Ask the expert: Harvey Pitt on Sarbanes-Oxley

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“In the wake of the corporate scandals of 2001, any belief that US companies were inherently better run or better regulated dissolved.”

So wrote Harvey Pitt, chairman of the Securities and Exchange Commission from 2001 to 2003, in the Financial Times on June 21.

Is he correct? Mr Pitt answers your questions below.

To make sure compliance is not onerous, to what extent do you think auditors should exercise judgement in interpreting applicability of all the Sarbanes-Oxley (Sox) Act requirements (especially 404 section) to a company? What I am trying to get at is, what is applicable to the likes of a company like General Electric, should not be applied to smaller company.
Anil Kapur, California

Harvey Pitt: Ideally, it would be preferable if we could leave determinations like these to the professional judgment of the audit profession. Unfortunately, in the US, the threat of liability overhangs all professional judgments, and that often interferes with reaching the right result. The SEC and the PCAOB have recognised this and have promised to issue guidance on this issue, which is a very constructive first step in the right direction. The bottom-line conclusion you articulate - that what is applicable to companies like GE shouldn’t be applicable to smaller companies - is absolutely correct.

You have rightly highlighted that many companies (both US and non-US domiciled) seeking to access capital/debt have, post-Sox, turned to exchanges outside the US, thus avoiding Sox over regulation. Is though not a bigger problem for the US, and business wishing to access US capital markets, the urgent need for tort reform and the class action system, referred to by noted Columbia Business School Dean Glenn Hubbard as America’s litigation tax?

Further, UK directors now too have to worry about the provisions of the UK/US Extradition treaty introduced post 9/11 to speed up the extradition of terrorists but used by the US Department of Justice against alleged white collar criminals? Perhaps the sequel to the seminal volume ‘Why do people hate America?” should be “Why should Brits avoid doing business with the US?”.
Douglas McBean, Edinburgh

Harvey Pitt: I couldn’t agree more that tort reform is essential in the US. Worse, there are indications that we are exporting this dubious characteristic as well. Private litigation can serve very beneficial and therapeutic purposes in assuring that capital markets are honest and fair. Unfortunately, the US system has long since passed that benchmark to the point where liability concerns threaten the correct functioning of our capital and other markets.

Can you please explain the insight behind your statement that “the one prosecution based on Sox - involving Richard Scrushy of HealthSouth - failed. As an Italian researcher on corporate governance, I am familiar with corporate scandals like Parmalat. I agree with your criticism of the one-size-fits-all approach of Sox, but I believe that strict punishment is important as a deterrent in corporate crime.

Furthermore, conflicts of interest in a market with high information asymmetries are the real problem and they should not only been disclosed but discouraged by the regulators. I know it’s a difficult task but it’s nonsense to produce a lot of legislation when we know where the sensitive matters are. Can you give me your comments on that?
Daniela, Italy

Harvey Pitt: Strict enforcement of essential rules governing our capital markets is very definitely an important facet in deterring corporate crime. That’s why we initiated the “Real Time Enforcement” program when I chaired the SEC, and ratcheted up the sanctions imposed upon officers and directors who were found derelict in their duties. The Scrushy prosecution failed because of a clever defensive strategy. My purpose in citing it was to make clear that the laws we had on the books prior to Enron were certainly up to the task of providing a basis for punishing wrongdoers. It is ironic that the one prosecution attempted since Sox was passed failed, demonstrating only that throwing another rule or statute at a problem isn’t always the right solution.

As for your observations about conflicts of interest, there is no question that these play an important role in some of the conduct we’ve witnessed. In the US, our general approach has been to require disclosure of conflicts, rather than prohibiting the conflict outright. That has changed in recent years, but I personally don’t favour absolute legislative prohibition of conflicts unless there is no other viable solution to the issue.

Although the SEC is saying that it will not attempt to influence local regulations in regard to the proposed NYSE-Euronext merger, are there any guarantees that this stance will not change in the future?
Rachel Gibbs, London

Harvey Pitt: I believe the SEC means what it says in this regard. There are no guarantees, however. A change in Congress or a change in SEC leadership could bring people with different philosophies. I am doubtful that won’t happen, but I offer no guarantees on that score!

Enough has been said about the negative effects that Sox has had on IPOs and how they have shifted away from US. The benefit to balance this negative effect will be the effect of more stringent regulation on the cost of equity and how it has made it cheaper. What other effects is Sox having on organisations? How is it affecting internal control measures and how might these have improved companies’ performance?
David Mora, Madrid

Harvey Pitt: I believe that Sox has had some very positive effects on corporations. Polls of corporate officers and directors, as well as empirical data, support the notion that companies that pay attention to their transparency and governance, and that assess and improve their internal controls, outperform their core peer group of competitors.

