Innovation and Corporate Governance

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Innovation and Corporate Governance

The impact of SarbanesOxley Act

Master Thesis

University of Groningen

Faculty of Economics and Business

Master

of Business Administr

ation

Stra

tegy & Innovati

on

September, 2009

Gabriela Sorocean 1830430

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PREFACE

This document is my Master’s thesis and is the result of the final project to obtain the degree Master of Science in Business Administration – Strategy and Innovation Management at the University of Groningen.

This master thesis is an explorative study in cooperation with Mr. Orosa, lecturer in strategic management who acts as the first supervisor of this thesis and Mr. Broekhuizen who acts as the second supervisor. The role of the supervisor is to guide the student during the course of the project, also according to the study guide for master programmes the student is asked to complete a scientific research project in the field of strategy and innovation.

I would like to thank several people that contributed directly or indirectly to the conception of this research, first of all, the interviewees whose valuable information has helped me to reach a sound conclusion regarding this intricate topic. Second, I would like to thank my friends that have been there for me all the way through the ups and downs of writing a thesis, encouraging me and standing by my side. Most of all, I would like to thank my mother, for everything.

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ABSTRACT

In this paper we analyze the impact Sarbanes-Oxley Act has on innovation. Corporate governance influence on innovation has received a relatively limited attention over the last few decades in the literature. Understanding the impact of the Act on innovation seems to be a serious omission. This study analyzes the core effects SOX Act has on corporate innovativeness. Sarbanes-Oxley Act was created to protect shareholders that were affected directly and financially by the unfair management conducts within corporations (Enron, WorldCom, Adelphia). Sarbanes-Oxley Act is mandatory, all organisations, large or small, must comply. The law obliges companies to perform monitoring by outsiders (independent directors) and less by insiders that are less objective and do not take into careful account shareholders interest and tamper the company’s risk taking factor.We will look into the laws that influence corporate governance policies and the main effects it has on innovation. Finally, we will analyze the effects of Sarbanes-Oxley Act on innovation within established multinational corporations.

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1. Introduction

In 2006, Apple started to ship its Mac computers without notifying the customers that they were equipped with the newest innovation in wireless technology, the 802.11n wireless card. The customers were informed later that the computers could use the wireless card, but that customers have to pay $1.99 in order to download the activation software. Apple’s response to customer’s indignation was that, due to accounting rules enacted by corporate governance law, the company was required to charge a minimal fee for the software because it had already recognized revenue on the computers when they shipped.

This kind of incidents shows that the relationship between innovation and corporate governance is subtle yet powerful. The Sarbanes-Oxley Act has been signed into law in July 2002, after major corporate governance failures, where financial reports were inflated and shareholders trust shattered. Analyzing the relation between innovation and corporate governance is well-timed, as scholars still debate the impact that Sarbanes-Oxley Act rendered on corporate governance policies. SOX Act maximizes monitoring over boards, obliges more internal verifications over financial reporting and tightens civil and criminal amendments for fraud and disregard of the federal security law. The goal of this research is determining whether the SOX Act, reduces innovativeness of public companies by inclining corporate governance toward sharper monitoring by outsiders and restricting objective decision making by insiders. If such a negative consequence occurs, it could be argued that the SOX Act affects society as a whole by deterring innovation. This paper researches the relation between innovation and corporate governance and will provide a deeper understanding of the effect Sarbanes-Oxley Act has on innovation.

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2. Research Design

2.1. Statement of the research problem

This thesis analyzes the impact Sarbanes-Oxley Act has on organisational innovativeness under the tight control of corporate governance policies. The goal of this research is to provide a core understanding of the impact Sarbanes-Oxley Act (SOX Act) has on innovation.

Hypothesis:

 What is the impact of Sarbanes-Oxley Act on innovation?

Sub-questions:

1. How is innovation undertaken by established corporations?

2. Is a high ratio of outside director’s impacts negatively on innovation? 3. How decentralisation and strategic internal control facilitates innovation?

Conceptual research model

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Fig 1: Conceptual Research Model

3. Sarbanes-Oxley Act defined

The Sarbanes- Oxley Act of 2002 (SOX Act) was signed into law by U.S. in July, 2002, with the express purpose of making financial reporting of publicly traded companies more reliable and transparent for stakeholders (Allen, 2002). It had all begun with the so called ‘bubble burst’, during depressed prices and financial scandals. Some companies had been found to have been ‘playing’ with creative accounting (Enron, WorldCom). Others were guilty of extracting generous self-benefits (Tyco, Adelphia) that brought companies on the verge of bankruptcy. The malfunction brought the urgency of reform in 2002, under the name of Sarbanes-Oxley Act. The main changes brought by SOX Act can be categorized under three main headings: audit- related changes, board-related changes, and disclosure and accounting rules.

3.1. Audit-related changes

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action-forcing rules. The conflict reducing rule aims at eliminating relationships that can bring pressure, seducement or temptation not to act diligently in regard of their corporate clientele. Action-inducing rules is mandating through law certain kinds of action, by altering arrangements for incentives and power, and imposing regulatory bodies and processes. Making sure that the audit process will be a genuine one and in line with the law.

3.2. Board-related changes

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3.3. Disclosure and accounting rules

Another major category of SOX Act changes involves financial disclosure to shareholders and public. The assumption is that the information will help investors to use their influence to (buy, sell, vote, sue) more efficiently and will outcome in less misfortunate investment decisions, shorter mispricing of shares, and lesser scandals and impostures. The main disclosure requirements come in areas as off-balance-sheet arrangements that require firms to disclose more about off-balance-sheet arrangements (this arrangement were inspired by Enron fiasco). Also, companies must discuss in their annual reports ‘critical accounting policies’ that are based on managerial judgements and estimates and economically important to the entire corporation and stakeholders. Party transactions must be disclosed more to the public under the suspicion that these might be unfair to the company and the shareholders, whereas public disclosure will obstruct miss-manipulations and ease remedies. Another action-inducing rule is that CEO and CFO have to personally certify the financial statements of the company, they do not guarantee the accuracy of those statements but surely they have become more cautious and focused on their financial staff. New ways of financial schemes will eventually emerge and avoid the current regulations. Nevertheless, it seems that the current regulations have created more confusion than order and a weight to carry in the form of enormous costs. Empirical studies generally support the proposition that SOX Act’s additional emphasis on financial control decreases innovation capacity for all public companies, regardless of size (Arewa, 2002). Hitt et al., has found a positive relation between an emphasis on strategic control and R&D, and a negative relationship between emphasizing financial controls and R&D (Hitt et al., 1996).

