by Scott Green*
The agents and gatekeepers of our public companies serve an important role in the capitalist system. At the
most basic level, they are the appointed guardians of a stockholder’s invested capital. The agents are our
boards of directors and executive management of our public companies and the gatekeepers are the
regulators, accountants, the lawyers, and even the financial analysts whose opinions we rely on when
investing capital. The near simultaneous implosion of Enron, WorldCom, Global Crossing and Adelphia
Communications together with the management hijinks at Tyco, HealthSouth and Imclone, among others, led
to a public crisis of confidence in our nation’s financial markets in 2001 and 2002. The vast majority of
agents and gatekeepers are honest, hard working people who want to do the right thing. However, this
tsunami of corruption threatened to sweep up the good with the bad in its destructive path. By the summer of
2002, restoring public confidence in our markets became paramount.
Congress responded to this crisis by passing the Sarbanes-Oxley Act (“SOX”) of 2002. The impact of this
legislation was significant and immediate. A survey released in March 2003 by PricewaterhouseCoopers
(PWC) found that the Act had already resulted in changes to auditing controls and compliance at 84% of
United States multi-national corporations. The Act expanded the regulatory oversight and guidance for
auditors, lawyers, and analysts as well as addressed many of the structural corporate reforms necessary
through interpreting rules issued by the Securities and Exchange Commission (the “SEC”) and a new set of
listing standards by the New York Stock Exchange (“NYSE”) and the National Association of Securities
Dealers (“NASD”). As is common with legislation impacting the financial markets, the Act provides an
overall framework for regulating the markets, while leaving detailed oversight to the SEC. The SEC in turn
allows the self-regulatory organizations (NYSE and NASD) to draft and implement detailed rules that
address the requirements of the Act as well as SEC requirements.
This article will review the more significant roles which certain agents and gatekeepers played in contributing
to the crisis of confidence leading up to the Sarbanes-Oxley Act and how the Act addressed these actions.
Specifically, the article will examine the Act’s response to related party transactions, financial reporting
management, excessive executive compensation, executive stock trading, and poor culture that led to the
current crisis as well as to the failings of our auditors, lawyers and analysts as gatekeepers. The article will
also briefly evaluate the limitations of the Act going forward. Additionally, it will examine the Act’s impact on
international companies and foreign governments. Finally, this article will analyze potential future
consequences of the Act along with providing recommendations on its implementation.
Related Party Transactions at Enron and Adelphia Communications
As defined in the Act, a “conflict of interest occurs when an individual’s private interest interferes in any way-
or even appears to interfere- with the interests of the corporation as a whole.” Such arrangements might
benefit the company and may not be detrimental per se. Where conflicts arise, they must be well
communicated, managed, and subjected to detailed and unimpeachable oversight to ensure that stockholders
benefit from doing business with the related party. This is easier said than done. Related-party transactions
are numerous and widespread. A recent survey conducted by the Wall Street Journal that evaluated over
four hundred of the nation’s largest public companies revealed that “some 300 of those companies reported
one or more related party transactions . . . many of these transactions involved millions of dollars.”
At Enron, Andrew Fastow, the Chief Financial Officer (the “CFO”), managed the creation of off-balance
sheet entities with the effect of creating an unrealistic picture of financial health for the company. In certain
instances, the CFO was also responsible for managing the off-balance sheet vehicles in which he had a
financial interest. This insider dealing resulted in the collapse of one of the world’s largest corporations. An
investigation by Enron’s Board of Directors found:
These partnerships . . . were used by Enron management to enter into transactions that it could not, or would
not, do with unrelated commercial entities. Many of the most significant transactions apparently were
designed to accomplish favorable financial statement results, not to achieve bona fide economic objectives or
to transfer risk.
—Excerpt from the Report of Investigation by the Board of Directors of Enron Corporation (Powers
Report)
In 1997, the CFO began creating Special Purpose Entities (“SPEs”) to hold assets and provide the
appearance of creating legitimate financing transactions. SPEs can be very effective financing and risk
management vehicles if used properly. A parent company’s debt level or other risk factors can hinder the
capability of a strong business segment to obtain favorable interest rates to finance its operations. In such a
situation, the parent can create an SPE and transfer the asset to it with the goal of receiving more favorable
lending rates. As long as there is another independent third party investor that has contributed at least 3% of
the assets, the SPE does not have to be consolidated into the parent for financial reporting purposes.
Furthermore, if the assets in the SPE are of high quality, banks will lend to the entity at lower lending rates
than could be received by the originating company. The SPE will then use this money to pay the parent for
the asset received. The bottom line is that the company obtains the money it requires, but pays less to obtain
it than would otherwise be the case.
However, Enron ran out of quality assets to transfer, so inferior assets were reassigned and Enron stock
pledged as a guarantee of payment to the banks. And who did Enron find to be that 3% investor in the
SPEs? The CFO, through a partnership called LJM, among others. But why would he want to invest in
poor quality assets? Because the fees Enron paid LJM for managing up the transaction eliminated his risk in
these vehicles. He effectively cashed out; so while he was an investor on paper, he really had no downside
risk.
Enron’s Board contained a former accounting professor, the former executives of an insurance company and
a bank, the former head of the Commodity Futures Trading Commission and a hedge fund manager. Enron’
s financial transactions were confusing even to this highly knowledgeable Board. What was clear is that the
Board did waive their conflict of interest rules to allow these transactions to take place. The Board’s
responsibility to understand these transactions is paramount where related parties are involved. They must
ensure that the transactions are in the best interests of the company and its shareholders.
