Sarbanes-Oxley, Dodd Frank, (Un)ethical Management, and Regulatory Burden

In the early 2000’s, a number of large companies in the US and abroad were found to have falsified financial reports, misleading investors by creating the perception through their financial reporting that they were more successful than they really were (Ferrell 2018). Companies like Enron and Worldcom, for example, went from being some of the largest in the world to virtually disappearing overnight after it was discovered they had been intentionally concealing their financial problems from investors (Funk & Wagnalls, 2018). One of the largest accounting firms at the time, Arthur Anderson, also found themselves caught up in the scandal with their accounting business ultimately collapsing due to their role in the scandals. As independent auditors, Arthur Anderson should have identified the issues with the financial reports and brought them to light, but instead were found to have helped cover them up due to their relationships with their clients (Funk & Wagnalls, 2018). In response to this, “in 2002 Congress passed the Sarbanes-Oxley Act, the most far-reaching change in organizational control and accounting regulations since the Securities and Exchange Act of 1934.” (Ferrell 2018, p. 13). This new law attempts to dissuade firms from falsifying financial reports by holding top executives accountable for the accuracy of the firm’s reports with the threat of large fines and even prison sentences for any executive who misrepresents their company’s financial position. In addition, “it also created an accounting oversight board that requires corporations to establish codes of ethics for financial reporting and to develop great transparency in financial reports.” (Ferrel, 2018, p. 13). Essentially, the Sarbanes-Oxley act made executives accountable for discovering and addressing ethical and legal risk within their firms. No longer would it be sufficient for executives to claim ignorance, as they can now be held accountable for simply being unaware of unethical accounting behavior within their organizations.

The country and world faced another financial crisis in 2008 when, once again, large firms were found to have been behaving unethically. Financial institutions such as Lehman Brothers and AIG collapsed as a result of irresponsible financial practices that put profit over sound investment principals. These institutions had made huge investments in high-risk financial products, primarily mortgage-backed securities and credit default swaps (Weiser 2009). These complex financial instruments were profitable as long as the housing market continued to appreciate, but “in 2007 house prices stopped rising; they began to soften and then to come down. As house prices continued their decline, it became clear that many mortgage holders would default.” (Weiser 2009, p. 12). When large numbers of mortgage holders did indeed default, the financial institutions suffered large scale losses and several even folded, unable to honor their swaps contracts. This led to a liquidity crisis, as institutions virtually stopped lending (Weiser 2009). Once again, the unscrupulous activities of executives chasing profits resulted in large scale losses and in this case, a near collapse of the US and world economy; once again US Congress would respond, this time by passing the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Dodd-Frank Act mandated federal regulation of the derivatives markets and created the U.S. Commodity Futures Trading Commission (CFTC). “The CFTC is a federal regulatory agency that became the main U.S. federal regulator of derivatives markets in 2010 through Title VII of the Act.” (Mankad, 2019, p. 2). The intent was to “promote financial stability, improve accountability and transparency, and protect consumers from abusive financial practices.” (Ferrell 2018). The act also defined what made a corporation too-big-to-fail (systemically important) and forbids a tax payer backed bailout to keep these institutions in business should they fail (Committee on Financial Services, One Hundred Thirteenth Congress).

Both Sarbanes-Oxley and Dodd Frank have had varying success. There is evidence that SOX has improved the quality and accuracy of financial reports. “…results suggest that the increased disclosure due to the implementation of SOX Section 302 has indeed reduced the information asymmetry in the capital markets in general.” (Gupta, 2018, p. 222). In addition, it its own internal review on the impact of Sarbanes-Oxley, Congress determined “the benefits to investors and the capital markets have already been quite dramatic. Not entirely measurable in all areas, but dramatic nonetheless. The primary purpose of the Act was to restore investor faith in the reliability of corporate financial reporting. In this regard, the Act has been an unmitigated success. The audit process has clearly been strengthened. Now subject to rigorous oversight and precluded from offering certain non-audit services to audit clients, accountants have refocused on the audit, achieved, greater independence from their clients, and are insisting with success, on more transparent financial reporting.” (Committee on Financial Services, One Hundredth Ninth Congress, 2005, p. 1).  On the other hand, while Dodd-Frank has indeed implemented regulations that should prevent financial institutions from taking on unacceptable amounts of risk, it has increased compliance costs for these institutions as well as had a slew of other unintended consequences. The added burden put on institutions to conform to the regulation has impaired market liquidity and reduced access to credit, increased costs of borrowing, restricted trade, put U.S. businesses at a competitive disadvantage, increased bank fees for both consumers and businesses, and reduced access to capital for small businesses (Committee on Financial Services, One Hundred Thirteenth Congress).

It is clear that when left without regulatory oversight, senior executives and board members cannot be trusted to make ethical decisions. Time and again powerful individuals and management teams have demonstrated that they will opt to take action that leads to the highest profits, regardless of any risk or other ethical considerations. Acts like Sarbanes-Oxley and Dodd-Frank are in turn required to discourage management from taking these sorts of unethical actions and to protect the honest investor from losing a substantial portion of their investment due to management wrong-doing or deceitfulness. However, it cannot be denied that the added cost of complying with these regulations creates added hardship to companies, especially smaller ones. Congress should update the laws to provide smaller companies some relief from the burden of complying with them. They should define different levels of compliance for different sized companies, differentiating more than just too-big-too-fail from the rest. Smaller public companies that, due to their size and influence, cannot possibly pose such a significant risk to the overall economy should not be held to the same regulatory standards as larger companies like Walmart, Exxon, Apple, UnitedHealth, and JPMorgan Chase. By reducing the regulatory burden on smaller companies, Congress can address some of the more substantial unintended consequences that have resulted from these acts, while still fundamentally achieving the necessary oversight they are meant to address.

References

Ferrell, O.C., & Fraedrich, John & Ferrell, Linda. (2018). Business Ethics: Ethical Decision Making and Cases, Twelfth Edition. Boston, MA: Cengage.

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