policy paper
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SARBANES -OXLEY – CONTEXT & THEORY:
MARKET FAILURE, INFORMATION ASYMMETRY &
THE CASE FOR REGULATION
Sean D. Jasso, Ph.D . © Journal of Academy of Business and Economics , Volume 9 (3) 2009 ISSN: 1542 -8710
ABSTRACT
On July 30, 2002, President George W. Bush signed into law the Sarbanes -Oxley Act of 2002, also
known as the Public Company Accounting Reform and Investor Protection Act of 2002. At the heart of
the Act is the mandate for corporate reform from the massive financial and leadership fraud of the late
1990s and early 2000s. This paper is part of a series of essays that attempts to look deep into the soul of
the Act not only evaluating the efficacy of the policy, but also to verify the heralding for a new dedication
to the ethical and moral boardr oom in the public corporation. The larger project consults legislative,
legal, historical, and philosophical primary and secondary research to confirm the big question, ‘Does
Good Behavior Pay Off?’ In this installment, I look to the Act itself recogniz ing that the literature on
Sarbanes -Oxley (SOX) to date has lacked the theoretical framework necessary for fully understanding its
public policy domain. The only consistent criticism on SOX from its inception has been from
management, economic, and politi cal scholarship predominantly targeting its financial impact upon the
corporation through its rigid compliance mandates. The primary objective here is to understand
Sarbanes -Oxley as public policy in response to market failure – that is, when the market s tops providing
efficient and ethical solutions to society.
Key words: Sarbanes -Oxley; Market Failure; Information Asymmetry; Public Policy Analysis;
Regulatory Environment; Benefits and Costs; Theory of Commerce; Ethics; Corporate
Governance.
1. INTROD UCTION
This paper addresses the questions how does the concept of market failure apply to ethical corporate
governance? Are corporate ethics authentic in the modern corporation or just lip service? Will Sarbanes -
Oxley achieve results? To attend to these questions the essay is organized in three sections. First, I
address the historical and philosophical context of the firm as depicted both by Aristotle and Adam Smith,
both leading thinkers on the concept of commerce and its impact on society. Second, I examine the issue
of market failure and information asymmetry, the theories guiding the reactive regulatory measures of
SOX attributed to corporate bad behavior. Third, I analyze the Sarbanes -Oxley Act from the perspective
of the policy analyst following the politics that designed the bill to the implementation agencies that
oversee its mandates.
The ultimate objective is to provide a better understanding of the regulatory connection between
government and the corporation. The guiding hypothesis is tha t Sarbanes -Oxley is effective legislation
implemented at the right time to not only protect the investor from corporate fraud and to force executives
to strengthen corporate ethical standards, but moreover, to solidify that the US market remains strong
and that it is not only open for business, but it is a safe place to work and invest. I argue that SOX is the
necessary policy tool to achieve these goals.
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2. ON THE THEORY OF COMMERCE
2.1 A Philosophical Analysis
As stated in the abstract, we look to the market for solutions such as products, services, jobs, and
investment opportunities. Why the market? The market in a capitalistic economy offers ownership of the
factors of production: traditionally land, labor, capital, resources, knowledge, and en trepreneurship. This
ownership is immensely personal, and through ownership, the capitalist is driven to sustain certain
freedoms associated with his independence and wealth maximization. In contrast to the capitalistic
system, a socialist system or the extreme of communism diminishes and eventually removes personal
ownership of market factors and transfers them to the government, whereby the government allocates the
production of the solutions described above. Ownership can be attributed to self -interes t, a guiding
theme in the discourse of commerce, trade, and the accumulation of wealth.
It is in fact, the self -interest theory that is at the root of the modern corporation – an institution that
personifies the American culture where the combination of entrepreneurship, capital investment,
commitment to quality and customer responsiveness has produced many of society’s great achievements
as well as its profound wealth. Unfortunately, self -interest has also contributed to some of society’s
greatest misf ortunes such as the unchecked market of the 1920s to the fraudulent and greed infested
corporation of the 1990s. Notwithstanding some of business’ unfavorable history, our teachers from
Aristotle to Adam Smith recognize that the enterprise is intended to be good for society. For example,
according to Calhoun, “…the function of business [or commerce] as ‘service’… [is] its aim as the
betterment of human life” (1926, p. 5). Here Calhoun is describing the ancient Greek concept of business
as a direct servi ce provider of improving the human condition from the products and services of trade,
commerce, and exchange. Often referred to as the father of the ‘self -interest’ ideal is Adam Smith, and
Morrow adds to the betterment theme and its connection to busines s describing,
The two main causes of the productivity of modern industry are the division of labor and the accumulation of capital. Self - interest is the explanation of both these key facts. The individual finds it more to his interest to exercise his st rength and develop his skill in one occupation and exchange the surplus of what he produces for the products of other men’s skill than to attempt to supply all his various needs by the labor of his own hands; hence the division of labor. Likewise, the acc umulation of capital: ‘The principle which prompts to save is the desire of bettering our condition, a desire which, though generally calm and dispassionate, comes with us from the womb and never leaves us until we go into the grave.’ Thus, by following h is own interest, as the individual sees it, he is furthering the progress of his neighbors and his nation toward wealth and prosperity…with Adam Smith, the material resources of the modern world, and the human traits which have created it, and attempts to determine under these conditions ‘wherein consists the happiness and perfection of a man, not only as an individual, but as a member of the family, and of the great society of mankind (1927, p. 327).
