Enterprise Resilience Management Blog

Of Diamonds and Dumps

Consumers rarely think about where the products they buy come from or where they end up when they are finally discarded. There is even less thought about the fate of people who provide products that we no longer buy because of the recession. Even those who provide high end products like diamonds have been affected. Diamond mining is tough work, but being unemployed can be even tougher ["Digging in the dumps," The Economist, 30 May 2009 print issue].

"The people of Sierra Leone’s Kono district, in the east of the country, know all too well about diamonds—for better and for worse. In the 1990s, the drugged-up rebels of the Revolutionary United Front controlled Kono’s mines by means of rape, murder and mutilation. When that bloody civil war ended in 2002, mining companies replaced the rebels but brought their own problems. The largest firm, South Africa-based Koidu Holdings, was pitted against locals over blasting schedules and environmental issues. Small-time local miners, little more than licensed freelancers prospecting by hand, were disappointed to find that most of the mines near the surface had been exhausted. The jobs, the volume of production and Kono’s cut of tax revenue from exports disappointed almost everyone. ... Such are the growing pains of a nascent industry in a dirt-poor African country."

The article isn't trying to demonize mining companies. In fact, it reports that "bigger companies, such as Koidu Holdings, have negotiated profit-sharing schemes that will benefit the locals once the mines start making money." The problem is that the current recession has caused commodity prices to plummet including the prices paid for diamonds.

"In response to collapsing demand, mining companies have been temporarily closing mines or reducing production. This does not hurt countries such as Australia and Russia all that much. But it squeezes poorer ones, particularly in Africa, very hard."

With mines closing, it is not just the miners who have lost jobs. Workers throughout the supply chain have suffered.

"At least three-quarters of the companies in Namibia’s young cutting and polishing industry have closed. ... In India, home to the largest diamond cutting and polishing industry in the world, at least 100,000 diamond polishers are out of work."

Ghana is another country whose labor force has been affected by the recession ["Recession in the West Cuts Off An Economic Pipeline in Ghana," by Karin Brulliard, Washington Post, 5 August 2009].

"When the U.S. housing crash triggered economic chain reactions around the world, one ended in a lush forest near [Aduase, Ghana], where on a recent day Emmanuel Awatey was tapping his machete on a log that he very much wanted to chop up. In previous years, Awatey would have done just that, and then carried the wood on his head to the red dirt road nearby. A truck there would have ferried it three hours to the Tekura handicrafts workshop in Accra, Ghana's capital, where it might have been carved into a stool by an artisan, then shipped duty-free to the United States, then sold at Cost Plus World Market for display in an American home. But the U.S. housing market and the global economy collapsed. And so has work for Awatey, the carvers and others working what had been a thriving pipeline from Ghanaian rainforest to American retail."

I wrote this post because I think it's good to remind ourselves occasionally of the people behind the products we buy -- people like Emmanuel Awatey. Awatey, like many other people trying to break poverty's grip, had tapped into the global economy and gained a foothold to a better future. Unfortunately, they are now losing that foothold.

"The financial crisis has checked demand for African commodities, slowing the continent's economies. Less visibly, however, it has also stunted small African exporters who had become fledgling trade success stories -- and micro-level poverty busters -- in a region often associated with gloom. In many cases, these exporters were lifted by a decade-old U.S. program meant to promote economic development through duty-free access to American markets. Now a U.S.-triggered meltdown is erasing many of the gains. ... [The recession has] also reverberated through particleboard factories, mango farms and jewelry studios. As in many sub-Saharan countries, Ghanaian textile and apparel exporters have been particularly hard-hit, ... among them is Prosper Adabla's formerly humming factory near Accra, which manufactured tube socks for export. An end to worldwide quotas on Chinese apparel exports in 2005 brought stiff competition. Two years later, Adabla's U.S. partner went bankrupt. Adabla shut his factory last summer, leaving $1 million worth of socks unsold and 1,000 workers jobless."

In an ironic twist, Brulliard reports that "in an era when retailers are trimming inventories, cutting price points and closing stores, African accessories count as luxuries." All of these stories underscore the fact that the world is more connected than ever before. Crises in the developed world have an exaggerated affect on the quality of life in the developing world. Other things that these stories confirm are the importance of economic diversification, supply chain resilience, and the creation of regional markets. I highlight the importance of these supply side issues during my discussions of Enterra Solutions' Development-in-a-Box™ offering with government and business leaders of developing countries.

But people in developing countries are not just involved in the supply side of the economic supply chain, some of them are involved in helping get rid of trash. People in India dismantle old ships while people in China dismantle old computers and monitors that come from all over the world. Unfortunately, the conditions under which they work, and the toxic substances to which they are exposed, put their lives at risk. Even people picking through trash created locally are subject to these conditions. Their plight is eloquently discussed in a recent op-ed piece ["A Scrap of Decency," by Bharati Chaturvedi, New York Times, 4 August 2009]. Chaturvedi is the founder and director of the Chintan Environmental Research and Action Group. He writes:

"Among those suffering from the global recession are millions of workers who are not even included in the official statistics: urban recyclers — the trash pickers, sorters, traders and reprocessors who extricate paper, cardboard and plastics from garbage heaps and prepare them for reuse. Their work is both unrecorded and largely unrecognized, even though in some parts of the world they handle as much as 20 percent of all waste. The world’s 15 million informal recyclers clean up cities, prevent some trash from ending in landfills, and even reduce climate change by saving energy on waste disposal techniques like incineration. They also recycle waste much more cheaply and efficiently than governments or corporations can, and in many cities in the developing world, they provide the only recycling services."

Most of us have seen pictures of men, women, and children crawling over heaps of trash to find material that they can use or re-sell. We appreciate the desperation that drives them to sort through garbage, but probably don't appreciate the fact that the current recession has made their desperation even more acute. Chaturvedi continues:

"As housing values and the cost of oil have fallen worldwide, so too has the price of scrap metal, paper and plastic. From India to Brazil to the Philippines, recyclers are experiencing a precipitous drop in income. Trash pickers and scrap dealers in Minas Gerais State in Brazil, for example, saw a decline of as much as 80 percent in the price of old magazines and 81 percent for newspapers, and a 77 percent drop in the price of cardboard from October 2007 to last December. In the Philippines, many scrap dealers have shuttered so quickly that researchers at the Solid Waste Management Association of the Philippines didn’t have a chance to record their losses."

We all know that loss of income affects the worker as well as his or her family. Chaturvedi describes what is happening to the families of "urban recyclers."

"In Delhi, some 80 percent of families in the informal recycling business surveyed by my organization said they had cut back on 'luxury foods,' which they defined as fruit, milk and meat. About 41 percent had stopped buying milk for their children. By this summer, most of these children, already malnourished, hadn’t had a glass of milk in nine months. Many of these children have also cut down on hours spent in school to work alongside their parents. Families have liquidated their most valuable assets — primarily copper from electrical wires — and have stopped sending remittances back to their rural villages. Many have also sold their emergency stores of grain. Their misery is not as familiar as that of the laid-off workers of imploding corporations, but it is often more tragic."

