Corporate Governance has become one of the hottest fields of international company law and economics. Whereas many European countries have chosen self – regulatory market based approaches or favour “comply or explain” provisions, the U.S. government decided to take mandatory legislative actions in the aftermath of various accounting and corporate governance scandals, headed up by Enron and WorldCom. This article explains why most, if not all of the relevant provisions regarding corporate governance, are ill conceived and thus should be withdrawn the sooner the better to prevent future economic harm. The author concludes with an evaluation and an outlook for alternatives.
Keywords: Corporate Governance, Sarbanes Oxley Act 2002.
When U.S. President George Walker Bush put the Sarbanes – Oxley Act 2002 (SOX) into force he declared: “Today I sign the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt. ” Whether the legal changes were as radical as politically proclaimed is debatable, yet SOX is insofar eminent as it stands for a significant drift in U.S. Corporate Governance spirit. In order to understand its importance it is indispensable to take into account the raison d’être by which the Act is driven. SOX is not just about specific modifications in accounting standards, disclosure provisions or criminal liability. The change for U.S. Corporate Governance is much more fundamental. Whereas, before the enactment of SOX, Corporate Governance was mainly regulated by the market, now it is the government that deals with the subject by adopting federal security laws. This replacement of rule – making power is significant. Before SOX it was general understanding that most possible efficiency is reached when the market is able to make its own rules. Until now, the question of who governs a corporation was intrinsically tied to the question why generally firms exist. Coase, Alichian and Demsetz offered solution to the question by coming up with the idea, that directors are able to monitor firms more efficiently than the market does and therefore have a right to be in charge of the decision making. On the contrary modern stakeholder approaches try to integrate the rights of employees into the decision making process, because it is believed to be just fair to have a piece of the pie of the decision making power if at the same time specific human capital is invested. Despite many of these approaches tackle the problem from different angles, they all have one thing in common. All of them rely on the self – regulatory efficiency of the market in order to explain Corporate Governance provisions.
The approach of SOX offer a different answer. Whoever has the most influential rights in the company, or whatever is most efficient for the company only plays a minor role. SOX’s major priority is the protection of small investors. Hence, whoever is able to punish misconduct most effectively should be given the oversight of corporate governance, and SOX believes the federal government to be the best institution which is able to cope with the task.
However, it is frequently argued in literature that the SOX approach is anything else but a good choice. According to Romano SOX is neither able to provide more trustworthiness, prevent future scandals, nor improve “good governance”, and is thus “ill – conceived”. In order to give a well founded analysis of this thesis, this article, ajar to the article of Romano, will place emphasis on statutory provisions of SOX to give answers. The requirement of independent audit committees, the restriction of corporations’ purchases on non – audit services from their auditors, the prohibition of corporate loans to officers and the requirement for CEOs and CFOs to certify financial statements and the consequences if they fail to comply, will be discussed. The author is aware of the fact, that due to the dimension of newly introduced provisions, it is only possible to discuss a small portion of the entire issue and therefore does not assert a claim to provide a comprehensive study of SOX. Instead emphasis will be placed upon special articles that are of great interest for the understanding of Corporate Governance.
B. Incidents which lead to the enactment of SOX
The SOX with its radical changes in U.S. Corporate Governance was not enacted “out of the blue”. It’s enactment was grounded on a series of precedent accounting and bankruptcy scandals which started with the collapse of Enron and was followed by the downfall of WorldCom, Adelphia Communications, Tyco, Sunbeam, Waste Management, Xerox, Global Crossing and others. The result was an almost unthinkable loss of stock value, which was underlined by a variety of causes. In the bull market of the mid 1990’s there was a high demand for stocks of fast growing companies which created the fantasy for huge future profit earnings. During that time the potential of growth was more significant for the determination of a high stock price than the analysis of current financial statements. Thus, “new – breed executives ”, which lead companies like Enron and WorldCom were concerned with beating the analysts’ growth expectations every quarter. This was mainly achieved by acquisition of other businesses and manipulation of financial statements. The necessary money was raised by paying vendors with (constantly higher evaluated) stock packages of the vendee company and loans from investment banking firms which were willing to lend huge amounts of money for two reasons. Firstly, they were afraid of not taking part in the bust. And secondly, investment – banking firms had a strong incentive to produce favourable reports and let the companies appear to look good in order to win lucrative investment – banking contracts. As a consequence the company stock value grew rapidly, which had the effect that the CEO of such companies became a “hero” in American society who brought wealth to his or her employees by raising the value of company stock and expanding the use of stock option grants. Under these circumstances concerns of excessive CEO remuneration packages and aggregation of decision – making power were mostly forgotten.