I highlight some of the older discussion pieces from th e early part of the 20 th Century primarily to illustrate
that the problems and opportunities associated with commerce are the themes of fairness and the
distribution of wealth, which, consequently, are themes business, government, and society contend with
today. For example, at the turn of the century Howerth asserts “the social question [of the present day] is
always a question of the many against the few, and manifests itself invariably in a struggle over some
form of institution; that is to say, a class struggle” (1906, p. 257).
Howerth is correct in his observation of such a struggle, given that class tiers are a fact of life one
hundred years after his publication. Nevertheless, another fact of life is that Adam Smith is often
misunderstood and the invisible hand theory among the self -interest theme is too often perceived as a
discouragement for the poor as well as an association with amoral domination of the elite few
monopolizing the acquisition of wealth. The fact is that Smith believed in the prom ise of business
exemplified by Harpham that “the call for a ‘system of natural liberty’ is not a rejection of the modern
commercial order and the economic growth that was an essential part of it; it is an affirmation of the
commercial order and a call to p lace future economic growth on more secure foundations” (1984, p. 768).
Smith would be content with the institutions that grow wealth among nations such as the Western banking
systems and their associated capital markets. Smith would also find pleasure i n the liberty associated
with the ongoing political trend of free trade, with its primary objective of satisfying a consumer driven 3
society. Smith would also find satisfaction from his initial inferences on capitalism that the institutions of
commerce hav e rigorous fiscal and monetary policy oversight on the stabilization of this sensitive, robust,
and resilient market of the modern day.
Indeed, a prosperous economy relies on another often criticized attribute of commerce: the maximization
of profit. Pro fit maximization, as the central focus for the firm is not immoral simply due to the fact that
profitability is a measurement of sustainability and growth potential. After all, growth expands demand,
requires more factors of productions such as labor, and often brings wealth opportunities to developing
communities. Nevertheless, profit maximization is also one of the central culprits in this discussion on
Sarbanes -Oxley, as greed of the owning and managing elite brings the corporation tumbling down along
with the many stakeholders who rely on the solutions the firm is meant to offer.
The interrelated characteristics of business and society are also the leading criticisms of business power
namely the theories described above – self -interest, the invisible hand, and profit maximization.
Additional theories include dominance models, where business as a dominant player is portrayed as the
most influential and powerful institution in society, in contrast to the pluralistic model, where business is in
balance w ith government and other social institutions (Steiner & Steiner, 2006, p. 13). These models are
helpful because they set the stage for the reality of the pre - and post -Sarbanes -Oxley era. We see the
1990s, especially the final years of the decade as well as the first years of the 2000s, as a boom era,
evidenced by significant technological innovation, exceptional economic growth, as well as a turnover in
American political leadership. Sadly, among all of this energy influencing the dynamics of business,
government, and society appears to be the germinating nucleus of immoral behavior – most directly in the
corporate boardrooms of large, publicly held corporations. Perhaps the most infamous scandal
associated with this stream of unethical activities is th e collapse of Enron Corporation. Enron has
become the epitome case study for teaching ethics – or more appropriately, the teaching of what ethics is
not. In the following section I describe the theoretical framework that characterizes the scandals
associ ated with Enron and the many others that shared the headlines. But first, some Enron statistics to
underscore the consequences of market failure and information asymmetry:
Bankruptcy facts: o 20,000 employees lost their jobs and health insurance o average se verance pay $4500 o top executives were paid bonuses totaling $55M In 2001: o Employees lost $1.2B in retirement funds o Retirees lost $2B in retirement funds o Enron’s top executives cashed in $116M in stock Criminal Charges o Guilty pleas: 15 o Convictions: 6 o Acquit tals: 1 o Pending cases: 11 Three California traders pled guilty to wire fraud Four Merrill Lynch executives pled guilty to fraud in the Nigerian Barge case Aug 23, 2000 stock hits high of $90 Nov 28, 2001 stock drops to $1 29,000 Arthur Andersen employees lost their jobs (Enron’s CPA firm) Enron shareholders suing Enron and their banks for $20B (Elkind & McLean, 2003).
3. PUBLIC POLICY THEORY OF SOX
3.1 A Framework for Corporate Bad Behavior
One of the guiding themes of this paper is the concept of the market as provider of solutions. It is a
competitive market, traditionally described as the economic environment of many buyers and sellers,
easy entry and exit for new and old firms, price taking as the standard pricing strategy, as well as the
measurem ent of economic success when marginal revenues are equal to marginal costs. Additional
assumptions and expectations of the competitive market include a level playing field for industries 4
competing for customers – customers who assume that they are privy t o all relevant information possible
for buying decision making as well as investment decisions for the capital consumer. As described above
in the Enron collapse, something that seemed so entirely right about this Fortune 15 Corporation was in
fact so pro foundly wrong. In the domain of economics and public policy, Enron represents a market
failure under the theory of information asymmetry . It is much easier, perhaps, to analyze a market or firm
that declines or fails because of outlying economic indicato rs – diminishing product demand, failure to
innovate, global competition, natural disaster to name a few. However, what is so morally frustrating, and
what drives the basis of this study, is that the root of the Enron collapse is simply, yet profoundly, b ad
behavior.
