Sarbanes-Oxley Act of 2002 | Infectious Greed: Restoring Confidence in Americas Companies

On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act, otherwise known as the Public Company Accounting Reform and Investor Protection Act of 2002 (henceforth, the Act). The new law sets up a new oversight body to regulate auditors , creates laws pertaining to corporate responsibility, and increases punishments for corporate white- collar criminals. The following discussions detail each aspect of the Act and comment on its ramifications and probable effectiveness given the problems that we have identified in the corporate system.

Public Company Accounting Oversight Board

The Act establishes a nonprofit corporation called the Public Accounting Company Oversight Board to oversee the audit of public companies and to protect the interests of investors and the general public by improving the accuracy of audit reports . The board will operate under the discretion of the SEC. Indeed, the SEC was charged with filling in the details and actually getting the board running. The duties of the board are to

register public accounting firms
establish or adopt auditing quality control, ethics, independence, and other standards
conduct inspections of public accounting firms
conduct investigations, disciplinary proceedings , and sanctions of accounting firms when justified
promote high professional standards and improve the quality of audit services
enforce compliance of the rules of the board, professional standards, and securities laws in regard to auditing
oversee the budget and manage the operations of the board

The five members of the board will be employed full time by the board and will exhibit independence from the public accounting firms being regulated . Only two of the board members can be (or can have been) a CPA. To a large degree, the board is an extension of the SEC. The SEC has oversight and enforcement authority over the board. For example, the SEC has authority over all rules proposed or changed by the board and all sanctions set.

Increasing regulation is a typical response from the government after the occurrence of ethical scandals. Politicians want to appear to be tough on crime, and one easy way to accomplish this is to vote for more law enforcers . This is probably a good reaction when there is a lack of regulators. In other words, the securities acts in 1933 and 1934 that created the SEC were helpful because there were no significant regulators to protect the public investor. However, too much regulation can stifle innovation, risk-taking, and general business activities. It is hard to know how much is too much.

In this instance, we believe the action to create new regulators is overkill. There isn't much the new oversight board will do that the SEC couldn't have done before if it really wanted to. The board will regulate accounting standards and the auditing process. But recall how quickly the combined team of the SEC and Justice Department took down Arthur Andersen. Arthur Andersen was indicted and found guilty very quickly ”long before any hint of indictments of Enron employees . Indeed, Arthur Andersen had been found guilty before Congress passed this new Act. The SEC could already act quickly and decisively against accounting firms when it wanted to.

Other activities of the new board deal with the process of adopting accounting standards and overseeing professionalism in the accounting industry. These tasks are already being accomplished through another private-sector body called the Financial Accounting Standards Board (FASB). Both Congress and the SEC have the ability to influence FASB's policies on creating GAAP. Essentially, this part of the Act simply moves responsibility from one private body to another. It also moves some of the enforcement function from the SEC to the new oversight board. However, since the SEC still retains the top- level regulating responsibility, the board just becomes another layer in the regulatory system.

Since we already have government regulators and private bodies overseeing accounting, we don't feel that the additional layer of regulations will solve much of anything. It still boils down to a very small number of regulators watching a very large number of accounting activities. Changing how those regulators are organized will not add much to their effectiveness. We advocate solutions that change the incentives and relationships of the people in the corporate system. This part of the Act does nothing to change the incentives and relationships identified in Chapter 5 and in Table 12-1.

Auditor Independence

The Public Company Accounting Reform and Investor Protection Act also attempts to protect investors by breaking the relationships among auditors, consultants , and the public company being audited . To accomplish this, the Act

prohibits accounting firms from providing both auditing and consulting activities for the same firm
gives the audit committee of the company's board of directors more authority over auditing activities
forces the lead audit partner in an audit team to change at least every five years
disallows auditing by an accounting firm if any of the top executives of the pubic company were employed by the accounting firm within the past year
requires a study to be conducted that investigates the potential outcomes of mandatory rotation of accounting firms conducting audits

This aspect of the Act addresses one of the problems with auditors as monitors of a firm. The consulting fees earned by accounting firms often greatly exceed the auditing fees they earn. Therefore, auditors of a firm have little incentive to question the aggressive methods of the company when their own consulting wing of the firm proposes those methods . Indeed, accountants conducting an audit could find themselves removed from the job and even fired for jeopardizing the lucrative consulting fees.

