Category Archives: Politics and Business

The End of Socialism but Not The End of Social Welfare

Dr. Allan H. Meltzer is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Resrve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank.   He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society.

Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.”

This Paper was presented in the September 2012 Mont Pelerin (Society) Meeting, Prague, Chekia


Socialism – public ownership of all (or most) productive assets – failed whenever it was tried.  Only two avowed socialist states remain – Cuba and North Korea.  Cuba is dragging itself slowly toward some private ownership.  Literally no one admires North Korea.

For reasons that Freidrich Hayek and some other founders of this society understood well, most socialist states were authoritarian and non-democratic.  India and Britain are obvious exceptions.  Both tried so-called democratic socialism.  Both eventually increased free market arrangements.  Growth rose and poverty declined markedly.

Only capitalism achieves growth in living standards and personal freedom.  Freedom depends on ownership of physical and human capital because capital permits people to become one’s own boss.  But freedom and capitalist development require the rule of law.  Rule of law mandates that all citizens are equal before the law and to the extent possible all are treated the same.

Hayek claimed that the rule of law contributed greatly to the success of British and U.S. capitalism.  Socialist countries rarely observe the rule of law.  They work to apply someone’s idea of a utopian society.  What they believe is good and right replaces the rule of law with decrees that allegedly achieves conformity to the socialist ideal.

In contrast, capitalism adapts to many different cultures.  Capitalism in Japan differs from capitalism in Western Europe, as these differ from U.S. capitalism or state capitalism in China and elsewhere.  In free societies, people choose the rules under which they choose to live.  In socialist societies, rulers impose their utopian vision.

The postwar years began with a widely shared belief that socialism would be the arrangement chosen in most countries.   Even Joseph Schumpeter drew that conclusion.  The founders of the Mont Pelerin Society dissented.  They were a small minority, but they understood that freedom was valuable to people in a way that rigid socialist orthodoxies never could duplicate.  And they understood that free men and women could achieve sustained growth.

The attraction socialism once had weakened as the Soviet Union failed to achieve either growth or freedom.   With the decision by authoritarian China and domestic India to expand private ownership and adopt liberalizing measures, all but a few, small countries abandoned socialist orthodoxy.

This defeat or rejection of socialism should not be misunderstood.  One of the main appeals of socialism was its advocacy of an egalitarian distribution of wealth, income and influence.  Hostility toward capitalism always highlights inequality and recessions or business cycles.  As many could see, and a few like Djilas wrote, socialism did not eliminate income differences.  It transferred power influence and high income to a “new class.”  And to the extent that measures of income inequality showed less dispersion, the price paid in income levels and freedom was high.  People in East Germany, North Korea, and China compared their fate to residents of West Germany, South Korea, and the Chinese Diaspora including Hong Kong, Singapore, and Taiwan.  The famous German wall restricted emigration not immigration.  No one chose to move east.

Political pressure for redistribution remained.  The social democratic welfare state offered grants and subsidies that redistributed wealth and income and increased the reported unemployment rate.  After climbing to within 80 percent of the per capita income in the United States, on average, Germany, France and Italy began to pay some costs of the welfare state.  From 1980 to 2005, these countries averaged one percent slower growth than the U.S.  After 25 years, a gap of 25 percent was almost entered explained by lower employment rates.

No country, democratic or authoritarian, accepts the distribution of income ground out by the market.  All modify the market outcome, most of them by taxing and transferring from high incomes to low.  The politics of the social democratic, welfare states can only reduce transfers and costly redistribution in a crisis.

You may be wondering how this introduction to the failed policies for recovery in the EU and the U.S.  I contend that failure reflects the dominant influence of social welfare redistribution over recoveries.  In the United States, President Obama’s principal economic adviser, Lawrence Summers, said in 2009 that policy actions should be “timely, targeted, and temporary.”  The so-called stimulus policies that the U.S. adopted gave temporary relief to public employees, teachers and police and subsidized investment in solar power, batteries, electric automobiles, and insulation.

The results show that the subsidized autos did not sell well, that the main subsidized producers of solar panels failed, and error, corruption, and political favoritism reduced effectiveness.  A detailed study of the nearly $900 billion called stimulus offers some examples.  (Grabell, 2012)

In Illinois, inspectors failed to detect a gas leak from a newly installed furnace that could have seriously injured the home’s residents.  Contractors billed for labor that wasn’t done and materials that weren’t installed.  Fourteen of fifteen homes visited failed inspection.  In New Jersey, auditors identified twelve households that were approved for free repairs despite having income of more than $100,000.  Agencies bought $1,500 GPS systems and underpaid their workers.  The state’s system of eligible applicants contained the Social Security numbers of 168 dead people.  A nonprofit in Waukesha, Wisconsin got stimulus money despite having spent weatherization funds on Christmas decorations, gift cards for employees, and a parking ticket.  An audit found that one employee’s husband received new windows from the agency, charging it $10,000—more than ten times the average cost.  West Virginia had to take over one agency’s weatherization program after finding “shoddy work, falsified reports, credit car abuses, and missing inventory.”  An inspection of a Houston nonprofit found that work was so sloppy that contractors had to go back and repair thirty-three of the fifty-three homes reviewed.  Investigators in California found untrained workers.  And Delaware suspended its entire program for nearly a year after a scathing report documented problems with nearly every aspect of the program, leading the Department of Energy to freeze its funds.

