We do not intend to respond on this blog to each piece of criticism of our positions by others writing in the area. We take this opportunity, however, to mention the post by Professor Larry Ribestein about an editorial I wrote in the Denver Post titled "Law could have aided Nacchio in '01".  We do so because it is an opportunity to examine some of the views of those who vociferously oppose SOX.  Ribstein's view on the editorial won support from a post by Professor Stephen Bainbridge (who notes the "uncritical endorsement" of the WSJ Law Blog of the views in the editorial at the same time he was uncritically endorsing Ribstein's). 

The editorial pointed out, based upon many weeks of observation at the trial of Joe Nacchio, that Qwest, back in 2001, seemed to be a company where the disclosure was largely under the control of the CEO (although the defense disputed it). Thus, for example, one of the critical issues concerned the timing of Qwest’s disclosure of the percentage of its revenues coming from non-recurring sources (labeled throughout the trial as one-timers). Testimony indicated that the information was not disclosed because Nacchio didn't wanted it disclosed.  One witness testified that Nacchio expected employees to follow the golden rule: Don't do anything that would make the stock price go down.

This was not an example of a secret piece of information.  Information about the the one-timers was apparently widespread.  Had SOX been in place in 2001, others involved in the process might have insisted that it be disclosed.  There is nothing like the possibility of a 20 year jail term for a false certification to focus the attention of the CFO on the accuracy of the financial disclosure.  The editorial did not key in on the prevention of fraud, only the improvement of the resulting disclosure.  How did Ribstein react to this fairly basic observation?  

After parsing through the sarcasm, he seems to take the position that SOX was meant to stop some fraud (but apparently not by those at the top) and that it really doesn't work at doing that.  This approach ignores the fact that SOX has done far more than prevent fraud.  There have been, since the adoption of SOX, a record number of restatements.  Officials at the SEC indicated that a majority of the restatements studied resulted from "flat out" error.  In other words, the pre-SOX system of internal controls wasn't robust enough to catch these mistakes.  And what were the costs of these flat out errors?  A GAO study estimated that the overvaluation of public companies resulting from financial statements that were later restated was an estimated at $63 billion on an adjusted basis. 

Ribstein also states that proponents of SOX overstate the benefits and understate the costs. In fact, opponents of SOX routinely overstate the costs. For example, look at the costs attributed to Section 404, the provision that requires accounting firms to attest to management's assessment of the internal controls. Those opposing SOX point to things like increased audit fees as examples of the increased costs.  Fees have gone up, but attributing the entire increase to Section 404 is wrong.  Fees would have risen even without the Section -- concern about litigation risk alone would have dictated greater care, a more arms length relationship with outside accountants, and a concomitant increase in fees.  For more on this, go here.

Most interesting, he dispenses with the point that had SOX been in place, Qwest might have disclosed the information on one timers. How does he do it? He simply says it wouldn't have happened. As he noted: “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.” Instead, “ [w]e have learned time and again that a determined CEO can thwart internal controls.”

What’s his basis for this assertion?  The post doesn't reveal any particular awareness of the circumstances at Qwest.  Instead, he largely supports his position with a single example, the fraud at Refco. Beyond the fact that one case does not prove his point, he happens to pick a curious example.  The fraud at Refco mostly occurred before the adoption of SOX (the relevant time period was the mid-1990s until 2005) and was uncovered almost immediately upon application of SOX, about two months after the company went public.  Moreover, it was uncovered by an internal investigation that apparently originated with the newly enhanced audit committee.  One could argue that in this case SOX operated the way it was supposed to.  In any event, it's not exactly a poster child for the failure of SOX. Take a look at the indictment of the CEO. It can be found at the DU Corporate Governance web site.

It is surely the case that if a fraud can be conducted by a single individual, whether a CEO or someone else, no set of procedures can guarantee discovery. In large public companies, however, massive frauds like those in Worldcom or Adelphia can only continue in an environment where many others within the company know about them.  What SOX did, among many many other things, was raise the consequences of turning a blind eye to these sorts of things.  And while it will never be possible to truly assess the impact of the Act on the instances of fraud (how can one show the number of frauds prevented), we do know that the number of securities class action law suits, one barometer of the amount of fraud, is, according to the Stanford Securities web site,  at a 10 year low.