HomePublications

Innovation and Corporate Governance

The Impact of Sarbanes-Oxley

Houman B. Shadab

October 5, 2007

Download PDF here

This article is forthcoming in the University of Pennsylvania Journal of Business and Employment Law, Volume 10, Number 4 (Summer 2008).

Highlights

Summary

Innovation is a process that results in new goods, services, methods of production, and forms of business organization. Innovation is ultimately the product of new knowledge and arises in response to economic change. Innovation requires companies to commit to long-term risky activities and is an organization-wide effort. This article shows that these characteristics of innovation give rise to an important corporate governance tradeoff, and that complying with the Sarbanes-Oxley Act of 2002 ("SOX") likely impacts this tradeoff to the detriment of innovation. 

Our Findings

• Consumers, investors, and companies are better off when innovation results in higher quality goods and services or entirely new methods of production and business organization.
• Decentralization, participation by insiders, and an emphasis on long-term strategic control are corporate governance structures that facilitate innovation.
• SOX requires all public companies to increase objective monitoring of managers by outsiders in an attempt to prevent corporate managers from abusing accounting rules and otherwise acting against the interests of shareholders.
• A substantial portion of innovative public companies provide the most value to investors and consumers by placing a greater emphasis on proximate monitoring by insiders than SOX permits.
• SOX's cumulative impact likely undermines the ability of a substantial portion of public companies to utilize knowledge assets, adapt to change through new products and forms of organization, engage in long-term risky projects, and otherwise undertake innovation activities.

By the Numbers

• Although SOX only requires CEOs and CFOs to certify financial statements, surveys show that the law had the unintended consequence of an average of over 20 other executives signing subcertifications, including a significant portion of executives primarily involved with business operations and not financial reporting.
• In 2000, 38.5 percent of the 500 largest U.S.-listed public companies did not have fully independent audit committees, and approximately 18 percent of all public companies did not have a majority of independent directors on their boards, and hence were not in compliance with SOX and related stock exchange reforms.
• To meet the increased independence and other SOX-mandated board requirements, companies added anywhere from 1 to 3 new independent directors to their boards rather than replace inside directors, thus increasing the size and independence of boards.

Recommendations

• Congress and/or the Securities and Exchange Commission ("SEC") should make voluntary those provisions of SOX that increased outside monitoring and the emphasis on short-term financial reporting in accordance with generally accepted accounting principles, which are fundamentally unsuited for innovation activities.
• Provisions that should be made voluntary include the SEC's particular "top-down, risk-based" approach to internal control assessment required to be conducted by management, and the requirement that the entire audit committee of all public company boards be comprised of outsiders with little knowledge of day-to-day operations.