Recently, Hendry described the concept of market failure within the paradigm of the American
enterprise:
…even in America, for long the spiritual home of free enterprise and individual achievement, the values that drive that enterprise and a chievement have been called into question, as businesses have been treated with a degree of suspicion not seen for nearly a hundred years…Traditional moral principles still matter, and for some people and in some areas they still matter deeply. But for mo st people, in most areas of life, they are no longer the only or dominant consideration. Increasingly, it seems, we weigh our perceptions of moral duty and obligation against perceptions of our own legitimate self -interest (2004, p. 1).
The problem at it s most basic level is that somewhere along the road of success, a handful of corporate
executives let greed, risk, the thrill of deception, and the lure of excessive and secretive profitability
obscure their ethical guidance system. This paper does not lo ok closely into the soul of the person to
unveil this problem – I reserve this study for my other collection of essays on the future manager.
However, in order to understand more fully the nature of the problem of bad behavior and the regulatory
windfall by way of Sarbanes -Oxley, we must first examine the theoretical context of the public policy field.
3.2 Market Failure and Information Asymmetry
I refer to the traditional approaches to SOX from what is now the standard in the field - the text of Weimer
and Vining’s Policy Analysis: Concepts and Practice, 3 rd Ed. The authors approach the understanding of
government regulations such as SOX by analyzing the problem from the policy analyst’s standpoint – that
is, client -based. Weimer and Vining affirm, “th e product of policy analysis is advice… relevant to pub lic
decisions and informed by social values” (1999, p. 1). With regards to our problem of market failure and
SOX, Weimer and Vining say that policy analysts
...need a perspective for putting perceived social problems in context. When is it legitimate for government to intervene in private affairs? In the United States, the normative answer to this question has usually been based on the concept of market failure – a circumstance in which the pursuit o f private interest does not lead to an efficient use of society’s resources or a fair distribution of society’s goods [Additionally], analysts must have an understanding of political and organizational behavior to predict, and perhaps influence, the feasib ility of adoption and successful implementation of policies. Also, understanding the world views of clients and potential opponents enables the analyst to marshal evidence and arguments more effectively. [The analyst would ask] the basic question…when co nsidering any market failure why doesn’t the market allocate this particular good efficiently? The simplest approach to providing answers involves contrasting public goods with private goods (1999, pg. 74).
Public goods are identified as nonrivalrous in c onsumption and nonexcludable in use, or both – the
authors refer to the ocean or national defense as a public good. Private goods on the other hand, are
rivalrous in consumption and excludable in ownership use. The authors refer to shoes as private – you
purchased them and no one else except you will use/consume your pair of shoes unless of course you
transfer the ownership to another. With regards to the corporate scandals and the government response
through regulation, the situation pertaining to publi c goods might refer to the free information available to
the potential investor, such as a 10K report easily obtainable using online databases that specifically
publish the financial reports of public companies. With regards to the private goods associate d with the
corporate product, consider the private ownership of stock.
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Market failure is described as the pursuit of private interest (such as an investor or other stakeholder of a
corporation) that does not lead to an efficient use of society’s resources (exemplified by fraudulent use of
investor funds for illegal corporate and executive gain) (Dierkens, 1991). Other leaders in the public
policy field connect the issues of market failure to the concept of externalities permeating the consumer
and provide r relationship. Externalities such as information deficits enable competitive failures
(Bozeman, 2002). This information deficit, in the case of corporate fraud, is simply lying, cheating, and
stealing. Weimer and Vining put the information problem int o the theoretical context of information
asymmetry , in essence, the centerpiece for Sarbanes -Oxley:
Information is involved in market failure in at least two distinct ways. First, information itself has public good characteristics. Consumption of inform ation is nonrivalrous – one person’s consumption does not interfere with another’s; the relevant analytical question is primarily whether exclusion is or is not possible. Thus, in the public goods context, we are interested in the production and consumpti on of information itself. Second – and the subject of our discussion here there may be situations where the amount of information about the characteristics of a good varies in relevant ways across persons. The buyer and the seller in a market transaction , for example may have different information about the quality of the good being traded (1999, p. 107).
Within the scope of Enron and other similar scandals, the product and service being ‘traded’ here is not
simply shoes or bread or a used car for that m atter, but a multiple stakeholder, market centered product:
employment, 401Ks, money management accounts, investment banking and capital accounts – it is
assumed that all of these purchases involve fair information and that the exchange transpired between
corporation and stakeholder/investor in a way such that the money used is in good faith for the growth
and innovation of the firm. In the case of the corporate fraud of the late 1990s and the early 2000s, all of
these professional assumptions are in fact null and void, and the consequences are not simply market
failure, but the collapse of organizations, livelihoods, retirement funds, and, most importantly, the collapse
of investor confidence in the American capital market – a place that was traditionally a good place for
positive self -interest where buyers and sellers would grow capital, wealth, and the future.
4. THE SARBANES -OXLEY ACT – Costs, Politics, and Policy Implementation
4.1 Costs and Critics
The domain of market failure and information asymm etry is the groundwork for understanding Sarbanes -
Oxley’s impact on so many areas of the investment world. Here I focus on the criticisms of the bill’s
costs, followed by a case study describing the politics that influence the birth of the bill, and I con clude
with a theoretical and practical analysis of SOX’s implementation plan. If you were to look into the
historical aspects of SOX, you will generally find biased media related stories of the corporate fraud cases
of Enron, WorldCom, Tyco – these are th e big ones. In your search you would find feature articles
highlighting the crimes of the CEOs and CFOs – the millions of dollars embezzled or the millions of
dollars in phony deals, the customized balance sheets, and perhaps you would also read about the large -
scale cover -ups from accounting firms such as Arthur Andersen, a one -time valiant leading CPA firm
grounded in corporate ethics and social responsibility (in its founding years).
