The Sarbanes-Oxley Act and its Effect on Investor Confidence
March 24, 2015
By Ali Perry, Penn Law ’15
Under the theory of a free market system, there is an assumption that investors always have the necessary information to make informed judgments. Therefore, through most of our country’s history, the prevailing economic policy has been predominantly pro-market, fostering entrepreneurialism and the development of a free market system. However, after a series of accounting scandals in the early 2000’s, this country saw momentous changes to its economic and regulatory structure. One of the more significant changes came with the enactment of Sarbanes Oxley, which was passed in the wake of this economic turmoil.
The Act aimed to bring stability back to the economy, with a focus on increasing financial transparency for investors. The stated purpose of the Act is “to protect investors by improving the accuracy and reliability of corporate disclosures.” It placed significant emphasis on companies establishing, assessing and reporting on its system of internal controls over financial reporting, and required auditors to annually report on the effectiveness of that system of internal controls. The basis for this requirement is that better internal controls result in better financial reporting and more investor confidence in financial reports. Twelve years into its enactment, the question still remains as to whether Sarbanes-Oxley has had a real, positive effect on the U.S. economy, and whether it truly has corrected the blatant information asymmetry that exists within the markets. History has shown that pro-market policies must be balanced with economic regulations. However, what the appropriate balance is has yet to be realized.
The rationale behind the Sarbanes-Oxley Act is best reflected by the events in the years preceding its enactment. The 1990’s marked an era of remarkable economic growth, largely driven by the Internet boom, which saw the formation of a new industry of internet-related companies propelled by venture capitalists. Market confidence was high and the NASDAQ reached an all-time high of over 5,000 points in March of 2000.[i] However, in the background of this economic prosperity, companies like Enron Corporation, a Texas-based energy company, were engaging in various types of accounting fraud that would lead to their ultimate demise and trigger a new age of economic regulation.
Enron filed for Chapter 11 bankruptcy in December 2001 after disclosing that it had made a series of accounting errors amounting to $1.2 billion.[ii], [iii] The following year, WorldCom, the nation’s second largest long-distance carrier, filed for Chapter 11 bankruptcy a month after a $3.8 billion accounting misstatement was discovered.[iv], [v] The realization that the Enron scandal was not an isolated incident provoked substantial demand for a congressional response. An “apparent crisis situation” unfolded in the U.S. economy, as more scandals were uncovered and a media frenzy developed.[vi] These business scandals were called a “perfect storm” that cast light on the reality that there were no checks-and-balances in corporate America.[vii] They shook the very core of the cherished economic principles of deregulation, privatization and globalization that marked the 1990’s era.[viii] At the same time, the economy was on the decline as the Internet boom began to disintegrate with start-up companies failing to realize profits and venture capital funding drying up.[ix] These accounting scandals cost investors millions of dollars and shed light on the apparent information asymmetry in the market.
The Sarbanes Oxley Act of 2002
The highly publicized and widespread string of accounting fraud cases prompted the legislature to enact the Sarbanes-Oxley Act of 2002 (“SOX”), which was signed by President Bush on July 30, 2002. [x] SOX has been called the “broadest sweeping legislation to affect corporations and public accounting since the 1993 and 1934 securities acts.”[xi] The Act made considerable changes to the regulatory environment, focusing on addressing the “systematic and structural weaknesses affecting [the U.S.] capital markets which were revealed by repeated failures of audit effectiveness and corporate financial and broker-dealer responsibility.”[xii] At the bill signing ceremony on July 29, 2002, it was stated that the Act’s overarching purpose was to enhance standards for accounting practices; strengthen independence of public accounting firms; increase corporate responsibility and the usefulness of corporate financial disclosures; to protect objectivity and independence of security analysts; and increase resources for the Securities and Exchange Commission (“SEC”).[xiii] Enhancing the role of the SEC was deemed especially important given that the SEC exists to filter full and accurate information about companies’ finances so investors and creditors can effectively allocate capital within the free market system. In doing so, the SEC can prevent information asymmetry where one party with superior information in a transaction has the ability to take advantage of the other party with less or inferior information.
The Act includes eleven titles of compliance and established the Public Company Accounting Oversight Board (“PCAOB”).[xiv] The PCAOB is a nonprofit corporation charged with overseeing the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.[xv] Its mission is to improve audit quality and increase the objectivity and accountability of auditors in order to benefit the investing public.[xvi] By increasing transparency and decreasing information asymmetry, there is an expectation that stock prices will become more informed, bid-ask spreads will be reduced, analyst forecast dispersions will lessen, and the cost of equity and debt capital will decrease.[xvii]
The question remains whether SOX and the PCAOB have been able to reduce market information asymmetry and to what end has any such reduction benefited the average U.S. investor? Although the PCAOB has reiterated in every press release and board meeting that its goal is to protect the average investor, many criticize that even after twelve years, the PCAOB has yet to make substantial improvements. As the watchdog of corporate accounting, the PCAOB has the power to rewrite audit standards and to inspect and issue reports on registered audit firms. Yet, critics point out that the PCAOB has been slow to act, veiled in secrecy and weak or weak-willed.[xviii] The number of audit deficiencies identified by the PCAOB each year has not decreased over time, which makes one question how effective it has been in improving audit quality and increasing transparency for investors.[xix] One argument can be made that disclosure of such deficiencies alone compels audit firms to improve audit quality and provides investors with a reminder of the risks of placing too much reliance on audited financials. Yet, it is still disconcerting to see that the number of deficiencies being identified has not decreased, since financial statements represent the main source of information for investors.
