EVENTS

Date:	Wednesday, May 5, 2004
Time:	9:00 AM -- 3:15 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

May 2004
Sarbanes-Oxley: A Review

On May 5, 2004, AEI hosted a conference to review the effects of Sarbanes-Oxley two years after it became law.  Adopted in the wake of Enron and other corporate scandals, the act and subsequent regulations by the New York Stock Exchange and NASDAQ mandated the dominance of corporate boards and audit committees by independent directors. It also established the first regulatory agency exclusively for auditors of public companies. The act has remained controversial, with some arguing that it was unnecessary and has led companies to become more risk-averse. 

Sanjai Bhagat
University Colorado at Boulder

 In practical terms, corporate governance includes the company's articles of incorporation, the mechanics of board elections; the responsibility of the board to act as fiduciaries of the shareholders; the responsibility of the board to hire, compensate, and fire senior management; and the public audits of the company. Board independence may still be a worthy goal, but in practice it should be pursued with a few important qualifications. First, independent directors need to be better incentivized, namely by increasing the amount of equity that they hold. Secondly, some directors who are usually classified as independent should not be considered truly independent of management because they are beholden to the company or the CEO in ways too subtle to be captured in customary definitions of "independence." Many have argued that excessive reliance on stock and stock-option-based compensation has focused management's attention on the share price-some might add that it has focused their attention too much on the share price. How does one address this in the corporate governance framework? The answer, surprisingly, is not that complicated--accounting.  Unless outright fraud is involved--for which there are criminal sanctions--accounting games tend to unravel in a two to three-year period. In light of this, one way to curb the temptation of senior managers to play games with their accounting numbers is the following: management stock and stock-option compensation contracts should require the managers to hold the shares or exercise their options at least three to five years after they leave the company. I might add that these provisions should extend to board members. In the interest of fairness, if we are asking managers and board members to bear more risk, they should be offered a greater compensation of restricted stock and restricted stock options upfront.

Ed Knight
NASDAQ

This is the year in which many of the rules required by Sarbanes-Oxley become reality.  Boards will put a premium on clear priorities, predictability, and efficiency.  In fact, more companies will choose not to be public companies.  Corporate governance reform sounds general, but it does have specific goals: to empower shareholders, independent directors, and audit committees, as well as to increase disclosure and transparency.  There are key considerations to help restore investor confidence: First, adopt significant listing standards that are clear and objective.  Second, it is important to note that one size does not fit all.  Flexibility can and often does make sense when considering the uniqueness of each company.  The NASDAQ approach offers greater flexibility, especially to smaller companies.  We also strive to be less prescriptive.  In addition, NASDAQ has heightened its requirements.  We require audit committee approval of related party transactions.  The compensation committee must approve of all officer compensation.  We have also improved disclosure requirements for non-U.S. issuers.  Finally, we enforce violations through delistings.

Nell Minow
Corporate Library

One of the problems of performing a study as to the effectiveness of independent directors is that there are no clear measures determining independence.  There is no SEC filing that will disclose all of the potential conflicts of interests.  More importantly, no SEC filing will be able to show independence of mind, heart, and courage.  I do not think there is any point in pursuing the issue of independent directors.  I believe that there will always be limits to structural institutions.  This must be kept in mind when discussing any kind of reforms.  In ten years we will see that any impact Sarbanes-Oxley could have had will be dwarfed by the market's own response, which is much more powerful.  What we have is an attempt to treat a state issue at the federal level. 

Jeffrey Sonnenfeld
Yale School of Management

There are key fields of board responsibility: the integrity of the enterprise, the mission and purpose of the business, financial health, and the responsiveness to interests of key stakeholders.  Traditionally corporate boards were responsible for auditing and monitoring, merging resources, and giving advice and support to the management.  It is important to first build an effective board, and this often starts with its culture.  It must create a climate of trust, foster open dissent, ensure individual accountability, and evaluate performance.  Director selection is also key.  Character should be stressed more than independence; sometimes inside information is useful.  Boards should find people who are passionately interested in the business and ruthlessly purge hidden commercial or social agendas.  The board must also be able to provide self-assessment.  Criteria useful in evaluating the board are board composition, culture, focus, execution, and the way information flows. 

Panel II

Stuart McFarland
Federal City Capital Advisors

My experience on several boards forms the foundation of my comments on board governance.  Independence is one of many factors that impact effectiveness, but I do not think that an independent board will necessarily perform better or worse.  I believe the key is board member competence and understanding of the business and its issues.  It is important that the members oversee and govern the enterprise, which will lead to better business performance.  First, directors must approve managers' strategies.  Second, they need to oversee management tactics.  Third, members must feel that they can challenge and disagree.  A close framework for scrutiny is essential. The board composition must be in step with the business and the shareholders. Perhaps the key is that the board can drive change in the management and the company.  At the end of the day, regardless of independence, boards will operate more effectively.  Where Sarbanes-Oxley falls short is the high cost of implementing its requirements.  Second, it takes management away from running the business.  Finally, boards are most effective when they question strategy, work with management, and understand the business. 

Julie Daum
Spencer Stuart

Companies are certainly taking the independence of boards seriously; however, changing the regulation is not what actually changed the behavior.  What has happened is that CEOs, mostly out of fear, have relinquished a lot of their control.  Boards have taken control, and they are beginning make the process of bringing on new directors much more open.  However, there are some negatives.  In terms of regulatory impacts, the mandate that a financial expert must be on the board exhausts too many resources and spends too much time on this issue.  There are more financial people on boards and less strategic consultants.  Board membership is taking more time, so now the traditional candidate pool has dried up.  What we find is that boards are now considering retired CEOs to fill in for the active CEOs, as well as younger management executives.  We have an increase in the amount of professional directors as a result.  While this does bring greater governance experience, it does not necessarily translate into better strategy and understanding of the particular business.  Board members must also be actively engaged. 