Amidst all of this bad news, which one might better understand the re ason for government intervention to
cure this problem, remain the critics of government that see corporate reform measures, such as the
Sarbanes -Oxley Act, as unfair, too costly, or an attack on profitability. In fact, the research on SOX is
predominantly critical of its costs and very soft on its benefits. For example, one recent dissertation
analyzing SOX asserts that the “loss in total market value around the most significant rulemaking events
amounts to $1.4T” (Zhang, 2005, p. 2). Costs and their rel ationship to profitability are indeed important to
the financial health of the firm and the evidence is clear from the growth in consulting firms, for example,
that have evolved to assist with the heavy compliance mandates of Section 404 (which I discuss i n detail
below) and the added staff and services required of public companies and the CPA firms who have also
added cost factors to respond to more demand via SOX. According to the co -author of the bill, Rep.
Michael Oxley, the “first -year costs of compli ance with the internal -controls requirements [are] less than
1% of total revenue” (Burns, 2004, p.2). Oxley appears to highlight the ‘less than’ but the reality is any
marginal cost to the firm has diminishing benefits over time. Observing the potential impact on Wal -Mart, 6
for example, if we look at recent published revenue reports for Wal -Mart Corporation, February 2006 total
sales were $25 billion. According to Oxley’s estimates, the cost of compliance at 1% of revenues is
approximately $250,000 additi onal dollars to W al -Mart’s February expenses. W al -Mart, America’s largest
retailer, produces over $300 billion in annual revenues, which means SOX is costing the firm no less than
$3 billion each year to comply with Sarbanes -Oxley (Wal -Mart). Certainly, Wal -Mart and other public
companies would enjoy the opportunity to spend this money on profit sharing (redistribution of wealth) or
on a number of capital investments targeted for growth.
However, like other regulatory mandates, such as laws implemented t o minimize or remove pollution as in
the Clean Air and Water Acts, these laws are costs to the firms in the form of taxes or permits. SOX, with
its clear mandate to reform corporate ethical behavior, is a tax -like cost that, like pollution control, is
int ended to help the greater good by increasing investor confidence through stronger transparency
requirements as well as strict punishments for executive fraudulent behavior. As with any regulation,
corporations are compelled to innovate their systems and p rocesses to reduce costs and stay
competitive. This will be the test of time for the new and mature corporations under Sarbanes -Oxley to
learn how to deal with this new cost initiative. The intrinsic value and hope, of course, is that both the firm
and i ts stakeholders bring ethics and corporate social responsibility to the forefront of the overarching
strategy and, most importantly, to the culture of the firm. Like pollution control, ethics control, for the next
generation anyway, is a regulated and a n ew reality.
4.2 Politics of Power – Business, Government, and Society
Sarbanes -Oxley is new to the world of business, and, like many forceful regulatory mandates, many
criticize the implications of why and how the law came into existence. History indica tes that corporate
fraud and its public policy components of market failure and information asymmetry requires some social
institution to cure the problem. When the market fails, society looks to government primarily for its ability
to create laws and all ocate resources on a broad national and global scale. There is little argument that
an Act of Congress is democracy in action to the best of the institution’s ability to respond to crises like
market failure. We see the Acts of Congress fueled by executi ve persuasion in the 1930s and 1960s, for
example, to move society out of economic depression with the responses to the market failure and the
Great Crash of 1929 as well as the social mandates in the 1960s for society to grow out of poverty and
civil righ ts ‘failure’. No matter how important the need for change may be, getting Congress and the
President to pass and sign legislation is intended by design to be no easy task and to be political. The
difficulties and opportunities lie in the politics – the s truggle for power, priorities, and positioning.
