Sarbanes – Oxley Act

The Sarbanes–Oxley Act of 2002 (Pub.L. 107-204, 116 Stat. 745, enacted July 30, 2002), also

known as the 'Public Company Accounting Reform and Investor Protection Act' (in the Senate) and
'Corporate and Auditing Accountability and Responsibility Act' (in the House) and commonly
called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002,
which set new or enhanced standards for all U.S. public company boards, management and public
accounting firms. It is named after sponsors U.S. Senator Paul Sarbanes (D-MD) and U.S.
Representative Michael G. Oxley (R-OH).

The bill was enacted as a reaction to a number of major corporate and accounting scandals including
those affecting Enron, Tyco International, Adelphia,Peregrine Systems and WorldCom. These
scandals, which cost investors billions of dollars when the share prices of affected companies
collapsed, shook public confidence in the nation's securities markets.

It does not apply to privately held companies. The act contains 11 titles, or sections, ranging from
additional corporate board responsibilities to criminal penalties, and requires the Securities and
Exchange Commission (SEC) to implement rulings on requirements to comply with the new
law. Harvey Pitt, the 26th chairman of the Securities and Exchange Commission (SEC), led the SEC
in the adoption of dozens of rules to implement the Sarbanes–Oxley Act. It created a new, quasi-
public agency, the Public Company Accounting Oversight Board, or PCAOB, charged with
overseeing, regulating, inspecting and disciplining accounting firms in their roles as auditors of public
companies. The act also covers issues such as auditor independence, corporate governance,internal
control assessment, and enhanced financial disclosure.

The act was approved by the House by a vote of  421 in favor, 3 opposed, and 8 abstaining and by
the Senate with a vote of  99 in favor, 1 abstaining. President George W. Bush signed it into law,
stating it included "the most far-reaching reforms of American business practices since the time
of Franklin D. Roosevelt."

Debate continues over the perceived benefits and costs of SOX. Supporters contend the legislation
was necessary and has played a useful role in restoring public confidence in the nation's capital
markets by, among other things, strengthening corporate accounting controls. Opponents of the bill
claim it has reduced America's international competitive edge against foreign financial service
providers, saying SOX has introduced an overly complex regulatory environment into U.S. financial
markets. Proponents of the measure say that SOX has been a "godsend" for improving the
confidence of fund managers and other investors with regard to the veracity of corporate financial
statements.
Outline:
Sarbanes–Oxley contains 11 titles that describe specific mandates and requirements for financial
reporting. Each title consists of several sections, summarized below.

1. Public Company Accounting Oversight Board (PCAOB)

Title I consists of nine sections and establishes the Public Company Accounting Oversight
Board, to provide independent oversight of public accounting firms providing audit services
("auditors"). It also creates a central oversight board tasked with registering auditors, defining
the specific processes and procedures for compliance audits, inspecting and policing conduct
and quality control, and enforcing compliance with the specific mandates of SOX.

2. Auditor Independence

Title II consists of nine sections and establishes standards for external auditor independence,
to limit conflicts of interest. It also addresses new auditor approval requirements, audit partner
rotation, and auditor reporting requirements. It restricts auditing companies from providing
non-audit services (e.g., consulting) for the same clients.

3. Corporate Responsibility

Title III consists of eight sections and mandates that senior executives take individual
responsibility for the accuracy and completeness of corporate financial reports. It defines the
interaction of external auditors and corporate audit committees, and specifies the
responsibility of corporate officers for the accuracy and validity of corporate financial reports.
It enumerates specific limits on the behaviors of corporate officers and describes specific
forfeitures of benefits and civil penalties for non-compliance. For example, Section 302
requires that the company's "principal officers" (typically the Chief Executive Officer and Chief
Financial Officer) certify and approve the integrity of their company financial reports quarterly

4. Enhanced Financial Disclosures

Title IV consists of nine sections. It describes enhanced reporting requirements for financial
transactions, including off-balance-sheet transactions, pro-forma figures and stock
transactions of corporate officers. It requires internal controls for assuring the accuracy of
financial reports and disclosures, and mandates both audits and reports on those controls. It
also requires timely reporting of material changes in financial condition and specific enhanced
reviews by the SEC or its agents of corporate reports.