Are there any estimates of how much income for the large law/accountancy practices has been generated by the Sox? What was their role, direct or indirect, in drafting Sox? When such an awful piece of legislation comes around, one must ask: cui bono?
David Potts, Potts Consultancy

Harvey Pitt: There have been indications of the expenses generated by Sox, and much of these have gone to lawyers, accountants and consultants. Sox was drafted largely by lawyers and accountants, outraged by the after-effects of the excesses of the 90s. Congress requires regulatory agencies to perform an economic assessment of the anticipated effects of their proposed regulations, but statutes are adopted in Congress without giving much attention to the economic consequences of bad drafting.

If the Sox is not the answer, then what is?
Charlie, US

Harvey Pitt: Some of Sarbanes-Oxley is the answer. As I noted in my Op-Ed piece, there are some useful approaches in Sox, including the creation of the PCAOB, the requirement that companies review and assess the efficacy of their internal controls and the requirement that options grants be reported within two business days. The “answer” of course is not for the US to impose its regulatory regime on other countries, but for all countries to attempt to work together to develop best-in-class global standards.

Could you envisage a dual-listing structure that would allow a US controlled exchange full autonomy at operational level?
Michelle Edkins

Harvey Pitt: I can envisage such a structure, and I think that will be the way a merged exchange system will operate, at least initially. There will have to be agreements between regulators as to which rules and laws will govern which entities and what questions, but I think the SEC in the US, and the EU are already embarked on that kind of effort.

In your article, you indicated that a simple solution for transatlantic mergers is to modify Sox to allow the SEC to give comity to comparable regulatory systems without requiring them to replicate every facet of Sox.

How would this allow full operational freedom for European exchanges? How do you reconcile a criminal sanction, court-driven enforcement system with the more pragmatic European-based one?
Paola Perotti, London

Harvey Pitt: The goal should be for world regulators to come up with best-in-class regulatory standards. It is important that we achieve regulatory convergence, and that means that all regulators have to be willing to listen to one another, and learn from the creative approaches every regulatory system devises.

If companies listed on foreign exchanges didn’t have to meet every standard of Sox, on the assumption that they were meeting comparable standards, tailored to the incorporating state’s particular requirements, that would allow European exchanges to maintain their separate identity, and yet consolidate trading platforms. US investors would be told what rules apply and how, and the effort that would be undertaken is to be certain that comparability on important issues exists.

Your last question makes an excellent point. You can have the exact same rules, but if the bodies enforcing those rules adopt different interpretations, it’s the equivalent of having differing standards. There needs to be convergence not just on the standards and rules that are articulated, but also on the interpretations and enforcement of those standards.

Is it possible to reconcile the shareowner focused European regulatory regime versus the market focused US regulatory regime? If not, does this make the goal of a US controlled global exchange an impossibility?
Peter Butler, CEO and Founder Partner, Governance for Owners LLP, London

Harvey Pitt: I think it’s definitely possible to reconcile different regulatory approaches. The real issue is how willing are the principals to reach an accommodation. If they are, it should be something that can be achieved. The suggestion that the US regulatory regime is market-focused, rather than shareowner-focused, may be too extreme, however. The US regulatory regime is definitely investor-focused as well as market-focused. The concern is whether regulators can abide by having different systems function side-by-side, and work to achieve convergence of regulatory standards. I definitely think that’s possible.

If you crossed the hands-off, principles-based UK Financial Services Authority with the rules-led SEC, would you get the perfect financial regulator?
Ben Bland, London

Harvey Pitt: I’m reminded of the old joke - what happens when you cross a lion with a parrot - the response, of course is “I don’t know, but when it talks, you listen”! I subscribe to the notion that the “perfect” is the enemy of the “good.” I’m not prepared to say that either the SEC or the UK isn’t perfect, but the fact is that a principles-based approach has many attractions, and the prescriptive-rules-based approach of the US system leaves much to be desired.

It leads to a check-the-box mentality, and it encourages people to pay attention to the words of regulatory enactments, rather than their music. I do believe that taking the best of both systems and moving toward convergence of regulatory approaches is something that is in the best interests of the regulators, as well as the regulatees.

Another way of putting this question’s premise is the notion that global regulators can achieve convergence of their regulatory approaches. Convergence means that regulators try to adapt their own systems to provide many of the same types of protections and requirements as their counterparts do. There isn’t any need for the FSA to replicate the SEC’s approach, or vice-versa, but there is much that both systems can benefit from if they move toward greater convergence of standards with their counterparts.