The most successful fiscal policies in postwar United States were the Kennedy-Johnson and Reagan tax cuts for households and businesses.  These programs marshaled profit incentives to guide investment choices.  The Obama program, like most political decisions were less concerned about gaining economic efficiency.  Their primary interest was to choose who paid and who received.  One of the major flaws in what are called Keynesian policies is that the designers act on the premise that what matters is the amount spent, not the way spending is allocated.  Keynes did not make that mistake.

In the European Union and the ECB, the daily discussion is about getting Germany and a few other fiscally responsible countries to bail out welfare state spending in the debtor countries.  I am frankly appalled by the pressure from bankers and their friends to get Germany to subsidize foreign welfare states.  The Financial Times is particularly outrageous.

Prime Minister Thatcher said that welfare states would shrink when they ran out of other people’s money.  We are there.  But instead of adjusting down, the bankrupt governments propose institutional changes that, if adopted, would sustain profligate redistributive policies.

High unemployment and prolonged recession or slow recovery are serious problems that require rational policy action.  Most welfare states are so large that rational policies are politically unpopular, perhaps unacceptable.

We are reaching the point at which welfare state promises of redistribution will shrink.  Or we will lose democratic capitalism.  Voters will not end the welfare state and redistribution, but promises in many countries greatly exceed resources available for payment.  Sweden, once the envied model welfare state has made a start by reducing some transfers.

The crisis is here now in the European Union and the United States.  Even those who favor programs and policies that transfer responsibility and decisions from the market to the bureaucracy must see how difficult it is for government to develop meaningful reforms.  No one believes that the unfunded promises that drive future U.S. debt and deficits will be paid if nothing is done.  On the contrary, everyone who seriously discusses the future welfare state debt and deficits uses the word “unsustainable.”

Many in the European Union point their finger at the “rich” Germans requesting even demanding transfers of one kind or another.  The German government points back saying “we have given ample support.  You, the debtors, must reduce domestic transfers and become more competitive by reducing real wages.  Another continuing stalemate.  Reluctance to recognize the problems of welfare states prevents a solution.

I find it appalling that almost all the daily discussion of the European crisis is about the debt incurred by Greece, Italy, Spain, and Portugal.  Almost daily the Financial Times publishes pieces that urge Germany to accept more inflation to bail out the banks and other lenders.  Do the writers and the editor think that the problem is entirely monetary, to be solved by lowering interest rates and printing money?

Germany recognizes that the problem is real, not just monetary or debt related.  Cost of production are 25 to 30 percent greater in Greece, Italy, Spain and Portugal.  Without lowering costs in these countries, growth cannot resume, or remain even if some stimulus gives temporary relief.  Germany wants real reform of labor, commodity markets, and government policy.

There are two ways to reduce real wages.  The so-called austerity favored by Germany would both reform the economies and force reductions in real wages.  After three years of economic decline, getting an additional 25 to 30 percent reduction in real wages in this way seems to me to be politically impossible.  Voters will not retain in office a government that adopts that policy; political opportunists oppose “austerity.”

Devaluation is an alternative way to reduce real wages.  The ECB should permit the indebted southern countries to form a weak euro temporarily.  The strong euro countries would adopt the fiscal restrictions to which their own representatives have agreed.  The weak euro countries would float down against the strong euro.  Once devaluation reduced real wages, countries in the weak euro would rejoin the strong euro by agreeing to the fiscal rules.

Devaluation would work quickly.  It is not without cost.  Two are of particular importance.  First, the devaluing countries must limit bank runs or currency runs by enforcing temporary exchange controls.  And they must avoid subsequent inflation.  Second, German and French banks would suffer losses on their holdings of foreign bonds.  The French and German governments should require their banks to raise half of their capital shortfall.  Government would supply the other half.  If a bank failed to raise its half in the market, it would be declared insolvent and taken over by regulators.  That gives the bank an incentive to raise its share of the capital infusion.

Social welfare state governments in Europe cannot agree on a solution to their major problem.  They resist imposing the requisite costs on their voters.  Often they fail to carry out the pledges they make.  They cannot agree to change who pays and who receives, the main point of the welfare state.  Most common is a demand for Germany to be more generous.  The German public refuses to pay more transfers to foreigners.

The euro problems are common problems for fixed exchange rate systems.  Governments must limit their budget deficits, the size of outstanding debt, and must keep their terms of trade close to their exchange rate.  Like many other fixed exchange rate systems, the euro failed to meet these requirements.  And it has not been able to agree on a program to restore stability and growth.  These failures will restrict the welfare state and egalitarianism.  It will not end pressures for redistribution.


The United States

The United States also fails to act to reduce or moderate future budget deficits.  Again, the problem is failure of the political system to reduce spending or agree on a comprehensive program to achieve budget balance.

The problem is not new.  From 1930 to 2012, the federal government approved a balanced budget or a budget with a surplus of revenues over spending in successive years only twice.  President Eisenhower was a fiscal conservative.  He favored balanced budgets in all years without a recession, and he gave many speeches about fiscally responsible spending.  President Clinton raised marginal tax rates early in his term.  But he also slowed spending growth enough to run budget surpluses for several years.  Budget surpluses raise expectations that future tax rates will be reduced.  Investment and growth increase.