3.4. Definitions

To be able to answer the above questions a sound framework research was compiled which is based on academic theory and is commenced further on. The most important concepts of this study are discussed below thus entering the conceptual research model.

Corporate Governance

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control. Also, the presence of top management can be seen as an important factor as it can provide the impetus for innovative change, organisational performance, and strategic decision-making (Hambrick and Mason, 1984; in Auh and Menguc, 2005). In this research the definition of Tylecole and Ramirez will be applied.

Sarbanes-Oxley Act

The Sarbanes-Oxley Act was signed into law in 2002 by the U.S. government with the express purpose of making financial reporting by publicly traded companies reliable and transparent for stakeholders (Allen, 2002). Key components of SOX Act address issues related to corporate governance, management reporting and internal controls, and auditor’s assurance over management assertions over internal controls, (Arnold, Benford, Canada, Kuhn, Sutton, 2007). SOX Act has been viewed as one of the most important piece of legislation related to financial reporting and protection of public interest Canada et al., (2007).

Boards

According to (Donaldson and Davis 1991; Williamson 1985; Mintzberg, 1983; Zahra and Pearce, 1989), the board of directors (BoD) ensures that the firm aims at attaining the maximum satisfaction of its shareholders or stakeholders in general. The board can be seen as a mechanism through which ownership takes part in the management of the company. The BoD is an organ that can improve management related problems and generally manage conflicts between ownership and the management of a business, it is a key corporate governance structure that ensures all targets of the shareholders and management are kept in line.

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granted by SOX regulations that specifically ask for independent directors with full monitoring capacity that act as primary defence system for shareholder interests.

Top Management

Top management teams are the agents that can determine the strategy of the firm and influence the firm outcomes (Carpenter et al., 2004; Hambrick and Mason, 1984). Top management is human capital possessed by an organisation, but it is not sufficient to create innovation, it also needs social capital, networks and relationships, common values and all this can be seen as parts of corporate governance (Aug and Menguc, 2005). Top management diversity has been found in the literature to have a positive effect on innovation. Heterogeneity refers to the level of diversity along demographic functional, and background dimensions in the composition of the group (Simons et al., 2999; Van Knippenberg and Schippers, 2007). Heterogeneous teams perform better in exploration rich, turbulent environments (Keck, 1997), are more innovative as they can combine diverse knowledge (Rodan and Galunic, 2004), and more successful in reaching out for distant markets (Tihanyi et al., 2000). The diversity of the management team is one of the most important factors influencing innovation capacity within a company.

Shareholders and Stakeholders

Corporations are legal entities, and in themselves are owners of their assets, with managers determining the use thereof. Shareholders therefore, do not exercise the right to use, but the right to benefit the corporation (Kang and Sorenson, 1999), in the form of residual cash flows of the corporation. On the other hand, stakeholders are individuals or groups where the on which the activities of the company has a direct effect and shareholders as individuals, institutions, firms or any other entity that owes shares in a company, (Mallin, 2004). Stakeholders are mainly: employees, providers of credit, suppliers and customers, local communities and environmental groups, (Mallin, 2004).

Innovation vs. Innovativeness

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value will be determined by the selectors, (Wijnberg, 2004). While Schumpeter says innovation is a form of new combination of already existing things. Also Wijnberg (2004) suggests that the most common distinction with respect to types of innovation is between product and process innovations. Organisational innovation isoften added to these two types. Zahra`s (1996) research that emphasizes the relationship between governance, ownership, and corporate entrepreneurship and research concentrated on the effects of ownership and governance on innovation strategies.

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4. Theoretical Background

4.1. Corporate governance defined

Corporate governance is the system by which companies are controlled and directed, and made accountable to shareholders and stakeholders, (Tylecole and Ramirez, 2006). Corporate governance consists of the rules, entities, and processes that govern how corporations use their assets to generate and distribute revenues among shareholders, employees, and other parties (O’Sullivan, 2006). Monitoring and controlling entities is also a type of governance structure, internal to the company as boards and external such as regulators, analysts and auditors. The empirical corporate governance literature largely finds that a corporation’s choice of governance structure is a result of its firm-specific characteristics. In other words, governance mechanisms are endogenously determined by firm attributes (Chidambaran et al., 2008). Furthermore, companies generally choose structures that maximize overall firm value, as opposed to choosing structures that benefit managers or some other corporate constituency (Boone et al., 2007). Both shareholders and stakeholders stress the relationship between providers and users of resources within the company, (Hermes, Postma and Zivkov, 2006). This shows that corporate governance is concerned with internal aspects of the company as internal control and external aspects as organisations relation with stakeholders and shareholders, (Mallin, 2004). The ultimate goal of any system of corporate governance is to maximize the wealth of stockholders (Bainbridge, 2001).

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Fig. 3: representation of internal and external relationships of corporate governance

The right part of the drawing depicts external governance that comes from the firms need to collect capital, the left part shows the basic corporate governance structures and its ties within the company

Source: Postma (2002), adapted from the World Bank

The internal and the external parts of corporate governance has higher implications than just assuring fair returns and shareholder protection, according to Clarke (2005) it has implications in particular critical to economic and social well-being.

4.2. Innovation

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knowledge most relevant for a given task (Lacetera, 2001). When economic growth and development depends on tacit firm specific knowledge centralized decision-making and outside monitoring are of limited value (Shadab, 2008). This is because tacit and particularized knowledge is costly to communicate, especially to those lacking familiarity with the context in which the knowledge arose (Nelson & Winter, 2005).

