LAW 421 WEEK 5 ARTICLE REVIEW AND POWERPOINT PRESENTATION

ECGI European Corporate Governance Institute Finance Working Paper No. 52/2004 Yale Law School Center for Law, Economics and Public Policy Research Paper No. 297 Yale University International Center for Finance Working Paper No. 04-37 New York University Law and Economics Research Paper Series Working Paper No. 04-032 The Sarbanes-Oxley Act and the Making of Quack Corporate Governance Roberta Romano Yale Law; NBER; ECGI This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at: The Sarbanes-Oxley Act and the Making of Quack Corporate Governance1 Roberta Romano Yale Law School, NBER, and ECGI September 26, 2004 Abstract This paper provides an evaluation of the substantive corporate governance mandates of the Sarbanes-Oxley Act of 2002 that is informed by the relevant empirical accounting and finance literature and the political dynamics that produced the mandates. The empirical literature provides a metric for evaluating the mandates’ effectiveness, by facilitating identification of whether specific provisions can be most accurately characterized as efficacious reforms or as quack corporate governance. The learning of the literature, which was available when Congress was legislating, is that SOX’s corporate governance provisions were ill-conceived. The political environment explains why Congress would enact legislation with such mismatched means and ends. SOX was enacted as emergency legislation amidst a free-falling stock market and media frenzy over corporate scandals shortly before the midterm congressional elections. The governance provisions, included toward the end of the legislative process in the Senate, were not a focus of any considered attention. Their inclusion stemmed from the interaction between election year politics and the Senate banking committee chairman’s response to suggestions of policy entrepreneurs. The scholarly literature at odds with those individuals’ recommendations was ignored, while the interest groups whose position was more consistent with the literature - the business community and accounting profession -- had lost their credibility and become politically radioactive. The paper’s conclusion is that SOX’s corporate governance provisions should be stripped of their mandatory force and rendered optional. Other nations, such as the members of the European Union who have been revising their corporation codes, would be well advised to avoid Congress’ policy blunder. 1 Earlier versions of this paper were presented as a plenary lecture at the 20th Annual Conference of the European Association of Law and Economics, the Matthews lecture at the University of Mississippi School of Law, the Harald Voss Memorial Lectures at the Institute for Law and Finance of Johann Wolfgang Goethe-Universität in Hamburg, and at the Vienna University of Economics and Business Administration and UNCITRAL Forum für Internationales Wirtschaftsrecht in Vienna, the University of Pennsylvania Institute of Law and Economics Roundtable, the Centre for European Policy Studies Roundtable on Corporate Governance Reform in the EU, the Kirkland & Ellis LLP Corporate Law & Economics workshop, and workshops at the University of Chicago, University of Denver, University of Iowa, University of North Carolina, and University of Virginia law schools. In addition to participants at those presentations, I would like to thank Jennifer Arlen, John Core, Alan Gerber, Jonathan Macey, Paul Mahoney and Mathew McCubbins for helpful comments. Table of Contents I. Introduction 1 II. Evaluating the Substantive Corporate Governance Mandates in SOX 12 A. Independent Audit Committees 13 1. Statutory mandate 13 2. Studies on Audit Committee Independence 16 B. Provision of Non-Audit Services 41 1. Statutory mandate 41 2. Studies of the Provision of Non-audit Services 44 a. Studies of Discretionary Accruals 46 b. Studies of Earnings Conservatism 71 c. Studies of Going Concern Opinions 73 d. Studies of Financial Restatements 79 C. Executive Loans 86 1. Statutory mandate 86 2. Study of Executive Loans 89 D. Executive Certification of Financial Statements 92 1. Statutory mandate 92 2. Studies of Executive Certification of Financials 95 E. Event Studies of the Enactment of SOX 102 III. The Political Economy of the SOX Corporate Governance Mandates 114 A. Background 115 B. The Legislative Debate 121 1. The Debate in the House 122 2. The Debate in the Senate 125 C. The Role of Policy Entrepreneurs 146 1. Witnesses at the Hearings 147 2. Executive Loans 150 3. Independent Audit Committees 153 4. Executive Certification of Financial Statements 162 5. Provision of Non-Audit Services 166 6. The Impact of Senator Sarbanes 170 D. Where Was the Delaware Delegation in the Legislative Process? 174 E. Interest Groups and Campaign Contributions in relation to SOX 185 1. The Split in the Business Community 187 2. Tracing the Money 193 3. Lobbying Expenditures 198 F. Were the SOX Governance Mandates an Instance of Symbolic Politics or Window- Dressing? 