Regulatory trends and corporate governance

governance. The Sarbanes-Oxley Act (SOX) has contributed to retrieving some of the trust that was lost in the wake of the turn-of-the-century corporate scandals. It has created other problems of its own that threaten to undermine the global supremacy of US capital markets. The exclusive competence of the States to adopt company law rules, combined with the ageing philosophy and framework of federal securities regulation as discussed in the first part of this chapter, has resulted in a system that relies more on regulatory and judicial enforcement and less on the accountability of companies to their shareholders.

In the US, responsibility for corporate governance-related regulation is divided between States and Federal jurisdictions. Federal regulation has been limited to issues of transparency and the functioning of the capital market. In contrast to the EU’s principles-based, minimum-harmonisation approach, Federal regulation is based on detailed rules that apply uniformly to all issuers. Core corporate governance rules are found in corporate law shaped by statutes and case law of individual States. Delaware is by far the most influential among the States, being the host of most US listed corporations. In addition, US listed companies face a rules-based corporate governance framework set out in the listing requirements of the major stock exchanges, implemented by the exchanges themselves. These requirements are mandatory for domestic US issuers. Foreign issuers in US markets have to disclose the main differences between their corporate governance and the requirements of the US exchange on which their shares are listed.

Transparency

Internal control over financial reporting and the vanishing international issuer

Given the limits of Federal regulatory jurisdiction, SOX should be read and interpreted in the context of regulating market transparency, not core corporate governance subject matter. Many commentators have pointed out that certain SOX provisions, such as the prohibition of lending to corporate officers, do not fit the context and might be going beyond the constitutionally prescribed jurisdiction of the Federal government. These jurisdictional limits help explain why, in contrast to the UK and the EU, US Federal regulation focused exclusively on internal control over financial reporting,29 when it came to regulating responsibility for internal control.

Section 404 mandates the annual filing of an internal control report that states management responsibility for establishing and maintaining an adequate internal control structure for financial reporting, and contains an assessment of

29According to Exchange Act Rules 13a–15(f) and 15d–15(f), internal control over financial reporting is ‘a process designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, or persons performing similar functions, and effected by the registrant’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles’.

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the effectiveness of internal control over financial reporting. This assessment is further attested by the external auditor. In the three years since implementation started, howls of protest have been raised over the enormous cost of this provision to issuers, with few benefits to show. On the cost side, one study suggests an average annual cost per company of US$ 8.5 million30 for the implementation of SOX 404. According to the Chief Financial Officer of Deutsche Telecom, the company spent over 20 million euros to prepare for SOX 404 implementation. This does not include ‘indirect costs of full international compliance with all kinds of stock requirements’ which are likely to double the figure.31 While it is true that some of these costs are once off, the breadth of the obligation is such that companies need to incur considerable ongoing costs to maintain and adapt the system, not to speak of the audit costs which have more than doubled as a result.

American commentators maintain that the SOX 404 approach of annual assessment, attested to by the auditors, is beneficial in raising trust in the postEnron US capital markets. This is not clear from a European perspective: while the board and management should have overall responsibility for maintaining effective internal control, an annual assessment and audit against a detailed ‘internationally recognised’ benchmark increases legal risk to an extent that goes far beyond what is reasonable and proportionate to the relatively limited incidence of expropriation and fraud. On the other hand, the increased legal significance attributed to internal control might severely inhibit the capacity of a private firm to make timely entrepreneurial decisions.

The US Securities and Exchanges Commission (SEC) and the Public Company Accountancy Oversight Board (PCAOB), the audit oversight body, have both been looking for ways to attenuate the cost impact of SOX. In December 2006, the SEC released new rules exempting smaller US companies from the requirement to produce a management report until December 2007, as well as the requirement to file the auditor’s attestation report until December 2008. The SEC also postponed section 404 implementation for foreign private issuers, who are not required to provide the auditor’s attestation report until July 2007,32 while making it easier for foreign private issuers to deregister with the SEC and terminate the corresponding duty to file reports.33

The SEC released in June 2007 new guidance regarding management reporting on internal control over financial reporting.34 The guidance promotes a risk-based approach allowing management to use their judgement and focus on the financial controls that might carry the risk of having a material impact on

30Figures cited in The Economist online edition, ‘The trial of Sarbanes Oxley’ (April 2006).

31Remarks by Dr Eick, CFO of DT in ‘Shareholder rights and responsibilities: the dialogue between companies and investors’, discussion paper issued by the Deutches Actieninstitut (2006), p. 23.

32See Securities and Exchange Commission, Final Rule 33–8760, December 2006.

33See Securities and Exchange Commission, Final Rule 34–55540, March 2007.