For years, much of the developed world has simply purchased and discarded products without much consideration for environmental costs -- including the cleanup of polluted refuse sites. Abuse of the commons has been allowed because it was thought to be an unlimited resource. We are learning that the commons are neither free nor unlimited. With land running out in many places for landfills, there has been some increased interest in recycling; but not enough interest. Until there is a robust aftermarket for recycled material (i.e., a way to make sustainable profits from recycling), getting rid of trash will remain a big challenge. In some European economic sectors, the concept of extended producer responsibility has been instituted. Under this concept, when a manufacturer produces a product it is also responsible for discarding it -- hopefully by recycling its parts. This creates what William McDonough has termed a "cradle to cradle" process. Extended producer responsibility results in manufacturers building products specifically designed to be recycled. Walmart is now jumping on the cradle-to-cradle bandwagon ["Can Wal-Mart Be Sustainable?" New York Times' editorial, 6 August 2009].

"Recently, Wal-Mart has been rolling out plans for what it calls a sustainability index — a measure of how green the products it sells really are. It is asking each of its suppliers, an enormous list of businesses, 15 questions about the life of their products from manufacturing through disposal: questions about greenhouse gas emissions, social responsibility, waste reduction initiatives and water use. It is a sound idea. And probably a very good marketing tool. ... Wal-Mart has already created a Sustainability Index Consortium, which will include environmental groups and other nonprofits, universities and businesses. The consortium will create the criteria for the index, and will share with Wal-Mart the task of building a product-by-product database measuring the environmental impact of each product’s life cycle. ... Wal-Mart has done consistently well by selling at low prices. Historically, however, cheap goods have often reflected careless and unsustainable environmental practices — clear-cutting entire forests, for instance, which is cheaper than selective logging. If Wal-Mart successfully combines cut-rate prices with high-class environmental stewardship, other businesses should follow."

Because trash has limited value before it completes the recycling process, it makes little sense to transport it over great distances. The establishment of regional and local recycling centers around the globe would benefit local environments, provide jobs, and save energy. I realize that the vision of global recycling centers remains a distant dream; but I also believe that actions begin with thoughts. Chaturvedi believes that the dream can emerge slowly in small steps and that doing so will help those now providing informal recycling. He concludes:

"In the long run, though, these invisible workers will remain especially vulnerable to economic slowdowns unless they are integrated into the formal business sector, where they can have insurance and reliable wages. This is not hard to accomplish. Informal junk shops should have to apply for licenses, and governments should create or expand doorstep waste collection programs to employ trash pickers. Instead of sorting through haphazard trash heaps and landfills, the pickers would have access to the cleaner scrap that comes straight from households and often brings a higher price. Employing the trash pickers at this step would ensure that recyclables wouldn’t have to be lugged to landfills in the first place. Experienced trash pickers, once incorporated into the formal economy, would recycle as efficiently as they always have, but they’d gain access to information on global scrap prices and would be better able to bargain for fair compensation. Governments should charge households a service fee, which would also supplement the trash pickers’ income, and provide them with an extra measure of insurance against future crises. Their labor makes our cities healthier and more livable. We all stand to gain by making sure that the work of recycling remains sustainable for years to come."

As I concluded in a previous post, "There is no doubt that the effort required to recycle waste material can be tedious and onerous. There is also no doubt that landfills are filling and waste streams will continue to grow as millions of more consumers are brought into the middle class as globalization helps lift them out of poverty. When recycling becomes a way of life and clean technologies help clear the skies, people will forget the burdens and appreciate the benefits."

Litigating the Past

There is an old joke that if you want to be competitive with a country like China all you have to do is send over a 1,000 lawyers and let them go to work -- the cost of China's goods will surely rise. The U.S. certainly has lawyers to spare. A decade ago BusinessWeek reported that Japan had only 16,800 licensed lawyers compared to 900,000 in the U.S. In the succeeding decade, the U.S. has produced a couple of hundred thousand more lawyers. With so many lawyers, it's not surprising that the United States became a litigious society. It's also not surprising that a percentage of those lawyers see class-action lawsuits as the road to riches. They have been able to convince untold numbers of litigants that there is easy money to be made by suing rich and well-insured businesses. When you look at many settlements, however, the only people who really seem to get rich are the lawyers. I don't mean to imply that the causes taken up by contingency fee lawyers aren't important -- they are. But most people believe that the primary beneficiaries of such lawsuits should be the victims not the lawyers. When big money is involved, however, the temptation to win at all costs is almost overpowering. That is why BusinessWeek reports that "multinationals have long worried about U.S.-style lawsuits taking root in other countries" ["A Bunch of Fake Claims Against Dole?" 6 July 2009 print issue]. The lawsuit against the Dole Food company in Nicaragua is an interesting case in point.

"In suits against Dole Food, Nicaraguan courts awarded $2.2 billion in damages to workers claiming they were made sterile by exposure to the pesticide DBCP on Dole banana farms in the 1970s. Dole has been battling efforts in U.S. courts to enforce these judgments at the same time it fights thousands of additional Nicaraguan DBCP claims filed in the U.S. In 2007 a handful of plaintiffs won $1.5 million in a trial presided over by Los Angeles Superior Court Judge Victoria Chaney. All of this inspired a documentary, Bananas!, which casts the farmworkers' legal team in a positive light. But a 60-page ruling released on June 17 [2009] by Judge Chaney concludes that many and perhaps all of the DBCP claims are fabricated. ... Chaney's 'findings of fact' chronicle a scheme in Nicaragua by attorneys, judges, and others to mass-produce fake cases. Among the findings: Recruiters rounded up men who never worked on a banana farm, providing them with manuals, videos, and 'field trips' to make them credible plaintiffs. Nicaraguan medical labs faked test results. 'An entire industry has developed around DBCP litigation in Nicaragua for the purpose of bringing fraudulent claims,' wrote Chaney, who authorized an investigation and hearings after Dole raised the issue of trumped-up claims. Chaney identified U.S. lawyers who, she says, 'actively participated' in the 'litigation fraud.'"

Dole may or may not have clean hands in this matter. Historically large corporations operating in developing countries have shown little regard for working or environmental conditions -- and those practices are coming back to bite them. The oil industry appears to be on the verge of an era of litigation and the possibility of bogus lawsuits, like the one against Dole, can only send shivers throughout the sector. There have been court cases against Shell in Nigeria, Chevron in Ecuador, and Exxon Mobil in Indonesia ["Oil Industry Braces for Trial on Rights Abuses," by Jad Mouawad, New York Times, 21 May 2009]. One of the most serious charges being made is against Royal Dutch Shell, which is accused of paying to have a Nigerian author and activist Ken Saro-Wiwa executed by Nigeria’s former military regime. Shell, of course, denied the charges but nevertheless agreed to settle the case for the $15.5 million ["Spilling over," The Economist, 13 June 2009 print issue].

"Shell denies any wrongdoing. It says the payout was a “humanitarian gesture”; some of the money will go to a new trust fund for the Ogoni. Shell now hopes that it might even resume oil production in the region. But things are unlikely to be that simple. There has been a mixed reaction to the settlement in Ogoniland. Some Ogonis are disinclined to forget years of mistrust and others are in talks to clean up the oil spills that have been left untended, still oozing into farmland and rivers after 15 years. Ogoniland is just a sliver of Shell’s onshore oil fields, and the out-of-court settlement is unlikely to end the company’s longstanding troubles in a volatile part of Nigeria that is even more violent now than it was back in the 1990s."

