Ideoblog

Sarbox on trial

SOX will be argued Monday in the Supreme Court. The suit challenges the constitutionality of the Public Company Accounting Oversight Board, which wields significant executive power although not appointed or overseen by the President as the Appointments Clause of the Constitution arguably requires in this case.

Today's WSJ opines:

The accounting board's wide-open mandate—to make whatever rules "may be necessary or appropriate in the public interest or for the protection of investors"—has cost the economy nearly $1 trillion, according to a study by AEI and the Brookings Institution. The benefit is supposed to be investor protection. But despite these costs, the law did nothing to warn about the meltdown of mortgage-backed securities, much less expose Bernie Madoff or other fraudsters.

As the Supremes now take their turn, the case has implications the regulation-loving press corps hasn't noticed. A decision to uphold the PCAOB would open the door for Congress to create any number of equally unaccountable regulators across the economy. However, a ruling against the PCAOB could bring down the whole law because Sarbox does not have a "severability clause," which means that if one part goes down the entire law may be invalidated.

* * * At stake here isn't merely a poorly written law that has done great economic harm. The issue is whether Congress, in its haste, can ignore the Constitutional order that has ensured accountable government for 230 years.

Back in 2002 I was among the first to cry out against SOX, in this paper, which argued:

The crashes and frauds of Enron, WorldCom and other companies have reinvigorated the debate over regulating corporate governance. Many pundits have called for corporate regulation to restore confidence in the securities markets. These recommendations appear to be supported by the fact that neither the contracting devices that were supposed to control managers, nor efficient securities markets, worked to prevent or spot the problems. Congress responded with the Sarbanes-Oxley Act of 2002. But this article shows that, given the limited effectiveness of new regulation, its potential costs, and the power of markets to self-correct, new regulation of fraud in general, and Sarbanes-Oxley in particular, is unlikely to do a better job than markets.

A few years later, Henry Butler and I wrote a book decrying SOX, and discussing the evidence that was accumulating against it, as well as the SOX suit. Here's an excerpt from the book abstract:

If the suit is successful, Congress likely will have an opportunity to repair the constitutional defect. Although political reality suggests that Congress will not abandon SOX, it may respond to the mounting criticism by fixing its most egregious faults.

The pro-SOX media and pundits scoffed at the suit. But as I pointed out back in 2008 when some DC Circuit judges appeared receptive to plaintiff's argument, the suit "may actually have some legs."

The appellate court rejected the suit, but the Supreme Court agreed to hear it. I joined an amicus brief arguing for unconstitutionality.

Now the pundits have retrenched a little to the position that even if the PCAOB goes, the rest of the act will be saved despite the absence of a severability clause. But the pundits have been surprised how far this suit has gotten already, and they may well be surprised again.

Meanwhile, Congress is thinking about amending the law to exempt small firms. This bill gives some indication of what might happen to SOX if the whole thing has to go back to Congress.

As I said back in 2006:

SOX wasn't just a bad law, but a uniquely bad law, passed under uniquely bad conditions without any of the safeguards that normally accompany major legislation.  And even if repeal or drastic shrinkage is impossible, it's still necessary to make the case as a warning against future SOX's.  One way to do that is to establish SOX as a paradigm of bad law. In other words, to make Sarbanes and Oxley the Edsel Fords of corporate governance regulation.

I've been watching the SOX debacle play out for seven years. It will be interesting to see how this ends.

Amending SOX

Just as Sarbanes-Oxley is under siege at the Supreme Court, the House Financial Services Committee has decided to adopt an amendment to its Investor Protection Act of 2009 bill to exempt sub-$75 million companies from SOX internal controls reporting.

A Times editorial and Times columnist Floyd Norris are apoplectic, seeing a sellout of investors by politically vulnerable Democrats to corporate interests.

SOX was a misbegotten, inadequately debated, debacle from the beginning. I saw this as evident from the beginning, and after three years of theory and evidence. Still later, Henry Butler and I wrote a monograph detailing the SOX debacle. I've continued covering the Act on this blog, including this 2008 critique of a previous Floyd Norris foray into SOX-land.