We applaud the lawmakers' attempt at addressing a conflict of interest problem through creating new or breaking old incentives. However, this solution does not address the other conflict ”the long- term relationship between the public company and the auditing firm. We feel that the best solution to fix the problems with auditing is hinted in number 5 above ”rotate auditors. In the next chapter, we describe in detail how this solution would actually solve both conflicts of interest for auditors and increase competition in the accounting industry. The Act only has the SEC conducting a study of this idea instead of actually implementing it.

Corporate Responsibility

The Act attempts to increase the monitoring ability and responsibilities of boards of directors and improve their credibility. Specifically, the Act

makes the audit committee of a board of directors both more independent from management and more responsible for the hiring and oversight of auditing services and the accounting complaint process
forces CEOs and CFOs to certify the appropriateness of the financial statements filed with the SEC
deems it unlawful to mislead, coerce, or fraudulently influence an accountant engaged in auditing activities
requires that the executives of a firm forfeit any profit from bonus or stock sales resulting in earnings that needed to be restated as a result of misconduct
prohibits executives from making stock transactions during the time in which the employee pension plan blacks out employee stock transactions

This portion of the Act has several very different types of ideas. The first section strives to make a board's audit committee more independent from the management team. While we believe more independence is good, why stop at just the audit committee? Why not strive to make the board in general more independent? The board is a critical monitoring mechanism in the system, and it needs more independence.

The second section states that CEOs and CFOs must certify the appropriateness of their public financial statements. The SEC initially implemented this policy by requiring certification from 695 of the largest companies. The first time this certifying process is done, it brings much publicity and media attention. However, after a year or two, the certification becomes old news and business goes back to usual. In a way, the purpose of the certifying process is a bit mystifying. Isn't a company's annual report started with a letter from its CEO? That letter summarizes in words and aspirations what the accounting numbers show later in the statements. From the investor's point of view, the CEO has always certified the numbers in effect, if not in legalese. It seems that the only real advantage of this policy is in prosecuting offenders and preventing, for example, the "I didn't know" defense used by executives in Congressional investigations of the Enron collapse.

The third section deals with specifying that accounting fraud is indeed fraud. Existing laws about committing fraud against public investors already cover accounting fraud. It might be useful to clarify a few points about the laws with this policy, but it doesn't add much to existing law or have a very real effect on behavior. After all, those who are perpetrating accounting fraud know it is wrong and do it anyway.

The fourth policy in the section of the Act requires executives to give back ill-gotten gains. Consider the CEO who gets a big bonus for good company performance or cashes in options at high stock price levels. If it is later discovered that the company's performance wasn't so good after all and the stock price was artificially inflated, that compensation must be paid back. This law lets executives know that they will not keep any money that they received by being deceitful. In this regard, the law is useful. However, it will not solve all of the compensation problems identified in Table 12-1. In other words, executives can still cash in all of their stock and options at the end of a long economic expansion. When the stock price falls in the ensuing recession , investors will still be angry that the executives received big paydays even though the stock did not hold up. The gains made by the executives are not ill-gotten if the stock price falls because of a recession.

Finally, the prohibition against executives making stock transactions during a time in which employees cannot make changes in their pension plans is a good idea. If employees can't sell their stock, why should the executives be able to? This will give executives and pension fund advisors the incentive to work hard to shorten blackout periods.

Enhanced Financial Disclosures

The new law tries to make executive actions more transparent to shareholders. Specifically, the Act

requires the disclosure of off-balance sheet transactions and corrections in reporting identified by auditors
decreases the time an executive has to report company stock (and other equity) trades to the SEC to two days
prohibits the lending of money by public companies to executives except for the use of home loans
requires increased internal financial controls and review by a board of directors
encourages a code of ethics for senior officers of the company and reports changes and exemptions to the SEC
requires a financial expert on a board of directors' audit committee

The outcome of the first two laws is to increase transparency. That is, corporate monitors and investors will have better information about executive actions and compensation. Transparency is very important and useful.