In contrast, from the beginning of the presidency of George Washington in 1789 to 1930, the federal budget had a surplus in two-thirds of the non-war years.   Wartime deficits did not continue after wars.  Peacetime governments reduced debt.  As late as the 1920s, Secretary Andrew Mellon was able to reduce tax rates and wartime debt by running budget surpluses.

After 1930, the Great Depression followed by several wars brought increased government spending.  The size of government, measured by the ratio of federal government spending to GNP or GDP rose from three percent in 1930 to about 18 percent average for recent decades.  The current administration increased spending to 25 percent of GDP.  Its budgets are rejected unanimously by Congress.  Unlike the early postwar budgets that included a heavy component for defense, social spending is by far the largest share of federal spending.  Most of social spending is labeled “entitlement spending” suggesting (falsely) that it cannot be reduced without depriving recipients of something that is their due.

So-called “entitlements” put future budgets on an unsustainable path in the United States and many other countries.  For the United States, future spending for healthcare and retirement has a present value of $70 trillion dollars or more.  There is no combination of tax rates, expected growth, and reductions of other spending that permit the promised entitlements to be paid.

Why was the modest size of government in the 19th and early 20th century maintained and accepted almost everywhere?  I credit two main, but related, reasons.  One was the international gold standard.  The other was the widespread belief that governments, like households, should balance their budget.  Persistent peacetime budget deficits were a cause for concern that a country would have to devalue against gold.  The currency would move to the gold export point, requiring intervention.  Intervention could succeed in stabilizing the gold exchange rate only if the market expected fiscal discipline to improve.

I have never advocated a return to the gold standard.  The principal reason is that the public prefers stable domestic prices and employment to a stable exchange rate.  A second reason is that a single country that fixed its exchange rate to gold would buffer shocks for all other countries by inflating and deflating when others demanded to buy or sell gold.  An effective gold standard must be universal or, at least, multi-lateral.

The enduring lesson from the gold standard years is that a publicly accepted a monetary rule that maintains a stable domestic price level (or low rate of inflation) also restrains budget deficits, just as fiscal restraint supports the monetary rule.


Collapse of the Welfare State

            After John Maynard Keynes read Hayek’s Road to Serfdom, he wrote to Hayek praising the book but disagreeing with its conclusion.  Keynes claimed that if well-intentioned people made the decisions, outcome would be beneficial and desirable.  This is a major flaw in the organization and operation of social democratic governments and welfare states.  They presume most often that they are selfless and know better than the public what is right.

The great German philosopher, Immanuel Kant, had a better understanding of human character.  He wrote: “Out of timbers so crooked as that from which man is made, nothing entirely straight can be carved.”  Christian theology at the time saw humans as morally imperfect.  Some exceptions can be found in all eras, but it is a mistake to rely on goodwill and good intentions.  Twentieth century experience in authoritarian states and the democracies of Western Europe and India alike reminds us that “power corrupts.”

Kant’s judgment warns us that we should not expect benevolent government regulation.  The rule of law directs government to treat all citizens as equal before the law.  This is an ideal that guides regulation toward desirable outcomes.

Detailed regulation often proclaims that it is done “in the public interest.”  Most often it brings special privileges, crony capitalism, corruption, and circumventions.  Powerful Soviet or Chinese officials had access to better opportunities, better food and healthcare than ordinary citizens.  Democratic India became known for bribery and corruption of officials to obtain special privileges.

After writing the Constitution of the United States, James Madison contributed to the Federalist papers to promote ratification.  He insisted that the Constitution limited the power of the federal government, and in Federalist 10, he warned about the threat posed by “factions.”  Today we replace factions with interest groups.  As Madison warned, interest groups protect their interests at the expense of others.

Interest group politics make it difficult to reform the welfare state or the pressure for egalitarian outcomes.  Here are some examples.  In the 1980s, it became clear that many savings and loan associations would fail.  Deposit guarantees protected depositors, but failure imposed losses on taxpayers.  The U.S. Congress acted to hide the problem, but managements knew that delay created opportunities to take risky gambles that would restore the value of equity if the investment paid off.  Since equity was low or negative, the cost of additional losses would be borne by taxpayers.  Some took the gamble.  Taxpayers’ losses reached $150 billion.

A few years later, President Clinton appointed Jim Johnson to head the Federal National Mortgage Association, FNMA.  FNMA began in 1937 as a purchaser and occasional seller of outstanding mortgages to smooth fluctuations in mortgage rates and create a more liquid market.  Later, the Federal Home Loan Bank Board created a separate organization (Freddie Mac) to buy and sell mortgages also.

Jim Johnson had been a campaign manager in Walter Mondale’s 1984 presidential campaign.  He was well connected politically and wanted to make housing ownership more egalitarian.  He saw an opportunity to expand FNMA’s operations while offering opportunity to low income home buyers.  The political appeal of expanding home ownership was popular.  To facilitate this program, the government agencies lowered down payments and eventually offered to buy sub-prime mortgages that had no down payment to borrowers that had no credit history.

Selling sub-prime mortgages to the two government sponsored buyers, FNMA and FHLMC, was a very profitable business.  Some mortgage lenders actively worked to issue such mortgages that could be resold profitably.  Major banks did the same.  An international agreement required the banks to hold larger reserves behind mortgages in their portfolios.  The banks circumvented the costly regulation by chartering subsidiaries that held the mortgages but evaded the requirement.  Regulators did not object.