Organisational flexibility vs. innovation

Compliance with SOX’s internal control duties may reduce organizational flexibility within corporations and thereby undermine innovation through strategic renewal or other attempts to adapt to change (SEC, 2006). The Advisory Committee ascertained that SOX reduces flexibility in firms based on two observations: small to medium sized companies are dynamic and constantly evolving, requiring frequent changes in production processes and job duties within the company (SEC, 2006). This dynamism limits the ability of these companies to have well-documented production processes as required by SOX because “flexibility and quick change often means that processes and internal controls change, and consequently that the documentation of those controls change” quickly as well (SEC, 2006). Large innovative companies enthusiastically adapt to economic change through strategic renewal, changing their routines to integrate new products and adopting radical process innovations. The organizational changes arising from such activities implicate processes in several different parts of a company and may result in a large corporation changing previously established boundaries, controls, and production processes Stieglitz & Heine (2007). When organizational innovation or a substantial change in routines takes place, under Section 404 management must assess the impact of such changes on internal control and reporting risk (Stieglitz & Heine, 2007). The dynamic nature of large innovative companies and management’s involvement in financial reporting thus indicate that SOX reduces flexibility in large public companies (Lynne Koehn & Stephen, 2006). The SOX Act has provoked changes in organisational flexibility by demanding a greater audit control.

Innovation and established corporation

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Companies can increase their competitiveness and profits by proactively seeking innovation that can disrupt their current state and lead to ‘creative destruction’ characterized by Joseph Schumpeter. Unlike other investment projects taken by corporations, innovation is a high-risk and long-term commitment (Holmstrom, 1989). Innovation is something unknown and needs the firm to perform R&D or other high-degree or uncertainty projects regarding final results (O’Sullivan, 2000). Many times, top management faces risky choices, one that may have a poor outcome (March and Shapira, 1987). These projects meet these criteria because many of them fail, those that survive may take years to generate a profit (Block & McMillan, 1993), and it is difficult to estimate their results a priori. Successful commercialization of particular innovations can take several years and may require sacrificing short-term profits to gain from the more important sources of company value in the long-term (Besanko et al. 1989). The success of an innovation requires employee’s dedication of their skills, also top management helps ‘push’ radical innovation as they are the main instigators for long-term, strategic decision making (Lassen et al. 2001). Hoskinsson, Hitt and Hill (1991), also noted that ‘choices that contain the threat of a very poor outcome are ones that involve a departure from established operations routines and procedures… when a firm tries to adopt an innovation… that requires a fundamental change in the way the firm operates’.

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flexible structures (Katz, 2006). SOX Act affects directly the flexibility and agility of established corporations through higher disclosure and accounting rules.

Strategic decision-making and innovation

Strategic decision making means adopting ’commitments, decisions, and actions designed and executed to produce a competitive advantage and earn above-average returns on investment (Hitt et al., 2001). To achieve innovation, strategic decisions should also foster long-term commitments or else ‘interest and attention become too dispersed’ (Lawson & Samson 2002). Strategic innovation requires a company to fundamentally re-conceptualize its existing business routines ‘to achieve dramatic value improvements for customers and high growth’ for itself (Schlegelmilch, 2007). Top managers are the decision makers primarily responsible for strategic decision making and entrepreneurship (Kuratko, 2004). On the other hand, the board of directors can also be directly involved through strategic renewal, close monitoring and strategic management. The board of directors is the modern corporation principal method of governance, enabling numerous interests and dispersed information to be coordinated and processed among corporate actors (Bainbridge, 2003). Strategic renewal is a process of internal change and reorganization that results in organizational innovation (Kuratko, 2005).

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over company’s investments thus avoiding any high-risk projects in order to protect shareholder interests. SOX Act board structure changes affects strategic and financial decision making in corporations.

Innovation and corporate governance

Because innovation requires coordination of activities on a company-wide basis, it is affected by the corporate governance structures and policies applicable to the entire organization (Langlois, 1992). It is important that companies find the right balance between outside monitoring in order to reduce opportunism and the use of best strategies to reduce managerial myopia. Based on the body of literature analyzed the main structures that facilitate innovation can be identified: (1) decentralized communication and transfer of knowledge, that gives the company the necessary flexibility and agility to react to fast changing environments; (2) and the importance of strategic internal control that encourages long-term risky ventures. When discussing the first principle, because innovation depends on the correct utilization of tacit and particularized knowledge (O’Sullivan, 2007), innovation requires corporate activities to be organized so that knowledge is generated and communicated to the appropriate decision makers (O’Sullivan, 2007). Mainly because tacit and particularized knowledge is costly to communicate, especially to those lacking familiarity with the context in which the knowledge arose (Nelson & Winter, 2005).

Knowledge generation and communication tend to benefit from adoption of decentralized governance structures, or those structures giving corporate agents, such as managers and their subordinates more discretion (Foss & Laursen, 2005). An important part of decentralization in the corporate context consists of allocating decision making authority to insiders who have superior knowledge about the company and its environment (Jensen & Meckling, 1998). Decentralized governance facilitates not only knowledge-utilization, but also the type of organizational flexibility that innovation requires (Krafft & Ravix, 1997). Changing and adapting organizational structures requires managers to have ‘control and decision rights over the firm’s assets (Stieglitz & Heine, 2001) which as a result facilitates strategic renewal and organizational innovation (Zahra et al., 1996).

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control is required for sustained innovation because strategic control focus on and evaluates long-term performance, establish risk-taking norms, and reward activities resulting in innovation (Hitt, 1996). On the other hand, over-emphasis of the financial control may inhibit the communication of tacit and local knowledge that is not subject to straightforward measurement and quantification in financial reports (Andrew et al., 2003). As a side-effect of decentralized strategic control whereas managers have high degree of influence and decisional rights it could take the lead of self-interest rather than company and shareholder benefit.

