Sarbanes Oxley 1 Arthur Anderson, Enron, Tyco, and WorldCom are just a few examples of public companies involved

in the biggest accounting scandals in the history of the United States. In the past, American investors expected CEOs and CFOs of large public companies to be honest, and that the auditors were diligent and did their job sincerely and truthfully. The American investors also thought that the federal government had rules and regulations that would insure that the financial statements of publicly traded companies were prepared fairly and could be relied on. The public also trusted that those individuals or corporations that did not follow these regulations would be caught and punished. For many years these assumptions seemed to be correct as it appeared that he Security and Exchange Commission had kept American businesses honest. However, as the gross accounting irregularities within companies such as Enron, WorldCom became known it seemed clear that the existing regulations could not protect the investor from unprincipled companies. As a consequence of these events, the US Congress passed the Sarbanes Oxley Act in 2002. Though Sarbanes Oxley has its benefits; it has also come under a lot of criticism by both Democrats and Republicans. Supporters say that it protects against corporate fraud while its detractors decry the costs which vastly exceed original estimates an claim it was nothing more than a hysterical reaction by congress to appear as if they were tough on businesses. In this paper I will attempt to review the benefits of the Sarbanes Oxley Act, its criticisms and the role it plays in ensuring a higher ethical standard for publicly traded American corporations.

Sarbanes Oxley 2 The Sarbanes Oxley Act was sponsored by Senator Paul Sarbanes (D-MD) and House of Representatives Michael G. Oxley (R-OH) and was designed to impose specific regulations on corporate governance gatekeepers, CEOs, CIOs, CFOs, and Legal Counsels for financial reporting of public companies. Sarbanes Oxley provided many provisions which included guidelines and oversight of accountants, stricter auditor regulations, greater corporate responsibility and accountability of CEOs and CFOs, and most importantly criminal penalties for major violations. The Sarbanes Oxley Act has 11 titles which provide information on what the company needs to abide by. In this paper I will focus on the four major titles of the Sarbanes Oxley Act which include Title II, III, IV, and VIII. The second section of The Sarbanes Oxley Act, Title II amends SEC Act of 1934 and serves to insure the independence of auditors. This section prohibits auditing firms from performing non-audit services for its clients for whom they performed an audit in the past 180 days. Additional regulations include conflict of interest in this title, where an audit firm cannot audit a client who employs a former employee of the audit firm that is now at a senior position in the company being audited. Title II also includes provisions that require the audit report to be presented directly to the audit committee of the board of the directors instead of to a person of interest in the company. (Grill, Bennet. 2009) Some of the regulations addressed in Article II were in response to the Arthur Anderson and Enron debacle. After Enrons fall, it was discovered that Enron was a very big customer for Arthur Anderson, and the chief account supervisor of more than 5 years, David Duncan, did everything he could to make sure that Enrons executive were kept satisfied. This was evident from the fact that Arthur Andersen earned $ 27 million in

Sarbanes Oxley 3 consulting fees and $25 million in accounting fees from Enron in 2000. This created a conflict for Arthur Andersons independence as an outside audit firm: the auditors were advising Enron what not to do, and the consultants were telling Enron how to override the auditors advice. (Earley, Christine E. 2004)

The absence of an audit committee at Enron created a lot of chaos and accountants conspired with the executives to create and enhance the financial reports. There were mutual benefits to Arthur Anderson and Enron as Arthur earned outrageous auditing and consulting fees while Enrons stock price soared because of falsified financial reports. Proponents of these regulations claim that if these regulations were in force to prevent these types of conflict of interest by the accounting or auditing firms, the Enron fiasco might not have happened. One of the criticisms for Title II of the bill is around auditors autonomy. Sarbanes Oxley is nothing more than just the restatement of the SEC rules, and it does not stop the audit firms from performing tax services for the client which might still weaken the accountants ability to be fair and independent. (Bansal, S Kandola. 2004) It also has enabled accounting firms to charge substantial fees for services because they are certified to perform these audits. According to a survey done by Kron/Ferry international Sarbanes-Oxley (SOX) compliance cost Fortune 500 companies and average of $5.1 Million increased in costs to be in compliance. Other studies have stated results that say that SOX has more than doubled the cost of being a public company. Another key title within Sarbanes Oxley talks about responsibility. Title III, mandates that the CEO and the CFO of the company certify and take personal responsibility for the accuracy of the financial reports. This act, specifically Section 304,

