Likely Effects of Stock Exchange Governance Proposals and Sarbanes-Oxley on Corporate Boards and Financial Reporting

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SYNOPSIS: One of the primary aims of the Sarbanes-Oxley Act of 2002, the New York Stock Exchange, and the NASDAQ corporate governance proposals is to improve the reporting systems for publicly traded companies. Many of the exchange proposals redefine the composition and duties of firms' boards of directors and their compensation and nominating committees. Sarbanes-Oxley places new duties on audit committees and provides oversight and restraints on public accounting companies. This paper describes many of the exchange proposals and puts them in their historical context. I also present the likely effects of the new corporate governance proposals on future boards of directors and assess their impact on the financial reporting system.

INTRODUCTION

The NYSE and the NASDAQ increasingly are banking on the ability of independent boards and board-monitoring committees to improve the financial reporting system. The move began in December 1999 when the NYSE and the NASDAQ adopted new listing requirements aimed at strengthening the independence requirement of audit committees for listed firms. December 1999 also ushered in strict and more explicit definitions of who is an independent audit committee director. However, despite these new requirements, a spate of highly publicized financial accounting failures occurred during 2000-2002. These failures included Enron, WorldCom, and Xerox, each Fortune 500 firms. Simultaneously, the Dow Jones 30 Index and the NASDAQ Composite Index lost 24 percent and 66 percent of their values, respectively, over this three-year period. Although much of their declines were related to recessionary factors, one cannot totally discount the adverse effects that the accounting scandals had on market values.

The NYSE and the NASDAQ responded to these financial accounting irregularities and erosion of shareholder confidence in the market system by proposing new corporate governance rules for listed firms. Quoting from the NYSE's August 1, 2002 press release:

   The New York Stock Exchange's board of directors today approved
   significant changes in its listing standards aimed at helping to
   restore investor confidence by empowering and ensuring the
   independence of directors and strengthening corporate-governance
   practices.

Simultaneously, the U.S. Congress amended the Securities Exchange Act of 1934 by passing the Sarbanes-Oxley Act of 2002. While this Act tangentially touches on board and audit committee independence issues, it provides a series of other corporate governance mechanisms and requirements intended to improve public companies' financial reporting systems. These mechanisms include creating an accounting oversight board, requiring CEOs and CFOs to certify their financial reports, and mandating fuller disclosures of off-balance-sheet items. The Sarbanes-Oxley Act also expands the power and scope of audit committees.

This essay describes and comments on the exchanges' corporate governance proposals. After a brief outline of the entire scope of the proposals, (1) I discuss the December 1999 audit committee regulations, highlighting their relationship to the proposed regulations. In particular, overall director independence, as defined in the current proposals, is related closely to the 1999 definitions of an independent audit committee member. Although the paper focuses on the NYSE and NASDAQ proposals related to overall board of directors and specific board-monitoring committees, I also discuss how Sarbanes-Oxley both complements and reinforces the exchange proposals.

As appropriate, I review existing academic studies that examine whether discernible links exist between the presence of independent directors on boards and board committees and the financial accounting reporting system. This review aids in understanding both the December 1999 listing requirements for audit committees and the new proposals seeking to strengthen the independence of the overall board and the board's nominating and compensation committees. …