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May 2011 — Web Exclusive

Sarbanes-Oxley, Eight Years On

By Michael Castellon

“The rest of the world is looking to the U.S. because we have such a thorough set of financial regulations.”

— Genevieve Beyea

How a Major Reform of Corporate   and Finance Law Affected Business

The booming economy of the 1990s ended abruptly with the arrival of the new millennium — and the revelation that a number of large, publicly held U.S. companies had fraudulently misrepresented their earnings and financial statements. Investors panicked as the breadth and scale of this fraud became clear, with crippling effects on the U.S. economy.

Congress approved the Sarbanes-Oxley Act of 2002 in the wake of these high-profile accounting scandals. Since then, the law has played a significant role in enhancing corporate and financial accountability and federal oversight.

Genevieve Beyea
Assistant Professor
Texas Tech University
School of Law

In this issue of Fiscal Notes, we speak with Genevieve Beyea, an assistant professor at the Texas Tech University School of Law, on how Sarbanes-Oxley has affected businesses throughout the U.S.

Beyea, a New York University School of Law graduate who teaches securities regulation and mergers at Texas Tech University, has written extensively on corporate law and acquisitions.

FN: For the uninitiated, what is the Sarbanes-Oxley Act of 2002?

Genevieve Beyea: Sarbanes-Oxley does a number of things aimed at improving corporate accountability and public company accounting practices. Among the most important of its provisions is the establishment of an oversight board for accounting firms. Another is the “whistleblower” provision, which protects employees who report accounting or audit problems to audit committees or the Securities and Exchange Commission (SEC).

When the dot-com bubble burst, at about the time of the Enron and WorldCom scandals, there was a backlash against fraud and some of the really bad ways in which some of the markets were working. A number of very big companies went under. Enron, in 1999, was the seventh-largest corporation in the U.S. by market capitalization, so when it went under there was a huge shock to the system, in the sense that no one saw this coming until it was too late.

It turned out that a lot of [Enron’s] assumptions about its future profitability were essentially made up. Investors became fearful of the market and the public became very angry. When that happens, there’s often public pressure to do something, and Sarbanes-Oxley was Congress’ response.

“[Sarbanes-Oxley]
puts more pressure
on the CEO to
better understand
the finances of his
or her company.”

— Genevieve Beyea

FN: And what does the law do?

GB: A number of things. For one, it created an oversight board for accounting firms. And all public companies were required to establish independent audit committees. For some companies, this meant hiring new directors. Audit committees can’t be made up of directors who are also officers or other employees of the company. So director independence became a big focus.

In addition to that, Sarbanes-Oxley puts increased responsibility on chief financial officers and chief executive officers in terms of financial accountability. It puts more pressure on the CEO to better understand the finances of his or her company.

FN: What were some of the criticisms of this?

GB: One of the big criticisms was that it pulls the CEO away from the strategic vision and management of the company, and more toward ownership and oversight of finances. CEOs are now deeper in the nitty-gritty of financial reporting.

FN: How has Sarbanes-Oxley affected the business climate?

GB: The initial cost — the initial investment needed to put systems in compliance — is often very large. But once that’s done, the annual ongoing costs aren’t so bad, except for the increased costs associated with auditing.

Now that most companies have put themselves in compliance, some of that criticism has gone away. Though there’s still this liability factor that hangs over the heads of CEOs and CFOs like a big stick.

One additional criticism is that Sarbanes-Oxley disproportionately affects smaller companies, who are less able to bear the increased costs of auditing than larger firms.

Accounting firms have been frustrated with Sarbanes-Oxley because they see it as [making] them responsible for things they normally wouldn’t be accountable for. Previously, the same accountants from an auditing firm might work for the company for 20 years. This resulted in deep personal connections, which might result in a biased auditor.

Now, every five years the lead and reviewing partner from the auditing firm must be rotated off the audit, which is intended to eliminate a lot of the conflicts of interest that existed before. This increases the costs of auditing, however, because the new auditing firm employees assigned to the company must essentially relearn information that those being rotated off had already learned.

The portion of the act calling for independent auditors has really caught on as a desirable thing. There’s a debate on whether it’s working or not, but overall it has caught on with little conflict.

FN: It seems like a lot of positive things have come from the legislation.

GB: In general, the rest of the world is looking to the U.S. because we have such a thorough set of financial regulations. This is a natural place for countries like China to look when developing their own provisions against corporate fraud.

FN: Do any corporations stand out as noteworthy examples of compliance with Sarbanes-Oxley?

GB: Most of the big public companies did a good job of getting this done. This is anecdotal, but in one of my courses I use Hewlett-Packard as an example of a company that has done a good job of implementing an independent audit committee and internal control requirements. As a class, we look at HP’s annual reports versus those of WorldCom just before its fall.

But most public companies complied to the extent they were able, mainly due to penalties for not complying by a certain date. For the most part, companies were ready to comply when the time came.

FN: The Dodd-Frank Act, passed in 2010, has a lot in common with Sarbanes-Oxley in that it provides sweeping regulatory reform. Can you talk a little about that?

GB: It’s a big piece of legislation similar to Sarbanes in that it’s a reaction to the recent financial crisis. The Dodd-Frank Act affects every area of financial regulation, including banks, consumer regulations and rules for the governance of public companies. It’s very broad, but not being felt yet because most provisions haven’t been implemented. Many will be by this spring, though. The effects are going to develop over the next few years.

Hopefully some good things come out of it, but inevitably there will be things that need further work. Many problems in the housing market, for instance, are too complicated to just legislate away.

Some of it comes down to behavior. How do you legislate in a way so people will be risk-adverse and less interested in short-term results? If you want a stock market with long-term, healthy gains, how do you create that? How do you manage that? For example, some people who held stock through the crisis, as long as it wasn’t in companies that actually went under, came out better than those who panicked and sold. That’s a broad generalization, but it is something people have noticed. FN

View Professor Beyea’s professional profile.

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