On July 30, 2002, President George W. Bush signed the Sarbanes-Oxley Act (SOX) into law. SOX and the regulations passed by the Securities and Exchange Commission (SEC) pursuant to its mandate are the most dramatic and wide-ranging rules to apply to U.S. public companies since passage of New Deal–era financial legislation. SOX was passed in response to several corporate governance scandals involving improper financial reporting at U.S. companies such as Enron and Worldcom and remains a controversial piece of legislation.
All companies publicly raising funds in the United States must comply with SOX, whether the company is based in or does business in the United States. SOX seeks to increase the monitoring of U.S. public company managers by parties such as directors, auditors, and attorneys. SOX requires each director on the board’s audit committee to be independent, which means that the director can provide no other services to the company and cannot receive fees other than for serving as a director. SOX also requires the audit committee to include a financial expert. In addition, the New York Stock Exchange (NYSE) and the NASDAQ stock market, in response to SOX and a request by the SEC to review their corporate governance requirements for listed companies, enacted rules requiring a majority of the directors on a board to be independent.
SOX also prohibits external auditors from providing any nonaudit services to issuers and prohibits lead auditor partners from providing services to the same company for more than five years. SOX established the Public Company Accounting Oversight Board (PCAOB), which is responsible for overseeing, investigating, and disciplining auditors. The PCAOB also took over the role of promulgating auditing standards for external audits of public companies from the American Institute of Certified Public Accountants.
SOX imposed new duties on company managers to improve the financial reporting process. Section 404 of SOX mandates that managers maintain, evaluate, and report on internal control over financial reporting. Internal control is a system to provide reasonable assurance to investors that a company’s financial statements are reliable and comply with generally accepted accounting principles. Pursuant to Section 404, managers are responsible for completing an annual report about internal control that discloses any material weaknesses. An outside auditor must also provide an independent evaluation of management’s assessment of internal control.
Under SOX, top managers have a particularly heightened responsibility regarding internal control and financial reporting. SOX requires the chief executive and chief financial officers to annually certify the truth of the company’s financial and nonfinancial disclosures and publicly disclose any significant changes in internal controls. SOX also requires attorneys working for the company to report any violations of securities laws or breach of fiduciary duty up through the corporate hierarchy. In addition, SOX increased criminal liability for violations of the federal securities laws, enabled the SEC to prohibit persons from serving as directors and officers if they are found “unfit” to serve, and prohibited companies from making loans to directors or executive officers. The SEC also implemented regulations pursuant to SOX to reduce potential conflicts of interest between securities analysts, who provide third-party research about companies, and their employers, who may have investment banking or other relationships with the same companies.
The reaction to SOX was swift and is ongoing. What is indisputable is that the direct costs of complying with SOX have been substantial and that the burdens are the greatest for smaller public companies. According to Financial Executives International, in 2007 U.S. public companies spent an estimated average of $1.7 million and 11,000 man-hours complying with Section 404 alone. Supporters of SOX argue that despite its compliance costs, the law was necessary to improve financial reporting, restore investors’ confidence in American capital markets, and prevent the types of abuses that occurred at companies such as Enron and Worldcom, which could be more costly in the long run.
Critics of SOX have raised several objections. They point out that SOX was rushed through Congress with little deliberation and that it improperly increases the role of federal corporate governance mandates at the expense of flexible rules from the states. Controversy over SOX has also centered on whether the law’s “one-size-fits-all” prescriptions can universally improve governance given the diverse characteristics of U.S. public companies and whether SOX decreased the competitiveness of U.S. capital markets.
Evidence of public companies increasingly going private, staying private, or choosing to publicly list and raise capital in non-U.S. jurisdictions may indicate that SOX imposes more costs than benefits. Evidence that the U.S. cross-listing premium (the additional amount investors are willing to pay for public companies governed by U.S. law) has decreased post-SOX, at least for some types of companies, suggests that SOX made U.S. financial regulation less valuable. However, U.S. capital markets were already losing their competitive edge as non-U.S. jurisdictions have continued to develop, making the exact impact of SOX difficult to isolate. Some also argue that even if SOX made U.S. markets less attractive, it did so only for poorly governed firms.
The events leading up to SOX and its fallout undoubtedly increased global attention to corporate governance issues. Several nations such as Japan and Germany modeled reforms after SOX, while the United Kingdom (UK) took steps to prevent SOX from applying to UK-listed firms.
- Stephan M
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- Michael F. Holt, The Sarbanes-Oxley Act: Costs, Benefits and Business Impacts (CIMA Publishing, 2008);
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- Roberta Romano, “The Sarbanes-Oxley Act and the Making of Quack Corporate Governance,” Yale Law Journal (v.114/7, 2005);
- Babajide Wintoki, “Corporate Boards and Regulation: The Effect of the Sarbanes-Oxley Act and the Exchange Listing Requirements on Firm Value,” Journal of Corporate Finance (v.13/2–3, 2007).
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