Anti-fraud law fails first major court test

John W. Schoen Senior Producer • Profile • E-mail

The acquittal of HealthSouth founder Richard Scrushy Tuesday represents a high-profile failure for the Sarbanes-Oxley Act, the comprehensive set of rules established by Congress three years ago in response to a wave of corporate scandals.

Even before the verdict was announced in Birmingham, Ala., the law was getting mixed reviews from companies, lawyers and shareholders. While most agree Sarbanes-Oxley has helped restore investor confidence in corporate accounting, companies have complained that the benefits of the new regulations are not worth the cost of complying with them.

And now a key provision — holding top executives personally accountable — has failed to pass  its first major test.

After more than a month of deliberations, a federal jury found Scrushy not guilty on all 36 counts the government brought against him. Scrushy — the first chief executive accused of violating the Sarbanes-Oxley law — was accused of orchestrating a $2.7 billion earnings overstatement at the rehabilitation and medical services chain over seven years beginning in 1996. He also was accused of conspiracy, fraud, false reporting and money laundering.

The “certification” provision of Sarbanes-Oxley — requiring corporate CEOs to sign off personally on accounting statements — was supposed to make it tougher for top executives to claim they didn’t know that underlings were cooking the books by requiring CEOs of more than 12,000 public companies to personally verify financial statements.

“The prosecutor can wave that personal certification in front the jury to show that the defense claim — that their head was stuck in the sand  — doesn’t hold water,” said Michael Zuppone, former head of Northeast regional office of the Securities and Exchange Commission.

But that’s exactly what Scrushy claimed: that he was duped by a succession of financial managers who cooked the books without his knowledge. The failure of the jury to convict him under Sarbanes-Oxley means that “the utility of the criminal certification statute will be very much undermined,” said Zuppone.

To be sure, the certification process is still a potent weapon for prosecutors. And the complexities of accounting fraud cases will always be difficult to try in front of juries, say securities lawyers. They also note that chief executives Bernie Ebbers of WorldCom and Dennis Kozlowski of Tyco were convicted for their corporate misdeeds without the benefit of the Sarbanes-Oxley law.

Cost of compliance
CEO certification was just a piece of the new law, which also requires companies to review their bookkeeping procedures to ensure they are tough enough to prevent fraud or catch it when it happens. That part of the law has apparently produced results.

When all of their reviews are completed, more than 14 percent of large public companies will have found their accounting procedures are not strong enough to catch problems, according to a review of SEC filings by the research firm AuditAnalytics.com.

The biggest problems identified by these reviews are in tax accounting and the way revenues are booked, according to AuditAnalytics.com.

Despite the problems uncovered, critics say the anti-fraud pendulum has swung too far, creating regulations that are too burdensome. Corporate executives are spending too much time worrying about accounting and not enough time running their businesses, according to Jacob Frankel, a former prosecutor and SEC lawyer who now advises companies working to comply with the law.

“I think there's a significant brain drain,” he said. “You have people that don't want to become officers and directors of a public company. You have attorneys advising young startup companies, saying don't go public. And I think there needs to be some new equilibrium created.”

Most corporate executives agree. Some 94 percent of companies working to comply with the new rules say the benefits just are not worth the added cost, according to a recent survey by Financial Executives International.

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