Corporate Governance in US: Impact of SOX
The Sarbanes–Oxley Act of 2002 (enacted July 30, 2002), also known as the 'Public Company Accounting Reform and Investor Protection Act' (in the Senate) and 'Corporate and Auditing Accountability and Responsibility Act' (in the House) and commonly called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002, which set new or enhanced standards for all U.S. public company boards, management and public accounting firms. It is named after sponsors U.S. Senator Paul Sarbanes and U.S. Representative Michael G. Oxley.
The Sarbanes-Oxley Act (SOX) mandated strict reforms to improve financial disclosures from corporations and prevent accounting fraud. SOX was enacted in response to the accounting scandals in the early 2000s. Scandals such as Enron, Tyco, and WorldCom shook investor confidence in financial statements and required an overhaul of regulatory standards.
This term paper will examine the impact of SOX in terms of
Benefits to firms and investors
Effects on exchange listing choice of non-US companies
Compliance cost to the companies in terms of higher disclosures
Effect on the executive compensation in US
This paper will also look into the criticism of the act and examine whether the act has indeed made any effect on the corporate governance structure of the US corporations or has driven them out to off shore locations which require far less disclosure.
Named after Senator Paul Sarbanes and Representative Michael Oxley, who were its main architects, the Sarbanes-Oxley Act introduced in 2002 seeks to address the precipitous loss of investor retail & institutional confidence in the U.S. capital markets. This loss of confidence by investors was the result of the corporate implosions and financial scandals that had taken place in the U.S. during the several months of 2001 and 2002 when their where high profile accounting scandals like Enron, WorldCom, Tyco, Global Crossing and many more costing billions of dollars of loss to investors.
The fundamental regulatory objectives behind the Sarbanes-Oxley Act are threefold
Protection of investors
Maintenance of market integrity, liquidity and transparency
Promotion of capital formation
These regulatory objectives are based on three core principles
Accurate and accessible information
This is the most important securities legislation affecting U.S. public companies since the U.S. Securities and Exchange Commission was formed in 1934. The reforms in the Sarbanes-Oxley Act are broad ranging, including provisions affecting corporate governance, disclosures by public companies, and the governance of the accounting profession and enhanced criminal penalties for securities fraud.
Legal provisions and mandatory disclosures
The Sarbanes-Oxley Act is arranged into eleven titles that describe specific mandates and requirements for financial reporting. Each title consists of several sections, summarized below.
Public Company Accounting Oversight Board (PCAOB)
This section establishes the Public Company Accounting Oversight Board, to provide independent oversight of public accounting firms providing audit services ("auditors"). It also creates a central oversight board tasked with registering auditors, defining the specific processes and procedures for compliance audits, inspecting and policing conduct and quality control, and enforcing compliance with the specific mandates of SOX.
This section establishes standards for external auditor independence, to limit conflicts of interest. It also addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients.
This section mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports. It enumerates specific limits on the behaviours of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance. For example, Section 302 requires that the company's "principal officers" (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly.
Enhanced Financial Disclosures
It describes enhanced reporting requirements for financial transactions, including off-balance-sheet transactions, pro-forma figures and stock transactions of corporate officers. It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls. It also requires timely reporting of material changes in financial condition and specific enhanced reviews by the SEC or its agents of corporate reports.
Analyst Conflicts of Interest
Title V consists of only one section, which includes measures designed to help restore investor confidence in the reporting of securities analysts. It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest.
Commission Resources and Authority
This section defines practices to restore investor confidence in securities analysts. It also defines the SEC’s authority to censure or bar securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer.
Studies and Reports
This section requires the Comptroller General and the SEC to perform various studies and report their findings. Studies and reports include the effects of consolidation of public accounting firms, the role of credit rating agencies in the operation of securities markets, securities violations and enforcement actions, and whether investment banks assisted Enron, Global Crossing and others to manipulate earnings and obfuscate true financial conditions.
