Do Independent Directors Curb Financial Fraud? The Evidence and Proposals for Further Reform

Cindy A. Schipani is Merwin H. Waterman Collegiate Professor of Business Administration and Professor of Business law at the University of Michigan Ross School of Business. This post is based on a recent article, forthcoming in the Indiana Law Journal, by Professor Schipani; H. Nejat Seyhun, Jerome B. & Eilene M. York Professor of Business Administration and Professor of Finance at University of Michigan Ross School of Business; and Sureyya Burcu Avci, University of Michigan Ross School of Business.

Around the turn of the millennium, a slew of corporate scandals involving outright fraud, including those at Enron, WorldCom, Global Crossing, and Adelphia Communications, among others, [1] plagued capital markets and shook investor confidence to the core. Faced with this runaway corporate malfeasance by managers of large firms around the turn of the millennium, Congress decided to discipline the managers by increasing the supervisory role of the board of directors. The Sarbanes-Oxley Act of 2002 (“SOX” or the “Act”), [2] was passed by Congress in an effort “[t]o protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.” [3]

This was not of course the only option for Congress. Congress could have also increased the direct supervisory role of the shareholders themselves. This alternative, Congress decided not to pursue. We are now nearly fifteen years down the road from the corporate scandals of the early 2000s, and we are now in a position to observe how well Congress’ choices have been working so far.

The actions Congress decided to take not only included increasing the potential criminal and civil fines and sentences for securities fraud, SOX also attempted to rectify perceived corporate governance failures by legislating rules that shifted the power from management to corporate boards, including the requirement that certain board members be independent [4] and competent audit committees be established. [5] For example, SOX demanded that the audit committee be comprised of entirely independent directors [6] and include at least one financial expert. [7] In addition, SOX included rules requiring outside auditors be independent. [8]

One would have hoped these SOX-created independent watchdogs would reduce the incidents of securities fraud and result in better governance. Yet, our analysis of the number of class action settlements for claims of financial fraud for settlements greater than $10 million shows no significant decrease since the adoption of SOX. We presume that settlements of over $10 million indicate serious concern of the board evidencing the viability of the suit. [9] The dollar amount for analysis was chosen to reduce the incidence of strike suits in our data. Thus, the lack of a significant decrease in these claims seems to indicate that it may have been unreasonable to expect independent directors —who almost by definition are not privy to the day-to-day affairs of the firm—to have enough incentives or information to ferret out complex, and likely hidden, fraud.

Moreover, and perhaps even more troubling, our data also shows that independent directors themselves are not necessarily immune from the temptations of financial fraud, particularly with the gains to be had from backdating stock options. SOX’s reliance on them may simply have transferred oversight responsibilities from compromised executives to compromised and ill-informed board members.

An alternative approach to the SOX mandates would have been to empower the shareholders directly and enable them to exercise a greater degree of direct oversight over the managers. First, it does not make logical sense for the shareholders to cede some of their supervisory role to the managers, the very same people that they are trying to supervise. This is a nonstarter. But this is exactly what happens when the managers vote shareholders’ proxy as they see fit. Second, the system of tracking the shareholders and registering all ownership of the security in the name of the shareholders is a long-ignored reform that puts the U.S. even behind most developing countries. It was now been more than eight years following the Madoff scandal and the U.S still does not register securities directly in shareholders’ names. This simple reform would put an end to all future Madoff-like scandals. Finally, the cost to shareholders from directly exercising their supervisory role and communicating with managers would be minimal in this electronic age. Companies could set up secure websites to allow the shareholders to review corporate issues and vote their choices.

We recommend that Congress take another look at this issue. Granted, some shareholders are not privy to the day-to-day affairs and unless their holding is substantial, may be rationally stay ignorant, there are also shareholders with substantial holdings who could be further empowered to provide an effective check on both the managers and the board of directors. To this extent, we thus propose that shareholder resolutions bind management (subject to minimum participation levels), one share to be required to have one vote, as well as for shareholders to have the ability to directly nominate and/or actively vote against board members.

We find that the outsider directors have failed with everyone else on the board to monitor the management. In this regard, we investigate the timing and backdating of executive compensation options between 1996 and 2015. In this study, we find that outside directors receive manipulated their option grants like the top executives do. Similar to options given to the top managements, outside directors use dating and timing techniques to manipulate stock options granted. Our evidence shows that they employ back-dating, spring-loading and bullet dodging games to increase the value of their options. Back-dating among other techniques provides remarkable profits to outside directors. Application of these techniques for late reported grants increase outside directors’ compensation by substantial amounts. Specifically, management received extra compensation amounts of 9.2%, 14.9% and 4.1% for the 1996-2002 period, 2003-2006 period; and the 2007-2014 period, respectively. For outside directors, the comparable numbers are 7.0%, 10.3%, and 7.5%, respectively. For large late reported option grants, abnormal returns increase even further.

Our evidence strongly suggests that outside directors are not fulfilling the monitoring responsibility placed on the by SOX. We recommend that the solution lies not in strengthening the board of directors, but by strengthening the power of the shareholders. We make three specific recommendations: First, we recommend that multi-class voting structures should be eliminated. The multi-class voting structures exacerbate the conflict between shareholders and the management and lead to inferior outcomes. Our second recommendation is to make the shareholder resolutions binding on the board of directors. Currently, management typically ignores the non-binding shareholder resolutions. Finally, we recommend that plurality voting be eliminated and replaced by majority voting for the board of directors. Majority voting shifts the relative power to elect the directors away from the management to the shareholders themselves.

The complete article is available for download here.


1See Scott Green, A Look at the Causes, Impact and Future of the Sarbanes-Oxley Act, 3 J. Int’l. Bus. & L. 33 (2004).(go back)

2The Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).(go back)

3Id. Preamble(go back)

4Id. at 46.(go back)

5Id. at 38.(go back)

6Id. at 38.(go back)

7Sarbanes-Oxley Act of 2002, supra note 1, at §407.(go back)

8Id. at §404.(go back)

9To exclude strike suits, we require a minimum settlement amount of $10 million. The years 2001-2002 appear to be anomalous due to the recession and cratering stock market. We find that between 1996 and 2000; 42.4 lawsuits per year for an average annual total of $3.3 billion were settled for $10 million or more, while the corresponding numbers between 2003 and 2008 are 42.4 lawsuits per year and average annual total of $3.1 billion. While there are no on-going cases from the pre-SOX period, the post-SOX numbers exclude a total of 13 on-going cases.(go back)

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