Spero Consulting

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.