Sarbanes Oxley at Five: Fraud Down and the Market Up

Five years ago today, Congress adopted the legislation commonly known as Sarbanes-Oxley or SOX.  The Act was a direct response to the massive corporate frauds that had occurred around that time, particularly the collapse of Enron and Worldcom.  The collapse of the two companies was symptomatic.  Financial statements of public companies could not be trusted.  After all, Enron only a year earlier had a value of around $80 billion and was ranked the 7th largest company in the Fortune 500 list.  In the space of a year, that entire value more or less disappeared. 

The adoption of SOX was hurried and it took place during an election year, with both Democrats and Republicans wanting to look tough on corporate scofflaws.  Without the pressure of an election, the Act probably would have remained moribund.  In fact, until the collapse of Worldcom, the legislation seemed to be going nowhere.

The Act generated a deluge of criticism within the Academy although not, largely, from corporate America.  The Chamber of Commerce was a steadfast supporter of the legislation.  So was Chairman Cox at the Securities and Exchange Commission. 

Academics, on the other hand, vehemently opposed the legislation in large part because it was a complete of rejection of their theory of corporate law.  These were the academics who favored regulatory systems that did not rely on mandatory requirements but instead allowed the various parties (shareholders, directors, suppliers) to bargain for their own set of rules.  They tended to overlook, among other things that the system was not set up to facilitate bargaining, particularly by shareholders, and that private ordering could also result in inefficient behavior.  SOX amounted to a rejection of this philosophy, both by imposing mandatory rules and preempting areas of state law, rejecting in part the Delaware approach to corporate governance.  These critics and their views are discussed at length in my paper, Criticizing the Critics:  Sarbanes Oxley and "Quack Corporate Governance." 

Now, five years later, certain things are clear.  What SOX did was go a along way to restoring investor confidence.  As we shall discuss over the next few days, the Act generated an enormous number of restatements.  In other words, once top officers became more directly responsible for the financial statements and accountants were more independent in their review, mistakes were discovered and corrected.  The evidence indicates that the incidence of fraud has declined.  This is no real surprise.  With a strong audit committee, a mandatory system for employee notification of problems within the company, and mandatory certification of filings by both the CEO and the CFO, it is harder to hide a widespread fraud.  With respect to international listings, the US continues to provide a premium for companies that meet the tough regulatory requirements in the United States.  In other words, the US is attracting listings through a race to the top. 

The final piece of evidence is the market.  With the Dow Jones closing above 14,000 for the first time in history, it is clear that investors have the confidence to keep on investing, something that could not be said in 2002.

For those opposed to SOX, the best form of advocacy would be to encourage Delaware to adopt more meaningful standards in the realm of governance.  Had Delaware had in place meaningful standards of behavior for directors, a meaningful definition of independent for directors, and a meaningful standard for ensuring that boards received adequate information about the activities of the company, this Act would likely not have been necessary.