Professor Joo's areas of interest include contracts, corporations and the intersection of race and law. After graduating in 1993 with a J.D. from Harvard Law School, Professor Joo served as Law Clerk to the Honorable Wilfred Feinberg of the U.S. Court of Appeals for the Second Circuit and as an Associate with Cleary, Gottlieb, Steen & Hamilton in New York City. Professor Joo has served as an Executive Committee Member for the Association of American Law Schools Section on Contracts and has published numerous articles including: Presumed Disloyal: Wen Ho Lee, the War on Terrorism, and the Construction of Race, 34 COLUMBIA HUMAN RIGHTS L.J. 1 (2002); Corporate Governance and the Constitutionality of Campaign Finance Reform, 1 ELECTION L. J. 361 (2002).; and Contract, Property and the Role of Metaphor in Corporations Law, 35 UC DAVIS L. REV. 779 (2002).
On September 16, 2002, Professor Joo spoke with the Business Law Journal about the Sarbanes-Oxley Act passed last summer. The new law followed in the wake of news reporting deep and widespread corporate accounting scandals involving companies like Arthur Andersen, Tyco, Enron, and WorldCom. In this interview, Professor Joo discusses his reaction to the new responsibilities of corporations for their financial reporting, the value of financial disclosure, and some thoughts on regulations concerning corporate governance.
Section 302 assigns responsibility to the corporation for financial reports and specifies that the principal executive and financial officers sign off on each quarterly or annual report. The officers are to attest to their responsibility for the inner controls of the corporation's financial reporting mechanisms.
Given the enormous responsibilities of CEOs and CFOs in publicly traded companies, how much more can they be expected to take on?
If you are going to be in charge, you have to take some responsibility. It is too easy to disclaim responsibility for the report because it is the result of a process of a dispersed bureaucratic structure. For instance, was the Enron debacle the corporation's fault or was it Arthur Andersen's fault? It is too easy to avoid blame. Someone has to attest to the financial report's accuracy. For CEOs and CFOs who make ten, twenty, or thirty million dollars a year, I can't have too much sympathy for the idea that they are overworked.
An interesting thing about Section 302 is that if you knowingly sign a misleading report there are criminal penalties. One of the problems with that is, if you don't sign the report at all, there is no penalty specified. A lot of CEOs and CFOs are saying they do not have the requisite knowledge to sign the report and can't attest to whether the contents are true or not. If enough companies take this position, then they might actually get away with not signing the report at all.
This applies particularly to the new head of Tyco. With former CEO Dennis Kozlowski removed, the new CEO has said he does not have the requisite knowledge of recent company finances to sign the report. Certainly that makes sense. Tyco is not the only company that is having a hard time and you could see why a new CEO could make that argument. But an old CEO could say that too and get away with it under the act because there is no criminal penalty.
In theory the market could punish people like that. If you have been the CEO for a number of years and yet have no idea if the books are accurate, then maybe they really are not. Shareholders should punish the stock price accordingly.
If lower managers falsified reports, could the person signing the statement possibly become liable for their acts?
Section 302 is not a strict liability provision. There has to be some sort of knowledge or constructive knowledge that the books are inaccurate. If you sign the books in good faith and someone is fooling you, you are not going to be liable. But also, under that standard, you can't claim that you're not liable because you were totally unaware of what your management was doing- because if you have no idea what your managers are doing, you can't sign the certification in good faith.
Does this strengthen controls that were in place before the Act?
I think so. If you look at corporate governance the way it is practiced today, CEOs have immense power. There is nothing in state corporate codes that say CEOs have to have immense power. If you had never seen a corporation in action you might think the board of directors is really powerful. That's not always true. In practice the CEOs often have the power. The CEOs now are in a position where they have potential liability and I am sure that is going to give them incentive to make sure that there are good people in charge. Previously I don't think there was as much incentive.
Sec. 403 requires more timely disclosure of transactions involving management and principal stockholders. Title IV provides for greater financial disclosure by corporations.
Does this give something more than a neutral meaning to share transactions by executives? Is there something about a sale of stock by an executive that should give rise to concerns about the health of a public corporation?
Well, they already do give rise to concerns and there already is a disclosure requirement. The new requirement really just makes them disclose more quickly. There are implications to sales of stock by an executive of the company. He knows something that other people don't. Whether it is technically insider trading or not, it is related to the same idea. If the person running the company does not have faith in the company, then the shareholders need to know that.
Think about Enron. While Ken Lay was assuring the employees that everything was fine, he and a lot of other top executives were profiting from the sale of their stock. The rule is based on the idea that management selling stock is negative information about the stock and negative information of the sort that the market has got to know. One of the important barometers of the health of a company is what the insiders do with their stock. Sometimes the news will report that insiders are buying stock, or a corporation is doing a stock buy back. That's a signal that insiders have faith in the corporation, and it can contribute to a mini rally in the stock price. Insiders want the market to know when they are buying the stock. So it goes both ways.
It is said that investors put too much weight on periodic financial reports and have punished corporate stocks when those corporations have failed to meet projected short term targets- even when the long term outlook for a company is positive. Is there a construction of the provisions that could interpret disclosure as being harmful to investors?
The problem with focusing on short term or quarterly reports is it distracts us from the long term viability of a corporation. For example, if you are in a bubble, then you don't really care if a dot-com has real assets or real long term value. You just care if the stock price is going up, or whether they can show paper profits this quarter. In fact, it has been said that over disclosure is a problem. Investors don't need more financial disclosure. If you ask a group of investors how much of the required disclosures they had actually read, it is likely to be almost none. Maybe they read the annual report. It is true that the institutional investors or the analysts will read more of the filings but it is likely that there is too much information for the average investor.
