In 2001 and 2002, financial reporting scandals at major publicly-traded U.S. corporations such as Enron and WorldCom fueled demand for wide-ranging corporate governance reforms. The changes proposed by public and private regulators have aimed to restore investor confidence, enhance management accountability, and improve shareholder value. Recent research evaluates the economic principles behind the government's response.
In his recent study, "Economics of Corporate Governance
Reform," University of Chicago Graduate School of Business
professor Randall S. Krosnzer notes that the reforms initiated
by the Bush administration in 2002 are among the most far-reaching
reforms to federal laws and regulations since the establishment
of the Securities and Exchange Commission (SEC) in 1934.
The most dramatic of these reforms are being achieved through
the Sarbanes-Oxley Act of 2002, which was passed by Congress
and is being overseen by the SEC.
In theory, the objective for managers of a publicly-traded
firm is to maximize shareholder value. The reforms of 2002
established a set of incentives and a monitoring structure
for shareholders to make sure that managers put shareholders'
interests first, rather than their personal gain.
The concerns leading up to the Sarbanes-Oxley Act and related
reforms were outlined in a speech given by President George
W. Bush on March 7, 2002, which sets forth a "Ten Point
Plan to Improve Corporate Responsibility and Protect America's
As Kroszner explains, the reforms suggested in the plan and
embodied in the Sarbanes-Oxley Act are based on three principles
of effective corporate governance: 1) accuracy and accessibility
of information; 2) management accountability; and 3) auditor
independence. These three principles help to insure that shareholders'
interests are protected.
Legislative reforms have a long phase-in period. The regulations
put forth by the Sarbanes-Oxley Act will not be fully implemented
until 2005. In the meantime, Kroszner's study characterizes
the potential effects and benefits of the Sarbanes-Oxley Act
and other reforms by considering how they implement each of
the three principles underlying President Bush's plan for
"The economic principles behind both President Bush's
approach and the Sarbanes-Oxley Act were well-motivated,"
says Kroszner. "We will still have to see whether the
specifics of their implementation will pass a cost/benefit
analysis once everything is in place."
Principles of Strong Corporate Governance
"Good corporate governance requires a strong board of
directors and auditors with independent minds asking tough
questions," says Kroszner. "Corporate governance
should ideally work like the checks and balances we have on
Securities regulations administered by the SEC supplement
both the law and market forces to create incentives for corporate
managers to provide timely and accurate information to investors.
Typically the information available to investors comes from
materials such as a firm's audited annual report and press
reports. Investors therefore must have confidence in the accuracy
of this information.
The Sarbanes-Oxley Act promotes the principle of accuracy
and accessibility of information in several ways. First, the
act introduces new disclosure requirements that require directors,
officers, and principal investors to reveal transactions in
company stock by the second day after a transaction. Faster
disclosure makes it easier for outsiders to act on news of
insider trading. Financial analysts and auditors also must
disclose any potential conflicts of interest.
Second, the Sarbanes-Oxley Act dramatically increases the
penalties for violating securities regulations. The act provides
for a fourfold increase in the maximum prison term for criminal
fraud-to 20 years rather than 5 years-and an even higher maximum
term of 25 years for securities fraud. Both of these increases
in prison terms are in addition to fines and other nonmonetary
sanctions. Recognizing that penalties cannot be imposed without
evidence that a violation has occurred, the act also increases
the maximum sanction for destroying documents, allowing courts
to impose fines and terms of imprisonment of up to 20 years
for this offense.
Third, the act creates new rules and institutions to govern
managers' and auditors' choices concerning the accuracy and
timeliness of corporate financial reporting. The act promotes
compliance with existing disclosure rules and strengthens
the auditing and documentation procedure to provide greater
confidence in the accuracy of the numbers that are reported.
Another underlying principle of recent reforms is emphasis
on management accountability, not surprising given the wake
of recent allegations of accounting fraud, and the detrimental
effects of these fraud cases on shareholders.
Under recent reforms, managers will stand a much greater
chance of getting caught when committing financial reporting
fraud. The Sarbanes-Oxley Act details several methods for
reforming management accountability, including spending more
money on enforcing laws against management and auditor misconduct,
especially financial reporting violations.