A few voices that pointed to the risk of defaults and losses were ignored or dismissed.  Congressman Barney Frank was chairman of the House Committee that had oversight responsibility.  He urged expansion of the program.  President George Bush viewed the programs as part of his “ownership” program.  He did not ask: What did the homebuyers own?  Many made no down payments; they “owned” an option to gain home equity if home prices rose, but they also owned the prospect of loss if home prices fell.

Contrary to repeated forecasts that home prices would not fall throughout the country, the unexpected happened.  The social welfare experiment in expanding home ownership to minorities and low-income families failed in a wave of mortgage defaults and foreclosed houses.

In January 2009, the Obama administration inherited the housing and financial failures.  Their program design called for a massive increase in government spending and temporary tax reductions.  Professor Lawrence Summers, head of the new president’s economic staff, said that the program should be targeted and temporary.  Bad advice!  Decades of economic research showed that temporary tax reduction and spending increases get very little response.

Congress developed the program details.  Their interest as always was in distributing financial support to their political supporters, so the supposed economic stimulus became an example of welfare state redistribution.  For example, money was spent to help states avoid laying off teachers.  When the funding was not renewed, lay offs resumed.  What was achieved?

A principal weakness of the program was its short-term focus.  A large stock of unsold houses and projected defaults on mortgages implied the recession would be deep and long lasting.  Properly designed policy changes would have avoided targeted and temporary changes and offered permanent incentives for investment.

The social welfare state empowers interest groups that demand support from their political allies.   Their main concern is benefits to them and their members.  They oppose efforts to reduce spending on their benefits.  Fire and police unions receive such large pension and health care benefits that state and local governments are forced to reduce spending on such basic functions of government as police or fire protection.  At the federal level, spending for pensions and health care forces reductions in spending for defense against terrorism.

Every knowledgeable observer agrees that projected growth of federal government spending is unsustainable.  Still, the federal government does not propose reductions.  Any solution that reduces spending acts like a tax levied against particular groups – the retired and their families, the teachers union, or some other organized group.  Greece, Italy and Spain waited for the crisis to force sudden changes that could have been phased in gradually and less painfully.  Must the United States repeat their error?

Similar problems threaten the survival of the European Union.  As in the United States, voters agreed to increase spending on redistribution for pensions, health care, and the unemployed, but most do not vote to pay for the benefits.  Budget deficits increase until they are unsustainable and markets are unwilling to finance them.

The political system cannot agree on a program.  Short-term palliatives prevent an immediate crisis, but the problems remain.  Uncertainty rises, so investment falls.  The debtors urge the creditor countries to pay more and to forgive debts.  The creditors demand reforms that open markets, reduce the power of labor monopolies, raise retirement ages, sell state industries, and reduces transfer payments.  Each of these affects a powerful interest group.  And it reduces the welfare states.



            James Madison warned that “factions,” now called “interest groups,” are a threat to democratic governance.  His fears are now reality.  The social welfare state has become the prisoner of interest groups that demand ever increased benefits and resist any changes that lower their benefits.

That puts the social welfare state on an unsustainable path leading to its eventual collapse.  Experience in the European Union and the United States shows these political unions headed for a crisis.  But it will not end the welfare state.  Political pressure for redistribution carried out in the name of equality is always present.  The most we can expect is enough less spending to maintain democratic capitalist governance.  And perhaps we can convince governments that changing incentives, not exhortation and direction, is the effective method for bringing change.




Grabell, Michael, (2012).  Money Well Spent?  New York: Public Affairs.

The Impact of Sarbanes–Oxley on Small Businesses

George A. Haloulakos, CFA DBA Spartan Research and Consulting, Core Adjunct Finance Faculty – National University

Co-authored with: Farhang Mossavar-Rahmani, DBA, Professor of Finance – National University

In 2002 Congress passed the Sarbanes-Oxley (SOX) Act after a series of fraudulent accounting and finance activities and questionable behavior by many high level corporate executives during the early part of the 21st century. The Act set new or enhanced standards for corporate officers and directors of all publicly traded US companies, as well as public accounting firms servicing those companies. In the context of Agency Theory, the main purpose was to restore investor confidence, prevent or reduce the management misconduct, and protect stockholder interest. The Act also holds both Chief Executive Officers and Chief Financial Officers of the companies criminally and civilly accountable for the financial reports of their companies.

Since passage of the SOX Act, many studies have been conducted to find out the impact of the Act on businesses. The results have been mixed. In some cases the value of stocks increased, but in other cases companies experienced a significant increase in costs. The Act also has created obstacles and has made it increasingly difficult for new or small companies to go public. In such cases the compliance costs were a major issue. In this study, we are examining three such companies that were negatively impacted by the SOX Act.


The Sarbanes-Oxley Act of 2002 also known as the “Public Company Accounting Reform and Investor Protection” Act, consists of 18 sections that serve multiple regulatory functions. The overall goal of the Act was to restore investor confidence by reinforcing corporate accountability as well as improving the accuracy and reliability of information provided to investors (Jain et al., 2006). The Act specially focuses on management responsibilities for internal control and auditing independence. The Act required the SEC to take certain actions to ensure that there are regulatory structures in place to implement it.

