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CHAPTER 1
Background
After reading this chapter, you will be able to:
- Understand the historical environment from which the Sarbanes-Oxley Act (SOX) was born.
- Understand the key principles in the development of the Act.
- Understand the role of the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) in SOX-related regulation development and enforcement.
Introduction
The Sarbanes-Oxley Act (Publication License No. 107-204, 116 Stat. 745) is a U.S. federal law that is known by several names, including:
- Public Company Accounting Reform and Investor Protection Act of 2002
- SOA
- SOX
- SarbOx
This law was created, in part, as a reaction to the corporate corruption scandals that occurred during the late 1990s and early 2000s. One of the primary objectives of the Act was to establish clear accounting and reporting practices for both the boards of publicly traded U.S. companies and public accounting firms. This was done in the hope of reinstating the trust of investors and the general public.
Essentially, SOX requires that every publicly traded company’s executive members evaluate and hold responsibility for the accuracy and completeness of all financial information that is released. This Act also requires that companies release information regarding those controls that are in place to ensure the accuracy of the financial information.
This chapter introduces the history of SOX and provides insight into the circumstances that resulted in its enactment.
Corporate Scandals
In the years surrounding the turn of the twenty-first century, several high-profile corporate scandals shook public trust. Insider trading, fraudulent financial records, and other deceitful incidents caused investors to question the integrity of the stock markets and their listed companies.
The poster children of this era include WorldCom, Enron, and Tyco International.1 The exploits of some of their key executives resulted in document manipulation to facilitate insider trades, hide debts, and inflate assets, in an effort to purposely mislead investors.
- WorldCom. As chief executive officer (CEO) of WorldCom, Bernard Ebbers was able to amass a large fortune during the 1990s. Ebbers used his stock holdings to finance personal ventures and further increase his assets. In the year 2000 WorldCom’s stock began its decline, and Ebbers was unable to cover his stock’s margin calls. To raise the funds Ebbers turned to WorldCom’s board of directors for loans and guarantees worth over $400 million.
Ebbers resigned from his position in mid-2002 after a federal probe began in April of that year into both his loans and WorldCom’s accounting practices. That June the SEC filed fraud charges against WorldCom, and on March 15, 2005, Ebbers was convicted on charges of fraud and conspiracy.
His legal conviction carried a sentence of 25 years in prison, which Ebbers is currently serving in a Louisiana federal prison. The former CEO has also agreed to civil lawsuit settlements that require the relinquishment of his assets.
Additionally, civil settlements also require Ebbers to issue financial restitution of $6 billion the investors that he defrauded. Although significant, this is relatively inconsequential when compared to the $180 billion lost by investors as a direct result of the WorldCom fraud.
- Enron scandal. As the United States’ seventh largest company, Enron once employed more than 21,000 people in over 40 countries. During its time on top, Enron was a major corporate competitor and held close ties with the White House.
In September 2006, Enron sold its last remaining business, Prisma International, thus completing its transition from industry leader to assetless corporation.
The company experienced its collapse as a direct result of corporate accounting fraud. In order to mislead investors and maintain its successful image, Enron manipulated its financial appearance by lying about profits and hiding debts.
Several Enron executives were convicted on charges related to fraud and conspiracy. For example, Andrew Fastow, chief financial officer (CFO), was sentenced to 10 years in prison and ordered to forfeit $24 million. Kenneth Lay, CEO, was also convicted and faced 45 years in prison after his conviction, but died before the sentence was handed down.
- Tyco International scandal. Tyco International’s CEO, Dennis Kozlowski, and CFO, Mark Swartz, were convicted on June 17, 2005, of stealing $600 million from the corporation. Their actions not only defrauded investors, but also directly resulted in the loss of several thousand jobs.
Unlike Enron and WorldCom, Tyco International has been able to persevere through the scandal. Although suffering severe financial setbacks, the company has rearranged assets, sold smaller businesses, and worked to regain the trust of investors.
Unfortunately, these are not the only scandals that scar corporate America’s past, although they are the ones that have received the most attention. These events created a collective sense of dishonesty and disregard for the rights of investors that has led to a breakdown of the trust that the public had for the U.S. markets and their company members.
Investor, Employee, and Public Trust
News of corporate corruption works to erode the trust of investors and employees whose resources are vital components of a company’s success. When a specific act of fraud or corruption occurs, the company feels the direct impact. However, corruption also creates a trickle-down effect whereby all companies in the economy suffer.
Investor trust in publicly traded companies is integral to the success of the trading system. Profiles of incidences of corporate scandal and investor deception serve to create investors’suspicion in all companies in which they invest. The collective result is that reasonable traders start to question whether their investments are being respected and whether they are being treated fairly. Essentially, shareholders can be abused only so many times before they start to become wary.
With enough occurrences of fraud, investors begin to invest more conservatively in order to protect their finances. Without investor activity, the U.S. stock markets would collapse and publicly traded companies would suffer. The result would be severe economic recession as seen in the Great Depression following the stock market crash of 1929.
In The Real World
Stock Exchange Crash in October 1929
We are all aware of the economic ramifications that the stock market crash of 1929 had on the United States and countries whose economy is directly linked to that of the United States.
After the reign of a bull market, the stocks of the New York Stock Exchange lost over 83% of their value between September 1929 and July 1932. This staggering collapse created unthinkable ramifications both nationally and abroad. Through this crash banks lost money, companies lost their fortunes, and the public lost not only their savings and jobs, but also their faith in the market. The result was the Great Depression, which plagued the economy for many years.
After the crash, members of the U.S. government agreed that part of their concerted effort to restore the health of the economy had to focus on reinstating people’s trust in the capital markets. They knew that unless citizens felt comfortable investing in the future of their country’s companies, industries, and markets would not recover.
This led to the creation of the Securities Act of 1933, which demanded that all publicly traded companies release their financial information to the public. Had such practices been established earlier, it is possible that the Great Depression would never have occurred.
The goal of the Securities Act was to make the investing process more transparent and eliminate the practice of insider trading. The overall objective was to provide investors with assurance that history would not repeat itself and that the stock market would be a safe place to invest.
As a vehicle for enforcing the Securities Act, the U.S. government also passed the Securities Exchange Act of 1934. This Act created the SEC and outlined the commission’s powers and goals.
The Securities Acts of the 1930s were effective in reassuring investors of the market’s safety, and the SEC is still a viable power within the corporate world. Yet since the 1930s, the landscape of corporate America has undergone major changes. Although still applicable and relevant, these earlier acts have lost some of their previous control.
Over the course of 70 years, the nature of business, the global markets, and the sophistication...