Butler and my book recommends, among other things, exempting small firms from SOX (at 91):

SOX presents significant problems for small firms, since their compliance cost per dollar of capitalization is much higher than for larger firms. Moreover, SOX's disproportionate impact on these firms is entirely unwarranted, since the corporate meltdowns that led to it were a phenomenon of large corporations. To the extent that SOX addresses the problems in the latter, its provisions are not necessarily appropriate for small firms. * * * In particular, small firms may have far less need for extensive internal controls provisions throughout the organization. * * *

For some critical evidence of SOX's perverse effects on small firms, see Kamar, Karaca-Mandic and Talley.

The justifications for a small firm exemption are even greater now. Given evidence of SOX's negative effect on risk-taking (see especially Bargeron, Lehn & Zutter), an exemption targeting the smaller firms that incubate the economy, can be seen as a cost-effective form of economic stimulus. Moreover, with more financial regulation and "investor protection" on the way, SOX's regulatory costs are likely to cut even deeper on the margin.

Of course, as discussed in the book, SOX's problems run deeper than small firms, and there are good reasons for trashing the whole thing, or at least making it optional. But a small firm exemption is a good place to start.

The SEC, Congress and SOX 304

There seems to be an emerging consensus to go after the SEC for going after Maynard Jenkins under SOX 304 even though he’s not accused of misconduct. The latest example is former SEC enforcement lawyer Russell Ryan, writing in today's WSJ, who says the SEC is “push[ing] the envelope" of the provision.

Frankly, I don't get it. Here, again, from my post a couple of weeks ago, is the language of SOX 404:

SEC. 304. FORFEITURE OF CERTAIN BONUSES AND PROFITS. (a) ADDITIONAL COMPENSATION PRIOR TO NONCOMPLIANCE WITH COMMISSION FINANCIAL REPORTING REQUIREMENTS.--If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for-- (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

The only reference to “misconduct” is clearly that of the issuer, not of the reimbursing executive. One could argue that the SEC should not use the authority it clearly has. But how can the SEC’s position in this case be viewed as “pushing the envelope” of the statute?

As I made clear in my last post, I don’t like this provision. But let’s put the blame where it belongs: on Congress, which enacted this misbegotten statute.

This is important because Congress is being asked to address another financial crisis. We shouldn’t assume that any Congressional errors will and ought to be corrected by the enforcing agency, and then blame that agency when it uses the authority Congress gave it. We should ask and expect Congress not to blow it again.

Two briefs arguing unconstitutionality of PCAOB

From Cato, Henry Butler and me . . . and from some other law professors. 

Punishing innocent executives: SOX's litigation time bomb goes off

I’ve written a lot about over-punishing corporate executives for mistakes in business judgment. This is bad, but there’s something even worse – punishing business executives even when they’re not accused of making a mistake.

This is the effect of SOX Section 304(a), which provides in part:

If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for-- (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

As Butler and I said in our Sarbanes-Oxley Debacle:

An important effect of SOX is to put an increased burden of the risk of corporate fraud on monitors and gatekeepers such as auditors, lawyers, outside directors, and senior executives. This is true not only of the liability provisions discussed above, but also of provisions like section 304, which requires reimbursement of compensation and stock profits following accounting misstatements, regardless of whether the executive knew of the fraud and even if he exercised all reasonable care in monitoring and instituting controls. This is questionable policy. 

This provision hasn’t been used against an innocent executive until now. Bloomberg reports that the SEC is set to announce that it will demand that Maynard Jenkins, former CEO of CSK Auto Corp., forfeit compensation for a fraud perpetrated by others in the company.  The Bloomberg article (which also quotes me) says:

Demanding Jenkins forfeit compensation may up the ante for other companies facing potential restatements. “It raises the question of whether this will become a standard enforcement expectation any time there is a restatement,” said Philip Khinda, a former SEC enforcement attorney now in private practice at Steptoe & Johnson LLP in Washington.

One may wonder why this provision hasn’t been used until now. One possible reason is that new SEC Chair Mary Schapiro wants to show that the agency that could ignore Madoff should not be shuffled out of existence in the looming reorganization of financial agencies. At least it has some teeth, even if they get sunk into a wholly innocent executive (or Mark Cuban).

Another explanation is the one forecast in “The Sarbanes-Oxley Debacle”:

While the first major market correction will be painful for investors, SOX will surely turn it into a festival for trial lawyers. Such litigation on this scale should not be confused with shareholder protection. SOX has created a ticking litigation time bomb.

