Faith in independent directors misplaced

May 16, 2017
Greta Guest,
Greta Guest, 734-936-7821, or Terry Kosdrosky, 734-936-2502,

ANN ARBOR—Class-action lawsuit settlements and amounts have not abated in the 15 years since Sarbanes-Oxley, according to University of Michigan researchers.

What’s more, both executives and outside directors still manipulate stock option grants using dating and timing tricks to increase the value of their options, they say.

Independent directors, audit committees and other reforms of the Sarbanes-Oxley Act of 2002 were aimed at preventing corporate abuses after Enron and a spate of corporate scandals.

But have independent directors made a difference? Not nearly enough, according to a study forthcoming in the Indiana Law Journal by U-M professors Cindy Schipani and Nejat Seyhun, along with postdoctoral research scholar S. Burcu Avci.

The researchers propose reforms that give shareholders more power and require some rule changes for board voting.

“Most of the Sarbanes-Oxley reforms hang their hat on monitoring management via a board with a majority of independent directors, but the reality is that it’s not happening,” said Schipani, professor of business law at the Ross School of Business. “And, according to the metrics we analyzed, there’s even complicity.”

Lawsuits and Abnormal Returns

Schipani, Seyhun and Avci examined the number of class-action settlements of $10 million or more for claims of financial fraud. There’s been no significant decrease in the number of lawsuits nor the amounts paid out since Sarbanes-Oxley, they found.

“It was probably unreasonable to expect that directors, who aren’t really privy to day-to-day affairs of the company, would have enough information or incentive to prevent or find complex and hidden fraud,” said Seyhun, professor of finance at the Ross School.

The researchers also studied abnormal returns on executive and director stock option grants, which suggest manipulation. The common types of manipulation are backdating, spring-loading (delaying announcement of positive news until after options are granted) and bullet-dodging (releasing negative news before option grants.)

Option grant data from Thomson Reuters was divided into three periods: pre-Sarbanes-Oxley (1996-2002), scandal period (2002-2006) and the post-scandal period (2007-2015). Their analysis showed that manipulation techniques led to extra returns for management of 9.2 percent, 14.9 percent and 4.1 percent in the three eras, respectively.

For outside directors, the extra returns were 7 percent, 10.3 percent and 7.5 percent, respectively.

“This strongly suggests that outside directors don’t fulfill the monitoring responsibility placed on them by Sarbanes-Oxley,” Seyhun said.

Suggested Reforms

The U-M researchers suggest putting more emphasis on shareholder oversight and propose a number of changes that would increase their power:

  • Limit multiclass shareholder structures with unequal voting rights. The parent company of Snapchat recently did an IPO with zero shareholder voting rights.
  • Make shareholder bylaws that pass proxy voting binding on the board of directors.
  • Require that directors receive a majority of the shareholder vote, not merely a plurality.
  • Require that any director who doesn’t receive a majority vote resign from the board.

“The board system is broken,” Schipani said. “While it’s very important for corporate governance, it doesn’t serve the monitoring role well. It makes more sense for boards to focus on strategy, helping management solve problems, and be the group of very bright people management can turn to for guidance. It’s hard to do that and be the cop on the beat. We think it’s time for a different structure.”


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