WEBVTT - Pressure on Companies to Commit Securities Fraud 0:00:03.160 --> 0:00:07.960 This is Bloomberg Law with June Bresso from Bloomberg Radio. 0:00:09.000 --> 0:00:12.480 As a response to several corporate and accounting scandals in 0:00:12.520 --> 0:00:16.520 the early two thousands, Congress past the Sarbanes Oxley Act 0:00:16.600 --> 0:00:21.560 in two thousand two with bipartisan congressional support. As Sarbanes 0:00:21.600 --> 0:00:25.840 Oxley celebrates its platinum anniversary, we'll look at how effective 0:00:25.880 --> 0:00:29.440 it's been. Joining me a securities law expert James Park, 0:00:29.600 --> 0:00:32.239 a professor at u c l A Law School. His 0:00:32.320 --> 0:00:36.240 new book is called The Valuation Treadmill, How securities fraud 0:00:36.280 --> 0:00:40.200 threatens the integrity of public companies. Jim tell us about 0:00:40.240 --> 0:00:45.360 Sarbanes Oxley in a nutshell uh. Sarbanes Oxley basically says, 0:00:45.400 --> 0:00:48.760 if you're a public corporation with stock that's trading in 0:00:48.800 --> 0:00:52.240 public markets, you have to invest in measures to prevent 0:00:52.320 --> 0:00:56.840 securities fraud. So there's a wide number of provisions or 0:00:56.920 --> 0:00:59.400 passed as part of the law, and I think some 0:00:59.520 --> 0:01:04.120 of the more important ones are certification requirements, where the 0:01:04.280 --> 0:01:08.920 CEO and CFO have to basically certify that there's no 0:01:09.040 --> 0:01:14.560 material misrepresentations in the company's disclosures. A public company also 0:01:14.680 --> 0:01:19.120 has to establish a system of internal controls um that 0:01:19.160 --> 0:01:23.520 will help inform the company's managers about the company's financial condition, 0:01:24.040 --> 0:01:27.360 and every year they are obligated under Sarbane Boxley to 0:01:27.520 --> 0:01:32.319 evaluate the effectiveness of those internal controls and then importantly, 0:01:32.600 --> 0:01:38.039 a independent auditor um has to review and attests to 0:01:38.120 --> 0:01:42.080 the management's evaluation of the internal controls um. Those to 0:01:42.160 --> 0:01:46.039 me are the core provisions of Sarbane Zoxley as they 0:01:46.080 --> 0:01:49.840 relate to public companies and tell us about the reasons 0:01:49.920 --> 0:01:53.200 for the law why it was passed. In my view, 0:01:53.640 --> 0:01:59.400 the law was the culmination of years of securities fraud. 0:01:59.600 --> 0:02:04.280 Case is that the sec basically pursued starting in about 0:02:04.360 --> 0:02:08.160 n or nine nine and basically towards the end of 0:02:08.160 --> 0:02:11.960 the nineteen nineties, there was significant pressure on public companies 0:02:12.000 --> 0:02:16.919 to deliver quarterly results to meet analysts projections of their 0:02:16.960 --> 0:02:20.080 revenue and earnings, and many of them were cheating. They 0:02:20.080 --> 0:02:23.960 were cheating by violating accounting rules so that they could 0:02:23.960 --> 0:02:27.400 report revenue that was a little bit higher profits that 0:02:27.440 --> 0:02:31.080 were a little bit higher. And this structural pressure to 0:02:31.200 --> 0:02:35.000 maintain your evaluation, in my view, was the main reason 0:02:35.120 --> 0:02:38.359 for the law. The best justifications for the law, you know, 0:02:38.400 --> 0:02:40.359 in terms of the events that led up to the law. 0:02:40.400 --> 0:02:43.000 I think it's worth talking about those a little bit. 0:02:43.360 --> 0:02:47.280 You know, I started practicing law around this time, about 0:02:47.280 --> 0:02:49.639 twenty years ago, and then this is the time when 0:02:49.639 --> 0:02:53.320 security fraud was national news. It was really one of 0:02:53.360 --> 0:02:57.800 the major national concerns. You have the December two thousand 