Views on the Securities Exchange Act Amendments on CEO Certification and Related Issues

- Government bill No. 162396, 2003.6.19.:

Partial Amendment to the Securities and Exchange Act -

1. Review of the Direction of the Amendment

For companies to earn the trust of the market and investors, it is essential that accounting information be prepared accurately and provided in a timely manner. From this perspective, it is understandable that the United States, which had long prided itself on being advanced in accounting, passed the Sarbanes-Oxley Act in order to overcome the market’s crisis of confidence caused by a series of accounting fraud cases such as Enron and WorldCom. Korea likewise has ample reason to strengthen the operation of its accounting and disclosure systems in order to prevent problems similar to those seen in the United States.

Enhancing corporate transparency to protect investors and improve the efficiency of the stock market is desirable not only for investors but also for companies, in that it raises market value. However, just as even good medicine can have side effects when taken to excess, it is necessary to reconsider whether reforms are being pushed forward too hastily in disregard of the realities of corporate accounting and overly driven by the justification for reform, or whether unnecessary overlapping regulations are being imposed. In particular, this bill appears to focus on strengthening the responsibility of controlling shareholders and management, giving it more the character of regulation of large corporations than of improving the accounting system and managerial transparency. More broadly, it excessively imitates the U.S. system, despite differences in business conditions, and reveals problems such as duplicate regulation of matters already governed by other laws.

2. Rapid Increase in the Introduction of Management Transparency and Accounting-Related Systems

Since the foreign exchange crisis, corporate governance reform and accounting and disclosure-related systems have been introduced in a flood. By adopting cumulative voting and making outside directors mandatory, protection for minority shareholders and the independence of management were secured, and audit committees were made mandatory for listed corporations, KOSDAQ-registered corporations, and securities companies with total assets of 2 trillion won or more.

In addition, the independence of auditors was strengthened by reducing the influence of controlling shareholders over the audit function, such as by preventing controlling shareholders from exercising voting rights exceeding 3% of voting shares when appointing auditors. On the accounting side, Korean corporate accounting standards were fully revised into standards consistent with international norms, and combined financial statements—virtually unprecedented in the world—were made mandatory for the 30 largest business groups. To root out window-dressing accounting, cases uncovered through supervision were reported to financial institutions and related agencies and also disclosed to the public. In 2001, through the enactment of the Corporate Restructuring Promotion Act, companies with assets of 7 billion won or more and companies with credit exposure of 50 billion won or more were required to establish internal accounting control systems, while a system was also introduced to protect whistleblowers reporting accounting fraud. In addition, quarterly reports, an electronic disclosure system, and a fair disclosure system were introduced to protect investors and enhance the transparency of the securities market. The problem is that yet more new systems are being pursued without sufficient examination of the side effects or practical suitability of the systems already introduced.

3. Evaluation of the Bill

First, making CEO/CFO certification of business reports and other filings mandatory in order to strengthen management’s responsibility for the adequacy of disclosure documents (Article 8 of the amendment) is, above all, largely duplicative regulation. Even now, in the case of public companies, the representative director must affix his or her seal to business reports and securities registration statements, and if he or she does so knowing that they contain false statements, the penalty is imprisonment for up to 5 years or a fine of up to 30 million won. In addition, under auditing standards, a “management representation letter” acknowledging management responsibility must be prepared and signed by the representative director and the executive in charge of accounting and submitted to the external auditor. It is regrettable that a system formed in a context different from our own is being accepted without sufficient filtering. In the United States, because the board of directors has authority to approve financial statements, CEO certification is needed in some respects to establish responsibility thoroughly. In Korea, however, business reports go through a rigorous confirmation procedure involving the person responsible for internal accounting management, the audit committee (chaired by an outside director), the board of directors (with at least one-half outside directors), and the shareholders’ meeting, and are approved at the general meeting. In this respect, CEO certification is largely regulation on top of regulation.

Meanwhile, in Korea, where the Business Judgement Rule has not been clearly established and where no sentencing guidelines have developed to reduce punishment or fines when internal control procedures have been sufficiently followed, imposing excessively broad responsibility on CEOs could become an excessive burden that may only shrink business activity. Fortunately, this amendment defines punishable conduct as signing “knowing the fact of false entry,” so criminal sanctions are unlikely to be abused. Even so, in the case of group companies preparing combined financial statements, requiring the CEO to certify the propriety of accounting treatment at all affiliated companies is unquestionably a serious burden. Moreover, current corporate accounting rules in practice lack clear standards for determining whether window-dressing accounting has occurred and depend on the subjective judgment of supervisors. As a result, there is a strong possibility that, depending on interpretation, conduct may at any time be regarded as a violation, leaving ample room for controversy over the appropriateness of punishment. Under such exposure to virtually unlimited liability, one cannot help but worry who would readily step forward to serve as CEO or CFO in the future.

