Quack Corporate Governance: Sarbanes-Oxley May Have Satisfied a Political Need, but It Will Do Little to Protect Investors or Strengthen the Market

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THE SARBANES-OXLEY ACT OF 2002 (SOX), in which Congress introduced a series of corporate governance initiatives into the federal securities laws, is not just a considerable change in law, but also a departure in the mode of regulation. The federal regime until then had consisted primarily of disclosure requirements rather than substantive corporate governance mandates. Those mandates were left to the state corporate law. Federal courts had enforced such a view of the regime's strictures by characterizing efforts of the Securities and Exchange Commission to extend its domain into substantive corporate governance as beyond its jurisdiction, SOX alters that division of authority by providing explicit legislative directives for SEC regulation of what was previously perceived as the states' exclusive jurisdiction.

SOX was enacted in a flurry of congressional activity in the run-up to the midterm 2002 congressional elections after the spectacular failures of the once highly regarded firms Enron and WorldCom. Those firms entered bankruptcy proceedings in the wake of revelations of fraudulent accounting practices and executives' self-dealing transactions. But many of the substantive corporate governance provisions in SOX are not regulatory innovations devised by Congress to cope with deficiencies in the business environment in which Enron and WorldCom failed. Rather, they may more accurately be characterized as recycled ideas advocated for quite some time by corporate governance entrepreneurs.

EVALUATING SOX

A considerable body of corporate finance and accounting research analyzes the efficacy of the substantive corporate governance mandates of SOX. The data do not support the view that the legislation will improve corporate governance or performance.

INDEPENDENT AUDIT COMMITTEES Section 301 of SOX requires all listed companies to have audit committees composed entirely of independent directors, as defined by Congress. The rationale for the rule is that such directors can be expected to be effective monitors of management, and thereby reduce the possibility of audit failure, because their financial dependence on the firm is limited to directors' fees. (Misstating earnings will not, for example, increase independent directors' income as could be the case for insiders with bonus compensation related to earnings.) Congress also mandated disclosure of whether any of those directors are financial experts, along with an explanation--for firms with no expert on the audit committee--of why no committee members are experts.

A large literature has developed on whether independent boards of directors improve corporate performance. Across a variety of analytical approaches, independent boards do not improve performance. Boards with too many outsiders may, in fact, have a negative impact on performance. There are fewer studies--four as of this writing--of the relation between audit committee composition and firm performance. None have found any relation between audit committee independence and performance, despite using a variety of performance measures, including accounting and market measures as well as measures of investment strategies and productivity of long-term assets.

Twelve studies have examined the impact of the independence of audit committees on the probability of financial statement misconduct rather than performance. Of the 16 total studies of audit committee independence, 10 (including the four studies of explicit performance measures already noted) find that complete independence of the audit committee does not improve performance--whether performance is measured conventionally or by the existence of accounting improprieties--and one study reports inconsistent results (under one model formulation, independence improves performance, but not under all other models tested).

The data are mixed on whether even a committee with a majority of independent directors improves performance. …