Incidents Which Led to the Enactment of the Sarbanes-Oxley Act - Research Paper Example

Incidents which led to the enactment of the Sarbanes-Oxley Act The research presented in this paper provides the historical context of theSarbanes-Oxley Act, referring to the Enron’s scandal. The radical changes discussed in provision of the SOX were not enacted out of the blue, but were caused by the financial frauds occurred in American economy for the last decade. Sarbanes-Oxley act was enacted in the wake of series of precedent accounting and bankruptcy scandals, known by the downfall of WorldCom, Adelphia Communications, Waste Management, Tyco, Xerox, Sunbeam, and Global crossing. However, the most significant challenge occurred in 2001 when Enron’s stock collapsed and the company became a bankrupt in few weeks. As it turned out, the Enron Corporation was involved in an elaborate scam and financial machinations, such as exaggerating the positive financial statements, performing transactions through the shady dealings, omissions and misrepresentations; and insider trading. In spite of the possible prevention of complete collapse, the Enron’s officers continued to hide the financial problems of the company. Additionally, it was discovered that the Enron Audit Committee also was deficient. All these factors and many others have led to the enactment of the Sarbanes-Oxley Act. The Act is comprised of key provisions that describe the specific requirements, mandatory for preparing financial reports. Even though the Sarbanes-Oxley Act is recognized to be a major improvement to corporate governance, it still has significant constraints. Experts tend to criticize this Act, concluding that new provisions are not flexible and hardly achievable in real situations. Introduction Sarbanes-Oxley Act enacted only 8 years ago became a broadly discussed topic by people of different ages, professions and interests. This tendency can be explained by few financial scandals and bankruptcies, including the cases of Enron, WorldCom, Tyco and others. This paper is aimed to provide a research on which incidents have led to the enactment of the Sarbanes-Oxley Act, focusing mainly on the Enron’s case. And what measures have taken American government to cease financial frauds within the country. Sarbanes-Oxley Act The Sarbanes-Oxley Act (SOX) has been put into force in 2002 by the U.S. President George Walker Bush. During the SOX enactment, the President declared that it was “the most far-reaching reform of American business practices since the time of Franklin Delano Roosevelt” (cited by Kuschnik, p.65). Being enacted as a reaction to increased frequency of the accounting scandals with the purpose to prevent and deter financial reporting frauds and to restrict other unethical behavior, today SOX stands for a significant drift in the U.S. corporate governance spirit (Kuschnik,, p.65). The Act, enacted 8 years ago is not just a supplement to accounting standards, criminal liability or disclosure provisions; it is much more fundamental legal issue (Kuschnik, p.66). Before the Sarbanes-Oxley Act, the corporate governance structure have not been a matter of federal law, only a private matter between managers and shareholders with certain restrictions incurred by the state law (Tipgos & Keefe, n.p.). Considering the fact that the radical changes reflected in SOX were not enacted out of the blue, it is necessary to understand the main driving forces that have led to the enactment of new fundamental reforms (Kuschnik, p.66). 1. Events contributed to the adoption of Sarbanes-Oxley Act Sarbanes-Oxley act was enacted in the wake of series of precedent accounting and bankruptcy scandals, which started with the collapse of Enron and was followed by the downfall of WorldCom, Adelphia Communications, Waste Management, Tyco, Xerox, Sunbeam, Global crossing and others (Kuschnik, p.66). To better understand the core problems of these bankruptcies and accounting frauds, preceding the Sarbanes-Oxley Act, further discussion will be focused solely on the American company - Enron Corporation. Enron Corporation About the company Enron Corporation was an old line company, the core business of which was based on energy (Ruder, p.2). Owing electric power production facilities and natural gas pipelines the company employed 21, 000 staff and operated in more than 40 countries (BBC news, n.p.; Ruder, p.2). Enron Corporation has grown from nowhere to be the seventh largest company in the United States for 15 years (BBC news, n.p.). However, the American Electricity Corporation came into history as the company which managed to decline from business superstar to embarrassing bankruptcy (Fox, 2003, v.). So, how did a hundreds billion company collapse in a matter of few weeks? Elaborate scam of Enron In the 1990s, Enron’s business was mainly focused on trading in various energy vehicles, including contracts to provide electric power in the future at fixed prices and similar contracts to deliver water rights, broad band transmission systems, wing power, energy gas and other products (Ruder, p.2). The Enron Corporation was involved in an elaborate scam (BBC news, 2003, n.p.). The company’s accounting strategy was based on the principle of creating “special purpose entities”, with a purpose to finance activities of Enron, to shift debt from company’s books and thus to hide credit risk (Ruder, p.2). In this way Enron executives were planning to use the special purpose entities (SPEs) with an overriding goal to reduce pressures on the company’s balance sheet (Ruder, p.2). In addition to these advantages, some of the