Corporate and Criminal Fraud Accountability
This section is also referred to as the “Corporate and Criminal Fraud Accountability Act of 2002”. It describes specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations, while providing certain protections for whistle-blowers.
White Collar Crime Penalty Enhancement
This section is also called the “White Collar Crime Penalty Enhancement Act of 2002.” This section increases the criminal penalties associated with white-collar crimes and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.
Corporate Tax Returns
This Section states that the Chief Executive Officer should sign the company tax return.
Corporate Fraud Accountability
This Section recommends a name for this title as “Corporate Fraud Accountability Act of 2002”. It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties. This enables the SEC to resort to temporarily freezing transactions or payments that have been deemed "large" or "unusual".
The Act provides for increased criminal penalties for a broad range of white-collar crimes and an increase in the statute of limitations for securities fraud lawsuits. The statute of limitations for private rights of action with respect to securities fraud is extended to the earlier of two years after the discovery of facts constituting the violation or five years after the violation.
Section 802 deals with the punitive measures of SoX. The Act provides for criminal penalties only for knowing or willful violations of this provision. A knowing violation by a CEO or CFO of this certification requirement is punishable by a fine of up to 1 million U.S. dollars and imprisonment for up to 10 years, a willful violation raises the maximum fine to 5 million U.S. dollars and imprisonment to 20 years.
For the protection of whistle blower policy the maximum mandated sentence is 10 years.
In the event of accounting re statement by the company due to material noncompliance of the company, as a result of misconduct, with any financial reporting requirement under the securities laws, Forfeiture by CEO and CFO of Bonuses and Share Trading Profits is mandated.
The act has shortened the duration related party transaction or insider trading could be reported to 2 days. Prohibition on Insider Trades During Pension Fund Blackout Periods The Act prohibits executive officers and directors from purchasing or selling equity securities of the company during certain black-out periods, as defined in the Act, imposed on a company individual account plan
The act also prohibits loans to Executives and directors of the company by company.
Corporate Governance before SoX and irregularities, creative accounting
Corporate governance in US before was ruled by host of different regulations. Like disclosure for the publicly listed companies were governed by the regulation of SEC. While the performance of the board of directors was governed by the duty specified like duty of loyalty, competence and some other non-fiduciary duties.
However one of the difference form SoX to previous regime was lesser severity of punishment for white collar crime and non-direct culpability of CEO,CFO with misappropriation and fraud. This lead to spate of financial frauds in the year of 2001 and 2002.
One of the biggest frauds in US corporate history is the Enron scandal, revealed in October 2001, which eventually led to the bankruptcy of the Enron Corporation, an energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was attributed as the biggest audit failure.
Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives that, through the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives not only misled Enron's board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues.
Shareholders lost nearly $11 billion when Enron's stock price, which hit a high of US$90 per share in mid-2000, plummeted to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynegy offered to purchase the company at a fire sale price. The deal fell through, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom's bankruptcy the following year.
Prevailing CG practices in US before SOX
Earlier in the US executive compensation were marked by excessive compensation which was unrelated with the performance, leading to agency problem with the shareholders.
For Example Disney President Michael Ovitz was paid over $ 130 million in severance package for tenure lasting less than 2 years. The compensation was in form of cash, stock options and soft loans.
Such excess were aplenty in the US corporates moreover the CEO, Presidents treated company as personal piggy bank by taking out soft loans, making company pick tab for their parties, holidays and in many cases pay for charities in their name.
Like Conard Black who was Chairman of Hollinger Inc. used to take money from his company and pay for his trysts, charities.
Earlier in USA, board obligations and responsibilities are established by the business judgement rule stipulates that “directors make their decisions on an informed basis, in ‘good faith’ .... and that directors be disinterested and independent4”. To make this concept operational, legal precedent has created the concepts of ‘duty of care’, and ‘duty of loyalty’.
These rules have not changed significantly after SOX though the scrutiny by board over the performance of the executives have increased manifold. No longer is the board considered to be weak and bending to the whims and fancy of Chairman/CEO. There has been increase in number of CEO being forced out of their position for non-performance.
