The Free Enterprise Fund’s Mallory Factor observes in this WSJ ($) op-ed today that even notorious anti-business politicians such as House Democrat Nancy Pelosi and the Lord of Regulation are starting to question the over-reaction that is the Sarbanes-Oxley legislation.
Factor’s piece is a good summary of the core defects of SOX, but Larry Ribstein has provided the more thorough and thought-provoking commentary as he has been traveling the country this week talking about SOX. In preparing for a talk at Berkeley, Professor Ribstein sums up the superficial nature of the only line of defense that he has heard defending SOX:
I’ll be particularly interested to hear whether anybody has a cogent defense of SOX. All I’ve heard so far along these lines is this: “There was fraud; fraud is bad; SOX is against fraud; therefore SOX is good.” This seems to assume that we should favor legislation that purports to restrict fraud regardless of cost, and regardless of effectiveness. And even this has been mainly from journalists, accountants, regulators and legislators — i.e., those with a stake in the regulation. I’d really like to hear something more from disinterested parties.
Then, in regard to Peter Lattman’s post regarding revelations of more alleged fraud at Refco, Professor Ribstein notes that SOX did not prevent the Refco frauds from occurring:
Significantly, all this is after SOX, and occurred after Refco had gone through the intensive scrutiny involved in an IPO.
Some might say that the lesson from all this is the need for still more regulation. I’d be interested in hearing about the regulation that could have prevented the problems indicated above. Requiring certification of internal controls isn’t very effective when the fraud is by the certifying CEO, as may be the case here.
I would say, and have said, here and here, that the more realistic lesson is that no amount of regulation can prevent fraud by the most determined fraudsters. It can, though, catch law-abiding firms in a spiral of regulatory costs.
Once again, Tom is right on the money. Audiences in various countries have asked my opinion of SOX. I reply that SOX is the political solution to a deliberately misstated problem. As such, it would be a miracle if it were in any way helpful.
You cannot legislate honesty or morality. It is up to each of us to live right and try to leave things better than we found them.
The Enron fraud is frightening because an as yet undetermined number of people at Enron conspired to cheat investors by framing Andersen. We know that Fastow was the central figure because various banks complicit in the fraud documented his oral promises of repayment. Enron Bankruptcy Examiners determined that these banks knew of Enronís fraud because the banks signed contracts asserting they were ìinvestingî in Enronís SPEs while at the same time the banks recorded the transactions on their own books as loans. Explanations for the failure to secure written loan agreements were documented in loan committee agendas, loan committee minutes and loan applications.
Knowing that Andersen was framed, the government proceeded to condemn Andersen without ever giving them a chance to speak, to the laughter and applause of many. Inciting or participating in a lynch mob is no more honest than Fastowís behavior, a very low standard indeed.
The Andrew Fastows of the world are glib liars. They are good at it. When auditors question a transaction, the frauds produce another lie or fraudulent document. Thatís what they do. So when disaster strikes and the public wonders (with the clarity of hindsight) why something wasnít pursued, it probably was, but met with yet another lie.
SOX does nothing to prevent fraud, with one exception. It is difficult to believe but until SOX, lying to an auditor was only a misdemeanor. Increasing the penalty to a felony is helpful but hardly a fix-all. The rest of the bill is feel-good legislation designed to let voters think that the government can prevent fraud.
Far more to the point would be an examination into why politicians were eager to grant Enron an exemption from investor protection laws. The exemption allowed Enron to set up the huge number of SPEs where the frauds were committed.
Public accounting is not without its own problems. Mandatory non-consolidation of SPEs that have only 3% outside equity is absurd. Recognizing this, the requirement has been changed to mandatory non-consolidation with at least 10% outside equity. How can anybody with a straight face say that an SPE with only 10% outside equity is independent? Since 1988, Andersen lobbied for mandatory consolidation of all SPEs in order to prevent ìfinancial statement engineeringî and ìaccounting results that are contrary to the economics.î Andersen was unsuccessful in getting the standard changed. Now nobody is left to lobby for it.
From day one, most businessmen understood that SOX was the business equivilent of pictures of missing children on the side of milk cartons. It was designed, amid a clamor by the public for reform and in time for the 2004 general election, to make the investing public believe something was going to change. SOX was designed to be ‘feel good’ legialation and not as meaningful reform. I struggle to list actual prosecutions for violations of SOX. Corporate exectuives howl loudly at the burdens they are being placed under while all the time knowing full well that once the investing public was lead to believe that something had changed, things would go back to how they had been for years. As with most reform legislation, SOX was enacted to much fanfare and, as we are seeing now, watered down to be essentially meaningless once the initial clamor passes. In the end, SOX will go the way of campaign and lobbying reform. Nothing has really changed, the investing public is still going to be abused and life as we know it will move along. The bottom line is that there is no political advantage to actually changing the status quo. I am a conservative who has worked on Wall Street for some of the largest financial institutions in the world. Not for one day did I think anything would change because of SOX and not for one day did I think that 5 years after it was enacted SOX would be the enforced law of the land. Looks like I was right.