Also, information asymmetry occurs between managers and their direct monitors (independent directors and investors). These asymmetries give managers the ability to benefit themselves because in such situations the cost of monitoring are high and it is difficult for outside monitors to evaluate management conduct (Hansmann & Kraakman, 2004). According to Boot and Macey (2004), ‘proximity exists when monitors maintain close contact with the management and participate in important decision on a real-time basis. Objectivity exists when monitors… remain distant from management and evaluate them without influence by management….. a tradeoff between monitoring functions exist because monitors that obtain close proximity necessarily forego objectivity, and objective monitors must maintain sufficient distance from management, which results in a loss of the advantages of proximity’ (Boot & Macey, 2004). Proximate monitoring facilitates communication and knowledge transfer due to the close ties with the management and participation in decision taking that results in higher possibility to transfer tacit knowledge effectively. Proximate monitors have deeper knowledge about the company that allows them to make use of strategic control instruments to direct long-term growth of innovation projects. Therefore, proximate monitoring is the most suited for decentralized and strategic control that reduces myopia and encourages innovation.

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experience higher costs from myopia or opportunism. The appropriate mix between objective and proximate monitoring that will bring most of the value to shareholders. SOX Act board related changes increases objective monitoring in corporations and thus reduces commitment to long-term risky projects.

4.3. Conclusion on the literature

The below model represents the impact of SOX through corporate governance layers on innovation: board composition, top management monitoring, and shareholders influence and control. Hard law as SOX Act affects directly the corporate governance policies which must comply with stricter regulations, thus affecting innovativeness in the company through external/internal control and regulations. Many of the effects can not even be measured immediately as the lost opportunities take time to be truly measured and understood.

The conceptual research model shows how SOX while at the top of the chain impacts innovation at the end of the chain by penetrating through several corporate governance layers. Does it make a difference whether the board is an insider or outsider director? If yes how does that impacts innovation capacity of a firm? Is proximate monitoring and strategic control benefiting innovation? What is the direct impact of higher public disclosure and stricter financial control?

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5. Methodology

In the following chapter the research methodology is discussed. Topics as research design, data collection, research sample and the coding method are applied as to make the research method more clear and transparent.

Literature review

Two major reasons exist for reviewing the literature (Sharp and Howard, 1996 in Saunders, Lewis and Thornhill, 2000). The initial search facilitates the creation of the research and gives the opportunity to have a critical review of the literature (Saunders, et al., 2000). The process of critically reviewing the literature means that one is studying the literature on a given subject, in order to identify the literature published on the chosen research topic, that can be applicable, enhance the subject knowledge and help to clarify the research questions further (Saunders, et al., 2000).

Motivation of the case study selection

Case studies are a method to create grounded theory and have the aim to provide description, test or generate theory (Eisenhard, 1989) and they give an in-depth contextual analysis of events or conditions (Cooper & Schindler, 2003).

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and relationships. Cross-sectional analysis is advocated as a means as avoiding the limitations of standard case study methods where little is generally known after conclusion of the study as the applicability of the findings beyond the one organization studied. Based on this strategy, this research consists of four case studies of established companies that comply with SOX Act reporting. The companies were approached through interviews with individuals responsible of SOX Act implementation and other employees involved in the development of innovation processes of the firm. The main strategy behind the interviewing technique is to address employees directly involved in the SOX Act implementation rather than targeting certain high ranked positions that might just be out of observation. Theory was developed to generate valid research questions and a process of replication was used to proceed with same questions at the interviews with each informant.

Data collection

The data collected might be qualitative (e.g., words), quantitative (e.g., numbers) or both (Eisendhardt, 1989). The information collected for this research is qualitative as it will be conducted through semi-structured interviews; this type of interviews have been qualified as the most appropriate for exploratory and explanatory studies (Saunders et al., 2002). A list of themes and questions has been prepared in advance but these can vary from interview to interview in their appearance, order, depth and specific context (Saunders, et al., 2000). According to Saunders et al., (2000) semi-structured interviews may be used in order to understand the relationship between variables, such as those revealed from descriptive studies Hoskinsson et al., (2002) and Zahra (1996).

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the main information was extracted. The appropriate number of cases depends upon how much is known and how much new information is likely to be learned from incremental cases (Thomas, 1990).

Sample Construction

In the exploratory stage of a pilot survey of research projects, a non-probability sample is the most practical way to approach research (Saunders, et al., 2002), thus this approach is applied to the herein research. A series of four purposively selected case studies are conducted with corporations from different industries and their strategy used to comply with SOX Act objectives. Purposive (or theoretical) sampling offers a degree of control rather than commit to any selection inherent in pre-existing groups. Purposive sampling allows putting into light deviant cases, enabling ‘the exception to prove the rule’. Through purposive sampling companies from different industries were selected in order to penetrate the main issues encountered regarding Sarbanes-Oxley Act and its impact on innovation. This way of sampling might appear a contradiction, as a small sample may contain cases that are completely different, representing extremes within the field of study (Saunders et al, 2000). Patton (1990) argues that this is in fact strength. Any patterns that do emerge are likely to be of particular interest and value and represent the key themes and document certain uniqueness of the cases (Saunders et al, 2000). Saunders et al. (2000) warn that such samples cannot, however, be considered to be statistically representative of the total population, in this case all the public companies from U.S. and EU that comply with SOX or its related provisions. When companies are carefully chosen and the interviewees are experts in the topic, the purposive sample selection is a good method in a small sample to represent the population (Bowen, et al., 1996). The case approach used in this paper focuses on interviews with key individuals that are responsible for SOX Act implementation effort in the company; rather than focus on key positions in the company (e.g. top managers, directors, CEO’s that are at the observation levels not the implementation levels).

Selection

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operate and have subsidiaries across the globe and are listed on the major stock exchange markets. To be included in the sample the firms must have filed at least one patent during the sample period (2002-2009). We consider that R&D is being an input to innovation and patents and citations being outputs of innovation. According to Kleinkneckt (2002) R&D efforts can be measured by expenditures on R&D (as a percentage of firm’s total sales) or by the number of persons carrying out R&D (as a percentage of total employment in the firm). Patents are often used as an (intermediate) output to innovation (Kleinkneckt, 2002). The model is tested by using ex-ante and ex-post measures of the degree of innovation. Thus, R&D intensity is used as ex-ante measure of the degree of innovation, and patents filed with the US Patent Office as well as citations to these patents as the ex-post measure.

