Its almost hard to remember the vehement outpouring of criticism that swirled around Sarbanes-Oxley for the first three or four years after its adoption.  Everything was criticized, whether the hurried process employed in adopting the Act to greater reliance on independent directors.  For more on these views, see The Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.

Any piece of data that could be used to challenge SOX was trotted out, the need for rigor usually a casualty of the process.  The decline in IPOs, the drop in foreign listings, the number of companies "going dark" were all trotted out as "proof."   But probably none was trumpeted louder than the rise of private equity and the likely disappearance of public companies from the market place.  No longer willing to put up with aggressive shareholders and the costs of SOX, companies would simply sell out to private equity firms.  Take a look at Lynn Stout's position on the subject.

To the extent companies sold out to private equity, it had little to do with the costs of SOX or whiny shareholders.  Instead, it took place because of self interest.  Private equity funds were able to raise large amounts of capital and borrow at low rates.  With these funds available, they could afford to pay exorbitant amounts to buy out public companies. 

Those days, however, are gone.  The debt markets are largely frozen.  Now we learn that the capital side of things is likewise winding down.  According to the WSJ, private equity has been drawing a "cold shoulder" from large institutional investors.  As the WSJ has noted:

• Public pension funds and endowments are turning down invitations to make private-equity investments. The nation's largest public pension fund, the California Public Employees' Retirement System, or Calpers, is asking private-equity firms to ease off on requests for additional capital it had previously committed to deliver. . . . Harvard University, with an endowment of $36.9 billion under Jane Mendillo, is seeking to offload about $1.5 billion in investments with private-equity firms such as Bain Capital LLC, according to people familiar with the situation.

The article also noted that the two publicly traded private equity funds had seen their shares fall by 70%. 

All of this is to say that the use of private equity as a source of cricisim for SOX was misplaced.  But then, so was most of the criticism of SOX.  Instead, what seems clear now is that SOX did not go far enough.  Perhaps that will be a topic addressed by the new administration.

One of the early claims was that SOX would damage public equity markets.  Companies were fleeing SOX and taking their IPOs overseas.  Companies would rather sell out to private equity or "go dark" rather than confront the costs and risks of SOX.  These claims have, in general, been shown to be inaccurate or overstated, sometimes after an examination of the empirical evidence and sometimes after watching the market.  The anecdotal evidence likewise suggests a contrary interpretation. 

Purveyors of private equity were among the loudest to decry the impact of SOX.  The Blackstone Group did this.  Henry Kravis at KKR was more balanced, viewing SOX as a benefit for shareholders, but still finding reason for concern:  

• "One consequence, however, is that they are also being more conservative and risk averse. An enormous time is spent on legal process by the board, rather than pushing innovative ideas. Sometimes this is to the long-term detriment of the business. It is easier to say “no” to risk and play it safe than it is to examine the risk closely to determine if it is the right decision for the business. To the extent that Sarbanes Oxley causes public companies to be less competitive, there is an opportunity for the private equity industry in taking these businesses private and putting some energy back into growing them."

• The coming IPO is in some ways designed as an antidote to its secretive and hardball-playing image by highlighting the firm's "best practices" of corporate governance and employee compensation. On the coming "road show" to present the transaction to potential investors, KKR is expected to emphasize how the new KKR will push the company's management into deeper alignment with shareholders. By buying back the KPE stake (which is itself just a vehicle for existing KKR investments) the executives will only be adding their exposure to KKR deals.

In that regard, the NYT discussed a new study done by Professors Doidge, Karolyi and Stultz (from Ontario and Ohio State respectively) on why some foreign firms have decamped from the US to determine what role if any that SOX played in the process.  It is not, by the way, the first time that we have had an opportunity on this Blog to discuss their work.   As the abstract to the paper concludes:

• We find that these firms experienced significantly slower growth and lower stock returns than other U.S. exchange-listed foreign firms in the years preceding the decision. There is weak evidence that firms experience negative stock returns when they announce deregistration and stronger evidence that the stock-price reaction is worse for firms with higher growth. When we examine stock-price reactions around events associated with the passage of the Sarbanes-Oxley Act (SOX), we find negative average stock-price reactions with some specifications but not others. Further, there is no evidence that deregistering firms were affected more negatively by SOX than foreign-listed firms that did not deregister. Our evidence supports the hypothesis that foreign firms list shares in the U.S. in order to raise capital at the lowest possible cost to finance growth opportunities and that, when those opportunities disappear, a listing becomes less valuable to corporate insiders so that firms are more likely to deregister and go home.

