The social construction of Sarbanes-Oxley.

• Author: Langevoort, Donald C.

TABLE OF CONTENTS INTRODUCTION I. ORIGINS A. Misunderstanding Benefits B. The Cost Problem and the Debate over Internal Controls II. IS SOX JUST ABOUT INVESTOR PROTECTION? III. THE CONTEST OVER SOX'S MEANING AND LEGITIMACY A. Corporate Executives B. Institutional Investors C. The Securities Industry D. Accountants and Auditors E. Lawyers F. Regulators G. The Media H. Corporate Employees IV. INTERPRETIVE INTERACTIONS A. Pressure Toward Compromise B. Contesting the Role of the Independent Director V. SMALL ISSUERS, FOREIGN ISSUERS, AND U.S. COMPETITIVENESS CONCLUSION INTRODUCTION

The meaning of the Sarbanes-Oxley Act (1) ("SOX") is still being contested even though it is now nearly five years since its enactment. This is not to say the words and phrases that make up the statutory mandates and implementing regulations are hopelessly muddled. Though there are plenty of ambiguities for lawyers and their clients to worry over, most of the requirements are clear enough as "law on the books" to expect at least formalistic compliance with them. But simply because something is enacted into law does not tell us much about how strongly it will influence economic behavior. At the very least, there is the rational calculus of likelihood of detection and magnitude of sanction. Most of SOX's implementation and enforcement is left to the discretion of the Securities and Exchange Commission ("SEC") and other public agencies. (2) We therefore should estimate what the regulators will do--which will bring into play an interesting mix of external politics and the agencies' own beliefs. (3) Courts, too, will play a role in saying what SOX means when they review the Commission's rules and enforcement actions, as will Congress in its continuing legislative oversight.

Socio-legal researchers tell us, however, that even the coupling between official legal interpretations and social behavior is fairly loose--that absent unusually high rates of detection and prosecution, compliance decisions are based at least as much on the perceived legitimacy of the law and prevailing norms in local context as any deliberate risk calculation. (4) Business people form their own beliefs about SOX independently from official interpretations, and they act accordingly. So do other groups like lawyers, accountants, investors, media, and politicians. These groups' perceptions influence each other as to appropriate corporate governance and behavior. (5) This is more than just a political battle, although the political dimension is surely potent. SOX has a cultural dimension as well, which political muscle alone cannot easily override.

The viewpoints in competition range from the idea that the Act ought to be firmly embraced for stopping a threatened market meltdown by restoring trust between companies and investors to the notion that it is a quack cure for an overblown problem and (7) a $1.4 trillion debacle for investors and the economy. (8) The more interesting questions are who is debating and why. Rent seeking is palpable, but far from the whole story. The economics and ideology of manager-investor relationships (9) and the United States' lawmaking competence in the global economy are also in play.

The closer one looks at SOX and its origins in the financial scandals of the early 2000s, the blurrier the picture, which lets commentators see what they want to see and draw inferences accordingly. (10) That is why social construction is so crucial. My aim in this paper is to illuminate the social nature of SOX's diffusion into practice. I will leave to the reader the judgment about whether this has been or will be good or bad, and for whom. If I seem to challenge SOX's critics more than its supporters, it is because the critics have been more venomous than is fair. Venom aside, the bite still deserves attention.

A reasonable concern is that we should not worry about something as fuzzy as social construction. We can observe how SOX has influenced behavior since its adoption, and that is what is important--not what self-interested parties say or think about the law. Numerous empirical studies in law, accounting, and finance have tested SOX's effects. These studies, however, are preliminary--because the rule-making process takes time, many of the Act's mandates did not go into effect until very recently, and implementation of certain provisions for some affected parties is still being delayed. (11) They also suffer from their own methodological challenges, because the events surrounding SOX were very noisy. Quite apart from the legislation itself, political attitudes and investor expectations also shifted in response to the financial reporting scandals. (12) Determining whether reactions were to the legislation itself or these other effects is hard. (13) Finally, we cannot assume that first reactions to any law will necessarily be sustained: there can be an overreaction in the first instance that calms as the interpretation of the law shifts both officially and unofficially.

