Sarbanex-Oxley & the Subprime Crisis

One of our readers points to this column Did Sarbanes-Oxley miss a trick during subprime? in the Mint, where the author observes that the subprime crisis occurred despite the existence of stringent legislation such as the Sarbanes-Oxley Act (SOX). However, unlike past corporate governance failures such as Enron & WorldCom (that that triggered the passage of SOX), there has been no allegations of fraud in the current episode.

Here are some extracts:

“During the recent subprime crisis in the highly interconnected banking and financial services in the US, banks did not seem to know one another’s appetite for risk. They (and other investors) also do not seem to have been able to rely on auditors and rating agencies of counterparties to provide an objective measure of the latter’s financial position. This is surprising in a post-Sarbanes-Oxley world, where almost all information and controls are supposed to be monitored.

Many of the organizations that have between them written off over a hundred billion dollars of value during the so called subprime crisis were audited and were subject to the rigours of SOX. It should be fair to assume that the same process was carried out at Citibank, Merrill Lynch, UBS and Bear Sterns. The public would surely want to know why SOX, a law that has more teeth than a buzzsaw, missed it and what can be done to prevent a recurrence of such a crisis.

It is difficult to be persuaded, as many articles have us believe, that “nobody understood what the risks of subprime lending was”. Opacity is rarely accepted by either auditors or rating agencies as an argument. When something is complex to understand or unclear, there is a duty of responsibility to err on the side of conservatism and raise a red flag.”

The author concludes by noting that there is no direct solution to the problem:

“There is no single answer to this issue. What is however clear is that within five years of the implementation of one of the most stringent laws in the world, we again face a situation where shareholders are not able to rely on custodians of accuracy. Rating agencies and audit firms would do well to examine why they missed signs of a crisis and make these reasons public so that others may avoid those pitfalls in future.”

As we have discussed in the past (here), disclosure and transparency could operate to partially deal with the problem. That is precisely what SOX seeks to achieve. But, that rationale may not operate in the context of complex transactions such as those that gave rise to the subprime crisis whereby the nature of arrangements and the value of the securities parties were dealing in (such as collateralized debt obligations) were not fully comprehensible even to the sophisticated players in the market.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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