Investor Protection

Investors have certain rights that are generally protected through the enforcement of rules, regulations, and laws. Many of these rights include disclosure and accounting rules that provide investors with the information they need to exercise other rights. Other protected investor rights include things such as participating in shareholders' meetings, receiving dividends on pro-rata terms, voting for directors, subscribing to new issues of securities on the same terms as insiders, being informed about the risks, obligations, and costs of an investment, and having orders executed promptly at the best available price.

In addition, as we saw with companies such as Enron, Adelphia, Tyco, and WorldCom, among others, investors need protection from financial scandals. Quite often scandals involve insiders using their discretion to mislead investors and other outsiders through their financial reporting. Investors have the right to receive clear and timely information that allows them to make informed decisions.

Through the use of earnings management (deliberately manipulating a company's earnings so that the figures match a predetermined target) or impression management (presenting a company's performance in the best light possible, potentially resulting in selective financial communication), companies can structure their disclosures in ways that are potentially misleading or unclear. Such earnings opacity can take the form of earnings aggressiveness (results from the tendency to increase reported earnings), loss avoidance (results from the tendency to avoid reporting negative earnings), and earnings smoothing (results from reporting artificially stabilized earnings). These three practices undeniably weaken the link between accounting performance and the true economic performance of a company. In addition, this obfuscation of financial disclosures can make it difficult for investors to make accurate informed decisions; therefore, investor protection is needed.

Often, investor protection through legal action is highlighted as the key factor affecting the quality of earnings reported. This is because insiders enjoy fewer private control benefits and hence have lower incentives to conceal firm performance from outside investors.

In the aftermath of the stock market crash of 1929, the U.S. Congress created the Securities and Exchange Commission (SEC) as part of the Securities Exchange Act of 1934. This was intended to restore investor confidence in our capital markets. Still, today, the mission of the SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

Sixty-eight years after the SEC was created, Congress passed the Sarbanes-Oxley Act (SOX). SOX (also known as Public Company Accounting Reform and Investor Protection Act) was signed into law by President George W. Bush on July 30, 2002. It has had a major impact on the way that all U.S. publicly traded companies conduct and document their businesses. Essentially, SOX was created to reverse the public's declining trust in the accounting and financial reporting process by providing a level of investor protection through regulation. To accomplish this, the Public Company Accounting Oversight Board (a private-sector, nonprofit corporation) was created to oversee the financial reporting of public companies. SOX requires companies to, among other things, have their chief executives sign off on their financial statements; strengthen auditor independence; and have an internal [Page 940]audit function that is examined by external auditors. More than five years after its passage there can be little doubt that SOX has strengthened corporate accountability, thus successfully providing a level of investor protection.

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