A festival for regulators, too.  So the downturn coupled with more aggressive regulators and an open-ended law like SOX should make for an interesting, if toxic, mix.

SOX for the little guy

From the unincorporated business blog comes a report on the Incorporation Transparency and Law Enforcement Assistance Act (S569). The motivation for this piece of legislative detritus seems to be that since a tiny percentage of LLCs are being used for criminal activity let’s wreck LLCs for all firms. Hey, sounds sensible to me.

The bill requires all state-law corporations and LLCs to make disclosures about their beneficial owners, defined as “an individual who has a level of control over, or entitlement to, the funds or assets of a corporation or limited liability company that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the corporation or limited liability company.”

There is no definition of “control, manage, or direct,” but who cares, given “as a practical matter” and “directly or indirectly”?  Does this mean voting power? Financial leverage? Family ties? There are civil and criminal penalties for false beneficial ownership information. State laws are not preempted if they require additional information or impose additional limits on public access to the provided information. Someday the courts will decide how much of the rest of state business association law is preempted.

Note that the law only applies to corporations and LLCs. No doubt this will lead to a boom in limited partnerships, etc., and end the LLC era. But never fear: the act calls for study of whether we need to be worried about other business entities.

Not to be outdone by Congress, the National Conference of Commissioners on Uniform State Laws has a draft of a "uniform" law (which means it's uniform if all of the states are silly enough to adopt it): The Uniform Law Enforcement Access to Entity Information Act (pronounced “youleeay”). The theory here seems to be that any state law beats any federal law. 

Youleeay fills the gaps left by the federal bill by applying generally to state business entities that require filings. Youleeay requires disclosure of holders of various types of “governance” and “interest” holders, including shareholders, members, limited and general partners, LLCs members, etc. A “material” non-compliance with the statute warrants judicial dissolution in an action brought by the state attorney general as well as administrative dissolution, but no other penalties, including piercing the veil.

If this law is passed in your state, whether you need to worry depends on whether you’re a criminal. If you’re a criminal, no problem: you just form a general partnership or a non-profit entity, which the law effectively doesn’t reach. Of course you can’t earn a profit or get limited liability, but if you’re a criminal using the entity to hide ownership of property, do you care? Also, keep in mind that the penalty for non-compliance is dissolution. So you have to form another of these things. Big deal.

On the other hand, if you’re not a criminal, alas, you’re in trouble if this statute applies in your state. You might find your firm blowing up unexpectedly if, like many (most?) small business owners you make a mistake or fail to update a filing. Then who knows whether the liability shield will apply (the statute protects against veil-piercing, but not necessarily if the business has been dissolved and wound up). Your partner or co-member might welcome dissolution in some situations and so might whisper in the AG’s ear that there’s a problem with the ownership disclosures.

Remember: if business associations are illegal, only criminals will have business associations.

Email comments.

(Minor revisions 7/13/09)

Obama proposes SOX II

Here's a nifty summary, and Bainbridge's early critique.

I haven't evaluated the proposal closely, and won't be able to for awhile because I'm about to get out of range for a couple of weeks. But I do have a few quick thoughts on particular elements of interest. 

First, we have to keep in mind that this isn't really a legislative package, but a kind of starting gun to let the intense lobbying begin.  It will be interesting to compare the proposal to the sausage that emerges at the other end of the grinder.

Second, since we're about to embark on SOX II, wouldn't it be useful to look again at what happened with SOX I?  Here's Butler and my analysis.  At the end of our book we have some suggestions for regulatory humility, such as optional provisions and sunsetting.  I fear that in the end we will find that we learned very little from the SOX debacle.

Third, the Obama proposal suggests (p. 13) requiring hedge fund registration under the Investment Advisers Act overseen by the SEC.  It also proposes that hedge funds be required to make reports on funds under management sufficient to indicate whether they pose a threat to financial stability. 

This is particularly misguided.  The best commentator on that is Houman Shadab.  See here and here.  The bottom line is that hedge funds are more a solution to problems of the financial system than a cause. 

The "systemic risk" argument is totally misguided.  As Jon Macey has noted, hedge funds actually combat systemic risk by, essentially, betting against the "system."  One way to make them part of the problem is to force enough disclosure that other financial institutions can follow them off any cliffs they seek to explore.  See Macey, PROMISES KEPT, PROMISES BROKEN 265-72(2008).

