I. Introduction
Major efforts to regulate securities markets have historically been precipitated by sharp declines in stock prices accompanied by high-profile corporate scandals that pressure lawmakers to respond in order to restore market confidence. At first glance, the passage of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) easily fits this pattern. After it reached a peak in the spring of 2000, the stock market steadily fell as the internet bubble of the 1990s deflated. By the end of 2001, Enron, which tried to portray itself as a company that would capitalize on innovation to rapidly grow, filed for bankruptcy after major restatements of its financial statements. After WorldCom, a telecommunications company that tried to hide the decline of its business through a brazen accounting fraud, filed for bankruptcy in the summer of 2002, Congress quickly passed Sarbanes-Oxley and President Bush signed it into law.
Commentators have questioned whether Sarbanes-Oxley, which imposed mandates on all public companies over a certain size, was justified. If it was simply a political response to the high-profile collapse of a handful of companies led by executives with personal incentives to commit fraud, why should all public companies be required to implement its reforms? Because it increases the costs borne by all public companies, the burdens of Sarbanes-Oxley have continued to be controversial as the number of companies going public has declined.
This article argues that Sarbanes-Oxley cannot be understood solely as a response to the failures of Enron and WorldCom. While these two notorious scandals were the proximate cause of the law, the issues addressed by Sarbanes-Oxley were highlighted by the SEC years before the stock market collapsed.
The foundation for Sarbanes-Oxley was laid during the midst of the internet bubble that began to inflate during the mid-1990s. In a 1998 speech at NYU School of Law, SEC Chairman Arthur Levitt criticized what he called the “Numbers Game.” He argued that public companies were widely violating Generally Accepted Accounting Principles (GAAP) to meet quarterly projections of their earnings and revenue. Levitt’s speech was prompted, in part, by an initial string of major securities frauds that were uncovered over the latter half of the 1990s. These frauds at Cendant, Waste Management, and Sunbeam were later overshadowed by more notorious events, but they represented a first wave of securities frauds that occurred years before the passage of Sarbanes-Oxley.
Many of the accounting misrepresentations made by Enron and WorldCom were meant to meet projections that would enable these companies to maintain the illusion that earlier trajectories of their performance would continue. While auditors had conflicts of interest that prevented them from taking a firmer stance against questionable accounting, and executives had personal incentives to keep the price of their company’s stock high, the particular misstatements that were highlighted by these scandals were shaped by an environment where meeting short-term performance metrics had become more important. It is notable that, while the failures of gatekeepers and corrupting influence of executive compensation were widely discussed after the passage of Sarbanes-Oxley as drivers of public company securities fraud, Levitt’s “Numbers Game” speech did not mention conflicts of interest in the auditing profession or the shift to compensating executives with stock.
Sarbanes-Oxley addressed the pressure to meet projections in a variety of ways. Because public companies operate within an environment where short-term metrics are widely used to assess market value, structural measures to ensure the integrity of public reporting are necessary.
II. Two Waves of Accounting Fraud
Sarbanes-Oxley was not the result of a few isolated company failures. The Enron and WorldCom scandals were part of a second wave of securities fraud that was preceded several years before by a string of serious accounting transgressions by public companies. Even prior to Sarbanes-Oxley, the SEC had focused on combatting the “Numbers Game.” In doing so, it did not lobby Congress to act but instead encouraged the self-regulatory organizations that govern stock exchanges to pass measures to reduce the risk of accounting fraud. According to Levitt, earnings management was “a financial community problem” that could not be solved by a “government mandate.” Shortly before Enron restated its earnings, there was a sense by SEC officials that these efforts had resolved the problem of pervasive earnings misstatements by public companies.
Part of the reason that Sarbanes-Oxley relied on statutory mandates was that there had already been an effort to address the pressure to commit securities fraud through other measures. Sarbanes-Oxley reinforced and built upon rules that had been passed earlier by stock exchanges and the SEC. Even though these legislative efforts were somewhat redundant, they enhanced prior changes to better address the problem of public company securities fraud.
