The Sarbanes-Oxley Act of 2002, by discouraging companies to go public, will exacerbate the shortage of equities, with a negative effect on the U.S. stock market, although this was not the intent of its authors.

The formal intent of the Act was to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.”

This goal will not be achieved. In fact, the opposite may be the outcome.

Inspired by Enron

The December 2001 bankruptcy of the Enron Corporation was the legislative inspiration for Senators Sarbanes and Oxley who swallowed hook, line, and sinker the popular press story that the Enron bankruptcy would not have happened if it were not for devious accounting practices of its admittedly unscrupulous executives.

When Enron shares reached the all-time high of $90 in August 2000 (just as the Great Bubble of the 1990s was about to burst), its shares were selling at a speculative 61 times earnings with a dividend yield of only 0.5%. The financial statement of December 2000 showed a current ratio of a mere 1.06 with equity only 17.4% of total assets. The company was engaged principally in speculating in exotic energy contracts and derivatives. Its bonds never rose above the lowest investment grade.

In other words, a quick examination of the published statements would reveal the plain truth, even to an amateur analyst, that this was an extremely highly-leveraged speculative company, with no cash reserves or working capital, borderline credit, with little investment merit and with stock that was wildly over-priced, floating in the clouds of Wall Street ballyhoo.

Many things, from a terrorist bombing to a catastrophic hurricane, could have driven Enron into bankruptcy. The company existed on the extreme edge of an asset-lite financial fantasy world created by Jeffrey Skilling, the Harvard MBA and fair-haired boy from McKinsey and Company. Just as in the case of Long Term Capital Management, the nutty ideas of the Nobel Gods had fallen to earth.

The Sarbanes-Oxley Act would not have prevented the Enron bankruptcy and does absolutely nothing to protect investors against the far more common, harmful, and widely accepted corporate practice of diverting hundreds of billions of dollars of corporate cash reserves each year into company executive bank accounts through stock buyback-option schemes, instead of equitably paying dividends to shareholders.

See: Essays on Stock Buybacks and Options.

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The Financial Accounting Standards Board (FASB) is made up of seven members, six of whom are either ex-partners of major accounting firms or former high-ranking financial executives of their clients.

Unfortunately, there is no effective ombudsman or meaningful representation on the accounting standards board for tens of millions of small investors that entrust their life savings to the U.S. capital market.

However, this was not the intention of Congress when the Securities and Exchange Commission (SEC) was established in the 1930s.

The SEC has always had the power to directly set accounting standards and require their enforcement by public companies.

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