0:02:57.800 --> 0:03:01.079 and one bankruptcy filing of Enron, and then the next 0:03:01.200 --> 0:03:04.119 month in January of two thousand and two, Global Crossing 0:03:04.200 --> 0:03:08.239 files for bankruptcy. That spring, in April two thousand and two, 0:03:08.360 --> 0:03:13.680 Elliott's sister bring major case against Merrill Lynch for issuing 0:03:14.000 --> 0:03:18.080 false research recommendations with respect to stocks that it was 0:03:18.600 --> 0:03:22.120 promoting as part of its investment banking business. June two 0:03:22.160 --> 0:03:26.640 thousand and two, Adelphia files for bankruptcy. And then what 0:03:26.840 --> 0:03:29.720 really prompted the passage of the law is July two 0:03:29.760 --> 0:03:33.040 thousand into World Cops files for bankruptcy. So you have 0:03:33.120 --> 0:03:37.400 a string of major public company bankruptcy that really pushes 0:03:37.480 --> 0:03:41.440 Congress to act. And the law was passed virtually with 0:03:41.640 --> 0:03:46.720 unanimous approval, and it was zero in the Senate, foy 0:03:46.800 --> 0:03:50.400 three to nine in the House, and President George W. Bush, 0:03:50.440 --> 0:03:53.920 a Republican, signed the law on July. Do you think 0:03:53.960 --> 0:03:57.000 it's worked. Has it been successful? I think it has 0:03:57.040 --> 0:04:01.560 been successful. It is a tough law, though to gauge 0:04:01.720 --> 0:04:05.000 with expect to how well it is working. Um, it's 0:04:05.080 --> 0:04:09.720 very hard to really measure exactly what the impact of 0:04:09.760 --> 0:04:13.640 the law has been. But we do have anecdotal evidence 0:04:13.720 --> 0:04:20.120 where public company managers report that they are more careful, 0:04:20.600 --> 0:04:26.360 more systematic about investing in internal controls to prevent securities frauds. 0:04:26.480 --> 0:04:30.120 So we have that sort of qualitative evidence that would 0:04:30.120 --> 0:04:33.640 support the idea that the law is working. We also 0:04:33.720 --> 0:04:38.520 have evidence from accounting leak statement re statements are basically 0:04:38.600 --> 0:04:42.880 when a company acknowledges that there's a material misrepresentation in 0:04:42.920 --> 0:04:48.160 its financial statements. And we see accounting lead statements of 0:04:48.560 --> 0:04:53.800 SEC filing company steadily declining. I'm over the last fifteen 0:04:53.839 --> 0:04:58.200 twenty years. In two thousand and six, seventeen percent of 0:04:58.320 --> 0:05:03.839 SEC filers we stated their financial statement was five percent, 0:05:04.120 --> 0:05:07.719 and that may indicate that internal controls are catching some 0:05:07.839 --> 0:05:11.520 of these mistakes earlier. There may be an upsurge. In 0:05:11.520 --> 0:05:14.120 two thousand and twenty one with SPACs there were a 0:05:14.160 --> 0:05:18.320 lot of spacty statements, But after that, Bliss I expect 0:05:18.400 --> 0:05:21.440 we might see that trend to continue to fall. The 0:05:21.480 --> 0:05:24.080 other evidence that it has worked is we have not 0:05:24.160 --> 0:05:27.080 seen another end Ron or World Top. We have seen 0:05:27.440 --> 0:05:31.200 some securities frauds over the last fifteen to twenty years 0:05:31.200 --> 0:05:35.599 by public corporations, but we have not seen as many 0:05:35.680 --> 0:05:38.880 of them as we saw around that time. And if 0:05:38.920 --> 0:05:42.960 you look at the data on private securities class action filings, 0:05:43.640 --> 0:05:49.320 the percentage of those lawsuits that alleged a financial misstatement 0:05:49.400 --> 0:05:52.640 has the client over the last decade or so. Coming up, 0:05:52.640 --> 0:05:56.040 I'll continue this conversation with you cel A law professor 0:05:56.160 --> 0:05:59.760 James Park, and we'll talk about how securities fraud threatens 