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Late in 2001, Enron Corp. collapsed amid allegations of corporate misconduct and accounting fraud. Early the next summer, Adelphia Communications Corp. and then WorldCom Inc. each went bankrupt with similar allegations of criminal misconduct. The media was in a frenzy, with reports of executives getting rich while investors lost billions and retirement accounts evaporated. In an understandable effort to address investor angst and calm the markets, Congress rushed to enact the Sarbanes-Oxley Act. The broad-reaching legislation was drafted and passed in about a month — an incredibly short time, given the complexity of regulating markets and public companies. The result, as is often the case with legislation dealing with highly complex problems, was a strange brew of some obviously useful reforms, a bit of good-faith but misdirected over-regulation and a few absurd and probably unnecessary directives. It is not clear to me whether SOX helped relieve the worries of the investing public, but it is clear that it generated a tremendous amount of worry for corporate executives, accountants, lawyers and other deal professionals. To many, it seemed that the cure offered by SOX would be more deadly than the disease. Here we are, three years later. How has it turned out? It’s time for a report card on some unscientifically selected provisions of SOX, with grades determined at the author’s sole discretion. ACCOUNTING AND AUDIT COMMITTEE PROVISIONS: A- Establishment of the Public Company Accounting Oversight Board, clearer and more conservative rules on auditor independence, audit partner rotation, audit committee standards and better disclosure of off-balance-sheet matters all seem to be good things, protective of the investing public, and while not cost free, these provisions are not hugely burdensome. Note that this grade does not consider the relative merits of any pronouncements by the PCAOB. NEW, STIFFER CRIMINAL PENALTIES: D- SOX increased or imposed potential criminal penalties for all sorts of activities. For example, a corporate executive now may face jail time (up to five years) for what could be merely negligent actions, such as signing a certification of internal control compliance when the executive hasn’t made what a court later determines to be a sufficient inquiry of the existing controls. SOX added up to 10 years for mail or wire fraud and up to 25 years for securities fraud — significant increases in sentences and more jail time than for most violent crimes. Participants in the Enron, Adelphia and WorldCom collapses have been convicted under pre-SOX laws, and many will serve very long prison terms. Does adding a few years, for example, to Bernie Ebbers’ sentence, already nearly a life term given his age, really serve to deter anything? RESTRICTIONS ON LOANS: F Loans to officers of companies with publicly traded securities are now flatly prohibited. Why? The Rigases used Adelphia as their private bank — conduct that was a breach of fiduciary duty, corporate waste and downright fraud and that was successfully prosecuted under pre-SOX laws. Preventing a well-informed and independent board of directors from approving a modest relocation loan to a newly hired senior officer employs the same logic that would criminalize ownership of a cell phone because it can be used to coordinate criminal activities. In the hands of a criminal, anything can be used as a tool for crime. CERTIFICATION OF FINANCIALS AND INTERNAL CONTROLS: INCOMPLETE Perhaps the most burdensome of the new SOX provisions, the certification requirements set forth in �302 of SOX provide some benefit to the investing public by increasing confidence that financial information is correct, giving senior management a strong incentive to be sure it is so. Of course, if senior management wants to commit financial fraud, adding a few years of jail time for filing a false certification on top of potentially years of jail time for committing the underlying fraud is unlikely to be a deterrent. What the certification process does is provide an incentive to honest managers to be especially careful. In a sense, it criminalizes certain negligent corporate behavior. This is revolutionary. For example, Delaware law does not even impose civil liability on directors for mere negligence. However, the real question about SOX is: At what price? Direct SEC compliance costs (audit costs, etc.) have increased significantly. Management time is spent on SOX compliance rather than on making money for stockholders. As a result of this distraction and potential personal exposure, senior management and boards of directors are less likely to undertake strategic transactions or will do so in a much slower and more cautious manner. The result may be somewhat less deal activity, not a good thing for the economy as a whole, since assets will be less likely to move to where they can generate the most value. As corporate America gets used to the new rules and the risks of a post-SOX world and as best practices are developed regarding internal controls and the like, this negative effect on deal activity should decline (which seems to be the case right now). Will the total costs, both out-of-pocket and broader economic costs, exceed the benefits of somewhat more reliable financial information for the investing public? The jury is out. Eric Simonson is a partner in the corporate securities/mergers and acquisitions practice at Preston Gates & Ellis. Copyright �2005 TDD, LLC. All rights reserved.

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