Finally, putting aside the effectiveness of the PCAOB’s oversight over the accounting industry, there is the ever-present question of whether market information is being distributed evenly among different investors? Clearly, company management and other corporate insiders have more information available to them than the average U.S. investor. Securities regulations, like SOX, attempt to limit the ways in which corporate insiders can capitalize on such information, but insider trading is still prevalent within the marketplace.[xx] Therefore, even if SOX and the PCAOB are effective in regulating the auditing community, increased transparency and disclosures have not been able to counteract situations where insider fraud and collusion are present.
Only time will tell if SOX and the PCAOB are in fact making positive changes to the marketplace, and in terms of investor confidence, the current economic regime appears far from perfect. Investors must be able to not only trust the information that companies are disclosing, but must also have access to a sufficient amount of information. If not enough information is being disseminated into the market, than addressing the quality of the disclosures being made only addresses one aspect of the information asymmetry. Disclosures must not only be credible but also complete in order to give average investors a fair chance in the marketplace.
[i] Jim Zarroli, A Decade Later, Nasdaq Is Half Its All-Time High, NPR (Mar. 10, 2010), http://www.npr.org/templates/story/story.php?storyId=124537450.
[ii] See BBC News, Timeline: Enron’s rise and fall (summarizing the events surrounding the collapse of Enron), at http://news.bbc.co.uk/2/hi/business/1759599.stm (last visited Apr. 16, 2013).
[iii] Linda O. Smiddy & Melissa Ihnat, Introduction: Conference on Enron, Worldcom, and Their Aftermath, 27 Vt. L. Rev. 817, 822 (2003).
[iv] Amanda Ripley, Cynthia Cooper: The Night Detective, Time Magazine (Dec. 30, 2002), http://www.time.com/time/magazine/article/0,9171,1003990,00.html.
[v] Luisa Beltran, WorldCom Files Largest Bankruptcy Ever, CNN Money (Jul. 22, 2002), http://money.cnn.com/2002/07/19/news/worldcom_bankruptcy.
[vi] Robert B. Ahdieh, From “Federalization” to “Mixed Governance” in Corporate Law: A Defense of Sarbanes-Oxley, 53 Buff. L. Rev. 721 (2005).
[vii] Gregg Fields, Enron scandal sparked major changes in financial industry, Union-Tribune San Diego (Jul. 11, 2004), http://www.utsandiego.com/uniontrib/20040711/news_lz1e11fields.html
[ix] Investopedia, The Internet Bubble, http://www.investopedia.com/terms/i/internet-bubble.asp
[x] Allison Fass, One Year Later, The Impact of Sarbanes-Oxley, Forbes (Jul. 22, 2003), http://www.forbes.com/2003/07/22/cz_af_0722sarbanes.html
[xii] Ginger Carroll, Thinking Small: Adjusting Regulatory Burdens Incurred by Small Public Companies Seeking to Comply with the Sarbanes-Oxley Act, 58 Ala. L. Rev. 443-444 (2006).
[xiii] 2002 WL 1747712.
[xiv] See AICPA, Summary of the Provisions of the Sarbanes-Oxley Act of 2002, at http://www.aicpa.org/InterestAreas/ForensicAndValuation/Resources/FraudPreventionDetectionResponse/Pages/Summary%20of%20the%20Provisions%20of%20the%20Sarbanes-Oxley%20Act%20of%202002.aspx (last visited Apr. 16, 2013).
[xvi] See PCAOB, PCAOB Strategic Plan 2013-2017, available at http://pcaobus.org/About/Ops/Documents/Strategic%20Plans/2013-2017.pdf.
[xvii] Debby Van Geyt et. al., Does High-Quality Corporate Communication Reduce Insider Trading Profitability?, 37 Int’l Rev. L. & Econ. 1, 4 (2014).
[xviii] David S. Hilzenrath, Critics Question Effectiveness of Auditing Oversight Board, Jul. 11, 2010, available at http://www.washingtonpost.com/wp-dyn/content/article/2010/07/10/AR2010071000074.html.
[xix] See Elizabeth Kroger Davis, An Overview of Recent Trends in PCAOB Inspection Reports, Aug. 23, 2013, available at http://www.law360.com/articles/466472/an-overview-of-recent-trends-in-pcaob-inspection-reports (showing the number of audit deficiencies by audit firm have not decreased over the past couple of years).
[xx] See SEC Enforcement Actions: Insider Trading Cases, Jun. 17, 2014, available at http://www.sec.gov/spotlight/insidertrading/cases.shtml.
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