|
|
|
|
CIAO DATE: 12/03
Acting in Haste on Corporate Governance
On The Issues
November 2002
Congress and the stock exchanges rapidly answered the cry to act in the wake of corporate scandals. In their eagerness to appear responsive, however, they instituted unnecessary and potentially damaging reforms, when, just as in the past, market forces would have largely resolved the problems.
The ubiquitous press coverage generated by the corporate scandals of this past spring and summer has now faded, and U.S. public companies and auditing firms are left with the task of adjusting to the changes that the political and regulatory process has wrought.
The scandals at Enron, WorldCom, and other companies represent failures of corporate governance, the system of controls for dealing with what economists call the "agency problem"—an owner's difficulty in controlling the behavior of an agent. For public companies, where the shareholder owners are very numerous and diffuse, the agency problem is severe. These companies are run by professional managers, and some mechanism is necessary for making sure that the company is managed in the interests of the shareholders rather than those of the managers. The system of corporate governance addresses the agency problem by relying on three main elements—a board of directors, which oversees how management is operating the business; an audit committee of the board, which oversees the work of the company's independent auditors; and the independent auditors themselves, an outside firm charged with responsibility for assuring that the company's financial statements, prepared by the company's management, conform to an agreed set of accounting rules known as generally accepted accounting principles (GAAP).
Under traditional corporate law in the United States, the board of directors of a corporation is ultimately responsible for the control of the company's affairs. The board is elected by the shareholders and appoints the company's management; the management in turn runs the business day-to-day, under the direction and authority of the board. All significant corporate acts—mergers or acquisitions, the issuance of shares, the sale or leasing of significant amounts of property—are not valid unless taken pursuant to authority granted the board, which has a trustee's duty to act solely in the interests of the corporation and the shareholders. However, the board is a part-time body, and the system has evolved so that most actions are initiated by management and approved by the board. The principal duty of the board, then, is to oversee the management on behalf of the shareholders, and if the members of the board fail to perform this function, they can be held legally liable.
The audit committee is a special committee of the board of directors that has responsibility for overseeing the work of the company's independent auditors. One of the key responsibilities of the audit committee is to assure that the auditors are acting independently of management when they review the company's financial statements. Like other members of the board, the audit committee can be legally liable if they fail to perform their responsibilities diligently.
Finally, the auditors are engaged by the company to use a high degree of professional competence to review the company's financial statements, and certify that they have been prepared in accordance with GAAP. If they are negligent in performing this responsibility, they can be legally liable to the corporation or in some cases to investors who bought or sold the company's shares in reliance on the auditors' opinion.
In the Enron debacle, all of these elements of the corporate governance system failed simultaneously, and for this reason Enron is bound to be seen in the future as a difficult and challenging case. On its face, Enron appeared to meet all the standards that would be expected of a well-run corporation. It had an independent board of seventeen members, only two of whom were "insiders"—that is, members of the company's management. The rest were chief executive officers of other companies, academics, and former government officials. Enron's audit committee consisted entirely of independent directors, and was headed by a former professor of accounting at Stanford Business School. The company's auditors were Arthur Andersen, one of the world's largest and most respected auditing and accounting firms. Yet, an apparent accounting fraud was carried out by management literally under the noses of the board, the audit committee, and the accountants. Since there is no indication that members of the board, the audit committee, or Arthur Andersen were bribed or otherwise suborned to permit the fraud to take place, the Enron case raises important questions about the efficacy of the corporate governance system.
These questions were not pursued in the pell-mell rush to enact legislative and regulatory responses to Enron and WorldCom. If they had been, the ensuing debate might have made clear that the corporate governance system is able to heal itself; legislation was not necessary and—depending on its content—was bound to have significant unintended costs. Although the immediate response in Congress and among the regulators was to adopt new rules, new rules were not the answer. Nothing shows the futility of this effort more clearly than the fact that the principal "reforms" required that boards of directors be composed of a majority of independent directors, and that audit committees consist entirely of independent directors—requirements that Enron itself would have met. Indeed, an analysis of the Sarbanes-Oxley Act of 2002—the congressional response—and the regulations adopted by the principal securities exchanges, shows that none of them was necessary, and all of them entail tangible and intangible costs for public companies and the economy generally that far outweigh the benefits they are likely to produce.
