Sarbanes-Oxley Revisited

Brian Doherty from the January 2009 issue

In January 2006, reason interviewed four businesspeople and financial professionals to assess the costs and benefits of the 2002 Sarbanes-Oxley Act—the last big federal response to fears of chaos, greed, and fraud in financial markets. Sarbanes-Oxley was intended, we wrote, to "crack down on accounting irregularities, punish those responsible for hiding them from the public, and curtail potential conflicts of interest in corporations' relationships with their auditors."

Recent academic studies of Sarbanes-Oxley have deepened our understanding of the law's effects. The corporate law specialist Kate Litvak, writing in the Journal of Corporate Finance, found that foreign companies whose U.S. listings subject them to Sarbanes-Oxley regulations show stock price drops compared to foreign companies that are not subject to the law. Litvak's results indicate that the market thinks Sarbanes-Oxley is more harm than help. In a 2007 survey of professional fraud examiners, three-quarters said institutional fraud was more prevalent than before the law was passed.

The eventual total costs of SarbOx to the U.S. economy are not yet apparent, since the Securities and Exchange Commission (SEC) has continued to exempt nearly 5,000 smaller companies, with market capitalizations of less than $75 million, from SarbOx's orders to audit their financial control systems. That exemption is currently set to end in December 2009. The total compliance costs for the U.S. economy as a whole are then likely to soar.

In the light of the current financial crisis, and of recent grand and overbroad power and money grabs by the likes of the Treasury Department and the SEC, CPA Karen DeCoster sounded prescient when she noted that "the bigger cost [of SarbOx going forward] is in terms of the centralization of a regulatory system that can effectively stifle the free market via the imposition of arbitrary decree." SarbOx could be seen as clearing the brush for a U.S. economy where every move and decision is under watchful (and controlling) federal eyes.

Compliance consultant Stephen Stanton was on the money when he told reason: "Most business failures have nothing to do with accounting, stated financials, or fraud. Most business failures have to do with having wrong strategy, inefficient operations, poor marketing." In the face of market chaos far worse than the upheaval that inspired Sarbanes-Oxley, we can see that the real problems have to do with fundamentals of market valuation and bad decision making for which regulatory requirements like Sarbanes-Oxley's have little relevance.

Related: In the same issue, reason investigated how the government used Sarbanes-Oxley rules to strong-arm the media in the Valerie Plame case.

Comments

|12.22.08 @ 12:40PM|#

We hear a lot of conservative and libertarian complaints about the effects of mark-to-market accounting understating the actual value of companies, but doesn't the vaunted omniscient Market of which you're so fond *know* that mark-to-market can have this effect (it's all over the WSJ editorial page, which I presume the Market reads) and therefore take it into account to whatever degree the Market, in its wisdom, deems appropriate?

|12.22.08 @ 12:43PM|#

As truly awful as the entire conception of implementing Sarbanes-Oxley to prevent fraud was, I have to say the Steve Forbes of the world whining about Mark-to-Market can just suck it as far as I'm concerned.

The idea that our economy is in jeopardy because our financial institutions aren't allowed to pull asset evaluations out of their ass is poppycock. The assertion that all these assets are "undervalued" is also bullshit. What you can sell it for is what it's worth. If it was worth more, someone would pay more.

SIV|12.22.08 @ 12:53PM|#

Thanks to Sarbanes-Oxley I had to sign over 2 years worth of back time sheets.I shudder to think how much worse our current economic unpleasantness would be if I hadn't.

nvisible Finger|12.22.08 @ 12:54PM|#

Mark-to-market is a good idea. Allowing mark-to-fraud is a bad idea.

The market eventually figures out which companies' balance sheets are fulla shit, so that particular regulation doesn't matter much anyway.

Interbank lending has dried up because Bank A knows Bank B's balance sheet is a lie. Bank A knows this because Bank A's OWN balance sheet is a lie.