Shell was likely willing to settle because the trial that was to be held in New York was going to accuse the company of "crimes against humanity" according to Mouawad. He reports that "the trial [was] the latest in a series of cases aimed at some of the world’s biggest oil companies, asserting misdeeds in developing countries where they were once seen as unassailable. Oil companies are being sued on charges of environmental damage, collusion with repressive governments and contributing to human rights abuses, among others." According to The Economist, Shell's settlement is unlikely to end litigation against the company.

"The payout could also spark further court battles invoking the same American law, the Alien Tort Claims Act of 1789, originally intended to counter piracy, under which the Shell case was brought. It has been used to great effect in recent years, first against foreign officials who violated human rights, and later against firms that appeared to abet such acts. Most of the lawsuits against big companies, however, have been settled out of court, setting no clear precedents."

Mouawad reports that other companies involved in ongoing or past litigation include:

"Chevron [which] could face up to $27 billion in liability in Ecuador for pollution of the jungle. [And] Exxon Mobil [which] is being sued by Indonesian villagers from the province of Aceh who allege human rights violations committed by soldiers hired to guard a natural gas plant. ... In 2004, Unocal, a California oil company accused of using slave labor in the construction of a pipeline in Burma during the 1990s, agreed to compensate villagers there. The terms of the settlement were not made public."

One of the challenges facing leaders of large, multinational companies is ensuring that a system of values is infused through the workforce. The reason that enforcing a value system is so difficult is because ambitious individuals are likely to ignore the values if they believe doing so will advance their careers. I'm a believer, however, that a company must behave ethically and morally and those values cannot be situational. If you care about pollution in your own backyard, you should care about pollution in someone else's backyard. Good corporate behavior is not just the morally correct thing to do, it is also good business. Just look at the potential ramifications of the case against Chevron in Ecuador ["In Ecuador, High Stakes in Case Against Chevron," by Juan Forero, Washington Post, 28 April 2009].

"If the judge rules against Chevron, the company could face the largest damages award ever handed down in an environmental case, dwarfing the $3.9 billion awarded against ExxonMobil for the 1989 spill in Alaska. A report by a court-appointed team last year concluded that pollution caused mainly by Texaco's Ecuadoran affiliate, Texaco Petroleum, had led to 1,401 cancer deaths in this stretch of Amazonian jungle. The team's leader, Ecuadoran geologist Richard Cabrera, reported finding high levels of toxins in soil and water samples near Texaco's production sites and assessed damages at up to $27.3 billion."

Forero reports that "the case has attracted the attention of energy companies worldwide." Companies are beginning (very slowly) to change their ways according to an article published last year in The Economist ["Strange bedfellows," 24 May 2008 print edition].

"A survey by Greener World Media, a consultancy, found that although companies made plenty of announcements in 2007, real environmental progress was hard to spot. But firms are keen to form partnerships with environmental groups precisely to avoid being accused of 'greenwashing'. Besides providing expertise, activists can lend credibility to a company's environmental programmes. Whether activists are 'selling out' when they deal with big firms is the subject of much debate. ... Yet alliances between companies and activists are not as strange as they might seem. For bosses planning long-term capital investments, says Michael Lenox, an expert on corporate sustainability at Duke University, 'uncertainty is more damaging than regulation.' This puts bosses in the same boat as activists: both want regulators to hurry up and set the rules. 'We can't solve these big global challenges without business engagement,' says Mr Cramer, 'and business can't operate without solving these problems. So there is philosophical alignment.' Even so, there is a limit to how much voluntary action can achieve, says James Speth, dean of Yale's School of Forestry and Environmental Studies. In a new book, 'The Bridge at the Edge of the World', he argues that environmental externalities are an unavoidable feature of capitalism, and that bosses are trapped in a system that requires them to act unsustainably when they have the chance. 'In the end,' he says, 'a responsible company is one that is required to be responsible by law.' But until regulators act, companies may find that teaming up with activists is the best hedge against uncertainty."

I'm probably not quite as cynical as Professor Speth. I believe that companies can be responsible without being required to legally act that way. I do agree, however, that regulations help as do standards. Behavior that is measured and monitored is generally improved. The industrial age corporate world is beginning to learn that there is a price to pay for poor performance in the past. Let's hope that the information age brings with it more informed and better behaved businesses. The lawyers will always find something to sue over, but reducing the number causes they pursue is good for both consumers and business. It just may not be good for the lawyers.

Lest readers think that I'm anti-lawyer, let me set the record straight. I take full advantage of legal protections both personally and professionally. My company's general counsel is my most trusted advisor and friend. Any business leader who believes that he or she can be successful without good legal advice is acting the fool. When you really need a lawyer, they can be your best friend. Lawyers, unfortunately, have received a bad reputation from the unethical behavior of a small percentage of lawyers. Past abuses by large corporations will continue to be litigated in the courts. Where real abuses have been committed, it is only right that they should be corrected. My focus, however, is on the future and trying to convince companies in emerging market countries to start out doing things right so that they don't have to look back at some future time and start worrying about getting sued for past misdeeds.

China Discovers Lawyers

In America, lawyers can be ridiculed with humor without touching off any of the "political correctness" alarms raised when other groups are attacked. Attacking lawyers, of course, is nothing new. In the New Testament we read, "Woe unto you, lawyers! for ye have taken away the key of knowledge." Florynce R. Kennedy, herself a lawyer, once said, "The question arises ... whether all lawyers are the same. This is like asking whether everything that gets into a sewer is garbage." Perhaps the most famous line ever written about lawyers is contributed to William Shakespeare. In his play Henry VI, Dick the butcher utters, "The first thing we do, let's kill all the lawyers." The fact is, however, that when lawyers are needed -- to protect their rights or provide defense -- people quickly put aside their negative perceptions and embrace lawyers as friends if not saviors. Still, people elsewhere marvel that America is such a litigious society. Lawsuits are often viewed as a road to an easy fortune. Lawyers are, in part, responsible for creating this culture through advertising, class action lawsuits, and contingency cases. Legal costs, however, are a necessary (and worthwhile) business expense, especially when it comes to copyrights, patents, and protecting intellectual property. This is a lesson the Chinese are quickly learning ["850,000 lawsuits in the making," The Economist, 12 April 2008 print edition].

"Western firms are always complaining about the theft of intellectual property in China. From knock-off designs to copycat brand names, pirated music and fake drugs, China has a well-earned reputation as a free-for-all when it comes to patents and copyrights. Worse, there often seems little hope of redress: the courts are too distant and too incompetent; the laws are too weak or too vague; the culture is too resistant to the very idea of intellectual property. Yet help is at hand, in the form of Chinese firms with patents to defend. Since 2003 the number of trademark applications has grown by 60%; the number of patents has nearly doubled (850,000 are now active) and the number of lawsuits about intellectual property has more than doubled. The government is encouraging the trend in many ways, including signalling to the press to cheer it on."