5. Analyst Conflicts of Interest

Title V consists of only one section, which includes measures designed to help restore
investor confidence in the reporting of securities analysts. It defines the codes of conduct for
securities analysts and requires disclosure of knowable conflicts of interest.

6. Commission Resources and Authority

 Title VI consists of four sections and defines practices to restore investor confidence in
securities analysts. It also defines the SEC’s authority to censure or bar securities
professionals from practice and defines conditions under which a person can be barred from
practicing as a broker, advisor, or dealer.

7. Studies and Reports

Title VII consists of five sections and requires the Comptroller General and the SEC to
perform various studies and report their findings. Studies and reports include the effects of
consolidation of public accounting firms, the role of credit rating agencies in the operation of
securities markets, securities violations and enforcement actions, and whether investment
banks assisted Enron, Global Crossing and others to manipulate earnings and obfuscate true
financial conditions.

8. Corporate and Criminal Fraud Accountability

Title VIII consists of seven sections and is also referred to as the “Corporate and Criminal
Fraud Accountability Act of 2002”. It describes specific criminal penalties for manipulation,
destruction or alteration of financial records or other interference with investigations, while
providing certain protections for whistle-blowers.

9. White Collar Crime Penalty Enhancement

Title IX consists of six sections. This section is also called the “White Collar Crime Penalty
Enhancement Act of 2002.” This section increases the criminal penalties associated with
white-collar crimes and conspiracies. It recommends stronger sentencing guidelines and
specifically adds failure to certify corporate financial reports as a criminal offense.

10. Corporate Tax Returns

Title X consists of one section. Section 1001 states that the Chief Executive Officer should
sign the company tax return.

11. Corporate Fraud Accountability

Title XI consists of seven sections. Section 1101 recommends a name for this title
as “Corporate Fraud Accountability Act of 2002”. It identifies corporate fraud and records
tampering as criminal offenses and joins those offenses to specific penalties. It also revises
sentencing guidelines and strengthens their penalties. This enables the SEC the resort to
temporarily freeze transactions or payments that have been deemed "large" or "unusual".

History & Context:

A variety of complex factors created the conditions and culture in which a series of large corporate
frauds occurred between 2000–2002. The spectacular, highly-publicized frauds at Enron, WorldCom,
and Tyco exposed significant problems with conflicts of interest and incentive compensation practices.
The analysis of their complex and contentious root causes contributed to the passage of SOX in
2002. In a 2004 interview, Senator Paul Sarbanes stated:

The Senate Banking Committee undertook a series of hearings on the problems in the markets that
had led to a loss of hundreds and hundreds of billions, indeed trillions of dollars in market value. The
hearings set out to lay the foundation for legislation. We scheduled 10 hearings over a six-week
period, during which we brought in some of the best people in the country to testify...The hearings
produced remarkable consensus on the nature of the problems: inadequate oversight of accountants,
lack of auditor independence, weak corporate governance procedures, stock analysts' conflict of
interests, inadequate disclosure provisions, and grossly inadequate funding of the Securities and
Exchange Commission.

 Auditor conflicts of interest: Prior to SOX, auditing firms, the primary financial "watchdogs"
for investors, were self-regulated. They also performed significant non-audit or consulting work for
the companies they audited. Many of these consulting agreements were far more lucrative than
the auditing engagement. This presented at least the appearance of a conflict of interest. For
example, challenging the company's accounting approach might damage a client relationship,
conceivably placing a significant consulting arrangement at risk, damaging the auditing firm's
bottom line.

 Boardroom failures: Boards of Directors, specifically Audit Committees, are charged with
establishing oversight mechanisms for financial reporting in U.S. corporations on the behalf of
investors. These scandals identified Board members who either did not exercise their
responsibilities or did not have the expertise to understand the complexities of the businesses. In
many cases, Audit Committee members were not truly independent of management.

 Securities analysts' conflicts of interest: The roles of securities analysts, who make buy
and sell recommendations on company stocks and bonds, and investment bankers, who help
provide companies loans or handle mergers and acquisitions, provide opportunities for conflicts.
Similar to the auditor conflict, issuing a buy or sell recommendation on a stock while providing
lucrative investment banking services creates at least the appearance of a conflict of interest.

