Has Sarbanes-Oxley Made a Dent in Corporate America’s Armor?

In the 12 months since it was signed by President Bush, the landmark Sarbanes-Oxley Act has caused U.S. companies to spend heavily on compliance, altered the culture of boardrooms and boosted the business of firms that offer ethics and compliance consulting. Improved behavior on the part of companies as a result of Sarbanes-Oxley is impossible to quantify. But to whatever extent misbehavior has eased, the impetus behind it has not been the provisions of Sarbanes-Oxley. Rather, it has been the disclosure of wrongdoing at firms like Enron and WorldCom and the ensuing public outrage, according to Wharton faculty members.

Wharton experts say some provisions of the bill and related actions will likely improve corporate behavior. Some, though, are little more than public-relations window-dressing. In addition, others may prove risky for companies seeking to balance strategic control of a company’s direction with accountability to shareholders.

“I’m not sure Sarbanes-Oxley has had as much impact as the scandals themselves, which have made organizations want to avoid scandals in the future,” says finance professor Marshall E. Blume. “Right after Enron I was talking to an oil company executive who told me, ‘We’re going to put everything in the annual report now.’”

With Sarbanes-Oxley, notes Robert E. Mittelstaedt Jr., vice dean and director of Wharton Executive Education, “we are trying to prescribe actions, structures and mechanisms to accomplish certain goals when the real thing that will accomplish those goals is a change in mindset.” The difficulty is “you can’t legislate a change in mindset on the part of directors. Sarbanes-Oxley is mostly positive, but I believe three-quarters of the boards in this country were already very close to meeting all the criteria that it set up, with some minor modifications.”

Thomas W. Dunfee, professor of social responsibility in business, suggests that “it’s too soon to know in any detail the impact that the legislation is going to have. It’s like an artist’s rough preliminary sketch: A great deal of detail has to be filled in. What’s key is that Sarbanes-Oxley was a symbolic act and people are now watching. That’s probably as effective a way to get behavior changed as a lot of specific, more picayune rules.”

Pin Stripes for Jail Stripes

The Sarbanes-Oxley Act of 2002 was drafted by Congress in the wake of scandals involving cooked books, exorbitant salaries and loans to CEOs, conflicts of interest by auditors, and hyped-up stock reports by securities analysts at some of America’s highest-flying companies and investment firms. Thousands of shareholders lost billions of dollars and many saw their retirement savings evaporate as the companies’ stocks collapsed. Accompanying Sarbanes-Oxley, the U.S. Securities and Exchange Commission and the major stock exchanges have developed guidelines designed to improve corporate governance.

Sarbanes-Oxley contains sweeping provisions affecting some 15,000 publicly-traded companies in such areas as auditor independence, corporate responsibility, improved financial disclosure, analyst conflict of interest and accountability for corporate criminal fraud. Among other things, the legislation:

·                           Requires chief executive officers and chief financial officers to personally attest to the accuracy of earnings reports and other financial statements.

·                           Sharply curtails the kinds of non-auditing consulting services that outside auditors can provide to companies whose books they review.

·                           Protects whistle-blowers.

·                           Strengthens criminal penalties, including fines and jail terms, for certain misdeeds by executives.

·                           Requires investment firms to take steps to improve the objectivity of reports by securities analysts.

·                           Establishes a Public Company Accounting Oversight Board to oversee the audits of companies that are subject to securities laws.

·                           Bars executives and directors from coercing outside auditors to issue misleading financial statements and requires them to relinquish any compensation they earned as a result of bogus statements.

In Mittelstaedt’s view, a key strength of Sarbanes-Oxley is its stiffer jail terms. “Penalties for white-collar crime had historically not been really significant,” he says. “It’s very important that Sarbanes-Oxley makes clear that not only can there be penalties in terms of jail time but in terms of disgorging gains and profits. That wasn’t possible under previous law. Whether they would ever admit it or not, [executives] were probably willing to go closer to the edge because they knew the risk of serious consequences wasn’t that great.”

For John Percival, emeritus professor of finance, requiring top executives to sign off on financial statements is another important provision of the act. “That’s a clear change from what we used to have and you wonder why it wasn’t always the case,” he says.

Percival is not certain that the possibility of lengthy incarceration will dissuade executives from misbehaving, but he says Congress nonetheless did the right thing in increasing jail sentences. “I don’t know if it will work, but I do think it is the right thing do in a fairness sense. There’s been too much collective responsibility and not enough individual responsibility. Too many people who did not do the things that led to the problems have been forced to bear the consequences, and the people who did the wrong things have not suffered enough of the consequences.”

Challenging the CEO

In the aftermath of the scandals, and as a consequence of rules drawn up by the New York Stock Exchange and other exchanges, many companies have embraced the idea of having independent boards of directors who feel comfortable asking questions and challenging CEOs. The faculty members agree that this is largely a positive development but one that is not without potential pitfalls.

