When a series of accounting scandals, such as those at Enron and WorldCom, shook corporate America in the early 2000s, the U.S. government responded with a new federal law to reform business practices.
Among other things, the 2002 Sarbanes-Oxley Act (SOX) required the boards of publicly-traded companies to have a majority of outside, independent directors and for the firms to implement audit, nominating, and compensation committees comprised solely of independent directors.
These requirements aimed to increase transparency and reduce management control. Assuming managers might use their power for their own interests, the SOX provisions limit managers from influencing committee and board deliberations because CEOs and other members of the management team can’t sit on the committees and are outnumbered on boards.
And with a hefty price tag – it’s estimated SOX investments cost $1.4 trillion – the big question is: Did SOX work?
Paying the price
New research from Karin Schnarr, EMBA ’08, PhD ’15, an assistant professor at Wilfrid Laurier University and Associate Professor Glenn Rowe shows the SOX provisions did not have the intended effect, neither reducing levels of managerial entrenchment nor having the potential to improve shareholder value.
“SOX has not done what it was supposed to do and, in fact, it has done the opposite in a couple of cases, and has probably been a waste of time and money,” said Rowe. “My sense is that SOX should be repealed and its requirements should be done away with.”
Their study looked at the impact of board structural changes implemented from 1999 to 2009 by 335 firms from the S&P 500. They assessed the effects on corporate governance and shareholder value based on lower levels of managerial entrenchment as per the Entrenchment Index (E-Index). They also assessed whether it made a difference if the firms made changes voluntarily in the pre-SOX era versus when mandated through SOX. Results showed, either way, the reforms did little to strengthen the firms’ corporate governance.
The study provided two important insights:
- Managers still prevail – Increasing independent board and committee members did not reduce managerial entrenchment, as shown through higher E-Index levels at the firms. The researchers suggested that perhaps the independent directors were not paying as much attention to the companies as the management and affiliated directors who had more to gain from the companies’ success. Or, as the number of independent board members increased, more managerial entrenchment provisions were introduced; and,
- One size does not fit all – Implementing new audit, nominating, and compensation committees also did not reduce managerial entrenchment. The researchers propose that perhaps the SOX-mandated committees did not make sense for some firms. If so, they might have prioritized form over function or appointed management-loyal outside directors.
“It’s a cookie-cutter approach that treats all firms the same, but it’s possible that firms in different industries require other types of committees to do what’s right for shareholders,” said Rowe. “Firms might not be able to put in place the appropriate committees because they have to spend so many resources on the committees mandated by SOX.”
Moving beyond window dressing
The findings also suggest other elements might instead need attention when constructing boards and board committees to improve corporate governance practices.
“It sends a strong signal to regulators in North America and abroad that the time and energy spent by corporations and governments implementing these sweeping changes are only superficial and symbolic signals with few tangible links to improving governance,” said Schnarr.
The paper, “The Impact of Sarbanes-Oxley Changes and Board Independence Power on Selected Governance Practices at the Board Level,” co-authored by Schnarr and Rowe, will be submitted to a management journal.
At a broader level, Rowe said he’s also interested in exploring how board members interpret the phrase: in the “best interest of the corporation,” which is in the Canadian Business Corporations Act.
“Are they going to interpret it as in the best interests of shareholders (known as the shareholder primacy norm), in the best interests of all stakeholders, or in the best interest of the corporation itself? When you have 10 to 15 board members, some could have one perspective and others have another,” he said. “If you have a discussion about it, you can at least understand where each is coming from and perhaps develop better ideas of what board members should do.”