Corporate governance: Sarbanes-Oxley Act, related legal issues, and global comparisons.

• Author: Holcomb, John M.

"I don't sense an enthusiastic pursuit of the fundamental principles of corporate governance even today.... I see a reluctant minimalist approach, staying one step ahead of the regulators more than anything else.... I am trying to find my own way in getting a stronger board and stronger shareholder involvement on the issues.... If you're not utterly insensitive to matters, you have to agree that shareholders are getting more active and restless. They want more say." (1)

When even a leading corporate CEO such as Andrew Grove is skeptical of the system of corporate governance in place today at most corporations, there is a real problem. Many of the corporate scandals of the past two years come back to the deficiencies in corporate governance. At Enron and other companies, the focus was on the failure of the audit committee of the board of directors. At Tyco and WorldCom, the focus was on the willingness of the board to approve lavish loans and compensation for the CEO and other top officers. At other companies, the focus has been on both the structure and composition of the board, and particularly on its lack of independence. We should remember, however, that in terms of independence, some consider the Enron board to have been a model board of directors.

HISTORICAL EVOLUTION

Reform of corporate governance is not a new issue. It is now simply a more compelling and urgent issue, perhaps because adequate responses were not forthcoming earlier. Ever since the 1970s, there has been a concern about the independence of the board. Irving Shapiro, then CEO of DuPont, was one of the leading spokespersons for greater board independence and for an infusion of independent outside directors. Diversity on the board became an issue as well in the 1970s, partially in response to the civil rights era and to issues of minority and women's rights. These were modest suggestions at the time, in contrast to Ralph Nader's more aggressive call for federal chartering of corporations. In the 1976 book Taming the Giant Corporation, he and Joel Seligman criticized the lenient governance standards imposed on corporations through the state chartering mechanism, especially for those major companies chartered in the state of Delaware. (2) They proposed instead that corporations be chartered by the federal government and that every corporation with over $700 million in assets have a board of nine members, representing various corporate constituents, including workers, consumers, suppliers, environmental advocates, and community members. (3)

That proposal strikes at the heart of the ongoing debate over corporate governance--to whom should corporations be ultimately accountable, shareholders or stakeholders? The classical corporate model or ownership model would answer "shareholders." (4) The more modern theory would answer "stakeholders." (5) Some claim that is more consistent with the managerial model of most large corporations, though others claim the managerial model has degenerated into a form that elevates managerial self-interest and executive ego over the interests of any stakeholders. (6) The separation of ownership and management characteristic of the large modern enterprise analyzed by Adolph Berle and Gardiner Means in the classic work The American Corporation and a large body of literature on the issue, has spawned a governance trap. (7) With no real consensus on the accountability model of the corporation, there is much confusion and disagreement over just how it should be governed.

The need for a committee structure on the board became a prominent issue in the 1970s as well. (8) With the scandal over inappropriate payments to foreign government officials in the early 1970s and the subsequent passage of the Foreign Corrupt Practices Act in 1977, the requirement that corporate boards have an audit committee became a legal requirement. (9) Corporate public policy or public responsibility committees became more common among Fortune 500 companies at the time as well. (10) In response to a shareholder resolution that Ralph Nader filed against General Motors as part of his Campaign GM, requesting that the company form such committee, the company did so. (11) A few years thereafter, a survey by the Conference Board found that over a hundred companies had formed such board committees. (12)

Beyond audit and public policy committees, the gradual formation of nominating and compensation committees also followed over time. Nominating committees were a response to the need to both diversify boards and to identify outside directors not beholden to CEOs. (13) Compensation committees were a response to the need for a check and independent voice on decisions over executive compensation, and they have assumed an even larger significance with the rising controversy over CEO compensation. (14) The latter issue is examined in another section of this article, but it is inextricably tied to the issue of corporate governance. In fact, some see it as the major unresolved issue of corporate accountability and credibility, even with the Sarbanes-Oxley law and other recent reforms. (15) In terms of public perception and corporate image, it leaves a more indelible impression on the public than any other issue, it also goes beyond corporate accountability and is symbolic of the issue of social justice that heavily resonates with a large portion of the public.

Duties of Directors

Beyond the structure and composition of the board, the legal duties of the directors have also become more stringent over time. Historically, good-faith errors in judgment by board members enjoyed the defense of the business judgment rule, a rather permissive rule that prompted a court to defer to business judgment rather than substitute its own. The Delaware Chancery Court issued many decisions providing for a wide expanse of managerial prerogative. (16) Over time, however, even the Delaware courts have begun to demand more in the way of due care and diligence, informed decision-making, and independent judgment by corporate directors, through such decisions as Smith v. Van Gorkum. (17) Regarding board member independence, there is one major point of legal vulnerability for many current board members and that is potential conflicts of interest they might have as insiders or quasi-insiders.

Board-Management Relations

In the midst of rising concerns over CEO compensation and with the greater role now being played by outside directors, evidence exists that boards are being tougher in holding CEOs accountable. (18) In their annual survey of CEO turnover, Booz Allen Hamilton experts have found that performance-related turnover reached a record high in 2002. (19) It constituted 39 percent of all CEO successions, including those who voluntarily retired and merger-related turnovers. (20) The highest rates of performance-related turnover were in the information technology, telecommunications services, and consumer discretionary industries. (21) The most impressive finding is that the "return gap"--the difference in the total shareholder return between a company's return and the total market return for voluntarily retired and fired CEOs--declined to 6.2 in 2002 from 13.5 in 2000 and 11.9 in 2001. (22) This demonstrates that boards are now judging CEOs more harshly and that forced dismissals took place for underperformance that earlier would have been tolerated.

Despite the renewed assertiveness of some boards, the examples of recent board failures are many. Most often, those failures have been due to inattention rather than lack of independence, although there is sometimes a mixture of the two. The Freddie Mac case is an instructive one. (23) A series of interviews related to the Freddie Mac accounting issues "shows a board whose members struggled, and sometimes hesitated, to take tough action against top executives they had known and respected for years." (24) The board's audit committee finally hired former SEC General Counsel James Doty to conduct an investigation, later broadening that investigation and requesting a report to the full board. (25) The firm's auditor, PricewaterhouseCoopers (PwC), refused to accept representations from Freddie Mac's president and chief operating officer, and Doty found pages deleted from the COO's diary that may have shown his direct involvement in the accounting problems related to over one trillion dollars of derivatives and an effort to hide fluctuating earnings and create an impression of smooth earnings growth over time. (26) The board, initially wanting the COO to resign, only then decided it must fire him, and forced out the CEO and chief financial officer as well. (27) While Doty's report "largely absolves the board," saying that management withheld key information from the board, other finance experts believe the report is too soft on the board, that the board "should have been more aggressive, asked more questions and relied less on what officials were telling them." (28) The Economist found the following as key features of the Freddie Mac crisis: "missing documents; lavish executive pay; uncooperative directors; and indications that Freddie Mac's reported figures are wrong, and its internal controls are in chaos." (29)

Subsequent to forcing out the three top officers, the board then promoted the chief investment officer to be president and CEO. (30) However, the Doty report directly implicates him as well in circumventing new derivatives accounting rules and even in dividing the derivatives transactions so they would not have to be disclosed to the board. One business reporter therefore concludes, "Restoring Freddie's credibility ought to mean getting rid of everybody involved--up to and including the board of directors." (31) The Doty report found that the tone of the organization and goal of attaining smooth reporting earnings for "steady Freddie" was set at the top. (32) Another report concludes:

The convoluted strategies Freddie...