The Sarbanes-Oxley Act and the Evolution of Corporate Governance

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The purpose of this series of articles on the Sarbanes-Oxley Act of 2002 and the evolution of corporate governance is to determine the actions required to prevent a recurrence of the present investor confidence crisis in American financial institutions. The first step requires an analysis of the available empirical evidence on the recent corporate governance transgressions to determine their nature, the participants, and the probable causes.

During the fall of 2003, the author conducted a study of 116 of the most notorious cases of corporate governance infringements by corporations, public audit firms, and other financial market participants. The study involved over 150 public companies and their auditors. Company executives personally implicated in 39% of the infringements have been convicted, charged, plead guilty, or are being tried in court; 8% of the cases have been settled with the SEC; 27% are being investigated by the SEC, the Department of Justice, or other government agencies; and the remaining cases have resulted in voluntary restatements and write-offs.

What Went Wrong?

The study revealed that the most common transgressions are related to net profit overstatements using a creative variety of fraudulent accounting records affecting revenues, costs and expenses, or special reserves accounts. The number of executives who openly tapped company funds for their personal benefit or who profited from insider trading or misleading public disclosures is not insignificant. Below are the most common deviations from accounting standards.

Revenue recognition. The most common violations of revenue recognition include anticipated recognition; sales booked without transfer of property; “round-trip” transactions; deferred accounting of discounts, rebates, or guarantees; channel stuffing; collusion with vendors; and accounting of swaps as revenues.

One of the most outrageous cases of revenue overstatement was the reduction of $6.4 billion in revenues made by Xerox in June 2002, covering the 1997–2001 period. Only $1.9 million was an early recognition of revenues that belonged in 2002 and beyond; the balance was a plain overstatement of revenues, with an earnings impact of $1.4 billion.

Another technique, much used in the energy industry, was the recording of round-trip trades as sales. Enron, Dynergy, Reliant Resources, El Paso, CMS Energy, and Duke Energy all inflated revenue this way.

Reserves. Manipulation of reserves is another tool used by dishonest executives to meet earnings targets. The discretionary nature of these accounts provides the opportunity to meet Wall Street forecasts by increasing or decreasing earnings at will.

An example of overstatement of earnings by keeping reserves not entirely supported by the financial reality of the company is the 2003 write-down of $1.05 billion of tax reserves by Sun Microsystems.

AOL Time Warner and JDS Uniphase each made multibillion-dollar downward adjustments to goodwill in 2002. These adjustments are another example of untimely recognition of an economic reality. The bursting of the “tech bubble” in March 2000 reduced the market value of many dot-com companies so drastically that the prices paid to acquire these companies subsequently looked absurdly overstated.

Understatement of debt. The Enron and Adelphia cases are examples of debt understatement. In the case of Enron, special purpose entities hid billions of dollars in debt. As debt was understated, equity was overstated, giving the investment community a false impression of the company’s financial soundness. With the assistance of senior finance managers, Adelphia executives fraudulently excluded over $2 billion in bank loans from the balance sheet.

Who Benefited?

Earnings per share is the most widely used measure for executive performance. Manipulation of earnings resulted not only in fraudulent financial results, but also in greater executive compensation. Aside from this form of personal benefit, the study disclosed other schemes of dishonest personal gain.

Misleading public disclosures. Enron executives’ optimistic outlook in meetings with Wall Street analysts just days before the collapse of the energy giant was a shocking example of unethical behavior.

The recent Schering-Plough case—in which an earnings warning was made public after private meetings with selected investors and analysts and the subsequent loss of 20% of the company’s market value in three days—is also indicative of how far dishonest executives can go to mislead the public, to the advantage of a few market participants.

Direct personal benefit. Several executives, including the Rigas family of Adelphia and Tyco International’s senior leadership, openly siphoned company funds into their pockets.

Trading violations. The conviction of ImClone CEO Sam Waksal on insider trading violations is an example of executive greed.

Other trading violations include the pervasive breach of mutual funds after-hours trading limitations. Several executives of Alger Funds, Bank One, and Nations Funds have been fired over such violations. Alliance Capital, Federated, Janus, Schwab, and Strong Capital are all under investigation. Executives at Nations Funds, Pilgrim Baxter, and Prudential have been charged. Putnam has settled with the SEC.