To this end, Part I will take a close look at the legitimacy of SOX by examining the two plausible stories of SOX's origins and considering the early post-SOX evidence on its costs and benefits. There is no clear-cut answer to the question of how much SOX benefits investors; both positive and critical positions are plausible. Costs have been far greater than expected, but more from SOX's implementation than from the legislative text. Before turning to how and why implementation has occurred that way--which to me is the central question of interpretation--Part II considers whether there is an alternative interpretation of SOX that explains its motivations and likely long-term effects. This raises the possibility that SOX's most important effects may be less about investor protection than about renegotiating the boundary between the public and private spaces in big corporations, a much deeper ideological issue. The legislation may reflect a political instinct that incentive structures in modern public corporations generate risks that require public (not just investor) accountability to be legitimate. I suggest the "independent" director, currently seen largely as an investor advocate, is being pushed toward becoming a "public" director whose main assignment is to keep risks and rewards in a socially acceptable balance. Part III then turns to the various interpretive communities debating SOX's meaning, anticipates how they are likely to respond, and considers the resulting behavioral impact of their criticism or praise. In Part IV I predict, consistent with neither enthusiasm nor harsh criticism of the legislation, that the interpretive pluralism will gradually moderate both costs and benefits, slowly tilting toward the "public values" account described in Part II. Part V addresses the most specific criticism of SOX, involving so-called going-dark transactions and the impact on foreign issuers. I conclude by connecting SOX to larger questions about how law becomes part of social and economic practice.

1. ORIGINS

   By most accounts of the recent corporate accounting scandals, Enron by itself would have produced little more than marginal, mainly symbolic shifts in federal regulation. But the political dynamic changed in June 2002 when the WorldCom scandal led to an even bigger corporate implosion. Political sentiment became angrier, and Democrats were prepared to make these twin scandals--which by now had produced widespread loss of jobs and billions in financial losses for investors--a major campaign issue in the fall elections. The House and Senate quickly agreed to cooperate on a hybrid bill--although for procedural reasons the Democrat-controlled Senate handled most of the work--and SOX was enacted by the end of July. The November elections produced gains for the Republicans, including taking control of the Senate. In hindsight, this suggests either that the Republicans acted prudently in taking away the Democrats' edge by their show of bipartisan cooperation or that they badly overestimated the electoral significance of the scandals and compromised in an unnecessary panic.

   Few would quarrel with the basics of this story. In terms of the legitimacy of the legislation, however, the story has two plausible interpretations. One interpretation--now heavily emphasized by SOX's critics--argues that it demonstrates undue haste on difficult issues of financial regulation, resulting in a defective legislative product. But one could just as easily say that key legislators seized a moment when the public's attention was sufficiently focused so that normal partisan obstructionism and special-interest domination were briefly displaced. Which of these two interpretations prevails will tell us something about how SOX is ultimately understood.

   This Part considers two related criticisms of the legislative process meant to undermine SOX's legitimacy. Section I.A examines the claim that Congress grossly overestimated the benefits SOX's reforms would generate; Section I.B examines the claim that Congress ignored the costs as well.

   1. Misunderstanding Benefits

      Roberta Romano, a vocal critic of SOX, provides the most sophisticated academic exploration into SOX's origins. (14) Romano focuses on a handful of provisions in the legislation that come closest to the substance of corporate governance as opposed to securities disclosure. Her most potent claim is that with respect to director independence and nonaudit services, a large amount of empirical work had been done by financial economists testing whether there were grounds to believe that a change in regulation would produce better outcomes (e.g., superior returns for investors), and that the weight of the research was that it would not. This leads her to conclude that SOX was careless legislation, paying no heed to available data about whether the changes were likely to produce better outcomes in corporate behavior or to the question of what costs the...