Document Type

Working Paper

Publication Date



Center for Law and Economic Studies


Center for Contract and Economic Organization


Between January 1997 and June 2002, approximately 10% of all listed companies in the United States announced at least one financial statement restatement. The stock prices of restating companies declined 10% on average on the announcement of these restatements, with restating firms losing over $100 billion in market capitalization over a short three day trading window surrounding these restatements. Such generalized financial irregularity requires a more generic causal explanation than can be found in the facts of Enron, WorldCom or other specific case histories. Several different explanations are plausible, each focusing on a different actor (but none giving primary attention to the board of directors): 1. The Gatekeeper Story looks to the professional "reputational intermediaries" on whom investors rely for verification and certification - i.e., auditors, analysts, debt rating agencies and attorneys - and views the surge in financial restatements as the product of both (a) reduced legal exposure for gatekeepers (as the result of legislation and judicial decisions in the 1990's sheltering them from liability) and (b) the increased potential for consulting income or other benefits from their clients (resulting in gatekeeper acquiescence in accounting or financial irregularities). This is essentially the story to which the Sarbanes-Oxley Act responds. 2. The Misaligned Incentives Story instead focuses on managers and a dramatic change in executive compensation during the 1990's, as firms shifted from cash to equity-based compensation. Stock options (and legal changes that enabled management to exercise the option and sell the security without any delay) arguably gave management a strong incentive to inflate reported earnings and create short-term price spikes that were unsustainable, but which they alone could exploit. Sarbanes-Oxley does not address this potential cause of irregularities. 3. The Herding Story focuses on the incentives of investment fund managers and argues that they are uniquely focused on their quarterly performance vis-a-viz their rivals. As a result, they have an incentive to "ride the bubble," even when they sense danger, because they fear more the mistake of being prematurely prophetic. Again, Sarbanes-Oxley does not address this cause of bubbles and price spikes. This comment compares and contrasts these explanations, finding them highly complementary.