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Thursday, November 21, 2013

Sarbanes Oxley: A decade plus and how is the economy doing? Pt I in a series

As I continue to watch the economy flounder, I decided look at several things that I think are hamstringing us as a country. We could be so much better but for these things.
  1. Obamacare -- I've discussed in detail of all the myriad problems with this monstrosity and I will continue in future posts. 
  2. Minimum Wage Increase -- Passed in 2007 by the newly minted democrat congress. I'll take on that in Part II.
  3. Dodd-Frank -- I will tear into that in Part III. This will actually tie into the community reinvestment act from the Carter administration.
  4. Energy Policy -- Part IV. Why do we not have keystone yet? And how much cheaper could gas be if we weren't so bullheaded about oil?
  5. Sarbanes-Oxley -- Which is Part I, and the inspiration for this article. 
These articles will take me some time and will be long winded. So apologies for the longer delays between posts.

Sarbanes Oxley: A Knee-Jerk Reaction 

When Enron threw things into a tizzy, the press stoked up public reaction to ridiculous levels. Yes, Enron was bad. I do not want to underrate it but in terms of dollars and damage, it is a piker compared to the Federal Government level of waste and corruption, but it was an isolated incident. Unfortunately, World Com decided to go up at the same time for much the same reasons: corruption at the top. Compounded with Arthur Andersen's cooking of books and we have some pretty high profile disasters.

Trouble is, they did break laws that were already on the books. There was the fraud charges not to mention lying to a criminal investigation. What they did eventually came crashing down of its own accord. New laws were not necessary.

Have you ever in your grade school youth gotten in trouble because of what another student was doing? "Since Tommy did X, the whole class will be writing a paper tonight on why X is bad!" Ever have a teacher do that? "Since Billy is laughing and talking, the entire class now has to run laps," that sort of thing. I never agreed with it. Billy screwed up, go punish Billy. Tommy did X, make Tommy write the paper.

The 9/11 reaction with TSA is a prime example of the government taking that kind of logic to an extreme. Since Muslim terrorists killed 3000 people, every Grandma in a wheelchair is now subject to a strip search. Ridiculous. Now I understand the stakes are much higher with 9/11 than with laughing and carrying on in grade school, but the idea is the same. Put new laws and restrictions in on everyone for the actions of a few.

To paraphrase Spock, The rights of the many outweigh the crimes of the one. Especially if the many have committed no crimes. Laws should never be created to try to prevent actions, but rather to put stiff penalties on those whose actions would deprive another citizen of their life, liberty, or pursuit of happiness. Once a law is put in to prevent the breaking of an existing law, then people who never committed a crime will now be deprived of their life, liberty, or pursuit of happiness.

To take it back to my example, 9/11 was a crime of murder and property damage. The TSA rules now deprive people of the liberty to travel without having to be subjected to unwanted searches. Mothers having to taste their breast milk, old ladies getting frisked in their wheelchairs, men having to explain to groping officials to not "touch their junk."

Are these laws necessary for the safety of passengers? Do they work? Should we be doing this to people who simply want to go to grandma's for Thanksgiving, who have no intention of causing harm, nor would they ever be suspected of such?

Perhaps. It's irrelevant insofar as we have accepted this as a people. We have not voted in representation that would overhaul the TSA and get rid of some of the mind numbing political correctness that results in story after story of dumb security workers making dumb decisions in searching people. We have accepted the inconvenience and occasional breaches of liberty in exchange for safety on the airlines. It is our choice and it is perfectly acceptable to make this choice, but make no mistake: We have given up some freedoms in the name of safety. Whether that causes long term repercussions or not still has a while to flesh out.

So back to Enron. While 9/11 resulted in a catastrophic loss of life, Enron resulted in a loss of money. Some people lost a lot but again, all in all, a pittance compared to what the feds lose yearly. Enron's total losses were 11 billion dollars. Consider my example of medicare that loses 65 billion yearly, compared to Enron's one-time failure, seems like the news coverage was overblown.

This was not loss of life, this was a failed company that people could freely choose to be a part of or not be a part of. Yes, of course, people were lied to. The damages should be rendered to the injured parties. And that did happen. The laws were already in place to get compensation as best as possible and punish the guilty.

But people are a panicky, emotional bunch and we wanted blood over this atrocity. After all, the press told us how bad it was and the fact that the food network cooked Enron burgers (flame broiled, of course) meant that this story must be VERY IMPORTANT and therefore congress needed to DO SOMETHING. (Never mind the total lack of press coverage over the aforementioned medicare fraud, or the hundreds of other examples of government waste and fraud, from the GSA scandal to payments to dead people.) This means votes so congress was all too happy to oblige. Enter Sarbanes-Oxley.