Was Action by Congress and the Exchanges Necessary?
Corporate governance is a goal-oriented system. Its purpose is to protect shareholders against the depredations of management. As such it has always been—and will always be—a work in progress. As new problems come to light, the system should adjust accordingly. Companies have strong incentives to follow good corporate governance practices because investors can take their investments elsewhere—reducing the value of the company's stock and increasing its cost of capital—if they are dissatisfied with how a company is managed. In extreme instances, such as Enron, WorldCom, and others, investor and shareholder divestment can be stunningly quick, putting whole companies into bankruptcy in days or weeks once investors and shareholders realize that the directors and auditors have failed to protect them.
In other, less dramatic cases, corporate governance brings about important and necessary change—gradually but effectively. A good example of how this works occurred in the 1980s. At that time, so-called raiders took over many companies, then broke them up and sold them off in pieces for more than they were worth as consolidated entities. This process, although truncated by some management success in getting protection from state legislatures and courts late in the 1980s, sent a powerful message to boards of directors that the managements of their companies might not be creating value for the shareholders. Soon, CEOs were losing their jobs if the stock price did not improve—a strong sign from investors that the company was going nowhere. Directors began to insist that managements show increases in shareholder values, the tenures of nonproductive chief executive officers were shortened, and even during the boom period of the mid-to-late 1990s companies continued to cut staff in an effort to increase productivity and profitability. It is important to note that this ethos among directors remains in effect, even though the takeover period is almost twenty years in the past. Those not distracted by the Enrons, WorldComs, and Tycos, still see CEOs "retiring" early because they have been unable to maintain a high level of profitability, or return their companies to profitable growth. When combined with advances in technology during this period, the sensitivity of directors to stock prices was responsible for the high productivity of the U.S. economy today.
The adjustments in standards that brought about this change were not required by new laws or regulations; they were the results of a change in corporate culture that took place in thousands of board rooms, and among thousands of managers. Directors understood that if they did not insist on achieving and maintaining profitability for the shareholders, they were not doing their jobs. Indeed, if the voices calling for takeover regulation in the 1980s had been heeded, and new legislation or regulatory restrictions had protected inefficient or incompetent corporate managements from hostile takeovers, the U.S. economy would likely be as geriatric and inflexible today as the economies of those European countries where regulations operate to prevent corporate takeovers.
As might have been expected, given the responsiveness of corporate governance to investors and vice versa, immediately after Enron collapsed the reform of corporate boards began. Business Week, which has been surveying corporate boards and classifying them as strong or weak since 1996, devoted the cover story of its October 7, 2002, issue to these developments and declared that a scandals had sparked a "revolution" in corporate governance:
"Enron is bringing about the most sweeping structural changes in governance that have ever occurred" says Donald P. Jacobs, former dean of Northwestern University's Kellogg School of Business and a governance watcher. "We thought there had been an enormous increase in the quality of boards, but Enron has shaken the hell out of confidence." . . . That wake-up call has spurred companies to make radical improvements. Problems that were simply ignored a couple of years ago are now the subject of heated boardroom debate. . . . Bad boards, in particular, have made extraordinary strides in confronting these questions. Spurred in many cases by scandal, crisis, or a plummeting stock price, former laggards have become ardent believers in good governance. . . . Perhaps the most important driver of change is the markets. Increasingly, institutional investors are flocking to stocks of companies perceived as being well governed and punishing stocks of companies seen as having lax oversight. . . . "I think the real impetus [for reform] will not be the NYSE, the President, or Congress—it will be the reality of the marketplace," says Henry R. Silverman, Cendant's CEO.