Finally, the Securities and Exchange Commission (SEC) was not without fault either because it omitted to effectively investigate and review financial statements and cover up fraudulent actions, which was caused by inadequate federal funding.
As the stock market bubble bursted and the presidential elections were just around the corner, Bush decided to take quick action to calm the troubled market, restore public and investor confidence and prevent future scandals.
C. SOX Corporate Governance Provisions
Many Corporate Governance provisions that the SOX introduces are not “the invention of the wheel” but rather “recycled ideas advocated for quite some time by corporate governance entrepreneurs ”. In order to heal the economic wounds that were caused by Enron et al. SOX mainly focused on “disclosure as the cure”. Better enforceability is grounded on two pillars. Firstly, monitoring, which consists of a system where every party involved monitors the other and is obliged to report violations to SEC, and secondly, punishment by SEC in case of non compliance.
I. “Inside” disclosure and monitoring provisions
Inside control and monitoring mainly focuses on officers and directors and operates in a number of different but related ways. The Board officers monitor employees, the Audit Committee monitors the Board (as well as “outside” auditing firms), and the employees monitor the whole corporation through the help of whistle blowing protection.
a. Sec. 301 SOX – Public Company Audit Committees
Sec. 301 SOX, which is an amendment of Sec. 10A(m) of the Securities Exchange Act of 1934 (SEA) requires all listed companies to have an audit committee, which is entirely composed of independent directors and is supposed to work as a watchdog for the actions taken by the Board. Furthermore the audit committee is directly responsible for the appointment, compensation and oversight of any outside auditor.
The raison d’être of this provision is to break open “club resistance ” between the board and the audit committee and thus, by making it a requirement to put solely “outsiders” on the audit committee, to have it act more effectively. However, in dictating that only the audit committee has power to “hire and fire” outside auditors, shareholders are deprived of their right of decision making and the board might run into trouble of realizing their oversight duty. Furthermore, the SOX provision excludes entire categories of experts from the audit committee which leads to a lack of diversity and inflexibility when the business environment changes.
Also, there is opinion in Corporate Governance literature, that the proposed composition of an audit committee (exclusiveness of independent auditors) does not lead to better but even worse results, because it is argued that too many outsiders might have a negative impact on performance. Even though this view is not shared by all experts there is prevailing opinion that at least a composition of exclusively independent auditors does not have neither a positive, nor a negative effect on better Corporate Governance. Beasley et al. found out that, whereas the composition of the Audit Committee does not have a great impact on the prevention of fraud a majority of independent directors on the Board does have an effect. This can be explained by the fact that, even if the Audit Committee or outside auditors were willing to report fraudulent conduct, the Board must be willing to take action. With a majority of independent directors on the Board this is more likely to happen.
Finally it is held that financial expertise and frequent meetings might be of value for investors. Yet SOX does not require such an expert to sit in the Audit Committee but only that his or presence is disclosed. Therefore it can be asked, if the solution offered by SOX matches the problem involved, because the changed composition of the audit committee does not seem to be of much help to prevent accounting misconduct in the future.
b. Sec. 302 and 906 (a) SOX – Corporate Responsibility for Financial Reports
According to Sec. 302 SOX the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are required to certify periodic reports which, to the best of their knowledge, do not contain material misstatements and fairly represent the firm’s financial conditions and results
of operations. The provision, which was highly influenced by President Bush, is a reaction of significant accounting inaccuracies and manipulations of dozens of public companies with the SEC in 2001 that were often driven by fraudulent actions by senior managers, which were exceptionally difficult to uncover.