The companies researched are headquartered in U.S. or at European level and are affected directly by SOX Act. Ex-ante and ex-post measures are calculated as follows: R&D intensity calculated as the ratio of a firm’s R&D expenditures to sales and patents as the ex-ante measure of a firm’s innovativeness. For ex-post measures of innovation data on patents filed at the US Patent Office (USPTO) constructed by Hall, Jane, and Trajtenberg (2001), a mere count of the number of patents that were filed by a firm in a particular year. Also, to see the economic importance of the innovation, all subsequent citations (until 2009) made to these patents (see Griliches, Pakes, and Hall, 1987). Since the year of application for a patent captures the relevant date of the innovation for which a patent is filed, the patents will be dated according to the year in which they were applied for. This also avoids any anomalies that may be created due to the time lag between the date the patent was applied for and the date when it was granted. In the analysis will be used only patents actually granted.

Main criteria:

 The company has to have its home base in U.S. or EU (as long as they comply with the guidelines prescribed under the 1934 Act)

 The company is a listed corporation on the stock market

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Table 1: companies and the fulfilment of the selection criteria

Cases: Criterion 1 Criterion 2 Criterion 3

Case A Yes Yes Yes

Case B Yes Yes Yes

Case Y Yes Yes Yes

Case Z Yes Yes Yes

Method for Case Analysis:

Case study research can involve either single or multiple cases, and numerous levels of analysis (Yin, 1984). Although the terms qualitative and case study approach are used interchangeably (Yin, 1981), case study research can involve qualitative data only, quantitative only, or both (Yin, 1984). This approach can be highly synergistic.

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6. Case Study

This chapter discusses the final results of this study. The results will be analyzed according to the conceptual research framework. This chapter summarizes the cases that have been researched and introduce the outcomes of the interviews. All four companies are internationally established corporations that are headquartered in U.S. with subsidiaries around the globe thus the business complexity are high. A summary of the cases is provided below.

Cases

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Case B: Company B designs and sells networking and communication technology and services. The company was the first to introduce to the market really new products that produced technological shifts in its industry. Product innovation is the main type of innovation. Also the company is listed in the top 50 innovative companies situated on the 35th position. It employs 66.000 thousand people and with an annual revenue of $39 billion for the fiscal year of 2008. Company B is audited by one of the Big Four public accounting firms. With a market capitalization of $100 billion the company was required to comply with SOX Act. As in the case of company A, company B felt the cost of complying with SOX Act has been excessively high due to lack of appropriate guidance from SEC and PCAOB. The uncertainty has forced company B to hire one of the Big Four public accounting firms. During the second year of SOX Act compliance a Director for SOX Act procedure had to be hired who estimates that about 70% of SOX Act costs has not been productive. SOX Act compliance did not have an important impact on the company as majority of regulatory processes were already implemented and it did not bring any improvement. The final conclusion was that SOX Act was not a good investment of company resources. The firm felt the processes were already in excellent condition and they have only absorbed an extra cost.

Case Y: Company Y is one of the world’s leading logistics services company founded in 1971 based in the United States. It delivers to 380 destinations through aircraft, maritime and land transportation. It employs 252.000 people, with annual revenue of $38 billion for the fiscal year of 2008. With a market capitalization of $23 billion the company was required to comply with SOX ct. The main innovation is process and customer experience innovations. The company didn’t hire initially a consulting firm to comply with SOX Act the task being shared amongst its employees. Unfortunately, many of the documentations and implementations needed to be re-performed by a later hired consulting firm that prepared the company for the auditing by the one of the Big Four accounting firms. While all the costs have risen the company also incurred up to 100% rise in auditing fees. The main department targeted was IT as it was responsible for the implementation and automatization of the new software. The entire IT department has made a concerted effort to progress and integrate with SOX Act requirements.

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of $14 billion is has to comply with SOX Act requirements. The company was among the first to introduce the innovative thin-film technology that used little to no raw material for the solar panels (raw material, silicon, makes up to 70% of the final cost of a solar panel); thus cutting cost dramatically of the next generation solar panel products. The main innovation is process and product innovation. The IT audit department of the company was lacking the necessary capabilities to manage the SOX Act compliance so a international firm or a Big five companies was contracted to implement and asses IT function. The necessary software was bought from external consultants. While the general costs were according to initial budgeting the auditing cost has risen by 135%. The CEO was against certain requirements of SOX Act and resisted implementation thus causing the audit firm to do extra testing to meet SOX Act audit conditions adding up extra cost.

Board roles within the cases analysed

As mentioned before boards play an increasingly important role especially after SOX Act implementation. Starting with simple advice and monitoring of the management team up to strict financial and strategic control over the company’s strategies and venues. The below table shows the different roles boards assume in the studied companies. Also, in the table can be found a summary of the decision control strategy that takes place: whereas some apply strategic or financial control or both for arriving at their decision making.

Table 3: roles of the boards in the companies analysed

Cases: Advice Monitoring Control Finance Control Strategy

Case A x x x

Case B x x x

Case Y x x x

Case Z x x x

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apparently less used advising role was primarily used in one single company whereas the rest of the companies believed it was not the board’s duty to do so.

Strategy

The below table shows what parties are responsible for innovation activities within the company. The table shows what individuals play an important role for both corporate governance and innovation for the studied firms. The involved parties are boards, management teams, shareholders and finally employees. Also we can observe who is responsible for strategy development and innovation initiation within the case study firms. Table 4: Strategy and innovation

Strategy and Innovation Responsibility for: Strategy development Innovation initiative Innovation control Board A,B,Z,Y Top MNG A,B,Z,Y Shareholders Z A,B,Y Employees A,Y

As we can see in the table the boards are holding the main responsibility for strategy development and planning within the companies. While the top management holds the position of innovation initiators within all the four case study analyzed. In one single case where entrepreneurial shareholder held a higher percentage of shares on the company they also actively involved in strategic development and planning in the firms. In the cases studied strategic development, strategic planning and innovation initiation are operated through the common participation of boards, top management and employees. The interviewees for cases A and Y mentioned that the company specifically emphasized the role of proactive and creative thinking in employees and appreciated innovative ideas and ventures for the firms. Innovation

