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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Between 1999 and 2002, U.S. private pension funds lost US$1.2 trillion in value.

It turns out that $282.2 billion of the decline in private pension fund value over 1999 to 2002 was due to net withdrawals from these plans, but even so, the drop in market value amounted to $979.7 billion.

It would almost seem that pension fund managers had been speculating with retirement money, attempting to beat each others’ short-term performance statistics, with little interest in safeguarding the assets of plan beneficiaries.

But half of U.S. private pension funds were organized as ‘defined contribution’ plans, such as 401(k)s, in which the fundamental asset allocation decision was made not by fund managers, but by the plan beneficiaries themselves.

During the 1990s, millions of private ‘pension fund’ decisions were made not by pension fund managers but by unsophisticated workers who, believing the “Common Stock Legend“, blindly allocated their long-term assets to equity mutual funds.

In 2004, 44.4 million workers were insured by PBGC under ‘defined benefit’ private pension plans, which comes down to pension assets of about $40,000, on average, per worker — hardly enough to provide much of a ‘defined benefit’ in old age.

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Stock buybacks by U.S. Nonfarm Nonfinancial Corporations reached an annual level of $208.8 billion in Q3 2004, 76.6% higher than the frantic pace of buybacks at the peak of the Great Bubble in 2000.

The level of buybacks was 3.3 times corporate profits after taxes and dividends — an indication of how anxious corporate executives were to give value to stock options before FASB 123 accounting rules kick in later this year.

Profits before taxes in Q3 2004 were 20% higher than in 2000, but buybacks expanded by 77%.

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