Sarbanes-Oxley Act and the Evolution of Corporate Governance
Note: Second in an ongoing series
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.
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.
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.
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.
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.
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
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
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.
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.
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.
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
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.
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.
personal benefit. Several executives, including
the Rigas family of Adelphia and Tyco International’s
senior leadership, openly siphoned company funds into their
violations. The conviction of ImClone CEO
Sam Waksal on insider trading violations is an example of
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.
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.
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
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.
investors pay for the long and expensive list of dishonest
corporate executives and market participants.
Were the Transgressors?
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.
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.
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.
$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.
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.”
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.
time has come to examine the root of the problem and prevent
breaches of fiduciary duty by individuals or corporations
that hold investors’ money.
Did This Happen Again?
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.
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.
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.
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
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.
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.
This series of articles is published by special arrangement
with the Institute of Management Accountants (IMA). The IMA
is the largest association dedicated exclusively to advancing
managerial finance and accounting professionals through certification,
thought leadership, communication, networking, and advocacy
of the highest ethical and professional practices. Jorge E.
Guerra, a consultant with the IMA and a former Fortune 500
financial executive, contributed to the series.