This Isn't the Time for Sarbox II

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Much, if not all, U.S. securities regulation can be traced to an economic recession, a market crisis or the Great Depression. The basic regulatory structure of the securities markets was created in 1933 and 1934 following the market crash in 1929. The Securities Investor Protection Corporation (SIPC) was created in 1970 following the “back office crisis” of the late 1960s and the Sarbanes-Oxley Act of 2002 was passed following the collapse of Enron, WorldCom and others in 2001 and 2002.

Much of this regulation has provided useful protection to investors and the capital markets, but many regulations quickly passed following market crises have later been determined to be detrimental to the capital markets and the companies operating in those markets.

The Sarbanes-Oxley Act is a recent example of reactionary regulation. In July of 2002, the Act was passed in the Senate with a 99-0 vote and in the House with 423-3 vote during the same month as the WorldCom collapse.

Since its passage in 2002, for many, Sarbanes-Oxley has become the poster-child of unnecessary regulation, inept Congressional interference in the capital markets and a failure by the Securities and Exchange Commission to promote efficient markets. The principle criticism of the Act relates to the unnecessary and negative impact many presume it to have upon the competitiveness of the U.S. capital markets and the resulting impact of companies preferring to raise capital overseas.

The mere reference to, or mention of, Sarbanes-Oxley often evokes an instant negative reaction by finance and business people. Since its passage, Sarbanes-Oxley has now become the focal point around which many deregulatory arguments are made and many of these arguments had gained support, until the onset of the current liquidity crisis.

The deregulatory tide of the past few years has now turned and the credit crisis has given substantial strength to a pro-regulatory movement. Fed Chairman Bernanke, Treasury Secretary Paulson and SEC Chairman Cox – previously regular supporters of deregulation – seem to have each conceded that there have been failures in one way or another of the regulatory structure. Given the current crises, any other position would seem absurd. Nevertheless, Congress and the new administration must be reserved when they begin to consider new regulations in 2009.

In 2002, a lack of confidence in market information and transparency was at the heart of the crisis. As a result, regulatory action to re-establish market confidence was the order of the day.

The crisis of this day is one of liquidity. Actions such as TARP and other governmental bailouts are the manner in which the liquidity crisis is being addressed in the short-term. Many are currently criticizing TARP and the other government bailouts, and there will be many instances where hindsight will reveal mistakes associated with these bailouts.

Hindsight has also revealed mistakes in the passage of the Sarbanes-Oxley Act.

A defense in 2002 of quickly enacting Sarbanes-Oxley without thorough review and consideration of the unintended consequences, sounds a lot like the tone of the current defense of TARP and other bailouts. The argument generally goes, “better to do something in a time of crisis to restore confidence and get it partially right, than to do nothing at all.”

When Congress returns to consider new regulations, they need to remember that regulation is not the short-term fix to the current problems and speed is not the principal concern. Forcing unnecessary regulations will only further stifle a market recovery. Regulations impose a real and immediate increase in the cost of doing business, further feeding recessionary forces in much the same way that a tax increase could stifle economic recovery.

Congress and the regulators now need to thoughtfully and carefully consider any changes to be made and be cautious not to enact regulatory reform simply because reforms are popular following a crisis. There were clearly some regulatory and legislative failures leading to the current problems, but these problems are not in every corner and they do not need to be addressed by excess regulation.

Much criticism has been aimed at the SEC and Chairman Cox for the SEC’s failure to be at the forefront of actions taken in response to the current crisis. This criticism highlights a misunderstanding of the SEC’s powers and the cost of new regulation during a time of economic crisis. In a liquidity crisis, money is the way to address the short-term issues.

Unlike the Treasury Department and the Federal Reserve, the SEC has no money to spend to address the liquidity issues. Enacting or pursuing reactionary regulation simply in the name of doing “something” would inevitably lead to detrimental and unintended consequences and may assist in prolonging the recession. The SEC’s restraint should be applauded instead of criticized.

In the frenzied political and regulatory environment in which we currently live, it is easy to get caught up taking action without deep analytic review and there is substantial pressure from constituents to take action …. any action, simply to avoid criticism for doing nothing. When it comes to enacting new regulations, a decision to take action simply for the sake of doing something is, in this case, worse than doing nothing.

Eric R. Smith is an attorney with Venable LLP in Baltimore, Maryland. His practice focuses on securities law disclosure obligations, mergers and acquisitions and corporate finance.
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