The New Federalism
More broadly, SOX ushered in a new Federalist era in corporate governance, one that applied national rules to boards traditionally governed by state corporation law. A case in point happened in the aftermath of the financial crisis of 2008, when Congress passed along party lines and President Barack Obama signed the voluminous Dodd-Frank into law on July 21, 2010.
Passage of the act—considered the most sweeping overhaul of the U.S. regulatory system since the Great Depression, when Congress passed the Securities Acts of 1933 and 1934, which created the SEC—perpetuated what has become a widely acknowledged pattern of legislative response to financial crisis. What financial crises all seem to have in common, regardless of whether that crisis roils a single individual or the entire market, is a loss of investor and public confidence. And the response dating all the way back to the Great Depression has been increased regulation. The déjà vu pattern repeated itself with Dodd-Frank, as Congress tried to shore up investor confidence, particularly in the banking sector, but in effect federalized the board of directors’ compensation committee in a fashion similar the effect of SOX on audit committees.
Until SOX, say legal observers, state law had jurisdiction over the governance of corporations. Because some 60 percent of American businesses are incorporated in Delaware, the courts in Delaware have traditionally had a great influence on other state laws. Today, they continue to lead the way in maintaining some balance between federal laws’ regulatory jurisdiction and incursions by federal lawmakers into what has been the traditional province of the state.
Peter Atkins, a partner at Skadden who is highly respected for both mergers and acquisitions and corporate governance, has consulted to numerous boards, including Enron, HealthSouth and McKesson, in responding to crises they confronted. In a talk he gave to directors in June and which he shared with NACD Directorship, Atkins said that while the traditional source of corporate governance, state corporate statutes, hasn’t changed all that much, there has been what he calls a “dramatic expansion” of the role and responsibility of directors that “reflects an enormous surge in the scope and meaning of corporate governance.”
The corporate governance environment today “includes requirements, rules and proddings,” Atkins says, from such diverse sources as “the SEC, the stock exchanges, SOX and Dodd-Frank, the Department of Justice, state attorneys general, shareholder governance activists, hedge funds and other shareholders with specific interests, proxy advisory firms, academics in various disciplines, the advent of whistleblowers on a broad basis, specific legislation that continues to expand the need for legal compliance and risk management including the Foreign Corrupt Practices Act—and last but not least, the spillover in print and electronic media coverage of business news from the relative quiet of the business section to the often harsh spotlight of the front page.
“And right in the bull’s eye,” Atkins contends, “sits the board of directors.”
SOX included a directive to the stock exchanges for governance standards. A year and a half after the passage of SOX, in November 2003, the SEC approved new listing standards for U.S. public companies on the New York Stock Exchange and Nasdaq (with Amex rules soon to follow). One of them required independent directors of all listed companies to meet regularly in executive sessions without management present. That, in effect, was intended to free directors to talk openly about concerns stemming from conversations with management. Like many regulatory changes, this had its precedents—it was recommended in the 1996 Report of the NACD Blue Ribbon Commission on Director Professionalism. Yet there is no doubt that mandating this practice for NYSE- and Nasdaq-listed companies boosted the rise of the independent director.
Joseph Berardino was CEO of Andersen Worldwide, which saw its conviction for obstruction of justice in the Enron matter overturned in 2005 by the U.S. Supreme Court. There was a time, Berardino says, when he thought he would never work again, but like many caught in a downward spiral, he didn’t give up. “I’m a good Catholic boy,” he says. Berardino joined Alvarez & Marsal in 2008, a global consultancy that specializes in corporate turnaround, restructuring and performance improvement, where he is in charge of building a consultancy around healthy companies. He also serves on the boards of publicly traded Value Vision Media and Quiksilver and privately held Neuberger Berman.
Given his experience, Berardino says what he now takes into boardrooms is a strong belief that what happens in the boardroom is all about “the conversation. Are we having the right conversations in the boardroom?” Berardino says that despite the regulations that SOX imposed on audit committees, and more recently the mandates on compensation committees stemming from the passage of Dodd-Frank, the main issue is old-fashioned business operations. “I would argue that without exception audit failures stemmed from business failures,” he says. “Then the cover-up is always worse than the crime. If you want to protect shareholders, it all starts with the health of the business.”
Regardless of the complexity of the business, he maintains, “The right conversation always starts with ‘What are the key risks? What are our competitors doing? How are we doing compared to our competitors?’”
Does Berardino think the quality of audits is better today? “The auditor’s job is to give assurance. What the market really wants is insurance. That’s a fundamental disconnect,” he says. “If the company blows up, the auditors get sued. If you think of the audit process as an assembly line, the auditors are at the end of that line. And rather than doing the right audit, there’s a tendency to do what I call a defensive audit.”
Even so, there is proof that SOX has had at least some positive effect. The number of companies filing financial restatements has decreased dramatically. Initially, restatements rose as executives sought to correct past reports, peaking at 1,790 in 2006, according to the research firm Audit Analytics. Since then, restatements have leveled off to about 790 for each of the past two years (2011 and 2010).