0:05:59.760 --> 0:06:03.600 the integrity of public companies. This is Bloomberg. I've been 0:06:03.640 --> 0:06:06.640 talking into u c l A law professor James Park. 0:06:06.680 --> 0:06:10.520 He's got a new book coming out entitled The Valuation Treadmill, 0:06:10.800 --> 0:06:15.719 How securities fraud threatens the integrity of public companies. Give 0:06:15.800 --> 0:06:18.680 us the broad outlines. What's your book about. It's a 0:06:18.839 --> 0:06:24.120 history of securities fraud regulation and it basically goes from 0:06:24.120 --> 0:06:26.960 the nineteen seventies until the present. There are a lot 0:06:27.000 --> 0:06:30.000 of books that look at individual frauds. You know, you 0:06:30.040 --> 0:06:32.760 think of the book on Enron's modest guys in the 0:06:32.880 --> 0:06:37.360 room really delved into that particular fraud in death. What 0:06:37.400 --> 0:06:39.640 I wanted to do was I wanted to see and 0:06:39.720 --> 0:06:43.800 explore how securities fraud has changed over time UM, and 0:06:43.880 --> 0:06:47.520 so I look at five or six major frauds over 0:06:47.560 --> 0:06:51.440 the decade. Each fraud is meant to be representative of 0:06:51.520 --> 0:06:54.760 a particular period in time. So I start out in 0:06:54.800 --> 0:06:58.840 the nineteen seventies with the collapse of the Penn Central Railroad, 0:06:59.400 --> 0:07:03.640 and that was a really significant event because before UM 0:07:03.680 --> 0:07:07.080 that particular scandal, there's sort of a belief that large 0:07:07.160 --> 0:07:10.280 companies did not commit securities fraud and that it was 0:07:10.320 --> 0:07:13.040 really a problem for smaller companies. But when you have 0:07:13.120 --> 0:07:16.600 the sort of nation's largest railroad filing for bankruptcy, that 0:07:16.640 --> 0:07:20.240 really shapes the assumption that large companies are not vulnerable 0:07:20.320 --> 0:07:24.080 to securities frauds. In the nineteen eighties, you have cases 0:07:24.120 --> 0:07:28.080 against technology companies. Apple, for example, was hit with a 0:07:28.200 --> 0:07:32.840 hundred million dollar verdict or it failed Lisa Computer, and 0:07:33.120 --> 0:07:35.720 that case raised a lot of similar issues as we 0:07:35.760 --> 0:07:39.840 saw in the Sarano's case recently with Elizabeth Holmes. At 0:07:39.880 --> 0:07:44.200 what point do you say that a product has failed 0:07:44.680 --> 0:07:48.120 and to what extent is a failure to reveal the 0:07:48.200 --> 0:07:51.800 failure of a product fraudulent to investors. And of course 0:07:51.840 --> 0:07:54.400 I talked about Enron and a lot of the cases 0:07:54.440 --> 0:07:58.600 around that period, such as the zero accounting fraud, which 0:07:58.640 --> 0:08:01.480 was the first time the sc SEE impose a substantial 0:08:01.520 --> 0:08:05.480 civil penalty on a public corporation. And then I talked 0:08:05.520 --> 0:08:08.120 about the financial prices of two thousand and eight, why 0:08:08.160 --> 0:08:13.200 were there not more security spout cases filed after that crisis? 0:08:13.600 --> 0:08:15.840 And then I moved to the present and talked about 0:08:15.840 --> 0:08:19.160 how security spout theories are now being applied in the 0:08:19.200 --> 0:08:22.360 E s G context. When there's an E s G disaster, 0:08:22.520 --> 0:08:26.040 there's often allegations of securities frauds. So I really try 0:08:26.160 --> 0:08:31.720 to walk the reader through the decades and explain how 0:08:31.840 --> 0:08:35.800 securities fraud has changed and evolved over time as a 0:08:35.840 --> 0:08:41.640 problem for public corporation. Has securities fraud gotten more sophisticated? 0:08:41.840 --> 0:08:45.240 As you know, technology has improved or is the same old, 0:08:45.280 --> 0:08:50.400 same old, It has evolved, It has changed in many respects. 