TCS Daily

Race From the Cure

By Stephen W. Stanton - December 2, 2002 12:00 AM

How many times does an average child burn himself on the stove? For most kids, once is enough to learn the lesson: Be careful near the stove to avoid getting burned. The recent stock market decline burned many investors. Long before Washington did anything about it, many market participants stopped playing with fire.

Stock prices may now reflect a healthier level of risk aversion than we saw during the days of infinite P/E ratios. Analyst reports of Wall Street shills are now lining birdcages. Crooked executives are heading to jail. Complicit banks coughed up hundreds of millions dollars for their improprieties. Better late than never, investors learned that a diversified portfolio must include more than the stock of one company. Investors are buying treasuries, bonds, and other previously overlooked asset classes.

Investors, analysts, accountants, and executives are extra careful to avoid being burned again. Accounting irregularities suspected at AOL? The stock is hammered down from $39 to less than $9 per share in the past year. Arthur Andersen caught covering up a questionable audit? The Justice Department prosecutes, clients flee, and the firm implodes. SEC chief appears too cozy to accounting firms? Public outcry drives him out of office. And the biggie: handcuffs for executives that cross the line. In short, capitalism is working under the current system.

Free market capitalism does not eliminate these occasional excesses, but it does provide efficient resolution when such problems arise. Unfortunately, elected officials are suspicious of capitalism. Congress evidently believes markets do not and cannot correct themselves. Therefore, Congress passed the sweeping Sarbanes-Oxley bill, imposing strict and specific measures that actually harm the market participants they were supposed to benefit.

Take a moment to enjoy the irony... Under the pretext that markets are unresponsive, the public coerced Congress into passing overreactionary legislation: The Sarbanes-Oxley bill. Its ambitious provisions run counter to the advice of Alan Greenspan, who cautioned, "We have to be careful, however, not to look to a significant expansion of regulation as the solution to current problems... Regulation has, over the years, proven only partially successful in dissuading individuals from playing with the rules of accounting."

Unintended Consequences

Like most hastily passed legislation, the goals of Sarbanes-Oxley are laudable. The provisions are supposed to ensure a greater degree of transparency, disclosure, fairness, accountability, and auditor independence. The law seeks to deter corporate chicanery by imposing stiffer criminal and civil penalties while forcing attorneys to blow the whistle. The law also gives the SEC broad powers to stop analyst abuses. Unfortunately, not only will Sarbanes-Oxley fail to fully achieve its objectives, like almost all knee-jerk legislation, it is rife with potentially devastating unintended consequences.

For example, the law only applies to public companies. So many companies simply refuse to go public. One CEO recently told me that he put plans for an IPO on hold because he felt the current environment was a witch-hunt. He refused to go on record for fear of being burned at the stake himself. Now his company remains private, and his investors are not protected by any SEC requirements such as quarterly reporting, annual audits, and disclosure of insider trading. This company is not alone. Many concerned executives are keeping their firms private, inadvertently limiting investor protections and relying on inefficient capital markets that constrain productivity growth.

In addition, public companies are actually going private. According to estimates from Forbes, small public companies each spent roughly $160,000 annually on lawyers and auditors prior to Sarbanes-Oxley. Forbes expects that cost to double or triple. It may not sound like much, but consider that less than 3% of our 20,000 public companies are in the Fortune 500. For most businesses, a half a million dollars is real money. Global Water Technologies already delisted over rising compliance costs. Other firms are forcing investors to liquidate their holdings with reverse stock splits in an aggressive attempt to go private. Surely, Senator Sarbanes did not intend to bully investors.

Redistributionists should be appalled by the regressive impact of Sarbanes-Oxley. It puts a disproportionate burden on small businesses. Large firms can exploit scale economies, spreading rising compliance costs over billions in revenue. Yet small firms have the same obligations and face the same penalties as multinational behemoths. So why will investors bother with small firms? What venture capitalist wants to incur these expenses and face this legal liability? With the road to IPO now longer and harder to travel than ever, why will entrepreneurs sacrifice so much? Sarbanes-Oxley stifles innovation. Only the largest firms benefit from maintaining the status quo.

The bad news does not end there. The new law makes some vital business services more expensive or less useful. For example, audit firms have traditionally used their access to client financial records to provide tax advice. If the SEC rules that tax consulting is a violation of auditor independence rules, that would leave three unwieldy possibilities:

  1. Companies would need to hire another firm to provide tax services, performing a considerable amount of redundant, expensive, and disruptive audit procedures.
  2. Auditors would need to share their complete audit workpapers with competitors providing tax services.
  3. Thousands of companies would need to hire, train and retain larger in-house tax departments that would sit idle for most of the year.

Sarbanes-Oxley has created far more unintended consequences than could possibly be addressed in a single column. Good intentions have been confused with red tape. Not surprisingly, this rushed piece of legislation does not improve on centuries of accumulated wisdom and market discipline. The UK's Institute of Directors has called the U.S. measures draconian. Unlike dynamic and self-correcting market forces, legislation is enduring. Sarbanes-Oxley may indeed save the markets from falling off another cliff, but only by keeping them near the bottom.



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