“The truth is there has been a significant shift in power in boardrooms in the past six to 12 months; it’s palpable,” says Mittelstaedt, who serves on three boards. “The Enrons, WorldComs and other horrendous failures have made directors realize they need to take more responsibility. Directors have finally gotten that message in a way they hadn’t in the past. In one of my companies, the CEO is not driving the process of looking for a new board member to replace one who died. The board is.”

In light of the heightened focus on their actions, more boards have begun to evaluate their own performance as a group, according to Mittelstaedt. In addition, chairpersons of committees, especially audit committees, have accepted the fact that they need to make sure auditors do not get too cozy with management.

Mittelstaedt says corporations are witnessing what he calls “the empowerment of timid directors. Sarbanes-Oxley has made it okay for directors to speak up in board meetings. There were directors previously who weren’t sure what they were doing or that their opinion mattered, who now have become emboldened because it’s clear that independent directors can have a voice in the operation of the board.”

One potential problem associated with director empowerment is that inexperienced or less sophisticated board members can, by asking too many questions about basic details, eat up valuable meeting time or run the risk of having the board’s oversight responsibilities devolve into micromanagement. “But on the whole I would say director empowerment is good,” says Mittelstaedt. “What will take time to sort out is the appropriate level of involvement.”

Shareholders’ Right to Vote

Regulatory efforts to curb the power of what critics call the “imperial CEO” took a step forward on July 15 when SEC Chairman William Donaldson announced an important potential shift in the way companies are governed. He said the agency would adopt measures to make it easier for shareholders to elect independent directors. Despite Sarbanes-Oxley’s many provisions, the act did not address the issue of giving investors a greater say in how companies are managed.

SEC officials have not yet worked out the details of how the election of independent board members would occur, but they are reported to have said that the proposals would not make it easier for corporate raiders to nominate candidates. What’s more, the officials said, any new regulations would limit the number of independent directors who could be elected.

Nonetheless, some faculty members said the SEC idea could open up a complicated can of worms. “This looks totally half-baked to me at this point,” says Robert W. Holthausen, professor of accounting, finance and management. “You could envision this perhaps leading to better governance,” but it could also create “an unbelievable mess” by opening the door for dissident shareholders to wreak havoc with a company.

He adds: “That’s not what the SEC has in mind, but if it’s not careful when it goes to write the regulations, this could become an enormous quagmire. I’m not sure whether in reality the SEC is going to get what it wants.”

Blume says it is far from clear how the whole concept of board independence will pan out. “The big question is will these changes with independent directors cause a greater alignment of management decisions with the interest of the stockholders. I think the jury is out on that.”

Percival notes that having more outside directors “is both positive and negative. They have to be knowledgeable. They have to be people who know how to use financial information intelligibly. By going to independent directors, you are getting objectivity and, hopefully, different perspectives. The risk, however, is that by going to independence you run the risk of having people who are not [as knowledgeable as they should be].”

Dunfee is familiar with the rationale against opening up boards to outside directors, but nonetheless supports the idea. “The standard argument [against independent directors] is that you get a director representing a narrow constituency rather than the corporation as a whole.” For example, “this person could represent a union or a small shareholder group that has some interest perhaps contrary to the typical shareholder in the company. There’s also concern that if directors have access to certain information, leaks could occur. There’s an assumption [that the independent director] would disrupt things, but I don’t know whether that’s true or not.

“I’ve always liked the idea [of independent directors]. I favor shareholder democracy rather than the Soviet-style elections that we have in most cases. If you could have an election process that’s not excessively costly, that allows shareholders, particularly institutional shareholders, to nominate directors, the process would benefit from being liberalized.”

Dunfee notes that the role of the board is a sensitive one, since it has more than one role to play. “There’s always been a dichotomy,” he explains. “We want the board to be watchdogs to some extent but it also contributes to the strategic direction of the company. Independence may be more supportive of the watchdog function than the strategic direction.”

What will be the ultimate outcome of Sarbanes-Oxley and the accompanying push by the SEC and others for board independence and closer oversight of financial reporting? The faculty members say it is too soon to tell, but they note that even a cursory look at history shows that a certain amount of funny business is an inevitable part of doing business.

“This has happened before,” says Percival. “The numbers may not have been as big and compelling but there have been other scandals and there has always been a temporary reaction to that and some inevitable temptation to go back to business as usual. I’m not sure any law is going to change that.”

Given the nature of accounting, Percival adds, putting together financial statements is “always going to be at least partly art and partly science. The whole nature of accounting requires assumptions. You can do all the Sarbanes-Oxleys in the world, but people are still going to make assumptions.”

Says Blume: “If you’re a member of a board in today’s world, you’ve got to be squeaky clean. How long that will last is another issue.”