The Sarbanes-Oxley Act of 2002 has been hailed as the legislation that will restore public confidence in corporate America and the capital markets. Unfortunately, it will probably have little more lasting impact on actually improving governance than will guidelines.
According to a PricewaterhouseCoopers Management Barometer survey, only about one-third of executives surveyed believe that Sarbanes-Oxley will restore confidence in the capital markets or aid their companies’ ability to create shareholder value. Only 9 percent of executives characterized it as a good and adequate response to problems in accounting and reporting. Not to paint too dark a picture, the legislation does hold forth some potential benefits. The act calls for establishing the Public Company Accounting Oversight Board with authority to impose penalties for violation of its rules.
If its leaders are committed to real change, this new Board could have a significant and meaningful effect on corporate governance practices. Under the law, the Board has the authority to change the interpretation of GAAP to tighten loopholes, to eliminate special interest exemptions, and to move GAAP away from a rules-based toward a more principles-based system. This prospect would certainly terrify anyone who has manufactured earnings or benefited from them. It might also be of special concern to managers and directors who would then be unable to fall back on the “it conforms with GAAP” defense. Unless the new Board uses its powers well, with the appropriate degree of proof of culpability, its ability to impose and enforce penalties will quickly diminish.
Other Sarbanes-Oxley provisions have generated a lot of press, but in reality represent only marginal changes and benefits. For example, the benefit of the provision requiring that CEOs personally certify financial statements is primarily psychological. In truth, they’ve always had that responsibility. Perhaps now they will take it a bit more seriously. (A drawback of this provision is that it tends to let directors off the hook; many directors believed that they and the CEO already certified the financial statements when they submitted a Form 10K SEC filing.)
Much of Sarbanes-Oxley deals with separating financial auditing from management consulting and with addressing conflicts of interest or inappropriate relationships among corporate financial officers and their independent auditing firms. Those are important, but shouldn’t directors have been sufficiently diligent to address such obvious issues without the hammer of legislation? Debating that point is of little use; the legislation is sufficiently loose that abuses and problems will most likely continue.
With the exception of making loans to selected officers, Enron appears to have been in substantial compliance with Sarbanes-Oxley at the time of its catastrophic fall.
The act also attempts to recoup from CEOs any incentive income they earned within a year of having issued misleading financial statements or within a year of material reporting irregularities. If the income falls outside of the one-year limit, the CEO gets to keep the money, which weakens this provision significantly.
If Sarbanes-Oxley had been passed in the 1990s, would it have prevented the abuses and scandals of the past few years? The evidence seems to point to “no.” With the exception of making loans to selected officers, Enron appears to have been in substantial compliance with the corporate responsibility provisions of Sarbanes-Oxley at the time of its catastrophic fall.
A Wonderful World of Governance
The Walt Disney Company has been criticized widely for its poor governance practices. The basic complaint is that CEO and board chairman Michael Eisner has the company’s directors in his pocket, and the board is not independent. That said, several directors, Stanley Gold (CEO of Shamrock Capital Partners) in particular, have challenged Eisner on the company’s poor performance and high pay package. Most likely in response to pressure from the press and governance experts, Disney has said that it is taking steps to improve governance. A careful analysis, however, reveals that these are less than giant steps.
The board, chaired by Eisner, met on December 3, 2002, and announced that it had adopted a stricter definition of independence, consistent with NYSE guidelines. As a result, Stanley Gold, whose daughter worked for Disney, was disqualified as an independent director, making it impossible for him to serve on key committees including the governance and nominating, audit, and compensation committees. At about the same time, Disney cancelled contracts with two other board members, former U.S. Senator George Mitchell, whose law firm provided legal services to Disney, and architect Robert Stern. While Gold, the dissenter, was disqualified as an independent director, Mitchell and Stern maintained their “independence” because their contracts had been cancelled.
Eisner then announced that he favored the appointment of a “presiding director” who would chair at least two board meetings annually, at which Eisner and management would not be present. Eisner also hired Ira Millstein, a respected lawyer who has served on several Blue Ribbon Commissions on governance, which bolstered the perception of good governance at Disney. Millstein noted that many companies were appointing lead directors or even separating the role of board chairman and company president/CEO. The implication was that Disney’s move was consistent with such good governance.
How did this play out in practice? Whether the individual is called “lead director” or “presiding director,” he or she has only as much power as they can assume or as the CEO allows. In Disney’s case, Eisner continued to serve as both chairman of the board and CEO. Eisner appointed Mitchell to the position of “presiding director.” Obviously intelligent and certainly well-respected, Mitchell comes with great credentials. What he doesn’t come with is an abundance of time to devote to the job. Mitchell serves on a total of eight boards, sits on ten important subcommittees of those boards, and is chairman of four of the committees—all while being a practicing lawyer. This is the man who is expected to identify issues, collect and analyze information, lead discussions on relevant issues, and based on those discussions, maintain a meaningful dialogue with management and foster a checks and balances culture.
At about the same time that Disney was touting its new and improved governance, more information about the company’s disclosure practices and director independence came to light. In its annual report filed in December 2002, the company confirmed two previously undisclosed items: (1) It paid more than $600,000 to a company affiliated with a director for use of a private plane; (2) It gave $20 million and pledged an additional $5 million to a charity whose CEO later became a Disney director. Spinning these facts as fast as possible, Millstein noted that in most cases these disclosures were not required and said, “As long as you tell everybody what you’re doing, that’s good governance,” a position with which investors who claim no governance expertise at all might take issue.
Good Governance Takes More
Jeffrey Sonnenfeld in a Harvard Business Review article titled “What Makes Great Boards Great,” says that, by definition, guidelines and checklists address structural issues such as board composition, board size, age of directors, number of meetings, number of meetings without management, existence of committees, powers of various committees, and definitions of independence. He points out, however, that what determines the quality of governance is “not rules and regulations, it’s the way people work together.” In other words, social and cultural issues, not strict adherence to guidelines and checklists, are the differentiating factors between good and poor governance. Sonnenfeld also maintains that almost no correlation exists between good governance and such characteristics as the age of board members, their independence (as defined by Sarbanes-Oxley), the size of the board, and committee structures.
Rules and regulations do not force directors to think independently, nor do they assure that directors have sufficient understanding of an issue to make a well-reasoned decision. Some regulations and guidelines attempt to define independence in concrete terms. Others are designed to give directors an opportunity to confer among themselves in committee or executive sessions. None of these guidelines can ensure that directors understand the details of the business sufficiently well to raise the right questions. Similarly, requiring boards to spend more time, hold more meetings, or form more committees in no way ensures that directors are actually attempting to do a good job.
Duty of loyalty, as defined by Monks and Minow, requires directors to “demonstrate unyielding loyalty to the company’s shareholders.”
Regulations containing penalties for failure to exercise duty of care or duty of loyalty, discussed in detail in the next few pages, are not much more effective. The burden of proof for criminal or even civil penalties should be high. The SEC has prosecuted takeover professionals and some Wall Street types, but very few directors have been prosecuted, and the threat of punishment appears not to be an overwhelming deterrent.