Sarbanes-Oxley

In Week 1 we studied the general importance of the "rules of the game" (property rights and the rule of law) to a well-functioning economy. This week, we focused in more closely on the "rules of the game" regarding corporate governance and financial reporting. The Week 6 topic of fraudulent financial reporting relates to corporate top management that enriches itself and abandons its obligations to shareholders, employees, creditors, government, and the general public.

The Agency Problem
Economists call this failure of duty the problem of "agency." Top management is supposed to be the fiduciary (faithful agent) of the shareholders that own the enterprise. But a corrupt agent neglects fiduciary duty to the principal in favor of his/her own selfish interest. Lawyers refer to this same problem as a failure to perform “fiduciary duty” and a "conflict of interest." Ethicists see the problem as deviation from moral conduct. But, whatever terminology is used, the problem remains the same: how can the management agency be kept faithful to its fiduciary duty to the owners, and to the other stakeholders (employees, creditors, government, and the general public)?

This is a fundamental and difficult problem. The founders of the United States confronted it in attempting to create a federal government that would be powerful enough to perform its functions, but not so powerful that it would become as oppressive to Americans as the English government the American Revolution had overthrown. The founders used the Constitution to achieve these objectives by the means of the separation of powers, the Bill of Rights, and various checks and balances.

The SEC and Full Disclosure
After the great depression of the 1930's the U.S. government formed the Securities and Exchange Commission (SEC) to oversee the U.S. financial markets. The basic policy of the SEC has