0:08:50.480 --> 0:08:52.600 And you know, if you look at some more recent 0:08:52.679 --> 0:08:57.760 securities frauds that we're seeing, they are not like the 0:08:57.880 --> 0:09:00.719 end rons and world times. They are doing things that 0:09:00.760 --> 0:09:04.320 are more subtle than violating accounting rules, and they are 0:09:04.960 --> 0:09:10.000 changing operational decisions in certain ways to generate additional cash 0:09:10.040 --> 0:09:14.199 flow in ways that are facially legal but could be 0:09:14.280 --> 0:09:17.440 deceptive to investors. At the end of twenty twenty, the 0:09:17.559 --> 0:09:21.720 SEC filed a big case against General Electric. General Electric, 0:09:21.760 --> 0:09:25.120 as you may know, revealed massive losses about five years 0:09:25.160 --> 0:09:29.480 ago in various businesses that investors were very surprised at. 0:09:30.120 --> 0:09:34.120 And you know, once the losses were revealed, the value 0:09:34.120 --> 0:09:37.080 of the company declined by an amount greater than the 0:09:37.120 --> 0:09:39.640 combined value of Enron and World Times. And what the 0:09:39.760 --> 0:09:45.360 SEC discovers is they're they're not really violating accounting rules, 0:09:45.400 --> 0:09:49.120 but they are doing things like selling more and more 0:09:49.480 --> 0:09:53.280 of their receivables in order to generate cashflow now to 0:09:53.400 --> 0:09:56.600 create the appearance that their businesses are strong, when in 0:09:56.679 --> 0:09:58.640 fact they were weak. And so this is a bit 0:09:58.760 --> 0:10:01.720 more of a subtle type of securities frauds that we 0:10:01.840 --> 0:10:04.600 see in that case. Another example of this type of 0:10:04.960 --> 0:10:08.760 earnings management fraud is under Armour. They basically we're trying 0:10:08.800 --> 0:10:12.560 to maintain the appearance that they were growing every year 0:10:12.559 --> 0:10:16.880 by about so one of the ways they tried to 0:10:17.240 --> 0:10:20.040 create the appearance of such growth is that if they 0:10:20.080 --> 0:10:22.240 had to hit a certain number at the end of 0:10:22.240 --> 0:10:25.760 a quarter, they would ask their customers to take products early. 0:10:25.960 --> 0:10:28.640 Products they had ordered later on, they asked them to 0:10:28.640 --> 0:10:30.959 accept it early so they could count it as revenue 0:10:31.040 --> 0:10:34.560 right away. And so that technically does not violate accounting rules, 0:10:34.600 --> 0:10:38.920 but it does create a deceptive portrayal of the company's 0:10:38.960 --> 0:10:44.080 condition and prospects. So we've seen a recent collapse in 0:10:44.280 --> 0:10:48.960 technology stock prices. Will that lead us to the next 0:10:49.160 --> 0:10:52.920 endron or world come very possible? You know, security s 0:10:52.920 --> 0:10:57.960 frauds tend to be revealed in bad times because at 0:10:58.000 --> 0:11:00.840 some point you're not able to maintain the fiction that 0:11:00.920 --> 0:11:04.080 your company is not performing as well as you have 0:11:04.160 --> 0:11:08.120 been portraying it as performing. And if you think about 0:11:08.160 --> 0:11:11.080 another recent event in the news, the Elon Musk and 0:11:11.160 --> 0:11:16.120 Twitter battle, in some ways, he's alleging that Twitter has 0:11:16.160 --> 0:11:20.000 committed a type of security fraud against him. Um. He's 0:11:20.040 --> 0:11:26.839 saying that they're published estimate of dam accounts is to 0:11:27.120 --> 0:11:31.400 love um and that he was essentially misled into buying 0:11:31.520 --> 0:11:36.000 this company that has, you know, a higher percentage of 0:11:36.120 --> 0:11:41.160 fake accounts, which might affect your assessment of their future prospects. Now, 0:11:41.200 --> 0:11:44.600 I personally don't think that this is a strong argument. 