Significant reasons for adopting SARBANES-OXLEY ACT (SOX)

A vari­ety of com­plex fac­tors cre­at­ed the con­di­tions and cul­ture in which a series of large cor­po­rate frauds occurred between 2000–2002. The spec­tac­u­lar, high­ly pub­li­cized frauds  exposed sig­nif­i­cant prob­lems with con­flicts of inter­est and incen­tive com­pen­sa­tion prac­tices. The analy­sis of their com­plex and con­tentious root caus­es con­tributed to the pas­sage of SOX in 2002

• Audi­tor con­flicts of inter­est: Pri­or to SOX, audit­ing firms, the pri­ma­ry finan­cial “watch­dogs” for investors, were self-reg­u­lat­ed. They also per­formed sig­nif­i­cant non-audit or con­sult­ing work for the com­pa­nies they audit­ed. Many of these con­sult­ing agree­ments were far more lucra­tive than the audit­ing engage­ment. This pre­sent­ed at least the appear­ance of a con­flict of inter­est. For exam­ple, chal­leng­ing the com­pa­ny’s account­ing approach might dam­age a client rela­tion­ship, con­ceiv­ably plac­ing a sig­nif­i­cant con­sult­ing arrange­ment at risk, dam­ag­ing the audit­ing fir­m’s bot­tom line.
• Board­room fail­ures: Boards of Direc­tors, specif­i­cal­ly Audit Com­mit­tees, are charged with estab­lish­ing over­sight mech­a­nisms for finan­cial report­ing in U.S. cor­po­ra­tions on the behalf of investors. These scan­dals iden­ti­fied Board mem­bers who either did not exer­cise their respon­si­bil­i­ties or did not have the exper­tise to under­stand the com­plex­i­ties of the busi­ness­es. In many cas­es, Audit Com­mit­tee mem­bers were not tru­ly inde­pen­dent of management.
• Secu­ri­ties ana­lysts’ con­flicts of inter­est: The roles of secu­ri­ties ana­lysts, who make buy and sell rec­om­men­da­tions on com­pa­ny stocks and bonds, and invest­ment bankers, who help pro­vide com­pa­nies loans or han­dle merg­ers and acqui­si­tions, pro­vide oppor­tu­ni­ties for con­flicts. Sim­i­lar to the audi­tor con­flict, issu­ing a buy or sell rec­om­men­da­tion on a stock while pro­vid­ing lucra­tive invest­ment bank­ing ser­vices cre­ates at least the appear­ance of a con­flict of interest.
• Inad­e­quate fund­ing of the SEC: The SEC bud­get has steadi­ly increased to near­ly dou­ble the pre-SOX lev­el.^[8]In the inter­view cit­ed above, Sar­banes indi­cat­ed that enforce­ment and rule-mak­ing are more effec­tive post-SOX.
• Bank­ing prac­tices: Lend­ing to a firm sends sig­nals to investors regard­ing the fir­m’s risk. In the case of Enron, sev­er­al major banks pro­vid­ed large loans to the com­pa­ny with­out under­stand­ing, or while ignor­ing, the risks of the com­pa­ny. Investors of these banks and their clients were hurt by such bad loans, result­ing in large set­tle­ment pay­ments by the banks. Oth­ers inter­pret­ed the will­ing­ness of banks to lend mon­ey to the com­pa­ny as an indi­ca­tion of its health and integri­ty, and were led to invest in Enron as a result. These investors were hurt as well.
• Inter­net bub­ble: Investors had been stung in 2000 by the sharp declines in tech­nol­o­gy stocks and to a less­er extent, by declines in the over­all mar­ket. Cer­tain mutu­al fund­man­agers were alleged to have advo­cat­ed the pur­chas­ing of par­tic­u­lar tech­nol­o­gy stocks, while qui­et­ly sell­ing them. The loss­es sus­tained also helped cre­ate a gen­er­al anger among investors.

Exec­u­tive com­pen­sa­tion: Stock option and bonus prac­tices, com­bined with volatil­i­ty in stock prices for even small earn­ings “miss­es,” result­ed in pres­sures to man­age earn­ings.^[9] Stock options were not treat­ed as com­pen­sa­tion expense by com­pa­nies, encour­ag­ing this form of com­pen­sa­tion. With a large stock-based bonus at risk, man­agers were pres­sured to meet their targets.