The Economist reported in the May 31st issue that CEOs in the United States used to come in large part out of the marketing department.  This reflected the importance of this function in the profitability of the company.  But times have changed and so have the principle stepping stones for CEO.  In 2005, 20% of the CEOs in the United States were former chief financial officers. The article noted that the new emphasis on financial reporting has allowed CFOs an opportunity to be in the limelight and to shine, presumably attracting the attention of the board of directors.  Perhaps.  But it likely also reflects the importance of financial and risk management in the profitability of a business, something made very clear by the subprime lending problems of late. 

Other interesting stats?  It takes a CEO on average 24 years to reach the top.  The number of women CEOs (as of 2001) had increased to 11%.  The average age of a CEO in the US was 56, in Europe 54, with 26% of the CEOs in the United States rising through the ranks of the company rather than coming from the outside (compared with 18% in Europe).  As for the number of CEOs replaced, in 2007 the percentage was 17.6% in Europe and 15% in the US; the average tenure in the US nine years, the average in Europe seven. 

The Secretary of the Treasury has already indicated that he is concerned about the number of restatements.  As he has previously noted: 

• Restatements "have the potential to confuse investors and erode public confidence in financial reporting.  Some of these restatements might not be material to investors, and others may simply reflect new accounting interpretations." 

Well the data is in.  A Treasury (aka the Paulson Department) commissioned study has produced data on restatements.  The data largely confirms what has already been written.  Moreover, it provides little real support for Paulson's view that investors may be confused or public confidence may have eroded.  What does the data show?  The study examined restatements from 1997 to 2006. According to the summary of the study:

• While the number of restatements increased from 90 in 1997 to 1577 in 2006, the bulk of the restatements were from non-exchange traded companies (increasing from 23% in 1997 to 62% in 2006).

The executive summary also pointed out that the growth in restatements preceded the adoption of SOX, with the growth beginning in 2001, "well in advance of the passage of the Sarbanes-Oxley Act."  The paper attributes the increase to the economic downturn.  Perhaps.  But 2001 was also the year of the collapse of Enron and probably the beginning of the period when relations between accounting firms and companies were becoming more arms length.  It has always been the case that the role of SOX in encouraging accounting firms to take a more neutral approach to audits of public companies had been overstated, ignoring the market forces (and concern over liability) that were pushing them in the same direction. 

In any event, once SOX was put in place, large companies found themselves needing to restate their financial statements.  "Section 404 appears to be associated with an increase in restatements beginning in 2003, particularly among large companies. The size of restating companies appears to diminish in 2006, after larger companies implemented SOX." 

As the number of restatements has increased, the number associated with fraud have remained steady and, as a result, declined as a percentage of restatements.  In addition, the market reaction to restatements has likewise declined.  The data is consistent with the market not reacting negatively to restatements that both result in improved financial reporting, something that will ensure greater accuracy for subsequent financial statements, and from restatements that do not reflect a fundamental problem with the company's business. 

• In the past, America's lenient attitude to bankruptcy encouraged entrepreneurship, by making it easy for people to start over if they failed.  (According to one study, in fact, more than fifteen per cent of personal bankruptcies are the result of failed business ventures.)  A paper by John Armour and Douglas Cumming has found a close correlation between the nature of a country's bankruptcy laws and its rate of self-employment:  the more liberal the laws, the more likely people are to start businesses and work for themselves. . .  That will probably mean that we end up with fewer business failures, but there'll also be fewer successes.

We hear a great deal on the impact of regulation on business behavior -- witness the continued controversy over the application of SOX Section 404(b) to smaller companies.  We hear a great deal less on the impact of tightened regulation on individuals and its impact on entrepreneurial behavior. 

The latest piece of evidence comes from the Center for Audit Quality.  A report issued by the organization includes a survey taken of audit committee members.  Before we review the results, lets recap the requirements of SOX.  SOX largely defined the jurisdiction of the committee, provided that the directors had to meet a stronger definition of independence, all but required financial expertise and provided that the committee was guaranteed funding to perform its functions.  One might imagine that audit committee directors approve of the changes but are working harder.

The survey indicates agreement that the time commitment has increased, as has the interaction with external auditors (90% say this has occurred), that investors are more confident in the financial statements (65%), that the audit quality has improved (82%), and that the risk of a material inaccuracy is lower than the pre-SOX days (67%).  What is the reason for the increased confidence in the integrity of the financial statements?  Tighter internal controls, increased scrutiny by external auditors, more checks and balances in place, and increased communication and disclosure by company executives.  Finally, 92% of the directors themselves said that "their increased oversight" had a positive impact.

SOX can't prevent all fraud and it can't stop stupid decisions by boards or executive officers (such as excessive exposure to the subprime market) but it can reduce incidents of fraud and eliminate the kinds of mistakes that deprive the market of confidence in the financial statements.  In short, SOX was and is about integrity.  Henry Paulson should take note of this in considering the proper regulatory approach.

