Corporate Scandals and Sarbanes-Oxley

Corporate Scandals and Sarbanes-Oxley
Table 10.5 Corporate Scandals
Celebrity scandals often create “buzz” and actually make celebrities richer. But scandals in the business world
often lead to the forfeiture of millions of dollars as well as prison sentences. We illustrate some notable corporate
scandals below.
Ponzi schemes are named after Charles Ponzi,
who in the 1920s paid returns to investors using
money from new investors rather than firm
profits. Inevitably this kind of scheme falls
apart because it becomes impossible to attract
enough new investors to pay existing ones.
More than one wry cynic has noted the
similarity between Ponzi schemes and how the
Social Security system is funded.
Enron executives used accounting
loopholes to create shell companies to
hide billion in debt from failed deals
and projects. Although these smug
executives thought they were always
“the smartest guys in the room,” the
loss of $11 billion in stock value and
the prison time served by many of
them proves otherwise.
Corruption was a family affair at Adelphia
Communications Corporation, which was
named after the Greek word for brothers.
Adelphia was the fifth largest cable company in
the United States until father and son team John
and Timothy Rigas were found guilty on
securities violations tied to their theft of $100
million. Another Rigas son, Michael, pled
guilty to falsifying financial reports.
First off the ground in 1930, American Airlines
flew atop the headlines in 2009 when the Wall
Street Journal accused the airline of hiding
repeated maintenance lapses on over a dozen
MD-80 aircraft.
Although Chiquita Brands sells
healthy snacks, their corporate actions
upset many stomachs in 2007 when
they were fined $25 million by the
U.S. Justice Department for having
ties to a Columbia paramilitary group
on the department’s list of foreign
terrorists organizations.
The Madoff investment scandal that broke in
2008 provided a modern twist on the classic
Ponzi scheme. NASDAQ chairman Bernard
Madoff pled guilty to eleven federal crimes that
constituted the largest investor fraud ever
committed by an individual. Madoff was
sentenced to 150 years in prison.
In the 1990s and early 2000s, several corporate scandals were revealed in the United States that showed a lack of
board vigilance. Perhaps the most famous involves Enron, whose executive antics were documented in the film
The Smartest Guys in the Room. Enron used accounting loopholes to hide billions of dollars in failed deals. When
their scandal was discovered, top management cashed out millions in stock options while preventing lower-level
employees from selling their stock. The collective acts of Enron led many employees to lose all their retirement
holdings, and many Enron execs were sentenced to prison.
In response to notable corporate scandals at Enron, WorldCom, Tyco, and other firms, Congress passed sweeping
new legislation with the hopes of restoring investor confidence while preventing future scandals (Table 10.5
“Corporate Scandals”). Signed into law by President George W. Bush in 2002, Sarbanes-Oxley contained eleven
aspects that represented some of the most far-reaching reforms since the presidency of Franklin Roosevelt. These
reforms create improved standards that affect all publicly traded firms in the United States. The key elements of
each aspect of the act are summarized as follows:
1. Because accounting firms were implicated in corporate scandal, an oversight board was created to
oversee auditing activities.
2. Standards now exist to ensure auditors are truly independent and not subject to conflicts of interest in
regard to the companies they represent.
3. Enron executives claimed that they had no idea what was going on in their company, but Sarbanes-Oxley
requires senior executives to take personal responsibility for the accuracy of financial statements.
4. Enhanced reporting is now required to create more transparency in regard to a firm’s financial condition.
5. Securities analysts must disclose potential conflicts of interest.
6. To prevent CEOs from claiming tax fraud is present at their firms, CEOs must personally sign the firm’s
tax return.
7. The Securities and Exchange Commission (SEC) now has expanded authority to censor or bar securities
analysts from acting as brokers, advisers, or dealers.
8. Reports from the comptroller general are required to monitor any consolidations among public
accounting firms, the role of credit agencies in securities market operations, securities violations, and
enforcement actions.
9. Criminal penalties now exist for altering or destroying financial records.
10. Significant criminal penalties now exist for white-collar crimes.
11. The SEC can freeze unusually large transactions if fraud is suspected.
The changes that encouraged the creation of Sarbanes-Oxley were so sweeping that comedian Jon Stewart
quipped, “Did Wall Street have any rules before this? Can you just shoot a guy for looking at you wrong?”
Despite the considerable merits of Sarbanes-Oxley, no legislation can provide a cure-all for corporate scandal
(Table 10.6 “Sarbanes-Oxley Act of 2002 (SOX)”). As evidence, the scandal by Bernard Madoff that broke in
2008 represented the largest investor fraud ever committed by an individual. But in contrast to some previous
scandals that resulted in relatively minor punishments for their perpetrators, Madoff was sentenced to 150 years
in prison.
Table 10.6 Sarbanes-Oxley Act of 2002 (SOX)
In the early 2000s, highly publicized fraud at Enron, WorldCom, Tyco, and other firms revealed significant issues
including conflicts of interest by auditors and securities analysts, boardroom failures, and inadequate funding
of the Securities and Exchange Commission. In response, Senator Paul Sarbanes and Representative Michael
Oxley sponsored legislation that contained what former President George. W. Bush called “the most far-reaching
reforms of American business practices since the time of Franklin D. Roosevelt.” We outline the eleven key aspects
of the law below.
Accounting firms were complicit in some fraudulent events. In
response, SOX created a board to oversee auditing activities
within these firms.
To restore investor confidence in securities analysts, SOX expands the
SEC’s authority to censure or bar them from acting as a broker, advisor,
or dealer.
Concerns about conflicts of interests arising from accounting
firms acting as consultants and auditors for the same firm led
SOX to establish standards to ensure that auditors would be
truly independent.
The comptroller general and the SEC are now required to carefully
monitor any consolidation among public accounting firms, the role of
credit agencies in securities market operations, securities violations, and
enforcement actions.
Senior executives must take individual responsibility for the
accuracy of their firms’ financial reports and they must forfeit
the benefits arising from any non-compliance.
To preserve potentially incriminating documents, SOX creates criminal
penalties for altering or destroying financial records.
To create more transparency, SOX enhances reporting
standards for off-balance-sheet transactions and requires timely
reporting of material changes in a firm’s financial condition.
In the past, white collar crimes often received a proverbial slap on the
wrist. SOX significantly increased the penalties associated with
white-collar crimes and conspiracies.
Securities analysts must disclose any conflicts of interest
involving a firm.
In response to past fraud and records tampering, the SEC can
temporarily freeze transactions deemed unusually large.
The CEO is required to sign his/her firm’s tax return. This may
prevent CEOs from claiming that they did not know tax fraud
was occurring within their firms.

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