0:11:44.920 --> 0:11:49.000 The real reason why Twitter stock prices declined is that, 0:11:49.280 --> 0:11:52.880 you know, with interest rates rising because offense trying to 0:11:52.920 --> 0:11:57.520 head off inflation, that means that valuations of companies with 0:11:57.640 --> 0:12:01.240 future earnings tend to go down. But you know, this 0:12:01.320 --> 0:12:05.120 is a type of securities fraud argument that Musk is 0:12:05.160 --> 0:12:08.679 asserting partly because he wants to get out of the deal. 0:12:08.720 --> 0:12:10.360 And I think the reason he wants to get out 0:12:10.360 --> 0:12:13.160 of the deal is because he has offered to pay 0:12:13.200 --> 0:12:16.240 too much for Twitter um and so I expect that 0:12:16.280 --> 0:12:21.480 we will start seeing more securities frauds if the market 0:12:21.600 --> 0:12:25.120 keeps going down and the economy keeps deteriorating. Is the 0:12:25.240 --> 0:12:29.880 enforcement of the securities laws rigorous enough? Is it heading 0:12:29.880 --> 0:12:35.280 off problems? It's always a great question. And you know, 0:12:35.360 --> 0:12:38.320 the Securities and Exchange Commission does the best that it 0:12:38.520 --> 0:12:41.880 can with its limited resources. I think it could always 0:12:41.960 --> 0:12:47.520 use more resources. They have been fairly active in bringing cases, 0:12:47.720 --> 0:12:50.080 and I think they have, you know, just in the 0:12:50.160 --> 0:12:54.400 last month or so, filed some good cases, some interesting cases. 0:12:54.440 --> 0:12:58.760 But in my view, it's only a small fraction of 0:12:58.800 --> 0:13:01.920 the fraud that is actually happening, that the sec has 0:13:01.960 --> 0:13:05.280 the ability to really investigate and bring a case. Again, 0:13:05.679 --> 0:13:10.760 I do think that private investors and their attorneys who 0:13:10.800 --> 0:13:15.320 are bringing securities class actions play an important role in 0:13:15.520 --> 0:13:19.840 enforcing the law against securities fraud, and they are often 0:13:20.240 --> 0:13:23.199 very active. UM. One other thing that has helped, and 0:13:23.280 --> 0:13:27.560 this is part of Sarbanes Oxley, is the protection for 0:13:27.600 --> 0:13:31.520 whistleblowers within the company as well as the incentive to 0:13:31.600 --> 0:13:34.600 come forward, which were put in place by Dodd Frank. 0:13:34.960 --> 0:13:37.079 I think that's been very helpful to the Securities in 0:13:37.200 --> 0:13:41.800 Exchange Commission in finding securities fraud, and it deters securities 0:13:41.840 --> 0:13:45.959 fraud as well, because UM, if you know that your 0:13:46.000 --> 0:13:50.400 employees have incentive to report fraud, that might make it 0:13:50.440 --> 0:13:53.480 more difficult to actually commit a fraud. And so I 0:13:53.520 --> 0:13:56.600 think that the system has improved over the last twenty 0:13:56.679 --> 0:14:00.959 years and that regulation UM has a rest security s 0:14:00.960 --> 0:14:04.320 fraud in many ways. But I do suspect that we 0:14:04.360 --> 0:14:07.480 are not catching all of it. Is there any way 0:14:07.679 --> 0:14:14.040 to quantify how much more than they've caught, It's hard 0:14:14.120 --> 0:14:16.840 to quantify. I suspect that there are a lot of 0:14:16.920 --> 0:14:22.080 questionable practices that just never come to light because you know, 0:14:22.280 --> 0:14:25.760 a company might you know, have questionable accounting, but no 0:14:25.800 --> 0:14:30.200 one ever really discovers it because the company ends up 0:14:30.720 --> 0:14:34.400 doing pretty well for other reasons. So I think that, 0:14:34.920 --> 0:14:37.880 you know, I would guess that maybe at most were 0:14:38.360 --> 0:14:40.600 catching half of it. And I think that's just a 0:14:40.720 --> 0:14:42.920 