Studienarbeit, 2005, 21 Seiten
The U.S. Sarbanes - Oxley Act 2002. “Big Brother is watching you”
or adequate measures of Corporate Governance regulation ?
Keywords: Corporate Governance, Sarbanes Oxley Act 2002.
force he declared: “Today I sign the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt. 2 ” Whether the legal changes were as radical as politically proclaimed is debatable, yet SOX is insofar eminent as it stands for a significant drift in U.S. Corporate Governance spirit. In order to understand its importance it is indispensable to take into account the raison d’être by which the Act is driven. SOX is not just about specific modifications in accounting standards, disclosure provisions or criminal liability. The change for U.S. Corporate Governance is much more fundamental. 3 Whereas, before the enactment of SOX, Corporate Governance was mainly regulated by the market 4 ,
* PhD student University of Tuebingen, LL.M. student University of Aberdeen. I would like to express my gratitude for Prof. John Patterson, University of Aberdeen, and Prof. Martin Nettesheim, University of Tuebingen, for helpful comments, advice and inspiration.
coming up with the idea, that directors are able to monitor firms more efficiently than the market does and therefore have a right to be in charge of the decision making. On the contrary modern stakeholder approaches try to integrate the rights of employees into the decision making process, because it is believed to be just fair to have a piece of the pie of the decision making power if at the same time specific human capital is invested. Despite many of these approaches tackle the problem from different angles, they all have one thing in common. All of them rely on the self - regulatory efficiency of the market in order to explain Corporate Governance provisions.
The approach of SOX offer a different answer. Whoever has the most influential rights in the company, or whatever is most efficient for the company only plays a minor role. SOX’s major priority is the protection of small investors. Hence, whoever is able to punish misconduct most effectively should be given the oversight of corporate governance, and SOX believes the federal government to be the best institution which is able to cope with the task. However, it is frequently argued in literature that the SOX approach is anything else but a good choice. According to Romano SOX is neither able to provide more trustworthiness, prevent future scandals, nor improve “good governance”, and is thus “ill - conceived” 7 . In order to give a well founded analysis of this thesis, this article, ajar to the article of Romano 8 , will place emphasis on statutory provisions of SOX to give answers. The requirement of independent audit committees, the restriction of corporations’ purchases on non - audit services from their auditors, the prohibition of corporate loans to officers and the requirement for CEOs and CFOs to certify financial statements and the consequences if they fail to comply, will be discussed. The author is aware of the fact, that due to the dimension of newly introduced provisions, it is only possible to discuss a small portion of the entire issue and therefore does not assert a claim to provide a comprehensive study of SOX. Instead emphasis will be placed upon special articles that are of great interest for the understanding of Corporate Governance.
B. Incidents which lead to the enactment of SOX
underlined by a variety of causes. In the bull market of the mid 1990’s there was a high demand for stocks of fast growing companies which created the fantasy for huge future profit
corporations to be able to raise listing fees and boost reputation; Ribstein, 28 J. Corp. L. 1,57 (2002-03). Before SOX, Corporate Governance in the U.S. mainly relied on self regulatory approaches by the states, listing standards by the NYSE and a division between federal and state jurisdiction.
by paying vendors with (constantly higher evaluated) stock packages of the vendee company and loans from investment banking firms which were willing to lend huge amounts of money for two reasons. Firstly, they were afraid of not taking part in the bust. And secondly, investment - banking firms had a strong incentive to produce favourable reports and let the companies appear to look good in order to win lucrative investment - banking contracts. 13 As a consequence the company stock value grew rapidly, which had the effect that the CEO of such companies became a “hero” in American society who brought wealth to his or her employees by raising the value of company stock and expanding the use of stock option grants. 14 Under these circumstances concerns of excessive CEO remuneration packages and aggregation of decision - making power were mostly forgotten.
Finally, the Securities and Exchange Commission (SEC) was not without fault either because it omitted to effectively investigate and review financial statements and cover up fraudulent actions, which was caused by inadequate federal funding.
As the stock market bubble bursted and the presidential elections were just around the corner 15 , Bush decided to take quick action to calm the troubled market, restore public and investor confidence 16 and prevent future scandals. 17
C. SOX Corporate Governance Provisions
Firstly, monitoring, which consists of a system where every party involved monitors the other
Inside control and monitoring mainly focuses on officers and directors and operates in a number of different but related ways. 21 The Board officers monitor employees, 22 the Audit Committee monitors the Board (as well as “outside” auditing firms), and the employees monitor the whole corporation through the help of whistle blowing protection.
Sec. 301 SOX, which is an amendment of Sec. 10A(m) of the Securities Exchange Act of 1934 (SEA) 23 requires all listed companies to have an audit committee, which is entirely composed of independent directors 24 and is supposed to work as a watchdog for the actions taken by the Board. Furthermore the audit committee is directly responsible for the appointment, compensation and oversight of any outside auditor.
