January 24, 2003
Enforcing the Sarbanes Reforms

In my view, the Economist is a little too smug and comfortable with the watering-down of the Sarbanes reforms as they move towards implementation:


Economist.com: America’s Securities and Exchange Commission has approved a new set of corporate-governance rules, as required by Congress under the Sarbanes-Oxley act passed last summer. After intense lobbying from accountants and lawyers, the rules have lost some of their bite.... The SEC has, however, backed down on one of its most far-reaching proposals: that lawyers be required to blow the whistle on clients’ potential securities violations if they got no response from senior management and the board. The rule change is now on hold following intensive lobbying by law firms. Instead, lawyers will only be expected to express concerns to the client.

It will be a year or so before the effect of all these changes is fully felt. Some sceptics feel that the SEC is putting in place a regime that will stifle entrepreneurship and drive talented people away from company boards. Critics on the other side of the debate say that regulators have conceded too much to special-interest groups. Now that it is being attacked equally vociferously from both sides, perhaps the SEC will feel that it is doing something right...


Setting the rules
Jan 24th 2003
From The Economist Global Agenda


America’s Securities and Exchange Commission has approved a new set of corporate-governance rules, as required by Congress under the Sarbanes-Oxley act passed last summer. After intense lobbying from accountants and lawyers, the rules have lost some of their bite


THE Sarbanes-Oxley act, passed last summer, is the most sweeping reform of corporate governance in America since the Great Depression in the 1930s. The demise of Enron, the scale of misreporting at WorldCom and the stock- and bond-market collapse they brought with them whetted the public appetite for reform, if not revenge. The result was a raft of measures covering everything from board composition to regulation of auditors. The detail of the rules was left to the Securities and Exchange Commission (SEC), which is to finish drawing them up by Sunday January 26th. Accountants and lawyers have lobbied intensely to water down the proposals; in some areas, they have succeeded (see table below).

The most important aspect of Sarbanes-Oxley was better regulation of auditors and restrictions on what they can do. The old system of self-regulation was replaced, amid much industry teeth-gnashing, by an independent regulator, the Public Company Accounting Oversight Board, under the auspices of the SEC. The structure is generally considered to be a good one, but the board’s debut was marred by a row over its chairman. The proposal to appoint William Webster—despite the former judge’s involvement in companies that were under SEC scrutiny—led to an outcry. This sparked the withdrawal of Mr Webster and the resignation of both the chairman of the SEC, Harvey Pitt, and its chief accountant. The oversight board remains leaderless, though it has held its first meeting. It may not get a new chairman until William Donaldson, a former investment banker, has been confirmed as Mr Pitt’s replacement at the SEC.

Sarbanes-Oxley also barred auditors from doing non-audit work for audit clients. A similar proposal by the SEC under Mr Pitt’s predecessor, Arthur Levitt, had been defeated by sustained lobbying by the accounting profession, represented by Mr Pitt, then a securities lawyer, and, ironically, supported by Congress. However, in the months since the act was passed, auditors have won the argument that they ought to be allowed to provide tax services to audit clients. Critics had pointed out that if auditors were allowed to design tax shelters, they would end up auditing their own work, a conflict of interest.

Moreover, accountants have won another battle. When Mr Levitt conceded that he would not be able to force auditors to give up non-audit work in 2000, he and the auditors struck a compromise: they would have to disclose what they were paid for audit and non-audit work (they earn three times more revenue from non-audit than from audit). Now, the accounting profession has succeeded in having the definition of “audit” widened, and also in having other work reclassified as “audit-related”.

The SEC is not alone in drafting new rules. The New York Stock Exchange (NYSE) has proposed reform of, for instance, company boards. Listed companies are now required to have a majority of independent (non-executive) directors on their boards. The power of the chief executive and chairman, usually the same person in American boardrooms, is to be counter-balanced by regular meetings of non-executives at which no executives are present, and by the naming of a “lead” independent director if one is chosen. The board’s all-important compensation, nominating and audit committees are to be composed entirely of non-executives, and the audit committee chaired by a “financial expert”. The SEC has had to widen the definition of financial expert because companies foresaw a run on chief financial officers—a real problem when companies are increasingly restricting the number of outside board appointments their senior executives can take on. The NYSE also recommends that companies publish corporate-governance guidelines, setting out, among other things, how they will evaluate the board and the chief executive on a regular basis.

Enron was brought down by the shifting of liabilities to off-balance-sheet “special purpose vehicles” whose existence was not disclosed to investors. From now on, the SEC will require companies to explain off-the-books transactions that could have a big effect on their financial position. In a related move, the Financial Accounting Standards Board, which sets American accounting rules, has adopted new rules requiring companies to consolidate such entities into their accounts in a wider range of circumstances.

