At the start of 2020, the COVID-19 pandemic posed an unprecedented threat to the economy and stock market valuations. Stock prices plummeted in March 2020 as the nation shut down, and many public companies suspended their forecasts because they no longer had confidence that they could predict their financial performance. Surprisingly, the market started to recover over the spring and summer. By the fall, the S&P 500 reached the level it was at before the start of the pandemic. By the end of 2020, the market saw a significant annual gain.

What does solvent mean? JP Morgan CEO Jamie Dimon, 2010 A little more than five years after the passage of the Sarbanes–Oxley Act of 2002 (Sarbanes–Oxley),1 many of the nation’s largest financial institutions failed or were pushed to the brink of failure. An unprecedented decline in housing prices reduced the value of securities backed by housing loans owned by many banks. The resulting insolvency of some of the most significant Wall Street giants prompted the worst financial turmoil since the Great Depression. The crisis raised serious questions about the efficiency of markets as hundreds of billions of dollars in market capitalization suddenly disappeared. The losses suffered by investors were more severe and long lasting than those that came out of the market crisis that helped give rise to Sarbanes–Oxley.

Had Xerox reported its revenues and earnings consistent with its accounting in earlier years, Xerox would have failed to meet Wall Street earnings-per-share expectations in 11 of 12 quarters in 1997–1999. Securities and Exchange Commission, 2002 While it did not receive the same attention as the cases arising out of the Enron and WorldCom frauds, the Securities and Exchange Commission’s (SEC) enforcement action against Xerox was significant because it was the first where the agency imposed a significant penalty on a corporate defendant for misleading investors about its financial results. The case was part of a concerted effort beginning in the latter half of the 1990s to address misstatements by public companies to meet market projections of quarterly earnings. Because many of the issues raised in public company securities fraud cases were present in the Xerox case, it provides an ideal introduction to the subject of securities fraud.

At some point, it becomes almost impossible for management to deliver on accelerating expectations without faltering, just as anyone would eventually stumble on a treadmill that keeps moving faster. McKinsey & Co., Valuation: Measuring and Managing the Value of Companies, 2020 The typical public corporation now runs on a valuation treadmill. If its stock is traded widely in public markets, it must take care to keep pace with market expectations. Whether it be through developing transformative new products or consistently meeting quarterly financial projections, a public company must continually convince investors that it will generate profits in future years just to maintain its stock price. If investors become concerned that a company’s profitability is declining, they can drastically readjust its valuation.

The thesis of this book is that securities fraud became a threat to the integrity of public companies as markets increasingly valued them based on projections of their future earnings. It became important for companies to consistently validate prior forecasts of their profitability to maintain their stock price. This created a systemic incentive for corporate managers to manipulate market perceptions of their company’s earnings potential. The Sarbanes–Oxley Act of 2002 (Sarbanes–Oxley) was an attempt to address this incentive by requiring all public companies to invest in measures that prevent financial misstatements. The law governing Rule 10b-5 developed as private investors and the SEC increasingly scrutinized whether misleading corporate narratives of the future were motivated by fraudulent intent.

This case presents the grimly familiar picture of disappointed investors crying fraud after fortunes were lost when a promising corporation stumbled. US District Court for the District of Massachusetts, 1993 In the Xerox and Penn Central cases, public companies misstated their financial statements to support false narratives of their ability to continue generating profits. Companies also shape investor perceptions of their future performance through disclosures about their businesses, particularly with respect to important products. Just as the conglomerates of the 1970s sought to satisfy market expectations by reporting earnings increases, the computer companies of the 1980s faced pressure to successfully complete the development of new technologies. Investors were willing to pay more for a stock to take into account the possibility that a promising product would be widely embraced by consumers. However, if there was a significant setback, they could lose faith and flee the stock. Computer company stocks were thus more volatile than the stocks of companies in traditional industries.1

It is not true, as Skilling claims, that the Government’s theory at trial was that Skilling made bad business decisions; its argument was that Skilling hid those bad business decisions from investors. US Court of Appeals for the Fifth Circuit, 2011

[B]ig corporations do not lose money. John Kenneth Galbraith, 1967 Publicly held companies do not lose money. Stanley Goldblum, President of Equity Funding Corporation of America, 1969 Between the end of World War II and the start of the 1970s, regulators did not view securities fraud as a significant risk for large public companies. Major corporations often had market power in their industries and could be counted on to generate profits. They reinvested these profits in research and development and managerial training to perpetuate their advantage. They could acquire competitors or companies in unrelated industries to create new revenue streams. Investors trusted the competence of professional managers who would make wise decisions that avoided major disaster.1 Under this paradigm of managerialism, corporate managers were not as pressured by stock markets. There was thus little reason for an established public corporation to misstate its financial results. Even if it did, such a misrepresentation would be unlikely to hide serious problems that threatened a company’s solvency.

78% of the surveyed executives would give up economic value in exchange for smooth earnings. Graham, Harvey & Rajgopal, 2005 Over the last twenty years, as memories of the crisis that spurred the passage of the Sarbanes–Oxley Act of 2002 (Sarbanes–Oxley) faded, public company securities fraud receded as a matter of national concern. The stock market losses arising out of the financial crisis of 2008 were only partly linked to securities fraud, and the slow economic recovery afterward did not generate many spectacular investor losses that could be firmly tied to a corporate misrepresentation. There is some evidence that companies responded to Sarbanes–Oxley by adopting more conservative financial reporting policies. Stronger internal controls may have been successful at checking obvious accounting rule violations.