For Example: Carly Fiorina of HP was forced out by the board in 2005 for lack lustre performance of HP under her aegis.
CEO position was much vaunted position in the US in earlier era which continued upto 2000’s. Not anymore as more and more CEO are now being forced out for poor performance and non-compliance with company’s charter or law. Such behaviour though not directly attributed to SOX but it has added the onus of the accuracy of the financial statements and integrity in cases of insider trading on CEO/Chairman adding to the pressures of the job.
Impact of Sarbanes-Oxley act
Sarbanes-Oxley act was drafted as a reaction to complex accounting practices which were exploited by the management of the many companies for their benefits in perpetuating fraud. Hence the primary focus of SOX was on correct reporting of the financials by the companies and putting that onus on the management of the company. Two direct impact of the SOX regulation were on accounting restatements of the companies and the executive compensation in the form of the options granted to the managers.
Due to greater amount of control of Sarbanes –Oxley act experts opined that the accounting restatements would go up in short to middle term and then level off.
According to the GAO (General Accounting Office USA) the number of companies announcing financial restatements from 2002 through September 2005 rose from 3.7 % to 6.8 %, restatement announcements identified grew about 67 % over this period.
Source: General Accounting Office USA, Report to the Ranking Minority Member, Committee on Banking, Housing, and Urban Affairs, U.S. Senate
Of the restatements identified, cost- or expense-related issues were the primary reason for restatements during this period and most were prompted by internal parties, such as management or internal auditors. Many industry experts and observers commented that increased restatements were the expected by-product of the greater focus—by company management, audit committees, external auditors, and regulators—on the quality of financial reporting prompted by SOX regulations.
The cumulative totals were 919 restatements over a 66-month period that ended June 30, 2002, and 1,390 restatements over the 39-month period that ended September 30, 2005. Over the period of January 1, 2002, through September 30, 2005, the total number of restating companies (1,084) represents 16 % of the average number of listed companies from 2002 to 2005, as compared to almost 8 % during the 1997-2001 period. The median size (by market capitalization) of restating companies increased from $277 million in 2002 to $682 million in 2005.
Some trends which were found by the GAO were
Cost- or expense-related reasons accounted for 35 % of the restatements
Most restatements (58 %) were prompted by an internal party such as management or internal auditors
These results are consistent with the impact of the SOX which was anticipated by industry observers.
Moreover the restatements did not adversely affect the stock price of the company which fell by average 2 % after the announcement.
Impact on executive compensation
Disclosure requirement imposed by Sarbanes Oxley act states that executive option grants be reported to the Securities and Exchange Commission (SEC) within two-business days of the grant date and investigate if the requirement has mitigated the stock price influencing behaviour of executives.
The suggestion that executives influence grant-date stock price is based on the well documented evidence that post-grant-date stock returns are, on average, significantly positive ((Yermack (1997), Aboody and Kasznik (2000), Chauvin and Shenoy (2000), and Lie (2005)).This evidence is viewed as consistent with influencing the grant date stock price to obtain stock options at lower exercise prices since the exercise price is usually set at the stock price on the grant date. Charges of stock price influencing have appeared in the popular press as well.
Such strict disclosure requirement has mitigated the tendency by executives to manipulate the stock price or information to benefit them from the grant of the options.
Two of the major ways to achieve significant returns on granted options used by executives were
Timing- Executives could time negative news about company to depress the stock price in short term and delaying positive news till after the grant making their options attractive
Back Dating- some managers might select the grant date as a date in the recent past at which the stock price was lower than that on the day they actually made the compensation decision
The two-day reporting requirement imposed by SOX makes it impossible to materially boost the value of the option grant through back-dating without appearing to violate the reporting requirement. This is because if options are backdated by more than two days, it will appear as if the grants are being reported late.
This has been validated by the research ((Narayanan and Seyhun (2005)) which further suggests that enforcing the disclosure requirement of SOX that require reporting of option grants within two business days of the grant date, and limiting the number of unscheduled awards can significantly reduce the ability to boost the value of option grants either through timing or through back-dating.
