Regulations in Corporate Governance Research Paper

Introduction

Corporations form one of the fundamental components of a country’s economic growth and development, as they constitute the basic unit of the market economy. Therefore, it is important for stakeholders, such as governments, industry regulators, and suppliers amongst others, to ensure that organisations are efficient and stable (Bainbridge 1179). Organisations face numerous threats emanating from internal and external sources. One of the major sources of internal threats in organisations relates to lack or failure of employees to adhere to the set code of ethics, which is one of the major reasons that explain the occurrence of corporate scandals. In an effort to mitigate organisational failures arising from scandals, organisations are incorporating the concept of corporate governance in their management practices. According to Bainbridge (1180), corporate governance refers to structures, mechanisms, and modalities through which a firm’s goals and objectives are set with regard to the firm and shareholders’ interests. Consequently, the core objective of corporate governance is to improve the shareholders’ value and attain financial stability. In addition, corporate governance aims at ensuring an effective control over a firm’s behaviour and performance. Effective corporate governance ensures that accountability, integrity, transparency, and trust are entrenched within an organisation. This aspect makes corporate governance stand out as a self-regulatory mechanism. The need for corporate governance in organisations arises from the existence of separation between a firm’s ownership and control (Bainbridge 1179). Despite managers’ efforts to nurture corporate governance, corporate scandals continue to be a major threat to corporations across the world. The Enron scandal and the 2008 financial crisis are some of the major corporate scandals of the 21^st century. This paper evaluates whether there is a need for more or fewer regulations in order to enhance corporate governance. The research paper also entails opinion on the nature of regulations that should be implemented.

The Sarbanes-Oxley Act [SOX]

The SOX Act is one of the regulations that were implemented by the United States government in an effort to deal with cases of corporate frauds. The Act was integrated in the United States legal system in 2002 despite its existence for over 70 years. The SOX have been very effective in enhancing corporate governance. Mitchell argues, “The principal causes of the corporate scandals of 2002 and the accompanying collapse in the stock market can be traced to the development of an investing and managing ethics that favoured short-term increases in stock prices over the long-run profitability and wellbeing of corporations” (p.1190). The SOX Act plays a fundamental role in enhancing corporate governance through the various requirements that organisations are required to adhere to in their operations. Prentice asserts, “A study conducted on 2500 firms in the United States shows that the implementation of the SOX Act led to a 10% improvement in corporate governance performance of the United States’ companies compared to their foreign counterparts” (714). One of the aspects that the Act enhances relates to full disclosure of an organisation’s financial position.

First, “the Act requires financial statements to certify that the financial statements issued to the public are transparent and represent the fair position of the organisation” (Prentice 720). The next requirement entails incorporating a comprehensive explanation of the financial statements issued in a non-GAAP format. Moreover, the entrepreneur should also integrate a comprehensive explanation of the off-balance sheet financial information. Incorporating such information minimises the likelihood of an organisation’s management team to conceal the firm’s financial operation through complex accounting and financial mechanisms. The Act has made it difficult for managers to manipulate stock prices. Therefore, the effectiveness with which an organisation communicates its true financial position to the public is improved (Mitchell 1190). Prentice (711) asserts that a number of successes have been derived from the SOX Act. First, the provisions of the Act played a significant role in reviving the United States’ capital markets, which were experiencing a free fall at the time of its enactment. For example, the S&P 500 and the NASDAQ market indexes had declined with a margin of 40% and 70% respectively (Prentice 712). In addition, most businesses in the United States have considered section 404 as the most ‘working’ component of the accounting reforms in that it has enhanced financial reporting (Prentice 716).

Arguments by authors on the need for more regulations and the justification of SOX and Dodd-Frank

Despite its effectiveness in promoting disclosure of an organisation’s financial performance, the SOX Act was not free from ineffectiveness. Some of the major failures of the Act are highlighted herein.