The theories that define the political milieu of the so -called ‘Enron era’ are few or nonexistent. Essentially
we have market failure attributed to fraud and investor deception. I would like to add a theor y for debate
as to why Sarbanes -Oxley was born, but first I refer to Belkaoui’s helpful overview of reactive public
policies attributed to the history of accounting, banking, and the financial markets of the United States and
their association with the ove rsight agency for these matters, the Securities and Exchange Commission
(SEC). Belkaoui writes,
The period between 1929 and 1933 saw a dramatic decline in stock prices, creating social upheaval and concern about the viability of the capital market system in the United States. More and better disclosure about corporate affairs was needed to allow for a better evaluation of the soundness of corporate endeavors. Congress intervened and passed the Securities Act of 1933 to require registration of new securi ties offered for public sales and the Securities Exchange Act of 1934 to require continuous reporting by publicly owned companies and registration of securities, security exchanges, and certain brokers and dealers. Both acts gave the Securities and Exchan ge Commission (SEC) the authority to protect the public interest by calling for the disclosure of adequate information when securities are exchanged or sold. Other acts were passed later to broaden and strengthen the responsibility of the SEC, namely (a) the Public Utility Holding Act of 1935, which requires registration of interstate holding companies covered by this law; (b) the Trust Indenture Act of 1939, which requires registration of trust indenture documents and supporting data; (c) the Investment C ompany Act of 1940, which requires registration of investment companies; (d) the Investment Advisors Act of 1940, which requires registration of investment advisers; (e) the Securities Investors Protection Act of 1970, which provides a fund through the Sec urities Investor Protection Corporation for the protection of investors; and (f) the Foreign Corrupt Practices of 1977, which governs questionable and illegal payments by U.S. corporations to foreign political officials and requires accurate and fair recor d-keeping and internal -control systems by all public companies (1985, p. 149). 7
According to my research, there is one element in the list of regulations above that receives very little
attention yet has a profound link to the bad behavior, most notably gr eed, attributed to the 1990s and
2000s problem we have been discussing. A brief case study of The Glass -Steagall Act of 1933 is a
probable window into the root of the problem and, ironically, it may be a combination of government
failure and market failur e
4.3 Glass -Steagall: A Brief Case Study and a New Theory for Understanding SOX
The following analysis is based on a personal interview with an anonymous money manager of a client -
based stock portfolio of several hundred million dollars in corporate stoc k. This source is credible
because this person is a long -time professional who worked directly with the players in the historical
overview that follows. Any element of bias attributed to the case study has been removed to the best of
my ability with hist orical fact checking against the equally biased, though not unavailable, media reporting
on the following events. In response to the market crash of 1929, Congress enacted The Banking Act of
1933 (also known as the Glass -Steagall Act), which essentially r esponded to the notion that commercial
banks, investment banks, and brokers should be separate industries to remove any conflict of interest.
Moreover, Glass -Steagall required the insurance companies to be separate industries – separated
primarily by non -interlocking boards of directors. History confirms that one of the theories behind the
Crash of 1929 and the depression that ensued was that these three industries were closely tied. The
Glass -Steagall Act, like many of its counterparts named by Belkaoui above, had remained the law of the
land since its inception. However, in 1999, Glass -Steagall is repealed, and it is the politics surrounding
this repeal that deserves careful examination.
In 1999, the repeal of the Act allowed insurance companies, comm ercial banks, and the investment
banking firms to come back together as conglomerate corporations. Three specific people were
instrumental in lobbying for the repeal: Sanford W eill of Citigroup, Chuck Prince (the lawyer for Citigroup
and W eill’s corporate counsel), and Alan Greenspan, the Chairman of the Federal Reserve Bank of the
United States. Greenspan, for example, thought that bringing these entities together would be a benefit
to the country because there would be cost savings and a better product for the consumer; the
competitive model had proven successful in Japan and Europe, where this togetherness is allowed.
Ironically, however, it is also in these foreign markets that rampant fraud is a problem in banking and
finance.
Why these men? W eill and Prince wanted to grow their conglomerate consisting of Citibank, Smith
Barney (their brokerage firm), and Travelers Insurance Co. (their insurance agency). The repeal of
Glass -Steagall allowed these three entities to come under one umbrella again thus providing similar
opportunities for potential corruption and fraud up to 1933. My personal interview with my source also
attributes bad behavior with another player, Jack Grubman, a renowned research analyst in the
telecommunications field and an employe e of Smith Barney. Grubman wrote voluminous reports on the
positive characteristics attributed to the reconnection of the three industries and, as a market analyst –
one whose recommendations money managers and Wall Street brokers rely upon in making deci sions for
clients – advised the investment world to buy telecommunications stock because they could under the
repeal.
Meanwhile, Grubman is attending the board meetings of WorldCom (no longer a conflict of interest under
the repeal) and in his attendance he is privy to inside information of the board at W orldCom.
Simultaneously, he is also making investment banking recommendations for WorldCom where Smith
Barney and Citibank will be the lending institutions to W orldCom. In fact, Citibank personally loans
money to WorldCom’s CEO Bernard Ebbers and also provides new issues of stock for clients at Smith
Barney to buy even though the WorldCom stock is plummeting all the way to becoming the largest
bankruptcy in American history. All along, Smith Barney is re ceiving commission income on stock sales
and Citibank and Smith Barney receive fees for investment banking all the while as WorldCom stock falls.
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The result of this reunion of companies due to the repeal of Glass -Steagall is a large income stream that
acc rues to Citigroup and to its subsidiary Smith Barney. Jack Grubman is fired and barred from the
securities industry for life and a $2 – 5 billion punitive settlement from Citigroup to the SEC ensues.
Additionally, W eill ends his 20 -year reign as CEO and Chairman of Citigroup and retires as chairman
emeritus. Chuck Prince, then the current CEO is named CEO and Chairman in April of 2006. This case
study is meant to provide an alternative, inside perspective of the events that are connected to corporate
ba d behavior. Are Weill and Prince and Greenspan bad people? Perhaps not. Are they law -abiding?
Indeed, they followed the law of the land – that is, the repeal of Glass -Steagall. We must look carefully at
the multiple players in the game during this tim e in history – Ebbers of WorldCom is going to jail for 85
years, Grubman must find an alternative industry to make a living, and millions of shareholders are still
recovering from their own financial losses. From the news, it looks like Weill and Prince a re doing all right
in retirement. But the ride from 1999 to the present has many consequences – some of which inspired
the Sarbanes -Oxley Act to protect the investor from aggressive, misguided perhaps, and downright
unethical corporate executives.