A. The Late 1990s Wave
Starting around the mid-1990s, public companies increasingly revealed significant accounting errors. These misstatements coincided with the increasing importance of meeting quarterly projections of financial performance. While projections became a common way of assessing corporate valuations by the 1960s, they were initially issued mainly with respect to annual results. By the 1980s, markets became more focused on evaluating shorter periods of performance and it became common for analysts to assess whether corporate results were consistent with quarterly projections. Corporations thus faced greater pressure to demonstrate revenue and earnings that met quarterly forecasts.
One way they did so was by improperly recognizing, in earlier periods, revenue that would be earned in later periods to meet or exceed a projection. By doing so, they created the impression that prior predictions of their earnings were sound and that their stock market valuation was warranted. One problem with this tactic was that it sacrificed future revenue so that it could be counted earlier. In future periods, the company would not only have to continue its normal trajectory of revenue growth, it would have to earn even more revenue to offset the revenue that had been shifted to an earlier period.
The SEC responded to these practices, in part, by clarifying its views of accounting rules. First, it tightened the concept of materiality, which shields companies from liability for misstatements that do not affect investor decisions, to make it clear that even small accounting errors can be important to investors if they permit a company to meet a projection. Before the SEC addressed the issue of materiality, auditors reportedly used a 5 percent rule where they did not view an accounting error as material if it impacted less than 5 percent of the revenue for a reporting period. The problem with this approach was that it permitted companies to use questionable accounting to produce just enough revenue to meet a projection. The SEC thus clarified that even small misstatements can be material if they affect investor perceptions of a company’s earnings trajectory. Second, it issued rules that clarified when revenue could be recognized by a company. These rules defined limits on the ability of companies to recognize revenue early to meet a projection.
In addition to viewing the “Numbers Game” as an accounting issue, SEC Chairman Arthur Levitt characterized the problem as an issue of corporate governance. In that speech at NYU School of Law, he contrasted a bad audit committee that met infrequently and rubber-stamped decisions with a good audit committee that met every month and was characterized by independent board members that asked tough questions of management. Just several months after this speech, a Blue Ribbon Committee formed by the New York Stock Exchange and National Association of Securities Dealers issued a report proposing that listed companies with a market capitalization over $200 million be required to have an audit committee composed solely of independent directors. This proposal and others were quickly adopted by the major exchanges, where the stock of the largest and most prominent public companies trade. The SEC also passed rules in late 1999 that required disclosure if a public company chose to include a non-independent member on an audit committee. In passing this regulation, the SEC referred to the “increasing pressure to meet earnings expectations” as necessitating “strong and effective audit committees” to “oversee[] and monitor[] management’s and the independent auditors’ participation in the financial reporting process.”
B. The Early 2000s Wave
Enron and WorldCom shattered the perception that prior regulatory efforts had resolved the problem of accounting fraud by public companies. Their misstatements were not minor efforts to tweak performance to meet projections. WorldCom brazenly moved billions of dollars of costs from its income statement to its balance sheet to offset its declining performance. Enron understated its liabilities by billions of dollars by moving them to Special Purpose Vehicles that it controlled. These two notorious examples were not the only multi-billion dollar accounting frauds during this period. Another notable case involved the iconic company Xerox, which moved billions of dollars of revenue to earlier periods in violation of GAAP to meet projections.
Rather than simply passing more accounting rules, Congress chose a broader approach. It set forth expectations with respect to the reliability of corporate internal controls over financial reporting that are meant to generally prevent material misstatements. Public companies had been required to have such controls since the 1970s, but there was no statutory mandate requiring them to assess and confirm their reliability. The most significant provision of Sarbanes-Oxley is the requirement that public company management periodically assess the company’s internal controls over financial reporting and that such assessments be verified by the company’s auditors. In doing so, it set forth a higher obligation for public companies to generally prevent material financial misstatements.