Kenneth Lehn (2008) summarized the key provisions of the Sarbanes-Oxley (SOX) Act as follows,

  • Increased disclosure requirements of public companies
  • Increased role of independent directors
  • Expanded liability of officers
  • Required companies to assess and disclose adequacy of internal controls
  • Created the Public Company Accounting Oversight Board (PCAOB) to regulate auditors
  • Prompted the Securities & Exchange Commission (SEC) and exchanges to adopt new corporate governance rules

In this landmark paper, Prof. Lehn cited very mixed results as measured by empirical financial research.  Specifically, he noted the following conclusions from various studies:

  • Zhang (2007) – SOX related events had negative effect on companies’ stock prices.
  • Li, Pincus, and Rego (2006) and Jain and Rezaee (2006) – SOX related events had a positive effect on companies’ stock prices.
  • Chhaochharia and Grinstein (2007) – Stock prices of large firms not in compliance with SOX increased around SOX’s passage; those of small firms not in compliance with SOX declined.
  • Wintoki (2007) – Stock prices of small, young, high growth companies declined around passage of SOX.
  • Litvak (2007) – Stock prices of foreign firms cross-listed in the U.S. declined vis-à-vis non-cross-listed matched firms around key SOX events.
  • Zingales (2007), Litvak (2007) – The premium for foreign firms cross-listing in the U.S. declined after SOX.
  • Doidge, Karolyi, and Stulz (2007) – The premium for foreign firms cross-listing in the U.S. did not change significantly after SOX.

Other studies confirm that the cost of implementation of the SOX Act were proportionally higher for small businesses than large ones. According to the finding of the SEC Advisory Committee on Smaller Public Companies (88):

From the earliest stages of its implementation, Sarbanes-Oxley Act Section 404 has posed special challenges for smaller public companies. To some extent, the problems smaller companies have in complying with Section 404 are:

  • Lack of clear guidance;
  • An unfamiliar regulatory environment;
  • An unfriendly legal enforcement atmosphere that diminishes the use and acceptance of professional judgment because of fears of second-guessing by regulators and the plaintiffs’ bar;
  • A focus on detailed control activities by auditors; and
  • The lack of sufficient resources and competencies in an area in which companies and auditors have previously placed less emphasis.

In this paper we study the impact of Section 3: Corporate Responsibility, Section 4: Enhanced Financial Disclosures and especially 4.1: Disclosures Controls, Section 4.4: Assessment of Internal Control and Section 4.5: Smaller Public Companies.

As part of this study we looked at the costs associated with implementing the SOX Act, which includes external auditor fees, director and officer insurance, board compensation, lost productivity, and legal costs. In general, each of these cost categories increased significantly between FY 2001 and FY 2006 (Foley & Larder Survey 2007).

Case study

Due to the aforementioned mixed results (as measured by stock price performance), and our view that perhaps the self-correcting nature of the financial markets had a greater impact than the passage of the SOX Act, we focused our research on how SOX affected risk taking. We examined real life case studies to assess how firms have incorporated SOX into their financial and strategic planning processes, and their corresponding outcomes.  While these real life examples do not necessarily represent an across-the-board or universal impact, the effect on risk-taking is noticeable and has material or significant financial consequences.

The following situations are offered with the permission of the participating firms subject to the aforementioned NDAs.[1]  These examples are provided to demonstrate how SOX affects risk-taking behavior, and in each case, the financial outcome associated with actions taken (or not taken) due to SOX.

We have selected three types of business models for this study: vision care solutions, oceanographic equipment and specialty consumer.  For simplicity, these companies will be denoted as follows:

VCS: Vision Care Solutions

OE: Oceanographic Equipment

SC: Specialty Consumer

Basic information (for more information please see Exhibit 1):


Revenues (E) in 3 years $8 million $1.5 million $4.5 million
Debt/Equity $50,000/$200,000 0/$500,000 0/$300,000
Number of  Employees (E) 18 6 15
Owners/Operators 1 2 3

(E) Estimate

Each of these companies or business models were owner-operated with the goal of eventually becoming publicly traded entities.  These case studies occurred between 2002-2010, in the aftermath of the passage of SOX.  In each case, the owner-operator developed a profitable specialty niche model that had scalability (i.e., could be replicated in different regions or potential for large scale production).

In each of these situations SOX proved to be costly, burdensome, time consuming and distracting.  The additional layer of costs and burdens in terms of time and implementation had the effect of diverting financial and intellectual capital away from innovation and product development and redirected toward compliance in the context of a very risk-averse internal environment.  The resulting financial outcomes in relation to both the explicit and implicit costs associated with SOX compliance are self-evident.  However, it should be noted that not all of these had unsatisfactory outcomes.  One instance proved to be very satisfactory, but nevertheless was influenced by the preoccupation with the danger and risk of making the slightest mistake that potentially could undermine years of work.

VCS (Vision Care Solutions)

The Situation: In the very early 2000s, VCS was founded by an electrical engineer who was inspired to create this company in response to the onset of his own visual impairment and his empathy for others who like him, were “legally” blind.  The VCS founder developed and patented three different vision care solutions that would provide glare protection without obstructing one’s line of sight.  Specifically, VCS’s strategy was to provide solutions for potential clients seeking improved safety, increased productivity and greater comfort by enhancing various eye-care products [e.g., prescription, plain or dark glasses, goggles, helmets and related] with enhanced glare protection.  As such, VCS identified three mass markets, each aligned with its specific vision care solution: (1) individual consumers of prescription and non-prescription eye glasses; (2) professional and amateur athletes; and (3) commercial drivers, truckers, pilots, railway drivers and ship captains.  The total value (US$) of these three mass markets was conservatively estimated to be in the range of $25 to $30 billion.

