When in July 2002 President George W. Bush signed the Sarbanes-Oxley (SOX) bill into law, he said that it would included "the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt." The SOX reforms were created to address the long-standing ethical and economic problems behind such scandals as Enron, Worldcom and Tyco.
In Senator Sarbanes's own words, the problems that led to the creation of SOX were "inadequate oversight of accountants, lack of auditor independence, weak corporate governance procedures, stock analysts' conflict of interests, inadequate disclosure provisions, and grossly inadequate funding of the Securities and Exchange Commission." These issues were identified after a series of Congressional hearings on the Enron, Worldcom and Tyco scandals (called the "Big Three Scandals") that unfolded between 2000 and 2002.
In a very real sense, Sarbanes-Oxley was created to reestablish confidence in the public markets, which was at an ebb in 2002. Trillions of dollars in market value were lost through the Big Three scandals that dominated the headlines. Investors had also been stung by stunning losses associated with the bursting of the Internet bubble. And, of course, in the wake of 9/11, the U.S. economy was facing a serious recession which the Federal Reserve was attempting to combat with historically very low interest rates. In this context, the Sarbanes-Oxley Act was a way Congress could appear on the right side of the corporate scandal issues while being seen to help the ailing economy.
Conflicts of Interest
One of the central issues identified by Senator Sarbanes was the conflict of interest that existed between auditing firms and the companies for which they also provided consulting services. A similar problem existed between stock analysts and investment banking firms that provide financing and merger assistance. Essentially, the auditors and analysts who were supposed to serve as neutral watchdogs over business had accepted lucrative service contracts from the companies they were supposed to monitor. Just a few years later, securities ratings companies were criticized for issuing AAA ratings on bonds backed by sub-prime mortgages in a similarly compromised set of arrangements.
Two major problems addressed by Sarbanes-Oxley were the responsibility, or lack thereof, on the part of executives for accounting malfeasance; and "perverse compensation incentives." These are monetary incentives that unduly influence the judgment of executives, or, which provide compensation disproportionate to success. Before SOX, executives had a defense of plausible deniability when accounting scandals unfolded, despite the fact that they were expected to know whether or not their financial statements were accurate. SOX ended this excuse by making executives responsible for accuracy at the risk of criminal penalties.
But, just five years after SOX, executive compensation was credited with encouraging banking companies to take the huge risks that led to several high profile bankruptcies and an industry-wide crisis. Given that some of the same types of problems the law was designed to correct were cited as causal factors only a few years later in the mortgage-backed securities crisis that rocked the global economy, the effectiveness of the reforms is questionable.
Inadequate funding of the SEC
The Securities and Exchange Commission (SEC), which was created in the wake of the stock market crash that preceded the Great Depression, is the primary agency responsible with enforcing securities laws. But inadequate funding made it impossible for the agency to be thorough, and reliance upon private civil suits to enforce smaller scale violations was explicit. After SOX, funding for the SEC nearly doubled, and its enforcement capability became more efficient. Still, when Bernard Madoff was finally convicted of massive securities fraud in 2009, it was revealed that the SEC had missed several easy and obvious opportunities to catch him earlier.