4.4 Sa rbanes -Oxley – A Public Policy Implementation Analysis
Having laid the theoretical public policy framework of market failure and information asymmetry as well as
providing an overview of the political sequences leading to the bill, I now look at SOX as a policy tool. To
best understand SOX for current and future management implications, we must examine the
implementation characteristics of Sarbanes -Oxley. The following analysis examines the legal domain
where Sarbanes -Oxley is codified and where it recei ves its administrative authority. I conclude my
analysis with a personal interview with two stakeholders on the receiving end of the bill and discuss their
first -hand assessment three years since passage of the Act.
4.5 The Legal Domain of Sarbanes -Oxley
A preface to the legislation is a brief commentary on where the law evolved. The law was formed by a
bipartisan effort of the U.S. Senate and House of Representatives. Specifically, the Senate Committee
on Banking, Housing, and Urban Affairs, at the ti me chaired by Senator Paul S. Sarbanes (D -MD), and
the House Committee on Financial Services, chaired by Congressman Michael G. Oxley (R -OH), are the
two congressional committees by design to manage market failures . The combined congressional
committees o versee the entire financial services industry, up to and including banking, insurance, and
securities. Consequently, it is Sarbanes and Oxley, by their current leadership of their committees, to
whom Congress, and the public for that matter, looks to addr ess the financial crises attributed to
corporate bad behavior in the early 2000s.
The Sarbanes -Oxley Act became law during the second session of the 107 th Congress on January 23,
2002 and was signed into law on July 30, 2002 by President George W. Bush. The law is officially named
The Public Company Accounting Reform and Investor Protection Act of 2002 (H.R. 3763, 2002), although
it is most recognized in the industry and by the government as The Sarbanes -Oxley Act or SOX. The law
is codified in U.S. Code at 15 USC Sec. 7201, Title 15 “Commerce and Trade”, Chapter 98 – Public
Company Accounting Reform and Corporate Responsibility (http://uscode.house.gov).
SOX has three primary authoritative bodies, beginning first with the Securities and Exchange Commiss ion
(SEC), whose primary function is to protect the buying and selling of securities. The laws governing the
SEC are described earlier, and after the Investment Advisers Act of 1940, the Sarbanes -Oxley Act of
2002 is the SEC’s most recent law it is charge d to oversee. In addition to the SEC, SOX has
implementation power by way of the U.S. Department of Justice whose primary function is to prosecute
the federal crimes associated with the Act such as “attempts or conspiracies to commit fraud, certifying
fal se financial statements, document destruction or tampering, and retaliating against corporate
whistleblowers” (Department of Justice). In partnership with the Attorney General, the Federal Bureau of
Investigation (FBI) is charged with the authority to inv estigate crimes associated with corporate fraud and
remains the primary detective agency to investigate and arrest corporate bad behavior. 9
I attribute the theoretical framework that best describes the policy process and implementation of laws
such as SOX to the work of Sabatier, who affirms that “the policy process requires looking at an
intergovernmental policy community or subsystem composed of bureaucrats, legislative personnel,
interest group leaders, researchers, and specialist reporters within a subs tantive policy area” (1991, p.
148). What the author recognizes is that the prescribed agencies noted above authorized to oversee
SOX have enormous governmental scope, and their unique agency cultures combined with their span of
control are important vari ables in the overarching successful and efficient implementation of the law. In
addition to Sabatier’s framework, Elmore’s theory of backward mapping asserts that “the closer one is to
the source of the problem, the greater is one’s ability to influence i t; and the problem -solving ability of
complex systems depends not on hierarchical control but on maximizing discretion at the point where the
problem is most immediate (1980, p. 605).” Both Sabatier and Elmore help provide the necessary theory
behind the successful implementation of public policy from the government’s perspective, primarily
pointing to the multiple layers of complexity of costs and benefits and politics associated with the entire
public policy process. To conclude, the multilayered policy process is best described by Simmons, Davis,
Chapman, and Sager as:
A sequential flow of interaction between governmental and non -governmental participants who discuss, argue about and find common grounds for agreeing on the scope and types of government al actions appropriate in dealing with a particular problem…The purpose here is to look beyond the decision nexus to the interaction involved in the policy process. Thus, attention centers on the psychology of the actors and the sociology of the groups (1 974, p. 458).
Noting Simmons’, et al. focus on ‘psychology of the actors’, the public policy process at all levels – design
through implementation – involves real people operating in a politically democratic and bureaucratic
domain. Consequently, policie s are imperfect, are managed by imperfect people, and manage imperfect
situations.
