Sarbanes-Oxley Act and the Evolution of Corporate Governance
Note: Third in an ongoing series.
conflicts of interest in the process of issuing and marketing
securities in America have motivated an urgent call for
comprehensive corporate and market governance reform. Reform
demands the reengineering of all activities in the process
of issuing and marketing securities, and the implementation
of controls that guarantee that the investor’s interest
is the ultimate goal of all participants in the process.
pillars of reform should be integrity, independence, transparency,
and accountability. The constituencies involved are:
Issuers: boards of directors, corporate management,
public audit firms, and employees;
Financial markets: investment banks, mutual and
hedge fund managers, self-regulatory organizations (SRO),
and trading specialists; and
Controlling parties: investors, securities regulators,
and the government.
reform is a people-driven process, and the top people involved
in issuing and marketing securities, as well as those in
the controlling constituencies, should lead the change and
set the example.
integrity must be the top requirement for those seeking
leadership roles within corporations, financial markets,
and controlling entities. Unfortunately, most of the corporate
and market leaders involved in scandals are notorious for
their greed and unethical behavior. The basic tools required
to improve integrity among business leaders are culture,
fear, and reward.
change is typically driven by personal attitude toward change
and an environment that rewards individuals for embracing
the new culture. By emphasizing the “fear factor”
through increased penalties and strict enforcement, the
latest regulatory actions by government entities fall short
in addressing cultural changes among business leaders.
corporate scandals requires that those selecting business
leaders focus on the integrity of candidates first, followed
by their skills and competencies. A successful selection
process would restrict nomination of top executives to only
those board members nominated by investors. Additionally,
time limits should be placed on the tenure of executives—perhaps
for the length of a strategic plan cycle. Longer tenures
tend to favor creation of empires that conceal improprieties
and unethical behavior.
among securities market participants has proven to be more
pervasive than initially anticipated. Transaction-driven
compensation and lack of control over trading activities
are the major causes of unethical behavior. Measures to
address this are under consideration, but the issue of compensation
for market intermediaries must be seriously addressed as
of independence is a serious threat to integrity, as it
hampers the ability to overcome conflicts of interest between
a leader’s personal benefit and a business’s
best interests. Corporate governance reform requires that
change start at the top and cascade down throughout the
organization. Therefore, independence must be of paramount
importance to each member of the board of directors. Director
selection is a key to structuring truly independent boards,
and the driving force behind it should be investors, not
executive management. Indeed, the process should be completely
overhauled to eliminate executive management involvement,
and board membership should be restricted to only the chief
effectiveness of the external audit function depends on
the external auditor firm’s independence from management.
Recent suggestions by the SEC to allow investor nomination
of director candidates and require disclosure of particulars
surrounding the selection (nomination) process are steps
in the right direction, although a more aggressive stance
on this issue would accelerate governance reform. For example,
an outright ban on cross-board memberships, a limit to the
number of directorships one can hold, and director reelection
restrictions are all measures that will contribute positively
to governance reform.
Sarbanes-Oxley Act includes provisions aimed at an independent
external audit function as a primary way to enhance corporate
governance. Related SEC regulations adequately prevent the
conflicts of interest facing auditors, which are dependent
upon executive management to efficiently perform their duties.
It is expected that the Public Company Accounting Oversight
Board’s (PCAOB) regulatory activity will strengthen
controls over the quality of audit work and determine stringent
penalties for audit firms that violate audit standards.
external audit–related issue that has not been properly
addressed is the conflict of interest between efficiency
and cost-effectiveness. External audit bids should be evaluated
based on the amount of work provided by seasoned personnel
and not by the overall cost. Additionally,
part of the auditor’s remuneration should be directly
related to the quality of the audit work, as measured by
the auditor’s contribution toward preventing fraud
corporate executives, independence requires a firewall separating
their personal interest from the best interest of the investors.
market intermediaries, independence will be achieved if
the following conditions are met:
Market and credit analysts work independently and are
not subject to pressures from other departments of the
investment bank for which they work. Regulators should
foster the growth of independent market and credit analysis
compensation of investment bankers, mutual fund managers,
and traders is structured to reward return to investors,
not transaction quantity or portfolio size.