What Happened Next:  VCS developed a prototype product for each of the aforementioned mass markets, lined up future engineering, technical, sales and support staff and a proposed manufacturing site.  Given the very large target markets, VCS sought equity financing via the public markets.  [Bank financing proved unsatisfactory given the inherently conservative nature of commercial lenders who deemed the business model extremely risky due to perceived over dependence upon the founder and being an emerging/early stage situation.]  The model VCS adopted was similar to the same one used by microbrewers that went public in the mid-to-late 1990s to capitalize on the growing public demand for craft beer.  In this instance microbrewers essentially used the Internet as well as financial literature attached to its product shipments to solicit equity capital.  However, by the time VCS was ready to embark on its capital raising efforts, the passage of Sarbanes-Oxley (SOX) created a whole new set of compliance protocols and filing of additional paperwork.

VCS diverted a portion of its limited capital to hiring attorneys and accountants to aid in compliance, but the financial cost associated with this process (even with self-help services) proved to be above plan.   Moreover, the additional 3 to 6 month period required to comply with new SOX standards proved very costly with a negative collateral development: loss of the manufacturing site and specialized personnel that had been previously lined up. These individuals could no longer afford to wait for a capital infusion, and thus sought employment elsewhere.   In a last ditch effort to sustain momentum, VCS sought grant funding from public and private sources, but the enormous paperwork and review process associated with this process proved to be an obstacle that the VCS founder was unable to overcome.

The Outcome: Following a promising start, VCS essentially went “dark” and suspended filing any further paperwork seeking equity financing.  Financial capital that had been earmarked for product and business development, and then later diverted to compliance with the new SOX regulations, evaporated.  As a result, VCS sought a more risk-averse strategy to pursue product licensing and/or a long-term special services employment contract to develop its products for a large company serving the vision care markets.  This has proven unsatisfactory as the perceived failure to raise equity from the public markets in its earlier efforts created a “stigma” for VCS thus deterring potential corporate suitors from investment.

The Verdict:  VCS believes that SOX and the resulting environment of inordinate preoccupation with compliance issues proved burdensome and ultimately a major obstacle to securing equity capital.  The negative effect of missing its window of opportunity with available skilled personnel and prime manufacturing space was due to the delay associated with compliance.   In addition, the financial capital was not available to retain those resources because it was being paid to attorneys and accountants.  VCS has never been able to recover from this as the founder personally financed development and patent filings for his work, and no further personal capital (debt or equity) was available to him.  As such, VCS is left to wonder what might have been!  It should be noted that the VCS founder has no illusions but would have preferred that the negative verdict be dictated by market forces (competition, supply & demand, and so forth) rather than the vagaries and delays associated with regulations that ultimately deter risk-taking.

OE (Oceanographic Equipment)

The Situation: In early 2007, OE was financially exhausted after having spent more than 5 years developing a technology product for personal and commercial uses in oceanography.  In the aftermath of SOX the company did not wish to pursue going public due to compliance costs, nor did it wish to disclose its technology with “angel” and venture investors because of the potential of giving up too much control and financial benefits of its intellectual properties.  OE considered forming a Limited Liability Corporation (LLC) and selling units to hobbyists, scientists and others who would have interest in the company’s technology, but ultimately vetoed this option due to potentially being overly cumbersome and time consuming.  Despite a potentially very large end-user market for its technology, the idea of investing additional financial and intellectual capital in order to navigate through the SOX protocols or satisfy the insatiable desire for control by venture investors and financial angels was viewed as unacceptable.  This forced OE to solely concentrate on how to monetize its intellectual properties in a timely manner, especially given its diminishing financial resources.

What Happened Next:  OE hired a consultant to establish a valuation for its technology and develop a combined licensing strategy and special services contract to help the founders recover its cumulative investment, provide a future stream of recurring income from its technology and stable employment.  While this was being done, a suitable candidate firm was found that was willing to pay for the technology, manufacture and distribute the product. This was done with the OE founders working in a consulting role to help implement this process.  Armed with a valuation study, OE proposed formation of a strategic alliance that called for an upfront payment to the founders (allowing the buyer access to the technology), and then a recurring income stream arising from a percentage licensing fee applied to future revenues. Additionally, there would be a long-term special services contract whereby the founders would receive compensation for helping bring the product to market and sustain its expected commercial success.  In principle, this agreement was accepted by the candidate firm with what proved to be minor adjustments or concessions by OE: the upfront payment would be paid in three equal installments over a 3-month period instead of a lump sum. Further, the majority of those payments would be classified as engineering fees rather than licensing fees so that it would not have to be treated as a capitalized expense item.

The Verdict:  OE believed this financial solution was optimal from the standpoint of reflecting its mission and values.  The technology was developed out of a love for oceanography, and this commitment was reflected by the founders putting their personal financial position at risk.  OE was created as a vehicle for the founders to create and develop the technology for commercial application.  Once completed—and after considering the further additional commitment of time and financial capital—OE determined that monetizing its intellectual properties and recovering its investment was not available only through the Initial Public Offering (IPO) venue, it could be fulfilled in a more efficient and less risky manner through a licensing agreement.  Hence, the aforementioned strategic alliance with the upfront installment payments, recurring licensing fee income plus the special services contract.  In this case, the new hurdles posed by SOX caused OE to reconsider carefully and ultimately pursue a strategic alternative that provided a much better fit in terms of reward and risk.  Since then, OE founders concede that had it been “easy” to go the IPO route, the sustainable financial returns might have been much lower (or non-existent) because OE was better suited as a product group for a large firm rather than a stand-alone entity.  SOX protocols ultimately proved to be a blessing for OE in securing an optimal financial strategy for its technology that enabled it to thrive in a more suitable venue than the publicly traded securities markets.

