Sarbanes Oxley Act of 2001

Sarbanes-Oxley.

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.

Introduction.

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 to all securities listed on the stock exchanges. And last of all, the Securities and Exchange Commission was established.

The law was often referred to as the "truth in securities" law. According to the SEC's web site, the Securities Act of 1933 has two basic objectives:

require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities.

This act was partly authored, ironically, by Joseph Kennedy, who was considered an expert in that he had made much of his money illegitimately through the sale of liquor. Although regulation enjoyed broad-based support, it had its opponents. The most prominent among them was the president of the New York Stock Exchange. However, he was soon silenced when it was found that he had been embezzling from one of the organization's charities after his post-prohibition investments in New Jersey Applejack had gone sour.

Roosevelt's message to Congress regarding the new Securities Act excoriated about financial practices that are neither ethical or honest, assumes the obligation of government to "give importance to honest dealing," and promises further legislation -- the Securities Exchange Act -- to correct unethical and unsafe practices so that we can return "to a clear understanding of the ancient truth" that financiers are "trustees acting for others." Although progressivism had dominated the United States political scene through the Wilson administration, the last several Presidents had been conservative and valued the market's ability to self-regulate. The last perceived threat to the national economy had come from banking trusts, prompting the establishment of the Federal Reserve. In the 1920's, Andrew Mellon was the Republican Party's principle financial guru. Mellon dropped the wartime progressive tax burden on the super-wealthy from above 70% to below 30%, causing the nation's rich to move their money out of largely tax exempt municipal securities and back into the market.

When a primary market is created for securities (an Initial Public Offering,) a company is required to distribute a prospectus. Smaller securities offerings or private offerings were exempt from the new legislation. Also exempt were intra-state offerings and municipal, state and federal offerings. By exempting small offerings from the registration process, legislators sought to foster capital formation by lowering the cost of offering securities to the public. Smaller offerings didn't have the 'hurdle rate' usually associated with compliance.

The SEC's first focus was to establish guidelines for the registration of new securities. Such a process allowed investors to make informed purchasing decisions when looking at different securities. Originally, compliance efforts were meant to maximize disclosure at a minimal expense. Such regulations pre-dated the establishment of a with-holding tax, so compliance was something novel rather than a new facet of financial bookkeeping.

According to the SEC, Registration must include:

description of the company's properties and business; description of the security to be offered for sale; information about the management of the company; and financial statements certified by independent accountants.

Registration statements and prospectuses (preceded by 'Red Herring' prospectuses) become public soon after filing with the SEC. These measures are primarily set up to defend the initial public market. It is understood that prior to the establishment of this market, the private holders, 'angel' investors and venture capitalists responsible for providing the initial financing for a new venture are willing to incur significantly greater levels of risk in order to reap the reward of a new opportunity. Venture capitalists and private equity departments of large investment banks have evolved into the industry's specialists in this particular field.

Although these requirements were made of companies in 1933, the SEC was established under another act in 1934; the Securities Exchange Act. This act pertained to the secondary market; the market in which people buy and sell securities rather than the initial market in which privately owned securities are made public. This act gave the SEC oversight with reference to the entire securities industry. The SEC was entrusted with the regulation of securities registration and placed over Self-Regulatory Organizations such as the National Association of Securities Dealers. The organization polices insider trading, which has been traditionally considered the biggest moral threat to the securities industry. This is still the case; those that would see their companies fail and act on this material information before it becomes public only enhance the threat of insider trading.

Insider trading is forbidden with respect to the offer, purchase, or sale of securities. The SEC defines an insider as someone who has material, nonpublic information. Material information is any information that is considered relevant to the value of the securities of the firm. Insiders are thought to have a responsibility to their companies and to the market to keep this information confidential. The Association for Investment Management Research maintains a more comprehensive set of standards, which is specific to securities analysts.

The act requires periodic reporting, which has become formalized in the 10-k and 10-q forms that provide the basis for most of the investment information that is available to individuals. Analysts, in addition, have at their disposal the ability to interview company board members on a regular basis and to participate in conference calls. The process by which information is disseminated is expected to be as uniform as possible, within reason. Companies that own more than 10 million in assets, whose securities are owned by more than 500 owners are required to post these SEC filings, which are then made available on the EDGAR web site. In addition, most companies provide Annual reports that act as a dressed-up version of the 10-k. They are considered the organ of management's opinion and its statement of the kind of guidance that they will provide the company over the course of the following year or several years.