Now the numbers are in for 2007.  Glass Lewis reports that the number of restatements fell to 1172, down from 1346 in 2006.  Audit Analytics found an even greater decline, with the number in 2007 falling to 1237, down from 1801 in 2006.  In other words, SOX is working.  With a recession looming and subprime problems growing, shareholders will at least not have to worry in general that there will be other, unexpected problems that arise from sloppy accounting and weak internal controls.

The scandal at Société Générale SA, albeit a French company, shows the type of fraud that can still occur and was not addressed by SOX.  The case involved a single trader who apparently was responsible for a $7.27 billion trading loss, trading scandal, according to a person close to the bank.  Where the fraud can be engineered by a single person, the mechanisms created by SOX will make no difference.  That will always be a potential cost to investors.  But what Enron showed was that frauds could take place over long periods, involve many within the company, and be largely directed by top management, all without detection.  SOX was designed to make that type of fraud far more difficult and the evidence indicates that it has.

Cornerstone notes that a portion of the spike was attributable to the increased litigation arising out of the problems in the subprime market, a "one time" event that "may not be indicative of future filing activity."  While probably true, the discussion on the D&O Diary accurately notes that these "one time" events seem to be a regular occurrence.  "[E]ven if the subprime litigation wave can fairly be characterized as a "one-time" event, that is hardly sufficient to marginalize its continuing significance. The fact is the world of D & O liability has experienced a steady progression of "one time events" in recent years -- the bursting of the Internet bubble, the telecom crash, the IPO Allocation cases, the corporate scandals, the options backdating cases, and now the subprime crisis."   

There are many intriguing questions buried in this data.  One of the most interesting concerns the role of the PSLRA in the decrease in the number of suits. Specifically designed to reduce the number of securities fraud class action suits, the Act did so primarily by increasing substantially the pleading standards for scienter, an issue addressed in 2007 by the Supreme Court inTellabs.  At the same time, the Act provided for a stay of discovery pending resolution of any motion to dismiss. 

The approach seems to be working.  According to Cornerstone, from 1996 through 2001, 35% of all cases were dismissed.  Most dismissals come at the motion to dismiss phase (as opposed to summary judgment).  The percentage, however, is increasing.  Of the cases filed in 2003 and 2004, 42% and 43% have already been dismissed, a percentage that will likely increase (15% and 21% of the suits filed remain unresolved, neither dismissed nor settled).  Of the suits filed in 2006, 20% have already been dismissed, with 72% unresolved.  

So, the number of suits are down and of those filed, more and more are being dismissed at the motion to dismiss stage.  No doubt a substantial number of these cases were dismissed on the basis of the failure to plead scienter.

But is this approach the right one to weed out "frivolous" law suits?  Because scienter can be an intensely fact based determination and because plaintiffs do not have access to discovery (any smoking guns within the company will remain secret), the PSLRA effectively reduces the number of suits but not necessarily by eliminating those that lack merit.  The cases that go forward are the ones where plaintiff can marshal enough evidence from public sources (including, increasingly, informants) to show some type of elevated state of mind.  For the most part, these include cases involving allegations of unusual trading by insiders, GAAP violations, and, increasing, deficiencies in internal controls. 

This approach isn't limited to the federal system.  The Delaware courts have likewise developed a system of dismissing cases by imposing almost insurmountable hurdles at the pleading stage.  This occurs, for example, with respect to the efforts of plaintiffs to show a lack of board independence, a standard that generally requires evidence of subjective materiality.

How could this be?  For one thing, there is very high investor confidence.  Take a look at the Investor Confidence Index produced by State Street.  Although there has been some decline in December, investor confidence for most of 2007 has remained remarkably high. 

While there are many reasons for this, certainly SOX has played a role.  Investors generally do not fear that large public companies are rife with fraud and represent Potemkin villages rather than going concerns. 

In United States v. Ionia Mgmt. SA, 2007 US Dist. Lexis 91203 (D. Conn. Dec. 12, 2007), defendant tried to get out from underneath a document falsification conviction by arguing that the falsified documents were associated with requirements previously imposed as a condition of probation.  As a result, when the Coast Guard inspected the relevant documents, it was acting not "within the jurisdiction of any department or agency of the United States," but on behalf of the judiciary, a requirement of the anti-shredding provision.  The court disagreed. 

• "Although the Defendant's argument -- that the Coast Guard had intruded into the realm of the courts in treating a condition of probation as its own investigation -- has perhaps superficial appeal, Ionia has failed to confront how federal law already contemplates the role of executive agencies and other entities in supervising certain terms of probation. Even the precedents relied on by Ionia confirm the cooperative role that the courts and probation department enjoy with other federal bodies in order to pursue their separate objectives."  