Enron was not the only company that had material related party transactions that brought down the
company. Conflicts of interest can be among the most damaging control weaknesses absorbed by a
company, particularly if they occur between the company and its founder. The Rigas family allegedly
borrowed more than $3 billion using the assets of Adelphia Communications, a company they founded.
Additionally, the company created a Rigas-run investment firm, helped purchase the National Hockey
League’s (NHL’s) Buffalo Sabres and built a golf course on Rigas-owned land. To compound matters, the
Rigas debt was not presented or disclosed in Adelphia’s financial statements, which would have produced a
markedly different picture of financial health.
The new listing rules of the NYSE require companies to adopt and disclose a code of business conduct and
ethics for directors, officers, and employees, and promptly disclose any waivers of the code for directors or
executive officers. The code must include, among other things, policies regarding conflicts of interest and
corporate opportunities. The company should also have a policy prohibiting conflicts and provide a means
for communication of potential conflicts to the board.
Furthermore, “Employees, officers and directors should be prohibited from (a) taking for themselves
personally opportunities that are discovered through the use of corporate property, information or position;
(b) using corporate property, information, or position for personal gain; and (c) competing with the
company.” Given the number of related party transactions currently in place, a tremendous amount of work
must be done to replace services or otherwise implement oversight controls for our largest public companies.
Additionally, the Sarbanes-Oxley Act specifically addressed off-balance sheet transactions such as the SPEs
used at Enron. The Act directed the SEC to provide rules requiring the issuer to “disclose all material off-
balance sheet transactions, arrangements, obligations (including contingent obligations), and other
relationships of the issuer with unconsolidated entities or persons.”
Fraudulent Financial Reporting at WorldCom
While Enron was arguably the primary driver leading to the creation of the Sarbanes-Oxley Act, WorldCom
was by far the largest single bankruptcy in history and significantly impacted the final legislation. According
to Congressman Micheal G. Oxley, one of the bill’s sponsors, “WorldCom took all the oxygen out of the
room because it was so huge-four or five times larger in bankruptcy terms than Enron. It really did change
the debate, particularly in the Senate.” The company experienced so many lapses in accepted governance
practices that the size and complexity of the company’s collapse alone provides a study in how poor culture,
control systems and oversight can easily lead a company to ruin. The reported financial condition of the
company was manipulated by management to such an extent that, what appeared to be a profitable company
was, in reality, bankrupt. Despite over $100 billion in assets, the company filed for Chapter 11 protection in
early 2002. By November of that year, the company admitted that it had overstated profits by $9 billion
between 1999 and early 2002, and possibly by as much as $11 billion. The inflated profits were largely due
to operating expenses that WorldCom had capitalized. Instead of recognizing expenses when they were due,
the company recorded them as assets, delaying their recognition as expenses to a future date. But the
company also manipulated reserves to offset expenses.
While Scott Sullivan, WorldCom’s former CFO, appeared to be the individual directing the management of
the financial statements, according to Dick Thornburgh, the bankruptcy court examiner, the Board did little to
question management about its merger and acquisition activity, and “the company’s burgeoning debt load.”
In addition, with
the Board “placing virtually no checks or restraints” on management, the Directors did little to question and
nor did they seemingly understand the ramifications of giving management the “authority to borrow an
unlimited amount of money without seeking the Directors’ approval.” The WorldCom Board also
authorized the company to make or guarantee over $400 million in loans to their Chief Executive Officer (the
“CEO”), Bernard Ebbers, without proper evaluation regarding whether he could repay them.
In this short case, we have examples of fraudulent financial reporting, imprudent loans to management, and a
lack of adequate oversight by the Board of Directors that undoubtedly impacted the thinking of lawmakers
and regulators drafting new legislation and implementing rules. The Sarbanes-Oxley Act, SEC rules and
NYSE and NASD listing requirements address these issues by:
• Requiring the principal executive officer and principal financial officer to personally certify their financial
statements with fines and incarceration as enforcement tools.
• Precluding the board from awarding loans to executives
• Requiring the creation of a written charter, not only for the board, but also for their governance,
compensation and audit committees and annual performance evaluations against these charters.
• Requiring independent directors to meet regularly in executive session without the company’s
management present.
Principal executive and financial officers must produce a section 302 certification to file with their annual
financial statements. These officers certify that they are responsible for internal controls over financial
reporting and, to the best of their knowledge, that the financial statements are accurate. Penalties for
knowingly filing false financial statements include fines of up to $5 million and 20 years in jail.
The implementing rules of the SEC also preclude boards from awarding preferential loans to their officers.
Section 402 of SOX makes it unlawful for a company to “directly or indirectly, including through any
subsidiary, extend or maintain credit, arrange for the extension of credit, or renew an extension of credit, in
the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer.”
Additionally, the listing rules of the New York Stock Exchange and the National Association of Securities
Dealers now require the existence of a fully independent audit committee that has a defined charter and
annual self evaluation process so an evaluation of diligence is present.
Compensation at Tyco
Executive compensation is one of the most contentious issues a board can face. The interests of the
shareholders must be weighed against the compensation requirements of its executive team. Even where a
compensation plan is derived at by a deliberate and prudent process, the amounts can be perceived as unfair
by rank and file employees and shareholders. Where there is no deliberate process, wholesale looting of the
company can occur. According to an indictment filed by New York State, Tyco’s Chairman and Chief
Executive Officer (CEO), Dennis Kozlowski is accused of running a sophisticated criminal enterprise—so
sophisticated, in fact, that prosecutors named it “Top Executives Criminal Enterprise,” which they used to
describe Kozlowski’s management team throughout the indictment. Kozlowski stands accused of 38 felony
counts of stealing $170 million directly, and $430 million indirectly through illicit stock sales. Some of the
other excesses the State accused Kozlowski of include:
• Deciding what bonuses would be paid to whom, and when, without regard to restrictions that the
board placed on executive compensation.