With Chinese political leaders openly encouraging their scientists and engineers to become more innovative so that China can become a global leader in innovation, this trend is likely to have legs.

"This enthusiasm marks a dramatic change. During the Maoist era, private property of any kind was seen as theft from the masses, and so subject to just expropriation. Only in 1985 did China begin to enact laws to protect patents. It did not enforce them much until 2001, when the authorities promised to crack down in order to win admission to the World Trade Organisation. China has since opened more than 50 courts that deal solely with intellectual-property cases, and Chinese firms are using them. Prominent litigants include a pram manufacturer protecting designs, a soya-milk producer defending an industrial process and a maker of Chinese medicines shielding a name that, roughly translated, means 'mind and blood purge'. As companies in China establish brands and develop products, the incentive to sue will grow, particularly because the cost of bringing a case is minimal. 'If you can afford a car, you can afford a lawsuit,' says Tony Chen, who works in the Shanghai office of Jones Day, an international law firm."

Although there has been an increase in lawsuits by individuals in China, Chinese leaders' enthusiasm for legal action is limited to helping businesses protect their interests. Human and civil rights enforcement are not greeted with the same eagerness. Another difference between the Chinese legal system and America's is that juries are largely uninvolved.

"In America, firms often settle intellectual-property cases out of court for fear of enormous awards by juries. That is not true in China, Mr Chen says, where a judge rules in the majority of cases and damages tend to be small. They normally cover legal costs, however, turning lawsuits into a self-funding method to battle piracy."

That's where the American and Chinese systems share a lot in common.

"Unsurprisingly, the main beneficiaries of the sudden interest in intellectual property are Chinese lawyers. Some reportedly earn more than $5m a year. Non-Chinese law firms sometimes provide advice on thorny cases. But they are not allowed to file patents or appear in court on behalf of a client—a proprietary process that Chinese lawyers are keen to defend."

If the lawyers turn out to be the primary beneficiaries of lawsuits, Chinese jokes about lawyers won't be far behind. For foreign companies that have seen their intellectual property rights ignored by Chinese firms, this new interest in protecting such rights is long overdue. Whether foreign IP rights will be pursued with the same enthusiasm as the protection of Chinese IP rights remains a question to be answered.

In a Twist: Industries Looking to be Regulated

The recent problems with food and toys coming out of China have created a situation where some industries that normally eschew regulation are calling for more of it ["In Turnaround, Industries Seek U.S. Regulations," by Eric Lipton and Gardiner Harris, New York Times, 16 September 2007].

"After years of favoring the hands-off doctrine of the Bush administration, some of the nation’s biggest industries are pushing for something they have long resisted: new federal regulations. For toys and cars, antifreeze and fireworks, popcorn and produce and cigarettes and light bulbs, among other products, industry groups or major manufacturers are calling for federal health, safety and environmental mandates. Some of those industries are abandoning years of efforts to block such measures, often in alliance with the Bush administration, which pledged to ease what it views as costly, unnecessary rules."

This doesn't mean that big industry suddenly got religion. They understand that new regulations are in their best interests.

"The tactical shift by industry groups is motivated by a confluence of self-interests: growing competition from inexpensive imports that do not meet voluntary standards, and a desire to head off liability lawsuits and pre-empt tough state laws or legal actions that were a response to laissez-faire Bush administration policies."

The article points out that industry's timing is also critical. They would rather have regulations passed under a Republican administration than a Democratic one. Apparently, industry doesn't hold out much hope for Republican presidential candidates in the next election.

"But industry officials, consumer groups and regulatory experts all agree there has been a recent surge of requests for new regulations, and one reason they give is the Bush administration's willingness to include provisions that would block consumer lawsuits in state and federal courts. Such pre-emption clauses were included, for example, in a drug label rule issued by the Food and Drug Administration in 2006 and in a new fire-prevention standard for mattresses imposed by the Consumer Product Safety Commission in July, said David C. Vladeck, a professor at the Georgetown University Law Center. The pre-emptions bar consumers from filing liability claims in courts and supersede any tougher state regulations, extremely valuable protections for a major manufacturer, Mr. Vladeck said. 'This is Christmas,' he said of industry, 'this is their wish list.' A number of businesses are seeking such pre-emptions, though the clauses are being challenged in many courts."

There are other reasons that industries want regulations besides clauses that provide them exemptions from lawsuits.

"Some industries and consumer groups are aligned in seeking the same regulations, though perhaps for different reasons. 'It's definitely a strange-bedfellow situation,' said Sarah Klein, a lawyer at the Center for Science in the Public Interest, which is seeking, along with grocery stores and produce growers, new requirements to prevent food-borne illnesses. 'The voluntary system is not working from a food-safety perspective, and it’s creating real problems for the industry.' Other industries, though, are endorsing mandated government standards that fall well short of what consumer advocates want or what tougher state rules require. Trade groups representing makers of antifreeze, upholstered furniture and all-terrain vehicles, for example, had long opposed federal regulations, but are now pushing the Bush administration for rules that consumer advocates say inadequately address safety or environmental concerns. ... Concerns about competition have led to other proposals. As imports from China have grown in recent years, low-priced Chinese products that do not meet voluntary industry standards have motivated trade groups to seek new safety mandates."

I've noted before that internationally recognized standards are important for ensuring that products are safe and workers protected. Industry is just beginning to realize that doing business with unregulated or poorly regulated industries can be a real liability. They may like the freedom that unregulated environments provide, but moving products made in such an environment into the global economy is problematic. In his Weblog, Tom Barnett wrote this about the article:

"Interesting dynamic with Chinese competition: because the Chinese undercut on both price and safety, U.S. industries see regulation as salvation. Oddly enough, so will the Chinese over time. The better our regs work upstream on the Chinese, the more we help their economy become more rule-bound. Good stuff for both sides."

There will always be a tension between regulators and those regulated, but that's not a bad thing. The big winners should be consumers and workers, both of whom should be safer as a result of good regulations around the world. How companies deal with regulations can make compliance either an asset or a liability. Enterra Solutions was originally founded to deal with compliance, security, and business optimization challenges. Whenever routine processes can be automated, especially those associated with regulatory requirements, time, resources, and manpower can be optimized giving the company a competitive edge. As companies learn that they must embrace a certain level of regulation, they will search for better ways to ensure compliance.

SOX Five Years On

Just over five years ago, Congress passed the Sarbanes-Oxley Act in response to the corporate scandals at Enron, WorldCom, Tyco, etc. There have been many complaints about the law and publicly-owned companies have chaffed under its compliance requirements. Over the past couple of years I have written a number of posts on the subject [SOX: The Ante for Business in the 21st Century; Why Regulatory Compliance Remains Important; U.S. Business Regulations to be Examined; More on Compliance & Over Regulation; Small Companies to Get SOX Relief; Attacks on SOX Continue; Investors Like SARBOX; More on the Upside of Sarbanes-Oxley for Investors]. The Economist provides a non-U.S. perspective of the law five years on ["Smelly old SOX," 28 July 2007], but the article begins by giving the common U.S. view of SOX.