The law also addressed the perception that conflicts of interest by auditors made them less willing to stop questionable accounting practices. It prohibited the provision of certain types of non-auditing services by auditors, and it required periodic rotation of the lead audit partner for the auditor of an issuer.
In addition, Sarbanes-Oxley reinforced prior measures to increase the independence of audit committees. The law tightened independence requirements for audit committee members of companies listed on an exchange. For a director to be considered independent, the director may not accept any “consulting, advisory, or other compensatory fee” from the issuer or be affiliated with the issuer. The rule also clarified that the auditor must be selected by and report to the audit committee, which must be provided the resources to hire its own advisors.
III. Diagnosing the Problem
As noted earlier, one of the criticisms of Sarbanes-Oxley is that it was an overreaction to a few rogue executives who were incentivized to inflate the value of their company’s stock to increase their personal wealth. If that was the case, then costly regulation of all public companies may not have been warranted. Criminal or civil sanctions against the culpable individuals would instead have provided sufficient deterrence to prevent similar frauds going forward. On the other hand, if the incentive to commit securities fraud is more systemic, broader measures would be warranted. This part thus evaluates the major causes of the two waves of securities fraud that preceded the passage of the law.
The prevailing view is that the incentives of corporate managers to inflate their stock and the failure of auditors and boards to stop them were the primary problems addressed by Sarbanes-Oxley. But Sarbanes-Oxley did little to address corporate executive compensation. Moreover, while auditors and boards surely could have done more to prevent questionable accounting decisions, they are only secondary participants in the vast majority of public company frauds.
As I have argued at greater length in my prior work, the core cause of the securities frauds that preceded Sarbanes-Oxley was a shift in the way that investors valued public companies. As projections of quarterly performance became more important, corporations were pressured to meet such projections to prevent a precipitous adjustment to their stock price. This pressure to deliver short-term results distinguishes public from private companies. Sarbanes-Oxley’s efforts to ensure the integrity of financial statements of public companies was therefore an appropriate response to the realities of modern valuation.
While valuation considerations have been the driving force behind public company securities fraud, it is important to recognize that there are many causes of such frauds. A combination of individual and corporate incentives—facilitated by the failure of gatekeepers—likely was responsible for frauds like Enron and WorldCom. However, some causes are more fundamental. Without the pressure of projections, we likely would not have seen the same types of cases that became prevalent toward the end of the 1990s.
A. Executive Compensation
The conventional explanation for the securities frauds of the late 1990s and early 2000s is that they reflected the influence of executive compensation packages that shifted from salary to stock during the 1990s. Corporate managers had less incentive to deceive investors when their compensation was fixed and did not fluctuate based on market performance. As their interests became more aligned with shareholders, they had reason to issue misleading information to keep the stock price of their companies high.
A problem with this explanation is that, in order to clearly capitalize on a securities fraud before it is discovered, executives must sell their shares while the stock price is inflated. If managers pump up the stock with a fraud and unload their shares before the fraud is discovered, they would be acting in a way that furthers their personal interests at the expense of the other shareholders. There are cases where such pump-and-dump schemes have occurred, but many securities frauds are not accompanied by unusually significant sales of stock. Even when there are significant sales of stock by executives, it can be difficult to precisely link such sales with a fraud. Executives have many otherwise legitimate reasons to sell their shares.
Executives can still benefit from a higher stock price that is the result of a securities fraud even if they do not promptly sell their shares, but they take on the risk that, if the fraud is discovered, the stock price will fall. During the period of non-discovery, the interests of executives and shareholders would essentially be the same. Both parties benefit similarly from a temporarily inflated stock price and thus one should not place blame for the fraud solely on the executives.
Even if they had not been compensated with stock and options, corporate managers would have faced pressure to maintain their company’s stock price. If the market value of a corporation plummets, investors will call for the replacement of the management team. The company will be less able to access capital markets to fund new projects and growth. Moreover, a weak stock price will mean that the company will be more easily acquired and will also not be in a position to acquire other companies.
