The Reasons for the Sarbanes Oxley Act
No single event precipitated enactment of the Sarbanes-Oxley Act. Rather, the comprehensive legislation was a response to several concurrent major corporate fraud, conflict of interest and accounting scandals that shook investors confidence in the viability and accountability of the corporate governance system as well as in the integrity of the nation's securities markets.
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Identification
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In 2002 Congress passed the Sarbanes-Oxley Act ("SOX"), known officially as the Public Company Accounting Reform and Corporate Responsibility Act, in order to bolster accounting, internal control and auditing standards at public corporations for the protection of investors. SOX established sweeping mandatory provisions to enhance corporate internal auditing and financial reporting control mechanisms so that fraud can be more easily detected.
History
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From 1999 to 2002, many shortcomings in the financial-reporting mechanisms at major publicly traded corporations led to the perpetration of fraud on a massive scale. The two most notorious instances of corporate malfeasance during this period occurred when the shares of two large, publicly traded companies, Enron and WorldCom, collapsed as a result of deliberate manipulation of the stock price by senior executives, buttressed by fraudulent and deceptive accounting practices. The collapse of each company's stock harmed not only shareholders, but the individual retirement accounts of many employees as well.
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Failure of Auditors to Discover Fraud
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Many highly respected accounting firms were implicated in these scandals for independently certifying financial statements that later turned out to be fraudulent and misleading. The abject failure to detect the manipulation of the financial records, as well as the failure to conduct an independent inquiry as to their accuracy, indicated that auditors relied unreasonably on the rosy, and unverifiable assumptions of senior management.
Accounting Firms' Conflicts of Interest
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Pre-SOX, it was not uncommon for some accounting firms responsible for certifying a company's financial statements to maintain lucrative nonauditing consulting contracts with the same company. These arrangements posed serious conflict of interest issues, leading many to assert that the fear of jeopardizing the consulting business could impair the ability of auditors to diligently and independently perform their duties in examining a company's financial statements for accuracy.
SOX eliminated this glaring conflict of interest by forbidding an auditing firm from securing any nonauditing business from the same company.
Captive Board of Directors
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A company's Board of Directors owes its shareholders a fiduciary duty of the utmost good faith and loyalty. As the Enron, WorldCom and other corporate debacles illustrated, many company Directors shirked their responsibilities and functioned as mere captives of senior management. Many failed to exercise their independent judgment, and failed to diligently oversee the actions of senior executives, particularly related to audit control mechanisms to insure the accuracy of financial reporting.
SOX now requires senior officers to personally attest to the accuracy of their company's financial statements.
Security Analysts' Conflicts of Interest
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Security analysts from many prominent investment banking firms played a significant role in the run-up of some of the Internet stocks during the pre-SOX period by issuing glowing recommendations, while failing to disclose that their employers had lucrative corporate finance deals with many of the same companies whose stocks they were recommending to investors.
SOX now requires securities analysts to disclose conflicts of interest associated with any stock they recommend to the public.
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