"Today, SOX, as it is known, is widely reviled. In boardrooms across the world's mightiest economy, it has become shorthand for foolish, heavy-handed state interference in the wealth-creating marvel that is corporate America. The cost of complying with its requirements, it is said, has been far higher than predicted. It is blamed for promoting risk aversion and mistrust in corporate boardrooms, driving a growing number of public companies into the clutches of private-equity firms, and undermining the global competitiveness of America's capital markets. Much is wrong with SOX. It was passed in haste, and shoddily written. It took little account of current thinking about what a well-designed regulatory system should look like. Section 404 has caused the biggest problems. It makes top managers responsible for a firm's internal risk controls, and requires companies to produce an annual report in which outside auditors 'attest' to their quality—a requirement that has turned out to be unreasonably expensive for small public companies."

Sounds pretty bad doesn't it? Well, the Economist believes it is not as bad as it sounds.

"Section 404 is being dealt with. Small companies have already won temporary exemption from full compliance. A newly issued set of guidelines for auditors ought to reduce the cost of complying with section 404 for other firms. And the other criticisms of the act are overdone. At a time when profits and share prices are touching record highs, it is hard to argue convincingly that America's bosses have lost their capitalist zeal. Boardroom processes have certainly become more bureaucratic since SOX took effect, and board membership has shifted from entrepreneurs to watchdog types. That, however, is not necessarily a bad thing. Bosses may take fewer risks than they did in the past—but they may be taking the sensible risks, and avoiding the bad ones. Firms are indeed flooding away from public markets; but that is happening across the world, so cannot obviously be blamed on SOX. More likely, SOX is a convenient scapegoat for the bosses of public companies, who tend to get more money and less exposure to complaints about fat-cattery when their companies go private."

The law was intended to help protect investors by forcing companies to be more transparent-- a sort of forced integrity. Integrity was a characteristic too many corporate leaders seemed to have lost during the run-up to the Enron scandal. The real losers in many of these cases were employees who not only lost their jobs but lost their entire life's savings because they were tied up in retirement accounts consisting mostly of company stock. The question is, "Has it worked?"

"Once they have stopped fulminating, many bosses privately admit that SOX has brought benefits. Managers are now far more confident about the quality of the numbers they get from their business units. And if buoyant share prices are any indication, the public seems to have plenty of confidence in the markets. Since the purpose of SOX was to get a better deal for shareholders, it may deserve some credit for that. Still, it is too soon for a final verdict on SOX. Only after the next economic downturn will it become clear whether the tighter rules have made American capitalism stronger or weaker. As Warren Buffett likes to say, 'It's only when the tide goes out that you learn who's been swimming naked.'"

The article was written before the latest stock market "corrections," but that correction had nothing to do with SOX. As most people are aware, the latest correction is primarily a response to bad business decisions by sub-prime lenders and investment groups willing to buy bundled mortgage security offerings with little due diligence on their part. Regulatory compliance will always be "painful" because it amounts to the non-productive expenditure of resources. On the other hand -- as the Economist article implies -- companies that have good compliance processes in place generally have higher valuations because investors have greater trust in them. Done right, therefore, a compliance process can actually be an investment rather than a liability. Companies that fully comply with SOX requirements won't be found swimming naked.

China Learning about Resiliency and Trust

I have written several posts that discuss the important role that trust plays in supporting the global economy. In recent weeks, China has learned a costly lesson about trust. It began with the pet food scare and quickly moved to exported food and other products intended for human consumption. China's immediate response was to execute its senior food regulator, but it was unclear to whom that severe signal was being directed. The New York Times editorial staff responded to this episode by sending a signal of their own to China's leadership reiterating the importance of trust not punishment ["Killing the Regulator," 16 July 2007]. They wrote:

"The Chinese government's extraordinary decision to execute its chief food and drug regulator for taking bribes and allowing the sale of tainted drugs is a perfect example of all that is wrong with China’s approach to regulation. Beijing's leaders — who disdain the idea of their own accountability — may think that killing the regulator is enough to reassure consumers at home and abroad that China is now ready to guarantee the safety of its products. But they’re wrong. What China needs is an effective and transparent regulatory system and a clear understanding that its export boom will suffer if it continues to sell tainted food, toys and toothpaste. Until that happens — and there is no guarantee that it will — American regulators will have to do more to screen Chinese imports to protect American consumers."

The timing of this latest crisis in confidence couldn't be worse for China's leaders. They are doing all they can to focus the world's attention on what is good and vibrant about China as they prepare to welcome the world to the 2008 summer Olympics. The New York Times editorial goes on to list a litany of problems that continue to plague China's consumer sector. It also admits what I have seen on my numerous trips to China -- China has a new breed of leader who is committed to making China world class in every way -- including consumer safety.

"The good news is that for the first time China’s leaders are talking about the need for more and better regulation. And Washington and other governments can help with offers of technical advice and warnings about the cost of failing to take it. But the scope of the problem is too big, too complex and too urgent for the United States — with $300 billion worth of Chinese imports a year — to wait for Beijing to act. American importers need to provide the first line of defense. Companies like Wal-Mart should send inspectors regularly to visit the factories of Chinese suppliers, to ensure that products are up to acceptable standards. Ultimately the American government will have to enforce these norms."

While China's long-term efforts will likely prove effective, its short-term public relations efforts may be backfiring. Washington Post Foreign Service correspondent Ariana Eunjung Cha believes that China's leaders have concluded that the current crisis is about bad press not Chinese regulation ["After Silence, China Mounts Product Safety PR Offensive," 14 July 2007].

"Scanning the headlines in the Chinese press, it's easy to conclude that the global brouhaha over product safety is not about China -- but about America. Investigative reports in the state-run media delve into the case of an exploding cellphone purportedly made by U.S.-based Motorola that allegedly killed a young man. They warn consumers not to use contact-lens solution produced by U.S.-based Advanced Medical Optics, which has been linked to rare cases of blindness. And they play up recalls of U.S. beef. Faced with mounting international concern over the safety of some of the products it exports, the Chinese government -- often perceived as defensive and clumsy in how it handles public relations -- is firing back."

Cha reports that China has flooded Washington with lobbyists and hired well-known public relations firms to get their message out.

"The result has been an aggressive campaign to save the 'Made in China' label by presenting an alternate view on consumer safety and globalization. The message is that China isn't the only country that has had problems with the products it exports. China, as government officials have been pointing out in recent days, rejects U.S. imports at a rate that is just a little less than the 1 percent of Chinese products rejected by the United States."

I don't think the "Made in China" label has been seriously undermined in areas except the food sector(both human and pet) and toothpaste sector, which have received the most press. China's leaders seem to think that if they can show that bad things are happening to their consumers who use imported products foreigners will be more sympathetic to defective products that originate in China. Their hopes are ill-founded. Unlike other developed countries, China has no history of strong regulation upon which trust can be based. It is still trying to build that history of trust and pointing fingers at others does nothing to help. Cha does agree that China's leaders are taking the matter of trust more seriously, even as they mount their PR campaign.

"At the same time, the Chinese government is trying to show that it is taking seriously recent recalls by making examples of individuals and companies that allegedly contributed to the problems. The recalls have included pet food laced with an industrial chemical, toys coated with lead paint, defective tires and toothpaste made with toxic chemicals. The government has played up the fact that Zheng Xiaoyu, country's former chief food and drug regulator, was executed this week and that 180 factories that put industrial chemicals into food have been shut down."