Sarbanes Oxley 4 asks for the CEO and CFO to forfeit their bonus or incentives received if the financial statements are found to be inaccurate and false.(Sapienza, A Vissing. 2009) During the scandals of the 2000s, the financial reports were investigated, and it was determined that there was massive fraud regarding how records were kept as well as how the value of the company was over-inflated.(Sapienza, A Vissing. 2009) One example is that the CEO and other executives of Waste Management fabricated earnings and cashed in by selling massive amount of shares. Another aspect to Title III, Section 306, is the blackout period which prohibits company executives from selling shares in the open market while employees are barred from selling or purchasing shares of the company through their retirement plan. During the Enron scandal, as the stock price tumbled, executives sold their shares of Enron in the open market; while the employees of Enron saw their retirement plan virtually disappear because they were in a blackout period.(Sapienza, A Vissing. 2009) One of the benefits of Article III has been that it has provided for appropriate measures so that the public knows about the health of the company and can hold executives responsible if they dont provide accuracy in the financial reports. (Braddock, CL. 2006) It has allowed for executives to be sued for misstatements about a companys health. However, there are people who criticize Article III stating that because of the conviction aspect of the law, it discourages risk taking and puts a halt on Entrepreneurship. (Lucci, JP. 2003) Another critical setback to Sarbanes Oxley was the acquittal of Richard M. Scrushy, HealthSouths CEO, whose list of charges included willfully certifying a securities filing in August 2002 that he knew to be fraudulent. This

Sarbanes Oxley 5 case was a very high profile loss for Sarbanes Oxley. (Jennings, MM. 2006) Article III has definitely setup appropriate measures for the rogue CEOs, however for law abiding CEOs, it can undermines the leadership of the executives and could affect the competitiveness of the company in the market. (Wegman. 2007) There are also arguments centered on the loss of civil liberties and the impact on due process. A CEO can be charged subjected to as much as 20 years in prison for inadvertent errors. It is possible under this act for a CEO to be charged because they failed to use the most current version of Windows. Because of this regulation it has been increasingly difficult and more expensive to hire highly skilled people for these positions. Costs are also increased because those employed in positions exposed to this liability require substantially more time to perform their duties so compensation had to be increased and these increases are substantial for the higher level corporate and board positions. One of the key issues that happened during the scandals of Enron and Tyco was how the financial information was reported to the public. Title IV puts stern regulations on public financial reporting and disclosures. (Rockness 2005) Within Title IV, Section 401, the bill asks for strict guidelines on how off-balance sheet transactions are reported. (Rockness 2005) Enron transferred its liabilities to newly created companies called Special Purpose Entities and sold its debt to the Special Purpose Entities as an asset to Enron, thereby creating fraudulent profits when there was only massive debt.(Healy. 2003) The idea behind this regulation was to make sure there was no wasteful spending of the corporate dollars and executives were not taking advantage of the conflict of interest that arose when they were able to loan themselves money from the corporation on

Sarbanes Oxley 6 favorable terms. This is what happened in the case of Dennis Kozlowski, former CEO of Tyco, where he received absolved loans and bonuses which were not disclosed to the shareholders of Tyco.(Shin, JY. 2005) On top of the extravagant loans, executives at Tyco including Dennis Kozlowski and finance chief, Mark Swartz, tainted the financials at Tyco and made away with almost half a billion dollars.(Brenner, R. 2005) Kozlowski was convicted and sentenced to a 8 1/3 to 25 year sentence in a New York prison for taking advantage of his position, defrauding investors, and pillaging Tyco of millions of dollars .(Brenner, R. 2005) One of the critical sections of Title IV is section 404. Section 404 requires companies to provide information on their internal financial controls and procedures as well as mandates that the auditors validate information in order to make sure that investors are more aware of the health of the company. Internal controls are not just about accounting, but even more importantly about the evaluation of companys risk assessment policies and its informational infrastructure. (Stephens, DO. 2005) Section 404 of the Sarbanes Oxley Act has been the most costly aspect of the act as it has increased audit, legal, consulting and other fees for a lot of public companies; (Carney, WJ. 2006) however companies have found it to be beneficial. The Chief Financial Officer for Staples used the compliance aspect of Sarbanes Oxley to get his company in order even though it was expensive, thus making Staples an improved company. (Taylor. 2006) On the contrary, Section 404 has caused a lot of problems as the costs of being a public company have increased 174 percent. As a result, according to Christian Leuz, a

