The 19th century British scientist Thomas Huxley once famously said, “Many a beautiful theory has been killed by one ugly fact.” Those words were true when he uttered them in the 1860s to support Charles Darwin's radical idea of natural selection—and they are equally true today, as Washington debates the merits of the Sarbanes-Oxley Act. And we have MF Global to thank for it.
The theory is, Sarbanes-Oxley imposes too high a burden on public companies to be worth the bother. You hear this all the time from Republican lawmakers and presidential candidates. Usually they only use the phrase “Sarbanes-Oxley” but the particular part of the law they mean is Section 404, which requires companies to: (a) declare whether or not they have effective internal control over financial reporting; and (b) have those internal controls inspected annually by an external auditor. Compliance with Section 404 costs too much money, the theory goes, so SOX should be revised or repealed to make U.S. corporations more competitive on the global stage.
The fact is, MF Global had poor internal control over financial reporting, and now cannot find at least $600 million—and possibly $1.2 billion—in customer deposits that were supposed to be protected in the event of bankruptcy.
Exactly how did MF Global lose that much customer money? Nobody knows. Evidence so far suggests that in the days before MF Global filed for bankruptcy on Oct. 31, the commodities trading firm transferred that customer money into its brokerage accounts to cover mounting losses. That's not supposed to happen, per order of the Commodities Exchange Act.
And yet, somehow, it did.
Strict internal control over financial reporting is supposed to prevent this sort of stunt, and in theory, MF Global had that internal control in place. In its last complete quarterly filing from Aug. 3, MF Global asserted on Page 97 that its internal controls were just peachy. Ditto for its last annual report from May 20, where you can see the assertions on Page 132. Its external auditor, PwC, never raised any concerns about MF Global since it became the firm's auditor in 2007. (PwC, by the way, billed MF Global $12 million in 2010 to reach that determination.)
Cynic that I am, I assume the $600 million in lost customer money will never be recovered. That's $600 million in capital intended for some other purpose—more trading, retirement savings, business expansion; whatever—that will never be achieved. Someone will hire fewer people because of this; someone else will work harder and longer into retirement years; another will pay a higher interest rate for a loan, and so forth.
In corporate compliance we often talk in abstract theories about best practices, so let's not forget the human element here: Real people put their faith in our system of corporate regulation to protect them, so they could get on with planning their lives. Then that system failed them, and they're suffering through an unwanted, unexpected risk as a result. If you ever wonder why employees commit fraud, or turn a blind eye to misconduct and tend to their own interests, or skip work to sit at an Occupy Wall Street protest, think of MF Global.
The easy shot here would be to dismiss conservatives and their anti-regulation rants as ill-informed, oblivious to the basic truth that the more inter-connected society is, the more regulation it needs to prevent catastrophic surprises. I'll certainly take that shot: Congress shouldn't repeal Section 404, and in fact should have extended Section 404(b) to small public companies since they commit fraud too.
But that stance doesn't address the basic problem that misconduct still happens. In other words, while repealing Sarbanes-Oxley or the Dodd-Frank Act would make matters worse, it doesn't automatically follow that extending or implementing those laws fully will make matters better. Indeed, I look at the misconduct at MF Global and think of the laws for gun control: large cities like Washington, D.C. or Chicago have some of the toughest restrictions on gun ownership in the country, yet they're still among the most violent cities in the United States. Gun advocates stress that outlaws couldn't care less about gun control laws—and I suspect that mentality is just as true for corporate wrongdoers.
The solution is not to dismantle or further undermine the regulatory structure we already have; MF Global has provided 600 million reasons why that is clear. Nor should we rush to embrace more regulation, either, if it won't make any difference. But we should all sit down and try to figure out how to make regulation of corporate conduct smarter—because we're not doing a great job of it now.