Once Worldcom went up, this was like gas on a fire as far as public outrages go. The media and politicians will never let a good outrage die out when you can get ratings and votes. So both houses of Congress acted quickly with newly drafted bills. Rep. Michael Oxley sponsored and passed a bill in the House while Sen. Paul Sarbanes sponsored and passed a separate bill in the Senate. They put it the conference committee crock pot and out came Sarbanes-Oxley. The bill was basically the same from both congressman with the exception that the senate version increased criminal penalties. They might have deliberated longer had Worldcom not blown and so on the tidal wave of public outcry, it whisked through and President Bush signed it.

A quick aside here, no party has their hands clean on this one. GOP at that time had 50 votes in the Senate with Cheney being the tiebreaker but the law passed with 99 votes. In the house it went for 423 votes. Bush signed it as fast as possible. Yea bi-partisanship! Both parties were equally opportunistic and gutless.

So what did it do? First the Act called for those who were convicted of participating in a conspiracy to commit a financial crime and those who actually committed that crime to be punished equally. So if you were a part of it in any way, shape, manner or form, there was no lesser punishment. I'm ok with this, again we're talking harsher punishments if you commit fraud. So far so good.

Second, the Act also provided a directive to the United States Sentencing Commission to sentence convicted offenders of the same crimes uniformly. Feh, ok. You all get 30 years if one of you do. Problem with that is juries may not see the same punishment as justice. Some may not have really participated to the degree that others. What if the jury decides to throw out the whole thing rather than hand out an over-the-top punishment? It happens.

Third: it required the certification of financial statement by both the CEO and CFO. This is ridiculous. CEO's and CFO's have different jobs, sometimes in different locations, sometimes even in different countries. Certifying that can be difficult and definitely time consuming for both positions. If they are in a fraud conspiracy together, then the both certify and move on. Thanks for making it easy! Ken Lay was the CEO and Jeff Skilling was the COO of Enron. Skilling was also the CEO of Enron's financing company. Andrew Fastow was the CFO. All were involved and convicted. Lay only got off by dying before trial.

So would this extra law do any good in Enron's situation? They were all cooking the books. All this does is to put undo stress and work on a company's execs who are supposed to be running the business. Certifying a financial statement is not a quick deal by any means. As far as convicting fraud, now you have to prove they knowingly certified a statement they knew to be false. Good luck with that. Knowing a person's heart is pretty tough. And now that they laid the blueprint, they know how to avoid looking guilty.

Finally look at the added regulations to the act in 2004. Known as SOX 404 (sounds like a web error) it mandated the periodic testing of internal controls. This is a horribly involved and complicated process that wastes thousands of man hours. Usually the controls are arbitrary and many many times there are exceptions. Company's have to hire audit firms or create their own audit positions within the company to comply. And this more than anything is what is bogging down the economy.

Why did we do all this? The ostensible reason is that these two companies had destroyed the public trust in all companies. Did they? Sure there was outrage but how much of it was stoked up by a media who already didn't trust big business? (Never mind they work for big companies.) Did you stop buying Apple Ipods because Enron didn't follow GAAP (generally accepted accounting principles)? Did you stop buying cars because GM and Chrysler went bankrupt a few years ago? I think we have this idea that the public is a bunch of generalizing dunderheads who assume that if one company is bad, they all are bad. Just like we all are just a news story away from being kneejerk racists, homophobes, bigots, etc. The media gins it up and the politicians follow. But if the press or a politician actually talks to the public and the public started showing that they can think for themselves, ala Joe the Plumber, they'll ruin him. The media and politicians have a narrative, they do not react to the public outcry, they use it and manipulate for their own purposes.

So let's see if any of these regulations worked? What has been the actual effect since it's inception 11 years ago?

Well let's first look at the certification regulation. The act specifies that there are no "material misstatements" when certifying a financial report. What what does that mean? Any "mistakes" are considered fraud and off to the hoosegow you go? Clayton Brite, of the University of Chicago writing his undergraduate law review had this to say:
It is a determination made by the company’s auditor using both quantitative and qualitative factors which results in a dollar value threshold. This dollar value, if achieved or surpassed by inaccurate transactions, would result in the company’s financial statements to be “materially misstated.” There is no standard set across all companies that must be met. In an SEC accounting bulletin, auditors were directed to not determine materiality solely on a quantifiable basis. Rather, the determination was to be considered with other factors. The auditor then makes a determination whether there is a “substantial likelihood” that a “reasonable person” would consider the information important.
When you put language in a law like "reasonable" and "likelihood" then the law is subject to all kinds of interpretation. What's worse, much of this is in the hands of the SEC whose auditors may have different definitions of "reasonable." Especially if they are democrat hacks who happen to be auditing a Koch Brothers company, for instance. What is the standard? None is given.

The net effect is that all companies will then error on the side of caution and overdo it. They will spend thousands of man hours trying to make sure they comply with some vague, nebulous idea of "materially." This is money that could be spent on growing the company and expanding profits.