Too bad the government's own balance sheet isn't marked to market. If it was, everyone would know it's insolvent.

|12.22.08 @ 12:59PM|#

"When I bought that briefcase at the yard sale, the guy told me it was full of hundred dollar bills; I wouldn't have paid nearly that much if I had known it was full of dog shit. But it's still worth what I paid for it, because that's how much I paid for it. And one of these days, some suck- errr, "investor" will believe me when I tell him it's full of hundreds."

Kolohe|12.22.08 @ 1:46PM|#

Warren, well said.

"This is a Rouchefoucauld. The thinnest water-resistant watch in the world. Singularly unique, sculptured in design, hand-crafted in Switzerland, and water resistant to three atmospheres. This is *the* sports watch of the '80s. Six thousand, nine hundred and fifty five dollars retail!"

"In Philadelphia, it's worth 50 bucks."

Geotpf|12.22.08 @ 1:55PM|#

Instituting mark-to-market may have caused the stock market to crash.

Not having it earlier may have caused the boom it the first place.

That is, mark-to-market merely ended a ponzi scheme. That's not a bad thing, other than the fact that thousands, possibly millions, of people will lose their jobs in the process. (No minor thing, that.)

alan|12.22.08 @ 2:01PM|#

JRD | December 22, 2008, 12:40pm | #
We hear a lot of conservative and libertarian complaints about the effects of mark-to-market accounting understating the actual value of companies, but doesn't the vaunted omniscient Market of which you're so fond *know* that mark-to-market can have this effect (it's all over the WSJ editorial page, which I presume the Market reads) and therefore take it into account to whatever degree the Market, in its wisdom, deems appropriate?

Is 'conservative and libertarian' codewords from the sandals and hirsute set these days for the vast majority of people who live in the day to day world of markets and resource scarcity because the language I quote above is
some serious anthropomorphically unsound ass ripage?

|12.22.08 @ 2:04PM|#

If mark-to-market was a voluntary system, libertarians would have no problem with it. But when the government mandates your accounting methods, there will inevitably be unintended consequences. For some busineses, mark-to-market makes sense, but it might not for others simply because their assets are not currently marketable.

And yes, some accounting practices are fraudulent. If you tell your investors that your assets are worth more than they are, you are committing fraud. But we already have courts to take care of situations like that. SOX doesn't prevent fraud any more than trigger locks prevent murder.

|12.22.08 @ 2:10PM|#

And just when we thought the fun would end! I see a new round of bailouts when the smaller companies have to comply with SarbOx. Biden, with his new "expand the middle class" mandate will rush to save these "middle class companies" because they're vital to the survival of the middle class American!

MNG|12.22.08 @ 2:38PM|#

I don't understand why so many of these major bills have to be passed in such a hurry. OK, I understand the people are demaning "action" and all, but why not pass some temporary measure tied to a committee that will work on a more permanent recommendation to be considered after careful reflection and investigation?

|12.22.08 @ 2:40PM|#

While discussion of mark-to-market rules is certainly welcome, I did want to note that despite what I had mistakenly written in an earlier draft of the piece, an earlier version that did not see print in the magazine but was mistakenly posted here, that particular rule was NOT part of Sarbanes-Oxley, and thus the proper version as it appears in the magazine and now here doesn't mention mark-to-market rules.

|12.22.08 @ 2:46PM|#

I don't understand why so many of these major bills have to be passed in such a hurry.

Because they can cram through some seriously egregious shit while everyone is panicking and clamoring for action.

Many pols are just scrambling to be seen doing something, but others are helping out their Wall Street buddies--and their own stock portfolios, of course.

Invisible Finger|12.22.08 @ 3:27PM|#

but it might not for others simply because their assets are not currently marketable.

And if the assets aren't currently marketable, then that means the market knows your assets have no current worth and therefore you can't get a loan because the market knows the actual value of your collateral. The accounting rule doesn't matter all that much.

|12.22.08 @ 6:22PM|#

While discussion of mark-to-market rules is certainly welcome, I did want to note that despite what I had mistakenly written in an earlier draft of the piece, an earlier version that did not see print in the magazine but was mistakenly posted here, that particular rule was NOT part of Sarbanes-Oxley, and thus the proper version as it appears in the magazine and now here doesn't mention mark-to-market rules.