Market exchanges progressively eliminate human participation
in determining the best price offered to investors for
securities purchases or sales.
change in the approach by government officials, regulators,
and investors toward governance reform is long overdue.
The emphasis must now be on proactive control over securities
issuers and marketers, with a focus on preventing conflicts
of interest arising from a lack of independence. Enforcement
and punishment of violators is important, but stronger preventive
measures will ensure the effectiveness of governance reform.
core of transparency is the fair, comprehensive, timely,
and clear disclosure to the investor community of important
business activities by securities issuers and marketers.
present regulations have resulted in an increase in the
amount of reporting, corporations and regulators have given
little attention to clarity. Investors must require that
business information be provided in plain English. It should
include an assessment of present business conditions, as
well as a future outlook with a sensitivity analysis.
assessment of present business conditions should include
not only a description and explanation of business performance
during recent periods, but also a trend analysis of the
key drivers of profitability, cash flow, and financing;
a status report on the achievement of strategic goals; and
measures taken by management to correct any deviations from
the strategic plan and previous earnings guidance. The business
outlook and the corresponding sensitivity analysis must
present a clear picture of future trends consistent with
present performance, along with a sensitivity analysis focused
on contingencies that may affect future performance.
SEC’s recently published “Commission Guidance
Regarding Management’s Discussion and Analysis of
Financial Condition and Results of Operations” (Release
Nos. 33-8350; 34-48960; FR-72, effective December 29, 2003)
addresses the presentation as well as the content and focus
of management’s discussion and analysis (MD&A),
which is considered the main vehicle for business leaders’
communication with the investor community.
following objectives for MD&A set by the SEC are adequate
and consistent with the aforementioned transparency requirements:
Provide a narrative explanation of company’s financial
statements that enables investors to see the company through
the eyes of management;
Enhance the overall financial disclosure and provide the
context within which financial information should be analyzed;
Provide information about the quality of, and potential
variability of, a company’s earnings and cash flow,
so that investors can ascertain the likelihood that past
performance is indicative of future performance.
SEC also mandates that the primary focus of the MD&A
should be key indicators of financial condition and operating
performance, materiality, material trends and uncertainties,
Release 33-8350 is a step toward transparency. If all corporations
adopt the spirit of this release, communication of business
performance and outlook will be enhanced substantially.
The SEC has proposed additional objectives for the communication
of fees and market activities that are expected to be released
same transparency needed for securities marketing activities
is also important to the communication between investors
and the business community:
All fees paid by investors to market intermediaries must
be publicly disclosed.
should be informed and be allowed to effect all market
relationship between fees paid and investor wealth should
be made public.
accountability requires a process that permits investors
to expeditiously restructure boards of directors that fail
to fulfill their duties. It also requires that business
leaders be compensated based upon performance. Corporate
executives’ compensation should be significantly variable,
and the variable portion should be directly linked to stockholder
wealth creation and granted at the end of a strategic planning
period to prevent a short-term focus. More important than
limiting compensation is the executive sharing in both success
and failure. Presently, many executives are overly rewarded
for success and are not penalized for failure. Generous
farewell packages with no link to performance should be
eliminated, and a process allowing the audit committee to
periodically evaluate the integrity of executives should
external auditor compensation should be significantly variable
and related to performance, as measured by the reduction
in fraud and restatements.
market participants accountable requires that the compensation
of market intermediaries be directly related to performance
rather than the volume or value of transactions. Today,
traders, fund managers, and investment banks are transaction-driven.
Because their compensation is not tied to investor wealth
creation, their interests are not aligned with their investors’
interest. Investors and regulators must take a proactive
role in fostering accountability. Investors should request
a direct role in structuring the governance bodies of corporations
and mutual funds. Regulators should focus on changing the
culture of investment banks and traders to one that promotes
investor wealth creation.
series of articles is published by arrangement with the Institute
of Management Accountants (IMA). The IMA (www.imanet.org)
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.