201 IV. Policy Implications 205 A. Converting Mandates into Statutory Defaults 206 B. Returning Corporate Governance to the States 212 V. Conclusion 215 “It’s hard to argue logic in a feeding frenzy.”2 I. Introduction The Sarbanes-Oxley Act (SOX), in which Congress introduced a series of corporate governance initiatives into the federal securities laws, is not just a considerable change in law but also a departure in the mode of regulation.3 The federal regime had until then consisted of disclosure requirements, rather than substantive corporate governance mandates, which were traditionally left to state corporate law and were not part of the federal securities regime. Federal courts had, moreover, enforced such a view of the regime’s strictures, by characterizing efforts of the SEC to extend its domain into substantive corporate governance as beyond its jurisdiction.4 SOX alters this division of authority by providing explicit legislative directives for SEC regulation of what was previously perceived as the states’ exclusive jurisdiction. SOX was enacted in a flurry of congressional activity in the runup to the midterm congressional election campaigns, after the spectacular failures of once highly regarded firms, the Enron Corporation and WorldCom, Inc. Those firms entered bankruptcy proceedings in the 2 Sen. Phil Gramm, quoted in Jim Drinkard, Scandal publicity drives accounting bill forward, USA Today, July 25, 2002, p.10A. 3 Pub. Law No. 107-204, 15 U.S.C. §§ 7201 et seq. (2003). Politicians heralded the act as the most important financial market legislation since the initiation of federal securities regulation in the 1930s. E.g., “President’s statement on signing of H.R. 3763,” Administration of George W. Bush, 2000, at 1284 (calling legislation the “most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt”); 148 Cong. Rec. S 7356 (July 25, 2002) (remarks of Sen. Corzine) (legislation “may well be the most important step” taken since the enactment of the securities laws). 4 See Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990) (striking down SEC action through its stock exchange rule-making authority to require one-share one-vote). wake of revelations of fraudulent accounting practices and executives’ self-dealing transactions. But many of the substantive corporate governance provisions in SOX are not in fact regulatory innovations devised by Congress to cope with deficiencies in the business environment in which Enron and WorldCom failed. Rather they may more accurately be characterized as recycled ideas advocated for quite some time by corporate governance entrepreneurs. For instance, the independent director requirement and the prohibition of accounting firms’ provision of consulting services to auditing clients, had been advanced as needed corporate law reforms long before the Enron corporation appeared on any politician’s agenda.5 That is not, of course, unique or surprising, as congressional initiatives rarely are constructed from whole cloth; rather, successful law reform in the national arena typically involves the recombination of old elements that have been advanced in policy circles for a number of years prior to adoption.6 There is no rigorous theory of how policy proposals come to the forefront of the legislative agenda, but the political science literature identifies shifts in national mood and 5 See, e.g., Stephen M. Bainbridge, A Critique of the NYSE’s Director Independence Listing Standards, 30 Sec. Reg. L. J. 370 (2002) (comparing the independent directors’ provisions to the abortive ALI corporate governance project of the 1980s). Efforts to separate auditing from consulting services were not new: Congress considered the issue in the 1970s, see Report on Improving Accountability of Publicly Owned Corporations and Their Auditors, Subcomm. On Reports, Accounting, and Management of the Sen. Comm. on Governmental Affairs, 95th Cong., 1st Sess. (1977); and more recently, under Arthur Levitt’s term as SEC chairman, the agency vigorously pursued the issue in two rule-making processes over , see Audit Committee Disclosure, Final rule, Release No. 34-4226 (Dec. 22, 1999), 64 Fed. Reg. 73389 (1999); and Revision of the Commission's Auditor Independence Requirements, Final Rule, Release No. 33-7919 (Nov. 21, 2000), 65 Fed. Reg. 76008 (2000) (hereafter Auditor Independence Rule). 