Reading time: 14 – 23 minutes

The Sarbanes-Oxley Act of 2002, by discouraging companies to go public, will exacerbate the shortage of equities, with a negative effect on the US stock market, although this was not the intent of its authors.

The formal intent of the Act was to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.”

Enron complex, Houston, Texas

This goal will not be achieved.

In fact, the opposite may be the outcome.

Inspired by Enron

The December 2001 bankruptcy of the Enron Corporation was the legislative inspiration for Senators Sarbanes and Oxley who swallowed hook, line, and sinker the popular press story that the Enron bankruptcy would not have happened if it were not for devious accounting practices of its admittedly unscrupulous executives.

When Enron shares reached the all-time high of $90 in August 2000 (just as the Great Bubble of the 1990s was about to burst), its shares were selling at a speculative 61 times earnings with a dividend yield of only 0.5%. The financial statement of December 2000 showed a current ratio of a mere 1.06 with equity only 17.4% of total assets. The company was engaged principally in speculating in exotic energy contracts and derivatives. Its bonds never rose above the lowest investment grade.

In other words, a quick examination of the published statements would reveal the plain truth, even to an amateur analyst, that this was an extremely highly leveraged speculative company, with no cash reserves or working capital, borderline credit, with little investment merit and with stock that was wildly over-priced, floating in the clouds of Wall Street ballyhoo.

Teetering on the edge

Many things, from a terrorist bombing to a catastrophic hurricane, could have driven Enron into bankruptcy.

It was no secret that Enron was on a tightrope

The company existed on the extreme edge of an asset-lite financial fantasy world created by Jeffrey Skilling, the Harvard MBA and fair-haired boy from McKinsey and Company.

Just as in the case of Long Term Capital Management, the nutty ideas of the Nobel Gods had fallen to earth.

The Sarbanes-Oxley Act would not have prevented the Enron bankruptcy and does absolutely nothing to protect investors against the far more common, harmful, and widely accepted corporate practice of diverting hundreds of billions of dollars of corporate cash reserves each year into company executive bank accounts through stock buyback-option schemes, instead of equitably paying dividends to shareholders.

See: Essays on Stock Buybacks and Options.

Setting up a new ‘oversight board’

The first thing that Sarbanes-Oxley does is to set up a Public Company Accounting Oversight Board.

This statutory five-person board now has four directors: an ex-congressman, an ex-general counsel to CalPERS, and two ex-SEC staffers.

The 'Accounting Oversight Board' has amateurs overseeing professionals

In order that decisions of the board are not swayed by any commitment to or in-depth, practical knowledge of accounting practices or standards, only two board members may be Certified Public Accountants.

The Public Company Accounting Oversight Board has extensive powers to regulate and interfere with the operations of accounting firms that audit operations of public companies.

The effect of this is to increase the costs of audits of public companies. These increased costs are paid, in the final analysis, by public shareholders.

The Board has broad powers to impose monetary sanctions on persons who violate its rules, as well as to impose a lifetime ban on involvement of such persons in the capital market.

The Board’s authority extends to foreign accounting firms that are associated with US issuers, even indirectly by audits of foreign subsidiaries of companies subject to US securities laws.

Focusing on corporate executives

Section 302 of the Act requires the principal executive and financial officers of public companies, or persons filling similar roles, to certify that each annual and quarterly report is true, complete, and not misleading, and that they are responsible for setting up effective internal controls to ensure that this is indeed true, and that such internal controls have been effectively established.

Section 401(j) requires that such certified disclosure include:

“ALL material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that MAY have a material current or FUTURE effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses”

The law is not clear as to whether such off-balance sheet relationships must be specifically enumerated, which for a large company would add hundreds of pages to the financial statements, or whether a broad statement of generalized risk will suffice, such as,

“Your company has thousands of relationships with other persons, that may involve contingent liabilities that do not appear on the balance sheet, any of which contingencies may have material future adverse effects on the financial condition of the corporation. For example, any of our clients, past, present, or future, may enter into a lawsuit claiming product liability and may be awarded damages that will be so large as to have a material adverse effect on our operations and financial condition.”

Whether the company chooses to enumerate all relationships that may have a material effect on future operations, or whether financial statements include general boilerplate as to unlisted potential risks, it seems clear that the Sarbanes-Oxley Act offers no advantage whatsoever to investors, since few will have the time or incentive to read through such nonsense.

