Would SOX have stopped Nacchio?

Jay Brown of the subtly titled race-to-the-bottom blog, which is covering the trial of the century (betcha didn't know that was the trial of Qwest's Joe Nacchio for insider trading) opines in today's Denver Post (HT WSJ blog):

We can't go back in time. But we can speculate. If Nacchio, in early 2001, had SOX, Qwest probably would have disclosed the information that later became the basis of the prosecution for insider trading. And . . . had Qwest told, it would have been OK if Nacchio sold.

Of course we can always speculate.  P.K. Dick wrote a wonderful sci-fi novel about what would have happened if the Allies had lost WWII.  Great fun. What if Lee had won Gettysburg?  What if Brad hadn't met Angelina. 

This is the sort of speculation that has shored up SOX's collapsing reputation in recent months. We're told to disregard all we hear about huge costs, because SOX had some sort of effect in increasing disclosure and restoring investor confidence. In other words, even if costs are quantifiable, benefits aren't. Sort of like MasterCard -- priceless. This sort of reasoning is generally hard to refute, which of course is its point.

In this case, though, the reasoning is even less useful than usual. SOX was intended to deal with Enron-type fraud where underlings in the corporation are determined to gild their performance by obfuscating corporate disclosures. Skilling and Lay weren't prosecuted for this problem – they were prosecuted and convicted for ignoring what eventually became clear.

SOX was not designed to stop fraud at the top. We have learned time and again that a determined CEO can thwart internal controls. Brown's op-ed argues that Nacchio was precisely that sort of executive, who sought to control disclosures at his firm.  SOX might have made this more difficult, but it's a stretch to assume it would have prevented the result. 

Consider the post-SOX fraud at Refco. As I discussed a year and a half ago, SOX did nothing to prevent that. A WSJ editorial at the time commented:

All those new laws, rules and regulators that Congress created after the WorldCom and Enron failures weren't able to detect, much less prevent, what is alleged to have been fraudulent behavior. Sarbanes-Oxley, which was supposed to protect investors from nefarious CEOs, didn't deter former Refco chief Phillip Bennett from allegedly disguising that an entity he controlled owed Refco hundreds of millions of dollars. * * * [N]one of this "oversight" stopped the accountants at Grant Thornton LLP from signing off on Refco's books before the broker's August IPO.. . . . It's always possible there is a simple explanation for the Refco mess: One or more of its senior managers lied to all kinds of people, perhaps at some level even to themselves. Human beings sometimes behave that way -- in government as well as business -- and no amount of "oversight" can prevent it.

In my earlier post I quoted a very similar point from my article about SOX published three years before Refco.  There are similar points throughout my and Henry Butler more recent book on SOX.

SOX has not suddenly made people more honest. At best, it has increased the costs of fraud, but of course without reducing the benefits.

Finally, it is important to keep in mind that even if SOX does reduce some smaller frauds, it does so at the significant price of sharply increasing costs to honest companies and preventing beneficial business from getting done.

Counterfactuals are fun, but must be used with caution as policy analysis.

Comments

[K. Williams]

Jeff Skilling was not prosecuted or convicted for "ignoring what eventually became clear." He was prosecuted for helping set up and run a deliberate scheme to deceive Enron investors by illegally setting up special purpose entities that were part of Enron but were described as separate from it. The conviction had nothing to do with his ignorance, but rather with his knowledge, as evidenced most notably by his agreement with Fastow to ensure him against any losses the SPE might suffer on Enron's behalf.

Lay, on the other hand, probably was convicted for his ignorance.