Getting to grips with Sarbanes-Oxley

A new survey has shown US public companies are finally getting to grips with Sarbanes-Oxley. Public companies spent a quarter less in compliance in 2006 than they did the year before. The Sarbanes-Oxley Act (commonly called SOX) is a controversial federal law passed in 2002 in response to the Enron, WorldCom and other financial scandals. Compliance with the law in 2006 cost companies $2.92 million on average compared with $3.8 million in 2005.

The drop is 35 percent compared to 2004, the first year companies were required to adhere to the law's strict accounting requirements. The survey was carried out by Financial Executives International who surveyed 200 companies, most of which had a market value of more than $75 million. While business groups such as the US Chamber of Commerce have criticized SOX for stifling innovation by subjecting companies to burdensome regulations, the act has done much to restore confidence in the integrity of the American business community.

The act was named after its sponsors Senator Paul Sarbanes (D-Md.) and Representative Michael G. Oxley (R-Oh.). The legislation establishes standards for all U.S. public company boards, management, and public accounting firms. It contains 11 titles which range from additional Corporate Board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law.

SOX established a new agency called the Public Company Accounting Oversight Board (PCAOB) which was charged with regulating accounting firms in their roles as auditors of public companies. The PCAOB is a private sector non-profit corporation based in New York which oversees the auditors of public companies to protect investors’ interests and ensure that audit reports are informative, fair and independent.

George W Bush signed the Sarbanes-Oxley bill into law in July 2002. In his signing speech Bush linked terrorism and fraud as undermining the US economy. Bush described SOX as “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt”. Bush said that under the new law CEOs and chief financial officers would have to personally vouch for the truth and fairness of their companies' disclosures. The act gave the SEC the administrative authority to bar directors and stiffened penalties for obstructing justice and shredding documents. It also increased the maximum prison term for fraud from five to 20 years. However Bush wasn’t always so eager to pass this legislation.

The aim of the law was to improve accountability of managers in the wake of the Enron scandal in 2001. But initially Congress was slow to react. Enron were big contributors to both sides of politics, but its largesse was mostly to the Republicans including a donation of $114,000 to the president. There were several committee hearings and a number of bills were introduced to address corporate misconduct. But with the Senate under Democratic control and the House of Representatives and White House under Republican control there was little agreement on how to address the problems.

In the Summer of 2002 came a second wave of corporate scandals, led by WorldCom and Adelphia. The stock market plummeted in advance of the midterm elections. Congress and the White House could no longer ignore the stench. Congress rushed to pass the complicated Sarbanes-Oxley Act before the August recess. The previously controversial proposal suddenly became very popular, passing 99-0 in the Senate and 423-3 in the House.

It was to be the broadest-sweeping legislation to affect corporations and public accounting since the 1933 and 1934 securities acts. SOX developed the Public Company Accounting Oversight Board, a private, non-profit corporation, to ensure that financial statements are audited according to independent standards. Top company officers are held directly responsible for financial accuracy with penalties for non-compliance up to $5 million in fines, a 20-year jail term or both. The law seeks to ensure securities analysts are objective and gives board audit committees (not the CEOs or chief financial officer) full control of auditors.

But critics of the law complain that the cost of compliance is too high; especially for smaller companies. Early studies showed companies were paying bills far in excess of what regulators had predicted. In response the SEC initially delayed implementation of a key section of SOX for companies with less than $75 million in market capitalization until this year; the internal-controls assessment requirements (called Rule 404). That deadline has now been extended further to 2009. Much remains to be done. Today’s survey result is showing that the SOX process is maturing but another 78 percent still believe the cost of compliance exceeds the benefits.

Enron: the smartest guys in Big House

The latest acts in the Enron tragedy were played out last month. The company’s leaders were found guilty after their protracted court cases. Chairman Kenneth Lay was found guilty on all charges and former CEO Jeffrey Skilling guilty on 19 of his 28 charges. Skilling faces up to 185 years in prison for the 19 counts of fraud, conspiracy, insider trading and lying to auditors. Lay has an equally absurd sentence. He faces up to 45 years in prison on the six counts of fraud and conspiracy in the Enron trial. In a separate bench trial for federal banking violations he was found also guilty and faces a maximum of 120 years in prison. That’s a total of 165 years all up.

Enron declared bankruptcy in 2001 after investigators uncovered accounting schemes that concealed billions of dollars of debt. They seemed to be at the top of their game. Earnings had increased 25%, and revenues more than doubled, to over $100 billion. Spectacular growth had turned an obscure energy company in the seventh largest business in the world. Nevertheless in March that year, Fortune magazine were starting to smell something fishy. It described their business as inscrutable, their debt strategy as dangerous. It concluded ominously, “Enron isn't leaving itself a lot of room for the normal wobbles and glitches that happen in any developing business”. By the end of that year, those wobbles and glitches had seriously derailed the company. Enron was brought down in America's largest ever financial scandal.