SC: (Specialty Consumer)

The Situation: From 2001–2003 SC was formed with the objective of further leveraging the “third space” concept that had taken hold during the 1990s.  The “third space” concept was based on the view that with flextime and the boundaries between home and work becoming ambiguous, more people were spending leisure time outside the work place and home.  The “third space” concept includes, but is not limited to, a gourmet coffee store model (e.g., Starbucks), health club, recreation centers, etc.  SC created a combined wine bar and retail store that would provide a channel of distribution for small west coast wineries that were thus far unable to compete for retail shelf space in traditional wine & liquor stores or in grocery stores.

What Happened Next:  SC worked closely with a financial consultant to create a business model that would be located in urban areas characterized by high foot traffic (e.g., tourists, hotel guests, cruise ship patrons, restaurant customers and so forth).  The SC model would allow such patrons to enjoy sampling premium quality wines from small wineries, purchase wine and complementary food offerings along with souvenirs, all the while enjoying quiet time with friends and/or business associates.  Essentially SC positioned itself as a wine version of Starbucks, and thus a scalable model that could be strategically placed to capitalize on the strong demand growth for wine while providing a distribution channel for small wineries located nationwide.

Due to the scalability factor, SC wanted to raise private equity to finance two (2) wine bars as a way of demonstrating its financial viability. Once those two operations were up and running, SC sought to tap the public equity markets to finance a large-scale expansion that would occur concurrently in various regions nationwide.  SC formed a series of contractual relationships with multiple wineries eager to participate, engaged other wine and food enthusiasts to run the operations.  Due to the aggressive (albeit achievable) growth plans, the imposition of SOX necessitated the use of significant financial capital to comply with the requirements of going public.  While necessary and appropriate given the desire to be a vital, active and growing public entity, this ultimately diverted funds away from retaining the specialized personnel for wine & food needed to run the operation; it also provided credibility with the investing public.  Without these people on hand, SC essentially became a “still born” idea as it became extremely difficult to move forward without their presence.  With the funds diverted to SOX compliance, it was a company that existed only on paper.

The Verdict:  SC initially believed that had it been able to spend its capital on retaining the specialty personnel needed to launch its flagship operation and building a “brick-and-mortar” business (i.e., deploy physical capital assets), which would have created a going-concern that would attract investor interest.  Ideally, SC thought of how the McDonalds brothers attracted the interest of Roy Kroc, who had the vision to transform the brothers’ burgers-and- fries outlet into a global enterprise.  But upon further reflection and additional research it became evident that, had the growth idea been confined to a small scale (i.e., build a single successful wine bar business first) and refine the concept so that it developed a track record that would later attract investment funding for scaling upward, this might have been more feasible.  SC sought to move forward way too fast.

While the idea of a wine bar was most feasible in terms of demand growth, profitability and return on capital, the near instantaneous formation of a large scale public enterprise might have proven to be very difficult to manage.   The cost estimate for SOX compliance associated with a near instantaneous formation of a publicly traded enterprise was approximately $1.5 million.  SOX compliance certainly absorbed a disproportionate amount of capital that otherwise would have been used for developing the business, but to cast blame for SC’s failure to become a reality solely upon SOX would be inaccurate.

Ultimately, the SC founders maintained their hobbyist interest in wine, but refrained from spending additional capital as their personal resources were exhausted and they had no interest in selling or licensing the model they created.  Preliminary feelers to prospective buyers or investors indicated that SC lacked sufficient product differentiation and a track record to warrant financial participation.  In a sense, the all or nothing approach taken by SC may have been its undoing.

The very rapid financial success each of the founders experienced in their individual corporate careers prior to pooling their resources for the SC wine bar venture resulted in overconfidence because they expected similar growth progression in the entrepreneurial venue.  Whether that would have occurred pre-SOX is unknown, but certainly the presence of SOX proved to be a formidable influence upon their business decisions and risk-taking behavior.


As all three cases show, the cost of compliance with SOX requirements have been the main reasons for the three cited companies not to pursue equity financing via the public market, and as a result they were not able to materialize their dreams.+++++++++++++++++++++++++++++++++++++++++

In short our finding indicates that SOX:

  • Reduces incentives for innovation and risk taking among entrepreneurs while increasing attention toward compliance because of inordinate fear of financial and legal penalties.
  • Has influenced diversion of personal capital by entrepreneurs from product development and related activities toward the hiring of attorneys and accountants in order to tap the public equity markets for capital funding.
  • Has reduced the flexibility of entrepreneurs in creating business models that otherwise would attract equity capital pre-SOX from prospective investors.

Exhibit 1


Explanatory Notes:

  • Employees for each firm are “independent contractors” and therefore not “permanent.”  Each firm sought or considered equity via the public offering route as a means to secure permanence in their “human resource” assets.
  • Only SC would have “internet” based sales as part of its expected revenue stream ($1 million or 22% of sales).  VCS and OE models did not have revenue-generating/transaction internet portals.
  • VCS would be a lab/manufacturer, OE would be contractor/vendor and SC would be retail (brick-and-mortar + internet portal).
  • Total owner capital $250,000 for VCS (with $50,000/$200,000 debt/equity mix), $500,000 for OE (all equity) and $300,000 for SC (all equity).  VCS owner committed 100% of personal financial resources as did OE owners, with the difference being that OE eschewed the use of debt.  SC owners set a limit or threshold on equity capital at risk, and would not commit any further.