• Hiding unauthorized bonuses in transactions booked as “nonrecurring charges.”
• Using the company treasury to pay his personal bills.
• Publicly supporting Tyco stock while privately selling it.
• Using corporate money to purchase directors’ residences at greatly inflated prices.
• Selling corporate residences to him at far less than fair value.
The SEC piled on the offenses by including in its complaint that Kozlowski:
• Used $7 million of Tyco’s funds to purchase a Park Avenue apartment for his first wife, from whom he
had been separated.
• Forgave tens of millions of dollars in loans to executives and directors, including himself.
• Accelerated the vesting of Tyco stock for himself and others.
• Used corporate money to buy his New Hampshire house for three times its apparent fair market value.
Kozlowski excesses began in 1997 with the purchase of the security firm ADT. The purchase enabled him
to further his hold on the board. The officers and directors of ADT were no strangers to generous
compensation packages. The Chairman kept his headquarters in Bermuda and used his yacht as a floating
executive suite. Kozlowski appointed two of ADT’s directors to the four-man compensation committee,
which quickly adopted ADT’s more generous compensation schemes. Under the plan, Kozlowski’s total
compensation rocketed from $8.8 million in 1997 to $170 million in 1999.
Still it was not enough. During this period, Kozlowski allegedly utilized his relocation accounts and an
employee corporate loan program - -a program designed to help employees pay taxes due on stock granted
under a Tyco stock ownership plan- - to buy homes, artwork, jewelry and a 1930’s vintage yacht. He is
also accused of using the accounts to reward favored executives, provide huge charitable gifts in his name
and throw extravagant parties.
The excesses did not stop there, either. Kozlowski owned houses in the posh districts of Greenwich,
Connecticut; Boca Raton, Florida; Nantucket, Massachusetts; New York City; and Beaver Creek,
Colorado. Why a person legitimately making $170 million in a single year would put it all on the line by
embezzling from his company is one for the psychoanalysts. Regardless, these events did lead the NYSE to
include in its listing rules the following requirements:
• The company must have a compensation committee comprised entirely of independent directors.
• The compensation committee must have a written charter detailing its purpose and responsibilities
which include, at a minimum, the review and approval of corporate goals and objectives relevant to CEO
compensation and evaluation of performance and determine as a committee, or together with the board, the
CEO’s compensation based on that evaluation. The committee will also make recommendations with respect
to non-CEO compensation.
• The compensation committee must prepare a committee report on executive compensation to be filed
with the SEC on form 10-K.
• The committee must perform an annual self evaluation of performance against their charter.
The lack of independence on the compensation committee was not the only conflict of interest on Tyco’s
Board. Another director, Frank Walsh, was paid $10 million and another $10 million was paid to his charity
for consulting work he performed for the company arranging an acquisition. So despite originally being
independent, his independence was compromised when he began consulting for the company. To address
this, the NYSE listing requirements also defines what constitutes director independence and requires the
entire board to evaluate the independence of each of its members:
“No director qualifies as “independent” unless the board of directors affirmatively determines that the director
has no material relationship with the listed company (either directly or as a partner, shareholder, or officer of
an organization that has a relationship with the company). Companies must disclose these determinations.”
New York Stock Exchange rules extend this definition for a period of three years after the end of the
relationship that disqualifies independence to both the individual in question as well as to their immediate
family members. A director or family member that receives more than $100,000 a year in direct
compensation or is an executive officer of another company doing more than $1 million or 2% of that
company’s consolidated gross revenues with the company would also preclude independence.
Executive Stock Trading at Imclone and Enron
There is not a more treasonous act to an agency relationship than that of a company executive using inside
information to trade ahead of his or her stockholders. Imclone’s former CEO, Sam Waksal, was convicted
for acting on insider information. He not only sold his stock just prior to public notification of the FDA’s
rejection of Imclone’s cancer drug Erbitux, but also tipped off family members. The revelations forced the
resignations of senior executives and continue to weigh heavily on the company at a time when it should be
concentrating its efforts on correcting its application and getting its drug approved. Waksal was eventually
sentenced to seven-plus years in prison for his actions.
While Waksal broke existing securities laws, director, officer and principal stockholder disclosures were
nevertheless tightened under the Act. Disclosures not only include transactions in equities, but swap
agreements as well with requirements for electronic filings to a publicly available website. If the company
maintains a website, they must also post this disclosure the day after filing. Furthermore, if an issuer is
required to prepare an accounting restatement due to material non-compliance of the issuer, as a result of
misconduct, with any financial reporting requirement, any profits realized from the sale of securities of the
issuer during that twelve month period must be forfeited.
The growth in defined contribution or 401k pension plans has been well documented. It has not been
unusual for a large percentage of a defined contribution plan’s assets to be comprised of company stock.
The company encourages, or even requires a portion of plan assets consist of company stock to keep it in
stable hands. At Enron, company stock accounted for 62% of assets in the employee’s 401k plan at the end
of 2000. What was unusual, however, was that employees at Enron were prevented from selling their
company stock while it imploded due to a company directed “black-out period.” “Black-out-periods” can
be legitimately instituted to change administrators, add or remove funds, close the books or other plan
events. During Enron’s black-out, however, executives freely sold their company awarded stock while rank
and file employees had their investments in company stock frozen via their 401k plan.