It is notable that Sarbanes-Oxley did little to regulate executive compensation practices. The clearest provision directed at securities fraud that enriches corporate managers was a provision that permits regulators to clawback bonuses, stock compensation, and trading gains linked to an “accounting restatement” that is a “result of misconduct” relating to noncompliance with securities law. In theory, such a clawback would reduce the incentive of executives to issue misleading information for their personal benefit. In practice, the SEC has not filed many cases under the clawback provision. The law also prohibited personal loans to corporate executives and directors. This provision was likely directed at the general perception that executives were wringing excessive rents from companies. However, such loans typically would not increase the incentive of managers to deceive investors.
B. Auditors
Another explanation for the securities frauds that motivated Sarbanes-Oxley was that the auditors had become too lax and permitted public companies to push the boundaries of accounting rules. Auditors’ sizeable consulting businesses gave them an incentive to please the public companies that they audited for fear that those clients would take their consulting business elsewhere. If they were more reliant on their auditing businesses for revenue, auditors would have been stricter in insisting on correct accounting. Perhaps a weak auditing profession emboldened public companies to increasingly use questionable accounting practices during the 1990s.
While auditors share part of the blame for the securities frauds that prompted Sarbanes-Oxley, in most cases, it is difficult to describe them as primary violators of the securities laws. A company’s auditor will rarely be the driving force behind a securities fraud. In some cases, an auditor may be a willing partner with management in permitting the publication of misleading financial statements. However, in other cases, the auditor may be deceived by managers who fabricate financial results. In most cases, auditors are balancing their professional obligations in good faith with the reality that they are serving a client in a context where the rules are not always entirely clear.
Even if they did not have consulting businesses, corporate auditors would have faced pressure by managers to permit accounting that allowed companies to meet their financial projections. It is thus unclear that auditors would have reacted differently to pressure from managers if they faced only losing that client’s auditing business. It is notable that a majority of the studies conducted prior to Sarbanes-Oxley did not find a correlation between the provision of nonaudit services and audit quality. Moreover, rather than eliminating consulting by public company auditors, Sarbanes-Oxley only limited it. Sarbanes-Oxley thus did not adopt the view that consulting inherently corrupts auditors’ decisions.
Stronger audits will certainly make it more difficult for corporate managers to commit securities fraud. However, even an ethical auditor can only do so much to prevent a public company from deceiving investors.
C. Corporate Governance
Securities fraud is often viewed as reflecting poor corporate governance. The failure of a public company in the wake of securities fraud is frequently linked to a board that was not sufficiently independent of corporate managers. Rather than question an overly rosy portrayal of the company’s business, the board may passively believe that a company’s disclosures accurately reflect reality.
Sarbanes-Oxley and other measures have thus pushed for more independence by boards. Rather than permit corporate executives to dominate boards, independent directors hopefully will check corporate fraud. An independent audit committee, for example, will help ensure that the auditors will be more directly accountable to the board rather than the corporate executives who may orchestrate an accounting fraud.
Even a vigorous board is limited in its ability to prevent securities fraud. Even if they are independent, board members suffer from an inherent informational disadvantage relative to corporate executives. It is difficult for any board to detect fraudulent practices that require direct knowledge of what is happening within the company. There will also be companies with boards that are not particularly independent where corporate executives do not commit fraud. Studies have generally not established a firm link between independent boards and firm value.
At best, better corporate governance might prevent securities fraud in certain circumstances. However, frauds can occur even when a board is diligent and independent. More independent boards would not remove the pressure on corporate executives to mislead investors.
D. Projections
Public companies misstate their financial statements to create a misleading appearance of their past and future performance. Because executives’ performance is judged by their ability to consistently meet projections of revenue and earnings, executives may resort to financial misstatement if they are in danger of reporting results that fall short of market expectations. By meeting projections, corporate managers can boost or maintain the value of their stock compensation. In a world without projections, auditors would face less pressure to accept questionable accounting decisions and corporate boards would have less need to monitor financial reporting.
