Did SOX Exacerbate the Crisis? and…
The Best is Yet to Come, Oh Yeah!
We don’t mean any baseball teams, we mean the Sarbanes-Oxley Act of 2002, which President Bush said at the time of its signing was “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt.”
Here is a description from Wikipedia: “… in response 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 the affected companies collapsed, shook public confidence in the nation’s securities markets.“ We’ve added the italics in the quote.
Well, another success for government regulation, don’t you think?
SOX seems to have been forgotten during the recent and ongoing panic. Eek! Eek! But, we think it will be back: when the indictments start coming. With a government bailout, someone is going to do time, and SOX will be the means by which they are convicted. On this topic we see no difference between the two Presidential candidates. They’ll like be equally vindicative; so, the future level of prosecutions should be about the same. (Our guess: you’ll hear both of them talk about it by late October, when the class envy and warfare is at its most pitched, and the two are at their most desperate.)
We do agree with President Bush’s excerpted statement, but it is doubtful that we share the same interpretation. He probably meant “far-reaching” in a good way.
SOX was and is still very far-reaching in both its high cost and waste of corporate resources. It was and is an auditor’s fondest and wildest dream: procedures and documentation to review and ”test” that, as we see, provide no benefit to anyone other than said auditors and their cousins; the corporate bureaucrats, whose positions exist to validate SOX processes and controls.
Depending upon the level of cynicism and skepticism among investors, SOX may have also played a role in the on-going financial crisis. (In this case, the greater than skepticism, the smaller the harm.)
If investors are truly cynical or skeptical, then SOX likely played no role in the crisis because neither cynics nor skeptics would have put any weight on it in the first place. It is possible that we are projecting here; we’re more of the latter than the former.
So if cynics and skeptics set prices, then SOX is merely a huge, but deadweight, cost to society, and please remember, this is the best case scenario!
On the other hand, if investors were fooled into believing that estimated accounting values were more reliable and relevant because of SOX, then the law and its implementation have exacerbated the mess. Please remember that marks on illiquid assets are nothing if not estimated accounting values, which require a process to follow every month or quarter.
The problem is that following a documented process each time an estimate is made doesn’t make that estimate reliable or relevant (informative). It just makes it documentable.
For example, one could thoroughly document the process of examining chicken entrails to divine the future to any level or degree of specificity. (We’ll focus on relevancy here, but there may be no reliability, either. This can happen if the process uses, say, an unrelated, random variable in the valuation or estimation.)
For example, one could map the various characteristics of the entrails into the standard, corporate green-yellow-red warnings of a PowerPoint “Dashboard” slide to provide indicators of something or other for an uninformed board of directors or senior management. If the result of that color mapping is an important variable in important decisions, then it would be a SOX control. So, the divination process would need to be documented and validated. It is easy to do but quite boring.
Similar arbitrary (and no less disgusting) processes, could be used to value any particular asset. These estimates would then affect income calculations for the period, including unrealized gains and losses.
Again, none of this has anything to do with finding the “true” value, which as we often note is often an impossibility. Instead, SOX involves documenting the process/control that the organization has followed to arrive at the estimate. That’s almost always possible to do.
By the way, if the reader doesn’t like chicken entrails, he or she may select any quantitative model and his or her choice of a particular and arbitrary probability distribution. See our essay, Uncertainty Management, for our views on these and related topics.
So, we find SOX and its rules to be worthless at best and misleading at worst. In that way, we could see how it might have misled the unsophisticated to place more faith in audited income and asset reports than is warranted. We could imagine such folks asking, “What CEO or CFO would mislead the public given the implications of being discovered?” We could then see such investors concluding that the reported numbers were firmer and truer than without such laws. Clearly, that would have exacerbated the ongoing crisis by (1) rewarding firms for reporting higher income, (2) encouraging them to continue (to expand) and do more of the same, i.e., add to their seemingly-profitable and valuable investments and trades.
Did any investors actually believe that SOX permitted reported numbers to be more meaningful? Possibly, but it really doesn’t matter at this time. Because that doesn’t preclude the cynical ones from suing. More importantly it certainly does not prevent cynical federal officials from investigating and indicting and prosecuting executive officers who signed and certified what turn out to be very misleading financial reports.
Our free advice: senior executives at large, failed public firms should consider selling their art collections and vacation homes and remaining stock–if it has any value–and building a defense fund. Also, shop for and retain the best civil and criminal defense attorneys that you can afford.
As Frank Sinatra sang, “The Best is Yet to Come.” We forecast that unfortunately for these senior executives and unjustly–in most cases–given the impossibility of the estimation tasks, the next President, his Attorney General, and the Congress will seek “justice” or at least the hides of the wealthy and “corrupt” who “got us into this mess.”
Given the arbitrariness of the law, those executives will have a difficult time defending themselves, and may wish that they had paid more attention–both on the job and in probability and statistics class. They may also want to go long Mackerel.
