An Interview with Sen. Paul S. Sarbanes

Sarbanes-Oxley Act Revisited

By Dick Carozza

The U.S. Sarbanes-Oxley Act, passed and signed almost five years ago, was a response to a major disruption in the capital markets and the lives of individual investors. Is it working? Sen. Paul S. Sarbanes says SOX lets the "watchdogs be watchdogs" and helps deter fraud. He also comments on the importance of Certified Fraud Examiners in the battle against white-collar crime.

The U.S. Congress has passed a handful of bills that are familiar with just the mention of one or two words or acronyms: RICO, Endangered Species, McCain-Feingold, PATRIOT Act. And now, SOX.

The origins of the Sarbanes-Oxley Act (the Public Company Accounting Reform and Investor Protection Act of 2002 in longhand) had been gestating for decades. But both houses of Congress passed it overwhelmingly, and the President signed it into law, in the wake of the horrendous publicity of major corporations toppling like building blocks on the floor of a toddler’s playroom.

In the ensuing five years, some have lauded the act. Many want parts of it clarified (notably Section 404). Some want Congress to reopen it. And others say it should never have been conceived.

Sen. Paul S. Sarbanes, co-author of SOX, says it was written in a timely and thoughtful fashion. In a wide-ranging interview, Sarbanes says that the act has “brought about a marked improvement in corporate governance. It has eliminated a number of conflicts of interest and enabled our system of checks and balances to work as they should. It enables the watchdogs to be watchdogs.”

He says no single act can cover all the bases; SOX created the private-sector, non-profit corporation Public Company Accounting Oversight Board to oversee the accountants of public companies.

“Our intention with this legislation,” he says, “was to establish a good solid framework within which people could go about their business. We want them to do it in an honest and ethical way and we hope that is the way most people will conduct themselves. For the ones who don’t, we tried to set up a system that will screen them out and punish dishonest behavior.”

Sen. Sarbanes and Rep. Michael G. Oxley will be among the keynoters at the 18th Annual ACFE Fraud Conference & Exhibition, July 15-20 in Orlando, Fla.

Sen. Sarbanes spoke to Fraud Magazine, from his home in Baltimore, Md.

Can you describe how the Sarbanes-Oxley Act originated, your involvement in its creation, and the circumstances surrounding it? 

I became the chairman of the Senate Banking, Housing and Urban Affairs Committee in June of 2001 when Sen. Jim Jeffords crossed the aisle and shifted control of the Senate to the Democrats. At that time, I set out an agenda for the committee but this issue wasn’t on it. We were concerned about the money laundering problem and that became our focus after 9/11. But then the Enron story broke.

Enron, in October of 2001, restated its earnings. This came as a shock because for some time the company had been regularly reporting extraordinary quarter-to-quarter growth and profits. Most people thought it was just booming along.

In November, it issued another restatement of earnings and in early December it filed for bankruptcy. Enron was the seventh largest company in the country. It was the largest bankruptcy in our history until it was eclipsed by WorldCom. As it turned out, Enron was the canary in the mineshaft. A number of very major public companies were relying on convoluted and often fraudulent accounting devices to inflate earnings, hide losses, and drive up their stock prices.

Our response began with a series of 10 hearings over a two-month period in the first part of 2002. We brought before the committee some of the best people in the country from both the private and public sectors. We began with five former chairmen of the SEC at the witness table – appointed by both Republican and Democratic presidents.

The committee carefully examined every aspect of the situation. At the time, some said all that was needed was to punish the individual bad apples, but as our hearings progressed we increasingly came to the conclusion that there were systemic problems.

We shouldn’t forget the magnitude of the losses. Thousands of jobs were lost; retirement savings dried up. Fortune magazine said: “phony earnings, inflated revenues, conflicted Wall Street analysts, directors asleep at the switch. This isn’t just a few bad apples we’re talking about here.” Money magazine described it as “a complete breakdown in the system.”

So we went to work and developed legislation that was approved by the committee on a good strong bipartisan vote – 17-4 actually. And then a few days after we approved it in the committee, the WorldCom situation surfaced. Of course, that gave it additional momentum when we took the legislation to the Senate floor and then worked it through the conference committee. The President signed it at the end of July of 2002. It was the most far-reaching securities legislation since the original securities acts in 1933 and 1934.

[The act is an amalgamation of Sen. Sarbanes’ original bill and Rep. Michael G. Oxley’s earlier bill. A joint Congressional Conference Committee reconciled the two bills and named it the Sarbanes-Oxley Act of 2002 on July 24. The next day, the House approved it by a vote of 423 to 3, and the Senate, 99 to 0. – ed.]

How important is it to protect the interests of U.S. investors, both large and small? 

If you don’t protect the interests of the investors, it deals a major blow to the workings of the economic system. The U.S. capital markets have established a reputation for integrity because we have a system designed to screen out people who are trying to cut the corners and rig the system. The integrity of our capital markets is very important to the strength of our economy. The blow to investor confidence at the time of Enron and WorldCom was of major proportions.