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Table 5: Innovation Typology Cases Company life-span (years) Innovation type Radical vs Incremental innovation at the start of operation Radical innovation by the time of interview Incremental innovation by the time of interview Case A 33 Product R x Case B 25 Product R x

Case Y 11 Service I x

Case Z 10 Product R x

As it can be seen three out of the four studied firms has started off the company with a radical product innovation while the remaining one started with an incremental service innovation. At the moment of interview SOX Act standards were adopted for several years, two of the companies maintained the highly innovative strategy while the rest recurred to incremental innovations. All the researched companies represent a poll of highly innovative companies that were constantly awarded in international company innovation rankings. All the interviewed personnel has stated that after SOX Act innovation activities has become a more intricate process to engage in and that shareholders would withhold from high risk projects. SOX Act impact on innovation

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Table 6: SOX Act impact on innovation

According to the information the interviewees has shared and as can be seen in the table all the four sample companies had registered increased costs for complying with SOX Act provisions. Cases: Increased costs Decreased flexibility Increased monitoring Decreased competitiveness Case A x x Case B x x x x Case Y x x Case Z x x x x

6.1. Sarbanes-Oxley Act impact on innovation

SOX Act impacts publicly traded companies whether they are located in U.S. or elsewhere as long as they meet the guidelines prescribed under the 1934 Act (Arnold, Benford, Canada, Kuhn, Sutton, 2007); Taub and Leone (2005) report that around 300 European companies are impacted. So far, evidence demonstrates that SOX Act likely had a disproportionate and negative impact on the shareholders public companies (Olin, 2007).

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documenting and reporting upon internal controls provides a disincentive to changing technologies and systems as all such changes necessitates an occurrence of these costs once again (Arnold, Benford, Canada, Kuhn, Sutton, 2007). Thus, technologies become more rigidly engrained into and organization’s processes (Davenport and Linder, 1994). Finally, SOX Act absorbs important funds while leaving less for other budgetary expenses, the company becoming more limited with key projects either being delayed or simply dropped (Shaw, 2007).

The SEC has identified that firm characteristics that are associated with higher risk of financial fraud are those companies that involve specialized knowledge, decentralized structure and operations that involve a large degree of subjectivity and judgement. These qualities apply to companies that engage in risky activities involving highly innovative opportunities. Due to these facts the costs of SOX Act internal financial control section would be downsized to this type of firms. Accordingly with this view, previous academic research finds that firms disclosing problems with internal controls before the Section 404 rules became effective tend to be younger, more complex, cash constrained, and faster growing than other firms (Ashbaugh-Skaife (2007), Doyle, Ge, and McVay (2007).

I. Emphasis on financial control (audit & accounting)

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boards. The risky projects get rejected since the decision making is based solely on financial data an independent directors lack the knowledge assets and the relational status with management teams as to be able to take into account company development ventures; the primordial interest in this situation is shareholder protection not company long-term development. In another study was found that while strategic control facilitates radical innovation, it undermines incremental innovation (Xinmin, 2007). All in all, the positive relation between strategic control and R&D suggests that decision making based on in-depth operational knowledge is in some ways more important for innovation than quantitative information or data from financial control. Operational knowledge increases in importance in dynamic environments where success depends upon bearing risks that are not subject to straight-forward quantifications (Munari & Sobrero, 2006). Financial control provisions from SOX undermine innovation capacity in firms; prior to the law firms were relying more on strategic control to reduce managerial myopia. The SEC identification of company characteristic associated with high risk of financial misstatements point out that higher emphasis on internal control is required for firms with ventures involving specialized intangible knowledge, decentralized organizational structures, and intricate operations that involve high amounts of subjectivity and judgment. These are characteristics of firms that are employed in risky projects that involve important growth opportunities. Thus the costs of the Section 404 fall disproportionately on risk-taking innovative companies. A reaction of companies to 404 Section is to withhold from risky investments that increase the expected costs of complying with 404 rules adopted by SEC. In an official letter to the SEC the Biotechnology Industry has stated ‘Many emerging biotech companies are directing precious resources from core research and development of new therapies for patients due to overly complex controls or unnecessary evaluation controls’. The financial control requirements has put a heavy strain on innovative companies by undermining their flexibility and agility response to fast changing environments and by this reducing their innovativeness.

II. Disclosure and Accounting rules

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weaknesses. Because innovation involves long-term activities that are not accountable in the short-term, management engages in transactions that can allow them to act opportunistically and manipulate financial data. Accordingly, subjective judgment is needed in order to control such transactions. The characteristics of such transactions include transactions involving higher agency costs (e.g., where controls are more susceptible to being overridden by management, Achilles, 2005), high-risk transactions susceptible to substantial economic loss, controls requiring substantial subjective judgment or accounting complexity to be properly implemented, interdependent controls, and transactions subject to economic and technological change (SEC Guidance, 335).

Studies of post-SOX Act disclosures of internal control weakness found more frequent disclosure of control weakness in companies operating in either dynamic business environments or undergoing rapid growth and internal change (Ashbaugh-Skaife et al., 2007). Because innovation activities are more likely to be found in companies subject to change or undergoing organizational change Doyle et al., (2007), this proves that pro-innovation activities are a higher risk than routine, non-innovation activities. Innovation activity is relatively higher source of financial reporting risk; it is also likely a more costly component of management implementing and maintaining control systems that provides decent assurance of financial statement accuracy. Management will engage in innovation less post-SOX Act because by doing this they will have to report a material weakness in internal control even where financial statements are not actually compromised (Butler & Ribstein, 2000). A guide that advices how to comply with SOX Act internal control requirements suggests that one straightforward way to reduce financial reporting risk is by ‘choosing not to undertake the activity that gives rise to risk’ (Ramos, 1998). Additionally, a survey by Financial Executives International found that public companies with a decentralized operational structure has spent over twice the internal control compliance costs (four million dollars) as those with centralized operations1.

