Enron and the other major cases of corporate fraud resulted in a fundamental loss of trust in corporate leaders and the system of corporate governance, after investors lost what is conservatively estimated to be tens of billions of dollars in lost savings and investments.
Congress reacted by passing the Sarbanes-Oxley Accounting Reform Act, a modest law that did not address some of the many factors that led to the collapse of Enron and major problems at other companies, including deregulation of Energy, banking and telecommunications; the perverse incentives created by stock option-weighted compensation packages -- the "steroids of corporate greed"; tort reform laws like the Private Securities Litigation Act, which created an incentive for the market system's "gatekeepers" to aid and abet the fraud instead of protecting shareholders.
Nor did Congress do enough to protect shareholders. For instance, it did not support the Consumer and Shareholder Protection Association Act of 2002 (S. 3143), introduced by the late Senator Paul Wellstone -- one of his last acts in Congress.
Despite the Congress' limited response to Enron, just four years later, corporate CEOs and key lobbyists are brazenly urging Congress and the SEC to roll back Sarbanes-Oxley while attacking it in the courts.
The Full-Court Attack on Sarbanes-Oxley
On February 8, 2006, the Wall Street Journal reported that the Free Enterprise Fund, a right wing think tank established in 2005 by members of the Club for Growth, hired a team of lawyers including Kenneth Starr to help it file suit in the U.S. District Court in Washington against the Public Company Accounting Oversight Board (PCAOB), which was created by Sarbanes-Oxley, on the grounds that the PCAOB violates the appointments clause and separation of powers principles of the Constitution. (To see related documents, news articles, etc. go here).
Ken Starr, who once asserted that lawyers share the blame for the epidemic of corporate scandals witnessed since 2001, was himself a partner at Kirkland & Ellis, one of Enron's law firms. K&E has never been charged with contributing to Enron's collapse, and was dropped as a defendant from one of the class action lawsuits filed against Enron and other "aiders and abettors." But the lawyers at K&E did nothing to prevent the crimes at Enron that led to its collapse, either. (E.g., the Powers Report to Enron's board noted that K&E was the attorney for LJM1, one of the "special purpose entities" set up by Andrew Fastow to hide Enron's debt. K&E attorneys did not consult with Enron's counsel to determine if it was a "related-party transaction." Also see Ellen Pollack, "Lawyers for Enron Faulted its Deals, Didn’t Force Issue," in The Wall Street Journal, May 23, 2002)
The FEF lawsuit is the first constitutional challenge to be filed against Sarbanes-Oxley. Other corporate front groups have also been searching for a way to attack the law. For example, as part of its "Investor Protection Program," The Washington Legal Foundation has suggested that certain provisions in Sarbanes-Oxley are vulnerable to constitutional challenge, arguing that a motion filed in the case of former HealthSouth CEO Richard Scrushy "raises serious questions about the vagueness of one of Sarbanes-Oxley's key provisions," though they conclude that Scrushy is unlikely to prevail using this argument.
A Loaded Chamber
Among the industry groups leading the attack on Sarbanes-Oxley are the Chamber of Commerce -- now considered the most powerful lobby group in Washington, and the Business Roundtable -- an association of CEOs from 150 of the largest corporations in America. To signal the rising importance of this issue, in February 2006 the U.S. Chamber released a report criticizing Sarbanes-Oxley.
No Democracy in the "Ownership Society"
The Chamber and the Business Roundtable have mounted a campaign against shareholder rights ever since Sarbanes-Oxley was signed into law. In recent years, for instance, both opposed a proposal to allow shareholders to nominate their own candidates for the board.
In February 2005, shortly after it was reported that the SEC would not support shareholders at Halliburton and other companies (Qwest, Verizon and earlier, Disney) who sought to make the companies more accountable by nominating their own board candidates, SEC commissioner Donaldson told the press that the proposal had no chance of passing in its current form and would have to be rewritten. Investors criticized the decision as poor public policy. Chris Cox, the SEC's new chairman says he supports making proxy statements available online, but has not yet come out in support of the proxy access rule.
The Chamber of Commerce has not only opposed shareholders, but used shareholders' own money to lobby against their interests. According to a report by Public Citizen, Chamber of Commerce President Tom Donahue sat on the boards of two renegade companies while opposing corporate reforms. One of those companies -- Qwest -- topped Fortune magazine's list of the "greediest in America" (9/2/02). Qwest's ex-CEO Joseph Nacchio cashed out $226 million in options before the stock dropped in value by over 95 percent, forcing the company to lay off at least 13,000 workers. Nacchio was later indicted for insider trading. Before Donahue and his fellow board members finally pushed Nacchio out the door, they handed him a huge severance package worth $12.4 million, along with other benefits including "continued indemnification against liabilities and expenses incurred in any proceeding (to) which Nacchio is a party because of his service to us." According to Business Week (7/26), Donahue raked in at least $160,000/yr for serving on the boards of Qwest and Union Pacific.