Why does the SEC not consider a passport type system for securities co-regulation, similar to that proposed for most Canadian provinces as a response to particular Canadian regulatory issues?
Roy Wares, Vancouver, Canada

Harvey Pitt: I believe that the SEC is exploring convergence issues with its global counterparts. A passport system - that is one that allows investors to apply for approval in one province instead of thirteen - makes sense in Canada, and is a concept that can be considered globally. It already is being considered and implemented. For example, the SEC has announced that foreign companies listed in the US markets will not be required to reconcile their IFRS-based financial statements with US GAAP. That is a step in the right direction, although the concept seems years ahead of the implementation.

How exactly do you think that Sox is going to stifle innovation, risk-taking and competitiveness? How much more stifling is it than, say, the introduction of International Financial Reporting Standards in the EU?
Thomas Balzer, Harare, Zimbabwe

Harvey Pitt: The premise of this question is that regulations always have some stifling characteristics, and that’s of course true. The objective, however, is to come up with regulations that make sure a variety of interests are protected, but at the same time, permit innovation, risk-taking and competitiveness. The problem with prescriptive rules, which is the US model, is that they create narrow bands of reference for those who are regulated, and they encourage a check-the-box mentality. IFRS, in contrast, is principles-based. It doesn’t assume there’s only one correct way to do things, it simply alerts those who are regulated to the purpose behind the requirements. Presumably, if people understand why there are rules, they can do a much better job of conforming to them. We’ve already seen the dangers that inhere in a prescriptive rules system, with the accounting frauds at Enron, WorldCom, Tyco and their progeny.

As with the Glass-Stiegel Act, what might you suppose will be the longevity of the Sox?
Jeff Fisher, US

Harvey Pitt: Glass-Steagall remained the law in the US for over six decades. It’s instructive, however, because in Europe some countries had laws that were the direct antithesis of Glass-Steagall. For example, in Germany, in order to be a broker-dealer in securities, you first had to be a commercial bank. This is why the notion of American geocentrism is so misguided. I believe that Sox needs to be refined. It does provide some useful disciplines, but it definitely requires work. That will be a long time in coming, unfortunately. As for Sox’s longevity, I think it will be here for a very long time. There is no current sentiment in the US to see it repealed.

Should not the SEC only allow auditors to be described as independent if they are appointed and controlled by shareholders who do not also control management? In some European countries the auditor is appointed and controlled by a shareholder committee - an approach I adopted in Australia to raise funds for a start-up company.
Shann Turnbull, Sydney, Australia

Harvey Pitt: I think the European approach you describe is one possible way to handle the issue, but in the US, especially after Sox, we require an independent Audit Committee to pick the auditors. This comports very nicely with the US system of corporate governance, where the outside directors are supposed to provide oversight (but not day-to-day management) of corporations on whose boards they serve. I think it would be unwieldy in the US if we tried to have shareholders or shareholder committees select auditors. The approach for a start-up company makes good sense, especially if the company is dependent upon non-management shareholders for its initial capital.

What is the impact of Sox on external auditor confidence and how much has it reduced the external audit role in verifying the financial statements of companies in USA and worldwide?
Faton Ahmetaj, Kosovo

Harvey Pitt: I think the problem with external auditor confidence is not so much Sox as it is the massive litigation liability system that operates in the US. Unless and until the US is able to cabin the explosive growth of liability imposed on outside auditors, they will always be functioning defensively. This ultimately doesn’t produce much benefit for investors. This is a significant issue that the SEC and the PCAOB (created by Sox) are working very hard to resolve sensibly.


Corporate scandals were not solely a US problem - think Parmalat. But, Mr Pitt argues, the remedy adopted - the Sarbanes-Oxley Act - was not the answer. As he points out, “every successful criminal prosecution of corporate officers to date has been based on pre-Sox laws and rules. The one prosecution based on Sox – involving Richard Scrushy of HealthSouth – failed.”

But as Mr Pitt sees it, Sox has thrown up other, much more serious problems, such as:

• Its “one-size-fits-all” approach to regulation stifles innovation, creativity, risk-taking and competitiveness.

• The exportation of Sox’s standards has created huge difficulties for multinational companies and produced scorn for US standards.

• Foreign listings and IPOs have defected from the US to other locations.

These issues have been thrown into sharp relief by US exchanges’ efforts to acquire foreign counterparts. The New York Stock Exchange has entered into a definitive merger agreement with Euronext, the pan-European exchange operator, and Nasdaq has acquired a 25 per cent stake in the London Stock Exchange.

These initiatives have sparked speculation that market consolidation would in effect export US regulatory standards across national boundaries. By virtue of cross-border market consolidations, Sox will become the de facto world standard of corporate regulation unless Congress acts.

“A simple solution,” writes Mr Pitt, “is to modify Sox to allow the SEC to give comity to comparable regulatory systems without requiring them to replicate every facet of Sox. This would give all regulators the ability to move towards a world best-in-class model without being anchored to, or by, geography.”

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