SOX and Executives busting rocks : an Editorial

‘Sunlight Is the Best Disinfectant’

U.S. Supreme Court Justice Louis Brandeis

The Sarbanes-Oxley legislation (SOX) was signed by George Bush July 30, 2002 in response to an increasingly skeptical public's view of corporate governance. Enron's fall in 2001 was followed by wave after wave of exposed executive kleptocracy. The point of the law was to dramatically increase corporate financial internal monitoring, auditing and reporting to achieve better transparency for current and potential investors.

Since then a backlash from Main Street (the HQ for many large cap companies in NYC) gathered momentum, suggesting that the reporting requirements were too expensive (particularly for small companies), resource intensive and was driving away foreign investment and domestic IPO listing on American exchanges. There's little debate that SOX is expensive to comply with; however, more recent papers describe lower borrowing costs and relatively increased share prices over time with compliant companies who show no material weakness in their financial reports.

The hue and cry over the "draconian" regulation has subsided since the credit crisis has exposed the results of extremely poor stewardship in the financial sector-- particularly amongst the investment banks (Bear Stearns, Merrill-Lynch etc) who had opaque balance sheets stacked with complex derivatives. Few can argue that less regulation would have prevented this disaster although one can surmise that badly designed legislation could easily do more harm than good. I agree that more is not always better and I do believe in the general principle of free markets--- within reason.

Quarterly and annual financial reports are signed by the CEO and the CFO. If a material misrepresentation is eventually found in that report, these executives can and will go to prison for up to 20 years. Despite what SOX critics say, they actually do go to prison for ---- ask Dennis Kozlowski and Mark Swartz of Tyco infamy, Kirk Shelton of Cendant, and of course Lord Black of Hollinger International. These white collar thieves were caught and put in jail for sentences that exceed that given to serial rapists here in Canada.

Whether you agree with that or not, it cannot be argued that this is a VERY strong disincentive to commit fraud.

When is the last time you can remember a Canadian executive going to jail for approving or actively participating in such obvious fleecing of the common shareholders? Remember Bre-X? No one spent a single day in jail for that one. It should be interesting to see if anyone actually gets materially punished for the Livent debacle. There are many more examples.

The reason I worry about investing in specific companies based in emerging markets (particularly Russia and China) is that standards of corporate governance simply do not exist by the oligopolistic nature of their governments. Security laws are antiquated and rarely invoked-- that is, unless you are an enemy of the current Czar (read the story of Mr. Khodorkovsky).

Most humans behave in a largely predictable manner due to internal and external incentives and disincentives. It shouldn't be surprising that the Chinese and Russian populaces have embraced their recently unencumbered markets. Whether we recognize it or not, we are all wired to be capitalists. We can choose to be a socially responsible capitalist like Warren Buffett or a ruthless backstabbing superficial ass like Mr. Trump. Without sensible regulation, history suggests that more Trumps and Lord Blacks emerge.

I maintain that despite several ugly blemishes that are in plain view (unlike many other countries in the world where the dirty laundry never sees the light of day), the large cap, wide moat, multi-national businesses based in the United States and subject to SEC scrutiny and US law are the easiest to analyze from the available information to the average investor. Their internal workings are the most transparent and their executives and corporate boards are the most accountable. I would suggest that the best way to invest in India and China is to buy companies like Caterpillar (CAT), 3M (MMM), Kimberly-Clark (KMB) or Harley-Davidson (HOG).

l