Donahue also attacked shareholder activists at the California Public Employees' Retirement System (CalPERS), which had led efforts to curb CEO pay and rein in corporate tax dodgers. Donahue baited CalPERS as a front for organized labor in a piece published by the San Francisco Examiner. Shortly thereafter, Sean Harrigan, a labor representative on the board of CalPERS, was removed from his position. Donahue failed to mention that the Examiner is owned by Philip Anschutz - the former chair of Qwest's board, who cashed out $1.6 billion in Qwest options before the company's stock tanked.
Although President Bush said "no boardroom is above the law" when he signed Sarbanes-Oxley, few board members, have been charged for their inept behavior. Although directors at Enron and WorldCom paid a settlement for their role in those debacles, most directors, including Qwest's Donahue and Anschutz, have never been charged. Shareholders of companies that are members of the Chamber should ask company executives why they are giving the Chamber the company's money (in the form of dues) when that money is in turn being used to lobby against the shareholders' interests.
To learn more about the Chamber's efforts, be sure to see:
Executive Excess and the Options Expensing Rule
Another post-Enron attack on corporate reform has been waged by some corporate interests who have resisted a proposal by the government's independent accounting experts at the Financial Accounting Standards Board (FASB) that would force corporations to stop using accounting gimmickry to hide stock options from investors.
To learn more, see our page on CEO pay.
Section 404 and the Corporate Strategy to Roll Back Sarbanes-Oxley
On July 23, 2004 the Washington Post reported that corporate "lobbyists already are laying the groundwork" for a 2005 Sarbanes-Oxley "technical corrections" bill that they claim would unburden shareholders and small business owners. Despite the fact that Sarbanes-Oxley has "nipped a lot of accounting problems in the bud" (Business Week, Jan. 05), corporate leaders keep griping about the internal controls requirements. And while SEC is still debating the merits of their argument, whether or not they are right, the criticism will continue, because a strategic decision was made long ago to use it as a wedge issue in a broader attack on the law. For example, see the Chamber of Commerce's Report.
The corporate attacks on Sarbanes-Oxley have focused on section 404 - the so-called "internal controls" requirement. In order to fend off Congressional action and appear to take the issue seriously, the SEC announced that it would hold a roundtable on the topic in February 2005, a decision that was applauded by the American Business Conference, a Washington-based coalition of CEOs from midsize corporations. On February 16, 2006 the SEC and the PCAOB announced that a second joint roundtable on internal controls issues would be held on May 10th at the SEC's HQ in Washington DC.
Despite vociferous complaints that the implementation of Section 404 of Sarbanes-Oxley has imposed millions of dollars in increased compliance costs, an independent study conducted by CRA International, Inc. that was jointly commissioned for the Big Four accounting firms and released in December 2005, noted that the costs associated with Section 404 are projected to decline substantially in the second year of implementation.
There is also strong evidence that the internal control requirements are resulting in greater investor protections. For example, the number of financial restatements -- up to an estimated 1110 companies in 2005 -- are at an all-time high, an indication that the requirements are working, forcing companies to discover internal accounting problems that need correction. In addition, a Report of the prestigious Conference Board Commission on Public Trust recommended that ALL public companies be required to have adequate internal controls, and was very supportive of the certification and reporting requirements of SOX 404.
Moreover, while the assertion has been made that the rules are costing small companies a lot, in fact, the SEC granted companies with market capitalization of up to $75 million an extension until July 2007 to comply with the rule.
Section 404: More Links That Explain Why The Critics' Arguments Are Wrong:
WSJ story (10/05) explains how small companies can benefit from Section 404.
Other Sarbanes-Oxley Regulations Under Attack
In addition to these broader attacks on Sarbanes-Oxley, specific requirements of the law have been attacked before they have been allowed to be implemented.
Letting the Lawyers Off the Hook The SEC has failed to follow through on a proposal to require corporate attorneys to report any fraud they witness out to the SEC in the event that no action is taken by corporate executives or the board when they report suspected fraud. (The so-called "noisy-withdrawal rule.")
Instead of requiring corporate lawyers who observe possible fraud to alert the public via the SEC, the Commission voted to allow lawyers to keep such observations internal, even in cases where internal officers do nothing to correct the fraud. Given the absence of strong state-level professional standards for attorneys, the SEC should not drop its "noisy withdrawal" requirement in the rules, as it originally proposed. It's not clear that in cases where top executives are complicit or a company has an endemically corrupt culture as seemed to be the case at Enron that simply reporting the fraud to the company's lead lawyer or to a director would have been enough to prevent fraud.
Worse, the SEC softened the language of what counts as "evidence of material violation" worthy of reporting even internally. Instead of sticking to its original definition of a material breach as "information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring, or is about to occur," the SEC defined it as "credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur," a more difficult standard to prove.
