The limitations of the Sarbanes-Oxley Act

USA Today (Society for the Advancement of Education), March, 2005 by Scott Green

POORLY DESIGNED corporate legislation can retard innovation and warp economic growth while good policy can create confidence in the capitalist system, encourage prudent risk-taking, and foster growth. Yet, even the most thoughtful and balanced legislation has its limitations. In the wake of unprecedented corporate failures due to managerial fraud, Congress passed the Sarbanes-Oxley Act of 2002 with the goal of rebuilding investor confidence and protecting capital markets. The recent recovery leaves little doubt that confidence has returned. However, whether the Act actually will protect financial markets by efficiently providing long-term deterrents to fraud at public companies is a valid topic of debate.

Executives who committed the numerous and exceptional frauds of 2001 and 2002 largely will be judged under laws existing prior to enactment of the Sarbanes-Oxley legislation. Regardless, Congress, in a nod to confidence-building, properly inserted additional governance and reporting safeguards into the Act. Certain requirements, such as executive certification of public company financial statements, are designed to ensure accountability for reported financial information. Congress also introduced mandates designed to improve the independence and financial competence of public boards of directors with a view towards better oversight of executive management. Still more legislative changes targeted the public accountants, attorneys, banking analysts, and other gatekeepers. The overriding goal was to provide better, more accurate information for investors by shining enough light on these companies to make massive financial reporting frauds harder to achieve without detection. Now the question becomes: Will this new legislation prevent a future crisis?

To understand the limitations of the Sarbanes-Oxley Act, it is helpful to be aware of what was in force prior to its adoption. After the stock market crash of 1929, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 to address perceived corporate abuse. A lack of transparency and fair dealing led Congress to pass these acts to regulate the securities markets. The markets previously were regulated by a patchwork of state laws that commonly were referred to as "blue sky" laws, many of which remain in place today. The 1933 Act was passed to meet two basic objectives: it requires that investors receive material information concerning securities being offered for public sale and it prohibits deceit, misrepresentations, and other fraud in the sale of securities. This legislation was designed to require issuers to disclose important information to investors so that they could make informed decisions. The theory is that greater public disclosure is bound to discourage bad behavior. As Supreme Court Justice Louis Brandeis stated, "Sunlight is the best disinfectant."

Congress also passed the Banking Act of 1933 to address harm caused by banks to the investing public. In short, the Act was designed to prevent banks from selling securities, thereby preventing them from peddling their soured investments to the public. There were certain sections of the Act, referred to as Glass-Steagall, which prohibited commercial banks from owning investment hanks and vice versa. For years, this was viewed as an overly broad approach to a specific problem, yet was not addressed until passage of the Gramm-Leach-Bliley Act of 1999.

The Securities Exchange Act of 1934 extended regulation to trading as well as securities already issued. The Act created the Securities and Exchange Commission (SEC) and empowered it with extensive regulatory authority over all aspects of the securities industry and markets. Additionally, the Act requires issuers to provide information to the marketplace by filing annual and quarterly reports. Finally, there are provisions that prohibit fraudulent activities that cheat investors.

In response to investment company abuses, Congress again acted to minimize conflicts of interest that arise in the operations of these companies. In 1940, the Investment Company Act and Investment Advisors Act were passed to regulate firms that exist primarily to invest in securities of other companies. Mutual funds are one type of investment firm covered. This legislation included vital anti-fraud provisions for all those who meet the definition of an investment advisor.

Despite previous legislation and Federal oversight, the savings and loan industry experienced a crisis in the late 1980s that led to even more regulation. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 was passed to "restore the public's confidence in the savings and loan industry." Deposit insurance and the system of oversight were restructured to reinforce the safety of deposits, and the Resolution Trust Corporation was created to dispose of the assets of failed institutions. Congress later added the Comprehensive Thrift and Bank Fraud Prosecution Act of 1990 to expand the authority of Federal regulators to combat financial fraud.