The SOX Win: How Financial Regulation Can Work
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As fears mount that Dodd-Frank, the financial overhaul law, is about to be emasculated, it's worth reflecting on the 10-year anniversary of a major regulatory success.
I'm speaking of the mocked, patronized and vilified Sarbanes-Oxley, the law that cleaned up American corporate accounting.
SOX, as it's known, was a response to an epidemic in corporate accounting fraud that swept American business in the late 1990s and early 2000s. Because the 2008 financial crisis dwarfs that earlier round of scandal, it's easy to forget how rotten things were, said Broc Romanek, editor of TheCorporateCounsel.net, a site devoted to securities law and corporate governance. "Everyone had lost faith in the numbers put out by big public companies," he said.
Cast your mind back. The scandals erupted in some of the purportedly best, most recognizable companies in America. Enron and WorldCom were the two biggest names and the two biggest failures. Tyco and Adelphia were in the second tier. But there were appalling accounting disgraces at HealthSouth, Rite Aid and Sunbeam. Waste Management and Xerox barely survived theirs.
Today, there are certainly debates about stocks and their valuations — and some questionable accounting — but no company that finds itself under scrutiny now is anywhere near as large, respected or publicized as those were then.
Something else characterized those dark days: the frauds often lasted and lasted. Investors known as short-sellers, who make money when stocks collapse, waged battles for years over certain companies. Today, accounting disputes are finished before they start. An accounting scandal at Groupon, the online coupon company, came and went in a matter of weeks back in the fall — resolved by the regulators before the company went public.
When SOX was passed, it was attacked — almost exactly like Dodd-Frank is today. Sarbanes-Oxley got "horrible press," said Jack T. Ciesielski, who edits the Analyst's Accounting Observer. People mocked it for requiring companies "to flow chart the keys to the executive washroom," he said. But the result is that accounting at American companies is much cleaner today.
The main criticisms of the law haven't panned out. Corporate earnings have soared, and no company has ever missed a quarterly estimate because it was spending too much on its accounting and internal controls.
Critics railed that it would cost small companies too much, which it may have, though the evidence is debated. They also argued that it would hurt initial public offerings, which it didn't. Yet, there remains vestigial criticism from the right; Newt Gingrich called for its repeal the other day on the campaign trail.
Is Sarbanes-Oxley perfect? Of course not. The financial crisis included accounting problems. The books of the American International Group, Lehman Brothers and Merrill Lynch misrepresented the true state of the companies. The auditors have managed to skirt blame — even more so than other gatekeepers, like the ratings agencies, have. But at its heart, the financial crisis wasn't an accounting scandal. It was a bubble, albeit one exacerbated by some book-cooking.
But the evidence in SOX's favor is that one big dog didn't bark. Even as the financial panic turned into the Great Recession, corporate America weathered the worst of the downturn without a series of major accounting frauds.
SOX required that chief executives and chief financial officers personally sign off on their companies' financial statements. That seems minor. No doubt a Madoff wouldn't be deterred by a little dissembling signature. But blackhearts aren't the typical accounting fraudsters.
At huge corporations, corruption usually develops slowly, incrementally, starting with a minor crossing of the line. At the end of a quarter, a sale is booked before it was actually ordered — to make the numbers for Wall Street. Over time, the fraud builds on itself and it's easier to keep the game going than to clean it up.
Requiring a step where the top dogs actually have to mark the books as their own territory halts that process. It steels their concentration and improves the culture, preventing those initial halting steps toward fraud.
The accounting industry has been improved as well. The new SOX-created industry overseer, the Public Company Accounting Oversight Board, has made inroads. Accountants have done a better job, remembering the devastating collapse of the accounting firm Arthur Andersen in the wake of the Enron debacle.
SOX wasn't the only factor in this cleanup, of course. The accounting trials of the early 2000s made a cultural mark. Kenneth L. Lay and Jeffrey K. Skilling of Enron, the Tyco fraudsters L. Dennis Kozlowski and Mark H. Swartz and Bernard J. Ebbers of WorldCom all had their day in court. All the world, including their executive peers, watched them go from their mansions to the big house.
Is there a lesson to draw here for the prospects of Dodd-Frank? The new law is more sweeping, more pilloried and more complicated. It is concentrated on one industry, which allows for a more unified opposition. Importantly, a round of perp walks and prison terms didn't accompany the law. Quite the contrary, the people responsible for the greatest economic collapse since 1929 have all danced away untouched.
But for all of the criticisms of Dodd-Frank, there has been a societal change in our views. Few can sustain an argument in favor of a gigantic, self-serving and rapacious financial sector. Some kind of financial reform law was — and still is — needed.
If lawmakers don't gut Dodd-Frank, then 10 years from now we just might be reflecting on how safe our financial system is.
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