Sarbanes Oxley – The Medicine is worse than the Disease: Part 1 Background
Sarbanes Oxley was passed in 2002 in reaction to corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, and WorldCom. The legislation set new or enhanced standards for all U.S. public company boards, management, and public accounting firms. The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law. This law has effectively killed off the possibility of going public in the U.S.
Stock Market and Securities History
The Amsterdam Stock Exchange in 1602 became the first modern stock market trading shares of limited liability corporations. The Amsterdam Stock Exchange was created by the Dutch East India Company and presumably traded shares in the company. A number of companies in England formed to exploit trade with various parts of the world, including the South Sea Company. The South Sea Company was granted a monopoly to trade with South America. In return the company took over England’s national debt from the war of Spanish Succession. The company tried to convince bondholders to exchange their bonds for high priced shares in the company. However, the company had to compete with 190 other companies attempting to raise capital in 1720. Because of this competition, the South Sea Company convinced Parliament to pass the Bubble Act, which made it illegal to establish new companies without statutory authority. The South Sea Company’s stock increased almost ten fold in a single year and then collapsed.
While in France, John Law, a Scotsman, started the Banque Generale a private bank that morphed into the central bank of France. Law then developed the Mississippi Company, which was granted a monopoly over trade with France’s Louisiana territory and control of its internal affairs. Using the banks ability to issue money, Law had the Mississippi Company take over rival trading companies in France. The Company also bought out various tax farming licenses in France. The shares of the Mississippi Company increased almost 20 fold in 1719 and came crashing down in 1720. The fall of the Mississippi Company resulted in a collapse of paper money issued by the central bank of France.
France and England both experienced an asset bubble shortly after limited liability stock companies were invented and stock markets to trade shares of these companies started. However, in France the bubble had longer lasting effects because the government granted the Mississippi Company the right to act as the central bank, the treasury department, issue paper money as legal tender and a monopoly over most of France’s trade. The South Sea Company in England was one of many companies competing for investment capital and could not issue paper money as legal tender. The South Sea bubble had little effect on England’s stock market, trust in paper money or foreign investors’ confidence in England’s financial institutions. The French lost confidence in the stock market and were leery of paper money for years. This stunted the development of modern financial institutions in France for over a century and contributed to England, not France, becoming the world’s greatest empire in the 19th century. France and England both experienced stunning failures as they adjusted to the innovations of modern finance, but France’s response was to reject innovations in finance and England’s response was to learn from the failure and continue to innovate.
The first stock market in the U.S. opened in Philadelphia in 1790. In 1792 twenty four merchants in New York met secretly to form the Buttonwood Agreement. The Buttonwood Agreement stated that the merchants would only trade with each other and set fees for transactions. This became the New York Stock Exchange. The Buttonwood Agreement was named after a buttonwood tree that was the traditional meeting place for the merchants to trade stocks.
A century before, the Dutch constructed a wall to protect themselves from Indians and pirates. The path had become a bustling commercial thoroughfare because it joined the banks of the East River with those of the Hudson River on the west. The path was named Wall Street. Early merchants built their warehouses and shops on this path, along with a city hall. The New York Stock Exchange was eventually located at 11 Wall Street. The American Stock Exchange (Amex) began in 1849 with the Curb Exchange and the California Gold Rush. The Amex played an important part in the financial and business transactions associated with the mining industry in the 19th century. The curb brokers gathered around the lampposts and mailboxes, resisting wind and weather, putting up lists of stocks for sale. The stock market in the U.S. was regulated only by common law contract and fraud rules for over a century.
The formative years of the U.S. focused financial regulation on banking, particularly, over whether the U.S should have a national bank. The debate pitted two of America’s founding fathers, Alexander Hamilton and Thomas Jefferson. Hamilton argued for a national bank, while Jefferson was against a national bank. Hamilton’s plan for a national bank also included a law that the federal government assume the war debts of all the states. The Virginias were against this, since Virginia had paid off most its war debts. Hamilton and Jefferson worked out a deal where Jefferson would support the assumption of the states war debts and, in return, Hamilton would support a bill to have the federal government located on the Potomac river in Virginia. Hamilton’s central bank was designed to hold the deposits of the federal government, make loans to the federal government, facilitate payments by the federal government and issue paper money. The bank would be a private bank, capitalized in part (20%) by the federal government and have both government and private citizens on its board. Hamilton believed that a bank run by the government would be tempted print too much money. The bank was required to redeem paper money in gold and silver and the federal government accepted the bank’s paper money as payment of taxes.
