OCTOBER 2004

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Checks and Balances

The Economics of Corporate Governance Reform

Research by Randall S. Kroszner

In 2001 and 2002, financial reporting scandals at major publicly-traded U.S. corporations such as Enron and WorldCom fueled demand for wide-ranging corporate governance reforms. The changes proposed by public and private regulators have aimed to restore investor confidence, enhance management accountability, and improve shareholder value. Recent research evaluates the economic principles behind the government's response.

In his recent study, "Economics of Corporate Governance Reform," University of Chicago Graduate School of Business professor Randall S. Krosnzer notes that the reforms initiated by the Bush administration in 2002 are among the most far-reaching reforms to federal laws and regulations since the establishment of the Securities and Exchange Commission (SEC) in 1934.

The most dramatic of these reforms are being achieved through the Sarbanes-Oxley Act of 2002, which was passed by Congress and is being overseen by the SEC.

In theory, the objective for managers of a publicly-traded firm is to maximize shareholder value. The reforms of 2002 established a set of incentives and a monitoring structure for shareholders to make sure that managers put shareholders' interests first, rather than their personal gain.

The concerns leading up to the Sarbanes-Oxley Act and related reforms were outlined in a speech given by President George W. Bush on March 7, 2002, which sets forth a "Ten Point Plan to Improve Corporate Responsibility and Protect America's Shareholders."

As Kroszner explains, the reforms suggested in the plan and embodied in the Sarbanes-Oxley Act are based on three principles of effective corporate governance: 1) accuracy and accessibility of information; 2) management accountability; and 3) auditor independence. These three principles help to insure that shareholders' interests are protected.

Legislative reforms have a long phase-in period. The regulations put forth by the Sarbanes-Oxley Act will not be fully implemented until 2005. In the meantime, Kroszner's study characterizes the potential effects and benefits of the Sarbanes-Oxley Act and other reforms by considering how they implement each of the three principles underlying President Bush's plan for reform.

"The economic principles behind both President Bush's approach and the Sarbanes-Oxley Act were well-motivated," says Kroszner. "We will still have to see whether the specifics of their implementation will pass a cost/benefit analysis once everything is in place."

Principles of Strong Corporate Governance

"Good corporate governance requires a strong board of directors and auditors with independent minds asking tough questions," says Kroszner. "Corporate governance should ideally work like the checks and balances we have on our government."

Securities regulations administered by the SEC supplement both the law and market forces to create incentives for corporate managers to provide timely and accurate information to investors. Typically the information available to investors comes from materials such as a firm's audited annual report and press reports. Investors therefore must have confidence in the accuracy of this information.

The Sarbanes-Oxley Act promotes the principle of accuracy and accessibility of information in several ways. First, the act introduces new disclosure requirements that require directors, officers, and principal investors to reveal transactions in company stock by the second day after a transaction. Faster disclosure makes it easier for outsiders to act on news of insider trading. Financial analysts and auditors also must disclose any potential conflicts of interest.

Second, the Sarbanes-Oxley Act dramatically increases the penalties for violating securities regulations. The act provides for a fourfold increase in the maximum prison term for criminal fraud-to 20 years rather than 5 years-and an even higher maximum term of 25 years for securities fraud. Both of these increases in prison terms are in addition to fines and other nonmonetary sanctions. Recognizing that penalties cannot be imposed without evidence that a violation has occurred, the act also increases the maximum sanction for destroying documents, allowing courts to impose fines and terms of imprisonment of up to 20 years for this offense.

Third, the act creates new rules and institutions to govern managers' and auditors' choices concerning the accuracy and timeliness of corporate financial reporting. The act promotes compliance with existing disclosure rules and strengthens the auditing and documentation procedure to provide greater confidence in the accuracy of the numbers that are reported.

Another underlying principle of recent reforms is emphasis on management accountability, not surprising given the wake of recent allegations of accounting fraud, and the detrimental effects of these fraud cases on shareholders.

Under recent reforms, managers will stand a much greater chance of getting caught when committing financial reporting fraud. The Sarbanes-Oxley Act details several methods for reforming management accountability, including spending more money on enforcing laws against management and auditor misconduct, especially financial reporting violations.