To prevent similar conflicts, Section 306 of the Act prohibits insiders from trading during pension blackout
periods. Specifically: “it shall be unlawful for any director or executive officer of an issuer of any equity
security …, directly or indirectly, to purchase, sell or otherwise acquire or transfer any equity security of the
issuer … during any blackout period with respect to such equity security if such director or officer acquires
such equity security in connection with his or her service or employment as a director or executive officer.”
The Culture at HealthSouth
It is hard to put a price tag on a strong, open and honest corporate culture, but easier to associate a cost to a
company of a closed, fraudulent culture with an imperial CEO. The Justice Department has charged Richard
Scrushy, the former CEO of HealthSouth, with an 85 count indictment which includes conspiracy, mail, wire
and securities fraud; false statements; false certifications; and money laundering. Investors have punished the
stock of the nation’s largest chain of rehabilitation hospitals, pushing it down over 75% since these issues
were raised. Fifteen (15) insiders have pleaded guilty to a number of charges of financial wrongdoing at the
company intended to mislead the financial community. Eleven (11) of these insiders who have been
cooperating with investigators describe a culture in which board minutes were altered, board members
investigated by the company’s security chief, and employee fear of reporting fraudulent activities, or even bad
news to management. Corporate counsel tells how he delayed giving bad news to the CEO because he
knew it would make him unhappy. An accountant who did report suspected fraud was later past over for
promotion. One supervisor went so far as to convince a physical therapist to drop his plans to report his
suspicions to the company’s fraud hotline.
Those who would flout the laws of our country will reward those that sustain them, and punish those that they
perceive as a threat. In order for corporate governance systems to work effectively, there must be a strong
culture which rewards doing the right thing and provides an effective means for reporting bad behavior.
Employees must trust that whistle blowing will not lead to punitive measures against them, rather that their
courage will be embraced. To help put these conditions in place, the SEC is implementing rules which
require each company to construct a code of ethics for senior financial officers. The audit committee of the
board of directors must also establish procedures for the confidential, anonymous submission by employees
of the issuer of concerns regarding questionable accounting or auditing matters.
Furthermore, Section 806 of SOX puts in place important protections for employees of publicly traded
companies that provide evidence of fraud. The act prohibits actions to “discharge, demote, suspend,
threaten, harass or in any other manner discriminate against an employee … because of a lawful act done by
the employee…” and provides remedies in the form of compensatory damages.
Obstruction of Justice at Arthur Andersen
While the poor judgment and professionalism of Andersen’s assessment of Enron and WorldCom’s financial
statements is what stands out in the minds of managers, regulators and the press, Andersen was actually
undone by being found guilty of obstructing justice. In an indictment filed in the United States District Court,
Southern District of Texas, the government accused Andersen of the wholesale destruction of documents
germane to the Enron case with the intent to “… alter, destroy, mutilate and conceal objects with intent to
impair the objects, integrity and availability for use in such official proceedings.” Found guilty, Andersen was
forced to disband and over one thousand of their clients had to find new auditors.
Interestingly, the indictment did spell out some of Andersen’s shortcomings regarding their work on Enron’s
financial statements. These include:
• Andersen did not object or otherwise cure public statements by Enron incorrectly characterizing
numerous charges as non-recurring, even though Andersen believed the company did not have a basis for this
conclusion.
• The Andersen team handling the Enron audit contravened the accounting methodology approved by
Andersen’s own specialist working in its Professional Standards Group.
• Internal reviews of the Andersen team assigned to Enron received a rating of “2” on a five point scale
with “5” being the highest.
• Andersen had direct knowledge of allegations of financial reporting fraud made by Sherron Watkins,
the famous Enron whistleblower.
So it is clear that, despite the indictment made concerning obstruction of justice, the government believed that
there were deficiencies in Andersen’s capabilities as independent auditor of Enron.
Enron was one of Andersen’s largest clients, reportedly the source for $25 million in annual audit fees and
$27 million in consulting and other fees. Andersen also performed the role of internal auditor for a period of
time which creates the appearance of a conflict of interest. How can the independent auditors opine on their
own work? The answer is, they can not.
To address the professional standards of the independent auditors apparently absent at Enron and others,
Congress established the new Public Company Accounting Oversight Board (“PCAOB”) under the
Sarbanes-Oxley Act to regulate the accounting profession and “to oversee the audit of public companies that
are subject to the securities laws and related matters, . . .” It has been charged with the awesome
responsibility of setting ethics and conflict-of-interest standards, disciplining accountants and conducting
annual reviews of the largest accounting firms. In short, the Board now has regulatory oversight of the
accounting profession and has taken over many functions that were previously self-regulated with oversight
from the Securities and Exchange Commission. Prior to this legislation, the profession monitored itself
through peer reviews and self-imposed standards with oversight from the SEC. Andersen’s legacy is the end
of the profession’s self regulation.
The Act further requires that partners only serve a client for five years at which time they must rotate off.
Additionally, the Act prohibits a registered public accounting firm who is providing audit services to
contemporaneously provide non-audit services such as bookkeeping, systems design and implementation,
appraisal or valuation services, fairness opinions and contribution in kind reports, actuarial services, internal
audit outsourcing services, management or human resource functions, broker/dealer, investment advisory or
investment banking services, or legal and expert services unrelated to the audit. Other services, including tax
services, are allowed with the approval of the audit committee of the board of directors.
