Sarbanes-Oxley Act--New Approach to Fraud Deterrence?

One of the highest profile white-collar fraud cases stumbled towards its conclusion yesterday when Enron founder, Kenneth Lay, and former Chief Executive, Jeffrey Skilling, were convicted of conspiracy, securities, and wire fraud. The verdict came in the sixth day of deliberations following a criminal trial that lasted nearly four months.

These guilty findings continue a string of government convictions in high-profile corporate scandals of recent years, including Rite-Aid (Martin Grass, CEO), WorldCom (Bernard Ebbers, Founder & CEO), ImClone (Sam Waksal, Founder & CEO)), Adelphia (founding Rigas family), and Tyco (Chief Executive, Dennis Kozlowski, & CFO, Mark Swartz).

In light of the Enron news, we thought it might be timely to revisit a question recently directed to the 10Q Detective by a loyal reader: "Has the SEC ever enforced Section 304 of the Sarbanes-Oxley Act of 2002?"

Beginning with Enron in the fall of 2001, a wave of management scandals scandals crashed on the U.S. economic shores. Responding to public outcry at this seemingly unending stream of corporate malfeasance, President Bush signed the Sarbanes-Oxley legislation into law on July 30, 2002.

At its core, the historic Sarbanes-Oxley legislation is about restoring investor confidence in the U.S. capital markets by promoting corporate transparency (by ensuring full, timely, and accurate disclosures of financial statements).

Section 304 - This section requires management to return bonuses or profits from stock sales received within 12 months of a restatement resulting from material non-compliance with financial reporting requirements as a result of misconduct. Albeit the 10Q Detective does not have a jurisprudential background, we believe that this provision should best be examined in parallel with an empowerment proviso, Section 305, which sets standards for imposing officer and director bars and penalties.

Looking at the SEC’s Division of Enforcement record for 2002 – present, the 10Q Detective could find only one case where Section 304 (Forfeiture of Certain Bonuses and Profit) has been used/enforced:

"This section has been used in the case of Wesley Colwell, an Enron employee who has agreed to be barred from acting as an officer or director of a public company, and who will pay $300,000 in disgorgement (a well-established, equitable remedy designed to deprive defendants of ill-gotten gains) and prejudgment interest and a civil penalty of $200,000." [ed. note. Why only him? How about Andrew Fastow?]

Since 1984, the SEC has used its leverage to slap civil and criminal fines on fraudsters—and recent success’ with these enforcement tools has weakened the necessity to turn to its new enforcement tools waiting in Sarbane-Oxley.

A look at some high-profile corporate scandals of recent years and the status of legal action in each case:

1. QWEST COMMUNICATIONS INTERNATIONAL INC. (Q-$6.82): While former Qwest CEO Joseph Nacchio awaits trial on 42 federal charges of insider trading accusing him of illegally selling $101 million in stock…. erstwhile Qwest executive Marc B. Weisberg was fined $250,000 and sentenced to 60 days of home detention after pleading guilty to wire fraud. The Company agreed last year to pay $250 million to settle SEC charges of fraud in a deal that did not include individuals.
2. ADELPHIA COMMUNICATIONS CORP. The founding Rigas family settled with the SEC and the Justice Department and agreed to forfeit over 95% of its collective value, estimated at $1.5 billion. Adelphia Common Stock investors lost approximately $3.9 billion (from the stock’s high in 1999).
3. WORLDCOM INC. In June 2005, founder & former chief, Bernard Ebbers, agreed to pay $5 million and transfer nearly all his assets [worth approximately $40 million] into a liquidation trust to settle civil charges related to the company's accounting fraud. Ebbers was convicted of fraud and conspiracy in the $11 billion accounting-fraud collapse of WorldCom in 2002. He was given a twenty-five year sentence, but walks free, pending his appeal. [ed. note. Should he lose his appeal, Ebbers is facing a "life-sentence," for given his age (63), he would probably die in prison]
4. GEMSTAR-TV GUIDE (GMST-$3.58). On May 8, 2006, a federal judge on Monday ordered the former CEO, Henry Yuen, to pay $22.3 million in fines and penalties in an investment fraud case. In March, Yuen was found liable for securities fraud in an SEC lawsuit that claimed he inflated the company's revenue by $248 million to boost its stock and for misrepresenting facts to Gemstar's auditors and falsifying its books. Nonetheless, the judgment against Henry Yuen was less than the $31.4 million sought by the Securities and Exchange Commission.
5. TYCO INTERNATIONAL LTD. (TYC-$27.22). Although he has yet to reach a settlement with the Justice Department & the SEC, last week, the erstwhile Chief, Dennis Kozlowski, agreed to pay about $21.2 million to settle New York state tax liabilities. Dennis Kozlowski and former CFO, Mark Swartz, each received 8 1/3 to 25 years for their "expensive tastes."
6. CENDANT CORP. (CD-$16.41). Former Cendant Corp. Vice Chairman E. Kirk Shelton was convicted in federal court in January 2005 of conspiracy and securities, wire and mail fraud. He was sentenced last August to 10 years in prison and ordered to pay full restitution for his role in an accounting scandal that cost investors and the company more than $3 billion. Shelton was ordered to pay $3.27 billion to Cendant.

In theory, Sections 304/305 ought to strengthen the SEC’s ability to obtain meaningful remedies and expand its authority to return funds to harmed investors. For example, the court judgment against the aforementioned Yuen of Gemstar was significantly less than the monies sought by the SEC. If ‘double-jeopardy’ does not apply, could the SEC seek recompense via Sarbanes-Oxley?

Citing research from Glass Lewis & Co., a leading investment research and proxy advisory firm, The Wall Street Journal recently reported that the number of financial restatements by U.S. companies soared to 1,195 last year from 613 in 2004. This is evidence, according to some, that Sarbanes-Oxley has had its intended effect on improved financial disclosure and governance.

Transparency may be improving, but—at present—Section(s) 304/305 still lacks bite. And we are still looking to the SEC to find a "test case" on which to cut its teeth.

"Laws are often made by fools, and even more often by men who fail in equity because they hate equality: but always by men, vain authorities who can resolve nothing.”

--Michel de Montaigne (1533 1592), French Philosopher