Independent audit committee

According to section 301 of the Act, all companies listed in the New York Stock Exchange market were required to have an audit committee comprising independent directors. The Act argued that such a committee would be very effective in monitoring a company’s management efficiency. The independence of the audit committee would be enhanced by the fact that their remunerations are limited to the directors’ fees. Consequently, the likelihood of directors engaging in fraud is relatively low as compared to situations whereby auditing is left in the hands of insiders whose remuneration is subject to bonus compensation. Through such a requirement, the Act postulated that the likelihood of minimising audit failure would increase significantly (Romano 1). The United States Congress also required organisations to disclose whether the individuals in the independent audit committee are financial experts. If the “committee does not have a financial expert, the organisation is required to explain why this was the case” (Hart 678).

Previous studies conducted show that the independence of the audit committee is not directly related to improvement in corporate performance. Romano (1) argues that organisations whose board of directors is comprised of too many outsiders may have a negative impact on the performance of an organisation. External board members may not have sufficient time to take care of the company’s affairs. External directors may owe their allegiance to the management team that appointed them, and thus they may not be very effective (Hart 679). Findings of 12 studies on the impact the independence of an audit committee on financial statement misconduct show that there is a minimal or no impact on improvement of an organisation’s performance due to complete independence of the audit committee. Moreover, available literature suggests that incorporation of exclusively independent directors as auditors does not eliminate the likelihood of financial statement misconduct.

Non-audit services

The SOX Act [section 201] forbids accounting firms from offering specific non-audit services to organisations in which they are contracted to provide auditing services. Examples of such services include investment and banking services, legal and expert services that are not associated with auditing, brokerage services, valuation and appraisal services, services related to designing and implementation of financial information systems, and internal auditing services. The rationale behind the prohibition towards the provision of non-audit services is that engaging in such services would compromise the auditors’ independence. The auditors would receive high remuneration of such services from organisational managers, which is an incentive to engage in questionable accounting and financial reporting behaviour (Romano 2). Prentice and Spence emphasise that the collapse of the Enron proves “that the provision of non-audit services, particularly at a significant level, undermines independence in appearance and threatens the credibility of audit” (1883). The hope of earning $100 million annually through the provision of consulting services motivated Arthur Andersen to allow Enron continue engaging in excessively aggressive accounting conduct.

A number of studies have been formulated in an effort to determine whether the provision of non-audit services by external auditors would compromise the quality of services offered by auditors. Seventy six percent (76%) of the studies show that SOX’s prohibition with regard to the provision of non-audit services is superfluous. Fifteen of the 25 studies conducted show that there is no direct correlation between the provision of non-audit services and the quality of services provided. One of the studies show that the quality of audit is not affected despite the auditors selected coming from big auditing firms such as Arthur Andersen. Alternatively, three (3) of the studies show that provision of non-audit services contributes towards improvement in the quality of auditing services provided (Mitchell 1193). Findings from these studies contradict the SOX’s prohibition. Only six (6) studies show that the quality of auditing is compromised by integration of non-auditing services in the process of auditing. The conclusion that the quality of auditing is not compromised by integration of non-auditing services is compelling enough to integrate non-auditing services.

Cost of compliance with section 404

The SOX was formulated with the objective of promoting corporate governance in organisations. However, most organisations have experienced a challenge in their quest to comply with the regulation due to the high cost of compliance. Section 404 of the SOX has a number of requirements. First, it stipulates that every annual report should be comprised of an internal control report. The report should outline the organisational “management team’s responsibility with regard to the establishment and maintenance of the internal control systems and the financial reporting procedures” (Mitchell 1197). Moreover, the financial report should also illustrate the effectiveness of the structures implemented. Secondly, section 404 postulates that every registered public accounting organisation contracted to audit the financial performance of another organisation should attest to the report. Section 404 continues to be the most controversial element of the SOX. Most small organisations are not in a position to comply with the section.

