Sarbanes-Oxley--context & theory: market failure, information asymmetry & the case for regulation.

Author:Jasso, Sean D.

    This paper addresses the questions how does the concept of market failure apply to ethical corporate governance? Are corporate ethics authentic in the modern corporation or just lip service? Will SarbanesOxley achieve results? To attend to these questions the essay is organized in three sections. First, I address the historical and philosophical context of the firm as depicted both by Aristotle and Adam Smith, both leading thinkers on the concept of commerce and its impact on society. Second, I examine the issue of market failure and information asymmetry, the theories guiding the reactive regulatory measures of SOX attributed to corporate bad behavior. Third, I analyze the Sarbanes-Oxley Act from the perspective of the policy analyst following the politics that designed the bill to the implementation agencies that oversee its mandates.

    The ultimate objective is to provide a better understanding of the regulatory connection between government and the corporation. The guiding hypothesis is that Sarbanes-Oxley is effective legislation implemented at the right time to not only protect the investor from corporate fraud and to force executives to strengthen corporate ethical standards, but moreover, to solidify that the US market remains strong and that it is not only open for business, but it is a safe place to work and invest. I argue that SOX is the necessary policy tool to achieve these goals.


    2.1 A Philosophical Analysis

    As stated in the abstract, we look to the market for solutions such as products, services, jobs, and investment opportunities. Why the market? The market in a capitalistic economy offers ownership of the factors of production: traditionally land, labor, capital, resources, knowledge, and entrepreneurship. This ownership is immensely personal, and through ownership, the capitalist is driven to sustain certain freedoms associated with his independence and wealth maximization. In contrast to the capitalistic system, a socialist system or the extreme of communism diminishes and eventually removes personal ownership of market factors and transfers them to the government, whereby the government allocates the production of the solutions described above. Ownership can be attributed to self-interest, a guiding theme in the discourse of commerce, trade, and the accumulation of wealth.

    It is in fact, the self-interest theory that is at the root of the modern corporation--an institution that personifies the American culture where the combination of entrepreneurship, capital investment, commitment to quality and customer responsiveness has produced many of society's great achievements as well as its profound wealth. Unfortunately, self-interest has also contributed to some of society's greatest misfortunes such as the unchecked market of the 1920s to the fraudulent and greed infested corporation of the 1990s. Notwithstanding some of business' unfavorable history, our teachers from Aristotle to Adam Smith recognize that the enterprise is intended to be good for society. For example, according to Calhoun, "... the function of business [or commerce] as 'service' ... [is] its aim as the betterment of human life" (1926, p. 5). Here Calhoun is describing the ancient Greek concept of business as a direct service provider of improving the human condition from the products and services of trade, commerce, and exchange. Often referred to as the father of the 'self-interest' ideal is Adam Smith, and Morrow adds to the betterment theme and its connection to business describing,

    The two main causes of the productivity of modern industry are the division of labor and the accumulation of capital. Self-interest is the explanation of both these key facts. The individual finds it more to his interest to exercise his strength and develop his skill in one occupation and exchange the surplus of what he produces for the products of other men's skill than to attempt to supply all his various needs by the labor of his own hands; hence the division of labor. Likewise, the accumulation of capital: 'The principle which prompts to save is the desire of bettering our condition, a desire which, though generally calm and dispassionate, comes with us from the womb and never leaves us until we go into the grave.' Thus, by following his own interest, as the individual sees it, he is furthering the progress of his neighbors and his nation toward wealth and prosperity ... with Adam Smith, the material resources of the modern world, and the human traits which have created it, and attempts to determine under these conditions 'wherein consists the happiness and perfection of a man, not only as an individual, but as a member of the family, and of the great society of mankind (1927, p. 327). I highlight some of the older discussion pieces from the early part of the 20th Century primarily to illustrate that the problems and opportunities associated with commerce are the themes of fairness and the distribution of wealth, which, consequently, are themes business, government, and society contend with today. For example, at the turn of the century Howerth asserts "the social question [of the present day] is always a question of the many against the few, and manifests itself invariably in a struggle over some form of institution; that is to say, a class struggle" (1906, p. 257).