CEO wanted, only knaves need apply

It seems to me that the real purpose of the Sarbanes-Oxley Act is not to protect investors, but rather to facilitate prosecution of executives whenever large companies, such as Enron, go bankrupt, giving rise to the inevitable public outcry to find someone to blame and punish, preferably with a long jail term.

Easing the jailing of executives

Sarbanes-Oxley is the white-collar-crime prosecutor’s dream law.

When combined with powers under the RICO Act and the star-chamber powers of US grand jury proceedings, Sarbanes-Oxley is designed to intimidate, impoverish, and imprison at will anyone who is foolish enough to accept a position as CEO or CFO of a US public company.

Executives can be prosecuted not only if they violate the provisions of Sarbanes-Oxley, but also if they are alleged to have attempted to violate the law, or to have conspired or attempted to conspire with others to violate the law, or to have done anything that might be construed as obstructing the prosecution or investigation of the myriad possible violations under the law.

The deletion of any e-mail or draft memorandum, or electronic document before five years have passed, by anyone in a company with tens of thousands of employees, may be construed as a violation of the law.

In the penumbra of prison, a knave CEO negotiates a juicy stipend

The practical effect of Sarbanes-Oxley is to attract a type of reckless executive who, in exchange for an astronomical salary paid in a short-period, is willing to risk reputation and liberty on the chance that he will not fall into one the many yawning legal mantraps, set up by Sarbanes-Oxley, that can catch even honest, ethical executives.

Incentivizing whistleblowers

Furthermore, any employee, contractor, sub-contractor, or agent of the company that reports a suspected violation of Sarbanes-Oxley to almost anyone, including federal agencies, members of Congress, and others in the company, is protected from being discharged, demoted, suspended, threatened, harassed, or in any other manner discriminated against in the terms and conditions of employment, and has rights to claim reinstatement in position, including back pay with interest and compensatory damages.

Executives who violate whistleblowers’ rights are subject to civil and criminal penalties.

The prudent employee of a public company, in order to ensure job security, may regularly drop a letter to his or her Congressperson, reporting suspected violations of Sarbanes-Oxley.

For help in this matter, there are Internet sites available. See: “National Whistleblower Center“.

Twenty years in jail for not certifying what no one can know

Twenty years in jail and $5 Million

If an issuer is required to restate a financial report due to errors in accounting, the principal executives of the issuer may be required to forfeit all incentive remuneration and profits from stock sales over a 12-month period.

Section 906 of the Act provides fines of up to $5 million and prison terms of up to 20 years for corporate officers for the crime of “failure to certify financial statements”.

Setting impossible standards

The fundamental problem with the Sarbanes-Oxley Act is the assumption that it is possible for someone who manages a large, complex global public corporation with tens of thousands of employees and products and with hundreds of thousands of off-balance sheet “transactions, arrangements, obligations (including contingent obligations), and other relationships” to actually honestly certify that a financial report is true, complete, and not misleading in all material respects, including anything that may have a future impact on the company, and that internal controls that assure that this is so have been effectively established.

General Electric, for example, has been named ‘America’s Most Admired Company’.

It has $5 billion in revenues, over 300,000 global employees, and multi-national diversified operations in commercial and consumer lending, insurance, healthcare, aviation, public media, and industrial operations from locomotives to plastics.

KPMG, General Electric’s auditor, states frankly in its certification of the company’s reports that “because of its inherent limitations, internal controls over financial reporting may not present or detect misstatements”.

Nevertheless, in its zeal to protect investors and obtain convictions to satisfy the mob when prices fall sharply on the stock market, Sarbanes-Oxley does not provide executives with any safe haven or loophole to avoid jail terms when their public company goes bankrupt, as happens from time to time.

Lessons from recent prosecutions

Government prosecution of corporate executives has become more efficient since the stock market bubble burst in 2000 and one might expect that public corporations will draw increasing fire as Baby Boomers retire and begin to dump equities at a loss on the market.

The authorities have their methods

From the Martha Stewart case we saw how a successful entrepreneur that caused no harm to her company was sent to jail on trumped up charges of ‘lying to a federal official’ about something that was not even a crime (her supposed insider trading).

Because it was politically expedient to do so, the judge disallowed a defense that Martha had no motive to lie because what she did was not insider trading, while allowing jurors to hear perjured evidence, and looking away when a juror was alleged to have been involved in perjury in connection with the trial.