Initially, the United States Security Exchange Committee (SEC) had estimated the cost of complying with the section to be $1.24 billion. However, other studies conducted show that the cost of compliance to be $ 35 billion, which is approximately 35 times higher. This cost is relatively high for most SMEs. A survey conducted by CRA International shows that the cost of complying with the Act for one year would cost a business with a market capitalisation ranging between $75 million and $ 700 million $1.5 million (Mitchell 1196). This figure accounts for 0.46% of its annual revenue. Most businesses in the United States perceive the cost of complying with section 404 of the SOX Act to be a major hindrance. Given the push back from entrepreneurs, the United States’ government, through the Public Company Accounting Oversight Board and the SEC, had considered reviewing the section. The occurrence of the 2007/2008 global financial crisis watered-down the efforts that had previously been made by the United States Congress with regard to improving section 404. On the contrary, the United States’ government focused on the “New New Deal”, which was meant to undertake a massive and comprehensive formulation of new regulations to control the financial markets. The global financial crisis was so complex compared to amendment of the SOX. The need to amend the SOX was motivated by failure of the internal control systems in some organisations. However, the global financial crisis was considered to have originated from systematic market failures as revealed by Dodd-Frank.

Executive loans

Section 402 of the SOX Act was amended in 2002 leading to the prohibition of organisations from issuing credit services to directors and other executive officers unless the organisation operates as a financial institution. The decision to prohibit extension of loans to individuals within an organisation’s top executive was informed by the failures of Tyco International, WorldCom, Enron, and Adelphia Communications. The top executives from these organisations had obtained million of dollars in loans from their organisation, and due to the loans, the firms’ shareholders and employees incurred substantial amounts of financial losses. For example, Tyco’s Chief Executive Officer, Dennis Kozlowski, was accused of engaging in fraudulent accounting practices and using the company’s funds for personal purposes. Moreover, he borrowed approximately $270 million most of which was used to purchase a yacht, real estate, and jewelleries. Adelphia Communications CEO was charged with amassing $3.1 billion through off-balance sheet loans. Similarly, WorldCom’s CEO, Bernie Ebbers, borrowed $ 408 from the firm, and used most of the loan for his personal purposes. Most corporate executives who sought loans from the organisation did not pay off such loans (Prentice and Spence 1893). The majority of the executives had cited that they would use the amount extended as loans to purchase company stocks, thus aligning their interests in the organisation with that of the shareholders. Despite some of the executives purchasing their company’s shares, they would resell the securities purchased immediately, hence minimising the likelihood of the organisation benefiting from the loan (Prentice and Spence 1894).

Such executive loans nearly forced some organisations such as Conseco into bankruptcy. Other executives who were not in a position to repay the amount of loan extended include executives from Gold Trust of America. It is estimated that approximately loans amounting to $ 1 billion issued prior to the existence of the SOX would be forgiven. The ability to borrow loans from their organisations also provided executives with an opportunity to engage in unduly risky investment practices in an effort to improve their company’s stock prices. Moreover, top executives from organisations faced with the challenge of insolvency would use executive loans as a strategy to siphon funds from the organisation.

The Congress’ decision to adjust the executive loans provision of the SOX was supported by a large number of organisational stakeholders. Prentice and Spence (1895) are of the opinion that the executive loans did not accomplish the purpose for which they were designed. Secondly, the executive loans led to develop of a culture of inaccurate financial reporting in an effort to commit fraud. Moreover, executive loans have been associated with poor organisational performance.

Executive certification

Prentice and Spence (1894) assert that section 302 of the SOX Act requires the Chief Finance Officers and CEOs of public companies to certify that the periodic reports issued are free from omissions and material misstatements. Moreover, the financial reports should represent the organisation’s fair financial condition. The objective of the SOX 302 is to improve the reliability and credibility of an organisation’s financial reports. Previous studies conducted reveal mixed opinion on the impact of executive certification on the investors’ confidence. For example, a study conducted by Romano (4) shows that executive certification requirement does not influence the performance of an organisation in the share price. On the other hand, another study conducted by Bhattacharya et al. (611-635) shows that executive certification leads to improvement in investors’ level of confidence. Some organisations undertake executive certification of their financial statements voluntarily. However, section 302 of the SOX Act ensures that organisations that have not formed a culture of voluntarily certifying their financial reports do so. Prentice and Spence (1901) assert that there is a strong empirical evidence indicating that section 302 of the Act does not only ensure that CFOs and CEOs execute their duties seriously, but also it ensures that they provide information that is relevant and valuable to the capital market.