Roderick Hills
Hills & Co.

Our society says that it wants rules.  I would say there are good and bad aspects of Sarbanes-Oxley.  Compliance is simply too expensive.  Additionally, I fear that it can be too political and has moved away from its use as a management tool.  The issue of directors is not how you get them, but how you choose them.  Companies are looking for directors that have the skills they need to help the company perform better.  The question is whether Sarbanes-Oxley is going to require too much.  Shareholder nominations should be tested before we mandate a general process.  The insider argument is a bit naïve.  Any fair analysis of corporate America, notwithstanding Enron, would show that we are doing a lot better today than we were twenty years ago.

Bill Walton
Allied Capital Corporation

Sarbanes-Oxley has changed the boardroom.  It has increased awareness, and I think that is a good thing.  Directors increasingly feel more accountable.  The costs, time, and money to simply comply have doubled in the last two years, especially when you consider audit committees and outside expenses.  The climate for a public company is also more difficult.  So many companies, including the accounting firms and the NYSE, have all been embroiled in a lack of investor confidence.  We all have a lot of work to do.  Good boards tend to be smaller and more independent-minded, and consist of decision-makers and leaders.  We encourage significant stock ownership and financial independence of the firm. 

Greg Bentley
Bentley Systems, Inc.

In 2002, we filed for an IPO on the NYSE after being privately held for almost eighteen years.  In spring of 2002 Bentley Systems withdrew its application for an IPO as a result of Sarbanes-Oxley.  The majority independent board requirement was the single most important reason why we withdrew.  We want to follow the learning curve of Sarbanes-Oxley and perhaps reconsider another IPO filing once we have seen all the adjustments, but we are in no hurry.  The costs for a public company are significant, especially for the audit committee.  The cultural implications at the board level can be argued, yet they introduce an "us" versus "them" aspect.

Panel III

Tom Hartman
Foley & Lardner

A recent study we conducted showed that nearly 56 percent of those surveyed believed that the corporate governance and public disclosure reforms are too strict.  Feedback also indicated that the practice of a "one-size-fits-all" approach to regulation is problematic.  The resources and controls of companies that have 150 employees versus those that have 1,500 are far too variable.  Overall, the feedback we generated indicated that we should evaluate the benefits versus the costs of the new rules mandated by Sarbanes-Oxley.  Senior management of public, middle-market companies expect costs directly associated with being public to increase by almost 100 percent as a result of corporate governance compliance and increased disclosure requirements under the Sarbanes-Oxley, new SEC regulations, and changes to exchange listing requirements. Legal fees are anticipated to continued to increase significantly, both to a public company directly and through separate counsel serving one or more board committees (e.g., an audit committee). While large-cap/large revenue public companies will see the largest increase in the cost of being public in absolute dollar terms, they are better able financially to absorb the increased costs.  The overall increases will fall disproportionately on small-cap and mid-cap public companies that may face crippling financial burdens to remain public in the new environment.

George Benston
Emory University

Possible benefits from Sarbanes-Oxley to investors include reducing misleading or fraudulent financial statements that result in mispriced stock prices, discouraging fraud by corporate officers, improving audits of corporations to bring about above listed benefits, and increasing investor confidence in financial reporting so as to reduce transaction costs.  The requirements for CEOs and CFOs are probably worthwhile.  The audit committee requirements are useful, particularly with respect to hiring, monitoring, and dismissing auditors.  Non-audit collateral services are not likely to benefit, as no evidence supports the contention that these services corrupted audits. Furthermore, tax advice and advocacy is still permitted.

It will raise the cost of both audits and other services. Benefits from CEO and CFO statements and audit committee reports probably exceed costs. There will probably be fewer misleading and fraudulent financial statements, assuming this actually happens, but since this applies to few corporations, costs probably exceed benefits.  Improved audits as a result of PCAOB oversight benefits could have been achieved by the SEC with actions against individual auditors and therefore the PCAOB cost probably exceeds benefits.

Cono Fusco
Grant Thornton LLP

Grant Thornton examined 222 announcements of companies seeking to go private.  Our analysis showed that only 60 percent of announced transactions actually closed.  The transaction size is a major success factor: under $25 million, 54 percent closed; over $100 million, 73 percent closed.  Common characteristics of companies experiencing successful transactions are low-market capitalization, thin trading volume, limited analyst coverage (not helped by reduced ties to investment banking), strong projected cash flows, and well-respected management.  Growth in private equity valuations falling to levels where LBO models meet targeted return requirements is clearly a contributing factor.  Key findings during the post Sarbanes-Oxley period showed that the number of companies seeking to go private increased by 30 percent.  The median deal size halved from $81 million to $39 million, and the number of proposed management buyouts increased by 80 percent.  Our conclusion is that by going private, companies can greatly reduce their level of risk associated with shareholder litigation while cutting costs and regaining a sense of control and confidentiality.

Grace Hinchman
Financial Executives International

In a FEI Section 404 Cost Survey conducted in January 2004 involving 321 FEI public companies, we found that companies expect to spend on average for compliance: 12,000 hours of internal work, 3,000 hours of external work, an additional $590K in auditor fees-an average increase of 38 percent, and an additional $700K in software and IT consulting.  This resulted in total first-year compliance costs of $1.9 million. For the largest U.S. companies (annual revenues greater than $5 billion), this generated 35,000 additional internal hours and 6,200 additional external hours on average.  This came to total first-year compliance costs of $4.7 million. 

AEI research assistant Jessica Browning prepared this summary.