US company law reform in the wake of Enron

Has the US government overreacted to the corporate scandals of Enron, WorldCom, Global Crossing and like? Is the Sarbanes-Oxley Act, passed in July 2002, an effective antidote to growing corporate dishonesty and a powerful catalyst in restoring investor confidence, or is it another set of overly restrictive rules that will punish most other businesses that have all along abided by the rules? How is the recent American reform looked upon as a model for the rest of the world?

 

For answers to some of these questions, in late October Bulletin spoke to Dr Bin Srinidhi, Associate Professor in CityU's Department of Accountancy and a key member of its Accounting and Corporate Governance Centre. Dr Srinidhi's interest in corporate governance research reflects his diverse background that combines studies of accounting, management and technology. He focuses on, for example, how different facts, such as the increase in knowledge-based assets rather than tangible assets, are creating a greater need for corporate governance to generate credible relationships between investors and managers. Part of Dr Srinidhi's work looks at how generally accepted accounting principles and their implementation interact with corporate governance. He has also written on the effect of changes in legislation on information asymmetry in the US and Canada, and on the effects of "poison pills" (anti-takeover devices) on both the generation and reporting of earnings in US companies. Recently, his research interests have turned to China, where he developed an earning management theory appropriate to the Chinese setting. He has also conducted an empirical study to investigate the impact of such expropriation measures as year-end audits, the external appointment of chief financial officers, and incentive schemes of bonuses and stock options on financial performance.

 

Q: Could we start off with your research interests? And how are they related to the current reforms in the wake of Enron and the Sarbanes-Oxley Act?

A: I'm involved in one project with Professor Ferdinand Gul and Professor Judy Tsui* on the effect of information asymmetry on earnings management. Information asymmetry occurs when managers of a corporation know things that are not known to investors and that's why managers need to report to investors. The higher the degree of information asymmetry the greater is the mistrust of what managers say, and the greater need for vigorous forms of contracting for managers to disclose what they know. The whole idea is to build the confidence level of investors so that they will feel comfortable to invest. As laid down in the Sarbanes-Oxley Act, US regulators in the wake of Enron would require better corporate disclosures but such disclosures are not only on disclosing more things but also on disclosing with greater confidence. That is, corporations should not only disclose more but should also be able to provide more evidence to back it up, so that investors will have more confidence in what has been disclosed. There are certain areas with a greater priority in disclosing, for example, the US has a huge amount of segment disclosures, but there is still a paucity in the areas such as related party transactions. Enron is a case in point. The problem with one bad apple like Enron is that investors will not be able to believe the numbers the managers of other firms are presenting, therefore hurting investors' confidence and the corporations' ability to attract capital financing and funding.

Q:  Where do the demands for corporate governance come from and how do scandals like Enron and WorldCom affect such demands?

A: The demand for corporate governance, according to the economists, comes from two sources: incompleteness of contracts and the legal environment. Incompleteness of contracts means that they cannot deal with all potential eventualities that may happen. For example, I have an employment contract with my employer but it will not be possible to contract with me on every eventuality. What happens if I fall sick for two days? The contract cannot specify explicitly or implicitly what is to be done in every possible situation like this. What my employer or any organization can do is to set up procedures on what to do if such eventualities take place and through such procedures to resolve the eventualities amicably between the two parties-or if not amicably, in a transparent way that is seen by everyone as decently fair. So corporate governance procedures are designed to settle incompleteness of contracts. Secondly, even if the contracts are complete, what is the extent to which the legal system in the country will help to implement these contracts? If it takes every lawsuit five or 10 years to clear, there is not much point in coming into the contract because there is so much delay that one can break the contract with apparent impunity. So confidence in the legal system on implementing the existing contracts is weakened or lost. In that case, corporate governance has to expand to cover some of the areas where the law is weak. Two possible situations can result: the law may be strong but the situation may be leading to incompleteness of contracts; or the law may be weak and one needs additional procedures put in place to take care of the weakness in the legal implementation system. These are the two main demanding forces. On the other hand, the supply of corporate governance comes from the legal, accounting, auditing and managerial systems. The basic issue in corporate governance is to match the demand with the supply.

Q: What are the corporate governance procedures? How did Enron fail?

A: Basically there are a couple of procedures. The first is the accounting procedure, that is, setting the standards-what kinds of standard, who sets the standards, who influences these standards, how does the government plays a role in standards setting? The second procedure is auditing procedure- the audit committee and its constitution, the independence of audit committee, the independence of the auditors from the organization that employs them, the competence of and remuneration for the auditors, the kinds of skills and knowledge auditors bring into the process, the audit quality, quality control of the audit procedure. The third area is management procedure-the internal control system inside the firm with clearly defined managerial responsibility. There are other procedures-does the management system create an environment in which an employee feels intimidated or inhibited to come forward when he or she sees something wrong? Externally, the stock exchange will lay down the rules on shareholders' rights in selecting the board of directors, on how the directors will actually represent the interests of the shareholders and on the skills they bring in, on the nature of the independence of the auditors, etc.