Conflict of Interest at Vinson & Elkins
As one of the oldest and most prestigious law firms in Houston, the firm of Vinson & Elkins was a trusted
advisor to Enron and was paid handsomely. Enron paid the law firm $36 million in 2001, representing
roughly 7% of their global revenue. In response to the Sherron Watkins memo detailing concerns about the
special purpose entities, Enron retained Vinson & Elkins to investigate the allegations even though Watkins
had specifically written that they should not be selected for examining these transactions due to the obvious
conflicts of interest.
Good investigators leave no stone unturned. They need to be independent, objective and have a heavy dose
of professional skepticism while performing their inquiry. Having worked on a number of transactions for the
company, and having a long, profitable relationship with its management, it would have been difficult for the
best intentioned lawyers to remain objective and diligent. Predictably, the firm’s investigation was ineffective.
In the report, Vinson & Elkins said that the issues raised “do not, in our judgment, warrant a further
widespread investigation by independent counsel and auditors.” The eventual bankruptcy of Enron puts this
opinion in a particularly harsh light.
The Sarbanes-Oxley Act allows the SEC to establish professional standards of conduct for the nation’s
attorneys. These standards include “up the ladder” reporting obligations that would be triggered when an
attorney “becomes aware of evidence of a material violation by the issuer or by any officer, director,
employee or agent of the issuer.” The lawyer would then have to report the matter to the chief legal counsel
of the company. If the attorney does not receive an adequate response from the company’s chief legal
counsel and the CEO, the lawyer must report the violation to the company’s board of directors, the audit
committee of the board, or a committee consisting of outside directors. That is where the lawyer’s duties
currently end. These actions protect the lawyer from disciplinary action and civil liability.
Analyst Independence at Investment Banks
Investors often rely on research conducted by analysts affiliated with broker/dealers. These analysts are
represented to be independent of a bank’s investment banking and trading operations. However, the
pressure to issue positive research for those companies with which the bank has a relationship can be intense
as there are millions of dollars in commissions and fees at stake. At times, the ties between a company and a
bank can be so strong, that research analysts are awarded unprecedented access and favored treatment
which presumably would be cut off if an unfavorable research report were issued.
The House Committee on Financial Oversight reviewed the ties between Jack Grubman, an analyst for
Salomon Smith Barney, and WorldCom’s CEO Bernie Ebbers and CFO Scott Sullivan. They found “a lack
of independence” with Grubman attending “company board meetings, exclusive of other analysts.” By
providing Grubman with access to information not available to other analysts, the company hoped to color his
analysis in their favor. Investors who relied on Grubman’s “independent and objective research” would be
disappointed as WorldCom collapsed.
Henry Blodget, the senior research analyst and group head for the Internet sector at Merrill Lynch, Pierce,
Fenner & Smith was permanently barred from the securities industry and fined for issuing fraudulent research
in which he expressed views that were inconsistent with his privately expressed negative views. In short, the
Securities and Exchange Commission found that he issued positive research on GoTo.com while privately
disparaging the company. Blodget also issued research reports on “six other internet companies that were
not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts
regarding those companies.”
The Act directed the SEC to implement rules to address “conflicts of interest that can arise when securities
analysts recommend equity securities in research reports and public appearances, in order to improve the
objectivity of research and provide investors with more useful and reliable information.” The Act also
prohibits retaliation by a broker/dealer for a negative research report on a present or prospective investment
banking client and requires safeguards to separate research from investment banking activities.
The Role of Self Regulatory Organizations (SROs)
The nation’s two largest stock markets, the New York Stock Exchange (NYSE) and the National
Association of Securities Dealers (NASD), are self regulatory organizations (SROs), meaning that they not
only provide a marketplace for stocks, but they also self-police their members and set listing requirements for
companies that wish to list their securities with them. This is all done under the supervision of the SEC. After
the passage of Sarbanes-Oxley, the NYSE and NASD embarked on an evaluation of their governance
structure with particular emphasis on the relationship of their regulatory enforcement efforts to the rest of the
organization. There is an inherent conflict between providing a competitive market and self-regulation which
both organizations are continually analyzing and attempting to address. The NYSE and NASD also issued
new listing requirements that went above and beyond what was required under the SOX.
Some additional NYSE requirements include:
• a board that consists of an independent majority
• a nominating/corporate governance committee that is composed entirely of independent directors
• a compensation committee that is composed entirely of independent directors
• additional audit committee requirements including the preparation of a charter and an annual self-
evaluation
• a requirement that non-management directors regularly meet in executive session without management
• that each company must have an audit department
• that each company adopt and disclose corporate governance guidelines which include director
qualification standards, responsibilities, compensation, continuing education, succession, and annual
performance evaluation of the board
• the adoption of a code of ethics for directors, officer and employees and disclosure of waivers for
officers and directors
• CEO certification that they are not aware of any violations of the NYSE corporate governance listing
standards
The listing requirements further define “independence” to create bright line criteria regarding whether a
director is and remains independent for the purpose of meeting corporate governance requirements. NASD
listing standards are similar except that the independence thresholds are lower reflecting the smaller market
capitalization of many of their listings. The NASD rules also do not require independent compensation or
nominating committees, but do require that a majority of the full board’s independent members approve
compensation and nomination proposals. While it is too early to determine how these rules will impact sitting
directors, there is little doubt that board independence will be improved going forward.