The SEC mandates the methodology that companies use in materials that solicit shareholders' votes in shareholder meetings or meetings convened to elect directors or approve other major actions by the board. Such information must be filed with the SEC prior to its dissemination to the public. They must fully disclose all material information to the voters. Exchanges such as the NYSE, ASE, and NASDAQ, and industry organizations such as the NASD and AIMR are required to register with the SEC. The SEC also requires brokers, dealers, transfer agents and clearing houses to register. Originally the SEC mandated commissions, but this has been rescinded since the 1960's, leading to a greater volume of trades.

Public opinion found three culprits for the stock market failure between 1929 and 1932, which have their parallels in the events leading up to the introduction of the Investor Protection act of 2002. It was common wisdom that irrational exuberance had lead to what was thought of as a 'speculative orgy.' Drawing on the anti-authoritarian suspicions of their populist, progressive forbears, many claimed that Investment Bankers and the Federal Reserve were to blame. Congressional leaders shared this opinion, as Walter Sach's megalo-maniacal delusions were not atypical. Many claimed that the guilty parties in the Federal Reserve had diverted credit from productive purposes to sustain the boon. Another set of culprits were the contrarian investors that sold short. Although technical analysis was more even more popular at the time than it is now (and remains one of the only ways to make money in a down market) many resented these specialists for profiting from others' misfortune. Market leaders claimed that such people allowed for stocks to avoid a steep upward climb in value that resulted from there being no sellers, but it was to become a difficult fight for these investors to maintain the legality of short selling.

The second reason was that of securities fraud. However, unlike the securities fraud of the last few years, this fraud usually involved start-ups or relatively new companies. Several examples were given during the Senate investigations into stock exchange practices, which occurred in 1933 and 1934. Some of the investment banks were directly implicated in the issuance of fraudulent securities. Initial Public Offerings today are usually under-written by several bulge-bracket banks, but in the 1930's this was not the case. In the recent collapse, several industries in particular were associated with securities fraud, including telecommunications.

The third reason was that of stock market price manipulation. This included the private sales of publicly traded equity securities and the active manipulation of securities by pools of investors. Bankers would also use depositor's money to trade speculatively. This has happened within the last ten years, but is usually limited to special cases. For instance, Nick Leeson destroyed Barings Bank by buying forward contracts to purchase Japanese Yen immediately before the Kobe earthquake. Companies would also keep stock values high for advertising or commercial purposes. This was more of an accusation than anything else - there are (and were) too many investors to structurally allow any attempt to control stock market prices to take place.

Many consider the Investor Protection Act of 2002 to be the most sweeping array of reforms since the initial acts that established the SEC in 1933 and 1934. This reflects several systematic similarities between the economic contexts of these acts. When later legislation was introduced, such as that which regulated mutual funds in 1940, this legislation was considered minor because it was not done in the wake of a 'speculative orgy' that resulted in a free-fall in shareholder value in the sense of the late 20's or the late 90's. Most legislation originates with a broad-based consensus of the need for social change or with lobbyists.

This should interest the analyst because legislation is introduced only after there has proven to be a need as demonstrated through market failure, rather than as new technology changes the nature of the market. It is interesting that the early 30's - considered by many to be the market's darkest days, also produced what were to become lasting scholarship in the field of stock market analysis. It was at this time that the Value Line Corporation was founded in order to determine the 'timeliness' of stocks - that is, when stocks should and when they shouldn't be purchased by investors. This index is still widely popular today. Also to emerge from this decade was Benjamin Graham and David Dodd's famous work, simply entitled Securities Analysis.

Graham and Dodd were seminal in that they relied solely on pragmatic criteria for determining the intrinsic value of a corporate stock. Whereas previous investors had assessed property value, Graham and Dodd looked at a company's ability to deploy capital to earn income, which they considered decisive in one's judgement about stock prices. Two factors were considered most important: the results of a careful, skeptical examination of elements affecting a corporation's future earnings. These included general economic prospects, probable industry growth, market shares, and dividend payout rate. The corporation's value was based on these measurements. The analyst would then proceed to compare the stock's value to the marketplace. The question asked was whether or not a "prudent business man" would pay for the opportunity "to invest in a private undertaking over which he could exercise no control." If the market price was less than the projected price, a "true investment opportunity" had been developed.

Four years later, John Burr Williams published his doctoral dissertation on The Theory of Investment Value. Although he agreed that the appropriate determination of a corporation's intrinsic value based on an assessments of the company's earnings capacity, he went further to say that a stock is worth the discounted present value of all future income. To Williams, a stock is worth "only what you can get out of it." Williams' model was intuitive; whereas previously investors had seen their ownership of equity as a claim on the assets of a company, Williams established it as a tool.