4.5 Sarbanes -Oxley: The Law & Comments from the Field
Like many laws, Sarbanes -Oxley must be read as a rule book thanks to the many mandates listed in the
bill. The follo wing summary highlights the bill’s most strenuous Titles as they apply to the response to the
problem of corporate bad behavior. I abridge the content for illustration purposes, but it is taken directly
from the language of H.R. 3763. The following are t he key components of SOX:
Title I: Public Company Accounting Oversight Board – reports to SEC o Oversees the audit of public companies o Establishes audit report rules and standards o Inspects, investigates, and enforces all compliance mandates o Empowers the Boa rd to impose disciplinary sanctions of neglect o Funds the Board through fees collected from issuers Title II: Auditor Independence o Prohibits auditors from performing alternative services (consulting) o Prohibits the auditor from being the lead for more than f ive years o Requires that creditors report to the audit committee Title III: Corporate Responsibility o Requires each member of the audit committee to me a member of the BOD o Instructs the SEC to require CEOs and CFOs to certify financial reports o CEO/CFO must f orfeit certain bonuses and compensation received if the company is required to make an accounting restatement due to the material non compliance of an issuer o Bans the trading by company directors and executive officers in a public company’s stock during pension fund blackouts Title IV: Enhanced Financial Disclosures * o Requires senior management and principal stockholders to disclose changes in the securities ownership Title V: Analysts Conflict of Interest o Restricts the ability of investment bankers to pre -approve research reports Title VIII: Corporate and Criminal Fraud Accountability o Imposes criminal penalties for knowingly destroying, altering, concealing, or falsifying records o Makes non -dischargeable in bankruptcy certain debts incurred in violation of s ecurities fraud laws 10
o Subjects to fine or imprisonment (up to 25 years) any person who knowingly defrauds shareholders of publicly traded companies Title IX: White Collar Crime Penalty Enhancements o Establishes penalties for mail fraud, violations of the Emp loyee Retirement Income Security Act of 1974, and establishes criminal liability for failure of corporate officers to certify financial reports (these crimes have penalties up to $500,000 and 20 years in prison) Title X: Corporate Tax Returns o Expresses the sense of the Senate that the Federal income tax return of a corporation should be signed by the CEO Title XI: Corporate Fraud Accountability o Authorizes SEC to seek injunction to freeze extraordinary payments earmarked for designated persons or corporate s taff under investigation for possible violations of Federal securities law o Increases penalties for violations of the Securities Act of 1934 to $25 million and up to 20 years in prison (H.R. 3763, 2002)
* It is in Title IV that the notorious Section 404 is located. Titled ‘Management Assessment of Internal
Controls, Section 404 is what the end user of SOX, that is, the corporation itself and its CPA firm, has the
most difficulty due to the compliance standards that essentially add the marginal costs to the firm. It is
also 404 that has given rise to compliance consulting firms to assist corporations prepare and manage
the regulations mandated in 404 and all of SOX as well.
4.6 Comments from the Field – An Interview with the Big Four and a CFO
In conjunct ion with the research program for this paper, I arranged a confidential personal interview with a
partner at one of the Big Four accounting firms (these include Deloitte, Touche, & Tohmatsu, Ernst &
Young, KPMG, and PricewaterhouseCoopers). Additionally, I arranged a confidential interview with a
CFO of a Fortune 15 company. My goal was to ask the first -hand implementers in the field and to learn
what type of impact SOX has had on the management of their organization. The following are the
questions and summary of the responses of my interviews.
4.7 Interview with a CFO of Fortune 15 Company (Transcribed Word -For -Word)
1. How has Sarbanes -Oxley impacted your company? Biggest impact is a greater awareness and ownership of business process owners [managers of functional departments] Appreciation for processes and controls – indeed a catalyst for positive change SOX is good for business for understanding how the business operates and for the consumer 2. What has been the most challenging issue to overcome pert aining to SOX? Organizations all have different starting points in compliance Also, some firms may be on different starting points with regards to all processes across the board. The more innovative and cutting edge a company is, the easier the company is able to adapt to large -scale regulations, mandates, etc. 3. What have been the most rewarding impacts regarding SOX compliance policies? A talent pool with better business judgment, more informed decisions to handle broader aspects of complexity 4. How would you rate (excellent, good, fair, none) the current corporate culture with regards to ethics across the many stakeholders of the company? Good. Transparency is key…frequent and candid communication…good process of [expediting] issues and problems through both the business and financial stream 5. Do you have a corporate code of ethics ? Indeed…we are a very regulated industry and codes are essential They are part of the culture – they are known and owned and held accountable Execs ‘walk the walk’ 6. What is you r opinion about recent reports that say the costs of SOX outweigh the benefits? Do you agree with this? 11
If efficient management processes are in place, then a firm should be able to handle such costs Indeed, the benefits outweigh the costs However, there are some firms in our industry that are not as innovative and ‘ready’ – hence, the costs are significantly higher Costs will eventually tale off and if processes are in place, control aspects will remain and the firm will be better for it 7. What does your company do to restore and build customer, employee, and investor confidence in your firm?
We rely on transparency and predictability elements in performance – we meet commitments with Wall St. – we share strategy – we communicate As for buyers and sellers – commitments on both sides of the supply chain and we are held accountable by way of getting or losing contracts based on ‘compliance’ commitments
8. How do you avoid an Enron?
Our culture eliminates bad apples – no one can stray from the pack Notes on Enro n – moral compass broken – short -term focus – confidence and courage element – team environment had a flawed level of integrity throughout the executive suite – all were bad apples
9. What is the future of SOX?
There could be a SOX II in the light of globaliz ation - we’re dealing with high risk countries such as India, China, Russia, etc., all having entirely different cultures of ethics. Hence, SOX II for global U.S. countries should be on the researcher’s list to investigate
Following this interview was an additional personal communication with a Big Four CPA Firm.