The Act’s Impact on International Companies and Foreign Governments
When SOX was drafted, “many international firms and foreign governments sought exemptions from the
legislation.” Despite much concern and lobbying, no exemptions or accommodations were made for foreign
entities in the Sarbanes-Oxley legislation. Those foreign entities that file 20-Fs with the SEC instead of the
10-Ks required by domestic public companies must also certify their financial statements. Additionally, a
registered public accounting firm must audit and attest to management’s assertions. The Act specifically
requires that foreign accounting firms register with the Public Company Accounting Oversight Board
(PCAOB), but the board is negotiating joint supervision rules with the European Union (the “EU”) that would
rely on the oversight of European regulators to conduct reviews of registered accounting firms in their
jurisdiction.
The recent massive fraud at the Italian company Parmalat shows that Europe is not immune from problems
similar to those experienced in the United States. Using a complicated and layered ownership structure, the
company effectively hid its financial problems from the world for years. Grant Thornton, the company’s
auditors, have been implicated in helping set up and continue to audit certain companies in question. In the
United States, the SEC has sued Parmalat accusing them of selling “bonds and other securities while engaging
in one of the most brazen corporate financial frauds in history.” This fraud promises to be as complex and
global as any before it. Some estimate the assets of Parmalat to be worth 1 to 2 billion euros, while debt has
been estimated to be as high as 14 billion euros.
Italy is not the only EU country experiencing corporate abuses. KPMG Forensic recently reported that the
number of big fraud cases in Britain almost doubled in 2003 to 153 from 83 the previous year. UBS (Union
Bank of Switzerland), one of Europe’s largest banks, has been implicated in bribery and share price rigging in
Hong Kong. Accounting scandals and irregularities have also been reported at the Dutch supermarket
group Ahold and Zurich-based Adecco, the largest temporary employment agency in the world.
Playing catch-up, the EU has made proposals to improve corporate governance and audit services
throughout the Union. Oversight is currently conducted on a national level with no uniformity between
member states. These new proposals include improved uniform disclosure requirements, better director
independence, and coordination of the corporate governance efforts of member states. There are also
initiatives to converge EU and US auditing standards, establish pan-European auditor ethics, and
coordinating national auditor oversight systems into a pan-European board.
The effects of the legislation in Asia have been less potent, however, as Japan has used Enron and other large
frauds as an excuse to put off real corporate governance reform. Not long ago, in a fraud similar to Enron,
Yamaichi Securities used off-balance sheet vehicles to manipulate their financials resulting in their collapse.
Furthermore, some believe Japan’s banking sector crises has been a partial result of poor corporate
governance and shareholder accountability. Despite this evidence that the Japanese governance system
needs improvement, problems in the US seem to have retarded reforms aimed at correcting these
shortcomings as critics point to the inability of US style corporate governance to prevent similar fraud.
So it is clear that, the impact of Sarbanes-Oxley overseas has been significant, both positive and negative,
and promises to continue to drive change throughout the world.
The Future of Corporate Governance
There is no question that the Sarbanes-Oxley legislation has had a significant impact on both the operations
and regulatory costs of public companies. If history is any guide, simply passing the Act will not deter fraud
and other criminal activity. Much of the bad behavior detailed above broke existing laws dating back to
1933 and 1934. Since passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, we
have experienced the S& L crisis and a series of corporate frauds and other financial shenanigans which
include the collapse of Drexel, Burnham and Lambert and Barings Brothers, the turmoil and sale of Kidder
Peabody and Banker’s Trust, and the bankruptcy of Orange County, California. The penalties may be more
stringent, and the chances of getting caught greater, but it is safe to say that neither Congress nor the SEC
can legislate or regulate individuals into doing the right thing. Like a single-minded killer, a criminal intent on
illegal behavior will not be dissuaded by laws and regulations. They will search for new ways to circumvent
existing behavioral boundaries and controls. It is not possible to know with certainty the next iteration of
fraud that will be created by these rogues, only that it will happen.
The questions then become, what will be the response to the next corporate crises? How many more
scandals will the public endure before they call the capitalist system into question? How much more
regulation can our public companies carry before they fall to foreign competition? The answers to these
questions depend on the type of, severity of, and response to the crises that surface. Public debate will once
again shape new legislation, regulations, or both to calm public fears and restore a sense of confidence in our
markets. The costs of this confidence can not be ignored. Large multi-national corporations expect to spend
over 35,000 hours complying with the internal control requirements of SOX and expect audit fees to increase
38%. This multi-million dollar burden will negatively impact the bottom lines of these companies. But the
cost to our economy from a loss of confidence in our markets can not be underestimated. The cost to our
public companies from a loss of our capital markets could easily dwarf such preventive expenditures.
There is an important relationship between open markets and regulation that our business and legislative
leaders must carefully monitor and make adjustments to address pending threats. Aggressive legislation and
prosecution by each of the states could tilt that relationship into over-regulation. There is a temptation for
states to jump on the Sarbanes-Oxley bandwagon without regard to what other states are doing. Both
California and New York have passed additional documentation requirements above what is required by
SOX. With every state passing rules, the complexity of corporate compliance multiplies with the potential
that a company has met the letter and spirit of the SOX legislation, and that of all states except the one where
they mistakenly have not complied with an arcane state rule. Some attorney generals have further suggested
applying elements of SOX legislation to non-profit organizations. Even private companies are not immune
from the spill-over effect of this and related legislation as they will have to be in a position to comply fully with
SOX and state laws before they go public. Even those that have no intention of going public may need to
comply with certain SOX practices to meet lender and insurance requirements. At some point, the burden
of compliance will be too much for our companies to bear.