DOH! Smooth move ex-lax.

Now I can go back to despising Sarbanes-Oxley without reservation.

|12.23.08 @ 3:10AM|#

In the Follow-Up feature from our January issue, Senior Editor Brian Doherty revisits his January 2006 article on the 2002 Sarbanes-Oxley Act, the last big federal response to fears of chaos, greed, and fraud in financial markets.

Don't forget the artificial Cost of Entry that this law imposes on smaller companies. Bigger companies have had to use more resources to comply with this useless law, but smaller, upstart companies do find it too costly. There is nothing noble about SarbOx

|12.23.08 @ 1:55PM|#

What most (almost all) people fail to understand about the value of SOX is that a "system of internal control" means a "Management System." The COSO guidance spells this out clearly. Being a quality professional I reasoned that an excellent management system could fit the 5 elements of COSO. In the September issue of Quality Progress I wrote an article linking ISO 9001 step by step to the COSO elements.
What this boils down to is developing financial management as a system that continually looks at how it is operating and how to continually improve it. I also showed in a September 2008 article that removing barriers that cause silos in an organization can improve overall operations that will lead to bottom line improvements. I recommend these two articles and others I've written to you.

|12.23.08 @ 5:35PM|#

A side effect of SarbOx is having to book options as an expense. Inadvertent consequence of this from what I have seen is the inadvertent creation of a tax-break.

Here's how it works:

Company makes $10 million in cash for a quarter. Corporate Income tax wants to shave ~30% or whatever it is.

Company officers award themselves a hoard of shares options, with a spread of $7 million from the market price of the shares, SarbOx says they have to take a hit on this for their profit statement, because they diluted everyone else's stock.

Company essentially gets to write-off $7 million in cash as not being a profit, thus saving a good chunk of revenue that otherwise goes to the Fed's coffers. Cash itself never left the control of the company. Plus, the company officers (and Directors) get to effect this tax-break by printing money (shares) for themselves. Nice.

You can manipulate the market price of the shares this way too. Analysts will hit the stock because it keeps missing "earnings" although the cash never went anywhere, company officers get to option stock at ever-cheaper prices because the price goes down. Analysts keep low-balling the stock because it keeps missing estimates.

Within at least a reporting quarter of all those options coming due, officers stop option-printing. All that cash starts showing up as "earnings" again. Stock makes analyst's targets, stock goes up - right when the officers exercise the stock. Pretty penny is made by all, company is highly tax-efficient with its cash at same time.

Anyone else notice this behavior in some securities?

|12.23.08 @ 7:03PM|#

OT: Brandybuck ... trigger locks are not intended to prevent murder. They are intended to reduce the number of accidental shootings, i.e. when a child finds Daddy's pistol and wants to show how the trigger works to their friends.

Similarly, SOX was not intended to curb all of the abuses that we now see running rampant, but rather to establish a mechanism whereby companies who had previously had insufficient public accounting practices would be compelled to be more transparent (and complete) in their public accounting.

SOX has no effect on greed, just like trigger locks have no effect on deadly intentions.

|12.23.08 @ 9:44PM|#

A very informative article by Mr. Doherty.

There is so much legislative excrement that should be repealed. People act like they have never heard of repeal.

|12.27.08 @ 12:46PM|#

I've been working in IT for investment banks for most of the decade. About half of the work I've done has been related to Sarbanes-Oxley in some way. Some of it has been working closely with regulators, in an investment bank that has since failed. None of the Sarbanes-Oxley work was of any value whatever - even towards the stated aim of making accounts more trustworthy, still less to the broader issue of avoiding problems in the financial industry. Sarbanes-Oxley was an enormous distraction to the people in risk management and information technology who might possibly have been in a position to avert the disasters that have now happened