Pressure on Companies to Commit Securities Fraud

threatens the integrity of public companies. Jim tell us about Sarbanes Oxley in a nutshell uh. Sarbanes Oxley basically says, if you're a public corporation with stock that's trading in public markets, you have to invest in measures to prevent securities fraud. So there's a wide number of provisions or passed as part of the law, and I think some of the more important ones are certification requirements, where the CEO and CFO have to basically certify that there's no

material misrepresentations in the company's disclosures. A public company also has to establish a system of internal controls um that will help inform the company's managers about the company's financial condition, and every year they are obligated under Sarbane Boxley to evaluate the effectiveness of those internal controls and then importantly, a independent auditor um has to review and attests to

the management's evaluation of the internal controls um. Those to me are the core provisions of Sarbane Zoxley as they relate to public companies and tell us about the reasons for the law why it was passed. In my view, the law was the culmination of years of securities fraud.

Case is that the sec basically pursued starting in about n or nine nine and basically towards the end of the nineteen nineties, there was significant pressure on public companies to deliver quarterly results to meet analysts projections of their revenue and earnings, and many of them were cheating. They were cheating by violating accounting rules so that they could report revenue that was a little bit higher profits that

were a little bit higher. And this structural pressure to maintain your evaluation, in my view, was the main reason for the law. The best justifications for the law, you know, in terms of the events that led up to the law. I think it's worth talking about those a little bit. You know, I started practicing law around this time, about twenty years ago, and then this is the time when security fraud was national news. It was really one of

the major national concerns. You have the December two thousand and one bankruptcy filing of Enron, and then the next month in January of two thousand and two, Global Crossing files for bankruptcy. That spring, in April two thousand and two, Elliott's sister bring major case against Merrill Lynch for issuing false research recommendations with respect to stocks that it was promoting as part of its investment banking business. June two

thousand and two, Adelphia files for bankruptcy. And then what really prompted the passage of the law is July two thousand into World Cops files for bankruptcy. So you have a string of major public company bankruptcy that really pushes Congress to act. And the law was passed virtually with unanimous approval, and it was zero in the Senate, foy three to nine in the House, and President George W. Bush, a Republican, signed the law on July. Do you think

it's worked. Has it been successful? I think it has been successful. It is a tough law, though to gauge with expect to how well it is working. Um, it's very hard to really measure exactly what the impact of the law has been. But we do have anecdotal evidence where public company managers report that they are more careful, more systematic about investing in internal controls to prevent securities frauds. So we have that sort of qualitative evidence that would

support the idea that the law is working. We also have evidence from accounting leak statement re statements are basically when a company acknowledges that there's a material misrepresentation in its financial statements. And we see accounting lead statements of SEC filing company steadily declining. I'm over the last fifteen

twenty years. In two thousand and six, seventeen percent of SEC filers we stated their financial statement was five percent, and that may indicate that internal controls are catching some of these mistakes earlier. There may be an upsurge. In two thousand and twenty one with SPACs there were a lot of spacty statements, But after that, Bliss I expect we might see that trend to continue to fall. The other evidence that it has worked is we have not

seen another end Ron or World Top. We have seen some securities frauds over the last fifteen to twenty years by public corporations, but we have not seen as many of them as we saw around that time. And if you look at the data on private securities class action filings, the percentage of those lawsuits that alleged a financial misstatement

has the client over the last decade or so. Coming up, I'll continue this conversation with you cel A law professor James Park, and we'll talk about how securities fraud threatens the integrity of public companies. This is Bloomberg. I've been talking into u c l A law professor James Park. He's got a new book coming out entitled The Valuation Treadmill, How securities fraud threatens the integrity of public companies. Give

us the broad outlines. What's your book about. It's a history of securities fraud regulation and it basically goes from the nineteen seventies until the present. There are a lot of books that look at individual frauds. You know, you think of the book on Enron's modest guys in the room really delved into that particular fraud in death. What I wanted to do was I wanted to see and explore how securities fraud has changed over time UM, and so I look at five or six major frauds over

the decade. Each fraud is meant to be representative of a particular period in time. So I start out in the nineteen seventies with the collapse of the Penn Central Railroad, and that was a really significant event because before UM that particular scandal, there's sort of a belief that large companies did not commit securities fraud and that it was

really a problem for smaller companies. But when you have the sort of nation's largest railroad filing for bankruptcy, that really shapes the assumption that large companies are not vulnerable to securities frauds. In the nineteen eighties, you have cases against technology companies. Apple, for example, was hit with a hundred million dollar verdict or it failed Lisa Computer, and that case raised a lot of similar issues as we

saw in the Sarano's case recently with Elizabeth Holmes. At what point do you say that a product has failed and to what extent is a failure to reveal the failure of a product fraudulent to investors. And of course I talked about Enron and a lot of the cases around that period, such as the zero accounting fraud, which was the first time the sc SEE impose a substantial

civil penalty on a public corporation. And then I talked about the financial prices of two thousand and eight, why were there not more security spout cases filed after that crisis? And then I moved to the present and talked about how security spout theories are now being applied in the E s G context. When there's an E s G disaster,

there's often allegations of securities frauds. So I really try to walk the reader through the decades and explain how securities fraud has changed and evolved over time as a problem for public corporation. Has securities fraud gotten more sophisticated? As you know, technology has improved or is the same old, same old, It has evolved, It has changed in many respects. And you know, if you look at some more recent securities frauds that we're seeing, they are not like the

end rons and world times. They are doing things that are more subtle than violating accounting rules, and they are changing operational decisions in certain ways to generate additional cash flow in ways that are facially legal but could be deceptive to investors. At the end of twenty twenty, the SEC filed a big case against General Electric. General Electric, as you may know, revealed massive losses about five years ago in various businesses that investors were very surprised at.

