TCS Daily

SOXing It to Small Businesses

By Stephen Bainbridge - April 12, 2005 12:00 AM

On April 13th, the Securities and Exchange Commission will (finally) hold a hearing on the impact of Sarbanes-Oxley's internal controls reporting requirements. It's a small step in the right direction.

It's now beyond dispute that Sarbanes-Oxley has imposed a much higher regulatory burden on US public corporations than the law's sponsors ever imagined. It's also beyond dispute that those costs are disproportionately borne by small business.

Although many SOX provisions impact small business, the worst offender appears to be Section 404, which requires inclusion of internal control disclosures in each public corporation's annual report. This disclosure statement must include: (1) a written confirmation by which firm management acknowledges its responsibility for establishing and maintaining a system of internal controls and procedures for financial reporting; (2) an assessment, as of the end of the most recent fiscal year, of the effectiveness of the firm's internal controls; and (3) a written attestation by the firm's outside auditor confirming the adequacy and accuracy of those controls and procedures.

Study after study confirms that Section 404 has imposed huge costs on American business:

  • By one estimate, some companies will incur 20,000 staff hours to comply with Section 404, something the SEC estimated would take only 383 staff hours.
  • A Financial Executives International survey of 321 companies found that firms with greater than $5 billion in revenues spend an average of $4.7 million per year just to implement SOX section 404.
  • A survey by Foley & Lardner found that the average cost of being public for a company with annual revenue under $1 billion increased by $1.6 million -- 130% -- after SOC went into force.

In fairness, it must be acknowledged that some of these costs were one-time expenses incurred to bring firms' internal controls up to snuff.

Yet, many of these costs do in fact recur year after year. The internal control process post- Section 404 is heavily reliant on on-going documentation. Auditors are obliged to assume that the firm's financial control are not adequate absent full documentation of the financial accounting processes. As a result, firms must constantly ensure that they are creating the requisite paper trail.

Other on-going expenses documented by the Foley & Larnder study included legal fees, D&O insurance policy premium increases, and the need to pay higher director fees in order to attract qualified independent directors to serve on boards of directors. (The expanding duties and liability exposure of such directors has become a major recruiting problem for many firms.)

Finally, the Foley & Lardner study found that these costs are disproportionately borne by smaller public firms. That finding is confirmed by data from a study by three University of Georgia economists, who found that post-SOX director compensation increases have been much worse at small firms:

There is also strong evidence that SOX has imposed disproportionate burdens on small firms. For example, small firms paid $5.91 to non-employee directors on every $1,000 in sales in the pre-SOX period, which increased to $9.76 on every $1000 in sales in the post-SOX period. In contrast, large firms incurred 13 cents in director cash compensation per $1,000 in sales in the Pre-SOX period, which increased only to 15 cents in the Post-SOX period.

These costs have distorted very substantially corporate financing decisions. Amity Shlaes recently wrote an op-ed that appeared in TCS providing a fascinating look at how SOX discouraged one firm from using an IPO to raise money in the capital markets. This is not just an isolated case. As law professor Larry Ribstein observed, it appears that start-up "companies are opting for financing from private-equity firms," rather than going public. In the long run, or perhaps the not so long run, closing the public capital markets to start-ups may have a very negative effect on the economy, according to Ribstein: "since going public is an important venture capital exit strategy, partially closing the exit could impede start-up financing, and therefore make it harder to get ideas off the ground."

It isn't just start-ups that are being affected, moreover. The Foley & Lardner study found that 21% of the respondent firms were considering going private. A study by law professor William Carney found that of 114 companies that went private in 2004, 44 specifically cited SOX compliance costs as one of the reasons they were doing so.

In sum, SOX imposes high regulatory costs that place particular burdens on smaller publicly-held companies. As a result, many firms are deciding not to go public, while a substantial number of public firms are going private.

SOX thus reduces investor choice, makes many investments less liquid, and in the long run likely will discourage entrepreneurship by denying start-ups access to financing in the capital markets.

One hopes the SEC will get an earful on these topics at the April 13th hearing. One also hopes the SEC decides to do something about it, by carving out exemptions for smaller firms from the more burdensome aspects of SOX compliance.


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