Disclosure, Stupidity and the Stock Market

Remember the Sarbanes-Oxley Act (search)?

If you're an investor you may recall that Congress passed the SOA on your behalf in July 2002, in response to all the Bad Stuff happening on Wall Street, in corporate boardrooms, and elsewhere.

Its stated purpose was to "protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes." Don't miss the "and for other purposes" clause: Any Congress-watcher worthy of the name knows this is precisely the type of language that produces outcomes ranging from inspiring to nauseous.

"Inspiring" definitely applies for the accountants and attorneys charged with insuring their clients comply with the regulations. They are likely to consider SOA a full employment act.

"Nausea," on the other hand, may have come in waves over the corporations who have to pay for the audits. The Wall Street Journal reported that S&P 500-sized firms now pay triple the fees to outside auditors than they did before Sarbanes-Oxley -- as in a $2 million annual charge increasing to $6 million. Firms the size of Dow Jones Industrials pay quadruple the fees -- up to $8 million annually, or more.

Politicians gave birth to the SOA, so its ability to create jobs and increase spending naturally extended beyond the private sector. Enforcement of the law belongs to the Securities and Exchange Commission (search), which exists (according to its web site) "to protect investors and maintain the integrity of the securities markets."

The SEC's purpose makes the SOA's purpose redundant, you say? Don't be small-minded. Investors need a lot of protecting, and SEC/SOA is a marriage made in budget heaven. The SEC's Fiscal Year 2001 budget was $422.8 million; in its FY 2004 budget, that amount is virtually doubled, to $841.5 million. In 2002, the SEC had 3,009 full-time staff; for 2004, that number will increase to at least 3,730. Most of the new jobs are positions that equip the SEC to enforce what it calls "Full Disclosure."

So there's a lot of disclosing to do. But does "disclosure" really protect investors?

If you've read this far, you're probably guessing that I'm about to tell you that disclosure is overrated. But instead of investors who own S&P 500 stocks (search) (and didn't need Sarbanes-Oxley anyway), let's talk about the folks who were burned by truly vulgar examples of non-disclosure: Like "bulletin board" operators who, in exchange for a large fee, touted penny stocks (search) to their subscribers.

Those were the real abuses of the stock market "bubble:" gullible people grabbing up stocks based upon a counterfeit "recommendation," unaware that the stock picker was being paid to make that recommendation. No investor would take such bait from a stock picker who had to disclose such flagrant conflicts of interest, right?

For a direct answer to the question, let's ask a gentleman who should know: Mr. Stephen Cutler, director of enforcement of the Securities & Exchange Commission.

"It's a problem not solved by disclosure," Mr. Cutler says.

The "it" in question refers to investors who buy stocks based upon the recommendation of a stock picker, even after the stock picker discloses the fact that he's getting paid a huge fee to make that recommendation.

Mr. Cutler's remark appeared in the Jan. 12 Wall Street Journal, in an article titled "Street Sleuth: Return Of the Online Hype." It explains that investors have started to repeat the behavior that characterized the bubble mania -- namely grabbing up shares of questionable stocks based on the "hype" of stock pickers.

One such stock picker took a $20,000 fee to tout a penny stock on his web site, and duly disclosed the fee to subscribers. Nevertheless, according to the Journal, within minutes the recommended stock's price "had surged on heavy volume, which, by day's end, totaled nearly 10 times its daily average."

Back in the bad old days of the bubble, the stock pickers didn't disclose these conflicts; now they do. What hasn't changed is the bubble behavior of investors. The irony of the remark by the top cop at the SEC is so great that it's hard to know where to begin.

If disclosure hasn't "solved" the problem, why in the name of Dow Jones does the law require disclosure? Why waste time and money with an enforcement bureaucracy that goes after the effect instead of the cause?

Even before the SOA, the U.S. financial markets operated under a copious regulatory burden; apart from nuclear power facilities, I can't think of a more scrutinized industry. In the three years preceding the passage of Sarbanes-Oxley, the SEC averaged more than 500 enforcement actions annually; in 2001, it imposed civil fines and recovered illegal profits in excess of $500 million.

Go to the SEC web site. The longer you spend there, the more you'll understand the scope of what it does. Yet what you will not find is a credible explanation of how Sarbanes-Oxley is a greater "deterrent" than the hundreds of laws the SEC enforced beforehand. Would more staff and a bigger budget have stopped the well-known abuses from ... Enron (search)... or WorldCom (search) ... or brokerages ... or brokerage analysts ... or mutual funds ... or the NYSE ... or the other people and institutions which have not been "deterred" from fraud, scandal, abuse, stupidity and every other shortcoming known to man?

Congress could just try to get it over with and outlaw stupidity altogether; what they cannot do is outlaw bubbles, much less the behavior that makes bubbles expand. "It's a problem not solved by disclosure."

The bubble is back, despite Sarbanes-Oxley. The daily volume of bulletin board (penny stock) shares in 2003 was more than double what it was in 2000. In the period of disclosed hype, investors became more manic than in the time of bad old non-disclosure.

You're on your own -- yet that's not a bad place to be. Who is the best guardian of your finances? YOU ARE. The government cannot protect or help you as well as you can protect and help yourself.

Robert Folsom is a financial writer and editor for Elliott Wave International, a financial analysis company. He has covered politics, popular culture, economics and the financial markets for 16 years, and today writes EWI's popular Market Watch column. Robert earned his degree in political science from Columbia University in 1985.

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