Limits and danger of regulations of corporate governance

The United States has experienced a number of corporate failures over the past decade as evidenced by the failure of Tyco, Enron, Global Crossing, WorldCom, and Adelphia amongst others. Excessive remuneration to the top executives ranks as one of the major sources of corporate failures. Varying points of view on corporate governance in the United States have been advanced. Holmstrom and Kaplan (1) argue that the United States’ corporate governance system is very effective despite the criticisms that have been levelled against the system. For example, the performance of the United States’ stock market indices has been exceptional compared to other major indices over the past two decades.

Despite its optimal performance, a number of issues characterise the United States’ corporate governance system. Hart (678) emphasises that issues related to corporate governance in organisations arise if two main conditions, viz. agency problem and conflict of interest, are evident. The conflict of interest may involve diverse organisational stakeholders such as the owners, employees, managers, or employees. The first limitation of corporate governance relates to shareholder activism. First, the United States’ corporate governance system is ineffective with regard to integration of shareholders. The system has not been formulated as an effective market-oriented system. According to Hart (678), a market-oriented system is comprised of well-informed and active shareholders. Consequently, they are in a position to engage in corporate governance extensively through voice and exit. The level of shareholder engagement in matters related to corporate governance continues to be low despite the fact that their ownership stake in organisations, through mutual and pension funds, has increased significantly. For example, during the collapse of Enron, 60% of the company’s shares were under the ownership of institutional investors. However, they did not perceive that the company’s shares were over-valued. Shareholder activism is very critical in enhancing corporate governance in organisations.

In addition to the above limits, shareholders mainly depend on informal engagement in their effort to control organisational performance. Considerable numbers of institutional investors in organisations do not have adequate voting rights. Consequently, they cannot influence a firm’s management decisions and engage in behind-the-scenes control of the organisation.

Limits of board independence

Considering the low level of shareholder engagement in the operation of organisation, organisational control has been left in the hands of external individuals who include the independent board members (Hart 682).The agency theory posits that a board of directors that is comprised of external members is highly effective in monitoring the performance of an organisation. The board of directors is charged with a number of responsibilities, which include ratifying the decision made by the management, allocating rewards, and penalties, and appraising the performance of the management team. Consequently, one can assert that the board‘s independence is paramount in ensuring that an organisation’s operations align with the shareholders’ interest.

However, the current corporate governance in the United States prohibits the existence of an independent board of directors (Romano 36). Some critics of an independent board of directors are of the opinion that a board composed of too many external stakeholders may have adverse effects on corporate governance performance of an organisation. According to Hart (682), non-executive board members may not be very effective in monitoring an organisation’s performance, as they may have minimal financial interests in an organisation’s operation. However, previous studies conducted show that there is a positive degree of correlation between corporate governance and an independent board of directors. Independent board members are more likely to provide optimal organisational oversight.

Limits on board incentives

Another major limitation of corporate governance and regulations in the United States relates to board incentives. Currently, corporate executives in the United States have a significant influence in the operation of organisations. The current corporate governance system provides executives with the power to influence their personal remuneration such as salaries and bonuses. This element has significantly weakened the link between the executive’s remuneration and his or her performance. For example, the executives in the United States are in a position to inflate their earnings at the expense of the shareholders and employees’ interest. Prentice and Spence posit, “The power to control their earnings has motivated executives to focus on short-term earnings at the expense of long-term organisational performance” (1895). Another limitation of the United States’ corporate governance system arises from the fact that the board of directors determines the executive remuneration and incentives. Consequently, absolute independence in the determination of the boards’ incentive is lacking. In most cases, board of director members have minimal or no equity holdings in an organisation. As a result, their incentive to intervene in the event of ineffective corporate policies is low.