From Enron, we learned that an innocent accounting firm (Arthur Andersen) can be put out of business by an incompetent judge yielding to an over-zealous prosecutor’s desire for fame.

We also saw how a CEO (Jeffrey Skilling) could be sent to jail even when a company goes bankrupt on someone else’s watch, months later.

In the case of Ken Lay, we saw that a commonsense defense that bankruptcy is a normal business risk for a company that is highly leveraged without cash reserves, will not protect a CEO when enough shareholders and employees lose their life savings.

In the trial of Ken Lay, the prosecution never even attempted to show that anything that Ken Lay did or even Enron’s accounting practices actually resulted in the bankruptcy of Enron.

In the case of Bernie Ebbers and WorldCom, we saw that a defense that a CEO was too dumb to know what was going one won’t work, even when the argument is plausible.

Finally, in all of these cases we see how government prosecutors, zealous to obtain convictions and jail terms that will advance their careers, can spend tens of millions of taxpayer dollars and years of investigation to bring down targeted executives, eliciting testimony by threats and plea bargains from lesser employees that do not have financial resources to defend themselves, and ratcheting up penalties by claims of conspiracy and other legal provisions originally intended for organized crime lords.

Needed:  fools or knaves

It seems to me, that a reasonably intelligent, informed person, understanding the impossible standards of Sarbanes-Oxley, would avoid accepting responsibility as CEO or CFO of a large, complex public company in the United States, unless the pay was high enough to compensate the risk of going to jail for life if the company should go bankrupt within five years of leaving office.

Just to be safe, the rational CEO or CFO should be sure to have millions safely squirreled away in some offshore haven without an extradition treaty with the US, and be ready to hop on a plane for life abroad at the first sign that a politically motivated prosecutor has convened a grand jury and that he or she is the ‘ham sandwich’ that is likely to be indicted.

Under Sarbanes-Oxley all executives are guilty

The statute of limitations on the Sarbanes-Oxley Act is five years, but prosecutions seem unlikely unless stock prices fall catastrophically or the company goes bankrupt.

Headlines trumpeting losses to ’small investors’ will bring politically motivated prosecutors out of the woodwork.

The CEO of a large, long-established company with a triple-A credit rating may feel confident that there is no significant risk in signing the company’s financial statement.

However, a newer company, with weaker credit, unproven products, and strong competitors may have a much greater chance of getting into difficulty within the five year statute of limitations on Sarbanes-Oxley.

It is these newer, more entrepreneurial companies on which the future of the economy depends.

Going and staying private

The Sarbanes-Oxley Act ignores the one fundamental, dominant truth that should be evident to anyone who bothers to study the Federal Reserve national flow of funds accounts for equities. (Table F213)

The wise escaping unreasonable scrutiny and political expediency

For over a generation, US public companies have, on balance, been buying back more of their stock on the market than they have been selling as new issues.

In other words, the primary utility of the capital market for US public companies has not been to raise money to build factories and create jobs, but rather to provide a market in which companies can buy back stock in order to jack up stock prices and legally transfer shareholders’ cash to the holders of management options.

A rational executive, who is honest and sensible to his or her fiduciary responsibilities to long-term, minority investors, should disdain stock buyback-option schemes that are designed to put money into executive pockets at the expense of shareholders’ well-being.

Reducing the supply of equities

Because Sarbanes-Oxley places unreasonable criminal liabilities on anyone who assumes the role of CEO or CFO of a public company, and because additional equity financing is less important for established companies that are operating at a profit and able to finance growth out of retained earnings, many may decide that continuing to accept risks of having public shareholders is both imprudent and unwise.

There are other provisions of the Sarbanes-Oxley Act, but the major impact on the US capital market should be to significantly increase incentives for public companies to go private and for private companies not to go public.

As pointed out in the article “Equity Privatization: the Super-Rich Get Smart“, already about 7% of the equity market has been absorbed by private equity firms to an attempt to escape excessive regulation by the SEC and Sarbanes-Oxley.

There are anecdotal stories in the press about foreign issuers avoiding the over-regulated US market and companies deciding to ‘go private’ or ’stay private’.

In any event, Sarbanes-Oxley will not increase the supply of equities, but allows corporations to continue to manipulate prices upwards through stock buybacks, reducing the intrinsic value and supply of equities.

This does not bode well for Baby Boomers who continue to blindly invest in equity mutual funds as faithful believers in the “Common Stock Legend“.

What do you think?