Anti-shredding restrictions, therefore, can even apply where the investigation involves a judicial proceeding, at least if enforced by an executive branch agency. 

The attestation requirement has, however, apparently been expensive.  Moreover, with only four large auditors, there is little opportunity for companies to shop around and find more reasonably priced services.  Providing smaller companies (the Chairman contended that the number was 5000) with more time makes sense.  First, it provides additional time for these companies to get their accounting systems and internal controls in order.  Second, it still provides for accountability.  Management still must conduct the assessment. 

While there may be 5000 smaller companies, it is likely that a not insignificant number already comply with Section 404(b).  As Section 404(b) becomes best practice, those companies seeking equity infusions from private funds or are seeking to sell out to larger entities all have an incentive to comply. 

According to the litigation release, McGuire must disgorge somewhere around $12 million, including interest and pay a penalty of $7 million.  The bulk of the $468 million ($448 million) is to be paid back to the company under the compensation clawback provision in Section 304 of SOX.  This is the provision that requires the CEO and CFO to "reimburse" the company for certain incentive/equity based compensation or stock sales in the aftermath of a restatement that resulted from "misconduct, with any financial reporting requirement under the securities laws,"

All fairly impressive numbers.  But in fact, McGuire will actually disgorge nothing.  As the penultimate paragraph of the litigation release notes:

• Under the terms of the settlement, McGuire’s disgorgement plus prejudgment interest and his Section 304 reimbursement would be deemed satisfied by his return to UnitedHealth of approximately $600 million in cash and UnitedHealth options pursuant to the terms of his separate settlement with the company, also announced today, resolving employment claims and shareholder derivative lawsuits filed against McGuire in state and federal courts in Minnesota. McGuire’s settlement with the SEC is subject to the approval of the U.S. District Court for the District of Minnesota.

In other words, the only apparent addition made by the Commission was an insignificant penalty ($7 million is petty cash to someone who retains as theWall Street Journal notes, "about 24 million stock options that currently could be cashed in for a gain of roughly $800 million, on top of about $530 million in pay he pocketed while running UnitedHealth from 1991 to 2006.") and a ten year bar from serving as an officer or director of a public company.  Such bars, by the way, are usually for life so ten years is a bargain.  All of this suggests that the Commission piggy backed the private litigation, adding modestly to the outcome. 

This case illustrates an issue that came up in the Stoneridge litigation.  Some argued that there was no reason to extend liability to vendors under Rule 10b-5 because of the enforcement authority of the Commission.  In fact, it is private litigation that provides the greatest deterrence, as this case indicates.  

Those trying to find a negative impact of SOX have been stymied on numerous fronts.  We have a Dow Jones Average hovering up around 50% since the Enron low (despite the impact of oil prices) and even a tech stock rally going on, with Apple, Google and Research in Motion (makers of BlackBerries) all hitting record highs this year. 

We have a decline in the number of securities class action suits being brought, data confirmed by two different sources, and the continued existence of the cross listing premium, demonstrating that foreign companies listing in the US and meeting the higher corporate governance requirements (including those imposed by SOX) see their share prices rise. 

The most recent addition to the column concerns restatements.  Section 404 essentially required more rigorous internal controls.  Moreover, the provision did not leave the matter entirely to management.  Outside auditors had to review the controls and "attest" to their efficacy.  As one might expect, the implementation of tougher standards in this area resulted in the discovery of problems, something that has led to a dramatic increase in the number of restatements.  They have increased every year since the adoption of SOX. 

But presumably as companies get their internal controls in order, the expectation would be that the number of restatements ought to fall.  In 2006, while they increased again, they actually fell among larger companies, those that had been subject to Section 404 for the longer period.  Restatements for companies with a market capitalization of over $750 million fell by 25%.  So where was the growth?  Entirely among micro cap companies, those companies not yet subject to but preparing for the requirements of Section 404. 

One would expect, however, that ultimately the number of restatements would begin to fall as all classes of companies got their internal controls in order.  In fact, initial data from Glass Lewis, as reported by BNA's Corporate Law Daily (Sept. 25, 2007) suggests that this is the case.  According to the BNA report:

• Glass Lewis observed that so far in 2007, restatements are down across the board, with a total of 999 as of Sept. 12, compared to 1,103 for the same period in 2006. Fewer companies gave notice of a restatement by filing an 8-K report, Glass Lewis observed, with a total of 500 companies filing such reports through Sept. 12. More than half of those companies (271) had market capitalization of $75 million or less.

No doubt the year end data, when it comes out, will likewise reinforce this trend. 

We can't give SOX all of the credit for these developments, but we can observe the relationship.  Financial statements are likely getting more accurate, instances of fraud are falling and investors are flocking to the markets.  These days, for those opposing SOX, its hard to find an opening.