In addition, the government has taken steps to use its enforcement
resources more effectively. In July 2002, the Corporate Fraud
Task Force was established to better coordinate efforts between
the SEC, the Justice Department, and other institutions responsible
for detecting misconduct and imposing sanctions. Managers
must now clarify wrongdoing within their corporations. Among
other changes, the SEC now requires CEOs and CFOs to certify
the accuracy and completeness of their companies' financial
The reforms also increase the magnitude of sanctions that
managers receive upon detection, and introduce new sanctions
for managers who fail to abide by the new rules. For example,
the Sarbanes-Oxley Act now makes it a criminal offense, subject
to fines up to $1 million, to knowingly engage in the false
certification of financial reports.
The final principle underlying recent reforms is auditor
independence. It is important to limit auditors' tolerance
of false or careless financial reporting from corporate managers
and reduce the potential for conflicts of interest.
The Sarbanes-Oxley Act makes it more difficult for managers
to play a role in the selection and compensation of outside
auditors. A corporation's choice of auditor must now be made
by a committee of independent directors who are not employees
of the company, and have no relationship with the company
other than as directors. The act also requires that accounting
firms periodically assign a new audit partner to each client
account. The Public Company Accounting Oversight Board has
been formed to monitor and enforce the diligent supply of
outside audit services. Each public accounting firm must register
with the Oversight Board and submit to periodic performance
reviews, and must comply with sanctions if the Board discovers
Pros and Cons of Shareholder Democracy Reforms
In the "proxy process," individual shareholders
vote to elect corporate directors, choose an auditor, and
decide other matters through proxy materials sent by mail.
Currently, if shareholders want to nominate directors themselves,
they must engage in a "proxy fight" by obtaining
a list of voting shareholders, sending out their own materials,
and soliciting votes.
Recently, the SEC has proposed a rule on director nominations
where under "triggering events," certain outside
shareholders would be able to propose nominees to the board
of directors who would then be on the ballot and included
in regular proxy materials. The shareholders that would receive
these privileges would be large, long-term shareholders such
as pension funds and institutional investors, who have owned
a minimum of five percent of shares for at least two years.
The idea behind this new proposal is increased shareholder
democracy-allowing shareholders to exercise more control over
candidates for the board of directors.
The objective of any changes to the rules governing the nomination
and election of board members should be to increase shareholder
value. Kroszner argues that the potential costs of this shareholder
democracy proposal outweigh the benefits. Lowering the cost
for significant shareholders to have their nominees included
in the company's proxy materials, in certain circumstances,
is not an effective way to improve corporate governance, he
The proposed rules could increase the cost of the proxy process,
and the potential for contested elections might discourage
qualified directors from standing for election. Companies
also may have to provide greater compensation to attract qualified
directors. Contested elections could lead to fragmentation
of the board which might disrupt the decision-making process.
"The shareholder democracy proposal is the wrong answer
to the right question," says Kroszner. "A better
alternative would be to look at existing inappropriate legislative
and regulatory barriers (such as those governing pension funds
and mutual funds) that prevent large shareholders from playing
a meaningful role in many aspects of corporate control. Get
rid of the barriers first, rather than layering regulations
on top of regulations."
Balancing Public and Private Regulations
"One has to be very wary of overregulation," notes
Kroszner. "You don't want to kill the goose that laid
the golden egg. The entrepreneurial firm that gets outside
capital is a core part of capitalism."
A key issue to consider is the appropriate interaction between
public and private efforts to promote strong corporate governance.
For example, private-sector exchanges such as the NYSE and
NASDAQ require firms to meet listing requirements, including
having a majority of independent directors.
The efforts of legislators and regulators may in some instances
duplicate private-sector efforts. It will take time to fully
document the results of both public and private regulations.
"The Sarbanes-Oxley Act is a broad brush response,"
says Kroszner. "Many people have been concerned about
the associated costs of government regulations, but the private-sector
response has gone far beyond what Sarbanes-Oxley requires."
In order to raise capital, firms have to be credible in the
market. Even without legislative change, it is likely that
the private sector would have generated additional costs in
any event via firms being forced to spend more money on auditing
and monitoring systems.
"Many of the reforms are private-sector motivated, not
just government motivated," says Kroszner. "The
relevant benchmark for measuring the cost of the Sarbanes-Oxley
Act is not business as usual as of 2001, but what the market
would have provided anyway in terms of increased monitoring."