The Enron case created a challenge to the corporate governance system that in many respects was similar in scope to the challenge posed by the takeover period of the 1980s. For a variety of reasons, however, the reaction of the political system in 2002 was different. Although Congress and the Reagan administration stayed out of the takeover controversy—with good results—in 2002 both Congress and the president waded in. The result was a series of mandates and regulations for public companies, and a new regulatory structure for accountants and auditors. As is always the case with laws and regulations, decisions that were formerly left to the market, or to the directors and managers of a company, have now been channeled in directions deemed acceptable by the political process.
Was this the most sensible reaction to Enron and subsequent cases? The argument that it was must rest on the proposition that the corporate governance system could not have successfully responded to the problems Enron and the others exposed. But this is fundamentally implausible. Just a look at what happened to the malefactors in these cases makes clear that the punishments administered by the markets provide strong incentives for self-reform by all the parties that failed in Enron and similar cases. Enron, WorldCom, Global Crossing, Adelphia, and others are now out of business; their senior officers are unemployed; their directors are disgraced. Arthur Andersen, once one of the world's most respected accounting firms, has all but ceased to exist. All of these parties are now defendants in lawsuits by investors, employees, and others that will carry on for many years and may result in their financial ruin. Is it imaginable that—observing this—boards of directors, members of audit committees, and accounting firms would not have changed their procedures in order to prevent the same thing happening to them? This question raises another: Apart from the desire to be seen to be doing something—anything—in the face of massive press coverage and a falling stock market, can anything in the legislation and regulations that followed the Enron debacle be considered necessary—something that would not have been done by the normal workings of the corporate governance process? Regrettably, the answer is no.
The Sarbanes-Oxley Act of 2002. Although its proponents called it the most far-reaching securities legislation since the early 1930s, the Sarbanes-Oxley Act does not attempt to deal with corporate governance in general. Instead, aside from increasing the liabilities of senior corporate officials and the penalties for violating existing laws and regulations, it addresses only the relationship between the independent auditors and the audit committees of public companies. It also establishes a mechanism for regulating accounting firms that perform auditing services for public companies. In what it covers, however, the act will have a significant impact; among other things, it will significantly change the accounting and auditing business and substantially raise the costs of financial reporting for public companies.
The most important features of the act are the following:
Obviously, if the new requirements concerning the relationship between audit committees and independent auditors were desirable for investors, they could have been instituted by companies without the necessity for legislation. In fact, the audit committees of most companies—including Enron—were already made up entirely of independent directors, and in many companies the audit committee already had the primary responsibility for engaging and compensating the independent auditors. Similarly, if investors believed that a consulting relationship with a company's independent auditors compromised the auditors' independence, companies were free to limit these assignments in order to maintain investor confidence; Congress did not need to specify which assignments were permissible and which were not. Moreover, after Enron, auditors would certainly have had incentives to report to the audit committee or to the board of directors any discussions they had with management about alternative ways of treating important items, and audit committees and directors would certainly have had the incentives to be sure that they received such reports. Finally, to the extent that permitting audit committees to retain their own counsel and advisers would have added to the confidence of investors, companies would have had an incentive to adopt this practice voluntarily. Putting these requirements in the law does not enhance these incentives and introduces unnecessary rigidities that will be discussed below.
Another unnecessary step was the requirement for CEO and CFO certification of a company's financial statements. Under current law, companies themselves are responsible for reporting their financial results properly. If they fail to do so, the CEO and the CFO responsible will soon be looking elsewhere for employment. Imposing substantial monetary penalties for knowing misstatements is theoretically useful in deterring fraud by CEOs and CFOs, but the difficulties of proving whether such misstatements were made "knowingly" reduces the value of this remedy in comparison to dismissal and loss of benefits. In light of the collapse of Enron and WorldCom and the lessons this holds for managements, the certification requirement does not substantially increase the likelihood that financial statements will be properly prepared. While it is doubtful that the certification requirement adds any significant additional legal liability for CEOs and CFOs, it may have the effect of increasing the burden on CEOs or CFOs to prove, in subsequent civil suits based on inaccurate financial disclosures, that they conducted a thorough inquiry before certifying the company's statements. In that sense, the certification requirement materially increases their risks.
