Corporate Governance and Sarbanes-Oxley "Post-'Post-Enron'"
an interview with Professor Thomas Joo of UC Davis School of Law
Elizabeth Donald | UC Davis School of Law
Sheirin Ghoddoucy | UC Davis School of Law
Posted Monday, May 1, 2006
6 U.C. Davis Bus. L.J. 24 (2006)

Professor Thomas 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 a 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).

In light of the recent Enron trial, this interview with Professor Joo discusses Sarbanes Oxley nearly four years after its post-Enron enactment. In the Fall 2002 Edition of the BLJ, Professor Joo took part in an interview related similarly to Sarbanes Oxley.

Q: Since the Enron collapse an array of new laws and regulations has been adopted to tighten corporate oversight. Could you elaborate on what changes have been made since that time?

A: There have been a lot of changes, the main change being the Sarbanes-Oxley Act, which did two things. First, it created the Public Company Accounting Oversight Board (PCAOB), which is in charge of registering and inspecting public accounting firms, and for adopting and modifying audit standards. The registration of accounting firms used to be done on a state level; so in terms of federalism, that was a big change at least as a matter of principle. Whether that has any substantive effect is a matter of question. Second, the PCAOB has the power to bring enforcement actions, which, I think, is concurrent with the SEC's [Securities and Exchange Commission] enforcement powers. This means the PCAOB will pass regulations and, in conjunction with the SEC, have the power to bring enforcement actions.

Second, the Act does what critics would call a micromanaging of corporate governance by establishing some very specific requirements of corporations. For example, they must have independent audit committees. Again, this is something that historically has been done at the state level.

There are two big questions about these [independent audit] committees. First, what is meant by 'independent'? If you think independent audit committees are important, your definition is going to be different than if [you think] they are not. The definition of independence under Sarbanes-Oxley has been criticized. For example, the directors of audit committees are not supposed to draw any money from the corporation except in their capacity as a director. But, they're still being paid by the corporation to be a director and a member of the committee.

Second, does independence do any good? "Independent directors" often means "outside directors" - people who are from outside the corporation. By definition they don't work day-to-day in the corporation. So the question is, do these people have the relevant expertise to be able to determine whether the auditor is doing a good job? And even if they do, do they have the backbone to stand up to the board? Let's say the rest of the board wants to continue with aggressive accounting practices, and the audit committee thinks [the corporation] shouldn't. Well, these directors are outsiders who don't have a lot of political capital on the board; so they might get ignored, or they just might not have the strength to stand up. Keep in mind that the outside directors of the corporation are probably CEOs or CFOs from other corporations, where they are considered inside board members. How do they want their outside board members to act? Do they want their outside board members to act as watchdogs and be all uppity, telling them what to do? Probably not. So, there-but-for-the-grace-of-God-go-I when I'm acting in an outside director capacity, do I want to be uppity? Or do I just want to say, "I'm an inside board member at another corporation, and I think people should defer to me there; so being an outsider here, I should defer to the insiders here." Nobody really knows how the dynamics work in the boardroom.

Another problem has to do with capture. Enron supposedly captured Arthur Anderson in two ways. First, Anderson had worked so closely with Enron for so long - in fact, it had offices in Enron - that it became co-opted into the Enron culture. It's essential that auditors have a different kind of culture than the corporations they serve. Second, Anderson, having provided many other consulting services to Enron, wanted to keep its consulting business in addition to its auditing contract with Enron. Thus, it acted accordingly to keep its other contracts with the corporation.

Auditors should be conservative and skeptical. Entrepreneurs should be aggressive and optimistic. But if the auditors share office space with the client, they begin to identify too closely with the client and to take on the cultural characteristics of the client. And again, this is psychological speculation, but it's certainly plausible. To deal with this problem, Congress passed the rule requiring an independent auditing committee, but these rules have been criticized as not going far enough too.

It was suggested that companies should be required to rotate or change auditors every few years, which makes a lot of sense. But Sarbanes-Oxley merely requires that the lead partner of the auditing firm rotate every five years. Five years is a long time, and even once the lead partner changes, it's still the same firm. They also tried to limit auditors migrating to the board of the audited company. Often what happens is those who have been an auditor for a few years are hired by the company to go in-house. There could be conflict of interest issues there. But instead of prohibiting that all together, they simply impose a waiting period of one year. It's kind of like what's going on currently with whether [former] congressmen should be able to become lobbyists.

There is also the issue of multi-service firms providing services other than auditing. For example, Arthur Anderson provided so many [different services] that auditing was no longer the main way the firm did business for Enron. The question that then arises is whether you will compromise the integrity of your audits. Because if you're too tough of an auditor, Enron will fire you and hire a different auditor. And if they fire you as an auditor, they might fire you for all the other services you provide as well. Sarbanes-Oxley does prohibit some of those other consulting activities, and I think that's a good move.