And you know, once the losses were revealed, the value of the company declined by an amount greater than the combined value of Enron and World Times. And what the SEC discovers is they're they're not really violating accounting rules, but they are doing things like selling more and more of their receivables in order to generate cashflow now to create the appearance that their businesses are strong, when in

fact they were weak. And so this is a bit more of a subtle type of securities frauds that we see in that case. Another example of this type of earnings management fraud is under Armour. They basically we're trying to maintain the appearance that they were growing every year by about so one of the ways they tried to create the appearance of such growth is that if they had to hit a certain number at the end of a quarter, they would ask their customers to take products early.

Products they had ordered later on, they asked them to accept it early so they could count it as revenue right away. And so that technically does not violate accounting rules, but it does create a deceptive portrayal of the company's condition and prospects. So we've seen a recent collapse in technology stock prices. Will that lead us to the next

endron or world come very possible? You know, security s frauds tend to be revealed in bad times because at some point you're not able to maintain the fiction that your company is not performing as well as you have been portraying it as performing. And if you think about another recent event in the news, the Elon Musk and Twitter battle, in some ways, he's alleging that Twitter has

committed a type of security fraud against him. Um. He's saying that they're published estimate of dam accounts is to love um and that he was essentially misled into buying this company that has, you know, a higher percentage of fake accounts, which might affect your assessment of their future prospects. Now, I personally don't think that this is a strong argument.

The real reason why Twitter stock prices declined is that, you know, with interest rates rising because offense trying to head off inflation, that means that valuations of companies with future earnings tend to go down. But you know, this is a type of securities fraud argument that Musk is asserting partly because he wants to get out of the deal.

And I think the reason he wants to get out of the deal is because he has offered to pay too much for Twitter um and so I expect that we will start seeing more securities frauds if the market keeps going down and the economy keeps deteriorating. Is the enforcement of the securities laws rigorous enough? Is it heading off problems? It's always a great question. And you know, the Securities and Exchange Commission does the best that it can with its limited resources. I think it could always

use more resources. They have been fairly active in bringing cases, and I think they have, you know, just in the last month or so, filed some good cases, some interesting cases. But in my view, it's only a small fraction of the fraud that is actually happening, that the sec has

the ability to really investigate and bring a case. Again, I do think that private investors and their attorneys who are bringing securities class actions play an important role in enforcing the law against securities fraud, and they are often very active. UM. One other thing that has helped, and this is part of Sarbanes Oxley, is the protection for whistleblowers within the company as well as the incentive to come forward, which were put in place by Dodd Frank.

I think that's been very helpful to the Securities in Exchange Commission in finding securities fraud, and it deters securities fraud as well, because UM, if you know that your employees have incentive to report fraud, that might make it more difficult to actually commit a fraud. And so I think that the system has improved over the last twenty years and that regulation UM has a rest security s fraud in many ways. But I do suspect that we

are not catching all of it. Is there any way to quantify how much more than they've caught, It's hard to quantify. I suspect that there are a lot of questionable practices that just never come to light because you know, a company might you know, have questionable accounting, but no one ever really discovers it because the company ends up doing pretty well for other reasons. So I think that, you know, I would guess that maybe at most were catching half of it. And I think that's just a

very rough, rough guess. I think there are a lot of other questionable practices that you don't really know about it until there's some crisis at the company or a whistleblower finds it, you know, And part of the thesis of the book is that there's always this pressure on public companies to commit securities frauds because they are always

is pressured to deliver short term results. And I do think a lot of companies resist the pressure and temptation and are honest and they do report accurate financial results that issue correct disclosure. But there are a lot of others I think that give in to the pressure, and we may not discover all of them. Is there a lesson that you want readers to take away after reading

your book? You know, I think the main point, to tip it back to Sarbanes Oxley, is that you know, there's a good reason we have Sarbanes Oxley I think that's the one point I'm trying to make in the book, that security fraud is a structural problem. You know, one perception is that it's it's just bad people who commit securities fraud from time to time, people who are trying to trade on inside information, people who are trying to sell their stocks before the company collapses. And I think

that is an important part of security fraud. But you know, to me, what's more interesting is when otherwise law abiding executives to see investors. And I think they do so because there's a structural pressure on public companies that we see in modern times. And cb azoxy has been criticized

quite a bit over the years. It's costly, it reduces the incentive of companies to go public, and Congress has tried to implement various laws to try to reduce the cost, but it is still somewhat of a deterrence of being a public corporation. And so I think we continually have to justify a law that basically says, if you're a public corporation, you have to spend significant amounts in preventing

security frauds. And I think that this book makes the case that Sarbanzoxy is a necessary claw for all public corporations because securities fraud is a threat to all public corporations. Thanks for being on the show, Jim. That's u c l A Law professor James Park. The book is called The Valuation Treadmill, How Securities Fraud Threatens the integrity of public company knees. And that's it for this edition of the Bloomberg Law Show. Remember you can always get the

latest legal news on our Bloomberg Law Podcast. You can find them on Apple Podcasts, Spotify, and at www dot Bloomberg dot com, slash podcast Slash Law. I'm June Grosso and you're listening to Bloomberg