It is a true rags to riches and back to rags story. Enron Corporation was an energy company based in Houston, Texas. It was founded in 1930 as Northern Natural Gas Company, a consortium of three power companies. In 1979 they were reorganized as a holding company, InterNorth, which replaced Northern Natural Gas on the New York Stock Exchange. In 1985, InterNorth bought out the Houston Natural Gas Company in a transaction engineered by HNG CEO Kenneth Lay. Lay emerged as CEO and renamed the company as Enterone Corporation, with headquarters in Houston. When it was pointed out that enterone was a word referring to the intestine, it was quickly shortened to Enron. Enron was originally involved in the transmission and distribution of electricity and gas throughout the United States and the development, construction, and operation of power plants, pipelines, and other infrastructure worldwide. He appointed Jeffrey Skilling as COO in 1990. Skilling's big idea was that a company didn't need any assets.

Enron’s extraordinary growth was made through its pioneering marketing and promotion of power, communications bandwidth commodities and related derivatives. Derivatives are types of investments from which profits are derived over time from the performance of assets, rates or indexes. These included items such as weather derivatives. Weather derivatives are used as a risk management strategy for the likes of farmers to insure against frost-affected harvests and theme parks who hedge against rainy weekends in Summer. Enron used an index called ‘Heating Degree Days’ in their betting. Heating degree days are calculated annually by adding up the differences between each day's mean daily temperature and a so-called arbitrary "balance point" temperature of 18 °C above which buildings are assumed not to need heating.

Between 1995 and 2000 Enron were hailed as “the most innovative company in corporate America.” Weather was one of over 800 trading items Enron dealt in. Primary of these were trading in bandwidth, credit risk management, emission allowances, gas, lumber, power and steel. In the middle of the dotcom boom in 1999, they launched EnronOnline. It was the first web-based transaction system to allow consumers to trade commodity products globally. It proved to be a huge cash drain on Enron and forced the Finance department to dream up more creative activities to keep the company running.

Enron ran into major controversy when they signed a $3 billion contract with the Maharashtra State Electricity Board in Mumbai, India. Enron officials used its political clout in the Clinton and Bush administrations to exert pressure on the board. Ron Brown, the Commerce Secretary under Clinton, helped initiate the disastrous Dabhol power project, in which Enron saddled India's Maharashtra state with unneeded and expensive electricity. Kenneth Lay was one of George W Bush’s largest political donors and Bush used to refer to him as “Kenny Boy”. And when Bush became president, Enron persuaded Dick Cheney to pressurise India to go forward with the project. The World Bank refused to support the project. However. Pradyumna Kaul, a management consultant working for the Indian government said “they would have no alternative but to sign [Enron’s deal]. That was the only condition for the U.S. government to continue to support India on the foreign exchange financial front.” The project was halted by a local politician who was elected partly by promising to stop its construction.

Enron ran into further difficulties with its accounting firm Arthur Andersen. Andersen was one of the Big Five accounting firms but went belly-up after its association with Enron and others revealed flagrant irregularities. Arthur Andersen, the son of a Norwegian immigrant, founded the company in 1913 and ran it for 30 thirty years under the motto "Think straight, talk straight." However by 1980, they were no longer thinking or talking straight. In their cut-throat business they were forced to act fraudulently to protect greedy customers. The consulting wing had become more profitable and eventually split as Accenture in 2001. The wheels fell off completely in 2002 when Andersen was convicted of obstruction of justice for shredding documents related to its Enron audit. Although this ruling was overturned in 2005, the damage was long done and Andersen surrendered its licenses and its right to practice.

It was not long before Enron themselves faced their day in court. Much of its profits and revenue were the result of deals with special purpose entities. These are firms created by a company to fulfil narrow or temporary objectives to reduce financial risk. As a result, the core of Enron's debts and losses were not reported in its financial statements. It stood at the verge of undergoing the largest bankruptcy in history by mid-November 2001. Their shares plummeted from US $90.00 to US$0.30, an unprecedented and humiliating re-evaluation of blue chip stock. On January 9, 2002, the US Justice Department announced a decision to pursue a criminal investigation of Enron. Congressional hearings began on January 24. The result of those committee hearings saw Lay and Skilling indicted by the FBI for fraud. The other major outcome was the creation of the Sarbannes-Oxley (SOX) Act of 2002, a federal law that established stricter financial standards for all US public companies and accounting firms.

The shell of Enron still exists. Their home page states “Enron is in the midst of liquidating its remaining operations and distributing its assets to its creditors”. Lay and Skilling no longer appear on the board of directors and the chairman is now the grandiosely named but unknown John J Ray III of Wheaton, Indiana. He and his bemused staff must pick up the pieces. America is still reeling from the greatest financial hoax in history.