March 2006

Sarbanes-Oxley: What Have We Learned?

In July 2002, as a reaction to various corporate scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, commonly known as the Sarbanes-Oxley Act. In signing the act, President George W. Bush proudly declared that the U.S. government was enacting “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.” With the implementation of the act, however, the immense costs of compliance have become apparent, and business leaders question whether the act’s supposed benefits actually represent any real gain over the previous era. At a March 13 AEI event, Professor Larry Ribstein, a scholar of corporate and securities law, and Professor Henry N. Butler, an expert on the economic analysis of law, discussed their forthcoming monograph, The Sarbanes-Oxley Debacle: How to Fix It and What We’ve Learned (AEI Press, 2006).

Larry E. Ribstein
University of Illinois School of Law

This presentation today will not be able to cover everything in the paper, which we urge everyone to read.

Most pieces of significant legislation can be defended by invoking Congress’s deliberative process, but Sarbanes-Oxley (SOX) was passed in a legislative panic with virtually no meaningful debate. The costs of the legislation were not considered in any detail before passing the bill, especially those affecting small firms and international firms, as well as those stemming from the extensive disclosure requirements mandated by Section 404, the internal controls provision. Political opposition to the bill, which was concentrated among small businesses and entrepreneurs, never organized itself extensively or effectively. In the face of intense political pressure stemming from the scandals of Enron and WorldCom, both parties eagerly pushed this legislation through in the name of “restoring investor confidence.”

The direct compliance costs of SOX are about $6 billion per year, but this expense (which basically represents payments to accountants) is a small fraction of the total compliance costs for firms. The indirect costs from having to divert company resources are much greater and based on a back-of-the-envelope calculation of how SOX impacted American markets, they can be estimated at about $1.1 trillion. SOX also creates a litigation time bomb waiting for the next downturn in the market to set it off. SOX creates incentives for litigators such that next time stock prices fall, there will be a rash of suits against executives with no proof of classic misrepresentation required to prove culpability. This risk of liability along with the possibility of criminal sanctions created by SOX will make executives increasingly risk-averse, which is a loss for American investors.

The bust-fraud-regulatory panic cycle that resulted in the passage of Sarbanes-Oxley is nothing new in American history, and it will surely repeat itself in the future. Hopefully, the business world will learn the lessons of SOX and represent itself better the next time around.

Henry N. Butler
Chapman University and AEI-Brookings Joint Center for Regulatory Studies
 
In the monograph, we extensively utilize the perspective of agency theory to evaluate SOX in terms of how the law has affected how principals (investors) are served by their various agents (managers, accountants, and lawyers). If SOX is really what it claims to be--a bill that benefits investors--we should find evidence that investors have indeed benefited over the course of the last several years, in which SOX has operated. The evidence we have, however, points in the opposite direction. Various provisions of Sarbanes-Oxley seem to have the explicit goal of reducing fraud to zero, but this is not the outcome investors would prefer. Investors would prefer to spend money to reduce fraud only until the point at which the marginal costs of reducing fraud are equal to the marginal benefits. In the language of agency theory, it will not be efficient to attempt to reduce agency costs to zero, i.e. it is not cost efficient to control managers in everything they do, and so leaving some possibility of fraud be the efficient situation.

We should ask ourselves: what would the world look like without Sarbanes-Oxley? Would we have a depressed market overrun by fraud? The answer is clearly negative, as the market had and has a variety of means of self-regulating fraud, including signaling mechanisms such as reputation, analysis of evidence by experts, and the use of hedge funds. In addition, scandalous cases of companies collapsing do not pose a serious threat to the typical investor, who is able to insure himself against these sorts of failures by diversification. This typical investor is absolutely not better off because SOX is on the books.

