A legal scholar says lawyers, accountants and financial analysts failed to keep their bosses in check, which led to scandals.
John Coffee Jr., one of the nation's preeminent corporate scholars, believes that timid professional gatekeepers -- lawyers, accountants and securities analysts -- failed to blow the whistle on their crooked corporate bosses and, therefore, are at the root of the corporate frauds from Enron to the back-dating of stock options to the subprime mortgage crisis.
"In every financial debacle, one can usually identify a 'gatekeeper failure' -- that is, an intermediary on whom investors relied who failed to give the warnings expected of it," Coffee told a couple of hundred lawyers in Minneapolis last week.
"Gatekeepers are generally not the most culpable actors in these dramas. [That would be the CEO most often.] But their failure has sweeping repercussions. The public perception, however, is that the gatekeeper was an out-and-out conspirator with those perpetrating the fraud."
To prove that point with a dose of humor, Coffee, a lawyer, professor and director of the Center of Corporate Governance at Columbia Law School, then flashed a "Dilbert" cartoon on the overhead screen at the University of St. Thomas Law School.
Sure enough, a pointy-headed board member and shifty-eyed CEO are discussing rotten shareholders who are suing the company for misleading investors about "our financial problems."Since when is it illegal to shaft innocent people for personal gain?" asks the board member.
The CEO turns to the corporate counsel and says: "Don't put that in the minutes."I'll see what I can do," responds the lawyer.
Coffee's point: The exchanges may not be that blatant, but financial incentives and internal pressure may have been so strong for some accounting firms and internal legal staffs that they started to rationalize crooked definitions about off-balance sheet endeavors and opaque accounting with narrow, technically legal decisions that were, nevertheless, wrong and not in the long-term interest of all shareholders.
Impact of Sarbanes-Oxley
Some of the problem has been resolved by the Sarbanes-Oxley Act of 2002 and new rules that require CEOs and CFOs to personally certify critical financial statements. The act also bars external auditors from selling consulting services to the same client and includes disclosure rules governing securities analysts and their stock recommendations.
Yet, as long as senior executives have most of their compensation pegged to the company's stock price, there is a risk that they will inflate earnings. Coffee cited a 2004 academic study that showed that the level of stock-option incentives was the main difference between companies that had to restate earnings from previous years and those that did not in 2001 and 2002. The restating firms had CEOs who had in-the-money stock options worth an average of $30 million, while non-restating firms had CEO options worth only $2.3 million.
Coffee argued that corporate America needs to return to the old model of bringing in experienced outside lawyers at the board level to analyze, discuss and make recommendations on controversial issues. That wise counsel would report to the audit committee of the board, and would have to certify corporate disclosures as complete and accurate, along the lines of Sarbanes-Oxley.
Increasingly, corporate counsels farm out legal work based on bids from law firms. And much of the work is specialized, including "48-hour reviews" of important filings with the Securities and Exchange Commission to ensure they are technically correct. Coffee said there isn't time or involvement enough for those lawyers to fully investigate and comprehend them.
"Imposing a gate-keeping obligation ... essentially increases the attorney's leverage over the client," Coffee said.
Several corporate counsels responded by saying that more regulation isn't needed.
Lee Mitau, general counsel at U.S. Bancorp, one of the nation's biggest financial firms, said he doesn't dispute the importance of consulting wise outside legal advisers. But Mitau said his company is large, complex and "even I can't tell you that I have a firm grasp of what's going on everywhere."
He added: "There's a lot I don't like about Sarbanes-Oxley and its Section 404 provisions. But making the CEO and CFO sign financial statements [rivets their attention] ... and you'd be amazed at the elaborate due diligence inculcated into the process and into the company to ensure every material issue [is] certified."
Similarly, Heidi Hoard, general counsel of Tennant Co., said the 1990s-vintage scandals and related reforms and penalties already have "increased the attention by boards to corporate governance. The prosecutions and publicity had value."
Coffee makes a good point with his gatekeeper argument. But there seems to be little appetite for more legal reforms.
Neal St. Anthony 612-673-7144 firstname.lastname@example.org