Part of Sarbanes-Oxley struck down, but is the rest of the law worth keeping?
The Supreme Court struck down one element of the Sarbanes-Oxley legislation today, saying that some federal provisions that created the Public Company Accounting Oversight Board, a private regulatory body meant to discipline accountants who work with big firms, was unconstitutional.
The rest of Sarbanes-Oxley remains "fully operative as a law," Chief Justice John Roberts wrote, but it's worth taking a look back at Sarbanes-Oxley, which has in recent years come under fire as a stifling agent of businesses, rather than as business-neutral cop on the beat, which was its intent.
Sarbanes-Oxley was a sweeping set of laws enacted by Congress in the wake of the Enron and WorldCom corporate scandals at the beginning of this century, an effort to make sure those sorts of things don't happen again.
If the financial crisis of 2007-2009 was about over-leveraging and personal irresponsibility, then the big corporate blowups of a decade earlier were about illegal activity and bad behavior in the C-suites of some of America's biggest companies.
Enron -- actually a terrific idea as a business, an energy trading company -- created a balance sheet that even the most imaginative fiction writer wouldn't try to peddle to his readers.
Chief executive Bernie Ebbers lived like a pharaoh atop WorldCom, which went bankrupt in a massive accounting scandal.
John Rigas, founder of Adelphia cable company, treated his company like a personal ATM.
And on and on.
SarbOx, as it came to be known, was Congress's attempt to hold CEOs and other top corporate officials accountable for their actions. The law had 11 key provisions, which included the creation of the accounting oversight board. Some were meant to erase conflicts of interest with financial analysts, others increased jail time for jailed executives. Some were pure congressional grandstanding -- forcing a company's chief executive to personally sign earnings reports, a meaningless gesture. Others made more sense -- requiring companies to better disclose off-balance-sheet entities, which were the things that former Enron chief financial officer Andy Fastow set up (and ran -- conflict of interest) to hide Enron's mounting losses.
Right from the beginning, SarbOx drew criticism from smaller businesses, saying the rules and regulations it imposed cost more than they can afford. Compliance is expensive, and smaller businesses operate on much smaller profit margins than big ones, like Wall Street banks, which can afford legions of compliance officers.
Many laws have unintended consequences; in this case, SarbOx had costly unintended consequences on small businesses.
Then-SEC Chairman Chris Cox tried to scale back SarbOx for smaller businesses in 2007. Quoting from a 2007 Bloomberg story:
The SEC in December proposed changes to Sarbanes-Oxley's audit requirements that would let companies focus on items most likely to trigger financial restatements. The SEC's rules are to be aligned with a proposal from the U.S. audit-oversight board to let accountants rely more on companies' internal efforts.
The U.S. Chamber of Commerce and Treasury Secretary Henry Paulson say Sarbanes-Oxley and other regulations have hurt the nation's competitiveness. Business groups want revisions to Sarbanes-Oxley to exempt small companies from its auditing rules and give the SEC authority to weaken the law.
The section of SarbOx that was struck down today by the Supreme Court -- the accounting oversight board -- was presciently criticized for its shaky constitutional structure in this 2009 piece from the American Enterprise Institute's Alex Pollock:
"Let me come to the PCAOB and its dubious constitutional standing. Is this a private or a government body? It is neither. It was set up as a hybrid to avoid two kinds of discipline: the market discipline of being fully private and the discipline of being a government body, that is, the processes of appointments and appropriations and the apparatus of being part of the government. This avoidance of discipline was fully intentional on the part of Sarbanes-Oxley's creators. As mentioned, the PCAOB is supported by what is functionally a tax on public companies, and it is obviously a regulatory body. But, like the FASB, it claims that it is 'private.'
The PCAOB should have to decide either to be public, a part of the government with all that implies, or to be private with all that implies, but not both. This is the same logic many of us would apply to Fannie Mae and Freddie Mac. Such government-sponsored hybrids, which avoid the discipline of being private and avoid the discipline of being part of the government, should not exist."
In the aftermath of great financial crises -- like the one we just went through -- politicians respond to the cries of their constituents to Never Let This Happen Again. Congress is hammering out its big financial regulatory reform bill right now, which includes measures that are useful and those that are merely punitive, meant to throw red meat to an angered constituency.
Of course, in a market-based economy, booms and busts happen and it's impossible to ensure they won't. There are plenty of smart, good-government rules you can put in place. The best you can do for an investor is ensure transparency and let them make up their minds about how to invest their money. Capital and those who move it are like water -- they always find a way around.
Fortune magazine did this interview with Michael Oxley, one of the SarbOx co-authors, earlier this year and asked him why his law didn't prevent the 2007-2009 financial crisis.
Oxley offers the best defense of his law, which is probably the only defense, given that it's unprovable:
"Even though the recent meltdown has hurt confidence again, things could have been much worse if accounting regulations had been as lax as financial regulations."
June 28, 2010; 1:46 PM ET
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