FORUM COLUMN

By Mark Labaton

      Five years ago, in the wake of corporate accounting scandals that shook American markets and spooked investors, Congress passed the Sarbanes-Oxley Act, landmark securities law legislation to deter corporate fraud, protect investors and enhance confidence in U.S. capital markets.
      Leading up to the act's passage on July 30, 2002, Americans saw the demise of some of the country's largest corporations, including Enron and Worldcom, and investors collectively lost hundreds of millions of dollars because of stock fraud.
      Half of all American households invest in stocks listed on U.S. exchanges. For many of these investors, the frauds leading up to the act resulted in lost jobs and shattered dreams; the collapse of Enron alone resulted in 5,000 lost jobs, $1 billion in lost retirement savings and $40 billion lost to shareholders and bondholders.
      As a result, reform measures that previously would not have received serious consideration became law by a vote of 99-0 in the Senate and 423-3 in the House of Representatives. Since then, the act has largely accomplished its goals.
      By forbidding accounting firms from both auditing public companies and providing consulting services, the act ended a conflict that led to biased reporting of financial information.
      The act also lengthened the statute of limitations for some securities-fraud cases, increased Securities and Exchange Commission and U.S. Department of Justice funding to combat such fraud, added whistle-blower protections, outlawed insider "loans" and required the reporting of stock-options grants within two business days of their receipt - a change that has made it much harder to backdate these options grants.
      In addition, the act created the Public Company Accounting Oversight Board, a private-sector, nonprofit corporation with regulatory powers to "protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports."
      Accounting standards have improved, financial statements are more transparent, accurate and honest, multimillion-dollar corporate "loans" made with shareholder funds are no longer a problem and options-grant backdating has been sharply reduced (with most of the current cases based on pre-Sarbanes-Oxley conduct). In addition, the act has fostered better corporate governance, improved transparency and reduced corporate looting.
      Since the act, securities-fraud class actions have declined. According to the Stanford Securities Class Action Clearinghouse, although 497 cases were filed in 2001, only 116 were filed last year, and 55 have been filed so far this year, a decline partly attributable to the act, which required that public company CEOs and chief financial officers certify the accuracy of financial statements and mandated that companies adopt new audit procedures and controls to help detect and deter fraud.
      Does this signal an end to corporate crime? Hardly. Anyone who thinks corporate fraud will disappear because of the act fails to understand both history and human nature.
      Financial scandals occurred before Enron and Worldcom imploded, and they will continue as long as companies and individuals keep score by how much money they make, with little regard for the consequences.
      Indeed, since the act, the SEC has opened dozens of investigations relating to the backdating of options grants, and it recently formed a task force to investigate securities fraud in the subprime-lending industry.
      The better the economy, the shorter our memories. Yet, when markets or deals go sour, financial improprieties and fraudulent conduct are uncovered; problematic deals masked by a healthy economic climate unravel. This occurred in the 1980s with the savings and loan crisis. History might be repeating with the subprime-lending industry.
      Like other legislation, the act is an imperfect product of political compromises, with both limitations and critics: Some contend the act has done too little; others too much.
      Among the act's limitations are its failure to address the regulation of hedge funds, a source of trillions of dollars of executive compensation (even before the reporting of stock options) and the liability of "secondary actors" - lawyers, accountants, investment bankers and other gatekeepers in a position to enable or prevent fraud.
      On the other side, the conservative Free Enterprise Fund and an accounting firm being investigated for fraud jointly challenged the act's constitutionality. Although their effort failed in the U.S. District Court for the District of Columbia, these groups vow to press forward until their case is heard by the U.S. Supreme Court.
      Groups contending that the act imposes too costly a burden on public companies have focused their ire on the act's Section 404. This section gave federal regulators great discretion in implementing auditing standards that require company management to develop procedures to monitor and test internal controls for financial reporting. The purpose of these controls is to discover and root out accounting problems early on, thereby preventing fraudulent practices.
      On reviewing complaints from the act's critics and responding to political pressure, the SEC recently eased the internal auditing requirements for public companies with market capitalizations under $75 million.
      Investor groups, however, oppose these changes because of the prevalence of inaccurate financial statements for companies with market capitalizations under $75 million. Ten percent of public companies refiled their financial statements last year because of inaccuracies, with companies with a market capitalization of less than $75 million accounting for a disproportionate share of these financial restatements. Such companies are also less likely to carry sufficient insurance coverage for the consequence of fraudulent conduct than larger companies - a reason for greater scrutiny rather than less.
      Public companies with a market capitalization greater than $75 million also contend that complying with Section 404 costs too much. Ironically, such companies pay their CEOs more than $10 million a year on average without management balking, which is more than double the $3.8 million these companies pay to comply with Section 404 - a cost projected to decline significantly in the next few years as these companies continue to negotiate more favorable billing arrangements with their outside auditors.
      Rolling the act back further or gutting it would be a mistake. As Meyer Eisenberg, a law professor and former deputy general counsel of the SEC, recently told U.S. News and World Report, "if Sarbanes-Oxley went away, it would be a green light for the sharp operators to take advantage of the regulatory void."
      "And it would, in effect, be saying that we have collective amnesia and can't remember what happened three or four years ago and how many people were blindsided by the Enron, WorldCom and other scandals, which were the reasons for Sarbanes-Oxley in the first place," Eisenberg said.
      Five years ago, Congress enacted the act to protect investors, deter fraud and restore lost confidence in U.S. capital markets. It has done that.
      Almost 75 years earlier, Congress passed the landmark Securities Act of 1933 and the Securities Exchange Act of 1934. These two historic acts, passed in the wake of the Great Depression and vociferously opposed by Wall Street and other business interests, saved American capital markets. The Sarbanes-Oxley Act restored confidence in those markets, giving them another opportunity to flourish. Like a good cop on the beat, the act curbs corporate fraud. Sarbanes-Oxley mattered five years ago. It still matters today.
     
      Mark Labaton is a partner at Kreindler & Kreindler in Los Angeles, where he represents plaintiffs in securities, corporate governance, consumer and whistle-blower actions.