How Capitalism Will Save Us (40 page)

The SEC, meanwhile, compounded this error by inexplicably failing to fully enforce another rule—the ban on so-called naked short selling.
Short sellers are supposed to possess shares by borrowing them for a fee before selling them. Naked short sellers, in contrast, sell the stock without possessing the shares. This makes it far easier for the shorts to hammer a stock into the ground. As of this writing, the uptick rule still hasn’t been restored and naked short selling still exists. Why? In no small part because the SEC has an institutional bias in favor of short sellers.

Another regulatory villain was the U.S. Congress, which blocked reforms of Fannie Mae and Freddie Mac, the two government-created mortgage giants that helped fuel the market for subprime mortgages. Washington cronyism allowed these companies to become monsters—and it was also responsible for the regulators’ appallingly lax oversight.

Fannie and Freddie were not held to the same SEC standards as other publicly held companies. Moreover, Congress made sure that they didn’t have as strict capital guidelines as banks did. For example, banks are supposed to have one dollar of capital for every ten dollars of liability. Fannie and Freddie were allowed to carry a far greater debt burden—forty dollars or more of debt for each dollar of capital. Thus, they were able to buy insane numbers of mortgage loans. No one cared. Everyone assumed that if Fannie and Freddie faltered, Uncle Sam would come to the rescue.

Finally, we’ve mentioned the role of another regulatory bad guy, “fair-value” or mark-to-market accounting. Mark-to-market required companies to mark down the value of assets to what they would immediately fetch in an open market. These rules were established by the Financial Accounting Standards Board (FASB). They were a result of the politically charged aftermath of the Enron scandal.

Thanks to mark-to-market and the suspension of the uptick rule, short sellers proceeded to shatter financial stocks. The stage was set for the cataclysmic market meltdown and the events that followed.

Regulatory failure also played a key role in the rise of Bernie Madoff. He got away with his momentous fraud for decades not because of “too little regulation” but because of the astonishing failure of the Securities and Exchange Commission’s giant regulatory bureaucracy.

Madoff’s firm was an investment adviser and broker-dealer registered with the SEC. He employed three hundred people in a sleek New York City office tower. Madoff clients were some of the leading financial institutions around the world, such as HSBC, as well as some of the
world’s wealthiest individuals. Celebrities like Kevin Bacon were also clients. A former chairman of the NASDAQ stock exchange, Madoff was a social figure who sat on charitable boards. In other words, he could not have been more visible. Despite thousands of regulations and an expanding bureaucracy, the SEC could not detect his wrongdoing—even after multiple investigations and warnings from tipsters. Shortly after Madoff’s crime came to light, a
Wall Street Journal
article disclosed that a competitor had actually written to the agency that “Madoff Securities is the world’s largest Ponzi scheme” a full ten years earlier.

The SEC had plenty of rules and overseers to prevent a fraud like that of Bernie Madoff. Those who think that new layers of regulation will protect people from economic disasters like those of 2008 should think again. The real question is why so many regulations already in force so frequently fail.

S
arbanes-Oxley, or the Public Company Accounting Reform and Investor Protection Act of 2002, typifies the problems that can take place when politicians are pressed to “do something” in response to a crisis. Passed in 2002 in the wake of accounting and corporate-governance scandals that brought down Enron and other corporations, SOX was supposed to bring about better corporate accounting standards. But instead of improving corporate governance, the SOX legislation—as is typical of laws and regulations enacted in an emotional atmosphere—produced a host of economically destructive, unintended consequences.

Fraud, of course, is illegal. Executives from Enron and other corporations were indicted and convicted under existing statutes. Many experts thus believe SOX wasn’t needed. “The SEC already had the authority to do everything the law demands about accounting or corporate boards,” wrote Alan Reynolds of the Cato Institute in 2005.
⁶
SOX also has not prevented further scandalous corporate failures. One example: the sensational bankruptcy of the large commodities broker Refco, caused by the accounting criminality of its CEO. Banker and financial relations adviser Mallory Factor observed in
The Wall Street Journal
in 2006:

But haven’t investors been helped by the elaborate, expensive bookkeeping tests and controls required by SOX? Reynolds of Cato says those rules weren’t needed either:

Another problem with the law was that it requires, in Reynolds’s words, “that the audit committee of every corporate board be comprised entirely of independent directors with no company experience plus one financial expert who claims to grasp all 4,500 pages”
⁹
of GAAP. Yet as he points out, board independence was never an issue in the Enron scandal. The Enron board, he reminds us, “was 86 percent independent.”
¹⁰

T. J. Rodgers, founder, president, CEO, and a director of Cypress Semiconductor Corporation, complains that the FASB rules were created by a small group of ivory-tower “experts” with limited understanding of the Real World issues of corporate accounting:

According to Rodgers, GAAP’s complicated accounting standards have only made it
more
difficult for even top executives to understand a company’s financials.

But the worst part of SOX has been its impact on the U.S. financial sector, driving up accounting and compliance costs—both in regulatory fees and man-hours. Audit costs for U.S. corporations have risen 30 percent or more as a result of more stringent accounting and audit standards. In the Board’s first year of operation alone, the act’s regulations resulted in more than $35 billion in compliance costs imposed on the nation’s businesses.

The costs of being a U.S. public company are now more than triple what they were before the law passed, according to a study conducted by the Milwaukee-based law firm Foley & Lardner.

Fees required by the Public Company Accounting Oversight Board can run as high as $2 million annually for large firms. According to the accounting firm Deloitte, large companies have on average spent nearly seventy thousand additional man-hours complying with the new law.

But SOX has been hardest on smaller firms unable to shoulder the financial and manpower burden. According to one study, companies with annual sales below $250 million incurred a staggering $1.56 million, on average, in SOX compliance costs. Some smaller firms report that they are spending 300 percent more on SOX compliance than on health care for their employees. A survey by the American Electronics Association
found that companies with sales of $100 million or less are spending 2.6 percent of their revenues on SOX compliance.

The gargantuan burden of SOX has driven public companies from U.S. stock exchanges and discouraged privately held companies, especially small ones, from going public. A 2006 study by the Committee on Capital Markets Regulation found that only 8 percent of new stock offerings are now executed on U.S. exchanges, compared with 48 percent in the 1990s. According to the report, SOX’s compliance fees “are absolutely killing the U.S. in terms of maintaining listings dominance.”
¹³

A joint study by the Brookings Institution and the American Enterprise Institute found that the direct and indirect costs of SOX total a staggering $1 trillion dollars.

Fears of criminal prosecution for governance and accounting transgressions have made corporations more risk averse. The result: fewer innovations and less growth. In 2006, a University of Rochester study concluded that the total effect of the law was to reduce the stock value of American companies by $1.4 trillion.