As a countermeasure Sec. 302 SOX requires, that the Board actually concerns itself with the financial statements that the corporations issues and takes responsibility for them. As a consequence many public companies have set up special disclosure committees to aid the officers in meeting their certification obligations.
Sec. 906(a) SOX furthermore postulates the composition of an additional written statement (or equivalent) of the CEO and CFO. If they fail to comply with Sec. 302 (a) SOX a civil wrong has been done whereas a violation against Sec. 906(a) SOX, Sec. 906(c) SOX, which is a criminal provision, imposes penalties of fines up to $ 5 million and cumulatively 20 years imprisonment, if the mens rea requirement is met.
Both sections are not without critique to say the least. Firstly, it can be argued that SOX’s call for compliance, which is directed to all firms irrespective of their size and economic power, might lead to untimely or imprecise certifications especially from smaller companies because of the proportionally higher effort and costs that they have to make. Also, economic analysis points out that the SOX certification requirement does not have a significant positive impact on the stock value. From that fact, Romano draws the conclusion that the provision is “useless” because the market is able to predict beforehand what companies would certify and what companies wouldn’t. If scandals take place that involve a lack of transparency of financial reports the market adjusts voluntarily by increasing their disclosure because of the fear of being associated with similar practices. Thus, the certification requirement turns out to be a “non – event”. This conclusion seems to be somewhat misleading. It is certainly true, that the market adjusts once it knows what is brewing, but the problem is that many times it is not able realize misconduct on time. In the case of Enron, i.e. the stock price dropped from $ 80 to $ 40 when there was indication that the company has problems despite in reality Enron already had penny stock value.
* PhD student University of Tuebingen, LL.M. student University of Aberdeen. I would like to express my gratitude for Prof. John Patterson, University of Aberdeen, and Prof. Martin Nettesheim, University of Tuebingen, for helpful comments, advice and inspiration.
 Sarbanes – Oxley Act of 2002, 68 Fed. Reg. 5110 (Jan. 31, 2003).
 Press Release, Office of the Press Secretary, President Bush Signs Corporate Corruption Bill (July 30, 2002) (available at www.whitehouse.gov/news/releases/2002/07/20020730-1.html).
 Friedland, 23 Comp. Law. 383, 384 (2002) “fundamental change”.
 The term “market“ in this sense is not limited to the traditional market of trading goods and services, but rather represents every field where competition takes place to attract listed companies. Before the enactment of SOX there was a highly competitive “market” for U.S. states to attract corporation inter alia via (more relaxed) corporate governance rules in order to receive greater tax revenues and job opportunities. Moreover, there is a “market” of exchanges, such as the competition between NASDAQ and NYSE to enlist the most profitable corporations to be able to raise listing fees and boost reputation; Ribstein, 28 J. Corp. L. 1,57 (2002-03). Before SOX, Corporate Governance in the U.S. mainly relied on self regulatory approaches by the states, listing standards by the NYSE and a division between federal and state jurisdiction.
 Coase (manuscript 1937)
 Achian / Demsetz, 62 A.Econ.Rev. 5, 777 et seqq. (1972).
 Romano, Yale Law, ECGI Working Paper No. 52/2004, 1.
 From March 2000 through September 30, 2002, the U.S. stock markets lost half of their market captializations, reducing investors’ net worth by almost $ 8.5 trillion; cp. Wall St. J., Oct. 1, 2002. Stockholders lost almost $ 250 billion in market value because of the bankruptcy of Enron and WorldCom alone; Aronson, 8 Stan.J.L.Bus&Fin., 127, 130 (2002-03); also cp. Fairfax, 55 Rutgers L.Rev. 1, 1, 4 et seqq. (2002).
 Ribstein (2002) 9.
