Reflections on Sarbanes-Oxley: Lessons Learned & Implications for the Future

April 2, 2008

Speaker
The Honorable Michael G. Oxley, Of Counsel, Baker & Hostetler LLP; former Chairman of the House Financial Services Committee and co-author of the Sarbanes-Oxley Act

Presider
James McDonald, President & CEO, Rockefeller & Co. Inc.; Chairman, Japan Society

Michael Oxley, of Sarbanes-Oxley fame, spoke about trade, transparency, and how the Sarbanes-Oxley Act came to be.

Mr. Oxley, who represented Ohio's Fourth Congressional District and as Chairman of the House Financial Services Committee co-authored the legislation that bears his name, is currently a lawyer practicing at Baker & Hostetler in Washington.

"While I'm probably best known for the Sarbanes-Oxley Act," he said, "one of my real interests along the way during the 25 years in Congress was international trade. Every opportunity I got I supported and promoted free trade and spoke up for foreign direct investment in the United States."

Japan's direct investments in the U.S. have created some 600,000 jobs for American workers, he said. But with anxieties about overseas competition remaining strong, it's "a constant education process" to remind voters and lawmakers that "overall, the U.S. has gained, not lost, jobs, because of international trade."

"As a matter of fact, the last time we passed the Trade Promotion Authority," formerly known as fast-track authority, "it passed by one vote at 3:30 in the morning. And that's how controversial these proposals have become."

In his home state of Ohio, "the governor of Ohio back in the 1960s, Governor Jim Rhodes, read an article in the Wall Street Journal about Honda and how Honda was struggling against some of their competitors in Japan. He literally hopped on a plane a couple of days later and went over and had an interview with Mr. Honda, convinced Mr. Honda that he needed to locate his facilities in the market that he was seeking," Mr. Oxley recounted.

"And of course Honda, some 26 years ago, started their facility first with the motorcycle plant and then with an automobile plant. They now employ 16,000 Ohioans. They are the second largest employer in the entire state of Ohio," and vendors in north central Ohio "supply virtually every part of that automobile that's assembled in Marysville [Ohio], and now in East Liberty, Ohio."

"The winners in all this, of course, have been the consumers and the quality of the cars has clearly made a difference," he added. "So, the answer obviously is not to put up walls. Instead we should embrace that global marketplace."

"There's also, I think, a global marketplace of policy ideas," Mr. Oxley continued. When SOX was enacted, he himself had concerns that the new law might trigger a rush to the bottom, with other countries lowering standards to persuade companies to invest and list their shares in their own jurisdictions. "The good news is, quite the opposite occurred." There are now versions of SOX in many countries around the world, including Japan, India, Israel, Brazil, the EU and Australia. "Higher corporate standards do attract investors," he said, citing studies done by researchers at the University of Toronto and Ohio State and by the Association of British Insurers. "It has been my experience that capital goes where there is both safety and opportunity. It seems to me these rocky times, the safety part of that equation takes on increased significance."

In 2001, scandals at Enron, WorldCom, Adelphia and other companies led to a storm of public criticism and investor anger, Mr. Oxley noted. "We lost $8 trillion in market cap during that period of time--$8 trillion , which is more than the gross domestic product of the three largest countries in the EU."

"And the market continued to waver, because this new class of investors were really taking this personally," he said. By contrast, during the junk bond scandals of the 1980s, "Drexel Burnham Lambert disappeared, people went to jail, like Michael Milken and Dennis Levine, but it didn't have the emphasis, the poignancy, the interest of the average person living in Findlay, Ohio. Why? I guess because people didn't really understand what junk bonds were. Nobody in my constituency was participating in junk bonds. And so it was an interesting sidelight, a great story, but at the end of the day it really didn't have a lot to do with their lives."

With the rise of 401ks and IRAs and mutual-fund investment over the last couple of decades, "we became a nation of investors," he said. "Ninety-five million Americans owned stock mutual funds. And so all of a sudden they were paying attention."

As Chairman of the House Financial Services Committee, Mr. Oxley found himself the target of urgent appeals: "It was dangerous for me to go on the House floor during that time, because I would be set upon by my colleagues who would tell me the latest horror story of somebody back in their district who had lost their life savings or in some cases their job as a result of these corporate scandals. So, that's why the Congress needed to act," he said. "And, again, the idea of restoring investor confidence through more transparency and accountability, and that's how Sarbox, SOX, came about. It was basically that simple."

Mr. Oxley made a motion to name the legislation after his Senate counterpart, Paul Sarbanes, a Democrat from Maryland who chaired the Senate Banking Committee; Mr. Sarbanes, a Republican, reciprocated, and the Sarbanes-Oxley Act was passed with both bipartisan and bicameral support. "The bill passed in the House 430 to 3, and it passed the Senate 97 to nothing, which meant that Phil Gramm and Ted Kennedy both voted the same way. It gives you an idea about the spectrum" of political backing for the legislation.

