The Sarbox time bomb

Today’s WSJ notes that securities cases are temporarily down in this stable-to-up market, but attributes many of the suits that have been filed to stricter financial reporting, and warns:

Just wait for the next economic downturn, when class-action lawyers will be able to exploit Sarbox's new "internal controls" documentation as a roadmap.

Precisely. As I said in my paper, Sarbanes-Oxley after Three Years,

The main problems with the internal controls reports . . . may persist even after firms have established reporting procedures and infrastructures. Most importantly, SOX imposes significant new liability risks, since a clever trial lawyer might be able to trace virtually any business problem, in hindsight, to a failure to implement some internal control.

In other words, Sarbox has a litigation time bomb set to go off the next time stocks go down. This is should be enough to counteract all of the sanguine pronouncements we’ve heard lately about how well Sarbox is working. Reminds me of the joke about the guy who jumps off the roof of the 100 story building. When asked, around the 50th floor, how he’s doing, he says “ok so far.”

Defenders of Sarbox might persist in arguing that all this disclosure causes risks to be efficiently priced and gives firms the right incentives to address potential problems. But this heroically assumes an efficient litigation system that accurately assesses damages at the right deterrence/compensation levels and avoids problems like hindsight bias.

The real question is whether the risks from self-interested Enronesque executives exceed those from, among others, self-interested litigators and imperfect courts. It would be nice if someone actually tried to figure that out, including the overriding question whether this is better done by contract or by the states. But nobody did when Sarbox was enacted in a regulatory panic (see my article, Bubble Laws, 40 Houston L. Rev. 77 (2003)). The ingredients were poured into a petrie dish and left to fester for a few years. It will be interesting and, I think, distressing, to see what crawls out of the dish in a couple of years when the securities markets go down.