The recent Morgan Stanley settlement with the SEC has added a new twist to the mutual fund scandal. The Morgan Stanley case is different, as it involved financial advisers and branch managers that sold expensive mutual funds to investors and received extra compensation for the sales, a serious conflict of interest.

Investment banks that promote a stock while publishing analysis of the same stock have also exhibited a conflict of interests that impact investors. The recent settlement that provided for a payment of $1.4 billion by 10 of the major investment banks highlights the problem and the need for an urgent solution.

The sad story of pervasive conflicts of interest among sell-side market participants has other players: NYSE specialists. These transaction-oriented professionals are being probed for personal conflicts of interest in their role as intermediaries between selling and purchasing investors. Allegedly, they have been profiting by transacting with their own holdings instead of the investors’ holdings if the imbalance of purchase and sales orders permitted an easy profit.

Ultimately, investors pay for the long and expensive list of dishonest corporate executives and market participants.

Who Were the Transgressors?

Corporations. In 101 of the 106 cases studied, the people directly involved were company executives. The obvious conclusion is that the “tone at the top” in corporate America does not respond to ethics, but to greed and self-benefit.

The key issues are who should control dishonest executives and how this control should be implemented. The owners of the corporations must exercise close scrutiny over the actions of company management. The boards of directors and external auditors are the only tools available to investors.

Investment banks. Wall Street powerhouses had intrinsic conflicts of interest between their research and investment- bank units. The conflicts fostered the practice of publishing favorable analyst reports on the stocks of corporations doing business with the investment bank of the same institution.

The $1.4 billion settlement approved recently by U.S. District Judge William H. Pauley III requires the investment firms involved to undertake “dramatic reforms” to their practices, including separating their research and investment banking departments. Other key provisions of the settlement include $500 million in independent research funding for investors and investor education.

SEC Chairman William H. Donaldson said in a statement, “We now begin the process of implementing the settlement, which is an important part of our ongoing efforts to restore investor faith in the fairness and integrity of our financial markets.”

Other market participants. Recent ethical scandals involving mutual fund managers and NYSE trading specialists support the belief that more unethical behavior in the markets remains to be exposed.

The time has come to examine the root of the problem and prevent breaches of fiduciary duty by individuals or corporations that hold investors’ money.

Why Did This Happen Again?

At first, it seemed as if the lack of investor confidence in the markets was due to a flawed corporate governance process. The recent disclosure of mutual fund and specialist scandals requires that the scope of governance reform be expanded to include corporate and financial markets governance.

Fairness and integrity crises in the financial markets reoccurred today because remedies put in place when the ’80s and ’90s crises occurred were incomplete and did not adequately address the systemic conflicts of interest embedded in the corporate and financial markets governance processes.

Concerning corporations, the structure, organization, and membership of the corporate boards of directors charged with the responsibility of controlling management were virtually untouched. This provided a tacit endorsement of management’s controlling the nomination, structure, and operation of the board of directors. As a result, boards of directors became rubber-stamping bodies at the service of top management.

Auditor independence violations further eroded the efficiency of controls over management. Audit firms became engaged in a variety of consulting engagements for the managements of the companies they were auditing. The manipulation of corporate earnings during that time resulted in higher bonuses and perks for executives and, in the long term, multibillion losses to investors when the market saw the true financial picture.

Controls over conflicts of interest and the resulting breaches of fiduciary duty by mutual fund managers, trading floor specialists, investment banks, and other market participants proved to be lax and inefficient. Dishonest individuals took personal advantage of their knowledge, and control of specific market transactions went undiscovered for years. Even the markets’ self-regulating organizations, such as the NYSE, have embedded conflicts of interest in their organization.

This time around, Congress and federal securities regulatory agencies must undertake a comprehensive corporate and markets governance reform that eliminates—to every extent possible—the existence of conflicts of interest and establishes a control framework permitting the timely discovery and prompt sanction of any ethical deviations by market participants. The pillars of confidence in the markets are fairness, transparency, and ethical behavior of all parties entrusted with investor interests.