Taking A Bite Out of Enforcement

Corporate Research E-Letter No. 62, November-December  2006


By Philip Mattera

You’d expect now to be a time of humility and reticence for big business and its advocates. The wave of financial scandals that began with Enron five years ago shows no signs of receding, thanks to ongoing revelations about stock-option abuses. Corporate America’s Republican front men in Congress just received a resounding “thumpin’” in the mid-term elections. Fraud and mismanagement among U.S. contractors have exacerbated the mess in Iraq. Recent federal investigations have shown that major energy companies have not been properly paying royalties on the oil and natural gas they have extracted from public property. Former Enron CEO Jeffrey Skilling is starting his 24-year prison sentence for fraud and other offenses.

Whether out of denial of reality or brazenness, corporate interests are not on the defensive. Instead, they have been pursuing an aggressive campaign to weaken oversight of business by revising federal securities law and easing white-collar prosecution practices. Treasury Secretary Henry Paulson and business advocates such as the U.S. Chamber of Commerce are singing from the same hymnal, complaining that U.S. business is now overregulated and thus is suffering from a competitive disadvantage in world financial markets.

These efforts are already paying off. Just this week, the Department of Justice bowed to business pressure by announcing new restrictions on federal prosecutors handling cases against corporations. The next day, the Securities and Exchange Commission issued proposed new rules that would soften one of the key regulations enacted by Congress to prevent corporate fraud.

This deregulatory thrust would seem to be in conflict with plans by the new Democratic leaders in Congress to engage in tougher oversight of the private sector as well as the executive branch. It remains to be seen how tough that oversight will be, given that top Democrats have already endorsed some aspects of the corporate agenda. No matter who is in office, business always seems to be in power.


A major target of the new business offensive is the Sarbanes-Oxley Act, the law that was pushed through Congress in 2002 to enable the Republicans to claim that they were being tough on corporate misconduct in the wake of Enron, WorldCom and other business scandals. During that period, even corporate executives were preaching the gospel of stronger regulation. Paulson himself, then chief executive of Wall Street giant Goldman Sachs, gave a June 2002 speech at the National Press Club in which he offered his own ten-point plan.

Sarbanes-Oxley, which President Bush signed into law while declaring that “no boardroom in America is above or beyond the law,” raised penalties for securities fraud, required top managers to tighten internal financial controls and personally certify the accuracy of financial statements, barred special company loans to executives, toughened regulation of auditing firms, and increased the budget of the Securities and Exchange Commission (SEC) by 66 percent, among other provisions.

The ink was barely dry on Bush’s signature when his administration began issuing interpretations of the law that critics said were meant to weaken its impact. Soon thereafter, business lobbyists began shedding their reformist cloaks and warning of dire consequences—such as rampant shareholder litigation—that would supposedly result from Sarbanes-Oxley (known informally as SOX or SarbOx).

Outright opposition to SarbOx was slow in coming, in part because the SEC was slow in implementing the law. Months were lost amid a dispute over the choice of the head of an accounting industry oversight board—a dispute that led to the resignation of SEC chairman Harvey Pitt.

When Pitt’s successor, William Donaldson, adopted a more aggressive stance than expected, business began to mobilize. “CEOs are now coming out of their foxholes to fight back a fresh wave of reform,” Business Week wrote in early 2004. They began complaining that SarbOx compliance costs were too high, especially in connection with Section 404 of the law, which dealt with internal controls. Managers, it was claimed, were being distracted from their main responsibilities and were becoming too risk-averse. The same themes were soon being echoed by Treasury Secretary John Snow, who began speaking of the need for “balance,” an apparent code word for a rollback of SarbOx.


Rep. Ron Paul, a Texas Republican, did not hide behind a euphemism. In April 2005 he introduced legislation to repeal Section 404, declaring: “It’s time to make public what the business community already acknowledges privately: Sarbanes-Oxley is a disaster. Now that the Enron and WorldCom hysteria is over, it’s time to admit that Congress made a terrible mistake.”

Paul and other critics of SarbOx tended to overlook the fact that dozens of companies were reporting to the SEC that the reviews mandated by Section 404 had revealed that their internal controls were, in fact, not effective or were otherwise deficient, thus raising the risk of fraud.

Many firms were also forced to restate their financial results as a consequence of their reviews. Earlier this year, a tally by the research firm Glass Lewis found that restatements among U.S. public companies in 2005 had reached 1,195, nearly double that of the previous year. (Last month, the Acting Chief Accountant of the SEC said he expected the 2006 total to be even higher.) Glass Lewis argued that the restatements proved the value of Section 404, writing in its report: “It’s precisely because of the heightened auditing standards mandated by Sarbanes-Oxley that investors today are getting a true sense, finally, of just how much work remains to be done before they can feel confident about the accuracy of the financial statements prepared by corporate managers.”

