Q. What are the determinants of the structure of financial markets?

Describe the events

that led the US Govt pass the Sarbanes-Oxley Act of 2002 & Global legal settlement of

2002 specifically in the context of the financial system. How would these acts impact the
ability of firms to do business?

Ans:-The determinants of structure of financial markets are :-

1. Interest Ratio (ICR): It refers to number of time companies earnings before interest and
taxes (EBIT) cover the interest payment obligation. High IR means companies can have more
of borrowed fund securities whereas lower IR means less borrowed fund securities.
2. Debt Service Coverage Ratio (DSCR): It is one step ahead ICR, i.e., ICR covers the
obligation to pay back interest on debt but DSCR takes care of return of interest as well as
principal repayment. If DSCR is high then company can have more debt in capital structure
as high DSCR indicates ability of company to repay its debt but if DSCR is less then
company must avoid debt and depend upon equity capital only.
3. Cost of Debt: If firm can arrange borrowed fund at low rate of interest then it will prefer
more of debt as compared to equity.
4. Tax Rate: High end tax rate means companies prefer debt whereas at low tax rate we can
prefer equity in capital structure.
5. Risk Consideration: If firm’s business risk is low then it can raise more capital by issue of
debt securities whereas at the time of high business risk it should depend upon equity.
6. Regulatory Framework: Issues of shares and debentures have to be done within the SEBI
guidelines and for taking loans. If SEBI guidelines are easy then companies may prefer issue
of securities for additional capital whereas if monetary policies are more flexible then they
may go for more of loans.
7. Stock Market Condition: There are two main conditions of market, i.e., Boom condition.
Depending upon the market condition the investors may be more careful in their dealings.
During depression period in the market business is slow and investors also hesitate to take
risk so at this time.

Events that led the US Govt to pass the acts: -

The Sarbanes-Oxley Act was enacted on July 30, 2002 It is also known as the ‘Public Company
Accounting Reform and Investor Protection Act’ The main purpose of this act was to protect
investors by improving the accuracy and reliability of corporate disclosures made pursuant to
the securities laws, and for other purposes. This act was enacted as a result to a number of
corporate and accounting scandals including those affecting Enron, Tyco internationals,
Adelphia, Peregrine Systems, and WorldCom. The Securities Exchange Commission (SEC)
adopted many rules in order to implement the Sarbanes-Oxley Act. The Enron Scandal
escalated distrust amongst the shareholders, employees and government agencies. Thus, as a
result the Sarbanes-Oxley Act was passed to protect the interest of all affecting parties
The Enron Scandal resulted in a wave of new regulations and legislation designed to increase
the accuracy of financial reporting for publicly traded companies. The most important of
those measures, the Sarbanes-Oxley Act (2002), imposed harsh penalties for destroying,
altering, or fabricating financial records. The act also prohibited auditing firms from doing
any concurrent consulting business for the same clients.

Global Legal Settlement Act of 2002

The second policy arose out of a lawsuit brought by New York Attorney General Eliot
Spitzer against the ten largest investment banks (Bear Stearns, Credit Suisse First Boston,
Deutsche Bank, Goldman Sachs, J. P Morgan, Lehman Brothers, Merrill Lynch, Morgan
Stanley, Salomon Smith Barney, and UBS Warburg). Spitzer alleged that these firms allowed
their investment banking departments to have inappropriate influence over their research
analysts, thereby creating a conflict of interest. Therefore, a global agreement was made

The agreement includes these key elements

1) It requires investment banks to sever the links between research and securities
underwriting.

& It bans spinning.

2) The Global Legal Settlement has measures to improve the quality of information in
financial markets:

• It requires investment banks to make public their analysts' recommendations.

• It requires investment banks for a five-year period to contract with no fewer than three
independent research firms that would provide research to their brokerage customers.

Impact of these acts on ability to do business

The Sarbanes-Oxley Act imposes harsher punishment for obstructing justice, securities fraud,
mail fraud, and wire fraud. The act increased the maximum penalties for mail and wire fraud
from five to 20 years of prison time. Also, the Sarbanes-Oxley Act significantly increases
fines for public companies committing the same offense.

The costliest part of the Sarbanes-Oxley Act is Section 404, which requires public companies
to perform extensive internal control tests and include an internal control report with their
annual audits. Testing and documenting manual and automated controls in financial reporting
requires enormous effort and involvement of not only external accountants but also
experienced IT personnel. The compliance cost is especially burdensome for companies that
heavily rely on manual controls. The Sarbanes-Oxley Act has encouraged companies to make
their financial reporting more efficient, centralized and automated. Even so, some critics feel
all these controls make the Act expensive to comply with, distracting personnel from the
core business and discouraging growth.