A (Relatively) Situationist Account of Sarbanes-Oxley

Since its passage a half decade ago, the Sarbanes-Oxley Act has been the target of growing criticism. Many in the business community view it as a costly, unnecessary regulatory overreaction to a largely self-correcting problem. But some of the more thoughtful scholarship on the topic has been more positive (or at least less negative) about the Act’s effects. In our view, probably the best legal-academic article summarizing and sorting through the basic economic issues is John Coates‘s (Winter, 2007) piece in the Journal of Economic Perspectives, The Goals and Promise of the Sarbanes-Oxley Act. More recently, Donald Langevoort, another first-rate corporate law scholar, published a terrific (relatively) situationist article on the meaning and effect of Sarbanes-Oxley. We have excerpted the larger part of Langvoort’s introduction to that article below. The entire article (published in The Michigan Law Review) is available here.

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The meaning of the Sarbanes-Oxley Act (“SOX”) is still being contested even though it is now nearly five years since its enactment. This is not to say the words and phrases that make up the statutory mandates and implementing regulations are hopelessly muddled. Though there are plenty of ambiguities for lawyers and their clients to worry over, most of the requirements are clear enough as “law on the books” to expect at least formalistic compliance with them. But simply because something is enacted into law does not tell us much about how strongly it will influence economic behavior. At the very least, there is the rational calculus of likelihood of detection and magnitude of sanction. Most of SOX’s implementation and enforcement is left to the discretion of the Securities and Exchange Commission (“SEC”) and other public agencies. We therefore should estimate what the regulators will do—which will bring into play an interesting mix of external politics and the agencies’ own beliefs. Courts, too, will play a role in saying what SOX means when they review the Commission’s rules and enforcement actions, as will Congress in its continuing legislative oversight.

Socio-legal researchers tell us, however, that even the coupling between official legal interpretations and social behavior is fairly loose—that absent unusually high rates of detection and prosecution, compliance decisions are based at least as much on the perceived legitimacy of the law and prevailing norms in local context as any deliberate risk calculation. Business people form their own beliefs about SOX independently from official interpretations, and they act accordingly. So do other groups like lawyers, accountants, investors, media, and politicians. These groups’ perceptions influence each other as to appropriate corporate governance and behavior. This is more than just a political battle, although the political dimension is surely potent. SOX has a cultural dimension as well, which political muscle alone cannot easily override.

The viewpoints in competition range from the idea that the Act ought to be firmly embraced for stopping a threatened market meltdown by restoring trust between companies and investors to the notion that it is a quack cure for an overblown problem and a $1.4 trillion debacle for investors and the economy. The more interesting questions are who is debating and why. Rent seeking is palpable, but far from the whole story. The economics and ideology of manager-investor relationships and the United States’ law-making competence in the global economy are also in play.

The closer one looks at SOX and its origins in the financial scandals of the early 2000s, the blurrier the picture, which lets commentators see what they want to see and draw inferences accordingly. That is why social construction is so crucial. My aim in this paper is to illuminate the social nature of SOX’s diffusion into practice. I will leave to the reader the judgment about whether this has been or will be good or bad, and for whom. If I seem to challenge SOX’s critics more than its supporters, it is because the critics have been more venomous than is fair. Venom aside, the bite still deserves attention.

A reasonable concern is that we should not worry about something as fuzzy as social construction. We can observe how SOX has influenced behavior since its adoption, and that is what is important–not what self-interested parties say or think about the law. Numerous empirical studies in law, accounting, and finance have tested SOX’s effects. These studies, however, are preliminary—because the rule-making process takes time, many of the Act’s mandates did not go into effect until very recently, and implementation of certain provisions for some affected parties is still being delayed. They also suffer from their own methodological challenges, because the events surrounding SOX were very noisy. Quite apart from the legislation itself, political attitudes and investor expectations also shifted in response to the financial reporting scandals. Determining whether reactions were to the legislation itself or these other effects is hard. Finally, we cannot assume that first reactions to any law will necessarily be sustained: there can be an overreaction in the first instance that calms as the interpretation of the law shifts both officially and unofficially.

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To read all of Professor Langevoort’s article and how he takes up those challenges, click here. For related Situationist posts regarding the regulation of corporate misbehavior, see Sung Hui Kim’s posts: “Why Do Lawyers Acquiesce In Their Clients’ Misconduct?” Part I & Part II.