The Committee of Corporate General Counsel ("Committee") of the ABA Business Law Section presented a program on March 16 that included a panel entitled " New Commissions, New Recommendations: U.S. Capital Markets and Corporate Reforms." The panel discussed three reports ("the Reports") containing recommendations to improve the competitiveness of U.S .capital markets and the institutions that use them. These reports are (1) Report and Recommendations of the Commission on the Regulation of U.S. Capital Markets in the 21st Century established by the U.S. Chamber of Commerce ("Chamber Report"), (2) Interim Report of the Committee on Capital Markets Regulation ("CCMR Report") and (3) Sustaining New York's and the U.S.' Global Financial Services Leadership ("Bloomberg/ Schumer Report").
Editor: The Reports discuss the competitiveness of the U.S. capital markets. What, in your opinion, are the most significant issues affecting the competitiveness of our markets?
Ide: In my opinion, three areas of issues are having the most impact on the competitiveness of the U.S. capital markets. First, there are the issues surrounding the governance and regulation of companies. Second, there are issues with our current civil litigation and criminal justice system as they impact business. Third, there is the issue of globalization's impact on capital markets, including the decoupling of financial centers and the flattening out of how the capital markets work.
Editor: How are the issues concerning the governance and regulation of companies affecting our capital markets?
Ide: The credibility and transparency of our capital markets have historically been a magnet attracting foreign players to the United States. For a long period of time, we have offered the world's best system for the regulation and governance of public companies because we have a disclosure regime designed to assure honesty and transparency. That perception was undermined by the Enron era series of scandals which challenged our hallmarks of honesty and transparency. The wave of scandals and the resulting media attention triggered Sarbanes-Oxley and other remediation efforts designed to maintain the credibility of our markets.
There have been unintended consequences from the reforms that should be adjusted. Portions of the reforms produce burdens without benefits, making our public company markets less efficient and thus less attractive to domestic and foreign companies. The Bloomberg/Schumer Report says that while a strong regulatory system is vital to ensure market participant confidence, the system needs to be able to adapt as markets and regulated institutions undergo changes, particularly those resulting from rapid globalization.
We should not turn the clock back to the pre-Enron era but some adjustments are needed, particularly with respect to Section 404 of Sarbanes-Oxley. I serve on two public boards as well as on the boards of a university and a not-for-profit. The public companies went through expensive and unnecessary processes with their auditors to become "404 compliant." The university and not-for-profit became compliant at much less cost since materiality and reasonableness were standards the auditors allowed in the nonpublic company world. The PCAOB's new Standard 5 is designed to restore such flexibility for public company audits and that is an important reform.
Given the above experiences, it is clear that Section 404 needs reforms such as the new Standard 5. It is up to the PCAOB, SEC and auditors to continue towards a cost benefit approach using principles instead of rigid rules. More guidance is needed so companies and their auditors have a clear understanding of what is required and protections against frivolous litigation claims that audits should have been more extensive.
Editor: Has the enforcement and litigation mentality that followed in the wake of the scandals also had unintended consequences?
Ide: Our litigation system, both civil and criminal, has been a tremendous problem for companies for an extended period of time. The prosecution and civil litigation frenzy that followed the Enron era scandals made the situation worse. The country needs to engage in a national discussion to develop tort policies and approaches that are fair to everyone. The above Reports introduce a new sense of concern into that debate by emphasizing the impact on our global competitiveness due to the lack of balanced policies concerning tort liability and criminal prosecutions of public companies.
The current litigation system requires auditors to be more conservative in their approach to Section 404 which results in costly inefficiencies. I have seen audit fees drop considerably when one does not use the Big Four because smaller audit firms do not face the same litigation and regulatory concerns.