A study by Bargeron et al., compared the differences between 2,280 public companies in U.S. and U.K. before and after SOX Act implementation; it was found that U.S. companies reduced capital and R&D expenditures compared to British ones that has increased it (Bargeron, 2008). Also, Cohen has found a significant decline in post-SOX Act R&D spending (Cohen, 2002). A study by Kang and Liu analyzed the impact of SOX Act on

1

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managerial risk-taking by using a ‘hurdle-rate’ which is the minimum rate of return a manager would require before deciding to invest in a project (Kang and Liu, 2007). It was found a major increase in the hurdle rate after SOX Act implementation and attributed the increase to managers becoming more cautious in their investment decisions (Kang and Liu, 2007). This can be translated as management avoidance to merge with risky innovation that will bring a higher risk of having to disclose an internal control weakness. Additionally it was found that U.S. firms have increased their amounts of cash and cash equivalents, which represent non-operating, low-risk investments, as compared to the British companies. All this evidence is consistent with the view that SOX Act has discouraged corporate risk-taking and it complements previous research on this subject (Cohen, Dey, and Lys, 2007).

Overall, Section 404 augment the importance of financial versus strategic control, increases the costs associated with internal control evaluation and reporting risks associated with innovation activities and endangers the flexibility of even large established companies. The outcome of SOX Act is that it reduces innovation capacity of companies, if it was not for the SOX Act hard laws companies would stress more strategic control, facilitate more innovation activities, and adapt to change through continuous organizational innovation.

III. Board-related changes

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For example, Coles, Daniel, and Naveen find a direct relation between R&D expenditures and the proportion of a board consisting of inside directors. Smith and Watts (1992) note “It is difficult for shareholders or outside board members who do not have the manager’s specific knowledge to observe all the investments from which the manager chooses.

So far it has been proven that it is more difficult and costly for outsiders to get the necessary information regarding quality of investment in risky projects than it if for insiders, it is recommendable for high growth companies to have more insiders on the board than low growth companies. As these companies have to adjust in order to comply with SOX, their investments in high risk projects is to decline, because the new independent directors will have higher costs to acquire the information about the projects. From these very considerations SOX is expected to bring a decline in risky projects taken by companies due to the changes on their board structure and size; as boards have decisive voting role regarding major business decisions and transactions. On the other hand, Cotter, Shivdasani, and Zenner (1997) offered evidence indicating that outside directors enhance shareholder wealth during tender offers. A study by Rosenstein and Wyatt (1990) documented an association between increased shareholder wealth and the addition of outsiders to the board.

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Overall, corporate governance literature shows that innovative companies increase shareholder value with smaller and less independent boards. Innovation has high monitoring cost, and studies suggest that firms with high monitoring cost have more insiders on the board and smaller boards that provide proximate inside monitoring. While SOX Act has increased the independence and the size of the boards of innovative companies, it backfires by undermining the ability and susceptibility of such companies to freely engage in innovation. It has been concluded by empirical studies that higher post-SOX Act turnover rates for managers and directors are far from beneficial for innovation. A study by Kor, suggests that R&D spending decreased as managers tenure on the company increased, indicating that newer managers had incentives to take higher risks than more established senior managers (Kor, 2006). This may show that SOX Act increases innovation by bringing new managers that are more willing to take on higher spending and risks. According to empirical studies, R&D spending is associated with shared, team-specific experience by managers, suggesting that risky R&D investment flourish where there is trust and understanding (Kor, 2006). As a result, innovation can be suppressed by new managers as trust and understanding take time to create.

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Agency Costs (myopia & fraud)

Agency costs are a measure of the loss in value to shareholders (the principals) from directors and managers (the agents) failing to act in the best interests of shareholders Jensen and Meckling, (1976). One kind of agency cost comes from management failing to venture into long-term projects as it requires commitment and their short-term returns are vague. While shareholders can diversify their investment to spread risk, manager’s risk is non-diversifiable. Accordingly, managers have a tendency to take on less risk and other innovation-related activities than shareholders desire Munari & Sobrero (2003), Managers may focus on short-term gains, more objectively demonstrable performance, and maintaining current production routines rather than on long-term innovation projects and strategic renewal (Munari & Sobrero (2003). In the case managers become myopic by focusing on short-term financial results instead of committing to innovation, shareholders incur agency costs from foregone benefits. The principal source of agency costs in public companies is managers failing to expend enough effort to, for example, start a new product line (Aggarwal and Samwick, 2001). Aggrawal and Samwick suggest that by increasing objective monitoring that reduces opportunistic behavior is unlikely to bring extra value to shareholders of public companies. Accordingly, myopia is the result of not investing in long-term risky projects, thus reducing myopia seems more important goal than reducing opportunism.

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them with the necessary skills to use strategic control schemes and to take on and direct long-term development of innovation projects.

Conclusion to the case study part

The purpose of this research is to show how Sarbanes-Oxley Act affects corporate governance policies and how it impacts innovation within a company.

What is obvious from the very beginning is that the boards on all four companies have a deeply embedded role in monitoring and controlling finance and even in three out of the four companies being directly involved in strategic control. Strategic decision making is applied in combination with financial control in order to reach a decision. The tighter control over financial reporting and higher level of monitor ring is mainly resulting from SOX implementation and its requirements. All these activities have no other result than impair free flow of information, flexibility and willingness to easily start and engage in innovation activity.

Strategic development and planning is shared among boards and its shareholders. Top managers are mainly responsible with innovation initiative and to some extent employees also participate with sharing ideas and recommendations. Shareholders occupy the role of strategy developers and innovation controllers and merge their influence with boards and management for cooperation. But on the other hand, shareholders might abuse their control over innovation and choose too often for safe-side ventures which will bring the company on the verge of no risky projects thus no innovation.

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All the cases have reported increased costs and monitoring due to SOX implementation which affected negatively company’s flexibility and competitiveness. The bigger companies were less shattered by the financial issues but had real issues at implementing the changes throughout the entire company while the smaller companies had problems with the financial part and less of issues with flexibility and implementation. All the companies asked whether it affected their organisation flexibility through deeper documenting of processes that affected agility and time cycles. The firms would say a firm ‘Yes’ to all of the above. Company B noted that SOX impacted flexibility that doing something not in the formal documented way would be considered a material weakness. While company Z says clients do not always understand that some processes cannot be done due to control limitations while the competition did not face problems. Company Y seemed affected too saying that the routine business transactions have increased by overall 10% by this “losing business”.