 Inadequate funding of the SEC: The SEC budget has steadily increased to nearly double
the pre-SOX level. In the interview cited above, Sarbanes indicated that enforcement and rule-
making are more effective post-SOX.

 Banking practices: Lending to a firm sends signals to investors regarding the firm's risk. In
the case of Enron, several major banks provided large loans to the company without
understanding, or while ignoring, the risks of the company. Investors of these banks and their
clients were hurt by such bad loans, resulting in large settlement payments by the banks. Others
interpreted the willingness of banks to lend money to the company as an indication of its health
and integrity, and were led to invest in Enron as a result. These investors were hurt as well.
 Internet bubble: Investors had been stung in 2000 by the sharp declines in technology
stocks and to a lesser extent, by declines in the overall market. Certain mutual fund managers
were alleged to have advocated the purchasing of particular technology stocks, while quietly
selling them. The losses sustained also helped create a general anger among investors.

 Executive compensation: Stock option and bonus practices, combined with volatility in stock
prices for even small earnings "misses," resulted in pressures to manage earnings. Stock options
were not treated as compensation expense by companies, encouraging this form of
compensation. With a large stock-based bonus at risk, managers were pressured to meet their
targets.

Timeline & Passage:

The House passed Rep. Oxley's bill (H.R. 3763) on April 24, 2002, by a vote of 334 to 90. The House
then referred the "Corporate and Auditing Accountability, Responsibility, and Transparency Act" or
"CAARTA" to the Senate Banking Committee with the support of President George W. Bush and the
SEC. At the time, however, the Chairman of that Committee, Senator Paul Sarbanes (D-MD), was
preparing his own proposal, Senate Bill 2673.

Senator Sarbanes’ bill passed the Senate Banking Committee on June 18, 2002, by a vote of 17 to 4.
On June 25, 2002, WorldCom revealed it had overstated its earnings by more than $3.8 billion during
the past five quarters (15 months), primarily by improperly accounting for its operating costs. Sen.
Sarbanes introduced Senate Bill 2673 to the full Senate that same day, and it passed 97–0 less than
three weeks later on July 15, 2002.

The House and the Senate formed a Conference Committee to reconcile the differences between
Sen. Sarbanes's bill (S. 2673) and Rep. Oxley's bill (H.R. 3763). The conference committee relied
heavily on S. 2673 and “most changes made by the conference committee strengthened the
prescriptions of S. 2673 or added new prescriptions.” (John T. Bostelman, The Sarbanes–Oxley
Deskbook § 2–31.)

The Committee approved the final conference bill on July 24, 2002, and gave it the name "the
Sarbanes–Oxley Act of 2002." The next day, both houses of Congress voted on it without change,
producing an overwhelming margin of victory: 423 to 3 in the House and 99 to 0 in the Senate. On
July 30, 2002, President George W. Bush signed it into law, stating it included "the most far-reaching
reforms of American business practices since the time of Franklin D. Roosevelt."

Cost Benefits of Sarbanes – Oxley Act:

A significant body of academic research and opinion exists regarding the costs and benefits of SOX,
with significant differences in conclusions. This is due in part to the difficulty of isolating the impact of
SOX from other variables affecting the stock market and corporate earnings. Conclusions from
several of these studies and related criticism are summarized below:

Compliance costs

 FEI Survey (Annual): Finance Executives International (FEI) provides an annual survey on
SOX Section 404 costs. These costs have continued to decline relative to revenues since 2004.
The 2007 study indicated that, for 168 companies with average revenues of $4.7 billion, the
average compliance costs were $1.7 million (0.036% of revenue). The 2006 study indicated that,
for 200 companies with average revenues of $6.8 billion, the average compliance costs were $2.9
million (0.043% of revenue), down 23% from 2005. Cost for decentralized companies (i.e., those
with multiple segments or divisions) were considerably more than centralized companies. Survey
scores related to the positive effect of SOX on investor confidence, reliability of financial
statements, and fraud prevention continue to rise. However, when asked in 2006 whether the
benefits of compliance with Section 404 have exceeded costs in 2006, only 22 percent agreed.
 Foley & Lardner Survey (2007): This annual study focused on changes in the total costs of
being a U.S. public company, which were significantly affected by SOX. Such costs include
external auditor fees, directors and officers (D&O) insurance, board compensation, lost
productivity, and legal costs. Each of these cost categories increased significantly between
FY2001-FY2006. Nearly 70% of survey respondents indicated public companies with revenues
under $251 million should be exempt from SOX Section 404.
 Zhang (2005): This research paper estimated SOX compliance costs as high as $1.4 trillion,
by measuring changes in market value around key SOX legislative "events." This number is
based on the assumption that SOX was the cause of related short-duration market value
changes, which the author acknowledges as a drawback of the study.
 Butler/Ribstein (2006): Their book proposed a comprehensive overhaul or repeal of SOX and
a variety of other reforms. For example, they indicate that investors could diversify their stock
investments, efficiently managing the risk of a few catastrophic corporate failures, whether due to
fraud or competition. However, if each company is required to spend a significant amount of
money and resources on SOX compliance, this cost is borne across all publicly traded companies
and therefore cannot be diversified away by the investor.