This is perhaps the chief difference between securities fraud in the late 20's and today; companies in our time had mis-represented the numbers that are often used to determine an appropriate value. By the 1990's, many companies didn't pay any dividends and a discounted cash flow model was used to determine corporate value. Unfortunately, a company parts with a dividend and so it can be considered tangible. Traditionally, growing companies have opted to re-invest their incomes. The alternative would be to return money to investors that would then have to use the money to seek investments with lower yields.

The History of GAAP and Accounting Methodologies.

The new SEC had the authority to develop accounting standards. These had evolved much as did common law: through consensus and common practice. The Financial Accounting Standards Board, established in 1973, is the private organization that has the authority to recognize changes in common accounting practices. This organization falls under the authority of the SEC, as was established in the 1934 Securities Exchange Act. According to their web site, the FASB is part of a structure that is independent of all other business and professional organizations. Before this structure was created, financial accounting and reporting standards were established soon after the 1934 act by the Committee on Accounting Procedure of the American Institute of Certified Public Accountants (1936-1959) and later by the Accounting Principles Board, also a part of the AICPA (1959-73). Pronouncements of those predecessor bodies continue to remain in force unless amended or superseded by the FASB.

Whereas the 1933 and 1934 acts resulted from the interpretation of a perceived market failure, the FASB was created in 1973 because of awareness in the business community of a need for a permanent, separate authority to cover policy with respect to accounting standards for the preparation of financial reports. In many respects, the American Institute of Certified Public Accountants is the FASB's parent organization and represents the professional community of accountants. Self-regulation (to some extent, before the 2003 act) was regarded as fitting for the accounting and financial communities (the actions of investment analyst conduct is covered by the AIMR, the NASD covers the actions of broker dealers and registered representatives.)

The FASB claims as part of this mission that accounting standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information. However, it is more or less an attempt by the accounting profession to preclude the direct federal administration under the SEC allowed under the provisions of the Securities Exchange Act. FASB claims on its web site "Throughout its history, however, the (Securities Exchange) Commission's policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest."

Whereas the AICPA covers the actions of CPAs, which often work with individuals or small privately held firms, the FASB's primary focus is publicly traded companies. The stated mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. The FASB's intent is to perfect the discipline of financial reporting by ensuring that methodologies that are commonly used are both relevant and reliable in that they are comparable and consistent.

Comparability is especially important to investment professionals, and was a chief complaint of those that lost their money in the financial collapses of 2000 and 2001. Because many companies were exploiting methods of asset valuation in order to artificially inflate the presumed value of their assents, decrease their debt load, and enhance their revenue forecasts. In the case of many of the newer Internet companies, these were meant to enhance growth expectations, where in the case of telecommunications companies, they were meant to preserve an illusion of solvency.

FASB also attempts to keep standards current to reflect changes in methods of doing business and changes in the economic environment. This reflects the era in which the FASB was created. The dollar was allowed to float against gold for the first time during the Nixon administration following the disintegration of the Bretton Woods system of international exchange. Over the last 40 years, money has been allowed to travel freely across borders to a greater and greater extent. Regulation conscious individuals in the 70's and especially the early 80's commonly believed that government caused more problems than they solved; this is why attempts at new forms of managing securities exchanges came from within the investment community, even as technology changed and ultimately empowered the industry.

The collapse of Bretton Woods and emergence of the free exchange system is reflected in another one of FASB's stated objectives: It wishes to promote the international convergence of accounting standards concurrent with improving the quality of financial reporting. European accounting standards are considerably different in several respects. Europeans have almost all adopted International Accounting Standards (IAS) and there are more than 300 differences between the two methodologies. Under Germany's accounting standards, good will -- " the difference between the purchase price and fair value of acquired net assets -- " may be charged directly to shareholders' equity or capitalized and amortized over its useful life, which generally ranges from five to 15 years. However, under U.S. GAAP, goodwill must be capitalized and amortized through the income statement over its useful life, which is not to exceed 40 years. Amortization and depreciation rates for other assets differ from country to country as well.

In the United States, research and development costs are treated as expenses as they are incurred. According to International Accounting Standards, however, research costs may be treated as an expense, but development costs are capitalized. Under the IAS, a company's pension benefits are reported as accrued, while the U.S. GAAP reports them as projected benefits, which generally increases a company's expenses. There are three ways in the United States to project pension benefits, including one that takes into account all potential bonuses, promotions and new hires. These factors all make IAS and GAAP fundamentally different methodologies.