Enron represents a failure on many fronts, but mainly it is a failure of the management system, that is, the lack of a vigorous internal control system within the company. It also signifies a failure of the auditing system, on the part of Arthur Andersen, the auditing firm. Even though Andersen had the competence, they probably did not have enough independence. Enron is one of the many cases audited by Arthur Andersen that have had problems, such as Global Crossing.

Q: So, is the latest round of US reform in company law on the right track to address these failures?

A: In terms of the reforms, naturally, the answer shifts back to the auditing and regulations systems and the system of how and what the stock exchange should demand from the firms for their listing. There are two ways to look at this: to treat them as individual failures with lessons not necessarily requiring wholescale change; or as a complete failure in the overall system, representing some malaise in the core.

The US government seems to be treating it as a system failure. The extent to which the Sarbanes-Oxley Act, at least in the first reading, seems to be an overreaction. This act is meant to be a company law reform act and we should be very cautious about the cost and benefit of regulation. When the government brings in an act to make managers afraid of managing companies, even though most of them are honest, then this is a problem because it reduces efficiency and directly affects US corporations, in a bad way. As a manager, one must have some freedom to manage. One must take care of the illness without killing oneself, but still retain life. I think the law (the Sarbanes-Oxley Act) is over-prescriptive. Take for example, the auditing part-the act looks at audit committees and requires all members to be independent. If the members are not, one has to specify who are not independent. In terms of the auditors themselves, the law prohibits them from undertaking non-audit work. A firm can have PricewaterhouseCoopers doing the audit, for example, and Peat Marwick doing the non-audit work. This will create problems in the economy, for if auditors find non-auditing services more profitable, then they would rather take up the non-auditing work than the audit services.* The law ignores the fact that because the auditors know so much about the corporation, the cost of doing non-auditing work will be less.

Coming to the management system, the act is very harsh, too. It requires the CEO and CFO to certify the financial statement on a quarterly basis. It also requires the CEO and CFO to certify the existence of an internal control system; it demands that they certify that they have personally reviewed such a system within the previous 90 days. Any false certification is a criminal act, and clearly this sounds over-prescriptive to me because a CEO should balance the emphasis he gives to internal control with strategy, marketing and a whole lot of other important issues as well.

More disclosure seems to be fine, but this act requires the Securities and Exchange Commission (SEC ) to review the disclosures made by public companies at least once every three years. Considering the number of companies listed with the SEC, it would require a huge number of people and organizational resources to do this. It certainly looks like a little bit over-regulation in this respect.

Q: What about the proposal to set up a new regulatory board to oversee the accounting industry?

A: Setting up the Public Company Accounting Oversight Board seems to be a reasonable idea, given the failure of Arthur Andersen. The tragedy here is that the concept of the industry's self-regulation is giving way to public oversight which could eventually become bureaucratic, inefficient and even corrupt. Still, for the time being, it looks like the lesser of two evils. The SEC is to set up the board to oversee the accounting profession and to have two members with accounting background and others with a non-accounting background. The board will oversee all public accounting firms, and review and establish quality control procedures. However, the act makes no distinction between domestic and foreign companies. Any company listed in the US is subject to this act, whether it is a US or foreign company, which means that a US company operating in Hong Kong, for example, is clearly subject to this act too, and subject to SEC triennial review as well. So whatever happens to the US company in Hong Kong will be subject to review by the SEC at home as well as the public company accounting oversight board, which will oversee the auditing procedure. To some extent, the Hong Kong Society of Accountants says it looks like an intrusion by the US into other countries. It also undermines the principle of a level playing field. Clearly, under this act, US companies will be subject to more stringent regulations as compared to their competitors, and this may constitute a competitive disadvantage to US companies around the world.

There are both good things and bad things in the act. More disclosure requirements, greater auditor's independence-these are reasonable and good things. On the other hand, restrictions placed on management-what has happened is that Enron and WorldCom have created the impression that most management is dishonest and have to controlled like criminals-I think that is the last thing to do.

Q: Do you see, on the heels of such company law reform, that the American corporate governance model is moving towards a European model?

A: The culture is different. The objective of the Anglo-American accounting system in the UK and the US is oriented towards investors, and until most recently most of the European system was oriented towards banks and creditors. The difference is that equity investors are more interested in the growth of the company whereas creditors are more interested in risk aversion than the growth of the company. One can see in the US companies that there are more incentives for growth, but there is greater incentive for lowering of risk in Europe. The Europeans are more hierarchical and more formalized in their management system. That's good for control but not for creativity and growth, so it's a trade- off. I don't think the US should copy Europe, they should not move to the lower risk model. They should not become formalized at the expense of creativity.