Hamilton’s financial programs converted the U.S. from a financial basket case to a financial power
house with the highest credit rating in all of Europe. However, Congress did not renew the charter for the first Bank of the United States. As a result, the first Bank of the United States expired in 1811. President Madison was able to charter the second Bank of the United States in 1816 that functioned similarly to first Bank of the United States. President Jackson ran on eliminating the second Bank of the United States and in 1836 he succeeded. This was followed by the National Banking Act in 1863 which chartered a number of banks as national banks. The Act required that national banks be unit banks that could not operate across state lines. As a result of the unit banking rule, the national banks were dependent on a narrow local economy and could not diversify their loan and deposit base. The McFadden Act of 1927 prohibited interstate banking. These rules resulted in numerous (about 9000) bank failures in the U.S. during the depression, while Canada did not have a single bank failure.
Regulation of the securities market began with Kansas’ Blue Sky Law in 1911, which regulated securities offerings and sales to proactively protect the public from fraud. The law was championed by J. N. Dolley, a successful rural banker and republican politician. Within eight years 44 states had adopted similar laws. Dolley’s stated motivation was to protect the people of Kansas from unscrupulous stock peddlers. In addition, he argued that the law would keep “Kansas money in Kansas.”
Kansas’ Blue Sky law gave the banking commission broad authority to allow sales of securities in the state. The broad authority allowed the commissioner to determine the merit of a security for sale and reject any offering that “does not promise a fair return on the stocks, bonds, or other securities to be offered for sale.” During the first year of operation in Kansas the commissioner, Dolley, only approved 7% of the applications for securities.
A major motivation for these laws appears to be protectionism, the small local banks did not want to compete for depositors’ money. Many of these laws exempted banking securities from registration. Legal challenges to the Blue Sky laws argued they provided overly broad delegation of legislative powers to a regulatory body with no success.
Federal securities laws were first enacted during the Great Depression in reaction to the stock market crash of 1929 and the perceived failure of the state’s Blue Sky laws. Congress passed the Securities Act of 1933 (15 U.S.C.§ 77a et seq.) which regulates interstate sales of securities (original issues only) at the federal level. It requires that any offer or sale of securities using the means and instrumentalities of interstate commerce be registered pursuant to the 1933 Act, unless an exemption from registration exists under the law. This was followed by the Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq.), which created an independent regulatory agency, the Securities Exchange Commission (SEC). The SEC regulates secondary sales of securities including stock exchanges, enforces antifraud provisions, and enforces continuing disclosure requirements for issuers’ of securities. False or misleading statements in any documents required under the 1934 act may result in liability to persons who buy or sell securities in reliance on these statements. Congress passed the Public Utility Holding Company Act (PUHCA) in 1935, which limited electrical utility companies to a single state or limited geographic area. PUHCA also prohibited utility holding companies from engaging in unregulated businesses. This law was superseded by the Energy Policy Act of 2005, which now allows utility companies to operate across state lines. Several less important securities laws were passed around 1940. The Securities Investor Protection Act was passed in 1970, which created the Securities Investors Protection Corporation (SIPC). SIPC provides insurance coverage up to $500,000 of the customer’s net equity balance, including up to $100,000 in cash.
 Ferguson, Niall, The Ascent of Money: A Financial History of the World, The Penguin Press, 2008, p. 154.
 Ibid, p. 156.
 Ibid. p. 156.
 Ibid. p. 156.
 Ibid. p. 139
 Ibid. p. 140.
 Ibid. p. 150.
 Ibid. p. 157.
 Gordon, John Steele, Empire of Wealth: The Epic History of American Economic Power, Harper Perennial, 2005, p. 53.
 Gordon, John Steele, Hamilton’s Blessing: The Extraordinary Life and Time of Our National Debt, Penguin Books, 1997, p. 32.
 Ibid. p. 28.
 Ibid. p. 31.
 Ibid. p. 32.
 Ibid. p. 34.
 Ibid. p. 34.
 Ibid. p. 34.
 Ibid. pp. 38-39.
 Gordon, John Steele, Empire of Wealth: The Epic History of American Economic Power, Harper Perennial, 2005, pp. 223-224.
 Mohoney, Paul, “The Origins of the Blue Sky Laws: A Test of Competing Hypotheses”, Law and Economics Workshop – University of California, Berkley, Paper 5, 2001, p. 3.
 Ibid. p. 3.
 Ibid. p. 3.
 Ibid. p. 3.
 Ibid. p. 4.
 It is interesting to speculate how these cases would have turned out if the laws were challenged as a violation of the “interstate commerce clause.” This clause was designed to prevent protectionist measures between states.
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