Sarbanes-Oxley Act: regulatory response to securities fraud and analyst conflicts

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).

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.

The independence of an auditor is intuitively necessary. In order to provide a fair evaluation of a firm, the evaluation must also be objective. Since auditing is a process whereby a firm communicates the validity of its financial practices to investors and tax authorities, to pressure an auditing firm or committee to ignore facts or window dress poor financial processes is to sabotage the audit. Most major auditing firms recognize this; it is intuitive but does not preclude individual auditors from currying individual favor from companies they are expected to evaluate by providing euphemistic or deceitful reports. This was especially true in the case of Andersen and Enron: Andersen's leadership failed to monitor the actions of its auditors closely enough, where Enron's leadership was engaged in an active process of theft and sabotage.

Price Waterhouse, in its guide to the Investor Protection Act, stresses the recognition among leaders of the accounting profession that its days are numbered if professional integrity is not insured. PWC cites and understanding among private auditors and new legislative authorities that professional ethics or 'mental attitude' as being as important as compliance with applicable regulations.

Certain non-audit services generally provided by auditors in the past are forbidden by Sarbanes-Oxley because they are inconsistant with the independence required of the audit. These rules prohibit a fund's audit arm, either conditionally or categorically, from providing sevices to the fund or other entities in the investment company complex. Sarbanes-Oxley allows the PCAOB to establish new indepence rules as they are perceived to be necessary to the accounting profession.

Most instrumentally, a firm may not act as its own auditor, act as its audit-client's advocate, or be involved in the management of a firm that it is attempting to audit. Tax services are exempt from this new feature of the new legislation. These include tax compliance, tax planning, and tax advice. These services, when performed by an auditor, do not impair the auditor's independence, as long as the audit committee gives its pre-approval. Audit committees, however, are advised to review the specific services that will be offered. Price Waterhouse gives the example of representing a client in a tax court, which would violate the prohibition on acting as one's client's advocate. Additionally, the SEC has warned the audit companies to scrutinize services related to tax avoidance. This may have been prompted by Enron's creation of a holding company, to which it sold its assets.

Corporate Responsibility

The Corporate Responsibility requirement of the Investor Protection Act is considered to be at the heart of the legislation. This section establishes a mandate that principal corporate officers sign statements swearing that the required SEC filings - the 10-k forms and 10 - q forms, are accurate, and holds the board members criminally liable if they have been deliberately falsified. The CEO and CFO or their equivalents must submit a form verifying that, based on the officer's knowledge that the report does not contain any untrue or misleading statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of circumstances under which the said statements are made. The financial statements must, based on the officer's knowledge, fairly present the financial condition and results of operations for the periods presented in the report; usually three months or a year.

This feature of the Sarbanes-Oxley act was the most widely touted by President Bush last year. After he signed the bill into law, the nation's board members had only until mid-August to sign off on their companies' balance sheets and financial statements. This came immediately after the WorldCom scandal, and had the dual effect of preventing a run on the stock market and of saving face for the Republican Party, which is often accused of pandering to corporate campaign contributors. Whether or not the Corporate Responsibility measures are strong enough remains to be seen: while no more companies have been exposed as having intentionally defrauding investors, the bankruptcies of major corporations are not very common. The bill specifies harsh penalties for executives that knowingly violate its mandates: willful violation of a new obligation to certify the accuracy of their accounts will carry a sentence of 20 years. This provision was introduced to the bill after it had been in the Senate, which only called for a 10-year mandatory sentence.

Certain businesses were required to file later than August. America's treasury secretary, Paul O' Neill, called business honesty "the new patriotism." Some companies missed this first deadline, including several from the battered energy and telecoms sectors (including CMS, Dynegy and Qwest). Penalties for posting late, however, have not been well defined. Several companies filed with caveats. Among these was AOL Time Warner, which noted possible revenue overstatements at AOL. And several firms filed restated earnings, including Interpublic and Household International.

