Though news coverage of Enron has evaporated, its aftereffects remain. This supposed crisis led to an expansion of leviathan in the form of the Sarbanes-Oxley Act of 2002. Unfortunately, the costs of this act are not getting anywhere near as much coverage as the ‘crisis’ that fueled support for it.
The effects of this legislation are sweeping. 85% of major multinationals in the US have adjusted their compliance practices because of Sarbanes-Oxley. This act mandates that CEO’s certify that the information in financial statements information fairly presents the company’s financial condition and the results of operations. It also established a standards setting board, funded by what amounts to a new business tax. The initial out of pocket compliance costs of this act are in fact low. However, 71% of executives expect to see these costs rise in the future, and its benefits are highly questionable.
Officially, this law was supposed to improve the accuracy and transparency of corporate reports and disclosures, and to reinforce ethical corporate behavior. Actually, the persons most directly affected by it have little confidence in the ability of this legislation to produce these results. Only one third of corporate executives believe that this bill will restore investor confidence. Only 9% surveyed were fully satisfied with it.
While the expectations of executives concerning compliance costs and investor confidence are not necessarily accurate, the stifling effect that such regulations have on business behavior is real and cause for much concern. CEO’s now face penalties for false certification of $1,000,000 and/or up to 10 years’ imprisonment for “knowing” violation and $5,000,000 and/or up to 20 years’ imprisonment for “willing” violation. Corporations must now disclose “on a rapid and current basis” additional information about the company’s financial condition or operations as the SEC determines is necessary or useful to investors or the public interest.
While no reasonable person would oppose fair or accurate reporting of financial figures by corporations, the vague nature of elements of this law leave considerable room for abuse. What do terms like rapid and fair really mean? How do prosecutors know when a violation is knowing or willing?
Some executives now prepare ‘judgment reports’ to verify that profits attributed to different divisions of their enterprise are ‘fair and accurate’. This might seem like a small burden, but what is not so easily seen are the harmful changes in American enterprise. As one executive recently put it:
“The success of the American capitalist system has been built on innovation and risk-taking. Corporate governance distractions have resulted in some top managers becoming reluctant to take risks today. Yet that is what we are paid to do. Many are spending more time responding to the new requirements than developing the strategies that lead our businesses down new paths of growth.” (Maurice Greenberg, CEO American International Group)
This act, Greenberg warns, has had a chilling affect on the economy. Perhaps the blame that Democrats assign to George Bush for recent economic conditions is not entirely unwarranted. While Bush controls neither monetary policy nor events prior to his assuming office, he has increased wasteful spending, raised tariffs, and also dampened entrepreneurial action by signing Sarbanes-Oxley. One should not expect prosperity to follow such actions.
An appreciation for the importance of risk taking does have a sound economic basis. As Ludwig von Mises wrote1 , entrepreneurs bear uncertainty in the running of their enterprises. This is crucial to the functioning of the capitalist system because human action is dynamic in its nature. Economists of different perspectives agree with this. Frank Knight and Joseph Schumpeter saw the importance of entrepreneurs facing uncertainty and carrying out the process of creative destruction2 . Rarely do Austrian, Chicago, and Harvard economists all hold such similar opinions.
The SEC Commissioner takes a different view of this bill. While the commissioner recognizes that there are sound reasons to expect unwarranted expansion of government during perceived crises3 , he claims that this bill accounts properly for private compliance costs. In a recent speech, Atkins mentioned that “U.S. regulators are bound by law to take into account commentary submitted by those who would be affected by proposed rules.” One might think that such a rule is practical. However, Nobel Laureate George Stigler demonstrated that companies often “capture” regulators and then use regulations in anticompetitive ways. This need not be true. Professor Fred McChesney has shown that regulations can instead lead to rent extraction, as politicians use regulations to affect transfers. While there may be positive effects from this legislation in promoting better disclosure of financial information, the potential losses from anticompetitive and risk-avoiding behavior are great. This bill goes far to politicize markets and redirect private efforts to dealing with public actions. When has such change ever ended in greater prosperity and freedom?
While it is clearly the case that markets are imperfect, we should remember that private interests exposed Enron. We should also remember that government suffers from severe imperfections that can easily dwarf private failures. The people who fear informational problems in corporate reporting should turn at least some of their attention to the informational problems of government. Stockholders have strong reasons to ferret out information on their companies, yet it is often rational for constituents to be ignorant of data on the workings of government4 .
The politicization of enterprise redirects our efforts into unproductive competition over the distribution of wealth, rather than towards the production of wealth. For this reason, free societies are dynamic and prosperous and politicized societies are stagnant and poor. While the Sarbanes-Oxley act may have made good political sense, it has already had an adverse effect on commerce. The answer to this problem is simple. Repeal this act. Republicans are fond of claiming to be the party of less government. They should put these words into action, for a change.
- 1Mises, Ludwig von. (1997). Human Action.
- 2See Knight, Frank (2002) Risk, Uncertainty and Profit and Schumpeter, J.A. (1984) ‘Capitalism, Socialism, and Democracy’.
- 3Commissioner Atkins mentioned Professor Robert Higgs and his book “Crisis and Leviathan” in his speech.
- 4See Downs, Anthony (1997) An Economic Theory of Democracy, Tullock, Gordon The Politics of Bureaucracy (1987) and Mises, Ludwig (1994) Bureaucracy.