Sarbanes-Oxley

Going into the final decade of the 20th century, the United States had what seemed to be a well-regulated equity market. Various self-regulatory agencies were established by professions to guarantee their members' integrity. However, there were cracks in the system. Trust was placed in the hands of several accounting firms that represented over 70% of the country's corporate auditing activities, collectively known as the big six. However, the big six further coalesced with mergers such as that between Price Waterhouse and Coopers and Lybrand. By the end of the decade, the country's largest banks found themselves wielding an enormous amount of power and pushed a bill through Congress that would allow commercial and investment banks to merge, creating Goliath banks that handled the issuance of debt, underwriting, and the coverage of stocks for investors, as well as issuing commercial loans like home loans and maintaining checking accounts.

Following the failure of WorldCom, Enron, and several other firms that had unsuccessfully tried to implement new technologies and the use of double-bookkeeping, the Federal government finally became convinced that the Financial system needed redress. The Investor Protection Act that follows reflects these sentiments, and proposed new limitation that would not only cover issues such as corporate responsibility and analyst conflicts of interest, but also such issues as auditor independence and corporate tax returns. Among the most important features of the new legislation is the establishment of the Public Company Oversight Board, which differs substantially from the Financial Accounting Standards Board.

Like much legislation, Sarbanes-Oxley began with a reaction to an event that dominated the media and became part of the public's consciousness. The collapse of Enron, an Oil Services company thought at one point to be one of the largest in the United States, left many asking about the credibility of its auditors and executives. When it was found that both of these parties were largely deceptive, it became clear that America's reliance on the 'Final Four' Accounting firms to safeguard corporate responsibility was woefully lacking. At this point, the financial reporting basis for equity purchases was thrown into doubt. Despite historically low interest rates, few wanted to extend credit to companies that might or might not be actively manipulating earnings statements in order to curry investor favor.

America's companies needed a return of investor confidence. The House of Representatives, under Republican House Financial Services Chairman Mike Oxley, drafted a weak version of the law in March of 2002. When the bill reached the Senate, which was dominated by Democrats, it was significantly expanded. The final draft to be passed to the White House largely reflected the Senate's draft, as the collapse of WorldCom made the issue of corporate accountability seem all the more pressing.

President Bush, using the new law to boost his popular opinion among a public that had been punished when the broad-based ownership of equity backfired, remarked: "This law says to every dishonest corporate leader: 'You will be exposed and punished. The era of low standards and false profits is over. No boardroom in America is above or beyond the law.' This law says to honest corporate leaders: 'Your integrity will be recognized and rewarded, because the shadow of suspicion will be lifted from good companies that respect the rules.'" (Bush, July 2002)

The House provisions placed in the Senate bill inclued a stronger Securities and Exchange Commission oversight of corporate wrongdoing, stiffer penalties for corporate executives, and restitution for defrauded investors and real time disclosure of any information changing the financial health of a company. "It's not the total answer, but I think we've made excellent progress," Oxley said. (Roll Call, 2002)

The Democrats were also quick to congratulate themselves for the deal. House Minority Leader Richard Gephardt of Missouri called the bill an "unconditional surrender" to what Democrats have been seeking. Interestingly, this demonstrates the Democratic party's dedication to what they perceive to be a middle class that owns securities investments. "By now, it ought to be clear that it is long past time for this Congress to take strong action to address the crisis of confidence and to get our economy moving in the right direction again," Gephardt said. "We have an obligation, a responsibility, to restore people's faith." (Roll Call, 2002) The Republicans, long accused of being dominated by corporate interests, were equally happy with the outcome of debates on the Hill: "Our perspective is: Irrespective of which party we're talking about, it's a win for investment confidence in America," said Greg Crist, spokesman for House Majority Leader Dick Armey (R-Texas).

The Public Company Accounting Oversight Board

In early September, in my first public speech as a member of the Commission, I said that the "most important task that the Commission now has before it is the creation of a strong and credible Public Company Accounting Oversight Board." There should be no misunderstanding of the critical role to be played by the new Oversight Board. The future health of the accounting profession, and derivatively, of the quality and integrity of our financial disclosure process will depend, in meaningful part, on what we do today. In terms of the public's stake in what we are doing, the simple answer is that honest and high quality financial numbers are necessary to make our economic system work. The Oversight Board was the centerpiece of the Sarbanes-Oxley Act, which was the bold step Congress took to repair the damage inflicted by the scandals at Enron, WorldCom, and Andersen.

Harvey Goldschmid, Commissioner, SEC, October 25th, 2002.

