The Latest Threat To Investors

 

Some economic pundits are blaming some of the latest market problems on the jettisoning of several Depression era protections for investors, such as the repeal of the Glass-Steagal Act, which used to separate commercial banks from investment broker/dealers and the repeal of the Uptick Rule on short sales that may be contributing to the wave of short-selling.

Now, a more recent law protecting investors is under attack. Jane Bryant Quinn, the well-known financial columnist, warned of the latest threat to investors in her column in the Sunday, July 20, 2008 Washington Post. The Sarbanes-Oxley Act (“SOX”) was passed in 2002 after the Enron and WorldCom frauds and other accounting abuses came to light. Before SOX, the accounting industry was supposed to be regulating itself for both audit quality and integrity. In practice, accountants were turning a blind eye to several serious accounting misdeeds in exchange for large fees for their consulting practices.

SOX set up the Public Company Accounting Oversight Board (“PCAOB”) to create better auditing standards and police the quality of such standards. PCAOB, which is funded by public companies, has also set up enhanced requirements for auditing company’s internal financial controls and has required that chief executives and chief financial officers certify the accuracy of the financial statements.

A case that is now pending before the U.S. Court of Appeals for the District of Columbia Circuit may decide whether the PCAOB is unconstitutional because the U.S. Securities and Exchange Commission, rather than the President, appoints the Board members to the PCAOB.

Linda Lord, the head of Legislative and Regulatory Affairs for UBS, predicted it is “highly likely” that PCAOB would lose the case. She went on to write, “Not only will it [PCAOB] be put out of business, but SOX in its entirety will fall.” Such an event is possible because SOX lacks a “severability” clause. Thus if only one of its provisions is found to be unconstitutional, the whole law fails.

If the Court does strike down PCAOB, it could not come at a worse time for investors. Because of the Subprime crisis, the valuation of trillions of dollars of securities is in doubt. As Quinn noted “Nothing is more important to the functioning of markets than pulling reliable numbers out of this morass.”

Almost since its adoption, public companies both large and small have been lobbying to dump SOX on the grounds that compliance with the law costs too much money. The plaintiff in the current lawsuit, Beckstead & Watts, a small accounting firm in Henderson, Nevada, audits companies that trade on the over-the-counter bulletin board. PCAOB reviewed Beckstead’s audits in 2004 and found that in many instances, the firm “did not obtain sufficient competent evidential matter to support its opinion on the issuer’s financial statements.”

Empirical research has shown that SOX really does work. The research firm Glass Lewis out of San Francisco has reported that in 2003, 4.1% of all listed United States companies restated their earnings to correct mistakes. When SOX was initially adopted, that number jumped because of the strict scrutiny required by the new law. For example, in 2006, 11.5% of all public companies restated their earnings. As companies have improved their internal financial controls, that number has edged down.

While SOX is not perfect, it does seem to have fulfilled a major portion of its purpose in providing sharper financial information to chief executives, management and investors. Now is not the time to go backwards on that front.