Corporate Governance

Regulation, SOX, and the Importance of Market Integrity

By J. Robert Brown

As the debate swirls around the regulatory response to the current crisis in the financial markets, it bears noting the impact of Sarbanes Oxley, a law that until recently was pilloried as an example of over regulation.  Yet as we have noted, the number ofsecurities fraud law suits is down, so are thenumber of restatements.  Investor confidence is up (except to the extent shaken by recent events, particularly in the subprime market).  In other words, SOX confronted a problem with a direct solution and the solution worked.

The latest piece of evidence comes from theCenter for Audit Quality.  Areport issued by the organization includes a survey taken of audit committee members.  Before we review the results, lets recap the requirements of SOX.  SOX largely defined the jurisdiction of the committee, provided that the directors had to meet a stronger definition of independence, all but required financial expertise and provided that the committee was guaranteed funding to perform its functions.  One might imagine that audit committee directors approve of the changes but are working harder.

The survey indicates agreement that the time commitment has increased, as has the interaction with external auditors (90% say this has occurred), that investors are more confident in the financial statements (65%), that the audit quality has improved (82%), and that the risk of a material inaccuracy is lower than the pre-SOX days (67%).  What is the reason for the increased confidence in the integrity of the financial statements?  Tighter internal controls, increased scrutiny by external auditors, more checks and balances in place, and increased communication and disclosure by company executives.  Finally, 92% of the directors themselves said that "their increased oversight" had a positive impact.

SOX can't prevent all fraud and it can't stop stupid decisions by boards or executive officers (such as excessive exposure to the subprime market) but it can reduce incidents of fraud and eliminate the kinds of mistakes that deprive the market of confidence in the financial statements.  In short, SOX was and is about integrity.  Henry Paulson should take note of this in considering the proper regulatory approach.

Full post as published by The Race to the Bottom on April 03, 2008 (boomark / email).