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APPLICATION. Evaluating Sarbanes-Oxley and the Global Legal Settlement

Using the analytic framework discussed earlier, we now can turn to evaluating the Sarbanes-Oxley Act and the Global Legal Settlement.

We have seen that policies that regulate conflicts of interest can help to increase the amount of information in financial markets. Sarbanes-Oxley does exactly this when it requires that the CEO and the CFO certify the periodic financial statements and disclosures of the firm. It increases the likelihood that these statements will provide reliable information. In addition, Sarbanes-Oxley requires disclosure of off-balance-sheet transactions and other relationships with special-purpose entities. Again, this step can help increase information in the marketplace because these off-balance-sheet transactions were often used, as in the Enron case, to hide what was going on inside the firm. However, the costs of complying with the new regulations imposed by Sarbanes-Oxley are not cheap. Small firms are hit particularly hard: The estimated costs of complying with Sarbanes-Oxley exceed $800,000 for smaller firms with revenues of less than $100 million, which amounts to nearly 1.5% of their sales. Sarbanes-Oxley might severely hurt such companies' profitability and make it harder for them to make productive investments.

We have also seen that the market is often able to constrain conflicts of interest when it has sufficient information to do so. The Global Legal Settlement includes a provision that requires investment banking firms to make their analyst recommendations public. This policy will help the market to assess whether the analysts are acting in good faith. The SEC also requires increased disclosure by investment analysts, credit-rating agencies, and auditors, forcing them to reveal any interests they have in the firms they analyze. Provision of this information makes it more likely that financial institutions will develop internal rules to ensure that conflicts of interest are minimized, so that their reputations remain high and the firms profitable.

Of course, disclosure may not be enough to get markets to control conflicts of interest, because firms still have incentives to hide information so that they can profitably exploit conflicts of interest. Disclosure may also reveal so much proprietary information that the financial institution is unable to profitably engage in the information production business. In addition, some of the most damaging conflicts of interest have resulted from poorly designed internal compensation mechanisms, which are difficult for markets to observe. Supervisory oversight can focus on exactly these issues.

Increased supervisory oversight is a key feature of the Sarbanes-Oxley Act. First, the act establishes the PCAOB to supervise accounting firms. The PCAOB monitors compensation mechanisms to verify that they are in accord with best practices to control conflicts of interest. Second, Sarbanes-Oxley provides substantially more resources for the SEC. A supervisory agency cannot do its job properly without adequate resources. Indeed, one reason why the SEC may have failed to provide adequate supervisory oversight during the boom of the 1990s is because it was starved for resources. A similar problem occurred for the supervisors of the savings and loan industry, and it helped lead to scandals and a bailout that cost taxpayers more than $100 billion.

By keeping the audit committee independent of management, Sarbanes-Oxley eliminates the conflict of interest that occurs when the management of a firm hires its auditor. The PCAOB will be instrumental in writing the regulations to ensure that auditors will report to, be hired by, and be compensated by an independent audit committee that is supposed to represent shareholders other than management.

The Global Legal Settlement also directly eliminates one Wall Street practice that led to obvious conflicts of interest—spinning, in which executives received hot IPO shares in return for their companies' future business with the investment bank underwriting the new issue. The Global Legal Settlement punished investment banks that exploited conflicts of interest by imposing a fine of more than $1.4 billion. This tough punishment, along with the harsher criminal penalties established by Sarbanes-Oxley, provides incentives for investment banking firms to avoid taking advantage of conflicts of interest in the future.

The more radical parts of Sarbanes-Oxley and the Global Legal Settlement involve separation of functions and socialization of information. Sarbanes-Oxley makes it illegal for accounting firms to provide nonaudit consulting services to their audit customers. This law will potentially reduce the economies of scope available to auditing firms that also offer consulting services. It is unlikely that the proscription of nonaudit-ing services in this situation, as envisioned by Sarbanes-Oxley, would have prevented the recent audit failures. However, greater transparency about the nature and role of nonaudit services would be a valuable aid to control a firm's temptation to exploit this conflict of interest. Similarly, the Global Legal Settlement requires investment banking firms to sever the link between research and investment banking. This divestiture also has the potential to eliminate economies of scope in information production. After all, analysts may be able to obtain much more information on firms they cover when the investment banking arm of the firm can share information with them.

The Global Legal Settlement requires that for a five-year period, brokerage firms contract with independent research firms to provide information to their customers. In addition, part of the $1.4 billion fine paid by the investment banks will be used to fund independent research and investor education. While it remains to be seen how the terms of this agreement will be implemented, there are both potentially positive and potentially negative features. Independent research may produce unbiased information.

However, by socializing research, firms can no longer compete for customers on the basis of the quality of their research. Because they are being taxed to fund independent research, firms may decrease their investment in their own research analysis. Indeed, this is exactly what has already happened, with research budgets at the seven largest securities firms being cut almost in half since 2000. If the investment banks do not control the information that they are being forced to acquire, the analysis produced may be of a lower quality.

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