When the Enron and Arthur Andersen scandal erupted in late 2001, confidence in the securities markets plummeted as doubts about the validity of financial information lingered in the air. The subsequent drop in overall market prices only increased the threat of a recession. In response, Congress passed the Sarbanes-Oxley Act into law in the belief that it would pump confidence in the markets back up to its pre-existing levels and ward off the potential recession. Instead, the passage of the Act served only to exacerbate the economys downturn.
Theoretically, lower confidence in the marketplace is caused by an increase in the perceived inherent risk of investing in securities. Increased risk translates into decreased securities prices. The basic aim of Sarbanes-Oxley was to alleviate some of this risk and thereby increase prices.
But this goal was not accomplished. From September 2001 to April 2003 the Dow Jones Industrial Average steadily declined. Moreover, news of the impending passage of the Act did not seem to affect the market at all, and the stock market actually proceeded to crash to its lowest level in over three years almost directly after the Act took effect. Analyzing these trends, some financial analysts have concluded that Sarbanes-Oxley was actually a main contributor to these declines.
Why didnt the Act work as planned? The basic answer is that it had a tremendously negative impact on business activity by criminalizing the entrepreneurial spirit and increasing non-value-added costs.
For example, consider the new regulation that made a CEO criminally liable for the financial information of his company. This created a climate where the CEO could be viewed as personally liable for unsuccessful business ventures, which in turn made him fearful of taking risks which might have stimulated the growth of the company. Without risk-taking, growth slowsand investors were not willing to invest in such a constrained environment.
The Act also raised costs for companies. Officer liability insurance soared (increasing between 100 percent and 300 percent), as did audit and legal fees (which tripled). In addition, the new Public Company Accounting Oversight Board (PCAOB) is funded by fees imposed on public companies and accounting firms. Increased expenses such as these stunt the growth of companies as funds normally reserved for capital acquisitions must be used to pay these additional, non-value-added fees. And with threats of impending war and the economy in a recession as it was until March 2003, companies were already naturally hesitant to make capital investments. These disincentives just magnified the business sectors malaise as stagnation in capital purchases drove the economy further into the recession.
The increased costs have also prevented smaller companies from going public. And some public companies have actually decided to convert back to privately-held organizations to avoid the compliance issues of Sarbanes-Oxley. Many international companies report that their decisions to de-list or not even initially list on U.S. stock exchanges were prompted directly by the Act. The British insurance company Benfield and the German car manufacturer Porshe are two such companies that have decided against listing on the New York Stock Exchange due to the provisions of the Act.
These reasons all point out how the Sarbanes-Oxley Act not only did not serve to increase, but in fact decreased investor confidence in the markets. Savvy investors know that increased government regulation can ultimately impede businesses from making sound decisions, which can hurt their bottom lines and thus their stock prices. This fear does little to ease, and a lot to hurt, confidence in the marketplace, as well as ensure greater severity in an already impending recession. The economy simply could not recover properly while the presence of Sarbanes-Oxley loomed over it.
|Manuel C. Cosme was a public policy research intern at the Independent Institute, Oakland, California.|