In addition, the government has taken steps to use its enforcement resources more effectively. In July 2002, the Corporate Fraud Task Force was established to better coordinate efforts between the SEC, the Justice Department, and other institutions responsible for detecting misconduct and imposing sanctions. Managers must now clarify wrongdoing within their corporations. Among other changes, the SEC now requires CEOs and CFOs to certify the accuracy and completeness of their companies' financial reports.

The reforms also increase the magnitude of sanctions that managers receive upon detection, and introduce new sanctions for managers who fail to abide by the new rules. For example, the Sarbanes-Oxley Act now makes it a criminal offense, subject to fines up to $1 million, to knowingly engage in the false certification of financial reports.

The final principle underlying recent reforms is auditor independence. It is important to limit auditors' tolerance of false or careless financial reporting from corporate managers and reduce the potential for conflicts of interest.

The Sarbanes-Oxley Act makes it more difficult for managers to play a role in the selection and compensation of outside auditors. A corporation's choice of auditor must now be made by a committee of independent directors who are not employees of the company, and have no relationship with the company other than as directors. The act also requires that accounting firms periodically assign a new audit partner to each client account. The Public Company Accounting Oversight Board has been formed to monitor and enforce the diligent supply of outside audit services. Each public accounting firm must register with the Oversight Board and submit to periodic performance reviews, and must comply with sanctions if the Board discovers misconduct.

Pros and Cons of Shareholder Democracy Reforms

In the "proxy process," individual shareholders vote to elect corporate directors, choose an auditor, and decide other matters through proxy materials sent by mail. Currently, if shareholders want to nominate directors themselves, they must engage in a "proxy fight" by obtaining a list of voting shareholders, sending out their own materials, and soliciting votes.

Recently, the SEC has proposed a rule on director nominations where under "triggering events," certain outside shareholders would be able to propose nominees to the board of directors who would then be on the ballot and included in regular proxy materials. The shareholders that would receive these privileges would be large, long-term shareholders such as pension funds and institutional investors, who have owned a minimum of five percent of shares for at least two years. The idea behind this new proposal is increased shareholder democracy-allowing shareholders to exercise more control over candidates for the board of directors.

The objective of any changes to the rules governing the nomination and election of board members should be to increase shareholder value. Kroszner argues that the potential costs of this shareholder democracy proposal outweigh the benefits. Lowering the cost for significant shareholders to have their nominees included in the company's proxy materials, in certain circumstances, is not an effective way to improve corporate governance, he says.

The proposed rules could increase the cost of the proxy process, and the potential for contested elections might discourage qualified directors from standing for election. Companies also may have to provide greater compensation to attract qualified directors. Contested elections could lead to fragmentation of the board which might disrupt the decision-making process.

"The shareholder democracy proposal is the wrong answer to the right question," says Kroszner. "A better alternative would be to look at existing inappropriate legislative and regulatory barriers (such as those governing pension funds and mutual funds) that prevent large shareholders from playing a meaningful role in many aspects of corporate control. Get rid of the barriers first, rather than layering regulations on top of regulations."

Balancing Public and Private Regulations

"One has to be very wary of overregulation," notes Kroszner. "You don't want to kill the goose that laid the golden egg. The entrepreneurial firm that gets outside capital is a core part of capitalism."

A key issue to consider is the appropriate interaction between public and private efforts to promote strong corporate governance. For example, private-sector exchanges such as the NYSE and NASDAQ require firms to meet listing requirements, including having a majority of independent directors.

The efforts of legislators and regulators may in some instances duplicate private-sector efforts. It will take time to fully document the results of both public and private regulations.

"The Sarbanes-Oxley Act is a broad brush response," says Kroszner. "Many people have been concerned about the associated costs of government regulations, but the private-sector response has gone far beyond what Sarbanes-Oxley requires."

In order to raise capital, firms have to be credible in the market. Even without legislative change, it is likely that the private sector would have generated additional costs in any event via firms being forced to spend more money on auditing and monitoring systems.

"Many of the reforms are private-sector motivated, not just government motivated," says Kroszner. "The relevant benchmark for measuring the cost of the Sarbanes-Oxley Act is not business as usual as of 2001, but what the market would have provided anyway in terms of increased monitoring."


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Randall S. Kroszner is professor of economics at the University of Chicago Graduate School of Business.

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