4.8 Interview with a CPA of a Big Four Accounting Firm (transcribed word -for -word)
1. How has Sarbanes -Oxley impacted your company?
Dramatically…the reality is that the accountants have become a regulated industry. Meaning the public accounting profession. Before, we were self - regulated, like banks. From a resourcing standpoint, it has been a public demand on the accounting profession – example, now ‘date certain’ is a tremendous impact on the Big Four to hire additional resources, foreign countries if necessary, train them and meet our responsibilities…resulted in walking away from high risk customers for Section 404 In the audit side, there is a tremendous increase in demand in the ‘attest’ bu siness and in the tax side has created a situation where management – a market shift from your audit firm in specialty practice from audit business and some of the work has gone to non Big Four It has raised the bar for quality on audits – documentation ha s improved noticeably – what gets measured gets done when you become regulated 2. What has been the most challenging issue to overcome pertaining to SOX? Resourcing and training has been the most challenging to meet the demand in a changing market place – highly technical people – experienced auditors not just staff auditors How this is accomplished – longer and harder hours – transfer of experienced people from international to domestic demand – firing of clients 3. What have been the most rewarding imp acts regarding SOX compliance policies? Most rewarding impact – auditing committees are more interested in your ‘voice’ – taking the audit more seriously today – audit committees are much more engaged and a more diligent to their fiduciary requirements – partners and staff are more engaged and the clients are more interested … hence, good for confidence to be restored 4. How would you rate (excellent, good, fair, none) the current corporate culture with regards to 'ethics' across the many stakeholders of the company? 12
Regarding the Big Four…the cost of failure has never been higher and clients are taking the tone at the top – did you ‘message’ ethics and communicate it enough Companies had ethics policies…now, the emphasis has become more front and center and is it positive Internally, with regards to ‘independence’ as an auditor the Big Four has become much more focused as issues have been identified as standards met around the world – the controls in place that SOX asserts are more intensely monitored and mo re focused 5. Do you have a corporate 'code of ethics'? Code of ethics – common sense – every quarter and attached to the independence confirmation is the code of ethics…example of independence…if a family friend of mine is on a board – I couldn’t receive a gift to mitigate a perception of confidence or appearance of impropriety 6. What is your opinion about recent reports that say the costs of SOX outweigh the benefits? Do you agree with this? From the perspective of the Big Four…yes. It has been very cost ly – regarding 404 – but most of the dialogue is dealing with 404. I think for smaller companies it’s harder – such as new IPOs with 0 to millions [in revenues] – SOX is a good thing, but when government makes it a law, the intentions are good, but the r amifications are not always cost effective – there are talks of exceptions on the horizon
5. CONCLUSION
5.1 Final Assessment of SOX and the New Corporation
This paper set out to address the following questions: how does the concept of market failure ap ply to
ethical corporate governance? Are corporate ethics authentic in the modern corporation or just lip
service? Will Sarbanes -Oxley achieve results? The methodological approaches to these questions have
varied from a traditional public policy analysis where I examined the theoretical framework associated
with the need for SOX, to modeling the implementation stream, to personal interviews with the end -user.
Nagel provided helpful groundwork for my own questions as he offers a list of standard methodol ogical
perspectives public policy analysts must ask. He specifically pushes the analyst to “draw a conclusion as
to which policy to adopt from information on goals, policies, and relations; to establish the relations
between policies and goals; and to det ermine what policies are available for adoption and what goals are
appropriate to consider” (1988, p. 8). I refer to Nagel here primarily because he helps shape the
overarching objective in any policy analysis by centering the study on goals – the goals o f the government
(remove market failure); the goals of business (maximize profitability); the goals of society (look to the
market for solutions).
The paper is centered on early and contemporary theories of commerce followed by a comprehensive
discussion of market failure and information asymmetry – the theoretical roots leading to the
government’s response to the failure of the corporation. I then provided an analysis from the broker’s
perspective asserting that the repeal of the Glass -Steagall Act was a catalyst for the ensuing bad
behavior among the returning industries under one corporate domain. My objective was to also
categorize the authoritative and agency -power from which SOX obtains its legal and implementation
direction. The multi -level implem entation stream requires several years of future data to more fully
analyze the results – results that will measure the efficient output by government as well as its presumed
ability to impact corporate behavior. In these early years of the law, I found t he final impact at the
implementation level is most notable by the personal interviews of the practitioners in the field, the CFO
and CPA. The goal was to determine if SOX will work and if it is good legislation. The final verdict from
the field suggests that the law has indeed brought accountability, service, and compliance to the front of
the line in the corporation. Moreover, it appears to have forced companies to innovate their systems to
become more ethically inclined, but also to reduce the costs o f compliance.
Based on my findings, I affirm that SOX is good legislation as a reactive policy responding to bad
corporate behavior. I predict that the future of SOX will be debated for several years to come, but that the
recovery from the Enron -era wi ll need these years to distance the memories of the era of fraud.
Additionally, I predict that SOX will evolve to stay relevant to the demands of investors and to the realities 13
of American and global commerce. Finally, SOX will provide the balance necess ary, even initially by
force, to find the mean – to find the intermediate of good corporate behavior. In forthcoming essays, I
look beyond Sarbanes -Oxley by first leaping back to one of the centerpieces of ethics in the philosophical
context of Aristotle and then leaping forward to examine the results of the future manager’s outlook on the
ethical frontier of what I call the New Corporation – that is, the corporation where Sarbanes -Oxley is no
longer new, but part of the long -term corporate culture.
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Dr. Sean D. Jasso is a professor of economics at the Graziadio School of Business and Management at
Pe pperdine University. He writes, consults, and teaches in the areas of political economy, world politics,
and business strategy. You may contact him at [email protected].