Investors, after all, make the whole thing work. They’re the ones who are providing the resources so the entrepreneurial system can move forward, innovate, expand, and contribute to the strength of the economy.

The hearings clearly showed such problems as inadequate oversight of accountants, a lack of auditor independence, weak corporate governance procedures, and inadequate disclosure provisions. In the fall of 2001, Ken Lay was telling his employees that the company’s stock was an incredible bargain at current prices, but he didn’t tell them that he was unloading a substantial amount of company stock over the previous two months.

And then there were egregious stock analysts’ conflicts of interest. They were putting buy recommendations on companies they were promoting while sending e-mails to one another saying the stocks were dogs.

What do you think Sarbanes-Oxley has done for the U.S. corporate and investor sectors? 

It addressed the crisis of investor confidence. It’s brought about a number of marked improvement in corporate accountability. It has eliminated a number of the conflicts I mentioned earlier. Checks and balances are working again and the watchdogs are functioning as watchdogs. For instance, we tried to get the auditors into a more independent position so we precluded the auditors of a public company from providing a range of consulting services that were seen as carrying with them a conflict of interest.

What had happened was that the fees had shifted markedly from auditing to consulting and therefore had raised the concern that some would pull their punches on the audits in order to gain the consulting business. We do allow some consulting services that aren’t precluded, provided the audit committee specifically approves them.

We require that the audit committee be made up of independent directors; the auditors are now hired and fired and their compensation is determined by the audit committee instead of being decided by the very management whose activities the auditors are supposed to examine and monitor and report on. That shifts the focus in a way that is more likely to find and screen out bad practices.

Sarbanes-Oxley has affected countries all over the globe, not just in the United States. 

That’s an interesting point because there’s an argument being made that Sarbanes-Oxley is handicapping our capital markets but the fact is -- and the SEC has done a study of this -- that overseas they’re moving in the direction of the requirements that are in this legislation. In other words, in some places they’re trying to move to a higher standard. There’s an effort on the part of some to go to lower standards to draw business that way, but I don’t think that’s going to work. The United States has been the gold standard. If you can get listings here, it’s seen as a significant accomplishment for the firm.

The underlying rationale worldwide is strong. If investors are going to put their money into the market they have to have confidence that the information being given in these financial statements is accurate and they can rely upon them to make the decisions. Otherwise it’s all a rigged game and they’re going to flee from it.

It seems so basic, but much of corporate America appears to be divided. 

They’re split; some see it as an opportunity to enhance the workings of their business, which it certainly can do. And then there are the resisters. The SEC and also the Public Company Accounting Oversight Board, which was created to “oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports,” are developing guidance to assist smaller companies in complying with Section 404 of Sarbanes-Oxley.

Section 404 is only a couple of paragraphs. One paragraph says that a public company must have a system of internal controls, which the management reports on, and the other paragraph says that the system shall be attested to by the auditors. So it can’t be a phony system of internal controls.

Suppose someone came to you and asked whether you wanted to invest money in his company and you asked him, “How’s your system of internal financial controls?” And he said, “We don’t believe in such things as that – it’s a needless burden.” I doubt you’d put your money in his company.

Now about the cost of the 404 controls: If you haven’t had a very good system then it’s going to be more costly, but in some respects it’s a capital investment. Once you put in a good system the cost should decline in subsequent years; there’s some evidence that’s taking place.

We’re not trying to impose unnecessary burdens. But determining what’s necessary and unnecessary is the central question. We have to use wise judgment and careful analysis to reach the appropriate conclusions and, thereby, ensure investors will be protected and the integrity of the markets will be upheld.

Do you think a collective amnesia is starting now that things are settling down? 

When things get better, companies tend to forget what happened or how serious it was at the time. Trying to maintain high standards is a difficult job. One of the ACFE’s objectives is to train people to find and screen out these practices that undermine confidence in the workings of the economic system.

In fact, your efforts to develop professionalism with respect to the work of Certified Fraud Examiners is a very important contribution. And I know you’ve joined with the AICPA in setting up the Institute for Fraud Prevention – a research consortium into the issues and best practices. I think that’s a very good idea.

There are many companies that are saying Sarbanes-Oxley is inhibiting their abilities to make greater profits and compete professionally.

First of all, as I’ve said, there is a movement internationally to assure that public companies based outside the United States will have to meet these requirements or something close to them. At the same time, an argument is being made that IPOs [initial public offerings] are being made abroad rather than in New York to avoid Sarbanes-Oxley regulations. But that trend was happening before this legislation came along. For example, IPOs of state-owned enterprises being privatized in China and France are taking place in Hong Kong and Europe, respectively. Moreover, the investment banking fees abroad are markedly lower than they are in this country. The financial world is globalizing quickly, there’s a lot of capital abroad, and the competition has intensified. So to try to attribute their development to Sarbanes-Oxley doesn’t reflect the dynamics of what’s taking place.

