Sarbanes-Oxley and the Fallacy of Independence

Yesterday, I spent some time researching the directors of Enron. What I discovered made wonder whether the post-Enron reforms, particularly the Sarbanes-Oxley Act, are capable of doing what they were designed to do. It even made me think that the laws might be grounded on faulty reasoning.

The most significant product of the corporate scandals of the late 1990’s was the Sarbanes-Oxley Act of 2002 (“SOX”, PL 107-204). SOX, of course, apotheosized the idea of the independent director as watchdog. SOX section 301 requires a public corporation’s audit committee (SOX is only concerned with audit committees – broader requirements for director independence actually come from NYSE and NASDAQ rules) be composed entirely of “independent” directors. Independence means no extra payola and no affiliation with the issuer or its subsidiaries. Affiliation is a two-way street and it comes down to control. An affiliate is someone who controls or is controlled by the issuer. Control is the power to direct via ownership of stock or by contract (see: Bostelman, The Sarbanes-Oxley Deskbook, PLIREF-SAROX s 11:3-3).

In the SOX cosmology corporate officers are compromised by their emotional and financial investment in a corporation’s fate, and must be isolated from other management players like auditors and lawyers. In the words of Byron Dorgan, “There is something rotten going on inside some of these corporations,” (Cong. Rec. pp S5249 – 5251, 2002 WL 32054458). For instance, section 203 of SOX requires auditors be rotated to ensure that they don’t lose their objectivity by getting too friendly with management.

But, according to Woodrow Wilson scholar (and Enron board member) Herbert Winokur, Enron’s board *was* independent. As he told the Senate’s Permanent Subcommittee on Investigation, “Enron’s board was composed of 12 independent directors and 2 inside directors.” And, he’s right – according to Enron’s 2000 proxy statement (Def 14A, 5/2/00), of the 17 directors listed, only three are Enron employees (Lay, Skilling, and John Urquhart who is Lay’s “Senior Advisor”). If we expand the group to include anyone who’d lose their “independent” status under SOX 301 we get five more names (for a total of 8): Robert Belfer, Lay’s business partner and CEO of Belco, an Enron sub, John Duncan, director of Enron sub Azurix, Ken Harrison, CEO of Enron sub Portland Gas & Electric, Rebecca Mark-Jusbasche, CEO of Azurix, and Winokur himself, a director of Azurix.

Pretty cozy, right? You can just imagine the plotting of nefarious doings. But to assess whether SOX 301 can really improve corporate governance ask yourself this (or, allow me to ask it for you): if management’s financial and emotional investment is the problem and an independent board is the solution, does this law really make an independent board possible?

To answer that question, let’s look at the other people on the Enron board, circa 2000. Wendy Gramm and John Wakeham may not have been personally invested in Enron, but both staked their professional careers on the wisdom of deregulating the energy business. Gramm, an economist and wife of Senator Phil Gramm, was head of the CFTC under the first President Bush. Responding to an Enron petition, she, in the waning days of her tenure, exempted energy commodities and swaps from CFTC regulation (CFTC 3620-93, 1993 WL 13822). As Margaret Thatcher’s Secretary of State for Energy, Lord Wakeham was the man in charge of privatizing England’s electricity industry, and as the Independent observed, “Enron was the first US company to benefit from his work.” Gramm and Wakeham are independent by the SOX standard, but Enron’s success would prove the wisdom of their professional decisions.

Also on Enron’s 2000 slate are Charles Lemaistre and John Mendelsohn, respectively, the former and current directors of the MD Anderson Cancer Center in Houston. Enron was based in Houston, and it is certainly a possibility that Lay and Skilling knew Lemaistre and Mendelsohn socially.

I don’t mean to imply that Lemaistre, Mendelsohn, Gramm or Wakeham were in on the scam - quite the opposite. The officers of Enron were running a criminal enterprise and they cleverly populated the board with people who had built-in reasons for wanting Enron to succeed. They capitalized on personal connections and political agendas alike to create a passive overseer.

So, that’s my point – distinctions between inside and outside mean nothing when you’re dealing with a con. Con artists draw people in and then they use them - for money or just for their good name - and that’s already illegal.