Sarbanes Oxley 7 writer for The Journal of Accounting and Economics, around 20% of public companies are thinking of avoiding Sarbanes compliance by becoming private.( Leuz, C. 2007) The reason for this criticism is the cost involved for these companies for complying with Sarbanes Oxley is not proportionate between companies of different sizes. The costs associated with Sarbanes Oxley for a big company with revenue greater than $5 billion does not align with costs of a small company with revenue of around $150 million. (Leuz, C. 2007) Another criticism is that companies who can not afford to be compliant with Sarbanes Oxley are looking outside of the US to raise capital thereby reducing the strength of the overall US economy. (Zhang, 2007) After Sarbanes Oxley was enacted there was a large increase in the number of public companies that delisted. There also were reports that showed that many companies decided not to go public or decided to go public in a foreign exchange where the requirements were less costly. It is great to have different rules and regulations which discuss how the corporations should behave in order to protect the investor, but it is useless unless there are criminal penalties associated with it. Title VIII of Sarbanes Oxley, also known as the Corporate and Criminal Fraud Accountability act closes that gap. Section 802 adds criminal punishment for up to 20 years for anyone who destroys documents or falsifies records. It also adds punishment for the auditors and board members that includes fines up to $5 Million dollars per incident. Another aspect to Title VIII is section 806 which calls for protection for certain class of individuals who report the fraudulent activity to the right authorities. (Stephens, David. 2005) Before the Sarbanes Oxley Act, employers could fire an employee if they reported wrong doing within the company and employers

Sarbanes Oxley 8 knew how they could avoid being sued, however with the Sarbanes Oxley Act, there are protections for employees who discover fraud and report it to appropriate authorities. (Ribstein. 2002) Before the law, whistle-blowing employees were not fully protected, and there was no statute allowing for full compensation for employees who suffered injuries as part of the whistle-blowing process. With this law, if the employee is successful in winning the law suit, they are now entitled to back pay and potentially full reinstatement at their work. (Ribstein. 2005) Some of the criticism with title VIII is that the procedure for the bills cases is very slow, and the cases are going on longer than the mandated 180 days. The longer the case lingers, the livelihood of the whistleblower is compromised. Because of this, employees will not report the issue and hinder the Sarbanes Oxleys statute for encouraging whistleblowing. Another issue is that the statistics have shown that it is very difficult for a complainant to succeed at the initial stage of the Sarbanes Oxley proceedings. The win rate for employees under the Sarbanes Oxley Act has been very low, only two percent of the 286 cases resulted in a decision for the employee through May, 2006. (Ribstein. 2005) Since its inception, the Sarbanes Oxley law has drawn a lot of attention and discussion around its effectiveness. The regulations are certain to produce some benefits as it will lead to a higher probability that a publicly traded companys financial statements do not contain any material errors and can be relied upon. However, it is also clear that it has exerted a large cost on companies traded in the US markets.

Sarbanes Oxley 9 It was passed because executives did not act in an ethical fashion and some argued that something needed to be done while others argue that the actions of those executives was not legal before SOX was enacted. While compliance is clearly very costly and a larger burden to small companies it should be noted that in recent years, as more and more companies are adopting it, they are able to identify problems with their internal financial accounting system, and in response they are fixing the problems, lowering the operational cost and becoming more productive. (Leuz, C. 2007) The argument around companies going private and the US economy being affected is minimized by its supporters who claim these arguments are specious at best and a total lie a worst. According to some people, companies who are public get certain benefits, for example being able to raise capital, and have certain responsibilities to its investors to make sure they are investing in a company which is healthy and sound. (Leuz, C. 2007) However, the reality is that there has been a trend where companies increasingly choose foreign markets, and that US companies has to spend large amounts of money to stay incompliance with the regulations. Administrators of companies also have become more hesitant to take any risks for fear of falling out of compliance and subjecting themselves to devastating fines and penalties which can 20 years in jail. So once again both sides have valid arguments and no one can say that insuring that financial reporting it accurate and transparent is not a benefit but detractors would argue that the cost is just too great for the small incremental gains achieved by the act.

Sarbanes Oxley 10 There have been challenges with the Sarbanes Oxley Act because it was passed quickly as a response to the scandals that happened during that relatively short period of time and because of this too much of the energy has been focused on compliance rather than business growth. Some of the provisions within the Act have been unforeseeably expensive, and it is the responsibility of law makers to go back and review those provisions and fix them in order to increase the health of the American businesses. Over the past several months we have seen the value of homes and the investments of many Americans plummeted due to similar fraudulent activities. Due to the current sub-prime mortgage frenzy, it can be anticipated that there will be future revisions and additions of the Sarbanes Oxley Act in order to protect the American investors even further. The controversial nature of this Act is very likely to continue and with the failing economy the debate about the cost burdens placed on US companies will be raised to show how the act is hurting the US economy far more than it is helping. In May of 2009, the Supreme Court decided to hear a challenge to the constitutionality of the Act. This challenge that began in 2006 and was s defeated in a lower court but appealed to the Supreme Court. This clearly shows how divided and a resolute the differing sides are about this Act and given the fervor with which each side is arguing their case it is certain that the cost/benefit discussion is not likely to diminish in the near future. Consequently, there is no definitive answer to the question, are the benefits of this act worth the costs imposed on the companies required to comply with its provisions? Which also raises a more current and possibly more pressing question regarding what effect this is having on our economy?