What troubled the public about Enron and WorldCom was not devious accounting per se, but the fact that these big businesses suddenly contracted or failed, injuring many workers and pensioners.
Bankruptcies and accounting scandals are distinct events. Most big corporate bankruptcies in the wake of the 2001 recession (such as Bethlehem Steel, K‐Mart, PSI Net and W.R. Grace) had nothing to do with accounting scandals. Most accusations of accounting scandal (at Tyco, Xerox, Rite Aid and AOL) had nothing to do with bankruptcy.
The bookkeeping obsession of Sarbanes‐Oxley might nonetheless be defended as helpful to stockholders were it not for the fact that investors saw through Enron and WorldCom’s exaggerated earnings and hidden debts long before accountants or federal regulators did.
The stock market shoved WorldCom stock below a dollar long before any accounting scandal was revealed; Enron stock fell 61 percent before that story broke. Besides, Sarbanes‐Oxley wisely contemplates discarding the same whimsical, indecipherable GAAP accounting rules it so sternly sanctified. Section 108(d) required the Securities and Exchange Commission to submit a study on “the length of time required for change from a rules‐based to a principles‐based financial reporting system” of the sensible sort used in Europe.
Sarbanes‐Oxley also required that the audit committee of every corporate board be comprised entirely of independent directors with no company experience, plus one financial expert who claims to grasp all 4,500 pages of GAAP. This “reform” likewise bore no relationship to the Enron scandal. The Enron board was 86 percent independent, chaired by a Stanford accounting professor and rated among the nation’s five best by Chief Executive magazine.
Although overpriced consultants and overvalued corporate activists invariably rank board “independence” among their favorite formulas for corporate governance, there is no evidence it works. A Hewitt table in Forbes last October awarded Warren Buffett’s Berkshire Hathaway a “D” grade for corporate governance (the Berkshire board includes too many people who know the business), while giving Fannie Mae an “A” grade. Yet Fannie Mae has lately been plagued with charges of massive accounting trickery.
Nearly half the pages of Sarbanes‐Oxley were devoted to creating a new Public Company Accounting Oversight Board to do what the SEC already had the authority and responsibility to do. The novelty is that, unlike the SEC, this uniquely well‐paid board must be dominated by people with no expertise in accounting. The only clear result, documented by the Washington Post in August 2003, has been that many overburdened mid‐sized accounting firms simply stopped auditing public companies.
Section 302(a) of Sarbanes‐Oxley manages to worsen a dubious certification ritual the SEC had already put in place. Prison sentences of up to 20 years were enacted for executives who “willfully” certify incorrectly that corporate reports have “fairly” presented financial conditions and results. This put CEOs in the position of nervous auditors — a job few CEOs are qualified to do — rather than general managers who delegate such specialized chores to experts.
Jeffrey Garten, dean of Yale’s School of Management, predicted that “CEO’s are going to become more risk‐averse and big investments on risky projects are going to be held back.”
Aside from inducing economic paralysis through CEO timidity, the certification provision’s only concrete result has been to greatly increase the cost of director and officer liability insurance. Shortly after the law took effect, The Economist reported that “D&O premiums have risen as much as seven‐fold” in tech, telecom, energy and finance.
One of the unintended consequences of making executives and directors more vulnerable to personal lawsuits and imprisonment has been difficulty in recruiting qualified people and (ironically) higher pay required to entice anyone to take on the added risk. A Burson‐Marsteller survey found that 54 percent of senior officers said they would refuse a promotion to CEO in 2002 (twice as many as the year before), even as 73 percent of CEOs said they were contemplating quitting. A study of Fortune 1000 firms by Axentis LLC found that compensation of outside directors jumped from $40,000 to $100,000. A study of mid‐sized firms by Foley & Lardner also found that directors’ fees doubled after Sarbanes‐Oxley, as did accounting, audit and legal fees.
Section 440 greatly increased reporting requirements for publicly traded firms, at a cost estimated at roughly $2 million dollars on average, and more for larger firms ($30 million at G.E.). When added to the increased expense of insuring officers and directors, the accounting cost of complying with Sarbanes‐Oxley has made it far more attractive to be a privately held company, rather than a company listed on any U.S. stock exchange.
A Wall Street Journal report last December noted that “the number of companies that delisted their common shares from stock exchanges nearly tripled in 2003, in part to avoid some of the regulations required by Sarbanes‐Oxley. … Some foreign companies have also either delisted or announced they are considering such a move.”
Delisting clearly injures U.S. exchanges and related financial industries. But a far more important consequence of encouraging public companies to go private (and discouraging private companies from going public) is that it leaves fewer profitable investment opportunities available to U.S. stockholders and private pensions.
When attempting to weigh these costs of Sarbanes‐Oxley against any benefits, the costs are relatively clear and quantifiable. The supposedly offsetting benefits usually come down to just one, as The Wall Street Journal repeated — namely, “restoring confidence in U.S. markets.” But how could a law that increases the cost and risk of doing business as a publicly traded U.S. corporation possibly improve profitability and stockholder returns?
In reality, stock prices tumbled badly after President Bush first supported the Sarbanes‐Oxley law in early July 2002, prompting Delaware Sen. Joe Biden to suggest the president could best soothe the market if he stopped making speeches. The market then continued to fall for nine months. Stocks were not falling in 2002 because confidence was down, but because earnings were down. Earnings per share among S&P 500 firms fell from 13.7 cents at the end of September 2000 to 3 cents at the end of 2002.
Their quixotic mission of cheering up investors meant Sarbanes‐Oxley supporters imagined the ratio of stock prices to earnings (the P-E ratio) was too low in mid‐2002. Yet based on earnings of the previous 12 months, the P-E ratio for the S&P 500 was above 37 on June 30, 2002 — a month before Sarbanes‐Oxley was passed — but fell sharply to 27.1 three months later. Stocks finally recovered in the last half of 2003, but only because the economy and earnings recovered.
The Sarbanes‐Oxley law was unnecessary, inadequate and harmful. It was unnecessary because the SEC already had the authority to do everything the law demands about accounting or corporate boards. Sarbanes‐Oxley was inadequate, if not irrelevant, because it failed to deal with any fundamental institutions, laws or incentives that might have contributed to major bankruptcies in the wake of the 2001 recession. The 1968 Williams Act has made it too difficult to take over mismanaged companies, for example. And higher tax rates on dividends before 2003 helped devious managers camouflage overstated earnings (companies can’t pay dividends with bogus earnings).
Sarbanes‐Oxley has proven harmful to the U.S. economy, and to the value of stocks still listed on U.S. exchanges, because it greatly increases the costs and risks of doing business as a publicly traded U.S. corporation and it increases the risks of serving as a director or officer. Sarbanes‐Oxley has essentially the same effect as a large but unpredictable increase in corporate taxes. Congress must at least lighten the heavy load of this ill‐considered regulatory tax, assuming insufficient humility and courage to repeal it. Even in politics it is generally wiser to admit mistakes and fix them than to fall into the familiar bad habit of assuming that good intentions excuse bad results.