Conclusion
New legislation and regulation are normally a governmental response to issues or crises. We have shown
that the Sarbanes-Oxley Act was a response to a wave of corporate fraud and the passivity of our nation’s
boards of directors as well as audit, legal and analyst conflicts of interest and/or incompetence. Under the
supervision of the SEC, the NYSE and NASD have created new listing standards and the PCAOB has
initiated regulation of the accounting profession. Some states even added another layer of public company
regulation and are considering rules for not-for-profit corporations. Even public companies domiciled outside
the United States must comply with SOX if their securities are to trade in our public financial markets.
The need for this dramatic change, as costly as it is, was reinforced by the long line of corporate frauds
exposed over several months. But even the best legislation can not predict the shape or scope of the next
financial crises. Where the Sarbanes-Oxley legislation responded to the bad behaviors of yesterday, it will
not prevent bad people from finding new ways to do bad things. The recent mutual fund scandals adequately
make this point. Unlike other scandals before it, agents found new ways to reward themselves and favored
clients at the expense of those they were paid to represent. Mutual fund agents allowed privileged clients to
trade into their investment vehicles when it appeared, based on late breaking news, that such an investment
would immediately increase in value. Sometimes, the agents would trade for themselves. This activity diluted
the returns of those of us without privileged access who played by the rules.
What is clear is that the agents and gatekeepers must do all they can to ferret out and address bad behavior
before it has a chance to destroy a company. Simply implementing new governance processes means
nothing if there is not a culture of transparency and openness and a willingness to take action against those
whose actions breach the moral and ethical boundaries expected of them, regardless of their position or
power. We, as shareholders, employees, and pensioners, must expect nothing less and speak in one voice to
ensure that our agents and gatekeepers do just that.
* Scott Green, CPA, is the Global Head of Audit and Compliance for Weil, Gotshal & Manges, one of the
largest law firms in the world and a leader in the practice of corporate governance. A graduate of the
Harvard Business School, he is a recognized expert on management controls with more than fifteen years of
experience in the field and author of the book, Manager's Guide to the Sarbanes-Oxley Act: Improving
Internal Controls to Prevent Fraud (February 2004). He has also taught finance and banking at Hofstra
University’s Frank G. Zarb School of Business.
1.PricewaterhouseCoopers’ Management Barometer, Sarbanes-Oxley Act Requires Changes in Corporate
Control, Compliance, According to PricewaterhouseCoopers Survey of Senior Executives, (Mar. 24, 2003),
at http://www.barometersurveys.com.
2.Final NYSE Corporate Governance Rules, NYSE’S LISTED COMPANY MANUAL § 303A.10 (Nov.
4, 2003), available at www.NYSE.com/pdfs/finalcorpgovrules.pdf.
3. John R. Emshwiller, Business Ties: Many Companies Report Transactions With Top Officers, WALL
ST. J., Dec. 29, 2003, at A1.
4. William C. Powers, Jr., Raymond S. Troubh, Herbert S. Winokur, Jr., Report of Investigation by the
Special Investigative Committee of the Board of Directors of Enron Corp. (Feb 1, 2002), at http://news.
findlaw.com/hdocs/enron/sincreport/. See also ARTHUR L. BERKOWITZ, ENRON: A
PROFESSIONAL’S GUIDE TO THE EVENTS, ETHICAL ISSUES, AND PROPOSED REFORMS
147 (Diana Roozeboom et al. eds., CCH Inc. 2002) (providing in its Appendix A an excerpt from the
Report of Investigation by the Special Investigation Committee of the Board of Directors of Enron Corp.
(Powers Report)).
5. BERKOWITZ, supra note 4, at 148.
6. Id. at 151-52, 156.
7. See SEC v. Fastow (S.D. Tex. 2002), at http://www.sec.gov/litigation/complaints/comp17762.htm.
8.Associated Press, Enron Directors at a Glance (Sept. 25, 2002), at http://www.abcnews.go.
com/wire/Politics/ap20020925_1857.html.
9.Leigh Gallagher, What Did They Know?, FORBES, May 26, 2003, at 53.
10. See Final NYSE Corporate Governance Rules, supra note 2.
11. Id.
12. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745, 107 H.R. 3763, § 401(j) (2002).
13. See Barnaby Feder, Court Approves WorldCom Plan, N.Y. TIMES, Nov. 1, 2003, at C3.
14.House Committee on Financial Services, Rebuilding Investor Confidence, Protecting U.S. Capital
Markets, House Comm. on Financial Services, 107th Cong. Report on the Sarbanes-Oxley Act H.R. 3763
(Comm. Print 2002) at http://www.financialservices.house.gov/media/pdf/Sarbanes-Oxley%20Report.pdf, at
2 (last visted at March 9, 2004).
15. See Feder, supra note 13.
16. Barnaby Feder, Management Practice Enabled Huge Fraud, 2 Investigations Find, N.Y. TIMES, June
10, 2003, at C1.
17. Id.
18. Floyd Norris, Ebbers and Passive Directors Blamed for WorldCom Woes, N.Y. TIMES, June 10,
2003, at C1 (quoting Dick Thornburgh).
19.Id.
20.Richard C. Breeden, Restoring Trust: Report to The Hon. Jed S. Rakoff, The United States District
Court For the Southern District of New York, On Corporate Governance For The Future of MCI, Inc.,
(Aug., 2003), at 2.
21.Sarbanes-Oxley Act of 2002, supra note 12, at § 302.
22.Id at § 402(a)(k)(1).