Benefits to firms and investors

 Arping/Sautner (2010): This research paper analyzes whether SOX enhanced corporate
transparency. Looking at foreign firms that are cross-listed in the US, the paper indicates that,
relative to a control sample of comparable firms that are not subject to SOX, cross-listed firms
became significantly more transparent following SOX. Corporate transparency is measured based
on the dispersion and accuracy of analyst earnings forecasts.
 Iliev (2007): This research paper indicated that SOX 404 indeed led to conservative reported
earnings, but also reduced—rightly or wrongly—stock valuations of small firms. Lower earnings
often cause the share price to decrease.

 Skaife/Collins/Kinney/LaFond (2006): This research paper indicates that borrowing costs are
lower for companies that improved their internal control, by between 50 and 150 basis points (.5
to 1.5 percentage points).

 Lord & Benoit Report (2006): Do the Benefits of 404 Exceed the Cost? A study of a
population of nearly 2,500 companies indicated that those with no material weaknesses in their
internal controls, or companies that corrected them in a timely manner, experienced much greater
increases in share prices than companies that did not. The report indicated that the benefits to a
compliant company in share price (10% above Russell 3000 index) were greater than their SOX
Section 404 costs.

 Institute of Internal Auditors (2005): The research paper indicates that corporations have
improved their internal controls and that financial statements are perceived to be more reliable.

Effects on exchange listing choice of non-US companies

Some have asserted that Sarbanes–Oxley legislation has helped displace business from New York to
London, where the Financial Services Authority regulates the financial sector with a lighter touch. In
the UK, the non-statutory Combined Code of Corporate Governance plays a somewhat similar role to
SOX. See Howell E. Jackson & Mark J. Roe, “Public Enforcement of Securities Laws: Preliminary
Evidence” (Working Paper January 16, 2007). The Alternative Investment Market claims that its
spectacular growth in listings almost entirely coincided with the Sarbanes Oxley legislation. In
December 2006 Michael Bloomberg, New York's mayor, and Charles Schumer, a US senator from
New York, expressed their concern.[22]

The Sarbanes–Oxley Act's effect on non-US companies cross-listed in the US is different on firms
from developed and well regulated countries than on firms from less developed countries according to
Kate Litvak.[23] Companies from badly regulated countries see benefits that are higher than the costs
from better credit ratings by complying to regulations in a highly regulated country (USA), but
companies from developed countries only incur the costs, since transparency is adequate in their
home countries as well. On the other hand, the benefit of better credit rating also comes with listing on
other stock exchanges such as the London Stock Exchange.

Piotroski and Srinivasan (2008) examine a comprehensive sample of international companies that list
onto U.S. and U.K. stock exchanges before and after the enactment of the Act in 2002. Using a
sample of all listing events onto U.S. and U.K. exchanges from 1995–2006, they find that the listing
preferences of large foreign firms choosing between U.S. exchanges and the LSE's Main Market did
not change following SOX. In contrast, they find that the likelihood of a U.S. listing among small
foreign firms choosing between the Nasdaq and LSE's Alternative Investment Market decreased
following SOX. The negative effect among small firms is consistent with these companies being less
able to absorb the incremental costs associated with SOX compliance. The screening of smaller firms
with weaker governance attributes from U.S. exchanges is consistent with the heightened governance
costs imposed by the Act increasing the bonding-related benefits of a U.S. listing.[24]