Finally, there is the Oversight Board that the Sarbanes-Oxley Act sets up to regulate the auditing functions of the accounting industry. It is reasonably clear from the audit failures that were exposed in Enron, WorldCom, and other cases that the accounting industry's self-regulatory system was not satisfactory, but the destruction of Arthur Andersen would have provided sufficient incentive for a better system, without the need for legislation. Not only did accounting firms themselves have powerful incentives to set up a better self-regulatory system, but public companies—which have a great stake in promoting public confidence in their financial statements—would have insisted that a better system be put in place. Even if this had not happened, the SEC already had sufficient authority to discipline accounting firms and accounting practitioners, so that it could have insisted upon a better self-regulatory system for auditing. Indeed, the SEC had already proposed a perfectly satisfactory system when Congress acted.
Rules Adopted by the New York Stock Exchange and Nasdaq. Apart from the Sarbanes-Oxley Act, the most consequential regulations of any element of the corporate governance system in the wake of Enron are the new rules adopted by the New York Stock Exchange and Nasdaq. The new rules apply to all companies with shares listed for trading in these two venues. To the extent that these standards deal with relations between the audit committee and the independent auditors, they are not substantially different from the requirements of the Sarbanes-Oxley Act. But the rules also purport to reform elements of the corporate governance system, particularly the board of directors, that are not addressed in Sarbanes-Oxley. The most significant of these rules are the following:
Like the provisions of the Sarbanes-Oxley Act, all of these rules could have been adopted by companies themselves after Enron. And again, if these reforms truly serve important purposes, investors will reward companies that adopt them, and penalize companies that do not. It is hard, therefore, to escape the conclusion that these rules—like the Sarbanes-Oxley Act—are superfluous.
Do the New Regulations Do Any Harm?
Merely saying the post-Enron rules are superfluous does not of course mean that they will do any harm. Thus, one way to look at these changes is that, even though they may reduce the choices of investors and the flexibility of companies as to matters of organization, they will not have any significant adverse effects and may actually do some good. Investors will benefit, one might be argue, whether they place great value on the benefit or not, and requiring companies to adopt uniform corporate governance structures does not deprive corporations of anything central to their functions. This, however, is not the case. The requirements and new regulation imposed by the Sarbanes-Oxley Act, and the new rules of the NYSE and Nasdaq, will impose significant tangible and intangible costs on public companies and could have substantial adverse effects on both the competitiveness of U.S. companies and the efficiency with which the U.S. economy functions in the future.
Consider, for example, the Sarbanes-Oxley requirement that an audit committee of independent directors choose, compensate, and supervise the auditors. This seems to be a reasonable idea, the purpose of which was to make the auditors responsible to the audit committee and not the company's management. But mandating this relationship, rather than allowing it to develop if investors prefer it, could be troublesome.
Preparing accurate financial statements—in other words, fair presentations of a company's financial condition and results of operations—is not a mathematical or mechanical process. At its most difficult, it involves predictions about the future, and this often requires a detailed understanding of a company's business that is beyond the knowledge of auditors, audit committees, or boards of directors. To take a simple example, management is more likely than the board of directors or the auditors to be able to estimate the collectibility of receivables, and thus the size of the reserves that should be taken against the possibility of noncollection. Yet audit committees and auditors are charged with responsibility under Sarbanes-Oxley to discuss and consider "all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management officials of the issuer, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the registered public accounting firm." One of these alternative treatments would be higher reserves for uncollectible receivables, which would in turn reduce reported earnings.
