Staunch champions of corporate governance and fair financial reporting lost a friend over the holidays with the passing of former U.S. Rep. Michael Oxley on January 1. The Ohio Republican, co-author, with Democratic Senator Paul Sarbanes, of the landmark Sarbanes-Oxley Act of 2002 (SOX), was an ethical stalwart and strong advocate and warrior for corporate oversight and accounting reform.
SOX, drafted in response to a spate of high-profile corporate frauds around the turn of the century, significantly impacted the modern corporate governance landscape by elevating internal control over financial reporting to a top corporate priority. For anyone who entered the professions of accounting, finance, internal auditing and consulting after 2002, SOX has always been the law of the land. But those of us who remember the scandals of the Enron era can attest to the enormous problem placed on the doorstep of Congress at the time.
There are those who argue that SOX is excessively burdensome and overdone and, in essence, an overreaction to the acts of a few. But here’s the skinny: There were too many examples of egregious abuses. As a result of the bad behavior of an unscrupulous minority of executives, shareholders suffered significant losses, people lost their life savings and overall confidence in the capital markets waned dangerously. In the United States, a situation like this gives Congress a strong political will to act. And act they did. SOX is a compendium of the abuses of the Enron era. The law reads as if Mr. Oxley, Mr. Sarbanes and their authorship team listed all of the high-profile abuses on a whiteboard and then designed mechanisms to address each one. They did what they had to do to solve the problem they were faced with. In doing so, they sent a powerful message of accountability for fair public and financial reporting.
SOX certainly isn’t perfect, but it has stood the test of time. After an initial period of adjustment and the pains of a very messy learning curve following the law’s enactment, the increased emphasis on internal controls has resulted in a precipitous decline in restatements of financial statements. According to studies by Audit Analytics, the number of restatements has declined significantly since its 2006 peak. More importantly, the number and severity of accounting issues underlying each restatement also have declined. That’s good news.
SOX also created the Public Company Accounting Oversight Board (PCAOB) and popularized the COSO Internal Control – Integrated Framework. That Framework had been around since 1992 but it wasn’t used widely. When SOX Section 404 required an evaluation of the effectiveness of internal control over financial reporting, the Securities and Exchange Commission required “a suitable framework” to support that assessment. All heads turned to the COSO Framework, treating it as the only game in town. Today, the Framework is used by almost all issuers and their external auditors as a basis for their SOX Section 404 evaluations.
While debate on the relative costs and benefits of SOX Section 404 continues, there is empirical evidence that the capital markets place significant value on strong internal control. An earlier study released in May of 2006 by Lord & Benoit reported that shareholders benefit when companies have effective internal control over financial reporting. To illustrate, for the period from March 31, 2004 to March 31, 2006, the Russell 3000 share index increased by 17.7 percent. The Lord & Benoit study found that companies reporting no material weaknesses for either 2004 or 2005 enjoyed a 27.7 percent increase in share price. Companies reporting material weaknesses in 2004 but no material weaknesses in 2005 experienced a 25.7 percent increase in share price. However, companies reporting material weaknesses in both 2004 and 2005 suffered a 5.7 percent decline in share price. Therefore, the companies that reported that their internal control over financial reporting was ineffective both years experienced poorer performance in their stock price relative to the companies that did not.
Some have questioned the value of SOX, arguing that it did not prevent the financial crisis. The truth is that SOX wasn’t designed to prevent a crisis of this nature. The financial crisis was a systemic breakdown on a number of fronts involving an entire industry – a virtual “perfect storm.” To elaborate further on whether or not SOX could have prevented such a storm would detract from the message of this post. Suffice it to say that SOX doesn’t mandate how financial institutions are run, how risks are managed and when CEOs and their boards need to take a fresh look at the validity of the critical assumptions underlying their corporate strategy and business model.
SOX continues to fulfill its purpose, and Michael Oxley should be credited for the cultural change he enabled with this landmark legislation. He was a true statesman, a Republican who reached across the aisle to work with his fellow Democratic legislative partner, Paul Sarbanes, to enhance corporate management accountability to shareholders at a time when the reliability of public financial statements was called into question. These two men stepped into the arena as their country watched, with everyone knowing that something had to be done. Today, with forward progress in Washington D.C. so often hamstrung by partisan gridlock and intransigence, Sarbanes-Oxley shines as an example of what can be done when our elected officials come together to work for the common good.
Michael Oxley performed admirably when he had his moment in the legislative arena. He will be missed.