If this is quack corporate governance, I'm with the ducks...

For anyone in the corporate world, the word SOX is
dreadfully familiar as the radioactive fallout
emanating from the nuclear crater left by Enron,
Worldcom, Global Crossing, etc. In this article from
the May issue of the Yale Law Journal, Roberta Romano
evaluates the effectiveness of the corporate
governance provisions of the Sarbanes-Oxley Act, and
the political climate that surrounded its passage
(link via pointoflaw.com). It isn’t hard to discern
her opinion on the subject: the title is "The
Sarbanes-Oxley Act and the Making of Quack Corporate
Governance."

One of the paper’s main assertions is that when
Congress passes ‘emergency legislation’ in the midst
of a crisis climate, the results are often flawed
measures adopted with too little consideration - an
opportunity for interested parties to enact policies
that wouldn’t normally pass into law simply because
they are on hand with ready-made solutions. Congress
sees a bear in the woods and, eager to shoot, doesn’t
stop to scrutinize the first gun handed to them. The
bulk of the paper is devoted to tracing the history of
the corporate governance provisions as they made their
way into law, and I can’t argue with the
premise. In this case, however, I don’t believe the
result is as dire as claimed.

The first section of the article is devoted to
demonstrating that the four governance mandates
provide little or no value to investors, and it is
here that I find the arguments less than persuasive. I obviously don’t pretend that I am in the
same league with Professor Romano, a law professor at
Yale with a list of credentials as long as your arm –
I’m just a CPA who has some experience working as an
auditor and an accountant in public companies. Also,
Professor Romano draws on an impressive array of
quantitative studies, and I am not disputing the value
of that data – I definitely don’t have the resources
or likely the expertise to do that. I do think,
however, that these measures are too narrow to draw
the conclusion that the SOX governance provisions
provide so little value that their costs outweigh on
balance.

To begin with, a number of the studies Romano cites
appear to use company performance measured by earnings
as a benchmark, which doesn’t seem like an apt
standard since these provisions are not aimed at
improving profitability or stock prices – a
correlation either way wouldn’t support their value.
The article does break out the number of studies that
use measures that are more to the point
in determining quality of reporting(abnormal
accruals, restatements, earnings conservatism, etc.), which admittedly
also do not show any strong indications of the
provisions’ effectiveness – in other words, the
measured events occur with the same frequency with or
without them. All the same, the thrust of the
corporate governance provisions is to protect an
inherently non-quantifiable attribute: faith in
corporate reporting, and by extension, the equity
market as a whole. To that end, these were necessary
reforms whose worth exceeds their statistical
correlation with any given circumstance.

The four provisions are:

1) Mandatory independence of
Board directors serving on audit committees

2) Prohibition of certain consulting services on the part of accounting firms conducting an
audit

3) A ban on corporate loans to executive officers
or directors

4) Executive certification of financial
statements

The spirit behind these provisions is clearly qualitative rather than quantitative. In positions of public trust, it is just as important to avoid the simple appearance of impropriety and reduce opportunities for abuse as it is merely to refrain from illegal acts. These reforms are the law’s attempt to alter the mindset of the high-level players on both
sides of the reporting process, what auditors call the ‘tone at
the top’. The cold, hard truth (one that accountants freely admit) is that there are no true safeguards that will prevent or detect a determined fraud – in the end all we have to rely on is good faith. In my experience, the attitude shift these provisions are aimed at is taking place.

Romano cannot find any evidence that independent audit committees are more effective, but clearly they now take their duties much more seriously as a result of the legislation. Have a look at this survey of public and private companies conducted by the law firm Foley & Lardner (also via pointoflaw.com), particularly the ‘Verbatims’ section concerning audit committees. Respondents note that frequency of meetings and requests for information from management have increased, and one even notes the appointment of a ‘Lead Audit Director’. It begs the question, what were they doing before? The honest answer is not much other than being a reviewing committee for the external auditors. In the NYSE-listed company where I worked, the internal audit function didn’t even report to the audit committee before SOX, making their function all but ceremonial.

In her section on prohibiting accounting firms from providing specified consulting services to audit clients, Romano concludes this is a solution to a non-existent problem. Again, this is definitely an area where perception is as important as reality. There is an inherent conflict of interest in the audit function because the audited firm is the paying client – an arrangement that exists simply because there aren’t any good alternatives. A surprising number of investors, especially since the huge spread of participation in the market, are not aware of how this system works. But at least one commentator in the New York Times is questioning its validity this week, a sentiment that will only spread if continued abuses occur. If anyone truly doubts that firms weren’t being compromised by the fear of losing consulting work, consider the big jumps in audit fees since SOX. Some of that increase is due to the new internal control requirements, but not all of it – the truth is that audit fees had been beaten down too far to be profitable on their own. If nothing else, the reform has redirected firms’ attention to providing audit quality – again, note the tone of the comments in the ‘Verbatims’ section of the survey mentioned above. Every entry indicates that he tenor of the relationship has changed, strengthening the auditors’ position. This change simply had to occur if we were to maintain public faith in the audit function.

The ban on executive loans comes in for criticism in the paper since it removes a tool used to align the interests of shareholders and officers, since many of these loans were used to purchase company stock. If there is any non-problem listed in the article, though, it is this. Is there really any public company out there that has a big problem with a divergence of interests between management and shareholders? Have we seen lots of reports of rogue CEO’s out there not trying to maximize shareholder value? There are so many other instruments available to tie executive compensation to performance with much less opportunity for abuse that opposition to this provision doesn’t seem reasonable. This just removes one huge area for potential abuse or at the very least an appearance of impropriety.

Executive certification of financial statements is the most important of the four provisions, and was noted by one of the Foley & Lardner respondents as one of the reforms providing the most value for the least cost. This provision reseats responsibility for corporate reporting where it belongs – with the corporation. For too long, CEO’s have abdicated their duty in this regard. The most famous, of course, is Bernard Ebbers, who claimed on the stand an ignorance of accounting in general and the state of his own company in particular that is simply embarrassing. As with the other three CG provisions, Romano suggests stripping this reform of its mandatory force, allowing companies to weigh the costs and benefits of compliance. Presumably, the market would then award an appropriate value to those in compliance due to increased confidence in their reporting.

The flaw in that reasoning, however, is that the market is not entirely rational (as in ‘irrational exuberance’). Right up until the instant it melted down, everybody loved Enron – it was supposed to be the model for the next generation of the corporation. If there were a market incentive for following these practices, it would have existed before the crisis as well and we wouldn’t have witnessed the race to the bottom that we did.

There are a lot of things not to like about SOX and a lot that needs to be amended – particularly the internal control documentation requirements and other high-cost, low-value items– but the corporate governance provisions are the real heart of the reforms. Regardless of the truth of Professor Romano’s observations about the legislative process under crisis conditions, ‘quack’ is too harsh a term to apply to these provisions. Sometimes, in spite of itself, Congress does make good law.