Do Independent Directors Curb Financial Fraud? The Evidence and Proposals for Further Reform

Cindy A. Schipani, University of Michigan, writes on the Harvard Law School Forum on Corporate Governance and Financial Reform:

One would have hoped these SOX-created independent watchdogs [independent directors] would reduce the incidents of securities fraud and result in better governance. Yet, our analysis of the number of class action settlements for claims of financial fraud for settlements greater than $10 million shows no significant decrease since the adoption of SOX. We presume that settlements of over $10 million indicate serious concern of the board evidencing the viability of the suit. The dollar amount for analysis was chosen to reduce the incidence of strike suits in our data. Thus, the lack of a significant decrease in these claims seems to indicate that it may have been unreasonable to expect independent directors — who almost by definition are not privy to the day-to-day affairs of the firm—to have enough incentives or information to ferret out complex, and likely hidden, fraud.

Moreover, and perhaps even more troubling, our data also shows that independent directors themselves are not necessarily immune from the temptations of financial fraud, particularly with the gains to be had from backdating stock options. SOX’s reliance on them may simply have transferred oversight responsibilities from compromised executives to compromised and ill-informed board members.

An alternative approach to the SOX mandates would have been to empower the shareholders directly and enable them to exercise a greater degree of direct oversight over the managers.

This supports our view that no director can be truly “independent” unless elected through a robust nomination system that includes proxy access and a majority voting requirement — as well as a robust system for enforcing fiduciary obligation in voting institutional shares in the interest of beneficial holders.

Source: Do Independent Directors Curb Financial Fraud? The Evidence and Proposals for Further Reform

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