very rough, rough guess. I think there are a lot 0:14:42.960 --> 0:14:47.600 of other questionable practices that you don't really know about 0:14:47.640 --> 0:14:50.600 it until there's some crisis at the company or a 0:14:50.640 --> 0:14:53.600 whistleblower finds it, you know, And part of the thesis 0:14:53.640 --> 0:14:56.600 of the book is that there's always this pressure on 0:14:56.680 --> 0:15:00.000 public companies to commit securities frauds because they are always 0:15:00.080 --> 0:15:03.280 is pressured to deliver short term results. And I do 0:15:03.320 --> 0:15:06.440 think a lot of companies resist the pressure and temptation 0:15:06.720 --> 0:15:10.680 and are honest and they do report accurate financial results 0:15:10.680 --> 0:15:13.720 that issue correct disclosure. But there are a lot of 0:15:13.720 --> 0:15:16.120 others I think that give in to the pressure, and 0:15:16.200 --> 0:15:18.920 we may not discover all of them. Is there a 0:15:19.000 --> 0:15:23.080 lesson that you want readers to take away after reading 0:15:23.080 --> 0:15:24.880 your book? You know, I think the main point, to 0:15:24.960 --> 0:15:28.280 tip it back to Sarbanes Oxley, is that you know, 0:15:28.400 --> 0:15:31.240 there's a good reason we have Sarbanes Oxley I think 0:15:31.240 --> 0:15:33.640 that's the one point I'm trying to make in the book, 0:15:33.880 --> 0:15:37.560 that security fraud is a structural problem. You know, one 0:15:37.600 --> 0:15:40.680 perception is that it's it's just bad people who commit 0:15:40.720 --> 0:15:44.160 securities fraud from time to time, people who are trying 0:15:44.200 --> 0:15:48.120 to trade on inside information, people who are trying to 0:15:48.160 --> 0:15:51.280 sell their stocks before the company collapses. And I think 0:15:51.320 --> 0:15:54.360 that is an important part of security fraud. But you know, 0:15:54.440 --> 0:15:58.119 to me, what's more interesting is when otherwise law abiding 0:15:58.520 --> 0:16:01.640 executives to see investors. And I think they do so 0:16:01.720 --> 0:16:05.560 because there's a structural pressure on public companies that we 0:16:05.680 --> 0:16:09.720 see in modern times. And cb azoxy has been criticized 0:16:09.880 --> 0:16:13.280 quite a bit over the years. It's costly, it reduces 0:16:13.320 --> 0:16:17.080 the incentive of companies to go public, and Congress has 0:16:17.120 --> 0:16:21.440 tried to implement various laws to try to reduce the cost, 0:16:21.600 --> 0:16:24.240 but it is still somewhat of a deterrence of being 0:16:24.240 --> 0:16:27.200 a public corporation. And so I think we continually have 0:16:27.440 --> 0:16:31.600 to justify a law that basically says, if you're a 0:16:31.680 --> 0:16:36.240 public corporation, you have to spend significant amounts in preventing 0:16:36.360 --> 0:16:39.760 security frauds. And I think that this book makes the 0:16:39.840 --> 0:16:43.400 case that Sarbanzoxy is a necessary claw for all public 0:16:43.480 --> 0:16:48.440 corporations because securities fraud is a threat to all public corporations. 0:16:48.440 --> 0:16:50.680 Thanks for being on the show, Jim. That's u c 0:16:50.880 --> 0:16:54.040 l A Law professor James Park. The book is called 0:16:54.320 --> 0:16:59.120 The Valuation Treadmill, How Securities Fraud Threatens the integrity of 0:16:59.240 --> 0:17:01.760 public company knees. And that's it for this edition of 0:17:01.800 --> 0:17:04.480 the Bloomberg Law Show. Remember you can always get the 0:17:04.560 --> 0:17:07.760 latest legal news on our Bloomberg Law Podcast. You can 0:17:07.800 --> 0:17:12.040 find them on Apple Podcasts, Spotify, and at www dot 0:17:12.040 --> 0:17:16.480 Bloomberg dot com, slash podcast Slash Law. I'm June Grosso 0:17:16.640 --> 0:17:18.240 and you're listening to Bloomberg