The raison d’être of this provision is to break open “club resistance 25 ” between the board and the audit committee and thus, by making it a requirement to put solely “outsiders” on the audit committee, to have it act more effectively. However, in dictating that only the audit committee has power to “hire and fire” outside auditors, shareholders are deprived of their right of decision making and the board might run into trouble of realizing their oversight duty. 26 Furthermore, the SOX provision excludes entire categories of experts from the audit committee which leads to a lack of diversity and inflexibility when the business environment changes. 27
Also, there is opinion in Corporate Governance literature, that the proposed composition of an audit committee (exclusiveness of independent auditors) does not lead to better but even worse results, because it is argued that too many outsiders might have a negative impact on performance. 28 Even though this view is not shared by all experts there is prevailing opinion that at least a composition of exclusively independent auditors does not have neither a positive, nor a negative effect on better Corporate Governance 29 . Beasley et al. found out that,
GENERAL- Each member of the audit committee of the issuer shall be a member of the board of directors of the issuer, and shall otherwise be independent. (B) CRITERIA- In order to be considered to be independent for purposes of this paragraph, a member of an audit committee of an issuer may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee-- (i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof.”
This can be explained by the fact that, even if the Audit Committee or outside auditors were willing to report fraudulent conduct, the Board must be willing to take action. With a majority of independent directors on the Board this is more likely to happen. Finally it is held that financial expertise 31 and frequent meetings might be of value for investors 32 . Yet SOX does not require such an expert to sit in the Audit Committee but only that his or presence is disclosed. 33 Therefore it can be asked, if the solution offered by SOX matches the problem involved, because the changed composition of the audit committee does not seem to be of much help to prevent accounting misconduct in the future.
According to Sec. 302 SOX 34 the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are required to certify periodic reports which, to the best of their knowledge, do not contain material misstatements and fairly represent the firm’s financial conditions and results
support the proposition that requiring audit committees to consist solely of independent directors will reduce the probability of financial statement wrongdoing”; cp. further: Klein, 33 J. of Accounting and Economics, 375, 387 (2002); Chtourou/Bédard/Courteau (manuscript 2001) 1, 5 et seqq.; Xie/Davidson III/DaDalt, 9 J. Corporate Finance, 295, 299 et seq. (2003); contrary cp. generally Abbott/Parker/Peters (manuscript 2002), 3; NUS Business School, 1 Corp. Gov. Executive 1, 3 et seqq. (2003). Uzum/Szewczyk/Varma 60 Fin. Analysts J. 3, 33 et seqq. (2004) state that the number of affiliated (“grey”) directors is linked to the degree of fraud. Yet as Romano points out, this is not prima facie evidence in support of the Sec. 301 SOX provision, because it equals affiliated directors with independent directors, Romano (2004), 35.
rather flexible. I.e. the NYSE Listing Manual 303.01 (B)(2)(b) et (c) leaves it to the Board to define expertise and literacy. Also Cp. Sec. 407 SOX. The SEC is free to somewhat define the term “financial expert” although 407 (b) gave a mandatory guideline of considerations. Sec. 407 (b) SOX reads: CONSIDERATIONS- In defining the term `financial expert' for purposes of subsection (a), the Commission shall consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or from a position involving the performance of similar functions-- (1) an understanding of generally accepted accounting principles and financial statements; (2) experience in-- (A) the preparation or auditing of financial statements of generally comparable issuers; and (B) the application of such principles in connection with the accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) an understanding of audit committee functions“.
of significant accounting inaccuracies and manipulations of dozens of public companies with the SEC in 2001 37 that were often driven by fraudulent actions by senior managers, which were exceptionally difficult to uncover.
As a countermeasure Sec. 302 SOX requires, that the Board actually concerns itself with the financial statements that the corporations issues and takes responsibility for them. 38 As a consequence many public companies have set up special disclosure committees to aid the officers in meeting their certification obligations.
Sec. 906(a) SOX furthermore postulates the composition of an additional written statement (or equivalent) of the CEO and CFO. If they fail to comply with Sec. 302 (a) SOX a civil wrong has been done 39 whereas a violation against Sec. 906(a) SOX, Sec. 906(c) SOX, which is a criminal provision, imposes penalties of fines up to $ 5 million and cumulatively 20 years imprisonment, 40 if the mens rea requirement is met.
Both sections are not without critique to say the least. Firstly, it can be argued that SOX’s call for compliance, which is directed to all firms irrespective of their size and economic power, might lead to untimely or imprecise certifications especially from smaller companies because of the proportionally higher effort and costs that they have to make. Also, economic analysis points out that the SOX certification requirement does not have a significant positive impact on the stock value. 41 From that fact, Romano draws the conclusion that the provision is “useless” because the market is able to predict beforehand what companies would certify and what companies wouldn’t. If scandals take place that involve a lack of transparency of financial reports the market adjusts voluntarily by increasing their disclosure because of the fear of being associated with similar practices. Thus, the certification requirement turns out to
period in which the periodic reports are being prepared; (C) have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report;and (D) have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date; (5) the signing officers have disclosed to the issuer’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function)— (A) all significant deficiencies in the design or operation of internal controls which could adversely affect the issuer’s ability to record, process, summarize, and report financial data and have identified for the issuer’s auditors any material weaknesses in internal controls; and (B) any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls; and (6) the signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.” (b) [...] (c) [...] (Emphasis in original).
that the market adjusts once it knows what is brewing, but the problem is that many times it is not able realize misconduct on time. In the case of Enron, i.e. the stock price dropped from $ 80 to $ 40 when there was indication that the company has problems despite in reality Enron already had penny stock value 43 .
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