Title: Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002
Abstract: The latter part of the 20th century saw a debate about the appropriate approach to regulating the corporation. The traditional view was that governance of the large corporation was and should be largely determined by government regulation. This approach seemed justified by the lack of an effective means by which the shareholders could exert control over their ownership interests or the firm's governance terms. Under this view, as espoused by influential commentators such as the Columbian cartel (Adolf Berle,1 William Cary,2 and John Coffee3), the owners' powerlessness left managers with the ability to use their corporate positions to maximize their personal wealth and power. The proregulatory position has proven quite nimble, shifting from standard economic arguments favoring regulation to arguments that law is necessary to back the creation and maintenance of norms of trust and fairness.4 Other commentators, notably including Henry Marine, Frank Easterbrook, and Daniel Fischel, building on basic theoretical work by, among others, Ronald Coase, Armen Alchian, and Harold Demsetz, argue that the corporation was appropriately viewed as fundamentally the product of private contractual relationships, and should be entitled to the same presumption of efficiency as contracts generally.5 The twin pillars of this view are that aspects of corporate governance that might seem suspect, including the separation of ownership and control, actually make economic sense; and that public corporate governance arrangements are disciplined in efficient securities markets. The spectacular crashes and frauds of Enron, WorldCom, and other companies, including Sunbeam, Waste Management, Adelphia, Xerox, and Global Crossing, have reinvigorated this debate. The most public phase of the scandals began with Enron, which was at one time the seventh largest firm based on market capitalization, but in the fall of 2001 was suddenly shown to be a facade created by financial manipulation. WorldCom, which owns among other things the second largest long distance telephone carrier, disclosed in the summer of 2002 that it had created billions in earnings by IMAGE FORMULA6 capitalizing expenses as needed.6 These firms' managers have become poster boys for the problems of separation of ownership and control. The frauds occurred despite several levels of monitoring by, among others, directors, prominent accounting and law firms, institutional shareholders, debt rating agencies, and securities analysts. Supposedly efficient securities markets adhered to overly optimistic assumptions about firms' business plans in the face of mounting evidence to the contrary. Some argue that, because of the unreliability of corporate managers, monitors, and the market in these cases, government regulators need to restore confidence in the securities markets.7 The most important legal response was the Sarbanes-Oxley Act of 2002, summarized in the Appendix.8 This Act is the most sweeping federal law concerning corporate governance since the adoption of the initial federal securities laws in 1933 and 1934.9 This Article argues that, despite all the appearances of market failure, the recent corporate frauds do not justify a new era of corporate regulation. Indeed, the fact that the frauds occurred after seventy years of securities regulation shows that more regulation is not the answer.10 Rather, with all their imperfections, contract and market-based approaches are more likely than regulation to reach efficient results. Post-Enron reforms, including Sarbanes-Oxley, rely on increased monitoring by independent directors, auditors, and regulators who have both weak incentives and low-level access to information. This monitoring has not been, and cannot be, an effective way to deal with fraud by highly motivated insiders. Moreover, the laws are likely to have significant costs, including perverse incentives of managers, increasing distrust and bureaucracy in firms, and impeding information flows. …
Publication Year: 2002
Publication Date: 2002-10-01
Language: en
Type: article
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Cited By Count: 155
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