It was two years ago this month that WorldCom disclosed a $4 billion accounting fraud that sent the $103 billion company into bankruptcy. WorldCom was not alone in adopting shifty accounting practices in the high-flying nineties. Through similar chicanery, America's seventh largest company, Enron, left its investors with just pennies on the dollar.
It was also two years ago this month that Congress passed the Sarbanes-Oxley Act, or SOX, the most sweeping regulation of public corporations since the Great Depression, intending to prevent such frauds. But just as the act's regulatory structure is being put into place, corporate officials are lobbying harsh criticism at the act. They hope these complaints will weaken enforcement of the act, as well as stave off potential rule-making that could increase shareholder participation in board member selection and standardize the expensing of stock options. Meanwhile, the first major challenges to the law's criminal and civil liability provisions are in the courts. And corporations are betting Americans are too preoccupied with war and the election to care about how this could impact corporate responsibility.
SOX implemented a number of changes in the way accounting firms and corporations operate. The key provisions that have come under attack are the establishment of the Public Company Accounting Oversight Board to regulate the previously self-regulated accounting industry; the prohibition on auditing firms from offering lucrative consulting services to clients they also audit; the requirement that all members of a board's auditing committee be outside directors; and an especially dreaded portion of the law, known as Section 404, that requires CEOs and CFOs to certify the financial reports, with criminal liability for those certifying false reports.
But given the popularity of the act--only three members of Congress voted against it--corporate officials have only recently felt they had the power to complain. Most notably, John Thain, CEO of the New York Stock Exchange, publicly rebuked the law in an editorial for the Wall Street Journal. After praising U.S. tax cuts that overwhelmingly favor the wealthy, arguing that they had moved "to unleash the spirit of entrepreneurship," Thain complained that with the advent of SOX, "the pendulum has swung too far. The costs of compliance too high. The risks of litigation too great." These costs, Thain said, are causing foreign corporations to avoid doing business in the United States and even forcing some public corporations to go private.
It took two scions of American finance, Paul Volcker and Arthur Levitt Jr., former chairman of the Federal Reserve and former SEC chairman respectively, to defend SOX. In a June Wall Street Journal op-ed, they noted that implementation of SOX costs companies with greater that $5 billion in revenue an average of $4.7 million up front and $1.5 million annually. "From our perspective," Volcker and Levitt wrote, "$5 million down and $1.5 million a year is not too much to pay for a multibillion-dollar international company when compared to how much investors have lost-and stand to lose-if internal controls are not improved." They also noted that only 8 percent of foreign corporations planning to list their business in the United States considered SOX a reason to reconsider, according to a study by the corporate consultants Broadgate Capital Advisors and Value Alliance.
In spite of such defenses, a stream of critics have come forward to blame SOX for nearly everything. Typical among them is Peter Wallison, an economist at the conservative think tank American Enterprise Institute, who has written that SOX is to blame for the economy's bad performance, that it is a reaction of the "political class" and "media class" who don't understand the "investor class," and that SOX is destroying states' rights to incorporate businesses how they please. Similarly, the U.S. Chamber of Commerce has argued that SOX is so complicated, it is forcing small and mid-size accounting firms out of the business.
This grumbling by corporate leaders and others would imply that the accounting mess that nearly caused a market collapse only two years ago was a vestige of the past. All indications are to the contrary. On June 22, William J. McDonough, head of the Public Company Accounting Oversight Board told Congress that the board's first cursory investigation of the accounting industry revealed "significant audit and accounting issues." Further, some 323 companies restated their earnings last year, nearly the same as in scandal-plagued 2002, which saw 330 restatements, according to the Boston-based Huron Consulting Group. In April, an administrative judge ruled that Ernst & Young LLP, one of the Big Four, exhibited "blatant" disregard and "utter disdain" for the new accounting rules, and proscribed it from taking new clients for six months.
It doesn't help that the accounting is highly consolidated. After the collapse of Arthur Andersen LLP in the wake of Enron, just four accounting firms now audit more than 78 percent of all U.S. public companies. Those companies, in turn, produce 99 percent of public company revenue in the United States. These recent trends are troubling, given that a recent Harris Poll found that 59 percent of investors believe SOX will help protect their investments.
Perhaps the real impact of SOX, and the reason big business chafes under its impositions, is that it changes the way upper management operates. Board meetings are no longer idle affairs to fit in between rounds of golf, but now require intense scrutiny of detailed auditing and financial regulations. It also redefines the roles of outside directors, previously elaborate yes-men for management, and forces them to renegotiate control of the company. "Most boards are a lot more active, but they're struggling with the question of where and where not to be engaged," David Nadler, chairman and chief executive of New York-based Mercer Delta Consulting told the Wall Street Journal.
The future of SOX may well be determined in the courtroom. Last fall, Richard Scrushy, founder and one-time CEO of the nation's largest healthcare provider, HealthSouth, was indicted on 85 criminal counts relating to a $2.7 billion accounting fraud. It was the first criminal indictment under SOX, and Scrushy's lawyers argued that terms such as "fairly presents" and "in all material respects" in Section 404 are unconstitutionally vague.
Meanwhile, in the largest private cause of action to date using SOX, a pair of pension funds, as well as legendary shareholder class action litigator William Lerach, are taking aim at Royal Dutch/ Shell Group for lowering its stated proven oil and natural gas reserves four times and by 23 percent since the end of 2002. Not only are the 27 directors of Shell named as defendants, so are their accounting and auditing firms, PricewaterhouseCoopers and KPMG International. The outcomes of both cases will be a bellwether determining if SOX has teeth, or is one more paper dragon.