When some 330 pages of regulations were issued on internal-controls audits and reporting under Section 404 of the Act, compliance costs became a big issue, Mr. Oxley acknowledged. But the statute gives regulators flexibility to address just these kinds of issues, he said, and regulations now exempt, for the time being, some 80 percent of smaller public companies from 404 requirements.

With the blowup in the subprime mortgage sector, some say that "we thought we passed Sarbanes-Oxley to see that this kind of thing wouldn't happen again," but financial system reforms don't quite work that way, Mr. Oxley suggested: "Every scandal of this kind, or every downturn, has a different cast to it."

Nevertheless, he declared, "If there is one element running through this, it seems to me it is the lack of transparency." Just as Enron and WorldCom failed to report in a transparent way to the investing public, so did the mortgage industry fail to explain to customers the true risks of "no-down-payment, no-document loans and mortgages with very easy money."

Thus homeowners "didn't really understand the complications of an ARM, or what it even meant," he said. Furthermore, when the loans were packaged and sold, "a lot of very smart people didn't have enough ability or enough information to assess the risk." With Congress passing new legislation on procedures for designation of NRSROs, Nationally Recognized Statistical Rating Organizations, "we now have four new competitors in the credit rating agencies market, including a Japanese company, and I think that will ultimately open up the process a lot more and have a lot more competition going forward, and that's critically important."

Reforms under discussion include improved oversight of agencies like Fannie Mae and Freddie Mac and revitalization of the Federal Housing Authority, Mr. Oxley noted, as well as support for financial literacy programs, which "I think really do need addressing from a consumer-protection standpoint, and that's one of the things that Secretary Paulson said."

"But as Secretary Paulson also said recently on Fox News Sunday, I don't think you can alter the laws of gravity. And of course he's right. Ultimately the market has to work its way out. We need to find the bottom of this. We need to find how we can identify risk, how we can better deal with the risk and it's going to take a while to work out."

"It's remarkable that every time we've been through this and every time we're staring into the abyss, it seems like just a few months later things start to get better, we learn from our mistakes, we make the necessary changes and move on," Mr. Oxley concluded.

"That's that resiliency and flexibility that Chairman Greenspan talked about the American system, one that I think all of us ought to be very, very proud of, because the potential for disaster is right around the corner on virtually all of these, and yet every time we've had the good judgment and good sense to move forward and become stronger as a result."

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What are your perspectives on the cost-benefit question, whether the benefits of SOX justify its costs both in terms of time as well as out-of-pocket costs?

Much of this is subjective, but objectively, "since the time the president signed the bill, the market cap of virtually every publicly traded company in the U.S. has gone up considerably, even with the recent downturn," Mr. Oxley replied. The Act also has brought more transparency to the world of stock options: now that SOX requires insiders to post notice of transactions in company stock within 48 hours, virtually every stock-option backdating case being pursued is based on pre-SOX transactions.

Recently there have been proposals to suspend or postpone mark-to-market accounting for asset-backed and mortgage-backed securities, and to suspend temporarily capital requirements for banks that hold these things. Do you have any position on either of these?

These are issues for regulators, rather than the Congress, Mr. Oxley said.

"I have to say that, and you may point out with Bear Stearns, at the end of the day it wouldn't make any difference what their capital requirement was... When you've got a run on the bank, those capital requirements basically are going to be out the window."

"But I would think the regulators would not move forward without a fairly good feeling from the Congress that that's an acceptable move," he added. "So, it's a nuance about how our system works and most of the time it works pretty well."

Studies suggest that the primary deterrent to companies raising capital here and listing on American exchanges is not Sarbanes-Oxley but the litigation situation in the U.S. What are your feelings on how to remedy that?

Class action reform has cut down on forum shopping by the plaintiffs' bar, and the Securities Litigation Reform Act has reduced the number of frivolous strike suits; "but the suits that are filed actually have been successful, so it tells me they have gotten rid of the chaff and they have kept the wheat," responded Mr. Oxley.

Given deals that are very complex, disclosure obligations that are burdensome, some say overly so, and a trend in favor of principles-based rather than rules-based accounting systems, how do you really accomplish more transparency?

Policymakers had a legitimate desire to help people become homeowners, but in the marketplace, too many people lost sight of the realities of bubbles, whether it's in housing or in tech stocks, Mr. Oxley said. "These things end, and they end with a thud."
"You got somewhat of a herd mentality, and even the smart people that should have known better, should have dug a little deeper, didn't."

"One of the next steps in the whole process, following up on our bill that opened up the entry for nationally recognized credit rating agencies, would be, is there an inherent conflict of interest with the credit rating agencies who are in fact paid by the same people that they rate. Is that an inherent conflict of interest? And if it is, how do you change it to give it more credibility and more transparency?"

--Katherine Hyde