The SarbOx bashers also ignored reports that some companies were finding Section 404 to be beneficial. In November 2005, Business Week wrote: “By forcing executives to dig deeper into how their companies get work done, Section 404 is enabling business to cut costs and boost productivity.” The magazine cited cases such as Pitney Bowes, whose 404-mandated review paved the way to the consolidation of four accounts-receivable offices and a savings of $500,000 in the first year alone.


Over the past year, SarbOx opponents have taken two new tacks. First, they have resorted to the old big business lobbying trick of making it sound as if what’s being advocated is mainly for the benefit of small business. The implication is that the risk of financial impropriety is not so great when it comes to public companies of modest size, while in fact they have historically been responsible for the vast majority of fraud cases.

The other gambit has been to sound the alarm about a supposed shift of new equity offerings to stock markets outside the United States. Critics claim that the prospect of complying with SarbOx is prompting some companies to conduct their initial public offerings (IPOs) in places such as London—or not to go public at all. Much has been made of the fact that 19 small U.S. firms listed on London’s Alternative Investment Market last year and that 24 of the 25 largest IPOs took place abroad. Rep. Tom Feeney, a Florida Republican, warned of “an outsourcing of America’s 100-year lead in capital formation.”

“SarBull!!! The Truth Behind IPO Imbalance” was the headline of an article in Financial Week last month that did a good job of dissecting the claims that Section 404 was driving new stock issues out of the country. The article noted that a third of the top IPOs involved former state-owned enterprises that would not be inclined to list in the U.S., whatever the regulatory situation. It was no surprise that China Construction Bank, the largest new issue of the year, chose the Hong Kong exchange. The magazine also pointed out that quite a few of the other new issuers were companies that had little or no business presence in the United States and thus could not expect much attention from domestic investors.

It is odd that business advocates who normally extol globalization adopt a nationalist position in this instance. It must be particularly amusing to the big Wall Street investment banks, which are depicted as losing out from the supposed flight of IPOs abroad, when in fact these same institutions operate in all the major foreign financial centers. If, for instance, Goldman Sachs—which just reported a 93 percent increase in quarterly profits—loses an IPO deal in New York it may very well gain one in Hong Kong or London. The Wall Street firms long ago realized that overseas financial markets were, quite apart from the U.S. regulatory climate, becoming more formidable.

These flaws in the arguments of the SarbOx bashers have not deterred their campaign. This fall, the effort went into overdrive. New public statements by Treasury Secretary Paulson on “excessive regulation” were followed by the publication of a report by the self-appointed Committee on Capital Markets Regulation, led by free marketeer Glenn Hubbard, former head of the Bush Administration’s Council of Economic Advisors and now Dean of the Columbia Business School. The report rehashed the IPO flight argument and recommended relaxed implementation of Section 404.

It remains unclear how the new Democratic leadership in Congress will handle the debate over Section 404 and other aspects of financial regulation. Already, some Democrats have joined the ranks of those raising questions about SarbOx. In November, Sen. Charles Schumer of New York joined New York City Mayor Michael Bloomberg (a Republican) in publishing an op-ed in the Wall Street Journal in which they warned of overregulation of financial markets and argued that SarbOx “needs to be re-examined.” Sen. John Kerry of Massachusetts, incoming chairman of the Committee on Small Business and Entrepreneurship, has made public statements on SarbOx that emphasize the need to “increase America’s competitive edge.”


Corporate America’s anti-SarbOx offensive is starting to pay dividends. On December 13 the SEC said it would issue new “interpretive guidance” regarding compliance with Section 404. The Commission did not give in to pressure to exempt smaller firms from the rule. Instead, it will allow companies of all sizes to use more discretion in deciding which kinds of internal controls are truly necessary to reduce the risk of fraud. As part of this, smaller firms would be able to “scale and tailor their evaluation methods and procedures to fit their own facts and circumstances.”

On its face, this sounds reasonable, but the question is whether this flexibility will encourage new financial shenanigans. There is also the risk that the SEC’s capitulation to corporate pressure will encourage business to seek further weakening of Section 404 or its elimination. The Commission has already indicated it is considering further relaxation of rules for “smaller” firms, which will include those with market capitalization as high as $700 million.

In another sign of business success, the Department of Justice has just announced a new set of guidelines for federal prosecutors pursuing cases against corporations. The rules were issued by Deputy Attorney General Paul J. McNulty, who acknowledged that they had been adopted “after careful review and numerous meetings with those in the business and legal communities who raised concerns about the Department’s [previous] guidance.” In other words, he caved in to business interests.

The new guidelines will restrict the ability of prosecutors to pressure companies under investigation to waive the confidentiality of their legal communications—a common technique in developing evidence against an executive suspected of fraud. McNulty also put strict limits on the ability of prosecutors to pressure companies to stop paying the legal fees of executives under investigation.

We are at a crossroads. The results of the mid-term election can be interpreted, among other things, as a rejection of the Republican Party’s slavish adherence to the desires of big business. The order of the day should be tougher oversight of business, yet corporate lobbyists are on the offensive and making headway. It is not surprising that the executive branch, still under Republican thrall, is going along. The question is whether the Democrats, now in control of Congress, will draw a line in the sand.