According to the Economist, company executives may have an easy way out if things do go sour:

Those who certify dodgy accounts are not necessarily doomed to years in prison. Terms in the oaths such as "wilfully" and "knowingly" appear in enough places that clever executives -- "or those with clever lawyers -- "should have little problem escaping punishment by playing dumb. Just to make sure, in recent weeks wily bosses have been forcing their middle managers to sign documents saying that the information they have sent up to the CEO's office is accurate. If a company blows up, this will allow the boss to blame the small fry. The positive aspect of this is that, by signing off on their accounts, the underlings are being given a strong reason to resist pressure from above to cook the books, says Robert Pozen, a professor at Harvard Law School. (Economist, 8/17/02)

This section also covers things such as Rules of Professional Responsibilities for Attorneys.

Enhanced Financial Disclosures

The section of the Investor Protection Act that pertains to enhanced financial disclosures attempts to solve some of the problems that had been created by financial statements deliberately designed to obfuscate facts. Whereas deliberately mis-portraying material information is forbidden by the Act, certain methodologies for reporting information were legitimate before the Act was introduced, such as reporting events as non-reoccurring, which allowed many companies to keep true revenues hidden. These actions are forbidden under the ACT, which attempts to instruct companies to better portray their financial information.

Material off-balance sheet transactions are required to be disclosed by the act. Such transactions include contingent obligations and other relationships of the issuer with unconsolidated entities or other persons that might have a material current or future effect on financial information, changes in the financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.

Pro Forma figures, which are published before official figures, are now required to be filed with the commission or publically.

A results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.."

A b) COMMISSION RULES ON PRO FORMA FIGURES. -- "Not later than 180 days after the date of enactment of the Sarbanes-Oxley

Act fo 2002, the Commission shall issue final rules providing that pro forma financial information included in any periodic or other report filed with the Commission pursuant to the securities laws, or in any public disclosure or press or other release, shall be presented in a manner that -- "

1) does not contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the pro forma financial information, in light of the cir-cumstances under which it is presented, not misleading; and 2) reconciles it with the financial condition and results of operations of the issuer under generally accepted accounting principles.

STUDY AND REPORT ON SPECIAL PURPOSE ENTITIES. -- "

1) STUDY REQUIRED. -- "The Commission shall, not later than 1 year after the effective date of adoption of off-balance sheet disclosure rules required by section 13(j) of the Securities

Exchange Act of 1934, as added by this section, complete a study of filings by issuers and their disclosures to determine -- "

A) the extent of off-balance sheet transactions, including assets, liabilities, leases, losses, and the use of special purpose entities; and B) whether generally accepted accounting rules result in financial statements of issuers reflecting the economics of such off-balance sheet transactions to investors in a transparent fashion.

2) REPORT AND RECOMMENDATIONS. -- "Not later than 6 months after the date of completion of the study required by paragraph (1), the Commission shall submit a report to the President, the Committee on Banking, Housing, and Urban

Affairs of the Senate, and the Committee on Financial Services of the House of Representatives, setting forth -- "

A) the amount or an estimate of the amount of off-balance sheet transactions, including assets, liabilities, leases, and losses of, and the use of special purpose entities by, issuers filing periodic reports pursuant to section 13 or 15 of the Securities Exchange Act of 1934;

B) the extent to which special purpose entities are used to facilitate off-balance sheet transactions;

Analyst Conflicts of Interest

Commission Resources and Authority

Studies and Reports

Corporate and Criminal Fraud Accountability

White Collar Crime Penalty Enhancements

Corporate Tax Returns

Corporate Fraud and Accountability

SEC 1933

Savings and Loan Scandal

The Development of the reliance on financial metrics following Graham and Dodd.

GAAP

Financial euphoria in the late 1990's.

DCF Models.

The rise and fall of the Sell Side Analyst.

Reminiscences of Walter Sachs, Part II (New York, Oral History Collection, Columbia University, 1972), p. 22.