 In order to enhance financial figures Enron made use of extensive derivated trading with Special Purpose Entities (SPEs) so that investors got the impression that Enron made highly profitable transactions. On the other hand, debts were lead over to to kamikaze subsidiary companies like Chewco, which was undedectable because of tricky accounting practices. Hence, two goals were achieved: Firstly, a clean slate in the financial statements existed and secondly, there was no need to pay any taxes. When Enron’s investments began to decline, Raptor entities were established to purportedly hedge against the fall of value. By Octover 2001, the Raptors were not able to cover up the losses so that the whole system collapsed; cp. Ribsein, 28 J. Corp. L. 4 et seq. (2002)
 Sunbeam i.e. manipulated financial statement by, among other things, excessive write – downs in a “big bath” restructuring, booking phony sales and rebates and not accounting for accounting and other advertising expenses; Sauer, 57 Bus. Law. 955, 991 (2002).
 In the 1990’s market, the NASDAQ rocketed from 1400 to 5200 points within a few years.
 Aronson (2002-03) 130; Ribstein (2002) 3.
 Cp. Sanger, N.Y. Times, July 10, 2002.
 As Romano indicates, public confidence in big businesses dropped from averaging 29.33 % in the prior five years to 20 % in 2002, Romano (2004) 3.
 Corporate Governance scandals were not a new occurence in 2002. There have been famous U.S. insider trading scandals in the 1980’s, which lead to the enactment of the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA); 15 U.S.C. § 78u. What was new though was the extent of the damage caused.
 Romano (2004), 2.
 Backer (2005) 4.
 Backer characterizes this method as a system of surveillance, where, under the supervision of the government, “every watcher is watched”; Ibid.
 Ibid. 5.
 As Menard illustrates this can be achieved i.e. by appointing a single person as a “disclosure controls monitor” who would be responsible for documenting compliance with the company’s disclosure controls and procedures, preparing each SEC filing for the committee’s review, and suggesting improvements in the disclosure controls; Backer (2005) Fn. 34.
 15 U.S.C. 78f.
 As declard by SOX Sec. 301 [and subsequently by SEA Sec. 10A m(3)] independence means: “(A) IN GENERAL- Each member of the audit committee of the issuer shall be a member of the board of directors of the issuer, and shall otherwise be independent. (B) CRITERIA- In order to be considered to be independent for purposes of this paragraph, a member of an audit committee of an issuer may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee-- (i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof.”
 Erturk / Fraud / Johal / Williams, IPEG CG Paper Series, Working Paper No 1, 33 et seq. (2003)
 Romano (2004), 14.
 In contrast see In Re Oracle Corp. 824 A.2d 917 (2003 Del. Ch.).
 Black, 54 Business Lawer, 921 et seqq. (1999); Romano, 5 Industrial and Corporate Change 2, 277 et seqq. (1996).
 As Romano (Romano , 19,39) points out there is mixed data on whether a committee with a majority of independent directors improves performance, however it is prevailing that with 100 % independence this is not the case. “The compelling thrust of the literature on the composition of audit committees, in sum, does not support the proposition that requiring audit committees to consist solely of independent directors will reduce the probability of financial statement wrongdoing”; cp. further: Klein, 33 J. of Accounting and Economics, 375, 387 (2002); Chtourou / Bédard / Courteau (manuscript 2001) 1, 5 et seqq.; Xie / Davidson III / DaDalt, 9 J. Corporate Finance, 295, 299 et seq. (2003); contrary cp. generally Abbott / Parker / Peters (manuscript 2002), 3; NUS Business School, 1 Corp. Gov. Executive 1, 3 et seqq. (2003). Uzum / Szewczyk / Varma 60 Fin. Analysts J. 3, 33 et seqq. (2004) state that the number of affiliated (“grey”) directors is linked to the degree of fraud. Yet as Romano points out, this is not prima facie evidence in support of the Sec. 301 SOX provision, because it equals affiliated directors with independent directors, Romano (2004), 35.
 Beasley, 71 Accounting Rev. 4, 443 et seqq. (1996); Romano (2004), 29 citing Abott / Parker / Peters (2002); also cp: NUS (2003) 6 with reference to Beasley.
 Cp. Felo / Kristhnamurthy / Solieri, 10 (manuscript 2003) relying on AIMR scores to prove this assumption.
