Yesterday, we included a post that discussed the benefits arising out of SOX. We mentioned an improvement in the quality of disclosure. We also noted the phenomena of companies where the fraud was widespread but never disclosed, in large part because of the influence of the CEO.

SOX addresses those situations by requiring the involvement of other officers and directors in the disclosure process. In particular, the CFO must certify the accuracy of the financial statements, with a knowing violation resulting in up to 20 years in prison. The directors on the audit committee must meet an enhanced definition of independent and the committee has expanded involvement in the financial disclosure process.

An example of the need for this approach can be seen from a recently published report involving Computer Associates. An article in the WSJ on Friday noted that a special committee of the board had published the results of its investigation into fraudulent accounting practices of the company. The fraud – involving an extension of the quarter to capture additional revenue and known as the “the 35-Day Month” – resulted in a restatement of the company’s financial statements and eight former senior executives pleading guilty. The report is available at the DU Corporate Governance web site.

According to the report, the fraud occurred because of the control exercised by top officials at the company that fostered a “culture of fear.” Here is the description by the special committee:

• "Mr. Wang [the former CEO] shunned written policies and procedures in the apparent belief that they fostered bureaucracy and inefficiency. He avoided and discouraged group meetings, rarely, if ever, gathering even his most senior executives together in an organized way to discuss business. He reserved decision-making to a very limited group of executives that he controlled and dominated. As one witness aptly explained to the SLC, Mr. Wang ran CA as if he were “running it out of his garage.” While the SLC recognizes that excessive controls and procedures may contribute to bureaucracy and inefficiency, CA fell far short of approaching what was necessary to control a Fortune 500 company. Mr. Wang caused additional harm to CA by creating a “culture of fear,” which caused CA employees, at all levels, to refrain from offering dissenting opinions. He did this by making personnel decisions in an arbitrary manner, routinely firing CA personnel on a subjective basis. This had the effect of suppressing corporate dialogue, by both lower and midlevel employees, as well as in the highest ranks of senior management. According to one witness, CA employees felt as if they were constantly “hanging on by their fingernails.” In the SLC’s view, this culture was the breeding ground in which the 35-Day Month practice originated and later flourished. This atmosphere proved particularly toxic at CA, since, under Mr. Wang, missing Wall Street estimates was to be avoided at all costs. This problem was exacerbated by Mr. Wang’s preference for promoting from within, rather than looking outside the Company for experienced candidates to fill CA’s executive suite. As a result, Mr. Wang surrounded himself with young executives of limited experience – including CA’s Chief Financial Officer (“CFO”), and the heads of Financial Reporting and Sales Accounting – whom he and Mr. Kumar could easily dominate."

• "In the end, the fraud at CA was directed by a group of CA’s most senior managers who acted intentionally to violate the accounting rules and then covered it up. However, the fraud pervaded the entire CA organization at every level, and was embedded in CA’s culture, as instilled by Mr. Wang, almost from the Company’s inception. Indeed, the improper practices became CA’s standard practices to the point that the fraud was “hidden in plain sight” and became part of CA’s normal day-to-day business. CA’s failure to have an organizational structure, policies, and practices consistent with that of a multi-billion dollar market-cap, publicly-traded company contributed substantially to promoting an environment which allowed the fraud to begin and to continue at the levels it did for as long as it did."

To the extent the report is to be believed (the WSJ indicated that Mr. Wang disputed the content), it indicates that fraud can be perpetuated where the CEO can control the disclosure process. Under SOX, this is far less likely.