Enron also gave rise to new SEC rules about executive pay. One is the ending of the loophole that allowed senior managers plenty of time to report share sales if they were undertaken to repay a loan to the company (in the late 1990s, a large number of bosses borrowed money from their employer to buy the firm’s shares). A second new rule bars senior managers from dumping shares while employees are barred from selling.

The SEC has also moved to improve financial disclosure. Companies are now required to file their quarterly statements more quickly. Chief executives and chief financial officers in America’s biggest companies have had to swear to their accounts’ veracity, under pain of imprisonment for wilful misrepresentation. And the use of so-called “pro-forma” accounts, which exclude inconvenient expenses such as merger costs, will be curtailed.


Mr Pitt remains as SEC chairman for the time being. Though he is not known as a reformer, he did manage to push one change through: that mutual funds be required to disclose how they vote the “proxy” shares they hold on behalf of millions of private investors. Large fund managers, such as Fidelity and Vanguard, argued that the change would raise their costs and distract them from the job of managing money.

The SEC has, however, backed down on one of its most far-reaching proposals: that lawyers be required to blow the whistle on clients’ potential securities violations if they got no response from senior management and the board. The rule change is now on hold following intensive lobbying by law firms. Instead, lawyers will only be expected to express concerns to the client.

It will be a year or so before the effect of all these changes is fully felt. Some sceptics feel that the SEC is putting in place a regime that will stifle entrepreneurship and drive talented people away from company boards. Critics on the other side of the debate say that regulators have conceded too much to special-interest groups. Now that it is being attacked equally vociferously from both sides, perhaps the SEC will feel that it is doing something right.


Posted by DeLong at January 24, 2003 09:19 AM | Trackback

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Comments

The SEC rules regarding lawyers are essentially who was mandated by Sarbanes Oxley, albeit not as stringent as the rule originally proposed by the SEC. That can not fairly be characterized as "watering-down of the Sarbanes reforms"

Posted by: richard on January 24, 2003 06:25 PM

The SEC rules regarding lawyers are essentially who was mandated by Sarbanes Oxley, albeit not as stringent as the rule originally proposed by the SEC. That can not fairly be characterized as "watering-down of the Sarbanes reforms"

Posted by: richard on January 24, 2003 06:26 PM

Smugness and constricted insight has characterized the Economist's coverage of Washington for many years. Lexington, for example, seems largely to be a Heritage Foundation message boy. I thought the Economist was an exceptional publication until the mid-1980s, and it is still indispensible in many ways, but much of its US coverage now seems conventional (from a sort of cynical, conservative libertarian prespective) and predictable.

Posted by: Ben Brackley on January 25, 2003 07:33 AM

Smugness and constricted insight has characterized the Economist's coverage of Washington for many years. Lexington, for example, seems largely to be a Heritage Foundation message boy. I thought the Economist was an exceptional publication until the mid-1980s, and it is still indispensible in many ways, but much of its US coverage now seems conventional (from a sort of cynical, conservative libertarian perspective) and predictable.

Posted by: Ben Brackley on January 25, 2003 07:33 AM

Smugness and constricted insight has characterized the Economist's coverage of Washington for many years. Lexington, for example, seems largely to be a Heritage Foundation message boy. I thought the Economist was an exceptional publication until the mid-1980s, and it is still indispensible in many ways, but much of its US coverage now seems conventional (from a sort of cynical, conservative libertarian perspective) and predictable.

Posted by: Ben Brackley on January 25, 2003 07:34 AM

Oops. Sorry for the duplicate posts.

Posted by: Ben Brackley on January 25, 2003 07:37 AM

I thought the economist really changed in about 1998 or 1999--at least compared to 94 (when I started reading). The science coverage is excellent, and the US articles are decent--but the business and US editorial sections are quite poor.

There was a reorganization around that time, and though they have no bylines, I suspect there was a big change in at least the US editorial staff. For international coverage, I have no good basis for comparison, but I don't really trust it as much as I used to. It isn't worth the $135 per year anymore--not with all the other good publications out there.

Then again, it may have always been the same, and I just got older and less interested in the same old message. Quite hard to separate the two sometimes.

Posted by: Brennan on January 25, 2003 09:25 AM

I had been reading The Economist for about 30 years until th emid 1990's when I got so disgusted with their knee jerk ideological economic reactions that I cancelled my subscription. I started back about two or three years ago when enticd by a free copy of their pocket world in figures. The magizine is some better. They may have moved from the Heritage Foundation as a source to the American Enaerprise Institute.

With all its faults, I still consider it the best single source in print.

Posted by: Sam Taylor on January 25, 2003 03:10 PM

The fact that Harvey Pitt is still in control at teh SEC despite his "resignation" really says all you need to know about the situation.

Posted by: Ian Welsh on January 25, 2003 11:29 PM

Ditto, Ian.

I didn't even know that he was still in charge until last week.

Posted by: Barry on January 26, 2003 11:49 AM
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