Opinion

Despite the SOX’s effort to prohibit extension of loan services to executives, the term loan has narrowly been described. Consequently, there is a high probability of the executives using other mechanism to get the shareholders’ investments into their pockets. Prentice and Spence are of the opinion that executives “who receive loans are not giving up other forms of compensation return for receiving these loans” (1896). In addition, the last decade has been characterised by an increment in the number of executive compensation mechanisms.

According to Romano, “stopping loans is not likely to result in reduction in total pay, but will instead force firms to compensate officers using less efficient forms of recompense ” (3). Consequently, one can assert that section 402 of the SOX lacks clarity as it does not rank other forms of executive compensation; for example, the retention loans, travel advances, broker-assisted cashless option exercise, life insurance policies, relocation, and retention loans as executive loans. However, these types of benefits are still permissible. Prentice and Spence (1896) are of the opinion that the adoption of the broad ban prohibition on executive loans, as stipulated by section 402 of SOX, has led to extensive disruption of numerous harmless loan arrangements. In an effort to deal with the limitations emanating from section 402 of the SOX, organisations are forced to seek substitutes for the executive loans.

In a bid to minimise the occurrence of corporate fraud, it is imperative for the stakeholders within the United States’ legal framework to adjust the definition of loans. One of the ways through which this goal can be achieved is by ensuring that what constitutes a loan is extensively defined. Alternatively, the Congress and the SEC should integrate a cap with regard to the amount of executive loans and other forms of benefits that top organisational leaders can accrue annually. This move will aid in minimising the likelihood of the executives using their position for personal benefits. Additionally, in a bid to enhance corporate governance in the United States through the board of directors, it is essential for the US government to ensure that the board of directors is constituted optimally. One of the ways through which this goal can be achieved is by integrating both internal and external stakeholder. For example, the board of directors should also integrate ordinary employees. External directors may not have sufficient and quality information on an organisation’s performance compared to external stakeholders.

Ensuring employee representation in the board of directors may lead to improvement in corporate governance. Employees in the lower level of organisational management have sufficient inside knowledge on the performance of an organisation. Consequently, they are more likely to assist the board’s effort to monitor the performance of an organisation. Developing a balanced board of directors is likely to improve an organisation’s corporate governance. Considering this limitation, it is imperative for the United States’ government to adjust the current SOX requirement with regard to the board of directors. In my opinion, the board of directors should be comprised of internal and external stakeholders. The internal board members should be comprised of a number of ordinary employees.

One of the ways to develop a strong and effective board of directors is by selecting the board members through a formal procedure. The board of directors should be comprised of both large and small shareholders. Examples of large shareholders that should be integrated include institutional investors. In most cases, small shareholders do not have sufficient incentive motivating them to monitor organisational performance compared to large organisations. On the other hand, an effective remuneration and audit committee should be formulated. The committee should mainly be comprised of non-executive directors. Taking into account such measures will likely improve corporate governance in organisations. In addition, it is imperative for the United States’ government to adjust Section 404 of the corporate governance system. Currently, a large number of businesses in the United States, especially the small and medium enterprises, find it challenging to comply with the regulation. One of the ways through which this goal can be achieved is by reducing the cost of compliance. A downward adjustment on the cost of compliance will motivate organisations to comply with the section’s requirements. The ultimate effect is that corporate governance in organisations will improve. Moreover, it is also imperative for the US SEC and Congress to adjust the SOX in such a way that it provides external auditors with the discretion to offer various non-audit services, which will lead to success of the country’s corporate governance system.

Conclusion

This research paper has highlighted corporate governance as one of the most effective systems through which governments can enhance economic growth and development by eliminating corporate scandals. From the paper, it is evident that the United States’ government has tried to nurture corporate governance in the country through implementation of the SOX Act. However, the Act has been subject to a number of limitations, which have led to extensive criticisms. Some of the major criticisms and limitations of the system relate to requirements with regard to independent audit committees, provision of non-audit services, cost of compliance with section 404, executive loans, and executive certification. Other major gaps in the system relate to the shareholders’ contribution to corporate governance, board of directors’ independence, and the board’s incentives. Considering these challenges, it is imperative for the United States’ government to adjust the country’s corporate governance system as recommended in the paper.

Works Cited

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