And what's with this regulation by the SEC?  Are we satisfied with the great job that agency did supervising Madoff?  See here (detailing the SEC's massive regulatory incompetence in Madoff) and here (suggesting that the SEC was actually Madoff's unwitting accomplice). 

Fourth, the proposal calls for (p. 40) "increased national uniformity through either a federal charter or effective action by the states." Butler and I show that this objective in insurance regulation is misguided and offer a better alternative.

Finally, let's keep in mind that the US is no longer alone in the world.  Regulatory overkill here could be a boon for places like Singapore and Hong Kong.

Some thoughts on the Shareholder Bill of Rights

Martin Lipton, with Jay Lorsch and Theodore Mirvis, opine in the WSJ about the havoc that could be wrought by Schumer’s proposed Shareholder Bill of Rights Act of 2009. That Act would require shareholder say on executive pay, direct shareholder nomination of directors, majority vote for directors, and no staggered boards.

Schumer's proposal provides an opportunity for everybody to work out their favorite theories. Lipton, et al, true to their usual managerial perspective, are concerned about the potential for governance that is overly focused on the “short-term.” They would go in the opposite direction, with directors’ elected to 5 year terms.

Steve Bainbridge doubts there’s a problem with executive compensation and, true to his director primacy approach, questions the proposed solution.

I'm no fan of say on pay. But if we really want to get serious about shareholder power, why cram a federal law down their throats.  Indeed, why not go the other direction, to say on SOX? 

Or, how about even more shareholder say, by letting the shareholders choose their corporation's state legal regime? As Professor B discusses, leaving corporate governance issues to state law allows for some experimentation, and attaches market prices to the various alternatives. See my and Erin O’Hara’s Corporations and the Market for Law and The Law Market, ch. 6.

Finally, why corporate law? Why not choice of form as well as choice of law? Even if shareholder democracy is not the answer, that doesn’t mean we should lock control in directors make managers or directors trustworthy stewards. Of course what I’m thinking about is the uncorporation. My theory is that managers can be disciplined by giving them stronger incentives and lightening their grip on the firm's cash. 

The answer, at any rate, is choice.  I'm not ready to let Sen. Schumer and his friends decide how all firms should be governed.

More on Say on SOX

Last November I suggested letting shareholders opt out of SOX – a proposal that was also in my book on SOX with Henry Butler.

Last December, Henry Butler and I had an article in Forbes on this, discussed here, connecting it with “say on pay.”

Now Butler and I have a Washington Legal Foundation Legal Backgrounder developing the “say on SOX” idea.

I understand that this proposal bucks the groundswell for more regulation. But the WLF article shows not only why this idea is good policy, but also why it may not be as politically improbable as it might sound on the surface.

Shareholder power vs. mandatory securities laws

About a month ago I suggested making SOX optional.  Now Henry Butler and I have an article on this subject forthcoming in the December 22 Forbes.

Butler and I argue that the recent financial “crisis shows that SOX did not have the advertised payoff of flushing Enronesque risk out of the market.” So it’s not clear what shareholders got for all that money their firms spent on SOX. We suggest that it’s time to try an alternative: “SOX would remain, but firms could have their shareholders vote to opt out of some or all of its provisions. Or firms going public could opt out of SOX and let potential investors decide whether to buy their shares.”

We also make the connection with “say on pay:”

If shareholders should vote on pay, then why not on something that can have even more effect on profits. How about "Say on SOX"? 

Our proposal meshes with another one that’s getting some recent play: Adam Pritchard’s idea to let shareholders vote to amend the charter to modify the application of the fraud on the market theory, an important underpinning of federal securities class actions. Pritchard’s idea has now turned into a shareholder proposal at Alaska Air (here's an article, discussed in PoL).

Shareholder proposals could be the mechanism for adopting SOX opt-outs, too.  Of course SOX would have to be amended before such proposals would have an effect. 

So there you have it: shareholder choice vs mandatory federal protection. Using the corporate governance provisions of the securities laws (14a-8)  to opt out of the anti-fraud provisions of the securities laws.  As Henry and I concluded, “[i]t's time for the corporate governance reformers to decide what they really believe.”