Still, Cha insists, it is difficult to break habits fostered by years of propaganda aimed at putting a happy face on dire situations -- sort of like putting lipstick on a pig. China's propaganda machine is changing, however. Where once it was used primarily to influence internal politics, it is more and more geared to getting its message to foreigners. While such propaganda does little to foster trust, the fact that Chinese leaders care about foreign perspectives is a good sign. They are trying to connect.

"When questions about Chinese food safety arose in March, following the death of scores of pets in the United States, the Chinese government's response was silence. Then it was denial, as officials brushed off the accusations as fabrications and called them another salvo in a growing trade war between the two countries. But in recent days, the government has gone on the offensive. It is issuing almost daily statements saying how much it is doing to improve food and consumer safety. On July 3, it reported it was stepping up anti-corruption efforts. On July 4, it said it would ban firms that advertise medical claims that have not been approved by the government. On July 5 it said it was working on the country's first food recall system. ... In a two-hour session with reporters on [10 July], a panel of high-ranking officials from five agencies responsible for food safety handed out about 50 pages of information in Chinese and English about specific actions China is taking to overhaul its food and drug safety system. The officials repeatedly assured reporters that China's government is 'a responsible government.'"

Still, admitting errors does not come easy for the communist regime (or others for that matter). Take, for example, a recent news conference held in Beijing. Cha reports:

"At a news conference last week, Qin Gang, a Foreign Ministry spokesman, uncharacteristically fired back at reporters who asked if he would comment on why the quality of Chinese exports had become an issue of such intense debate worldwide. 'Why don't you tell me?' he said. 'If the media made less sensational news, the situation might not be so bad. . . . Chinese exports are at least as safe as U.S. exports -- if not better than them.'"

To underscore the fact that things are changing, Cha's article included a critical comment from a university professor -- something that would have been unthinkable in the past.

"Shi Anbin, an associate professor of media and cultural studies at Tsinghua University in Beijing, said that trying to turn the tables and focus attention on problems with U.S. products is 'not a wise strategy. We need to face our own problems rather than pointing an accusing finger at a scapegoat,' Shi said. 'I believe Chinese officials still need to learn some PR and communication skills.' ... Meanwhile, many Chinese companies that have been caught up in the recent recalls because they have produced shoddy products or because they compete with companies that do are taking their cues from the government and scrambling to distance themselves from the scandals. They frequently say it is unfair to treat all Chinese companies like criminal operations."

This winnowing process, accompanied by a strengthened regulatory and inspection regime, will go a long way towards helping China build the foundation of trust it needs to stay atop the global economic pyramid. Cha's article concludes with comments from a Dan Harris, an occasional reader of this blog:

"Dan Harris, a U.S.-based attorney who runs a popular China law blog and represents small to mid-sized companies doing business with China, said the shift in the government's public relations strategy 'is definitely smart on their part. They are not going to convince Americans that everything is okay just by denials.' He predicted it would take years, if not decades, to undo the damage done to the reputation of Chinese manufacturers in recent months. 'My view is that no matter what they say they are going to do and no matter how much they want to do it, the problem is so massive and so deep-seated that I think it's going to take huge amounts of money and a very long time for it to be cleaned up,' he said."

Dan is right. Trust must be earned and that takes years. Trust is developed more by actions than by words. China will likely continue its PR campaign -- because perceptions do matter -- but eventually PR must be replaced by action that fosters genuine trust. China will get there, but, as Dan says, it's going to take a very long time.

Incompetence to the Maxx

Last week the parent company of TJ Maxx (TJX) reported the theft of nearly 46 million credit and debit card numbers from customers in the United States, Britain and Canada. This didn't happen in one fell swoop (like the loss of laptop or theft of a CD), it took place over a period of years. ["Data Theft Grows to Biggest Ever," by Ellen Nakashima and Ylan Q. Mui, Washington Post, 30 March 2007].

"The figure, which the company said is incomplete, represents the largest reported computer theft of personal data in history. ... According to the filing, TJX discovered suspicious software on its computers Dec. 18 and began an investigation. Three days later, the company concluded that a breach had probably occurred and that the intruder was still on the system. The next day, it notified federal investigators. On Dec. 27, the firm learned that customer data had been stolen, and it notified banks and check-processing companies. On Jan. 17, TJX announced the intrusion but did not say how much data was taken. Based on the firm's investigation, the intrusion occurred in July 2005, on subsequent dates in 2005 and from mid-May 2006 to mid-January 2007. No customer data was stolen after Dec. 18, 2006. Three-quarters of the cards were expired or contained magnetic strip data that was masked or stored as asterisks rather than numbers at the time the information was stolen. The firm stored data, some of which dated to 2003 transactions. Expired cards can still be at risk because they are often renewed with the same numbers, and the TJX filing said the hackers' technology could have penetrated masked data. The thieves stole data from the firm's computer systems in Framingham, where transactions are processed for customers in the United States, Puerto Rico and Canada. They also took data from systems in Watford, England."

Anyone who has ever been mugged, had their car broken into, or had their house robbed knows how violated they feel afterwards. Forty-six million shoppers should have that same feeling right now. Whenever you hand over a credit or debit card to a merchant, you are demonstrating a high level of trust in that company -- both its employees and processes. You assume that they will take extraordinary measures to protect your property (in this case, your identity and credit). TJX violated that trust in a huge way and needs to take extraordinary measures to recover its reputation. Otherwise, the company should suffer the consequences to the Maxx.

"TJX, whose 2,500 stores include clothing chains T.J. Maxx and Marshalls, reported the breach in January but disclosed its massive scale for the first time in a filing made to the Securities and Exchange Commission after business hours Wednesday [28 March]. The computer breach is significant not only because of its scope but also because the hacker or hackers had access to the decryption tool used to decipher sensitive encrypted information and an ability to intercept data as shoppers' credit transactions were being approved. Thieves have been using the data to make fraudulent purchases in Florida and as far away as Sweden and Hong Kong, according to police and bank officials. Also taken were personal ID numbers, related names and addresses, and drivers' license, military and state ID numbers from 455,000 shoppers who made merchandise returns in the United States and Puerto Rico. The Framingham, Mass., firm acknowledged in the filing that it 'may never be able to identify much of the information believed stolen.'"

When you think about it, the entire economy relies on trust. People give merchants little pieces of paper (called money) or little pieces of plastic (called credit or debit cards) and in return customers get real products like televisions, computers, and meals. Merchants trust customers and and customers trust merchants. Break down that trust and you break down the economy. That is perhaps the greatest irony of identity theft. Criminals, whose activities undermine that trust, rely on it to make their crimes profitable.

Lawmakers who understand the importance of maintaining that trust have proposed legislation that would make companies responsible for breaches of trust.

"Legislation pending in Massachusetts would make retailers responsible for the financial cost of data breaches, currently covered by banks that issue the credit cards. Rep. Barney Frank (D-Mass.) is considering introducing a similar bill in Congress."