Enron’s SPEs were managed by the chief financial officer, Andrew Fastow (Ruder, p.3). Under his management, the company transferred some investments to SPEs with a purpose either to eliminate risky investments from the balance sheet or to produce an apparent immediate profit (Ruder, p.3). The company managed to lie about its profits, dramatically exaggerating the positive financial statements, and to perform its operations through the shady dealings (BBC news, n.p.). These activities included debts concealing operations, and misinterpretation of real performance. Enron’s officers failed to respect the accounting systems and to provide adequate, timely and true information about its financial position. They attempted to avoid disclosure of the company’s increasingly weakening financial condition and thus failed to warn market and all other interested parties about its potential losses and bankruptcy (Ruder, p. 6). In spite of the possible prevention of complete collapse, the Enron’s officers continued to hide the financial problems of the company (Ruder, 6). It has also been assumed that the Enron Audit Committee also was deficient; it was charged with monitoring the Enron’s financial books and records and the process of financial disclosure (Ruder, p.3). Suggestion that the Audit Committee did not audit thoroughly the Enron’s business operations has also given the basis for the Sarbanes-Oxley Act. While the company continued to show up in its accounts, shareholders were confident that electricity corporation was one of the best choices for money investment. However, when the real depth of the Enron’s lie was unfolded, both investors and creditors retreated, Enron’s stock collapsed, forcing the firm into bankruptcy in mid-December of 2001 (BBC news, n.p.). Enron’s alleged irregularities During the company’s illegal operating, there were two alleged irregularities in the actions between the sellers of securities and Enron Corporation: omissions and misrepresentations; and insider trading (Martinovich & Mykytiuk, n.p.). In the Enron’s case, the company’s defendants filled the financial disclosure forms and public statements that indicated good financial health of Enron, despite the fact that the situation was opposite and the company’s financial position was falling rapidly (Martinovich & Mykytiuk, n.p.). Misrepresentations and material omissions both refer to the subject of most securities fraud prosecutions (Martinovich & Mykytiuk, n.p.). Every public company is required to maintain detailed financial records and to report this information to the Securities and Exchange Commission (Martinovich & Mykytiuk, n.p.). The criminal securities fraud is constituted when the financial records are false. Insider trading was the second form of alleged irregularities that Enron executives have been applied (Martinovich & Mykytiuk, n.p.). It means that they were trading by securities on the basis of knowledge that was not available and accessible to the general public (Martinovich & Mykytiuk, n.p.). Thus, 28 Enron’s corporate executives, including Skilling and Lay, sold 21 million shares of Enron stock due through the scheme of insider trading (Martinovich & Mykytiuk, n.p.). Analysis and suggestions Focusing on the Enron’s case it becomes obvious that the principal weakness of its corporate governance structure was an excessive power concentration in the hands of company’s executives (Tipgos & Keefe, n.p.). This concentration of power allowed the Enron’s executives to conduct illegal operations and hide its true financial statements. Thus, it was necessary to rebalance or equalize this power to avoid financial frauds and bankruptcy. To stop management fraud it was necessary to balance corporate power among three key participants of the corporate processes: the board of directors, managers, and employees (Tipgos & Keefe, n,p.). These three groups would be enabled to communicate directly with each other and thus share critical information about the performance of company (Tipgos & Keefe, n,p.). To enhance integrity of financial statements and prevent management from manipulating the transactions and control overriding, it was be necessary to assign internal control to the employees (Tipgos & Keefe, n,p.).The board of the company would be responsible for creating and maintaining a structure, ensuring cooperation between the employees and managers (Tipgos & Keefe, n,p.). Under shared visions and responsibilities, constant watchfulness of each group should rebalance concentration of corporate power, prevent management fraud, assure true financial reporting and encourage good corporate behavior (Tipgos & Keefe 2009). Operating with the fact that the scope of corporate authority was strictly limited and framed by the legal issues, it becomes obvious that Enron’s officers did not act within their scope of authority. Key provisions of Sarbanes-Oxley Act Sarbanes-Oxley Act was enacted in a number of such cases as Enron, previously discussed and analyzed. Relying on the “advanced experience of financial frauds”, American government developed the Sarbanes-Oxley Act addressing to the main pitfalls. Today, the SOX is recognized to be a major improvement to corporate governance, because it authorizes the audit committee to control the processes of hiring and firing (Ruder, 9). As well it gives the audit committee the right to hire its own independent advisers (Ruder, 9). The Act is comprised of key provisions that describe the specific requirements, mandatory for preparing financial reports: 1. Public Company Accounting Oversight Board (PCAOB) According to the Title I, the Public Company Accounting Oversight Board has to provide interdependent oversight of public accounting firms that work as auditors (Sarbanes-Oxley Act, 2002). Additionally, there should be created a central oversight board, which will be responsible for registering auditors, controlling, and inspecting compliance with the SOX requirements (Sarbanes-Oxley Act, 2002). 