By nature, and to avoid the legal liabilities that this statutory requirement implies, audit committees and auditors are likely to prefer more "conservative" treatments of financial information, and thus are likely to require higher reserves for uncollectible receivables than management estimates are necessary. More conservative treatments, however, are not necessarily more accurate treatments—management could be correct about the collectibility of receivables—and over time the second-guessing and conservatism of audit committees and auditors could lead to financial reports that fail to communicate a company's true value. By placing responsibility on the audit committee for second-guessing management's judgments, the Sarbanes-Oxley Act could distort financial reporting as seriously as the management-dominated system it sought to replace. This is not to say that management's judgments should always be accepted, but only that placing the responsibility on the audit committee—by regulation—to second-guess management's judgments is to build in a bias in favor of more conservative judgments, which may not produce more accurate financial statements.
The inherent uncertainty associated with financial statements could produce even more troublesome results when combined with the act's requirement for CEO and CFO certification of financial statements and reports to the SEC. Because decisions on financial statement presentation are highly judgmental and often demand predictions about the future, requiring certification by CEOs and CFOs—on pain of fines up to $1 million—places them at risk of liability, perhaps even criminal liability, for "knowing" misstatements about matters that are inherently unknowable in advance. Notwithstanding that it will be difficult to prove knowing misstatements, the inherent uncertainty associated with this risk will almost certainly drive many qualified individuals out of public companies, or at least cause them to refrain from accepting CEO assignments, reducing the overall quality of corporate managements. Even before this legislation, many successful private companies found the decision to go public a difficult one to make—largely because of the additional costs and liabilities involved. After Sarbanes-Oxley, many companies that might have been willing to sell shares to the public will decline to do so.
The auditing oversight board will also have significant unintended adverse consequences. First, as with all bureaucratic bodies, its jurisdictional reach, its staffing, and its requirements for additional offices, travel, consultants, lawyers, and other advisers will continuously grow, along with the salaries of its members and staff and the fees of its consultants and advisers. These bureaucratic expenses will impose very large costs that the board can assess on all public companies without apparent limit. The SEC has authority to approve the budget of the board, but the SEC's incentives—far from limiting the board's spending—are to push the board into greater activity. Why should the SEC take responsibility for limiting the board's activities by limiting its budget? It will get little credit for this but much blame if another auditing crisis should come to light. Moreover, the SEC—which will control the board through its authority to appoint the board's members—is bound to discover that it can charge the board with projects the SEC itself would otherwise do, thus saving its own appropriated funds for other needs and increasing the costs that the board will assess on public companies.
Second, the oversight board will impose substantial costs on the accounting industry, which will pass these costs along in audit fees to their public company clients. The act authorizes the board to register all accounting firms that audit public companies; to establish auditing, quality control, ethics, independence, and other standards for accounting firms engaged in auditing; to conduct inspections and investigations; to carry out enforcement functions; and to "perform such other duties or functions as the board (or the commission, by rule or order) determines are necessary or appropriate to promote high professional standards among, and improve the quality of audit services offered by, registered accounting firms and associated persons thereof." Again, there is no legislative or financial limit on what these activities may entail, and all related costs will have to be borne by the accounting industry and eventually passed along to the public companies already bearing the burden of oversight board assessments.
Third, as with all regulatory activities, the costs imposed on the regulated industry will serve as a barrier to entry for smaller firms. It is reasonably obvious that a small auditing firm with, say, fifty clients, will find its regulatory compliance costs consume a much higher proportion of its revenues than the similar costs of a firm with 5000 clients. With the demise of Arthur Andersen as a significant factor in the business of auditing public companies, only four large accounting firms remain active in this field to service 16,000 public companies. Accounting firms will have significant market power to raise the rates for their audit services, and the costs imposed by the oversight board will prevent smaller firms from breaking into the oligopoly that now prevails.