However, the Act doesn't prohibit tax consulting, which creates a huge loophole. Tax consulting is a big business for [multi-service firms]. Tax accountants have to be very creative in defining things and interpreting regulations in order to minimize the tax burden. That seems like exactly the kind of stuff you don't want people to be doing in an accounting report to the SEC. It's kind of ironic that the one thing they allow people to do is tax consulting.

Q: You mentioned some possible problems with this legislation. Do you think those failures or omissions might be why the changes haven't necessarily been effective in solving accounting problems in the corporate world?

A: I wouldn't pin the blame on Sarbanes-Oxley specifically. The problem existed before Sarbanes-Oxley. I pointed out all the kinks of Sarbanes-Oxley, but I don't really think they're all that important. Why is that? Because I think that, looking at Enron, one of the problems was people simply ignoring existing regulations. It's not a lack of regulations; it's a lack of conformity to existing regulations. You can pass whatever rules you want; slimy people are still going to break them.

One way you can prevent people from breaking existing regulations is to enforce those regulations more strictly. I think it probably would have been better to crack down on enforcement of existing regulations, rather than to pass more of them that ultimately won't be enforced. If you create an expectation of relaxed enforcement, then people will simply continue breaking whatever additional regulations you do pass. They figure they're not going to get caught, so what's the big deal? That's a definite possibility.

For example, we've heard a lot about the special purpose entities that Andrew Fastow was involved in. He just broke the rules. It's not that there weren't sufficient regulations; there were specific rules about conflict of interest that he just ignored. And so what does Congress do? They pass more regulations aimed at special purpose entities. But what does that matter? That wouldn't have changed what happened with Enron. You should really ask, "[W]hy did he break the rules, and not should we make more regulations that are going to prohibit different conduct?"

Q: That seems to make sense in light of the fact that the PCAOB hasn't brought a significant enforcement action yet.

A: I don't really know what to make of that. It takes a long time to get off the ground. But then again, that raises the question of whether it was such a great idea to create another entity that's going to be somewhat duplicative of what the SEC does, as opposed to just giving the SEC more power and budget to go chase down people who are breaking existing rules. Another thing to note is that the PCAOB has had a few enforcement actions but all against minor firms. There used to be five major firms but Enron destroyed Anderson, which now leaves only four. I think there's a rational reason why the PCAOB would not want to bring a massive enforcement action, which could bring down another major firm. Then there would be the big three?

That would create another problem - the concentration of power in a small number of accounting firms. Maybe preventing consolidation of accounting firms and keeping them at a reasonable number is something that could affect the quality of accounting services. Otherwise, I also think the whole concept of rotation makes no sense. If you have to rotate among only [three] auditing firms, there won't be many rotations.

Q: Clearly enforcement of existing regulations was a problem that contributed to the Enron collapse. How did that affect the investors?

A: In the market's own logic and in the logic of the existing regulatory system, you can argue that Enron came out the right way. Enron tanked because the information got out, investors got wind of it and sold out their stocks. You could argue that the real problems of Enron were not SEC-related, but perhaps more related to 401(k)s.

The market discovered Enron's problem and punished it. The lack of 401(k) regulation meant, unfortunately, that some people disproportionately bore the cost of that tanking. Of course, that could have been avoided by rules concerning 401(k) diversification. To be harsh, one could argue that the investors and employees got what they deserved because nobody actually understood how Enron was making its money. Despite the lack of direct access to evidence of fraud, analysts were questioning how Enron's stocks were rising. In fact, some of the information pointing to the problems of Enron was available for evaluation, yet people continued to invest in the company? This is the message to corporate America and investors.

Q: Essentially, it seems like the costs should be borne by the investors. They should be more responsible, careful, and aggressive about seeking out information before they invest.

A: I think that's right. The problem with that is that there is no institutionalized system of investor education. You need a license to drive a car, yet you can buy stocks without knowing anything about investing. There has been no serious attempt of any kind by the government, or anyone else for that matter, to educate investors. Investment is becoming a public policy concern since people increasingly are investing their retirement money into the stock market. We certainly don't want retired people starving in the streets. I think society should pay for that, but I'd rather it not come to that. So why don't we make sure that people are well educated when they invest so that these problems don't occur?

I don't know exactly what the parameters of [an investment education program] would be. But it's a good idea to at least have some policies encouraging 401(k) diversification, and prohibiting companies from encouraging concentration.

William Bratton, a law professor at Georgetown University, posits that fraud is an inevitable cost of investing. There is always the possibility of fraud in investment. There's no way to completely guarantee against it. You've just got to understand that as an investor and live with it.

This is much like market fluctuation. You can never guarantee that it won't happen. You just deal with it by diversification - hedging bets. You should hedge your bets with respect to fraud as well. Not everyone is corrupt but some people are, and you have no way of knowing who they are. But if you broadly diversify, then you will be exposed to some good companies and a small portion of bad companies. If you put all your eggs in one basket then you run the risk of flushing your money down the toilet.