 Xie / Davidson III / DaDalt (2003), 295, 299 et seq. The positive effect of financial experts on the Audit Committee however is not undisputed. The argument of Abbott / Parker / Peters (2002), 3, that an increase of financial experts is to be valued positively because it leads to fewer re-statements can be countered with the assertion, that a reduction of re-statements are connected with the intension of financial experts to aid fraud and misconduct; Romano (2004), 26.
 Regarding the necessity to have at least one financial expert sitting on the audit committee the NYSE rules are rather flexible. I.e. the NYSE Listing Manual 303.01 (B)(2)(b) et (c) leaves it to the Board to define expertise and literacy. Also Cp. Sec. 407 SOX. The SEC is free to somewhat define the term “financial expert” although 407 (b) gave a mandatory guideline of considerations. Sec. 407 (b) SOX reads: CONSIDERATIONS- In defining the term `financial expert' for purposes of subsection (a), the Commission shall consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or from a position involving the performance of similar functions-- (1) an understanding of generally accepted accounting principles and financial statements; (2) experience in-- (A) the preparation or auditing of financial statements of generally comparable issuers; and (B) the application of such principles in connection with the accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) an understanding of audit committee functions“.
 Relevant parts of Sec. 302 SOX read: Corporate Responsibility for Financial Reports (a) REGULATIONS REQUIRED.—The Commission shall, by rule, require, for each company filing periodic reports under section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m, 78o(d)), that the principal executive officer or officers and the principal financial officer or officers, or persons performing similar functions, certify in each annual or quarterly report filed or submitted under either such section of such Act that— (1) the signing officer has reviewed the report; (2) based on the officer’s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading; (3) based on such officer’s knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report; (4) the signing officers— (A) are responsible for establishing and maintaining internal controls; (B) have designed such internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared; (C) have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report;and (D) have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date; (5) the signing officers have disclosed to the issuer’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function)— (A) all significant deficiencies in the design or operation of internal controls which could adversely affect the issuer’s ability to record, process, summarize, and report financial data and have identified for the issuer’s auditors any material weaknesses in internal controls; and
(B) any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls; and (6) the signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.” (b) [...] (c) [...] (Emphasis in original).
 Romano (2004) 92.
 President Bush ’s Speech, July 9, 2002 ( available at: www.pbs.org/news/ bb/business/july-dec02/bush_7-9.html; hereafter President Bush ’s Speech). Also see the “President’s Ten–Point Plan” (available at: http://www.whitehouse.gov/infocus/corporateresponsibility/index2.hml).
 Fairfax (2002) 1; Friedland (2002) 385.
 President Bush ’s Speech: “Currently, a CEO signs a nominal certificate and does so merely on behalf of the company. In the future, the signature of the CEO should also be his or her personal certification of the veracity and fairness of the financial disclosures. When you sign a statement, you're pledging your word, and you should stand behind it.“
 Friedland (2002) 385. Violations of Sec. 302 SOX can consequently lead to civil legal actions for damages.
 Sec. 906(c) SOX reads: CRIMINAL PENALTIES – Whoever (1) certifies any statement as set forth in subsections (a) and (b) of this section knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in this section shall be fined not more than $1,000,000 or imprisoned not more than 10 years, or both; or (2) willfully certifies any statement as set forth in subsections (a) and (b) of this section knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in this section shall be fined not more than $5,000,000, or imprisoned not more than 20 years, or both.”
 Bhattacharya / Groznik / Haslem (manuscript 2002), 11 et seqq.; Hirtle, Fed.Res.Bank NY Staff Rep. No. 170 (2003) 1 “[...] not statistically significant [...]”.
 Bhattacharya / Groznik / Haslem (2002) 12. Furthermore it is difficult to draw a conditio sine qua non connection between the provisions of SOX and its direct effect on the stock value. The work of Rezaee / Jain (manuscript 2005) which examined the influence of stock value on the direct enactment of Sox and finds such a positive connection, has been criticized as not being robust evidence; cp. Romano (2004) 106 et seqq.
 Ribstein (2002) 8.