The prohibition against lending an executive money is an example of fighting a symptom instead of the disease. In several of the scandals, executives appeared to abuse the loans they were given. This is less of a problem with loans as it is a problem with the monitoring by the board of directors. Loans, like compensation and other perks, can only be abused if the board lets the executives do it.

The last three rules are designed to increase the effectiveness of boards. We endorse them wholeheartedly, although most (if not all) companies already have a code of ethics. It is more a matter of following and enforcing it!

Analysts' Conflicts of Interest

The role of securities analysts and their failure to monitor a company is detailed in Chapter 8. In recognizing this failure, the Act tasks the SEC to develop rules for making sure that analysts are separated from investment banking activities and that any conflicts of interest that analysts may have are fully disclosed. As we discussed in Chapter 8, both the National Association of Securities Dealers and the NYSE have already made proposals along these lines, and the SEC approved of these proposals on May 10, 2002. Under the Act, the SEC is given one year to develop these rules further.

SEC Resources and Authority

One limitation that the SEC has had over the years is that the organization is small compared to the industry it regulates. The SEC regulates tens of thousands of public companies, investment banks, auditors, and other participants in the stock and bond markets. In order to help the SEC expand its monitoring and investigative capabilities, the Act appropriates more money for the SEC and mandates the hiring of at least 200 more employees. Will this be enough? Keep in mind that the Act simultaneously imposes many new responsibilities on the SEC.

Corporate and Criminal Fraud Accountability and Penalties

To make it easier to prosecute executive criminal behavior in the future, the new law spells out new or altered definitions of criminal behaviors and stiffens penalties. For example, the destruction or falsification of documents in a federal investigation or bankruptcy can be punished with a fine and/or imprisonment of up to ten years. Destruction of audit materials is punishable by a fine and/or imprisonment of up to five years. The statute of limitations for securities fraud is changed to two years after the discovery of the facts or five years after the violation. The bill also protects employee whistle blowers from retaliation by the company or its executives.

In most cases, the penalties for committing white-collar crimes were generally increased from a maximum of five years imprisonment to 20 years. While this pertains to just the maximum prison sentence , federal sentencing guidelines are also to be amended. That is, the intent is for the actual average white-collar prison sentence to increase, not just the maximum. The company CEO, CFO, and chairman are required to certify the appropriateness of the financial statements. If they willfully violate the integrity of the disclosures, they can be fined up to $1 million and serve up to ten years in prison.

Summary of the Act

This bill passed the House and Senate with overwhelming majorities and was signed very quickly by President Bush. There was a lack of the serious kind of debate that accompanies hotly contested bills. No one wanted to appear as if he or she were defending greedy executives. Therefore, it should not be surprising if we find that the new law does not directly address many of the problems in the corporate system. The bill was rushed, so we can almost expect it to be far from perfect and filled with holes. For example, there is nothing that helps shareholders influence the direction of their firm. Also, the bill does not address the problems with investment banks, credit rating agencies, and corporate attorneys . Even the lawmakers themselves seemed to recognize that more work needs to be done. Much of the Act directs the SEC to create the details within the general guidelines it provides.

The Act addressed many of the problem areas in the corporate system. Much of the new law includes more regulation and more penalties for white-collar crime. This is a common response of lawmakers during a time racked by scandal and public outrage. We feel that the stiffer penalties were warranted, but the increased regulation was not. Instead, we believe that setting up the right incentives would better influence behavior. If the Act promoted better behavior, other benefits would arise. For example, we wouldn't have to worry as much as to whether or not the SEC is overburdened. In some cases, the corporate problem areas of the incentive system and the monitoring system were improved by altering incentives, but, in other cases, the new law will have little or no effect.