance of conflicts of interest when dealing with management performance and compensation;
• Decide how to give shareholders direct input into the governance of the corporation; and
• Educate board members in the responsibilities they must fulfill as fiduciaries of the stockholders.

Investment banks, market-maker firms, mutual fund managers, and investment analysts must take the following actions:

• Create and strictly enforce firewalls to eliminate conflicts of interest that result when investment bankers pressure investment analysts for directed company evaluations; and
• Change the transaction-driven approach to a “put-the-investors-first” approach when effecting market transactions.

Public accounting firms must take the following actions:

• Foster a culture of responsibility rather than one of “get and keep” clients at any cost;
• Avoid even the appearance of a lack of absolute independence;
• Perform audits attesting “management performance,” not “performance for management”; and
• Redirect primary performance criteria toward integrity and professionalism rather than cost-effectiveness.

A Giant First Step in the Right Direction

The Sarbanes-Oxley Act emerged as the government’s response to the prevalent confidence and integrity crises. SEC Chairman William Donaldson, testifying in September 2003 before the Senate Committee on Banking, Housing, and Urban Affairs, said it has effected a “dramatic change across the corporate landscape to reestablish investor confidence in the integrity of corporate disclosures and financial reporting.”

The Sarbanes-Oxley Act places considerable emphasis on correcting the most critical manifestations of lax corporate governance practices, including:

• Management dealing in an environment full of pervasive conflicts of interest;
• Lack of strict transparency, reliability, and accuracy standards in financial reporting;
• Lack of independence between the key players in corporate governance (the board of directors, management, and auditors);
• Lack of adequate enforcement tools at the disposal of regulators; and
• Widespread conflicts of interest influencing securities market transactions.

What Now?

Addressing the systemic weakness of the corporate governance practices prevailing in the pre–Sarbanes-Oxley corporate environment requires more than correcting the most visible manifestations of the problem. Weak governance practices are the combined result of several offenders and lax controls over the performance of both management and the board of directors.

Laws and regulations have never been sufficient to guarantee society’s welfare or, in this case, improvement in corporate governance standards. Accountability is the key. The owners of America’s corporations—the stockholders—must hold accountable nonperforming managers, directors, auditors, and market participants, as the performance of these groups directly impacts shareholder value. The corporate governance process must be reengineered into one that guarantees performance excellence by management and the board of directors when performing their agency duties as trustees of shareholder confidence.

In Smith & Robertson’s Business Law, the authors define the relationship between agent and principal as follows: “an agent as a fiduciary (a person in a position of trust and confidence) owes to his principal the duties of obedience, diligence and loyalty; the duty to inform; and the duty to provide accounting.” The definition then cites various examples of the agent-principal relationship: “A fiduciary duty arises out of a relationship of trust and confidence. A duty imposed by law, an agent owes it to the principal and an employee to his employer. A trustee also owes it to a beneficiary of a trust, an officer or director of a corporation to the corporation and its shareholders, and a lawyer to his clients. The fiduciary duty is one of utmost loyalty and good faith.”

A review of the long list of corporate scandals during the past two years illustrates that in each case, a breach of fiduciary duty occurred, with the most common manifestation being the existence of conflicts of interest. The authors of Smith & Robertson’s Business Law define conflicts of interest as follows: “An agent must act solely in the interest of his principal, not in his own interest or in the interest of another. In addition, an agent may not represent the principal in any transaction in which the agent has a personal interest … The agent’s loyalty must be undivided and he must devote his actions exclusively to represent and promote the interest of his principal.”

Corporate governance reengineering should begin with a clear definition of the authority, duties, and accountability of the board of directors and management. Special emphasis must be placed on the accountability (duty to account) of the board of directors to the shareholders, and on its independence from management.

It has become obvious that an annual stockholders’ meeting and a proxy report controlled by management are not sufficient to provide shareholders with firsthand information on the corporation and its management’s performance. The alternatives are to increase the frequency and extent of information provided to shareholders, or to include on the board of directors several individuals directly nominated by stockholders. The second of these alternatives appears to be more cost-effective, and allows more efficient and timely communication with the stockholders. The presence of truly independent directors would also enhance the control mechanisms over the operation and performance of the board of directors.

Although implementing corporate governance best practices would result in additional operating costs, I must emphasize that good corporate governance is not an option but an obligation, if shareholder interest is to be protected. Compliance costs are only a small fraction of the gargantuan losses suffered by stockholders who invested in companies whose shares became worthless because they did not comply with good corporate governance practices. Stockholders of Enron and WorldCom suffered losses of more than $100 billion, while even the most aggressive estimates of Sarbanes-Oxley compliance costs amount to less than $5 billion.

Editor’s Note: This article is the first in a five-part series.

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