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Sarbanes-Oxley Act of 2002 and Earnings Management,” Journal of Law and Economics, February, 2008.

Litvak, Kate, “The impact of the Sarbanes-Oxley Act on Non-U.S. Companies cross-listed in the U.S.,” Journal of Corporate Finance 13 (2007), 195-228.

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Zhang, Ivy Xiying, “Economic consequences of the Sarbanes-Oxley Act of 2002,” Journal of Accounting and Economics 44 (2007), 74-115.++++++++++++++++++++++++++++++++++

Zingales, Luigi, “Is the U.S. capital market losing its competitive edge?” (November 2007). ECGI – Finance Working Paper No. 192/2007. Available at SSRN:

Kenneth Lehn, “Sarbanes-Oxley: A Review of the Empirical Evidence and a Proposal for Reform”, May 13, 2008.

SEC Advisory Committee on Smaller Public Company, Washington D.C., April 2005

President Obama and the November Presidential Election

Dr. John Psarouthakis, Executive Editor of, Distinguished Visiting Fellow at the Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland, and Founder and former CEO, JPIndusries, Inc., a Fortune 500 industrial corporation

President Obama is going into history as the first African American elected to the presidency of USA. However, he might also go into history as a one term president because of the economy travails, and lack of leadership to bring the country together as he so eloquently stated of his belief of this country in his 2004 DNC keynote speech. Instead he has, in my opinion, become a polarizing force in the political spectrum of the country. He has missed the opportunity to be a Statesman. He has remained a traditional politician when the country needed a leader to unify the people and bring us out of a collapsing economy and two wars.

He has developed an atmosphere of uncertainty with his approach of decision making. Even the most important legislation of his administration to date, Health Care Law, he delegated the initiative to former Speaker Pelosi until it looked doubtful it will pass. He then got involved in what many called “Chicago politics” to pass the bill.

The voters in 2008 were “hungry” for a change. They did not demand of the candidates to spell out the change they promised. Here we are four years later and we continue to deal with old style politics.


Pres. Obama seems unable to get a firm grip on the tough issue-the economy. His ideological bent for ever bigger government has blocked his thinking on how this country’s economy has grown and how jobs are created in the private sector. When the 25 million people who are unemployed or cannot find full time work will they find a full time job? Does our president understand what is going on? Blaming others here or overseas does not really define the problem and therefore improvement of the economic situation is not anywhere near!

Technology is eliminating jobs

Tellers, phone operators, stock-brokers, stock-traders: These jobs are nearly extinct. Since 2007, the New York Stock Exchange has eliminated 1,000 jobs. And when was the last time you spoke to a travel agent? Nearly all of them have been displaced by technology and the Web. Librarians can’t find 36,000 results in 0.14 seconds, as Google can.

Doctors are under fire as well, from computer imaging that looks inside of us and from Computer Aided Diagnosis, which looks for patterns in X-rays to identify breast cancer and other diseases more cheaply and effectively than radiologists do. Other than barbers, no jobs are safe.

But be warned the USA economy is incredibly dynamic, and there is no quick fix for job creation when so much technology-driven job destruction is taking place. Fortunately, history shows that labor-saving machines haven’t decreased overall employment even when they have made certain jobs obsolete. Ultimately the economic growth created by new jobs always overwhelms the drag from jobs destroyed—if policy makers let it happen.


The inexperienced officials around the President have managed the crisis as an exercise in political maneuvering to position the President for the election in November.

Some believed that President Obama’s personality and intelligence alone would be enough to convince and appease the voters. Some claim that the administration has won society’s silent consent. However, the government’s problem is not so much the frustration or the reactions from the various sections of our society but the uncertainty that is now eroding our confidence in investing in our economy. It appears we are moving an ever bigger government and more of a well-fare state
The Obama administration seems ineffective, but that should hardly come as a surprise since President Obama had no prior executive experience of any kind! He has lost touch with a great part of the society and he looks more and more as a spent political force. But in politics surprises are the norm!

This brilliant person with extensive academic education – a graduate of Harvard Law School and editor of the School’s Law Review – and an unusually powerful speaker has shrunk and turned into an ordinary politician.

The fact is that Obama inherited a deep financial crisis; the worse since the Great Depression. However, it is also a fact that instead of focusing his attention on handling the crisis – and primarily focusing to create an environment for entrepreneurial investments in the private sector of our economy–forming new jobs – he lost valuable time and wasted many political resources on his health care reform bill, and trying to convince us all that the previous administration continues to be at fault. Well if the previous administration had done a better job most likely senator McCain would have been elected. President Obama was elected because he promised to change things for the better people believed and trusted him to do so. He has not succeeded yet.

For me, the most essential of Obama’s problems is that after almost four years as president, there are still few people who know what he is thinking, what he represents, and what he believes. Polls show that most Americans like him and trust him. But they don’t think that he is capable of fixing the economy.

The keys to this election are the economic issues, and primarily the unemployment figures, but also personal likeability is turning out to be a factor.