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The Sarbanes-Oxley Act and the Enron Scandal - Why are they Important?

The Sarbanes-Oxley Act and Corporate Fraud


sarbanes-oxley act and Enron scandal

The Sarbanes-Oxley Act, passed in 2002, is aimed primarily at public accounting firms who participate in audits of corporations. It was passed in response to a number of corporate accounting scandals that occurred between 2000-2002. This act set new standards for public accounting firms, corporate management, and corporate boards of directors. Sarbanes-Oxley, or SOX, is a federal law that is the most comprehensive reform of business practices since Franklin D. Roosevelt was President of the U.S. and passed the New Deal.

What Caused the Need for the Sarbanes-Oxley Legislation?

The Enron scandal was certainly enough to show the American public and its representatives in Congress that new compliance standards for public accounting and auditing had to be put into place. Enron was one of the biggest and, it was thought, one of the most financially sound companies in the U.S. Enron was perhaps the catalyst for the Sarbanes-Oxley legislation.

Enron, located in Houston, TX, was considered one of a new breed of American companies. It bought and sold gas and oil futures. It built oil refineries and power plants. It became one of the world's largest pulp and paper, gas, electricity, and communications companies before it bankrupted in 2001. The government deregulated the oil and gas industry prior to the bankruptcy of Enron in order to allow more competition. Enron, among other companies, took advantage of this deregulation.

After deregulation, California experienced a series of rolling blackouts of electricity and significant spikes in the price of electricity. Enron's wholesale earnings quadrupled in one year post deregulation.

On top of that, Enron misrepresented its earnings reports to shareholders and employees alike. All the while, it was encouraging its employees to invest in Enron stock and only Enron stock. The earnings reports looked positive to investors and they were continuing to invest in Enron stock, even though the earnings reports were not accurate. Employees and investors had no way to know that. In hindsight, some think that the California energy debacle may actually have been manufactured by Enron.

On top of misrepresentation of earnings reports, Enron officials embezzled money from the firm while reporting fraudulent earnings to investors. Eventually, the company went bankrupt because of fraudulent earnings reports and embezzlement. This was quite a shock to the American financial system as Enron was seen as one of the top companies in the U.S. What is worse, so many employees of Enron lost basically their entire retirement portfolios that were filled with Enron stock as the value of it went to zero. Investors lost any money they had invested in Enron stock.

What is the Sarbanes-Oxley Act?

In order to cut down on the incidence of corporate fraud, Senator Paul Sarbanes and Representative Michael Oxley drafted the Sarbanes-Oxley Act or "SOX" prior to 2002. After drafting this act, both decided not to run for re-election in 2006. The intent of the SOX Act was to protect investors, and really all stakeholders in a business firm, by improving the accuracy and reliability of corporate disclosures, such as earnings reports, pursuant to securities laws and regulations.

The SOX Act holds company CEO's and CFO's responsible for the information presented by their company in financial statements. It created new standards of accountability for corporations as well as penalties of those standards of accountability are not met. SOX established new financial reporting standards.

SOX also addressed the way, and changed the way, corporate boards deal with their financial auditors. The auditors for Enron, Arthur Andersen, were initially found complicit in the Enron scandal, which caused the break-up and bankruptcy of the company. The Supreme Court, however, overturned that decision a few years later, but not in time to save the company.

All companies, according to SOX, must provide a year end report about the internal controls they have in place and the effectiveness of those internal controls.

What is the Purpose of the Sarbanes-Oxley Act?

Sarbanes-Oxley provides for increased corporate governance and corporate accountability. Our financial markets simply cannot function under the assumption that fraud is taking place in our largest and most important corporations. Therefore, SOX is in place to be sure that fraud on the scale of Enron never takes place again. Other firms, during the time of the Enron scandal, also failed due to fraud and corporate scandal such as Tyco, Worldcom, and Adelphia. Enron was not the only culprit.

If a publicly-traded company is not in compliance with the SOX law, the penalties are stiff. Multi-million dollar fines can result and imprisonment of the CEO or CFO. Penalties are based on the section of SOX that the company is not in compliance with.

In summary, the Sarbanes-Oxley Act of 2002 is probably the best piece of legislation to protect investors in modern times. It is a shame that it took debacles like Enron and others to shake up Congress into writing this legislation as many innocent people, investors and employees, literally lost their life savings. Perhaps SOX will make sure that doesn't happen again.

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