Corporate lawyers have argued that such a requirement would turn them against their own clients, despite the fact that their primary responsibility is to represent the interests of all of the shareholders, not just corporate executives, as was explained to the SEC by a group of experts on professional ethics for attorneys.
Muzzling the Whistleblowers In January, the 1st U.S. Circuit Court of Appeals ruled in Carnero v. Boston Scientific Corp., No. 04-1801 that Sarbanes-Oxley whistleblower protections do not cover foreign workers employed by overseas subsidiaries of U.S. companies. The decision is a major potential blow against efforts to crack down on corporate bribery.
At the same time that the courts are making it harder for whistleblowers who report corporate fraud overseas, the SEC is proposing to make it easier for foreign companies with New York stock market listings to terminate expensive financial reporting obligations in the U.S. According to the Financial Times, "The Securities and Exchange Commission plans to make it easier for foreign companies to end their reporting duties...after European complaints about the costs stemming from the Sarbanes-Oxley law on accounting and corporate governance."
Another Attack on Investor Rights: The Mutual Fund Rule On September 3rd, the Wall Street Journal reported that the Chamber was suing the SEC "over a mutual-fund rule aimed at improving corporate governance in an industry tainted by recent insider-trading scandals."
Congressional Complicity in the Attacks on Corporate Reform
The corporate community is having no problem finding allies on the Hill willing to fight back against Sarbanes-Oxley. Vocal congressional opponents of the Act include Rep. Jeff Flake (R-AZ) and Rep. Ron Paul (R-TX), Both are floating legislation to either undermine or repeal completely Section 404.
According to Roll Call, Rep. Tom Feeney (R-Fla.) had to cancel a planned New York fundraiser in November 2005, after the official invitation explicitly linked the event to legislation attacking Sarbanes-Oxley. "Feeney has worked in recent months to make himself known as a Congressional point man on reforming the 2002 Sarbanes-Oxley corporate accountability measure, meeting with industry groups and planning a “listening tour” with Reps. Mark Kirk (R-Ill.) and Gregory Meeks (D-N.Y.) on ways to make the bill’s regulations more business-friendly." Feeney's fundraiser, billed as a “Sarbanes-Oxley Reform Fundraising Luncheon” invited guests to contribute $1,000 per person or $2,000 per political action committee to attend a “VIP photo-op reception” or a mere $250 per person and $500 per PAC to sit down and have lunch. Feeney told Roll Call that he had canceled the event because of the wording of the invitation, which he blamed on “an over-exuberant supporter who was trying to help.” Feeney and Kirk were the featured guests at a Capitol Hill Club policy luncheon on Sarbanes-Oxley sponsored by the U.S. Chamber of Commerce and The Financial Services Roundtable.
Is the Accounting Industry Still in Trouble?
After the collapse of Arthur Andersen, the concentration of the accounting industry into four firms has raised concerns that the collapse of another “Big Four” firm could cause “paralysis in financial markets.” The Big Four audit 97 percent of all public companies in America with sales over $250 million. Few industry observers believe that any of the next-largest firms could handle the kind of giant, multi-national accounts that the global accounting firms are equipped to service. Moreover, in the event that only three big accounting firms remained, it would be difficult for the client companies to juggle the relationships necessary to comply with conflict of interest rules.
Moreover the possibility that another big accounting firm might collapse is not out of the question. The Big Four accounting firms face an estimated $50 billion in outstanding claims, and have huge problems getting insurance, particularly against unpredictable “catastrophic” risk. (See "Called to Account—The Future of Auditing," THE ECONOMIST, Nov. 20, 2004)
In 2005, the industry acknowledged its perilous position when it signaled its intent to introduce a legislative limit on auditors’ liability. (See Andrew Parker, "Accountants Win Support on Limited Liability," FIN. TIMES, Jan. 16, 2005)
The firms’ precarious position and continuing conflicts of interest provide a significant basis for federalizing the auditing function. Rep. Dennis Kucinich (D-OH) proposed this kind of an approach to financial auditing problems in early 2002, before Andersen collapsed and Sarbanes-Oxley was completed. Kucinich’s bill would have created a Federal Financial Auditing Corporation responsible for auditing all publicly traded corporations.
Are Hedge Funds A Greater Threat?
Many corporate managers now see hedge funds as an even bigger threat than Sarbanes-Oxley. WSJ columnist Alan Murray (12/14) quoted Wall Street lawyer Martin Lipton advising his clients "against overreacting to Sarbanes-Oxley, and instead listed the No. 1 issue for directors as 'anticipating attacks by activist hedge funds seeking strategy changes by the company to boost the price of the stock.'"
To learn more about restoring investor rights go here.
Sarbanes-Oxley and Investor Rights: Related Links:
AFL-CIO Capital Stewardship Program