    Howerth is correct in his observation of such a struggle, given that class tiers are a fact of life one hundred years after his publication. Nevertheless, another fact of life is that Adam Smith is often misunderstood and the invisible hand theory among the self-interest theme is too often perceived as a discouragement for the poor as well as an association with amoral domination of the elite few monopolizing the acquisition of wealth. The fact is that Smith believed in the promise of business exemplified by Harpham that "the call for a 'system of natural liberty' is not a rejection of the modern commercial order and the economic growth that was an essential part of it; it is an affirmation of the commercial order and a call to place future economic growth on more secure foundations" (1984, p. 768). Smith would be content with the institutions that grow wealth among nations such as the Western banking systems and their associated capital markets. Smith would also find pleasure in the liberty associated with the ongoing political trend of free trade, with its primary objective of satisfying a consumer driven society. Smith would also find satisfaction from his initial inferences on capitalism that the institutions of commerce have rigorous fiscal and monetary policy oversight on the stabilization of this sensitive, robust, and resilient market of the modern day.

    Indeed, a prosperous economy relies on another often criticized attribute of commerce: the maximization of profit. Profit maximization, as the central focus for the firm is not immoral simply due to the fact that profitability is a measurement of sustainability and growth potential. After all, growth expands demand, requires more factors of productions such as labor, and often brings wealth opportunities to developing communities. Nevertheless, profit maximization is also one of the central culprits in this discussion on Sarbanes-Oxley, as greed of the owning and managing elite brings the corporation tumbling down along with the many stakeholders who rely on the solutions the firm is meant to offer.

    The interrelated characteristics of business and society are also the leading criticisms of business power namely the theories described above--self-interest, the invisible hand, and profit maximization. Additional theories include dominance models, where business as a dominant player is portrayed as the most influential and powerful institution in society, in contrast to the pluralistic model, where business is in balance with government and other social institutions (Steiner & Steiner, 2006, p. 13). These models are helpful because they set the stage for the reality of the pre- and post-Sarbanes-Oxley era. We see the 1990s, especially the final years of the decade as well as the first years of the 2000s, as a boom era, evidenced by significant technological innovation, exceptional economic growth, as well as a turnover in American political leadership. Sadly, among all of this energy influencing the dynamics of business, government, and society appears to be the germinating nucleus of immoral behavior--most directly in the corporate boardrooms of large, publicly held corporations. Perhaps the most infamous scandal associated with this stream of unethical activities is the collapse of Enron Corporation. Enron has become the epitome case study for teaching ethics--or more appropriately, the teaching of what ethics is not. In the following section I describe the theoretical framework that characterizes the scandals associated with Enron and the many others that shared the headlines. But first, some Enron statistics to underscore the consequences of market failure and information asymmetry:

    * Bankruptcy facts:

    ** 20,000 employees lost their jobs and health insurance

    ** average severance pay $4500

    ** top executives were paid bonuses totaling $55M

    * In 2001:

    ** Employees lost $1.2B in retirement funds

    ** Retirees lost $2B in retirement funds

    ** Enron's top executives cashed in $116M in stock

    * Criminal Charges

    ** Guilty pleas: 15

    ** Convictions: 6

    ** Acquittals: 1

    ** Pending cases: 11

    * Three California traders pled guilty to wire fraud

    * Four Merrill Lynch executives pled guilty to fraud in the Nigerian Barge case

    * Aug 23, 2000 stock hits high of $90

    * Nov 28, 2001 stock drops to $1

    * 29,000 Arthur Andersen employees lost their jobs (Enron's CPA firm)

    * Enron shareholders suing Enron and their banks for $20B (Elkind & McLean, 2003).


    3.1 A Framework for Corporate Bad Behavior

    One of the guiding themes of this paper is the concept of the...

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