Over the past few years there has been a lot of concern that the US has become less competitive in attracting listings by foreign firm (Zingales 2007). A popular explanation is that the Sarbanes-Oxley Act of 2002 (SOX) has made it more costly for foreign firms to be listed in USA securities market ,more so it is argued by many researchers and popular press articles that fewer foreign firms now choose to cross-list in the US and firms already listed want to leave US equity markets.
Foreign firms or companies that list on US exchanges, such as the NYSE and NASDAQ, have to register with the Securities and Exchange Commission. Thus as result, are subject to US securities laws since 2002, these firms have also been subject to Sarbanes-Oxley.
Such increased scrutiny combined with increased cost to maintain the level of control mandated by SOX has impelled many companies to leave US securities market. However the research by many scholars have proved that the companies leaving US where on account of poor performance over many years and cannot be attributed on SOX.
For Example Ensco International the largest offshore jack-up oil and gas well drilling corporation in the world decided to move its headquarters from Dallas to London and became London listed company in 2009. Part of the move is said to be inspired by more lax regulations in reporting in London.
Effect on the listed equities on US securities market
According to research by (Xi Li (2003))  cross listed foreign private issuers who were impacted by the SOX act faced returns of -10% on the subsequent passing of the act while the issues which remain unaffected by the act didn’t had any negative return.
Such results have been corroborated by many independent studies which concludes in SOX was responsible for average -12% market return on the US securities market.
Number of foreign IPO listing on US Security market
Numbers of committees were formed to study the impact of the SOX on IPO listing of foreign firms in the US securities markets. One of them was Capital Markets Committee; Capital Markets Committee report presents data which indicates that the competitive position of U.S capital markets had significantly eroded: a decline in foreign company initial public offerings (IPOs), an increase in foreign firms’ private equity issues, an increase in domestic-going-private transactions and in venture capital exits by private sales rather than IPOs, and a decline in the listing premium for cross-listed foreign firms.
According to (Zingales 2007) while in the late 1990s the U.S. capital market was attracting 48% of all the global IPOs (global IPO are defined as IPO by company after they have gone public in their home market), its share has dropped to 6% in 2005 and is estimated to be only 8% in 2006. Even more surprisingly, in recent years some U.S. companies choose to list in London rather than in the United States.
Preference of USA as raising capital among firms
Another study was commissioned by New York Senator Charles Schumer and Mayor Michael Bloomberg to study the competitiveness of the New York vis-à-vis other foreign financial hubs of the world like London. The study was conducted by global consulting major McKinsey & Co.
McKinsey surveyed executive, investor, consumer, and labour group representatives, and experts in the regulatory, legal, and accounting professions in New York and in other major global financial centres. The McKinsey Study corroborated the Capital Markets Committee report’s diagnosis of the problem: it reviewed data indicating declining U.S. capital market competitiveness and highlighted SOX and litigation as threatening New York City’s pre-eminence as a financial centre.
The benefits of the Sarbanes–Oxley act are by their nature difficult to isolate as more of it is in intangible in nature, which doesn’t mean they aren’t real or substantial. Given the corporate scandals of the early 2000s, and the awareness of this behaviour by investors and other market participants, the chances are good that public and private enforcement and manager behaviour would have changed even had Sarbanes–Oxley not been enacted. The problems of estimating the effects of this legislation are not unusual or unique to SOX , but they may be more severe than is typical. Many studies of SOX find results consistent with intuitive hypotheses regarding likely effects, but most studies are unable to reject alternative hypotheses that other events caused those effects, and most studies report effects consistent with both positive and negative evaluations of the law’s core provisions.
The disclosures mandated by Sarbanes–Oxley appear to be valued by investors and the investor confidence increased after the passage of the Sarbanes-Oxley Act. Moreover Company choosing to go in dark i.e. stop reporting to SEC but continue trading were punished hugely on the market with their reluctance to conform to SOX taken as weakness in the forecast of earnings and growth prospects.
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