Profits! You said a baaaad word. Yes I said profits. Profits do not go all into the CEO's mattress, as much as your average, jobless, hippie would like to tell you, what with all his experience in matters of accounting and running companies and whatnot. Profits keep a company afloat. It cannot just break even, that will eventually lead to the company's ruin. It has to give out raises, it has to compete with other companies and lower prices. Which means it has to do things better and cheaper while competing for the best labor it can. No profits means no taking care of the workers, no health insurance, and finally, no company.

The economy is flagging and a big part of it is the Sarbanes-Oxley law. Now in full effect, it's no accident that things started flagging around 2007. The real estate market may have knocked the bottom out of the economy but things like Sarbanes-Oxley are the cement blocks companies have to drag behind them as they try to get themselves out of the hole.

Remember there are stiff, stiff penalties to screwing this up. Executives get paralyzed with fear of jail or at the very least, millions of dollars in fines. This hamstrings them from making good decisions for the company, decisions that really are to comply with what what Washington tells them.

The costs are impressive:
Complying with Sarbanes-Oxley Section 404 is very time consuming. On a quarterly basis, employees are required to meet with their auditors and go over their internal control policies and procedures. Auditors use this opportunity to determine if there are proper controls in place to ensure that only employees who are allowed to perform duties to carry them out. The reasoning behind this test is to ensure fraudulent or incorrect transactions can be reasonably prevented from being processed. In addition, auditors look for evidence of oversight or review by superiors to ensure transactions are not be performed unilaterally without review by one or more parties. They use their findings to submit a report regarding the “effectiveness” of the company’s internal controls. Effectiveness, as defined by the SEC with respect of internal controls, is the ability to prevent even one material accounting error from occurring. 
Although this thorough practice ensures a periodic review, it forces too much time and resources to be allocated to ensure auditor compliance. Quarterly tests of internal controls divert employee time and attention away from business practices and to administrative tasks. It is inevitable that these tasks will eventually be detrimental to the company’s “bottom line.”
Like it or not, the bottom line for any company is to make money. You think the small mom and pop shop down the street is doing it for free? Is the oh-so-social conscious actor doing his craft for free? Or donating all his millions, except for what he needs to live on, to charity? Yeah probably not. People want things and a nice life. There's no crime in that. These paternalistic regulations force people and companies to waste energy to prevent something that they are not doing in the first place: fraud. Well again, we already have fraud laws and they didn't prevent Enron. They did however make sure the guilty were punished when it went down.

And competitive capitalism made sure Enron went down. Companies who build their portfolio on lies are building a house of cards. Of course it will fail. Yes, people get hurt by Enron. But that was localized and temporary. Sarbanes-Oxley is ongoing and affecting EVERYONE who works in or with a public company. Which is just about the entire nation. Sounds to me far more people are getting hurt with these stifling regulations.

What about foreign companies? You think they want to come to the United States and sell products and employ people? You think they want all these headaches that makes it too costly and time consuming to expand to the United States? If you say yes, then you are a hopeless liberal.

There are still only 24 hours in a day. 2080 working hours in a year. Devoting more and more of those hours to trying to comply with audits take away time that could be spent in helping the company. Sure, they could hire more people but that's a cost with absolutely no return on investment. The only solution is to raise prices. But the wages a company pays now don't go up, they go down. They have to hire more people to sell a product. They can only spread out the wages so far based on the profit they make from the product and raising prices means selling less product. And every company is having this problem.

People work for one company but buy products from all sorts of different companies. And those companies have people who buy products from all sorts of different companies. And ALL companies are reducing wages and raise prices.

So now people have to spend more while getting less. See the problem?

Oh right, all of this happens only because companies are greedy. I forgot. Silly me.

Small companies also have to comply, some private companies also have to comply. Neither of these have resources to keep up. It makes it even harder for these mom and pops you liberals love so much.

I'll let Clayton Brite sum up:
When looking back upon the first ten years of the Sarbanes-Oxley Act, one can only conclude that it has placed an undue burden our public companies and stifled our economic growth. The Act’s costs have greatly outweighed its benefits and thus needs reformed. Its effects have been perhaps more pronounced by the current financial crisis and the slow economic recovery. It is my opinion that lawmakers felt the pressure to punish corporate Americans when they should have focused their attention on trying to reduce information asymmetry. Sarbanes-Oxley was written and passed within one month in 2002. With the empirical evidence we have now in its first decade of existence, it is time to go back and reform Sarbanes-Oxley and ease some of the burdens it has placed on companies which fall under its punitive purview.
Companies are not the enemy, they provide jobs, goods, and services we all enjoy. Hurting them hurts only ourselves. Punishing companies who have done no wrong in the first place is where I think government constantly is crossing the line. We are supposed to be free to pursue our happiness but big daddy government makes it harder and harder. Just try to create a company out of your garage these days. Most likely you'll need a myriad of permits before you've even sold your first widget. And if you have that much capital to start, why not just retire?

And the left wonders why the economy is dragging. Maybe because the government is too worried about touching a company's junk.

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