TJX's incompetence in protecting data should serve as a cold shower to sleepy merchants who remain lax or unvigilant in their transactions. The 17 February 2007 cover of The Economist carries the headline "The end of the cash era." If other major merchants prove as incompetent as TJX in handling credit and debit transactions, the cash era may be around for a long time.

"The breach is a wake-up call, analysts said, to retailers, consumers and regulators about the increased sophistication of hackers and the need to improve data security. 'In the old days, a fraudulent store employee could steal 30 or 40 credit cards a weekend,' said Mark Rasch, technology director with FTI Consulting, which helps firms prevent data breaches. 'Now we're at the point where a motivated hacker can steal 30 or 40 thousand cards in a weekend. And a team of motivated hackers can steal 30 or 40 million.' Avivah Litan, a security analyst with Gartner, said investigators told her they thought hackers gained access through a wireless network that managed the cash registers and terminals. Once in, they were able to find their way to systems in Britain, Puerto Rico and Canada. 'The lesson is that one little hole in your network through a wireless network can lead you to the entire corporate treasure,' Litan said. This month, Florida police arrested six people suspected of using stolen TJX credit card data to purchase $8 million in gift cards and electronic goods, said Keith Kameg, an officer in Gainesville. The arrests are among the first indications that the stolen information is being used to buy goods fraudulently, and Kameg and others said they expect many more cases to turn up."

The first consequences of the TJX breach are already beginning to occur.

"Since January, when TJX disclosed the breach, it has been the target of class-action lawsuits by shoppers in Massachusetts Alabama, California, Canada and Puerto Rico. 'They're obviously not happy,' attorney Jon J. Lambiras said of his clients in Massachusetts. 'They're very concerned that they're at risk for identity theft.'"

This story will continue to play out as more reports of identity thefts occur. Millions of unproductive hours are likely to be spent (along with hundreds of millions of dollars) in straightening out the mess created by this breach of trust. What is TXJ's response to this mess?

"TJX is cooperating with a federal criminal investigation. State and federal authorities are also looking into whether TJX violated consumer-protection laws. TJX spokeswoman Sherry Lang suggested that TJX was simply the most visible example of a widespread trend. 'Breaches go on all the time that never get detected and never get reported,' she said. 'I think we have been victimized here along with our customers.'"

Somehow I don't think the real victims will see TJX as a victim. In today's society, however, nobody wants to take responsibility -- it's always someone else's fault. That's not enjoying life to the Maxx or taking responsibility to the Maxx.

U.S. Banks Having Trouble with Basel 2

One the international standards that was aimed at improving the banking industry was hammered out in Basel, Switzerland, three years ago. According to an article in The Economist, the U.S. banking industry is having more difficulty than its European counterparts in implementing the Basel 2 accord ["A twist or two of Basel," 24 Feb 2007].

Since January 1st many European banks have begun implementing the new [Basel 2] rules, which govern how much capital they must set aside to cushion themselves from various calamities. The same process was meant to be unfolding in America. But there the banks are struggling to get their mouths around the new accord. A great deal of money is on the line for banks on both sides of the Atlantic. The more capital they must squirrel away to satisfy regulators, the more insulated they are from untoward events—but the less money remains to be put to work in order to make profits."

Considering shockwaves that have hit Wall Street as a result of defaulted high-risk mortgages, one would think that banks would have firm plans in place for making themselves more resilient to such calamities. In Europe, they apparently are:

"Happily for the bottom lines of big European banks, regulatory capital is expected to drop under the new regime—perhaps dramatically. Under Basel 2, the amount of capital a bank must sit on depends on the riskiness of its loans and other assets. So those expert in managing and minimising risk—by packaging loans into securities and selling them on, for example—can get away with a thinner cushion than others. Indeed, big, sophisticated banks will largely make up their own minds about how much capital to set aside, as long as their internal risk-management models are up to snuff. This is meant to reward the banks that already invest in cutting-edge risk-management methods, and prod others to catch up."

The news is not as good for U.S. banks:

"Banks in America, on the other hand, are glum. Their regulators have taken fright over studies showing that banks' required capital could fall by an average of 16% if they embraced the new accord. European regulators are inclined to let regulatory capital fall (subject to the discretion of national authorities). American regulators are not. They have now proposed changes in America's version of Basel 2 that will delay its implementation until at least January 2009. Under their proposals American banks will be subject to a number of 'safeguards' that keep capital cushions plump. These include the 'leverage ratio,' a blunt measure of a bank's lending exposure that is not linked to the riskiness of its activities."

One of the real peace dividends brought by the end of the Cold War was the fact that the global economy could move forward using the same rules. Basel 2 was supposed to establish that sort of international standard.

"The accord was intended as a single worldwide standard. But it now threatens to be qualitatively different in Europe and America. International banks that straddle the Atlantic are in a bind and America's large banks are especially irritated. On February 7th four of them, including Citigroup and JPMorgan Chase, wrote a letter of complaint to regulators. These extra restrictions, the banks wrote, give foreign competitors an edge, because they can hold less capital for identical assets. There may be some truth in this. But America's regulators are too uneasy about the Basel 2 project to lighten up. They think the accord relies too heavily on banks' in-house risk models, which are fallible and 'highly subjective,' as one regulator put it. Quietly, some also worry about European banks, which already have much higher levels of leverage than American ones and hold less capital to offset it. Others fret about a lack of transparency. Under Basel 2, national regulators can force individual banks to boost capital reserves if they see fit. But in Europe it is unclear what an unacceptable level of capital might be, or how bank regulators would react if a bank edged towards it."

U.S. regulators, according to the article, have reasons for being more rigid in their approach. The U.S. has suffered a series of financial institutional failures that resulted in losses for millions of victims. Since the government had to pick up the bill for many of the consequences of these failures, regulators are not eager to ease regulations aimed at preventing future financial crises. The Economist writes:

"There is no such ambiguity in America, where banks have been held to a stringent regime known as 'prompt corrective action.' This came into law in 1991 in the wake of America's savings-and-loan debacle, in which more than 2,900 banks failed. Then, regulators repeatedly threw lifelines to struggling banks, which only postponed their inevitable collapse. Now, they have much less scope for leniency. They must take specific, and increasingly severe, actions—from curbing lending to closing a bank—as a bank's capital ratios deteriorate. The idea is to intervene before banks get into trouble, and to make the consequences of falling into the red zone clear to banks and investors well before anything bad happens. American regulators will not budge on these issues soon. Indeed, Sheila Bair, one of America's bank regulators, thinks that her foreign counterparts should adopt something like the American approach to buttress Basel 2. A number of European bank regulators and academics agree. But politicians in Europe have reservations. They point out, rightly, that America's approach is largely untested, because the country's banks have enjoyed good times since 1991. They also worry that adding the leverage ratio, which disregards risk, to Basel 2 would render all their past work irrelevant."

American banking customers are much more interested in the security of their accounts than in the profitability of their bank. Basel 2 doesn't necessarily make these two positions mutually exclusive:

"In fact, each side can learn from the other. The Europeans should add clarity to Basel 2. The Americans should add a bit of urgency to implementing it. No doubt the accord has flaws, but these can be fixed later. In the meantime, it would be better to finalise a rule on Basel 2."