2. Auditor Independence Title II was created with a purpose to establish standards for external auditor independence. The main idea of this policy is to limit potential conflicts of interest (Sarbanes-Oxley Act, 2002). This title provides profound information about the auditors and their professional responsibilities. Considering the case of Andersen auditing and consulting services, the Title II restricts combination of these (and other non-audit) activities for the same clients (Sarbanes-Oxley Act, 2002). 3. Corporate Responsibility Title III “empowers” senior executives for taking individual responsibility for the completeness, adequacy and accuracy of corporate financial reports (Sarbanes-Oxley Act, 2002). 4. Enhanced Financial Disclosures Title IV describes such reporting requirements for financial operations, as pro-forma figures, off-balance sheet transactions, and stock transactions of company’s officers (Sarbanes-Oxley Act, 2002). This chapter mainly focuses on the financial disclosures and requires timely reporting of changes in the company’s financial state (Sarbanes-Oxley Act, 2002). 5. Analyst Conflicts of Interest This Title describes measures developed to help return the confidence of investors in the reporting of securities companies (Sarbanes-Oxley Act, 2002). 6. Commission Resources and Authority Title VI provides a description of practices necessary for restoring investor confidence. Additionally, it defines requirements necessary for practicing as a dealer, broker or advisor (Sarbanes-Oxley Act, 2002). 7. Studies and Reports 8. Corporate and Criminal Fraud Accountability Title VIII describes specific criminal penalties for financial frauds, including manipulation, alteration and destruction of financial records (Sarbanes-Oxley Act, 2002). 9. White Collar Crime Penalty Enhancement Title IX informs about increased penalties relating to the white-collar crimes and conspiracies (Sarbanes-Oxley Act, 2002). 10. Corporate Tax Returns 11. Corporate Fraud Accountability Criticism of the Sarbanes-Oxley Act Many provisions of the Sarbanes-Oxley Act are perceived to have only limited effect on corporate governance (Kuschnik, p.92). Kuschnik (2008, p.92) explains that an increase of independence does not automatically lead to better monitoring. Not being involved in the company as insiders, independent auditors face difficulties while detecting and realizing the affairs of the company (Kuschnik, p.92). A critic refers to the whistleblower protection rule as well, because it turns out to be ineffective in spite of assumed goals (Kuschnik, p.92). Kuschnik concludes that the system of federal monitoring for corporate governance lacks flexibility and effectiveness for adapting new economic scenarios (Kuschnik, p.93). Some other critical opinions relate to the conclusion that surveillance and punishment measures negatively influence on the economic spirit of the market (Kuschnik, p.93). The new provisions, stated in the Sarbanes-Oxley Act seem to create new financial and bureaucratic burden to the companies (Kuschnik, p.93). Conclusion The Enron’s scandal is considered to be a crucial moment in the history of the American economics and business, which has led to the enactment of the Sarbanes-Oxley Act in 2002. Relying on the “advanced experience of financial frauds”, American government developed the Sarbanes-Oxley Act addressing to the main pitfalls discovered during the whole “pleiads” of financial frauds and bankruptcies. Even though the SOX is recognized to be a major improvement to corporate governance, it still has significant constraints. Experts tend to criticize this Act, concluding that new provisions are not flexible and hardly achievable in real situations. Obviously, just enacting regulations and legal restrictions are not enough to prevent and deter financial reporting frauds. Probably such acts do not provide expected results, because human nature still lacks ethical educational and strong moral principles. References: BBC News (2002). Enron scandal at-a-glance. BBC News, World edition, Aug.22, 2002. Retrieved from http://news.bbc.co.uk/2/hi/business/1780075.stm#top Fox L. (2003). Enron: The rise and fall. John Wiley and Sons Inc., Hoboken, New Jersey. Kuschnik B. (2008). The Sarbanes Oxley Act: “Big brother is watching you” or adequate measures of corporate governance regulation? Rutgers Business Law Journal, Vol.5:1, pp.68-93. Martinovich E. and Mykytiuk J. (2006). Securities Fraud Lessons From Enron. Imhoff & Associates, PC. Criminal defense attorneys. Retrieved fromhttp://www.criminalattorney.com/blog/securities-fraud-lessons-from-enron/ Ruder D. (2002). Lessons from Enron: Director and Lawyer Monitoring Responsibilities. Retrieved from http://www.law.northwestern.edu/professionaled/documents/Ruder_Lessons_Enron.pdf Sarbanes-Oxley Act (2002). One Hundred Seventh Congress of the United States of America: the Act. 2nd Session. Find Law.com, Retrieved from http://fl1.findlaw.com/news.findlaw.com/cnn/docs/gwbush/sarbanesoxley072302.pdf Tipgos M. and Keefe T. (2009). A Comprehensive Structure of Corporate Governance in Post-Enron Corporate America. The CPA Journal online. Retrieved from http://www.nysscpa.org/cpajournal/2004/1204/essentials/p46.htm Read More