The Sarbanes-Oxley Act and Evolution of Corporate Governance

By Guerra, Jorge E. | The CPA Journal, March 2004 | Go to article overview

The Sarbanes-Oxley Act and Evolution of Corporate Governance

Guerra, Jorge E., The CPA Journal

The use and abuse of high-yield junk bonds, derivative instruments, and insider information characterized the 1980s' scandal cycle. The leveraged buyout cra/e and savings and loans debacle, coupled with the stock market crashes of 1987 and 1989, set the stage for the scandal cycle of the 1990s. And today, we once again face a crisis of investor confidence in the financial markets. Obviously, we did not learn the lessons of the past.

The critical question today is: Can we now finally fix the problem? The answer depends on how we define and implement the solution. First, we must determine what went wrong and identify the transgressors. second, we must get to the root of the problem and define why a crisis reoccurred. Third, we must develop an action plan that corrects-once and for all-not only the manifestations of the problem, but also its roots.

What Went Wrong?

In "Corporate Governance" (McGrawHiIl Executive MBA Series, New York, 2003, p. 229), the authors provide a comprehensive list of the most common transgressions to existing corporate governance rules:

* Executive compensation grossly disproportionate to corporate results;

* Stock promotion, such as initial public offerings (IPO), that has gone to an extreme in the creation of very questionable or unproven business concepts;

* Misuse of corporate funds;

* Trading on insider information, particularly by managers exercising stock options that have rewarded short-term thinking;

* Misrepresentation of the true earnings and financial condition of too many companies; and

* Obstaiction of justice by concealing activities or destroying evidence.

Who Were the Transgressors?

* Passive, nonindependent, and rubberstamping boards of directors;

* Nonaccountable CEOs and senior management involved in serious conflicts of interest;

* Transaction-driven investment bankers and market-makers, and biased and nonindependent investment analysts;

* Nonindependent public accounting firms; and

* Regulators paying more attention to the manifestations of the problem than to the systemic conflicts of interest at the core of poor governance practices.

Why Did This Happen Again?

The current crisis of investor confidence occurred because of flawed corporate governance processes. The core of the problem is a breach of fiduciary duty by the trustees of the investors' interests: the board of directors and management. A passive, nonindependent, and rubber-stamping board of directors made up of members selected by the CEO or chairman of the board is not a guarantee of effective oversight of management actions and conduct.

On the other hand, management teams that place their personal interests above investor demand for value creation when conducting the affairs of the corporation incur a systemic conflict of interest. Breaches of fiduciary duty by management and boards of directors were condoned by nonindependent auditors with limited capability and authority to challenge management.

These problems were further exacerbated by investment bankers and marketmakers focused exclusively on increasing their profits by enticing investors to invest in companies with unproven business models, giving rise to the tech bubble that burst in March 2000.

What Needs to be Done Now?

Regulators must take the following actions:

* Strictly enforce new rules issued as directed by the Sarbanes-Oxley Act aimed at transparent financial reporting and effective internal controls;

* Monitor and take necessary action to avoid the negative impact of unintended consequences from the application of Sarbanes-Oxley dispositions;

* Actively enforce laws and regulations relating to board of director and auditor independence from management;

* In rule-making activities, prioritize the shareholder's ability to monitor the board of directors' structure, operation, and performance;

* Ensure that the financial markets' self-regulatory organizations (SRO) adopt strict governance listing requirements; and

* Effect the necessary changes in the operation of the financial markets to guarantee a market free of the conflicts of interest now widespread. …

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