Enron and WorldCom also encouraged prosecutors to intrude into governance and to use the indictment threat to overextend their powers, because there were no policies in place to guide their behavior. The debate in this area is whether and when a company should ever be indicted. I would say only in limited circumstances, yet, we have not gone through a thoughtful and deliberate public policy development process relating to the indictment of corporations, instead of the individual employees who committed the wrongful acts. Arthur Andersen is a situation where prosecutors could have removed the problems without destroying the company. Andersen was, however, indicted and collapsed. Since then many companies have been wrongly forced under the threat of indictment into paying large fines and agreeing to unnecessary governance requirements. The Reports have surfaced for public debate the fact that prosecutorial abuses are deterrents to national survival in the global economic competition.
Editor: How has globalization affected our capital markets?
Ide: The final issue is that New York and London are never going to be back to their historic roles as the primary financial services centers. At one time information did not flow and networks were very tight which resulted in a monopoly on information and relationships that could only be accessed in New Your or London. That is changing and there is no going back.
Editor: The Reports suggest that the current prosecutorial environment in the U.S. has had a chilling effect on foreign companies seeking to enter the capital markets. Do you agree?
Ide: The Chamber Report states that the threat of criminal prosecution poses a unique challenge to business entities in the U.S. These actions can have catastrophic consequences on a business entity as we witnessed in the Arthur Andersen case. This results in a lot of uncertainty for companies seeking to enter the U.S. market and is likely to dissuade foreign companies from coming here.
Throughout history, we have all learned that promoting honesty and integrity through self-regulation is by far the most effective deterrent to fraud. The criminal justice system is an important backstop, but it should be precise in removing wrongdoers from companies and not be harmful to shareholders who are typically the major victims.
The Chamber Report recommends that Congress establish a self-evaluation privilege for companies. It argues effectively for such a privilege as a way of reinforcing the strong emphasis on corporate accountability and reform which has resulted in corporate officers and directors becoming more aggressive in their establishment of compliance programs, managing risk and addressing employee misconduct decisively. Self-evaluations should result in a candid report to boards of directors about any material potential compliance issues that a company may face.
This privilege would encourage companies to be more introspective and much more self-critical. Allowing a corporation to do its own detection through a self-evaluation privilege would be a significant improvement over the current system where companies are fearful to undertake internal investigations because of the potential for civil and criminal penalty claims due to the lack of the privilege and work product protections.
Editor: Critics of a self-evaluation privilege suggest that it would result in abuse by corporations. Is this a fair assessment?
Ide: It is important to remember that the attorney-client privilege and the proposed self-evaluation privilege do not cover facts. Facts must be disclosed to the other side during a dispute. The lawyer's mental impressions and notes surrounding the facts and observations are protected along with legal advice.
When the ABA Task Force on the Privilege studied claims that privileges allow abuses, we made it clear that a company is always required to provide facts during discovery. Unfortunately, some courts have made decisions that do not account for the distinction between facts and mental impressions of the lawyers. For instance, there are a couple of bad cases in the Southern District of New York that hold if facts from a lawyer's report are disclosed, the entire report is waived. The better case law says that this is not so. Therefore, a self-evaluation privilege would not protect facts, but would allow the company to have a privileged evaluation as to its situation. This allows boards of directors to make the right decisions for shareholders. Without the privilege, boards will not have the information they need, and that is harmful.
Editor: The Chamber Report recommends that prosecution of corporations be limited to exceptional circumstances where there is pervasive culpability throughout an organization. A similar recommendation is made in the CCMR Report. Do you agree?
Ide: The Arthur Andersen case raises serious policy issues. The CCMR Report rightly states that criminal prosecution of a business entity can bring about its financial ruin even before there is a conviction by a court. Certainly, the collapse of another major accounting firm resulting from a corporate prosecution would have devastating effects on financial markets. That Report points out that many of the firm's clients could not find a suitable new auditor.
The destruction of a corporation or other business entity harms innocent equity owners and other stakeholders. This inflicts grievous injury on the very shareholders who were defrauded. The Reports support the need to develop policy to prevent this from happening. The ability to impose a death sentence on a corporation is being abused by the enforcement community because prosecutors know that a threat of indictment will result in corporations caving into their demands - or even volunteering concessions with respect to waiver of the privilege and indemnification of employees whether or not there are formal policies protecting the corporation against such demands. That is not good policy.