We have more to say about the number of restatements and its relationship to SOX but today we briefly digress to discuss an editorial written in the WSJ by Joe Grundfest at Stanford. It is not the mission of this Blog to always comment on current developments but we cannot help but note a vigorous defense of SOX from academia. 

In the editorial, Joe discusses the decline in the number of class action securities law suits. He surmises that the decline may be a result of the amount of fraud taking place in corporate America, a decline he attributes in part to SOX. This is of course counter to those opponents of SOX who have argued that it has not resulted in any significant reduction in the instances of fraud.  For a discussion of these commentators and a criticism of their views, see more here. 

We note though, that Joe’s explanation is incomplete. He attributes the decline in fraud to the increased fear of penalties imposed on management, whether the risk of firing or the risk of indictment.  Recall that Section 906 of SOX contains a 20 year term for violation of the certification requirement. It is a fair enough proposition to say that this has caused management to "get religion" about the accuracy of financial disclosure.  

But, of course, fear of a penalty is only as good as the risk of detection.  Joe's editorial does not mention the provisions of SOX that have significantly increased this risk.  So, for example, Section 404, the most controversial section of SOX, provides for outside review of management’s assessment of internal controls. In effect, outside auditors now must comb financial reporting systems within companies for any signs of error. Officers worried about financial fraud and possible penalties know that this increases the risk of detection.  Add to that the provisions in SOX providing employee access to the board and protection for whistleblowers and you have an even greater likelihood of detection.  The idea that a fraud as widespread as the ones in Enron and Worldcom could go undetected for so long is dramatically reduced as a result of SOX, particularly Section 404.