This Board is established to provide financial oversight of publicly traded companies. Before the Enron collapse, it was believed that private auditing firms were capable of handling this responsibility. However, Enron convinced many that this was not the case, as several of Andersen Consulting's partners were complicit in the fraudulent activities that were to ultimately destroy the company. Interestingly enough, the establishment of the Board was heavily endorsed by all of the major accounting firms in order to stress that they didn't want to repeat the embarrassing legacy of the Enron scandal.

The stated purpose of the Public Company Accounting Oversight Board, which is a non-governmental board reporting to the SEC, is to provide for the interests of the public by encouraging the preparation of informative, accurate, and independent auditing reports. It operates as a not-for-profit corporation and must legally have a successor unless Congress rules otherwise. No-one within the organization is allowed to be a government employee. In many respects, this organization is similar to the NASD or FASB, but whereas the former regulates Securities professionals and the latter lawyers, the PCAOB's is chiefly responsible for overseeing the actions of corporate board members. Although board members and others who own more than 5% of a public corporation are expected to do a number of things under the SEC such as file when they buy or sell the company's equity, PCAOB requirements are far more stringent.

The PCAOB is responsible for insuring that organizations comply, and may bring non-compliant companies to court. In July of 2003, for instance, a board-ordered investigative report determined that top executives at Freddie Mac, another government-created company, managed earnings, but did not inflate them. This prompted the board of directors at that company to fire their CEO, president and CFO after their president, David Glenn, admitted to having altered old personal notes of his after they were found to provide damning evidence. Such incidents, before the existence of the PCAOB, used to be considered misdemeanors. It is fairly easy for an accomplished financier to alter reported earnings merely by including or failing to include certain expenses as regularly occurring ones. However, the rampant abuse of this ability lead investors to have faith in many failed companies despite an incapability of such companies to post favorable earnings results.

The effect of such activities has been to make top American executives far more conscious than they once were. Many have hired financial litigation specialists merely to cover the incident. The act allows for criminal proceedings to be brought against board members for financial misrepresentation. Beforehand, it was held that the actions of a company were not necessarily the result of board decisions and limited liability protected even the most instrumental executives from attacks on the companies they worked for.

The first section of the act not only requires public companies to register with the PCAOB, but accounting firms as well. Despite this, most accountants and corporate law firms herald the introduction of the Sarbanes-Oxley act, because corporations face more strict and personal penalties if they violate new regulatory requirements. The PCAOB will establish new accounting standards as they are proposed by professional accounting organizations, with a special emphasis on auditing reports. This places FASB (formerly entrusted with this capacity) under the jurisdiction of the PCAOB.

The PCAOB was born in a cloud of partisan bickering. The chief responsibility for its establishment fell to the Securities and Exchange Commission. John Biggs, the CEO of TIAA-CREF, a large teacher's pension fund, was eventually selected because he was 'more independent' than the other two men up for consideration, who many (including the Wall Street Journal and Washington Post) were thought to be too close to the Republicans who had ultimately endorsed the establishment of the bill. Biggs, a personal friend of United Nations Secretary General Kofi Annan, is prominent in New York's financial community and plays an active role in the New York-based Foreign Policy Association. The FPA hosts annual events and conferences, which feature world leaders as speakers. Biggs was selected as a candidate by three of the most prominent men in America's financial community: Federal Reserve Chairman Alan Greenspan, SEC Chairman Harvey Pitt, and Treasury Secretary Paul O'Neill. Biggs will sit at the head of a five-person board responsible for oversight of the new organization.

The Board may also convene or authorize the creation of expert advisory groups that it finds appropriate, including groups of accountants with the purpose of making recommendations concerning standardized practices regarding auditing, quality control, ethics, independence, and other standards. Here the PCAOB is co-opting, if not underscoring the authority of such organizations as FASB, NASD and AIMR. Such organizations should be expected to work closely with the new organization, although one can expect the PCAOB to retain direct contact with board members whereas professional organizations rarely do more than pursue fraud, maintain recourse for continued education, and issue certifications. This allows the PCAOB to wield direct influence over some of the United States' most powerful executives.

Auditor Independence

From the title, we can ascertain that this feature of the Investor Protection Act is a direct reaction to Andersen's failure to prevent Enron's board from defrauding its employees and shareholders. With its Auditor Independence feature, the Act formalizes measures to promote the independence of auditors, adding new processes to principles that are already embodied in existing securities laws and accounting standards. These laws protect investors in publicly held companies by requiring accountants that certify financial statements to be independent. This feature reflects existing standards of conduct among auditors, and enhances the trustworthiness of the audit. Necessary minimum qualifications are established in order to avoid disabling conflicts of interest. These also permit an audit firm to represent an independent auditing committee.