We’re receiving a number of reports that U.S. companies have found that Sarbanes-Oxley is working to their advantage. They feel they have a tighter control over their activities, which enables them to discover some loose practices. Their whole operations have been tuned up so they’re working a lot better. And they have greater confidence that they know what’s going on.

So you feel the sum total of Sarbanes-Oxley will make U.S. companies more competitive rather than less? 

It should contribute to that. There’s some burden initially, but once a company works through the initial challenge, it should be stronger and better-managed with greater confidence that there are no ticking time bombs. And, of course, your people – Certified Fraud Examiners – run into situations like this all the time. When things are going on beneath the surface, they need to be located and corrected. CFEs become an important part of risk management and avoidance.

Joseph Wells, who began the ACFE in the 1980s, predicted there would be large-scale corporate failures like Enron and WorldCom. So this is something the Association has been dealing with for almost a couple of decades now.

It’s interesting that when we held the hearings, a lot of what we eventually put into the statute had been recommended in earlier years by one blue-ribbon commission after another. So we had the benefit of all this work that had been done in previous years, but the earlier recommendations had never been acted upon.

Can you talk about the “tone at the top” principle? 

That came up time and time again in the course of our hearings. Bill Donaldson, when he was the chairman of the Securities and Exchange Commission, spoke very eloquently on this issue. In fact, there’s a quote of his I like to use: “Successful corporate leaders must strive to do the right thing in their business. And they must instill in their corporations this attitude of doing the right thing. Simply complying with the rules is not enough. They should make this approach part of their company’s DNA.”

This effort to create an environment in which you have honest, ethical, transparent business practices is extremely important. And you need the safety mechanisms to keep them in place.

It makes sense that if you take care of your employees and investors, it ultimately will be a profitable move.

Of course, the directors on public company boards have become more active. And the audit committee now plays a very important role because the auditors report to them. The result is a system of checks and balances with respect to management to help assure that activities are being conducted according to proper standards.

So, now another Sherron Watkins [Enron’s corporate sentinel] could possibly go to management or the audit committee and seriously be heard? 

There is a section in the legislation that provides strong protection for whistle-blowers. In addition, the companies must set up procedures whereby the reports of whistle-blowers can be heard and dealt with appropriately.

In February of last year, the Free Enterprise Fund, a nonprofit group, challenged the constitutionality of the PCAOB. What has been your reaction to its lawsuit?  

Of course, we live in a society in which anyone can bring a lawsuit. When we were writing the act we had the legislation carefully reviewed by the American Law Division of the Library of Congress for its constitutionality, and we also went outside to three or four distinguished law experts. And they all came back and said that it was clearly constitutional. We tried to do our work carefully. Some said it was done hastily. Well, it wasn’t. It was done in a fairly short period of time – some six months – but it was a very intense working period. U.S. District Court recently rejected the constitutional challenge.

There are some elements in the business community that are just unalterably opposed to any regulation. But our capital markets have traditionally depended upon a reasonable degree of regulation to make sure that they’re working honestly.

There are movements in some sectors that want to push Congress into actually rewriting the act or doing away with it. How serious do you think those are?  

I don’t expect the Congress to do that. The leadership of the relevant committees in Congress have indicated that they’re not inclined to open up the statute again. They think that fine tuning can be done through the regulatory process. Those people who want to open up the statute again ought to stop and think. They’re assuming that it will go in only one direction but the legislative process works in strange ways. There are many issues that we didn’t address in Sarbanes-Oxley, but about which there is considerable agitation such as executive compensation. And there are other issues that might find their way onto the legislative agenda.

We haven’t had any major corporate debacles since Sarbanes-Oxley was passed. 

The act is not an absolute guarantee. You will always have some sharp operators trying to get away with something. But hopefully the act will screen a lot of that out and they will be punished if they’re caught. Much of the act is designed to strengthen the system to keep the bad apples from developing in the first place.

That’s the mantra of the ACFE – emphasize prevention and deterrence. 

Exactly. That’s what your organization is focused on. In fact, you have a Fraud Prevention Checkup [ Prev_Checkup_IA.pdf] so you can review a company’s fraud protection and detection system. That’s a very good concept. With this you can enhance and strengthen the internal controls within the various departments of a company.

What can you say to encourage the fraud examiner who is daily looking for fraud and trying to prevent it and detect it?  

First of all, I would say that they’re doing very important work not only in the narrow, limited context of the particular company where they’re engaged in an investigation but with the contribution that they’re making to the overall workings of the economic system.

People don’t often connect the two. But if the overall economic system is going to work well so that people can have confidence in it, if it’s going to be fair and not exploit and take advantage of them, then it has to be done according to standards that place an emphasis on honesty and integrity. Fraud examiners are contributing to that broader picture.

The United States has been a huge economic success but we can’t allow ourselves to slide down the slippery slope and depart from high standards of conduct. The ACFE is making a very important contribution. Members are fighting for a good cause. I hope they keep that in mind no matter how difficult the immediate challenge may be.   

Dick Carozza is editor of Fraud Magazine.

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