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How the Protection of Law Was Lost
by Paul Craig Roberts

The Enron era accounting scandals have resulted in new legislation, Sarbanes-Oxley, which imposes criminal liability on the CEO and CFO of corporations with incorrect accounting statements. This reform will have unintended consequences, as have previous reforms.

A case can be made that the recent scandals are themselves the consequences of past reforms. The emphasis on quarterly earnings is the result of reform that aimed to provide investors with more timely information about the profitability and financial condition of public companies. Stock options resulted from reforms that sought to tie executive compensation to shareholder return as measured by the company’s stock price. Another reform capped executive salaries at $1 million. Compensation above this amount must be paid from after-tax profits or justified by performance. The practice of giving executives large options whose value depends on driving up quarterly earnings (the measure of performance) came from this reform. In the early 1990s the S.E.C. itself launched fictional quarterly earnings reports when that agency changed Rule 16b. Previously, executives who exercised their stock options were required to purchase the stock at the option price and to hold it for six months before selling. The rule change permitted executives to sell the stock the minute they exercised their options, thus eliminating the executives’ exposure to the market.

Reform took its toll on the culture of accounting firms. In a judgmental era, loose dealings ruined reputations. Partners were paid according to seniority. The accounting industry operated under self-imposed bans on price competition and advertising. With charges that the absence of price competition was anticompetitive, the Federal Trade Commission and the U.S. Department of Justice destroyed this accounting culture during the 1970s. Competition on the basis of reputation and probity was replaced with price competition. Partners ceased to be paid by seniority. Instead, they were paid according to the business they brought to their firms. Accounting firms began consulting with the corporations that they audited, adding conflict of interest ingredients to the more accommodating stance toward clients that price competition had forced upon accountants. Price competition brought pressure to make the client happy. The need to make the client happy undermined the independence of the auditors.

Reformers assume that rules can substitute for character, and they ignore the unintended incentives created by rule making. An accounting culture based on probity was replaced by one in which sharp practices are acceptable as long as they comply with SEC rules.

By making top executives criminally liable for material errors, regardless of whether fraud is intended, Sarbanes-Oxley violates two protective principles of our legal system: mens rea (no crime without intent) and actus rea (evidence of a criminal act). Violating these legal principles is a far greater offense than accounting fraud.

We often hear that "the rule of law" is an advantage we have over our competitors, but the rule of law has been replaced with the discretion of regulators and prosecutors. Today Americans draw prison sentences for unknowingly violating vague regulations, the meanings of which are interpreted by the regulatory police who enforce the regulations. Americans are indicted on the basis of novel interpretations of criminal liability created by the indictment. When felony was ruled by intent, legal certainty was required in order that people could be aware of acts that constituted criminal violations. Now that intent is no longer required, certainly in law has lost its relevance....