Because projections were a fundamental driver of the securities frauds of the 1990s and early 2000s, it was essential for Sarbanes-Oxley to implement structural reforms that addressed the pressure to meet or exceed projections. Regulation of internal controls over financial reporting recognizes the need to ensure the accuracy of corporate disclosure in light of such pressure. Both executives and auditors are enlisted in this effort. Top managers are responsible for establishing effective internal controls and evaluating such controls. An auditor must attest to an annual report by corporate managers on their review of the company’s internal controls over financial reporting.
In contrast to efforts directed at individual wrongdoers, internal controls are a way to wire the plumbing of the corporation to reduce the likelihood of securities fraud. If such controls are successful, they will reduce the pressure on auditors to misstate earnings because the structure of such controls will prevent questionable changes in accounting policies. Executives with a personal incentive to meet projections will find it more difficult to misstate earnings when controls are effective. Controls will help assure boards that financial reporting is fairly accurate and will also inform boards of suspicious activities.
It is telling that the Public Company Accounting Oversight Board, which was created by Sarbanes-Oxley, highlighted projections in setting forth standards for assessing internal controls. It instructed auditors that such controls should focus on: (1) “significant, unusual transactions, particularly those that result in late or unusual journal entries”; (2) “journal entries and adjustments made in the period-end financial reporting process”; (3) “related party transactions”; (4) “significant management estimates”; and (5) “incentives for, and pressures on, management to falsify or inappropriately manage financial results.” Ideally, auditors will be aware of the pressure to meet projections and evaluate internal controls with respect to whether they prevent financial misstatements that create the false appearance a company is meeting market expectations.
IV. Did Sarbanes-Oxley Work?
Sarbanes-Oxley was a structural response to the pressure on public companies to meet corporate projections through financial misstatements. A number of developments suggest that financial misstatements have become less prevalent in public companies since they became obligated to comply with Sarbanes-Oxley. Whether or not the law was the reason for this improvement is unclear. At the same time, the pressure to meet quarterly projections continues and public companies have used a broader range of tactics to meet market expectations. Repealing or scaling back Sarbanes-Oxley reforms would risk an increase in accounting fraud.
The declining number of public companies that issue restatements of their financial statements is evidence that the quality of reporting has improved over the last two decades. The securities frauds of the late 1990s and early 2000s were accompanied by a surge in public company restatements. These corrections reflected the prevalence of aggressive accounting during this period as well as the scrutiny of such practices by the SEC. Restatements can provide the foundation for a securities fraud claim in that the company has conceded that it has made a material misstatement. Moreover, securities class actions that are directed at public company restatements are more likely to result in a settlement than securities class actions that do not involve a public company restatement. Since the passage of Sarbanes-Oxley, the number of public company restatements has substantially declined.
The decline in restatements may reflect that internal controls have improved and been effective, but it might also reflect more lax scrutiny of public company financial statements. As memories of the securities frauds from the 1990s and early 2000s have faded, perhaps auditors have become less vigilant in requiring corporations to issue corrections. If so, significant accounting errors may still lurk in financial reports.
Another measure of the frequency of accounting misstatements is the number of private securities class actions that allege an accounting error. Rather than look at a public company’s voluntary decision to admit an accounting mistake, allegations by plaintiffs who have an incentive to find accounting errors to support their claims of securities fraud are a measure of the prevalence of accounting misstatements. As evident from data on securities class actions filed from 1996 to 2019 summarized in the table below, the percentage of class actions alleging a violation of GAAP has steadily declined since 2002. Such decline may simply reflect fewer accounting restatements, but it is independent evidence that supports the claim that Sarbanes-Oxley has worked.
Securities Class Actions Alleging GAAP Violation