6 John W. Kingdon, Agendas, Alternatives, and Public Policies (1984). turnover of elected officials, coupled with focusing events, as key determinants.7 At least two of those three elements were without question present to create the window of opportunity for advocates of the corporate governance legislation included in SOX: as indicated in Table 1, there was a shift in public mood regarding big business,8 and, as shown in Figure 1, a sharp decline in the stock market, coinciding with high profile corporate scandals causing significant displacement and financial distress. There was no turnover of elected officials prior to the enactment of SOX, the third element that is thought to be important in propelling proposals onto the legislative agenda, but it was widely perceived in the media that members of Congress were motivated by reelection concerns when a statute was hurriedly enacted in the summer prior to the mid-term elections, after months of languishing in committee, following heightened attention on corporate malfeasance when the WorldCom scandal erupted post-Enron.9 The suggestion from 7 Id. 8 As indicated in Table 1, the proportion of the public having either a great deal or quite a lot of confidence in big business in 2002, 20 percent, was the lowest percentage in over a decade, and represented a substantial drop from the relatively high level of confidence, averaging 29.33 percent (range of 28-31 percent) in the prior five years, . It is also more than 10 percent lower than the average, 23.86 percent, over 1990-96 (range of 21-26 percent), and 20 percent below the average for the decade , of 26.38 percent. Of course, it is quite probable that the two variables, public opinion of business and the level of the stock market, are integrally related, that is, when the stock market is doing well, the public has a positive perception of business, and similarly, its perception turns negative when the market drops, whether or not the change in price is related to corporate scandals. There is some credence to this conjecture: the correlation between the percentage of the public expressing a great deal of confidence in business and the S&P 500 composite index is significantly positive (at less than 5 percent), ranging between .55 and .59, depending on whether the closing price of the S&P is measured at the end of the month preceding the poll, the end of the month in which the poll was taken, or the average of the two months. 9 The House Committee on Financial Services held its first hearing on Enron in December 2001, and it reported a bill, which was passed shortly after its introduction, in April 2002. The Senate did not act on the House bill until after the WorldCom bankruptcy filing in the media was that the priority of members of Congress was to enact something, with the specific content of less concern and importance.10 The failure of Enron, then, provided the occasion for implementation of corporate governance initiatives that were already in the policy soup. What is perhaps most striking in the legislative process is how successful policy entrepreneurs were in opportunistically coupling their corporate governance proposals to Enron’s collapse, offering as ostensible remedies for future “Enrons”, reforms that had minimal or absolutely no relation to the source of that firm’s demise. The most opportunistic coupling in response to Enron’s collapse was the Bipartisan Campaign Reform Act of 2002 (commonly referred to as McCain-Feingold, after its principal sponsors), which was enacted many months before SOX’s passage,11 as Enron’s campaign contributions had nothing to do with Enron’s financial collapse, nor were there allegations to that effect. July 2002. For an example of press coverage that election concerns figured prominently in that timetable, see e.g. David E. Sanger, Corporate Conduct: The Overview, Bush on Wall Street Offers Tough Stance, N.Y. Times, July 10, 2002, A1 (reporting on a speech by President Bush to Wall Street on his approach to the corporate scandals, the article noted that the “Democrats have now seized on (the need for drastic legislative change in response to the corporate scandals) as a crucial issue for the November elections,” and emphasized how “partisan the battle has become.”) Similarly, press reports suggested that the Senate Democrats were not coming up with a consensus party bill, or compromise bill capable of obtaining some Republican votes, following the House action because the Democrats “[did]n’t want Bush and the Republicans to steal their thunder” and it “was not in the Democrats’ interest to compromise.” Amy Borrus and Mike McNamee (edited by Richard S. Dunham), Accounting: Congress Only Looks Like It’s Getting Tough, Business Week 51 (Apr. 29, 2002). News accounts that considered the House bill as too “lax,” maintained that legislators “were more interested in using accounting reform to score political points for the November elections than in reining in (accountants).” Id. 10 E.g., Wall St. J., July 11, 2002. As one television reporter put it, “This was a stampede... The House Republicans dropped their opposition to this legislation because there was simply too much pressure on them to pass something.” ABC News, World News Tonight, Congress passes new reform bill, July 24, 2002 (Linda Douglass, reporting). 11 Pub. Law 107-155, 116 Stat. 81 (Mar. 27, 2002). The aim of this paper is not, however, to analyze the peculiar disjunctur