23. See Final NYSE Corporate Governance Rules, supra note 2, at § 303A.4(a)-(b)(ii), § 303A.5(a)-(b)
(ii), § 303A.6, § 303A.7(c)(ii).
24. See id. at § 303A.3
25.House Committee on Financial Services, supra note 14, at 5.
26.Sarbanes-Oxley Act of 2002, supra note 22.
27.Id. at § 301.
28. Indictment for The People of the State of New York , New York v. Kozlowski, (No. 5259/02).
29. Id.
30.Complaint for SEC, SEC v. Kozlowski, (S.D.N.Y. 2002), at http://www.sec.
gov/litigation/complaints/complr17722.htm.
31. See Final NYSE Corporate Governance Rules, supra note 2, at § 303A.4(b)(ii), § 303A.5(b)(ii), §
303A.7(c)(ii).
32. See id. at § 303A.2(a).
33. See id. at § 303A.2(b)(ii).
34. Constance L. Hayes, Former Chief of Imclone is Given 7-year Term, N.Y. TIMES, June 11, 2003 at
C1.
35. David M. Katz, The Lay Deed or the Tiger, CFO.COM (Feb. 15, 2002), at http://www.cfo.
com/Article?article=6718.
36. Sarbanes-Oxley Act of 2002, supra note 12, at § 306(a)(1).
37. Milt Freudenheim, Former Chief of HealthSouth Refuses to Respond at Hearing, N.Y. TIMES, Oct.
17, 2003, at C1.
38. Sarbanes-Oxley Act of 2002, supra note 12, at § 806.
39. US v. Arthur Andersen, LLP, Criminal Action No. H-02-121, 2002 U.S. Dist. LEXIS 26870, at *15-
16 (S.D. Texas May 24, 2002) (quoting T. 18, U.S.C. § 1512(b)(2)(B)).
40. Lee Berton, GAO Says Big 4 ‘Oligopoly’ Can Hamper Business (Nov. 21, 2003), available at http://
quote.bloomberg.com/apps/news?pid=10000039&sid=aT2wnFt98bjA&refer=columnist_berton (last visited
Mar. 10, 2004).
41. See Andersen, supra note 39.
42. BERKOWITZ, supra note 4, at 9.
43. Id.
44. Sarbanes-Oxley Act of 2002, supra note 12, at § 101(a).
45. Id. at § 201(g)(1)-(9).
46. Id. at § 201(h).
47. BERKOWITZ, supra note 4, at 12.
48. Id. (quoting Vinson & Elkins).
49. SEC Standards of Professional Conduct for Attorneys Appearing and Practicing Before the
Commission in the Representation of an Issuer, 17 C.F.R. §205.3 (2003).
50. House Committee on Financial Services, supra note 14, at 21.
51.Joint Press Release, U.S. Securities and Exchange Commission, The Securities and Exchange
Commission, NASD and the New York Stock Exchange Permanently Bar Henry Blodget From the
Securities Industry and Require $4 Million Payment (April 28, 2003), at http://www.sec.
gov/news/press/2003-56.htm.
52. Sarbanes-Oxley Act of 2002, supra note 12, at § 501.
53. SCOTT GREEN, MANAGER’S GUIDE TO THE SARBANES-OXLEY ACT: IMPROVING
INTERNAL CONTROLS TO PREVENT FRAUD (John Wiley & Sons, Inc., 2004).
54. House Committee on Financial Services, supra note 14, at 18.
55. Daren Fonda, Revenge of the Beancounters, TIME, Mar. 29, 2004, at 38-39.
56. John Tagliabue, Layers of Ownership Conceal Trouble in Italy, N.Y. TIMES, Dec. 30, 2003, at C1.
57. Mary Williams Walsh, A U.S. Component is Added to an Italian Scandal-SEC Sues Parmalat,
Accusing it of Fraud, N.Y. TIMES, Dec. 30, 2003, at C1.
58.Fred Kapner, Crisis at Parmalat deepens as debt estimate hits E14bn, FINANCIAL TIMES, Jan. 22,
2004, at 19.
59. Bob Sherwood, Number of Big Fraud Cases Almost Doubles, FINANCIAL TIMES, Jan. 26, 2004, at
4.
60. Kieth Bradsher, Financial Scandal Hits Hong Kong, N.Y. TIMES, Mar. 2, 2004, at W1.
61. John Plender, Schooled by scandal: what auditors and investors still have to learn from Europe’s
accounting debacles, FINANCIAL TIMES, Jan. 21, 2004, at 15.
62. House Committee on Financial Services, supra note 14, at 18-19.
63 Id. at 19.
64. John Plender, Tilt in the balance of boardroom power, FINANCIAL TIMES, Jan. 21, 2004, at 8.
65. Id.
66. Id.
67. See Fonda, supra note 55.
68. Harvey Coustan, Linda M. Leinicke, W. Max Rexroad, Joyce A. Ostrosky, Sarbanes-Oxley: What IT
Means to the Marketplace, J. ACCT., Feb. 2004, at 46.69. BoardSource, Independent Sector, The
Sarbanes—Oxley Act and Implications for Nonprofit Organizations, at www.independentsector.
org/PDFs/sarbanesoxley.pdf (last visited Apr. 8, 2004).
70. Alan L. Goldberg, Sarbanes-Oxley reaches into private companies, S. FLA. BUS. J., Dec. 1, 2003.
71. Paula Lacey Herman, Practical impact of Sarbanes-Oxley on privately held companies, HARTFORD
BUS. J., Mar. 17, 2003