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Is Sarbanes - Oxley Act a panacea? Comments

Amy Tailor   |   November 23, 2007
Are you familiar with the Enron story? You could not have possibly missed the scandal that has entailed a series of bankruptcies and resulted in modification of the US legislation.

Let me remind you that the Enron scandal was revealed in late 2001. The company�s management, having used unreliable and even phony reports, was making billions of dollars. With the help of the well-known auditing company Arthur Andersen, the Enron chief officers conceived the actual state of affairs from their investors. In addition, they intentionally amended their financial reports to boost the confidence of their stockholders and potential investors on the Wall Street. Finally, the Enron managers engaged in fraudulent activities involving the pension fund assets. Shortly before declaring bankruptcy, the Chief Executive Officer of Enron assured the employees that purchasing the company�s stocks was a safe and reliable way of allocation of pension fund assets. He assured them that the stock price would increase. In the meantime, he himself was selling his shares on the plea of covering loans in order to avoid reporting on insider trading. Altogether, twenty nine officers made $1.1 billion from illegal insider trading just before the company declared bankruptcy. At the same time the company�s pension fund lost its entire savings.

What did really happen? Why didn�t the government prevent this from happening? Prior to the Enron scandal, the Securities and Exchange Commission required that all public companies submitted their financial reports which were randomly selected and audited. In cases of any standard violations it would usually take appropriate actions against a certain corporation. However, a big flow of new companies to the stock market in early 2002 weakened control over the existing companies. Thus, in 2002 only 16% of all public companies were fully examined, while 53% didn�t audited by the Securities and Exchange Commission.

The case with Enron was not the only one in the US history, but unfortunately it caused more financial troubles than ever. However, the good side of it is that it brought changes to the legislation. As a result of the Enron scandal, the Securities and Exchange Commission has passed several acts to take a stricter control over company�s financial reports. The creation of these acts brought attention of the executive and legislative branches of the government. On July 30th, 2002, President George Bush signed Sarbanes-Oxley Act which brought very significant changes in legislation since the 1930s.

The SOX was signed to �protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes�. [Sarbanes - Oxley Act]. Pursuant to this act, any company that actively trades on the US stock market or intends to go public must comply with certain system of internal control while composing financial reports. The US government hopes to prevent another Enron. It has toughened the penalties �by striking to $1 million or imprisoned not more that 10 years� in case of false, but unintended misrepresentation and �inserting $5 million, or imprisoned not more than 20 years� in case of deliberate manipulation. In addition, the SOX dictates that the SEC must check financial reports of each company at least once every three years. It has the right to decline the Board of Directors candidates if it believes that the candidates are inconsistent with their positions. In addition, the Accounting Oversight Board was formed, which controls all accounting activities. This board is required to inspect the activities of all accounting and auditing companies which work with public enterprises. This is far from the end of the list of all modifications related to the SOX.

The government made a huge work in order to protect investors� interests. The Act seems to anticipate every possible fraud. Can we make any conclusions five years after the Act was signed? I think we can. Let�s turn to statistics. Despite the fact that the Sarbanes - Oxley Act is a bone lodged in issuers� throats, as they think, the compliance with this Act is too expensive. However, investors are happy about it. According to the Securities and Exchange Commission chief accountant, the number of registered ineffective mechanisms of internal control over financial report has decreased significantly. In the first year after the Act was passed, 15.8% of companies have detected such problems. Only a year later there have been only 6.25% of such companies.

Well, we should be thankful to the SOX that the level of fraudulent activities is on decline. However, the cost of complying with SOX acts impacts smaller companies disproportionately, as there is a significant fixed cost involved in completing the assessment. For example, during 2004, U.S. companies with revenues in excess of $5 billion spent only .06% of their revenues on SOX compliance. As opposed to smaller companies, with less than $100 million in revenues, which spent 2.55%. So in few years individual investors will not be able to buy stocks of small public companies, just blue chips. This situation may result in capital outflow from the USA. Can we afford this? What is better, a feather in the hand or a bird in the air? It�s up to the government to decide. All we can do is just avoid risking our money.
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