Second, allowing civil liability to be imposed even on de facto directors and experts (Article 14 of the amendment) also has a strong character of overlapping regulation, since under the Commercial Act Korea already operates a de facto director system, under which a person who uses his or her influence to instruct a director in the execution of business bears joint liability with the director for damages. Unlike in the United States, controlling shareholders in Korea are broadly restricted in management participation through limits on voting rights, disqualification from serving as outside directors, and the like. In such a situation, increasing only liability raises issues of balance between rights and duties. In particular, imposing liability for damages on experts is, at first glance, justifiable insofar as it seeks to prevent the reckless issuance of insincere expert opinions. However, excessive burdens may instead suppress experts from expressing opinions, thereby restricting investors’ use of information. There is little doubt that market reputation is a more effective and essential means of disciplining experts.

Third, in order to prevent abuse of position by major shareholders and executives, the bill would in principle prohibit loans of money to such persons (Article 191-19, etc.). Yet current financial supervisory laws, including the Banking Act and the Mutual Savings Banks Act, already restrict loans and similar transactions with specially related persons such as major shareholders, while the Securities and Exchange Act and the External Audit Act impose disclosure obligations when a company lends funds to them. In that sense, the regulations overlap. In addition, Article 11(2) of the Fair Trade Act already requires board approval and disclosure of the details of transactions with specially related persons involving temporary advances, loans, shares, corporate bonds, and the like. Moreover, through the March 2001 amendment to the Securities and Exchange Act, transactions with the largest shareholder and specially related persons were made subject to board approval and a resolution of the shareholders’ meeting, so a considerable degree of transparency may already be said to have been secured. To be sure, insofar as excessive borrowing of company funds by specially related persons may cause conflicts of interest and abnormal accounting treatment, there is some justification for prohibiting such loans in principle. However, the scope of specially related persons subject to regulation is excessively broad and may infringe the principle of freedom of transaction for private enterprises. In reality as well, loans directly related to management, such as for the purchase of business land, are sometimes unavoidable, making such prohibition highly problematic. It should be taken into account that the U.S. Sarbanes-Oxley Act restricts loans only to corporate officers.

4. Desirable Direction for Legal Improvement

This bill largely accepts the contents of the corporate reforms hastily put together in the United States after the Enron incident. Some of these can hardly be called “reforms” in Korea because they are already in force domestically, while others are far removed from our practices and realities and thus lack practicality. For example, requiring the chief executive officer (CEO) to sign the financial statements effectively amounts to asking for one more written pledge of responsibility in addition to the current signed and sealed documents.

In order to assess the effectiveness of this reform bill, it is necessary to compare the U.S. reality, which serves as its frame of reference, with our own circumstances. The United States has operated a system disciplined by the market through GAAP standards and, in its accounting-related legal framework as well, had maintained its distinctive common law system. It was only after the accounting fraud scandals that it enacted the Sarbanes-Oxley Act under the recognition that comprehensive legal control was needed. By contrast, Korea has long maintained a statute-based, regulation-centered legal system through the Commercial Act, the Securities and Exchange Act, the External Audit Act, and the Certified Public Accountant Act. In addition, U.S. corporate management is characterized by granting the CEO both full authority over corporate management and enormous stock options amounting at times to hundreds of millions of dollars. As a result, corporate managers are in a situation where they cannot help but focus on short-term profits and are therefore strongly tempted by inflated accounting fraud. By contrast, Korean CEOs have fewer compensation incentives and conduct management activities under a wide range of economic and social regulatory constraints. Therefore, it is unpersuasive to transplant into domestic law, without any filtering, most of the provisions of a corporate reform law established to prevent the harms produced by American-style management.

In accounting, institutional stability is more important than in almost any other field. Simply listing foreign systems because their intent is good will not enhance the reliability of accounting information, nor will accounting transparency be achieved at a stroke by imposing duplicative regulations detached from reality. To resolve window-dressing accounting and accounting opacity, it is more urgent not to introduce additional new systems but to thoroughly enforce the many systems already introduced and supplement their weaknesses. All institutional introductions entail costs, and in the case of duplicative systems, the burden is even greater. In fact, it may be said that the problem with the numerous accounting and disclosure-related systems introduced since the IMF crisis is not that they were ineffective in enhancing corporate transparency, but rather that enforcement functions have been weak. Accordingly, it would be a more effective approach to enhance the function of accounting audits and provide incentives to establish systematic internal control standards within companies.

Seyoung Yang (Deputy Director, Corporate Policy Team, Federation of Korean Industries (FKI))

Wiki:

https://www.cfe.org/w/bbsDetail.php?idx=70

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Original title: CEO 인증 등 증권거래법개정안에 대한 견해

Author: Se-young Yang

Date: 2003-11-25

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=bill&pn=4&idx=25827