International cooperation and standards are critical for moving the global economy forward. Trying to find a European way or an American way or an Asian way to globalize will undermine the hope that this wave of globalization has brought with it.

More on the Upside of Sarbanes-Oxley for Investors

Last month I posted a blog about the fact that while public corporations dislike many provisions of the Sarbanes-Oxley legislation, investors seem to like it [Investors Like SARBOX]. I was commenting on a BusinessWeek article by David Henry ["Not Everyone Hates SarbOx," 29 January 2007]. Tom Barnett's web master Sean Meade pointed me to an article that discusses the fact that University of Iowa researchers Sonja Rego and Haidan Li confirm Henry's observations ["UI researchers show gains from Sarbanes-Oxley," Iowa City Press-Citizen, 20 February 2007]. The article notes:

"While corporate executives say their businesses are groaning under the weight of complying with Sarbanes-Oxley regulations, two University of Iowa business professors have found that most investors cheered the law during its early days. Research by Sonja Rego and Haidan Li in the Tippie College of Business shows that stock market values increased significantly as a result of the reforms imposed by the Sarbanes-Oxley Act in July 2002. The two authors said that while the law may impose burdens on businesses, it has restored investor confidence in a market that was battered by a six-month long string of corporate scandals from Enron to WorldCom. Their research also found that market values increased even more significantly for those corporations that were thought to have been the most aggressive in managing -- and occasionally manipulating -- their earnings in order to artificially inflate their stock price."

At Enterra we have argued for some time, based on research done by Gartner, that valuation increases when corporations are proactive in their approach to compliance. The article notes that corporations chafe under SOX requirements, but:

"Rego and Li's research found that whatever controversy there might have been about the potential costs SOX would impose was outweighed by its expected benefits as investors were looking to have their faith restored in the market. In their research, Rego and Li followed the price of 850 stocks starting on June 25, 2002, the date of the announcement of a $3.8 billion accounting fraud at WorldCom, the largest corporate fraud in American history at that time. Stocks sunk to new lows on news of the fraud, as investors increasingly lost faith in companies' earnings statements. The WorldCom scandal turned out to be the event that spurred Congress to reform corporate governance and accounting regulations. The government's response began almost immediately, with the SEC filing suit against WorldCom executives on June 26 and requiring chief executive and chief financial officers at all publicly traded U.S. companies to certify their companies' financial statements. Within a month, Congress had passed what would become the Sarbanes-Oxley Act, which was signed into law by President Bush on July 30. Stock prices began to rebound almost as soon as the SEC announced its actions on June 26, as stock returns increased by 3.6 percent by the end of the trading day June 27 from their lows of the day before. The market dropped again in the coming weeks amid more accounting fraud revelations and a general consumer gloom about the economy, but increased once more on July 24th, when a Congressional conference committee issued the Sarbanes-Oxley Act and sent it to the House and Senate for approval. On that news, the market jumped 5.4 percent. It jumped another 5 percent on July 29, when the SEC said it would publicly identify those CEOs and CFOs who did not certify their firms' financial statements. Overall, the market jumped 11 percent by the end of the study period on Aug. 15 from its post-WorldCom low on June 26. Li and Rego said the increase is largely the result of investor confidence that SOX would make companies' financial statements more accurate and reliable."

Congress is going to have to walk a fine line as it considers how to relieve some of SOX's more onerous provisions while preserving enough financial reporting to justify continued investor confidence. Whether it can accomplish this in the term leading up to the 2008 presidential elections remains to be seen. Businesses may see this as an opportunity to buy relief with political contributions, but this early in the race neither party has a clear frontrunner for president. Corporations may not see that as too problematic since they can beneficially concentrate on Congress -- especially on senators up for re-election and on House members. If remedial legislation fails to pass Congress, it really doesn't matter who wins the White House. The risk for Congress, of course, is that remedial legislation that retreats too much from stiff reporting requirements could result in voter backlash. Corporations are betting that voters won't care and hope the next election remains a referendum on the war in Iraq.   

Investors Like SARBOX

According to a BusinessWeek article by David Henry, Sarbanes-Oxley regulations have been a big hit with investors ["Not Everyone Hates SarbOx," 29 January 2007]. There has been no shortage of news about how unhappy businesses have been with the legislation and I've written several posts about their displeasure [Corporations, Compliance, & Competitiveness, More on Compliance & Over Regulation, Small Companies Get SOX Relief, and Attacks on SOX Continue]. Henry notes:

"The complaints have been so passionate that regulators are now planning to loosen the rules, probably before the year is out. Not so fast, says a growing chorus of investors. Lost amid all the boos over SarbOx, they say, are some major benefits. The biggest: SarbOx and related reforms have produced much more reliable corporate financial statements, which investors rely on when deciding whether to buy or sell shares. For them, SarbOx has been a godsend. What's more, says Duncan W. Richardson, chief equity investment officer at Eaton Vance Management and overseer of $80 billion in stockholdings, even the act's much disparaged requirements for testing internal financial controls could drive gains in corporate productivity and profits."

Henry notes that earnings statements have been better prepared and have contained less spin since SOX legislation was passed. In addition, executives seem to have a much better grasp of costs. Henry writes:

"Beefed-up disclosure requirements have also meant that companies now deliver numbers with fewer adjustments for unusual charges and write-offs, which in the past have been used to make earnings look better. Thomson Financial's Earnings Purity Index, which tracks earnings adjusted for such write-offs, shows improvements in each of the past four years. And now earnings reports reflect expenses for incentive stock options, information investors like that wasn't available before the big accounting scandals. Just as important, executives appear to have a firmer grasp of costs when they talk about operating margins, according to Richardson of Eaton Vance. He credits the improvement to the infamous Section 404 of SarbOx, which requires documented testing of internal controls. 'Even not-so-good management teams have good controls now, and that leads to an ability to cut costs,' he says."

While all of this sounds good, complaints have mostly been about costs making companies non-competitive. This is especially true for small public corporations. Henry notes:

"This isn't to say SarbOx is flawless. Section 404 is often applied unreasonably, causing costly checks of minor book entries. It's bad, too, that small-scale businesses find fewer benefits relative to the costs."

Large public corporations also have reason to complain because they have met the compliance challenge by throwing money and people at it. At Enterra Solutions, we believe costs and errors can be reduced by automating compliance associated processes. Once in place, these automated processes provide corporations with a competitive edge over rivals. Despite the praise for SOX, Henry warns that investors should still be wary of financial reports.

"Lack of growth often exposes aggressive accounting estimates used to manipulate earnings. And that's when some capital investments are revealed to have been hiding operating costs. Still, the next round of abuses to surface will probably not be as bad as it would have been without the reforms. Says Eaton Vance's Richardson: 'You're always better going into any downturn with tighter rules.' For regulators eager to start tinkering, that's food for thought.

Corporations can dream about Sarbanes-Oxley going away, but dreaming is about all they can do. Investors, regulators, and legislators have shown no penchant for letting businesses off the hook so that they can return to the accounting practices that brought down Enron and Worldcom. Henry indicates that even those who believe that the legislation needs tweaking need to be careful about how it is done.