SOX and the Prevention of Fraud

In debating the benefits of SOX, most opponents contend that the Act was designed to prevent fraud and that there is little or no evidence that it has worked. Or, as Larry Ribstein at Illinois felt comfortable opining in 2005, the Act was an over reaction at best and, at worst, “ineffective and unnecessary.”  They take the position that the costs of SOX outweigh the benefits. Said another way, SOX does not produce the “optimal amount of fraud.”  This is a position taken, for example, in a paper by William Carney at Emory.

One problem with this approach is that it links the benefits of SOX entirely to the prevention of fraud and ignores the improvements in the overall integrity of the disclosure process. One sign of this improvement is the number of restatements that have occurred since the adoption of SOX, something that we have discussed often on this blog. (The number of restatements in 2006, by the way, set a record).  The improvement in integrity has contributed to increased investor confidence. With the Dow Jones hitting records, we see considerable evidence of this confidence.

But returning to fraud, we already saw earlier in the year evidence that the amount of fraud had declined since the adoption of SOX. The Stanford Securities site reported that the number of securities fraud class action law suits filed in 2006 was the lowest since 1996.  (We discussed this data in a post here.)  Maybe the data will prove anomalous. Maybe the explanation is not SOX but the PLSRA and the tighter standards for establishing scienter (an issue pending at the Supreme Court). But at a minimum, it raises the specter that SOX has lowered the fraud rate. 

We get our second piece of data on this from PriceWaterhouseCoopers. The study found that only 106 securities class actions were filed in 2006, down 37% from the year before. It was a 10 year low and the lowest since the adoption of the PSLRA. What was the reason for the drop off according to PricewaterhouseCoopers?

• “The decline in the total number of federal case filings for 2006 appears, for the most part, to stem from the distraction of the options backdating cases brought during the year, which were mostly filed as derivative actions in state courts. In total, there were 108 derivative actions filed relating to options backdating cases. This situation is similar to the decline in federal cases during 2001, when there was a flurry of litigation activity with respect to the topical issue of the year: laddering cases. Then too, the total number of federal cases also declined.”

• “The decrease witnessed in 2006 may be due to the ongoing deterrent effect of the Sarbanes-Oxley Act of 2002, generally, and more particularly to the Section 404 provisions and the significant sentencing guidelines that aimed to improve corporate oversight and significantly punish corporate wrongdoers. The more rigorous involvement of regulators in recent years did not go unnoticed either. The unfettered high cost of settlements, which appears to have been driven by increased activism on the part of major institutional shareholders, may also have acted as a deterrent to those contemplating practices likely to be viewed as improper by regulators and shareholders alike. Of course, relative stability in the stock market, which is not conducive to high levels of shareholder actions, must be considered as well.”

So, a variety of reasons may explain the decline, with one of them the deterrent effect of SOX. We shall see next year, when the data is in, whether in fact the decline really is mostly related to the backdating cases.