Peter J. Wallison
AEI

The panic that produced Sarbanes-Oxley is analogous to the current port controversy. In both cases, Republicans acutely felt the danger of being scapegoated in an election year, and therefore went along with Democratic proposals, often enthusiastically. Several examples drawn from recent news put the lie to the idea that Sarbanes-Oxley could end all fraud. The Rudman Report on Fannie Mae furnishes an example of how an organization with extensive internal controls can nevertheless experience damaging fraud. In evaluating the costs of SOX, the evidence of what happened to U.S. markets as Sarbanes-Oxley gained momentum in Congress is compelling but not wholly sufficient because of everything else that was going on simultaneously. Even more compelling is a study done by Kate Litvak comparing the value of companies cross-listed in Europe and the United States with those listed only in Europe (available for download here). This study, along with the fact that the London Stock Exchange has been gaining in the past year at the expense of the New York Stock Exchange and the NASDAQ, shows how SOX puts the United States at a disadvantage in the competition to attract business and capital. The most familiar refrain in defense of SOX is that it “restored investor confidence.” Investor confidence did not need restoring, though, and what SOX actually did was significantly undermine that confidence by showing the poor business sense of our governing class and imposing massive costs on businesses.

Alex J. Pollock
AEI

My interest in this matter is to counsel action in reforming Sarbanes-Oxley because the costs it imposes are so onerous. The government’s estimate of compliance costs for SOX was off by a factor of fifty, an enormous figure, and one that should give the government pause when it attaches criminal liability to a similar miscalculation made by officials of a public corporation. The good news is that there are some lawmakers, such as Congressman Jeff Flake (R–Ariz.), who are interested in changing SOX, and we should do everything we can to supply them with data and ideas.

Among other faults, SOX codifies the current “independence fetish” of today’s corporate reformers. These reformers argue that involving independent directors in the process of corporate governance will cure all of its ills, but they offer no plausible mechanism for how this will happen. In actuality, independence is far less important than possessing relevant knowledge. The law also naïvely views accounting as being the simple gathering of uncontroversial facts, but in reality accounting is a complicated matter ultimately resting on judgment. Criminalizing bad judgments has a chilling effect on businesses’ ability to manage their own affairs.

Sarbanes-Oxley should have taken into account Pollock’s law of financial markets: when optimism settles on the market, it will create as much risk as it wants, no matter what regulators do. To combat this, we should provide investor education designed to make people skeptical, because a confident investor is a stupid investor. To make it a workable law, section 404 compliance should be made voluntary. If investors really want such extensive disclosure, then companies will continue to supply it. The law should also have a sunset provision, and Congress should make it clear that accountants’ professional judgments are deserving of respect. The best way to make the burden of SOX felt would be to require the public accounting firms doing the auditing to undergo such auditing themselves and see how they like it.

Richard Booth
University of Maryland School of Law

I agree with Mr. Pollock about the feting of independence in directors. The truth is that investors are indifferent to reforms ensuring independence because it is so easy for them to effectively insure against risk through diversification. Years ago massive corporate conglomerates took this risk-bearing function on themselves, but that age is over, and the current method of having investors bear the risk is much more efficient.

Sarbanes-Oxley also irrationally takes a stand against options for executives, making executive loans illegal. But its reasons for this ban are purely rhetorical, and in the end it has merely eliminated the most effective way to incentivize employees. It is a step in the right direction to discourage companies from giving employees “retirement funds” that are filled almost entirely with company stock, because such arrangements really are rather sinister and are likely to leave employees holding the bag in the case of any collapse.

Professors Ribstein and Butler are also right to highlight the litigation threats caused by SOX. While the act does not create a new cause of action as such, it will make new kinds of evidence acceptable in fraud-on-the-market cases, and many fewer unmeritorious cases will be dismissed as a result. Thanks largely to Sarbanes-Oxley, the future of securities-fraud class actions will reward those people who buy at exactly the wrong time at the expense of those who take the rational course of buying and holding regardless of market fluctuations.

AEI research assistant Philip Wallach prepared this summary.