NEWS INDEX Archives 2005 August

Sarbanes-Oxley Act unfair when company is bankrupt, law scholar says

Mark Reutter, Business & Law Editor
217-333-0568; mreutter@uiuc.edu

8/16/05

CHAMPAIGN, Ill. — The Sarbanes-Oxley Act – sometimes referred to as SOX – has come under heavy fire from business groups for adding to the cost of annual corporate audits. Another problem with the law is its encroachment on the U.S. Bankruptcy Code, according to an article in the University of Illinois Law Review.

Zack Christensen, an editor at the journal, faults the Fair Funds for Investors provision, contained in section 308(a) of SOX, for allowing the Securities and Exchange Commission to place civil penalties on a company that commits fraud on behalf of shareholders.

Passed in 2002 following huge shareholder losses at Enron Inc. and WorldCom, SOX set tough new standards for financial reporting and imposed greater accountability on corporate boardrooms and top executives.

While its aims are laudable, SOX still needs some fine-tuning, according to Christensen. For example, for companies under bankruptcy protection, the 308(a) provision conflicts with the rights of other creditors, including suppliers and former employees, to secure assets remaining in the company’s estate.

Using the WorldCom bankruptcy as an example, Christensen examined the SEC’s successful effort to secure $750 million in cash and stock for shareholders as part of the company’s emergence from bankruptcy last year. (The company, renamed MCI, has since been merged into Verizon Communications.)

Shortly before Congress passed SOX, WorldCom announced it had uncovered a $3.8 billion accounting irregularity and fired Bernie Ebbers, its founder and chairman. The eventual unraveling of $12 billion in inflated assets – the biggest corporate accounting fraud in U.S. history – and bankruptcy filing left shareholders with losses estimated at $200 billion.

Longstanding precedent calls for stockholders to be at the bottom of the list of creditors in the estate of a bankrupt company. But by invoking the Fair Funds for Investors provision, the SEC successfully won the $750 million settlement for shareholders.

Examining the legislative record, Christensen found nothing to suggest that Congress intended to override standard bankruptcy practices, which place shareholders’ claims below those of other creditors.

“Congress’ primary motivation behind implementing the Fair Funds for Investors provision was to promote a sense of fairness in the general public by requiring that corporate executives surrender assets to the shareholders who were harassed by the executives’ orders. Such a purpose does not justify disrupting the well-established distributional priority of the Bankruptcy Code.”

The author recommends that Congress amend the SOX provision to adhere to section 510(b) of the Bankruptcy Code before more conflicts arise between shareholders and other creditors of a bankrupt company.

His article is titled “The Fair Funds for Investors Provision of Sarbanes-Oxley: Is it Unfair to the Creditors of a Bankrupt Debtor?”