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7. Conclusion and Implications

Since SOX Act was implemented into law it had various impacts on organizations including tighter financial controls, lost productivity, less effective business objectives. Companies on the overall became consummated with complying with new regulations, restructuring of board’s composition and tighter financial control over key investment projects.

The findings in this thesis answer the hypothesis of: ‘What is the impact of Sarbanes-Oxley

Act on innovation?’ According to scholarly literature SOX Act creates fundamental burdens

on innovative companies; the promulgation of the law has put many firms in the situation where compliance costs has increased by 100% only from auditing and consultancy fees. Besides this outsider board director dominated acts as defence system for shareholders and literally avoids risky-projects proposed by managers through its voting power. This causes a reaction in management behaviour where they minimize the flow of uncertain investments and avoid introducing those to the board all together. The final outcome is that long-term high-growth projects are minimized by this reducing innovation within companies.

The few benefits that SOX has brought about seem to be benefiting shareholder and society as a whole, as company’s transactions and investment decisions are more transparent and accessible to the large public arena. This again on one hand is good; on the other it discloses material internal control weaknesses within the companies by this raising the cost of its capital, reducing investment capacity and registering decreased flexibility and competitiveness. The above arguments act as restraining orders on high-growth opportunities by limiting innovation within companies. The Act benefits for overall investors and society are noteworthy but more negative effects impact on core company operations and functioning. The SOX Act has brought a serious wave of radical changes to be made within companies as such reducing their flexibility and competitiveness degree. Many firms have paid a dear cost by putting themselves in a situation of de-listing as public companiy as to avoid SOX compliance. All the corporate governance changes seemed too complex and expensive for some companies to cope with; firms that choose integration have registered high degree of restructuring, implementation and lack of control of their own strategic investments.

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to facilitate innovation. Companies that would choose not to comply with SOX Act will have that choice reflected in their financial statements thus attracting more attention from analysts and other parties concerned for monitoring managerial opportunism.

Through making the innovation restricting provisions of SOX Act voluntary, innovative firms will have the chance to adopt a more proximate monitoring than permitted by present regulations and work to their full innovation potential; by not complying with the Act firms will experience less costs and higher level of inside dominated boards thus a higher chance for investment flexibility. Critics to the provisions of monitoring and financial control of SOX Act being made voluntary say that these restructuring will bring higher managerial opportunism (fraud). However, empirical studies has proven record that investors and consumers alike are not gaining when firms suffering from myopia costs are obliged to adopt provisions that would inhibit opportunism. Whereas voluntary provisions of SOX Act would increase opportunism in innovative firms; however the benefits from innovation would outweigh the costs and result in net advantages for the entire economy.

The importance of innovation is increasing for the overall benefit of the society, SOX Act will have its negative effects on company capacity to venture into risky projects and eventually innovate. The U.S. economy’s increasing reliance on knowledge assets increases the potential value of innovation because innovation is itself a product of learning and utilizing knowledge (Bettis, 1995). In response to the increasing importance of innovation, managers at companies worldwide consider innovation a top strategic priority, and plan on sustaining or even increasing the high levels of assets allocated to innovation activities (Andrew et al., 2002). Investors and consumers are not gaining more value when companies suffering from higher myopia rates are asked to comply with the Act, which is assumed to reduce opportunistic behavior. It would lead to higher levels of opportunism if SOX Act would have had provisions that are optional, but the gains from innovation would offset the higher costs and result in net value for consumers, investors and economy alike.

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adapt to changing environments and on the overall discourage corporate risk-taking and diminish innovation capacity.

Limitations of the study

As any scientific research this thesis also has some limitations. For the data collecting methods in-depth interviews were used rather than statistical or financial statements, this has been a qualitative research.

The selection of the cases took place based on the facts and figures regarding number of patents, citations made and amount of investment in R&D, also an important factor was the references made by third parties about the companies researched. The research has not concentrated on one single sector or industry. Also the information obtained from the interviews might have been partially judged by me or by the interviewees.

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Appendix 1 Questionnaire

General

1. What is your name?

2. What position do you hold?

3. For how long you have been employed with the company? 4. How old is the organisation?

5. How many people work for the organisation?

6. For how long you have been in charge to manage SOX/corporate governance implementation?

7. Did the company incur struggles with SOX implementation (financial, employee resistance, bureaucratic?)

Costs

8. Did the company register higher law compliance cost post-SOX than pre-SOX? 9. By how much did SOX increase fees from auditing and consultancy?

10. Are those fees onetime payment or constant incremental payments? 11. What are SOX impacts on company’s budgeting and financial resources?

12. Do you think over long-term these fees are amortized or it never pays-off the investment?

Board

13. How did SOX affect board size and structure? 14. Did you have to hire any outside directors?

15. Does outside monitoring influence strategic decision making?

16. Did financial control affect company’s ability to invest in risky projects? 17. Do outsiders act as direct monitors of shareholder interest?

18. If so, do you feel the monitoring over the company has increased? 19. How you feel new board members improved company performance?

Long-term Development

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21. If so, how did that affect its long-term growth and development strategies? 22. Did the company post-SOX increase/decrease its investments in risky projects? 23. Did the company reduce its R&D budget as a direct result of high compliance costs? 24. What main changes have SOX brought with it?

25. How do you feel the company benefited in from SOX Act implementation?

Competitiveness

26. Do you think it decreased flexibility and competitiveness compared to non-compliant firms?

27. If yes, through what mechanisms?

Innovation

28. Do you believe the Act has any influence on NPD strategies?

29. Post-SOX did the company engage more in incremental or radical innovation? 30. Do you feel the law helps or suppresses the innovativeness within companies? 31. Is innovation generally supported by new board members?

32. Do you think innovation in generally more important for the company or its financial stability and shareholder interest protection? Did your company find a balance between these two?

Note: not all the questions were asked in every interview in the same order; the questions were asked

Innovation and Corporate Governance