Rewarding Corporate Honesty

Small public companies have been bristling under the Sarbanes-Oxley Act, the post-Enron law intended to restore trust in corporate financial reporting. The Securities and Exchange Commission plans to relieve these small companies of some of the act’s requirements. Presumably, the costs imposed on these corporations outweigh the benefits to investors, so some recalibration seems appropriate.

But as the SEC considers which changes to Sarbanes-Oxley might be in order, it has a chance to do something else: reward honest corporations, large and small, for their good behavior.

The 2002 act includes two types of regulations. One type should apply to every public company — for example, basic accounting regulations. With good reason, the act specifies activities companies have to report, how to calculate various items in their accounting statements, and so on. Such regulations need to be standardized, because investors, regulators, corporate boards, and corporate management need identical measures to evaluate and compare the financial statements of enterprises.

The second type of regulation demanded by the act is different and more far-reaching. It directs companies to set up specific corporate structures and internal controls that are thought to discourage abuses. For instance, the act requires companies to form compliance committees within their boards of directors — even if there are only a few directors on a given corporation’s board. Right now, these regulations are standardized, too. But they shouldn’t be.

Corporations can be honest with different structures, depending on their history, size, type of business, and culture, and on the kind of people who work there.

Not all honest organizations follow the same business processes and internal controls. When all public corporations are required by law to follow the same internal structure and compliance rules, honest corporations that have not previously practiced the standard rules must change their internal processes.

This is not as easy as it sounds. Each organization has its own culture — automatic ways in which people expect one another to behave. Like all habits, these are efficient because they do not require the actors to continuously evaluate their actions or weigh the pros and cons of every decision.

Culture and processes, like all habits, are hard to change. This is both their virtue and their disadvantage. As every driver in a new area or an employee in a new organization knows, even good habits of safe driving or collegial behavior are hard to adjust to in an unfamiliar environment. Right now, Sarbanes-Oxley imposes on honest corporations the costs of changing familiar, honest habits into different honest habits.

These costs can be exorbitant and unnecessary. Why should honest companies have to change their ways? Because these corporations have withstood fraudulent competitive practices, they should be exempt from provisions of the act that impose costs of changing corporate internal habits and culture.

Obviously, rogue corporations should indeed change their culture and internal processes. Which is to say, they should change their bad habits. So the second type of regulations — the rules mandating changes in corporate structure — should apply to them and to them alone. And indeed, when rogue corporations are found in violation of SEC rules, most settlements with them include requirements for changing internal processes, which is as it should be.

Applying certain regulations only to rogue corporations would reward the good guys. Those who are freed of the required cultural changes can reap the rewards of lower costs, a better image among customers and investors, and a competitive advantage over those who gained a competitive advantage by illegal means.

How to distinguish the honest from the rogue? This can be done either automatically — you’re out unless proven to be dishonest — or by letting corporations apply for an exemption upon certain evidence of good behavior. Once the principle of reward is adopted, the rules to implement the principle could be designed. In sum, the SEC should consider rewarding corporate honesty by bestowing competitive advantage on the good guys.

Tamar Frankel, a Boston University law professor, is author of Trust and Honesty: America’s Business Culture at a Crossroad. This article appeared in the Boston Globe.