These additional costs, together with the new liabilities placed on CEOs and CFOs, could cause many companies to withdraw entirely from the public securities markets. Moves of that sort are likely to become more widespread in the future, as managements see greater profitability in operating as private companies, as well as the chance to escape extensive personal liability and harassing lawsuits. As it is, many companies only become public because a publicly traded stock makes it possible to attract high quality management with stock options. If the value of this compensation mechanism is cut back by the Financial Accounting Standards Board or additional action by Congress, we can expect fewer companies to offer their shares to the public, and many that are already public will develop ways to go private. The long-term effects of this are likely to be smaller and less well-capitalized companies in the U.S. economy and reduction in the effectiveness and reach of U.S. companies around the world.
Even the requirement that a majority of the members of boards of directors of listed companies be independent directors—and chosen by other independent directors—is potentially troublesome. Independent directors are likely to be far more conservative in their outlooks than corporate managements. They will incline toward less risk-taking, and prefer not to venture into new activities. This is entirely natural, since in general independent directors will not be rewarded for additional profitability, but will be penalized if their companies fail. There is nothing wrong, of course, with conservative management; many investors will—given a choice—prefer to invest in companies that do not take risks for faster growth. However, some investors prefer companies that take risks, and indeed portfolio theory suggests that all investors, depending on their financial position and age, have some aggressive investments in their portfolios.
Moreover, risk-taking by companies is what brings change and innovation, thus ultimately benefiting consumers and promoting economic growth. It is also vital for more fundamental economic reasons. As Milton Friedman recently noted: "The system doesn't work unless business is willing to take risks." In allocating capital, he continued, "losses are just as important as profits." In the most general sense, government regulation intended to reduce risk to shareholders will also reduce risk-taking by companies, and reduced risk-taking will have an impact on economic growth. We should recognize that financial and economic regulation is not cost-free; when we limit risk-taking by regulation, we are giving up something intangible but important. "The extent of government intervention in markets to control risk-taking," Alan Greenspan said recently, "is, at the end of the day, a trade-off between economic growth with its associated potential instability and a more civil but less stressful way of life with a lower standard of living."
Thus, while the changes imposed by the Sarbanes-Oxley Act and the stock markets were well intentioned, they are not in any sense benign. They could have major adverse tangible and intangible effects on how U.S. companies operate and how the U.S. economy develops in the future. Since virtually all of the mandates imposed in the wake of Enron could have been adopted by companies voluntarily if investors thought they were desirable, one would have to conclude that the benefits sought by these mandates are far outweighed by their adverse effects. Taken together, these largely unnecessary new restrictions recall the adage "Act in haste, repent at leisure."
What Policy Response Would Have Been Appropriate?
One of the strengths of a free capital market system is that it enables companies to structure themselves in a way that will attract the investors they want, and it gives investors a wide range of choices with which they can calibrate their risks.
The response of the corporate governance system to the takeover frenzy of the 1980s is again instructive in this respect. There was no regulation at the federal level; Congress did not step in; the president did not endorse action; yet companies adjusted to the message the market was sending. The change that occurred was a change of culture in boards of directors—a new understanding that in order to do their jobs right they had to take their managements in hand and demand better performance. It is important to remember in this connection that Enron had the kind of independent board and audit committee that is now required by law and regulation. That these institutions failed was not the fault of their structures; it was the fault of the standards—the culture—within which their members were operating.
To the extent that the recent reforms usher in a period of better management by boards of directors and better performance by auditors, it will not be because of the new laws and regulations. It will be the result of a change in the culture that prevails in boardrooms and within auditing firms. We could have had that change of culture, however, without the adverse effects that Sarbanes-Oxley and the stock exchange regulations are now likely to bring about. The appropriate policy response to the new challenge posed by Enron would have been to allow the corporate governance system to adjust on its own.
Peter J. Wallison is a resident fellow and codirector of the Financial Deregulation Project at AEI.
Email this citation