In the early 2000s, the US stock market was rocked by fraud cases that dented investors’ confidence. The Enron Corporation scandal and WorldCom scandal were the most publicized and led to prosecution and conviction of top executives. The cases revealed the need to overhaul regulation surrounding the reporting of financial dealings and balance sheet positions of companies.
Enron Scandal Brief
At the height of the scandal and eventual downfall of the company, Enron was a giant in the Oil and Gas industry. The company then diversified through subsidiaries and engaged in other businesses such as an Electronic Trading Website and a Video on Demand Service. Unfortunately, they started booking expected revenue from these new projects in their books and vastly inflated them. This happened for projects in the gas sector too.
The trend continued and the company used unorthodox accounting techniques to hide their debt too. Eventually, analysts began reviewing how they rated the Enron stock, which had peaked at more than $90 per share. Their CEO, Jeffrey Skilling resigned in August 2001 citing personal reasons (Connel, 2017). They reported a third quarter loss in October and the Securities Exchange Commission took an interest in the company’s dealings.
Investigations forced the company to restate its earnings from as far back as 1997. This revealed years of hidden losses and debt. A company that intended to merge with Enron, Dynergy, pulled back in light of the revelations. Enron filed for bankruptcy at the end of 2001 (Connel, 2017).
The Sarbanes-Oxley Act
Senators Paul Sarbanes and Michael Oxley sponsored the SOX Act of 2002. It sought to improve upon existing laws concerning sharing of crucial accounting information on listed securities. One of the major provisions of the Act touches on the responsibility of top executives who sign off financial statements. The law made them liable in cases where inaccurate financial statements are published.
The SOX Act also stated clearly rules regarding financial record-keeping for public companies. It is now clear that certain business records must be kept and for a certain minimum period. Executives now cannot get away with destruction of records. Whistle-blowers received a lot of protection because of the law. Companies can now not blacklist employees who reveal fraud to the SEC or testify in SOX related cases. Employees and contractors can report victimization incidences directly to the SEC.
The Public Company Oversight Board came into being because of the SOX Act. All auditors of public companies need to register with the board. The Board ensures compliance of audit firms to the SOX Act and other relevant laws. For instance, an audit company cannot do business with a company they are auditing.
Overall Effect of the Sarbanes Oxley Act
The occurrences that precipitated the Act clearly showed that the market could not operate without proper regulation. It was a pure case of market failure. The creation of the Public Company Oversight Board greatly reduced cases of conflict of interest in dealings between audit companies and their clients. Previously, audit companies provided other auxiliary services such as tax consultancy to their clients.
The law has affected private companies too because they need to adopt governance structure that are similar to public companies to earn the confidence of banks and investors. There are critics who argue that the internal controls demanded by the SOX Act are expensive to install (Slaughter, n.d). However, a majority of investors agree that it is a necessary evil to preempt possible losses from another possible Enron scandal.
Connell, M. (2017). The Fall of Enron and the Creation of the Sarbanes-Oxley Act of 2002.
Slaughter, Jeremy. (n.d.). The Impact of the Sarbanes-Oxley Act on American Businesses. Small Business - Chron.com. Retrieved from http://smallbusiness.chron.com/impact-sarbanes-oxley-act-american-businesses-1547.html