Q: Under the effect of the Sarbanes-Oxley Act, do you see the US GAAP (Generally Accepted Accounting Practices) moving towards IAS (International Accounting Standards) for the a greater harmonization of accounting standards?

A: Independent of Enron, there is a greater movement in the world towards the US system. The IAS has moved a lot towards the US model. There have been two competing forces in play: the force of globalization (the increasing movement of capital and trade, organizations like IMF helping in some way to spread the US way of doing business), and the force of localization that opposes globalization. Yet overall, the forces of globalization are too strong to be held back.

The European model has focused a lot on creditors and banks. Globalization has increased so much over the last decade that there is greater movement of equity capital around the world, so it means that they have to come up with a system more in line with the interests of equity investors, so international accounting standards have evolved with the US GAAP in mind. There is, in fact, very little difference between the US GAAP and the IAS but the difference between the IAS and old European models like the German system is huge. It takes a bigger leap for the European model to move away from the German model towards the IAS than for the IAS to move towards the US GAAP. But it doesn't end there; even if accounting standards are harmonized, it doesn't mean that corporate governance systems are going to be harmonized. We need to look at the auditing system, the quality control of auditors, the competence of auditors and their independence, management systems and the cultural aspects. I don't see how these things are going to be harmonized in the near future, but with increasing globalization, a movement towards bringing systems together is inevitable. The way these come together is to facilitate greater flow of capital and the creation of greater confidence among investors. Basically, it looks as if the US model is being applied more widely in a global context.

Q: Many critics take issue at stock options being used as an incentive to motivate directors and managers in the US enterprise model. Do you see any way around this thorny problem?

A: In the US model, stock options are a means to align the motivation of managers with the interests of shareholders. The notion that Enron and WorldCom is an obvious breakdown in this link I would partly agree and disagree with: the basic incentive of that system has not broken down, what has broken down in Enron is the regulation and disclosure and the ability to build confidence. So, that doesn't mean that the incentive system is bad. Without a proper incentive system, we could not have sufficient growth. It is very important to distinguish what failed and what did not. There is a great deal of creativity in the US because of the incentive system. The boom in economy and technology of the last 20 years can be attributed in a significant way to recognition of the need for incentives. Incentives need not be only in the form of stock options, they can come in many different forms. But to say that providing the incentive has created the problem is absurd. Enron and WorldCom represent just individual cases, and they might not be the central malaise in the whole system. The problem really is Enron has many kinds of transactions, which are not completely understood and could not be properly disclosed. If stock options are treated as expenses, then there will be less willingness on the part of the corporations to mete out stock options, thus reducing the incentives and propensity to growth. You have to strike a balance; the idea of stock options is still a good one and the idea of incentives is an important one.

Q: So, what is your main criticism of the latest round of company law reform in the United States, expressed mainly in the Sarbanes-Oxley Act?

A: I think we should let the market do the job, and there should be a proper balance between market force and regulatory mechanism. Lately, the pendulum has swung a bit. Regulations are basically of two types: one on information, the other on those on the actual operations of the corporation. Regulating the flow of information usually means an increase in the amount of information flow, forcing corporations to disclose more information to the shareholders and the public. This actually results in higher efficiency in the market, so regulation of information is not that bad. Regulation of information is very different from regulation of actions. There is a tendency to simplify things or overdo it, to sweep everything with the same brush. If you try to regulate what firms do, it may not be very good for the economy. The Sarbanes-Oxley Act both regulates the information as well as how directors manage. I am happy with the information side, such as, additional disclosure, providing more information, auditors' independence, which will likely increase investor confidence, but at the same time, I'm concerned that putting too many restrictions on managers and on how they manage their firms is going to stifle growth potential.

Q: What is the impact of the US corporate governance reform on other countries? Do you see Asian and European countries following the lead set by the US and setting up better corporate governance mechanisms?

A: I think whatever is done in the US will have a major impact on other countries. At a basic level, there are many US corporations operating throughout the world, such as GE, IBM and Microsoft. If they are affected by this (Sarbanes-Oxley) Act, it looks to me that the countries in which they operate are also going to be affected, because of the high level of interconnectivity today, the flow of capital from Japan to the US and from Europe and the US. Do I see a backlash against the trend? I believe countries they will be affected, but I do not believe they will follow the US lead. I actually think the reactions will be balanced, the reactions come not only from other countries but also from within the US, which will move to reduce some of the harsh language in the Act. In time they will find the right kind of balance between regulating the disclosure and flow of information on one hand and from regulating the actual actions, on the other. We'll reach a better balance over time.

 

* Professor Gul is currently Head of CityU's Department of Accountancy and Director of Accounting and Corporate Governance Centre while Professor Judy Tsui, a former head of the department is, is now Dean of the faculty of Business and Information Systems at the Hong Kong Polytechnic University.