34See Securities and Exchange Commission, Final Rule 33–8810, June 2007.

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financial statements, without the need to look to auditing standards. By limiting the scope of certification and assurance, the aim is to lower implementation costs. In line with the SEC, the PCAOB also modified its auditing standards to reflect a more principles-based approach to assurance. The area is financial controls that are more based on materiality.35

Looking to the future, US policy makers face a stark choice: further redraw the regulatory map – and it is unlikely that the SEC can do this without Congressional support – or see the competitiveness of the US capital markets continue to diminish. According to a 2007 report by McKinsey the threat to US and New York global financial services leadership is real. The report found that the decline in the pre-eminence of the US equity markets is already under way and is cause for concern ‘not only because of the significant linkages that exist between IPOs and other parts of the financial services economy, but also because of the importance of financial services jobs to the US, New York, and other leading US financial centers in terms of both direct and indirect employment, as well as income and consumption tax revenues’.36 Another 2006 study, commissioned by the City of London Corporation and the London Stock Exchange, concluded that ‘the rise in US compliance costs has increased the competitive position of the London markets’.37 Indeed, recent acquisitive behaviour by US stock exchanges in Europe can be explained in two ways: their desire to recapture a slice of global issuance that has permanently migrated as a result of US overregulation; and the building of a platform for US companies to avoid home country regulatory costs in raising capital.

Executive remuneration

While the SEC is limited in what it can do to address the shortcomings of the costly rules-driven US regime on financial internal control post-SOX, it has moved decisively to address growing concerns over transparency of executive remuneration arrangements.

Executive compensation has long been a battleground between investors and companies in the US. In contrast to the UK, over 90 per cent of S&P 500 executive teams are not remunerated for business performance beyond a two-year period.38 Long-term incentive stock-based plans focus on share price appreciation and do not include any performance or other option vesting or exercise hurdles.

35See PCAOB, Auditing Standard No. 5, June 2007.

36See McKinsey, Sustaining New York’s and the US’ Global Financial Services Leadership, January 2007, pp. 11 and 12. See also the Interim Report of the Committee on Capital Markets Regulation, November 2006.

37Leonie Bell, Luis Correia da Silva and Agris Preimanis, The Cost of Capital: An International Comparison, Oxera Consulting, June 2006, p. 5.

38B. Atkins, ‘Pay for the long term’, Directors Monthly, NACD, April 2006.

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As Bebchuk and Fried39 have documented, US firms have been considerably opaque in their remuneration reporting, and often use pay practices that purposefully obscure the total amount of executive compensation and the extent to which managers’ compensation is decoupled from their own performance. To this end, they have been assisted by a remuneration disclosure regime that has been built piecemeal and contains many inconsistencies.

The US exchanges, with the approval of the SEC, have been tasked with developing process rules for the way remuneration is set. These include a compensation committee of the board, consisting of independent non-executive directors, that should function transparently in setting executive remuneration. A considerable body of US board practice has evolved around these rules, but many critics doubt the degree to which it is truly effective. In its August 2006 initiative,40 the SEC sought to address the transparency of pay policies and practices and their outcomes – the levels and structure of executive remuneration – so investors can make their own considered judgements. The aim has been to consolidate and, in some respects, overhaul the disclosure regime. Many buy side organisations and investor groups (including the Council of Institutional Investors, the ICGN and the ISS) have hailed this effort as a milestone in promoting transparency in US capital markets.

At the heart of the SEC’s approach is a requirement for Compensation Discussion and Analysis, a plain English narrative of the company’s approach to compensation, much like the remuneration report required of UK listed companies. The rules focus on eliminating double-counting while providing more comprehensive disclosure of all elements of executive compensation. The 2006 rules require the disclosure of ‘total compensation’ in the Summary Compensation Table and enumerate the elements that comprise total compensation, including fair value basis for reporting option grants. Also, post-employment compensation disclosures are now required, including the potential payments from retirement plans, non-qualified deferred compensation and other potential post-employment payments.

According to ISS,

shareholders and board members should receive immediate benefits from the new tally sheets providing information on the total annual compensation packages paid to senior executives at U.S. companies. Additionally, we would expect abuses in the pensions, deferred compensation, severance and perquisites areas to dry up now that light will finally reach those previously dark recesses of the compensation landscape.41

39Lucian Bebchuk and Jesse Fried, ‘Executive Compensation as an Agency Problem’, Discussion Paper 421, Harvard Law School Olin Center for Law, Economics and Business, July 2003. Available at www.ssrn.com.

40Securities and Exchange Commission, Release No. 33–8732; 34–54302, August 2006.

41ISS statement at www.isssproxy.com.

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