I've already posted twice about the article I've been working on the past few months. Quick recap: an overlap of securities requirements allows us to see whether companies are actually complying with the law.
Answer: it looks like not always. We found 30 instances in our 200 company sample where companies disclose related-party transactions with CEOs, CAOs, and CFOs in their proxies but failed to disclose them when they occurred as ethics waivers in 8-Ks or on the website, as required by SOX Section 406. You may think, "no harm, no foul"--at least the market is learning about these transactions somehow. But proxy disclosure (like Christmas) comes but once a year, and contains a whole lot of stuff. So companies who avoid Section 406 "bury" these ethically questionable transactions at the end of the year, rather than disclosing them as they occur, all by themselves.
We also found 74 cases we term "in spirit" violations, where companies appear not to be disclosing because their codes of ethics don't prohibit related party transactions. No waiver needed! But Section 406 defines a waiver as "such standards as are reasonably designed to promote—(1) Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships", so it's a bit of a stretch to call something a "code of ethics" if it doesn't prohibit related party transactions.
This last point gets to our larger story, the limits of transparency. Section 406 was a direct response to Enron. You'll remember that Enron granted a waiver to its code of ethics to allow related-party transactions with CFO Andy Fastow, facilitating the deals with special purpose entities that helped perpetrate fraud on the market. The regulatory response was to require Section 406 disclosure, but that doesn't seem to be working. A lesson for today?
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1. Posted by Mike Guttentag on March 22, 2009 @ 23:08 | Permalink
Usha, I hope am not being too much of a nuisance, but another observation I would make about disclosure rules is that, particularly with respect to agency cost reduction and fraud prevention, part of the way disclosure rules may work is by altering behavior. In such a case, the possibility of having to make a disclosure acts as a prophylactic. I am not sure that this is an outcome which your research method directly addresses.
2. Posted by Usha Rodrigues on March 23, 2009 @ 5:32 | Permalink
Mike, you could never be a nuisance! And of course, you're right: disclosure rules do work by altering behavior. But that's why (I think) our sample finding is so interesting. Only 1 waiver was disclosed in the 200 sample companies, which on its own could mean EITHER that the disclosure requirement is deterring behavior OR that the "bad" behavior is still occurring, but companies aren't reporting it. But because of the overlap with Reg S-K, we're able to show that the behavior IS in fact still occuring, just not being disclosed properly. Section 406 is not having the intended deterrent effect, nor is it providing the information to the market that it's supposed to.
I put "bad" behavior in quotations because, as you pointed out in a prior comment, the regulations presume this information is material, but it may not actually be. It's a fair point, and one that we need to address more fully, I think, along the lines you suggest.
3. Posted by Mike Guttentag on March 23, 2009 @ 14:03 | Permalink
Thanks for welcoming my questions. Your work is certainly a major contribution to our understanding of what information public firms actually disclose. Part of what I was getting at was that you find much “bad” behavior remains undisclosed in a timely manner, but, because you do not have inter-year comparisons, it is difficult to know if there has been an overall change in the level of such behavior before and after implementing this particular disclosure requirement.
4. Posted by Usha Rodrigues on March 23, 2009 @ 20:00 | Permalink
A fair point, and part of what's so weird (to me, at least) about studying disclosure. Who knows how common noncompliance is? I remember from my comp. lit. days a professor from Mozambique being amazed that most Americans pay their taxes, even though the risk of audit is remote; in many countries, apparently, blatant noncompliance is routine. We just kind of expect that people (and corporations) follow the rules.
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