Some people have argued that if you look at the performance of the stock, the balance sheet doesn't necessarily predict how good the stock performance is. In fact, not only are you giving people too much information, but the information you are giving them may not really be relevant. Professor Paul Mahoney says that financial disclosure about issuers is sort of like a casino telling gamblers which slot machines have paid off most recently. The hard statistical fact may seem to help you make a decision but in fact the statistic is completely irrelevant. Which slot machines have paid off doesn't actually predict which ones are going to pay off next. We like to get hard numbers, and we feel well armed with lots of information, but the information may not be relevant to whether the stock is a good investment or not. What you should really tell people is that you can't guess the performance of any stock based on the financial statements. What you should really do is have a well diversified, long term portfolio. That is the closest thing you have to being likely to make money.
Title VII commissions studies on the role of Investment Bankers, Credit Rating Agencies, and even individual securities professionals in the stock market crash.
The implication is individual shareholders occupy a weaker position in the market in terms of their ability to make proper use of financial disclosures. The act does not mention the role of professional institutional investors like pension funds or mutual funds. Would it be fair to place some of the blame for the stock market crash on institutional investors?
Ten years ago it was widely argued that the solution to shareholder democracy was institutional investors. Most individual shareholders don't hold much stock and they usually are not well informed. They are also "rationally apathetic" when they hold so few shares. It may not be worthwhile to spend much time worrying about the health of the corporation. Institutional investors are different. They have huge holdings with a lot of money at stake. So they have the incentive and the ability to police the corporation's statements. During the 90's, that expected enforcement mechanism didn't work out. I would say, though, that the sins of omission by the institutional investors in failing to police really aggressively are not on the same scale as sins of commission by people like analysts and auditing firms who basically colluded with bad corporate managers. There is a big difference there.
But doesn't a big mutual fund have a similar conflict of interest? If they want investors, maybe a corporation's pension fund, they have an incentive to allow share prices to be driven up to make their investment products look more attractive to that secondary corporate business.
Certainly if institutional investors find themselves relying on large gains in their stock holdings to attract additional investment, they are not going to complain when their holdings of Enron or WorldCom have massive stock price increases in one quarter. Even if there is no aggressive misconduct, there is no incentive to question the gain. Institutional investors are no different from other investors in that respect, particularly because of the short term pressure to show profits. In the mid to late 90's, with investors expecting astronomical quarterly returns, relatively safe, widely diversified mutual funds became unattractive. Market pressure mutated institutional investors from long to short term investors. If institutional investors really conceived of themselves as long term investments, then they really wouldn't care if asking questions might burst a temporary bubble.
The act contains many provisions for monitoring executive governance. For instance, Section 407 requires the placement of a financial expert on the audit committees of publicly traded corporations, and Section 301 requires the expert be independent of any consulting or advisory role with the corporation or its subsidiaries.
Given that many directors are members of other boards or are executives with other corporations, is there an institutional limitation to providing true independence?
Yes, there is a limitation on what it means to get an outside person. Boards tend to be comprised of the same kind of people in the corporate culture. That is one reason why you might want to have a different method of election. In Germany and a few other countries there actually is a requirement that workers have a representative on the board. That is one way of providing the board with a radically different perspective. A representative of the workers is not somebody who is going to talk about his or her track performance. Such a representative would be more concerned with job conditions and wages. It has also been suggested that you should include people from outside of the financial and business world like environmentalists or scientists. You might place ethicists on the board. But how realistic is such a suggestion? The new requirement is an initial step towards a more basic kind of independence: to make sure that the directors who are supposed to be watching over the executives are not the executives themselves. But I think your question points out that there is a basic problem. There is a much deeper independence you could look for but I don't know how realistic it is. It is certain that the people who serve on boards tend to be cut from the same cloth.
I once saw a paper presented about four of the Fortune 500 companies. The author said that all executives could be traced to within six degrees of Vernon Jordan. Vernon Jordan serves on so many big boards that everybody knows Vernon Jordan somehow. But this kind of interrelationship is not necessarily bad. If you brought scientists or ethicists on board, there is a point at which you are limited on the return that they bring. The people who know the business best, the ones who are the most qualified, are the insiders. There is a tension there. You can have independence or you can have expertise, but it is really hard to have both.
There are other checks included in the Act. For instance, Title II concerns the independence of outside Auditors. In Section 307 rules are set for the professional conduct of outside attorneys. In particular, attorneys are required to reports any material violation of securities law or breach of fiduciary duty to the general counsel or the CEO of the corporation.
Can the attorneys play a prominent role in regulation, or is there a limitation to the scope of their duties?
The ABA's current report on the Model Rules for Professional Conduct points out that if you are a corporate lawyer your client is not the person who hired you. Your client is the corporation. The current model rules say that if the lawyer learns of misconduct by a corporate agent, the lawyer shall proceed as is reasonably necessary in the best interests of the organization, not the individual who hired him. In cases like Enron and WorldCom, it might have made a difference if somebody took their concerns to the board because primarily it was the executives and not the board who were corrupt. The Enron board professed to be shocked when they found out about the things that were going on within the company.
That goes back to your previous question about board structure and requiring outside directors. Those are good changes but the real thing you need is not just change in the structure of the board, you also need a change in the relative power of the board as opposed to the officers. Right now so much power resides with the officers that some boards seem to be rubber stamping whatever the officers want. That is exactly what basic corporate law says boards are not supposed to do. The directors are supposed to be the agents of the shareholders and watch over the officers and the business. Ask any CEO who he works for- is he going to say that he works for the board? He may not admit it but the board really works for him. I don't know whether legislation alone can change that. If you put the structure in place, somebody is still going to have to actually do the job of monitoring. Whether he or she actually does the job and monitors aggressively is another question.
Thank you professor.
Erik Loomis is a second-year student at the University of California, Davis, School of Law.