This post on Thomas Palley’s blog, which I found thanks to Mark Thoma’s Economist’s View, argues cogently for an expansion, rather than a rollback, of Sarbanes-Oxley, the corporate governance reforms implemented in 2002 in the wake of big corporate accounting scandals, such as Enron and WorldCom.
Palley, an economist, observes that Sarbox has not stopped the problems it was supposed to correct, namely CEO misbehavior and too-frequent financial restatements, and proposes a list of reforms.
Now in fairness, Sarbox was not intended to rein in CEO pay. But Palley is correct to see it as part of the problem, that CEO’s ability to earn a quick buck through options tempts them to get aggressive with financial reporting and take an unduly short-term approach.
The main complaints about Sarbox have been that it leads boards to engage in “box ticking” adherence to rules and that it is expensive. Since I don’t sit on the board of a public company, I can’t verify whether the rules are as onerous as claimed. Gretchen Morgenson pointed out in a recent New York Times article, “Memo to Shareholders: Shut Up” that directors’ and officers’ insurance premiums had decreased by nearly 50% since Sarbox was implemented, so this savings needs to be credited against any cost increases.
A WSJ commentary, “The Pump and Dump Economy,” by Michael Malone, an ABC columnist, claimed that Sarbox cost the average company $3.5 million (note no source was cited). And in an interesting departure, he asserts that big companies actually like Sarbox because it gave then a leg up over the small fry:
Not least — but worst — there is the Sarbanes-Oxley Act of 2002, whose self-monitoring rules Big Corporate initially resisted, but now embraces as an effective way to track internal financial operations. That alone should make you suspicious, because when established businesses like new rules it’s usually because it makes them more competitive against start-ups. Entrepreneurs have no constituencies, they don’t hire lobbyists or form PACs (like Google just did). Meanwhile, in an almost perfectly timed punchline, China’s biggest bank, ICBC, recently went public on the Hong Kong and Shanghai exchanges. The $19-billion IPO was the largest in history, arriving as Hong Kong becomes the world leader in IPOs.
The closer you look at Sarbanes-Oxley the more you realize it is almost perfectly designed to crush new business creation. The latest estimate for the annual cost of implementing Sarbox in a public corporation is $3.5 million. Pocket change for a Fortune 500 company; the entire annual profit of a newly public firm. Is it really any wonder that smart entrepreneurs look for a corporate sugar daddy instead of an IPO?
It seems that at least for corporate loyalists, Sarbox is a Rorschach test that allow them to project whatever bugaboo they have about regulation upon it.
Now I have been told by the former general counsel of a public company that Sarbox merely formalizes requirements that were already implied in previous law and case decisions. In other words, it simply articulates a standard that companies should have been following anyway (although it may be restrictive in setting forth specific procedures). So the squealing sounds disproportionate, and reveals the degree to which directors were lax about, and perhaps ignorant of, their obligations.
Palley’s proposals sound sensible, and not terribly costly to implement:
There is a growing business chorus calling for shrinking the Sarbanes – Oxley Act (Sarbox) regulating U.S. capital markets. Recently, a self-appointed “blue ribbon” committee financed by Wall Street interests called for making shareholder class action suits more difficult to bring, lowering the legal liability of auditors and directors, and easing accounting certification requirements. In response, the Securities and Exchange Commission (SEC) appears to be moving to implement some of this wish list.
However, corporate behavior over the last few years speaks for expanding Sarbox, not shrinking it. Thus, the CEO pay problem has continued – exemplified by recent massive termination payments to Bob Nardelli of Home Depot and Henry Mckinnell of Pfizer. Major accounting restatements continue at large corporations. And most importantly, there is the CEO stock option backdating scandal, which may extend to one thousand companies and appears to implicate boards of directors, including outside directors.
This backdating scandal scotches the notion that America’s corporate governance problem concerns a “few bad apples” and makes plain that the problem is the “barrel”. That speaks to expanding Sarbox rather than shrinking it.
Here is a set of reforms entirely different from those in the Wall Street blue ribbon Committee’s report. These reforms address the rotten barrel problem, thereby truly improving corporate governance and making America a better place for savers and investors.
Reform # 1. Require that the CEO and Chairman of the Board be different persons. Under current arrangements CEOs frequently also act as Board Chairman. That creates an absolute monarch who is almost completely free of accountability. Power tends to corrupt, and absolute power corrupts absolutely. Current US corporate governance arrangements have proven the truth of this aphorism, which speaks for having an independent chairman to whom the CEO is accountable.
Reform # 2. Stop share buy-backs. If companies want to increase pro-form earnings per share they can cancel existing shares (with stock options being cancelled proportionately). If companies want to return excess capital to shareholders they can pay special dividends. Stock buy-backs have terrible incentive properties. On the surface, they increase the share price, which benefits shareholders. Unfortunately, share buy-backs may be engineered to increase the share price in order to enhance the value of mangers’ stock options. Consequently, firms may waste capital by overpaying for shares, and shareholders actually lose though managers benefit.
Reform # 3. Allow shareholders with large long-held investments to nominate directors for election on the corporate proxy ballot. Under current rules, shareholders seeking to oust incompetent management must wage a costly proxy fight to get the question put. That advantages incumbent management that has the right, under the corporate proxy, to nominate whomever and propose whatever resolutions it wishes. Giving large committed shareholders access to the corporate proxy will make challenging incumbent management easier, thereby improving accountability and responsiveness to shareholders – which is what shareholder democracy is all about.
Reform # 4. Impose rules on management participation in buy-outs. A hard line would prohibit senior managers from participating for two years after leaving a company. A softer line would say that management must make available to shareholders the buy-out business plan. Currently, shareholders are being fleeced by management buyouts. Participating in buy-outs creates conflicts of interest, including locking firms into paying deal-breaker fees that discourage other buyers from making offers. Managers are the agents of shareholders and have access to proprietary information, yet they are allowed to use this privileged position to benefit themselves at the expense of shareholders.
Reform # 5. Make it obligatory for management to hold vested options for a period of three years. Some portion might even be required to be held longer. Under current arrangements managers often sell options as soon as they vest. That creates an undesirable incentive for short-term management that drives up today’s stock price, perhaps at the expense of long-term profits and long-term shareholder value. Requiring managers to hold on to vested options can realign incentives in a beneficial way.
Reform # 6. Managers should be required to refund performance bonuses paid on the basis of results that are subsequently revised down.
Reform # 7. Make CEO pay accountable and transparent. This can be done by requiring CEO pay packages be submitted to shareholders for approval. All options should be fully expensed. Pay packages should be presented with a comparison of the average pay-package of similarly positioned CEOs, along with metrics of relative performance such as return on equity. Such measures can guard against over-payment and also encourage pay-for-performance, which is the justification of these generous pay incentives.
Reform # 8. Strictly limit the number of directorships of publicly listed companies an individual can hold. The current system has created a “club” network in which CEOs and Directors are cozy with each other. This coziness weakens oversight and promotes CEO excess. Increasing the size of the director pool can help restore a more professional arms-length relationship in boardrooms between directors, board chairs, and CEOs. It also speaks to having worker directors on the board.
Rather than supporting a rollback of Sarbanes – Oxley, the facts of current U.S. corporate behavior speak to expanding it. Business conservatives have invited a debate over Sarbox. Progressive investor activists should accept that invitation and make the case for expanding Sarbox and deepening corporate accountability.
