Sarbanes-Oxley and Enron

Personally, I think you are insane to be a CEO or a board member of a public company under Sarbanes-Oxley.  There is no way I am going to sign a document on threat of prison that no one of the thousands of employees who work for me did anything to screw up the books.  Heck, I run a private company owned only by me where there is no incentive other than to report the numbers like they are, I sit next to my bookkeeper who is the only other one who touches the books, and I still find errors from time to time in past periods.

But what got me going on this post was a TV interview I tuned in the middle of last week.  I can't find a version online or even the name of the people interviewed, but the gist of the discussion was how Sarbanes-Oxley was going to prevent Enron-type situations that bankrupt investors.

I wonder how many people believe this?  Because Enron was going down, with or without the accounting shenanigans.  Its trading-based business model followed a life-cycle that should be familiar to anyone who has been in trading -- that is, they had unbelievable margins early on, but as others figured out what they were doing and duplicated it, the margins narrowed.  As trading margins narrow, the only way to maintain profits is to increase volume, leveraging up your capital into larger and larger trades at narrower and narrower spreads.  This volume strategy requires a very low cost of capital, which means low borrowing costs and a high stock price.  By hiding debt and losses in off-book subsidiaries, the Enron managers may have delayed the ultimate reckoning (by keeping equity prices high and its bond yields low), but the accounting games were not the cause of the failure.  In the same way, the march of long distance rates towards zero ultimately brought down Worldcom, not accounting.  In the latter case, if you borrow lots of money to buy long-distance companies, as Worldcom did,  assuming say 20 cent per minute long distance rates and then the rate goes to 5 cents, you are probably in trouble.

I am all for curbing the imperial CEO and giving shareholders and boards more power to police accounting and establish transparency.  I am not sure SarbOx does any of this.  My gut feel is that five years from now we will view SarbOx as more of an enabler for state attorney general self-promotion (as each races to try to prosecute some high-profile CEO for arcane accounting errors) and tort bar shenanigans.

I am honsetly curious, do any of you, as equity holders, feel better about your equities today with SarbOx than without it, especially given the added expense every company has had to take on?  It would be interesting to test the market's perceived value of SarbOx by allowing shareholders to vote to opt in or out of SarbOx.  Not only would their voting be interesting, but, if they opt out, it would be interesting to see if the stock price goes down (meaning SarbOx has perceived value) or up (meaning SarbOx is mostly perceived as extra regulatory expense).


  1. honestpartisan:

    You left out a pretty crucial component of Enron's collapse: self-dealing and lying. The most egregious example of that was Enron CFO Andrew Fastow's side deals with Enron. They hid the real losses Enron was enduring for the purposes of bolstering quarterly numbers and earned Fastow and his associates profits at the expense of the company he was supposed to be serving on behalf of the shareholders. And Enron's board was apprized of this, and had no problem with it! Holding the management of a publicly-traded corporation accountable is about stopping this kind of fraud, which I think should be pretty uncontroversial.

  2. honestpartisan:

    Sorry, on second read, I mis-commented -- you did mention the lying and self-dealing. But the point is not that Enron wouldn't have lost money. The point is whether shareholders and investors would have Enron's true financial picture revealed to them. The point is further that Enron shouldn't have been robbing its shareholders through the self-dealing.

  3. CT-GC:

    As a person who has done independent investigations for Boards in the past (so I've seen a little of the mindset of those who engage in accounting fraud) and who deals with reporting issues now, my sense of SarBox is:

    1) The new procedures companies have implemented as part of the required internal controls review will increase the accuracy of the financial statements of large companies on a micro-level -- that is, there will be fewer lost invoices, double-paid invoices and things of that nature. But those types of errors do not have a material effect on the financial results of a large company and fixing them will never repay the costs of compliance -- if the cost-benefit of doing so were positive, companies would have done so without a law.

    2) The increased focus on auditors will probably result in better accounting practices in some instances, preventing some errors in financial statements. But this will have a material effect on the financial results of only a few companies -- in no way offsetting the substantial increase in auditing fees over the market as a whole.

    3) Those who want to commit fraud will continue to do so. The reasons executives commit fraud have not changed. I really doubt those who were committing fraud in the past thought "well, if I get caught the only thing that will happen is I'll lose my job, all my money, and any chance of any future career, but at least I won't likely go to jail."

    SarBox is one more instance of Congress passing a law with absolutely no concept of what it actually means. The funny thing is, there is not a single federal agency -- including the Securities and Exchange Commission by its own admission -- who could come close to complying with SarBox. Yet the people who run these agencies face no risk of jail time (or probably even getting fired), no matter how grossly negligent they are in keeping their books.

  4. No name:

    I can't say anything official on this subject, but I've been invoved in SOX compliance work for 2 years, almost since the beginning. If you go back and look at the companies disclosing "material weaknesses" in their controls, nearly every one of them had a restatement of earnings. The market beat the crap out of them for the restatement (it adds an element of risk to holding their stock), but there was generally no additional hit to share price based on a bad SOX opinion. The SOX opinion carries no incremental information and thus no added benefit to the investor.

    The only benefits I see to SOX are:
    (1) It removes the "Sgt. Schultz" defense from senior management (although Scrushy got away with it). The certification by management alone would cover this, and do it cheaply.
    (2) It puts the surviving "Final 4" accounting firms on the hook for doing the job they should have been doing in the first place.

    Enron required the active participation of Arthur Andersen in setting up the special purpose entities used in hiding the off-balance sheet debt. Worldcom just needed Andersen to be incompetent. I mean, capitalizing expenses as assets? Hello? Is this supposed to be a new way of cheating? Or has it just disappeared from the curriculum since I went to my first accounting class?

    Until they force audit firm rotation on the big companies, a good bit of the risk is still there. SOX gave the auditors both a motive and a means of standing up to a sleazy CEO, but guess who still signs the checks?

  5. David:

    I normally post with my email and URL but just don't to take a chance as I work for a "Major Financial Institution" here in Phoenix. Not that what I have to say is career limiting.

    From my viewpoint the primary impact of S-Ox is to keep me employed. Both data security and auditing positions have been bolstered up to support this additional piece of govermental interference. Hell, I still trust big corporation more than the government.