The political pressure of the past several years following the dot.com bubble and the collapse of several major companies created a need for new securities legislation, which culminated last year in the Sarbanes-Oxley Investor Protection Act, which establishes new guidelines for the securities industry. Initially a Democratic brainchild, the act became favored by Republicans in the House when it was realized that such adjustments would be of great benefit to shareholder value in that they enhanced general financial stability. This is the most prominent piece of financial legislation since the establishment of the Securities and Exchange Commission in the early 1930's. The most widely recognized feature of the new legislation, which was introduced in 1992, is that board members are held personally and criminally liable for the accounting practices that the company employees. This act also establishes guidelines as to the coverage of securities by sell-side analysts who face a conflict of interest in offering objective advice about the financial nature of companies that their firm is issuing debt.
This report covers the Investor Protection Act of 2002, its development in congress, its historical context, what it means to accountants and organizations, how it has developed in the last year, and how it is expected to develop in the future. Particular interest will be paid to how it is expected to eliminate risk by preventing companies from certain moral hazards previously associated with the securities fraud that was feared to have become pandemic among equity analysts by late 2001. The report will also question that the intrinsic problems associated with irrational exuberance and the issuing of recommendations are successfully addressed by the new legislation.
According to 'Monkey House,' a popular expose of the investment banking community published before the financial disasters of 2000 and 2001, a securities analyst working for a major investment bank or brokerage firm can do his job in one of two different ways. He can either be honest about the equities he covers in which his firm maintains a financial stake, or he can paint a euphemistic view. Despite the wall between people within such organizations that are expected to provide impartial information and the investment bankers who are attempting to sell their pitch books to institutional investors in deals that would allow a company to issue more debt, the authors contend that the common wisdom in their firm, DLJ, was that the weight of pressure from their employers far outstripped the prospect of censure from the AIMR (Association for Investment Management and Research; the organization that maintains the Chartered Financial Analyst designation) and others. Although negative pressures existed, incentives were just as forceful: the authors spoke of the respective lifestyles between 'objective' analysts and their obedient counterparts in terms of restaurants: whereas the objective analysts could expect to be eating at Denny's, their obedient counterparts regularly dined in New York's best restaurants, such as Lutece, Four Seasons, and the Grammercy Tavern.
When calamity forced a closer look, it was found that the flaws of these analysts were also to be found in companies' accountants, their auditors, their CFOs and members of the board. Although it had been axiomatic that investment professionals provided the necessarily pseudo-factual rationale as to why companies with little or no revenue were worthy of high share values, few expected that such a seemingly well-structured system of valuation could mask such a scale of graft and irresponsibility. The thrust of the Sarbanes-Oxley is to tighten the screws on audit committees, accountants, and attorneys.
In the popular press, scandals such as that of Enron and WorldCom were portrayed in the 'class warfare' context generally ascribed to media pundits: the popular image was of 'Boiler Room' style registered representatives predating on innocent middle class homeowners. However, Wall Street was on the front lines, and was the hardest hit: suddenly financial professionals and auditors found themselves in the ill-repute afforded snake oil salesmen as the nature of valuation was brought into complete question. Companies were also left wondering in what context would investors trust them enough to provide the capital that was necessary for them to grow.
The Investor Protection Act was intended to address all of these problems and thereby return surety to an industry that can't exist without the standardized presentation and disclosure of relevant information. It was primarily aimed at the top: since fraudulent leaders controlled deceptive organizations, these leaders became the focus of new accountability requirements. Although the last major legislation in finance came in the early 1930's, there had since been attempts to self-regulate through organizations such as the National Association of Securities Dealers and the Association for Investment Management Research. This represented a transition over the course of 70 years from an investment environment that lacked any methodologies of comparing equity values to one in which these methodologies were rigidly defined.
During this time, the publication by Graham and Dodd of the first comprehensive book on securities analysis in the late 1950's represented a veritable revolution in investment analysis. The reason why the development of valuation models was so significant was that they allowed investors to use estimates of risk, future cash flows and financing rates to determine an appropriate price. Before, investors had to rely on balance sheet descriptions of past earnings to determine a company's value. As the exchanges' technological capacity to handle voluminous trades increased, so did the popularity of the equities market and equity analysts. By the late 1990's, investors could compare recommendations, read Annual Reports and place orders online. Companies had day-to-day feedback and an uninhibited flow of feedback from sales.
Two years ago, a popular series of television commercials for a financial web site on CNBC depicted a series of conversations between people that consisted of them saying things that they were privately thinking instead of what they were expected to say. For instance, an interviewer asks "MBA?" To which the interviewee replies "I added that this morning" and the interviewer retorts "I always put PHD." The 'punchline' to the commercials was "What if there was an investment community without any secrets?" It is considered common wisdom that the uninhibited flow of investment information lowers borrowing costs and makes equities more attractive. The Investor Protection Act of 2002, if successful, will add billions of dollars of value to publicly traded companies. If we are to see ourselves as long-term securities analysts, this is of categorical importance to us; it allows us to have the ability to predicate our investment decisions on the success or failure of existing legislation. In order to come to a conclusion about Sarbanes-Oxley, however, we must first review the history of securities regulation and valuation, look at the process that prompted the legislative process that brought us Sarbanes-Oxley, and then critically interpret the effect of this act on the financial stability of companies publicly traded in the United States.
The Securities Market (and its Enemies): A History
Thirty-five years after the collapse of the 1929 bull market, Walter Sachs of Goldman Sachs & Company was asked what led him and his firm to increase the speculative fever of 1929 by selling stocks in a madcap pyramid of investment companies. They were sparked, he responded, by a desire "to conquer the world!" It was "not only greed for money, but power....and that was the great mistake."
According to the original language of the Securities Exchange Act,
National emergencies, which produce widespread unemployment and the dislocation of trade, transportation, and industry, and which burden interstate commerce and adversely affect the general welfare, are precipitated, intensified, and prolonged by manipulation and sudden and unreasonable fluctuations of security prices and by excessive speculation on such exchanges and markets, and to meet such emergencies the Federal Government is put to such great expense as to burden the national credit." (Burk, 1992)
It is to be remembered that the bottom of the market did not occur in 1929, but rather in 1932: the steady decline of prices in the New York Stock Exchange reflected a loss of certainty that was widespread among investors. Three acts supplied the basis for federal securities regulation. They are the Securities Act, signed 27 May 1933, the Glass-Steagall Act, signed 16 June 1933, and the Securities Exchange Act, signed 6 June 1934. Passed within fifteen months of one another, the first two of these were enacted by the "hundred day" session of Congress with which Franklin Roosevelt began his tenure as President.
The Securities and Exchange Commission
Congress drafted the Securities Exchange Act in order to regulate the conduct of speculative trading. This regulation was to be achieved in three ways. First, practices such as wash sales, matched orders, and the dissemination of false or misleading information to raise or lower stock prices were banned. Other practices, notably short selling, were subject to closer supervision and rule. Second, because it was believed that price manipulation was facilitated by ignorance, registry and disclosure requirements that had been applied to initially offered securities offered under the Securities Act were extended…