TCS Daily

Shedding Light on SOX

By Stephen Bainbridge - December 7, 2005 12:00 AM

Behind the Times Select firewall, a New York Times business columnist recently offered a forceful defense of the Sarbanes-Oxley (or "SOX") legislation. Unfortunately, Joseph Nocera's passionate support for SOX led him to disregard Woodrow Wilson's dictum: "The thing to be supplied is light, not heat."

Nocera's piece is billed as a cost-benefit analysis. Yet, on the benefit side, it offers little more than self-serving praise by the law's own authors, while on the cost side it disregards much relevant evidence.

Here are the purported benefits Nocera identifies, with my counterpoints:

  • "Formerly a self-regulated profession, accountants now have to deal with a regulator - the Public Company Accounting Oversight Board - which audits their audits, and isn't shy about telling them what they've done wrong. Auditors are no longer allowed to do consulting work for the same companies they audit. Accounting firms no longer report to management; they report directly to the audit committee of the board, which, thanks to Sarbanes-Oxley, can be made up of only independent directors."
    • Nobody has yet shown that any of these changes would have prevented debacles like Enron or will do so in the future. Indeed, Enron itself had an independent audit committee headed by Robert Jaedicke, a professor of accounting at Stanford University, who could hardly have been more qualified for the job.

  • "It sought to increase badly needed money for the S.E.C., whose enforcement staff is bigger than it was before SOX."
    • A law the breadth of SOX was hardly necessary to increase the SEC's budget.

  • "It forces chief executives and chief financial officers to vouch, in writing, for their companies' financial statements."
    • This change largely duplicated existing law. Nobody has shown that it has accomplished anything that could not have been accomplished by rigorous enforcement of existing law.

  • "It outlaws most corporate loans to top executives."
    • In doing so, it federalized state law governing related party transactions, restricted corporate flexibility with respect to compensation packages, raised questions about the validity of advancement of litigation expenses under state indemnification statutes, and made it harder for companies in high housing-cost areas to attract talent by denying them the ability to subsidize mortgages.
    • When Nocera called to interview me for his column, I emphasized that one of the major costs associated with SOX was the further federalization of corporate governance. I explained to him that, as US Supreme Court Justice Lewis Powell explained in CTS Corp. v. Dynamics Corp., 481 U.S. 69 (1987), the country as a whole benefits because of corporate governance being regulated by the states rather than the federal government. The markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. None of this made it into Nocera's column, although he admittedly told me during the interview that it probably would not do so.

  • "It has forced directors to become more independent of management - allowing them to better serve shareholders, which is supposed to be their primary role."
    • As I explained in a recent article on director independence, these developments "are not supported by the evidence on director performance and, moreover, adopt an undesirable one size fits all approach." The point is not that independent directors have no legitimate role in corporate governance. State law appropriately looks to independent directors to approve conflict of interest transactions, for example. The point is only that one size does not fit all. Firms have unique needs and should be free -- as state law now allows -- to develop unique accountability mechanisms carefully tailored for the firm's special needs.

Turning to the cost side of the equation, Nocera wrote:

"Stephen M. Bainbridge of U.C.L.A., said that Sarbanes-Oxley, like most regulatory efforts, has had unintended consequences. 'They rushed this legislation through without any effort to figure out what it was going to cost,' he complained. 'And the costs have been higher than anybody thought.'

"Like most critics of SOX (as the law has since been nicknamed) Mr. Bainbridge focused most of his ire on a two-paragraph provision called Section 404, which calls for managements to assess their companies' internal financial controls -- and to have their outside accountants audit those controls annually.

"... It is, indeed, a significant new expense, though both Mr. Parrett of Deloitte and Mr. Nally of PricewaterhouseCoopers say that the costs have already started to drop significantly. It's also true, as the critics maintain, that some small companies are going private at least in part in anticipation of the added expense and regulatory burden of Sarbanes-Oxley. But it's worth remembering that small companies don't yet have to institute Section 404, because the S.E.C. is aware of the added burden, and is trying to figure out a way to reduce it.

The evidence suggests that Nocera is far too sanguine. You need to focus not just on the costs, but whether those costs are disproportionately borne by certain companies. The answer is that those costs in fact are borne disproportionately by small companies, even though the very smallest public corporations have been granted some temporary relief from full compliance.

According to a study by ARC Morgan, for example, companies with annual sales less than $250 million incurred $1.56 million in external resource costs simply to comply with one SOX provision (the internal controls required by section 404). Note that that figure includes internal costs, opportunity costs, and intangibles. In contrast, firms with annual sales of $1-2 billion incurred an average of $2.4 million in such costs.

As a result, SOX compliance weighs disproportionately on small public corporations. For many of these firms, operating on thin margins, the additional cost is a significant percentage of their annual revenues.

As for the claim that the high cost of SOX compliance is encouraging such firms to go private, a law review article Emory law professor Bill Carney documented evidence of just such an effect. Indeed, as Illinois law professor Larry Ribstein explains, there is considerable such evidence:

"There is evidence that SOX did have an effect in causing firms to eliminate or reduce public ownership. Studies have shown that 200 firms went dark in 2003, the year after SOX was enacted, that going private transactions increased after the passage of SOX, and that 44 of 114 firms that went private in 2004 cited SOX compliance costs as a reason. Evidence of smaller firms' negative share price reactions to SOX, and of more positive share price reactions to going private after enactment of SOX than before, supports the inferences that SOX caused at least some going private transactions, and that the costs of remaining public are higher after SOX. There is also evidence that firms with higher audit fees were more likely to go dark, thereby linking this decision with the costs of complying with SOX."

Turning to the normative implications of the problem, Ribstein explains:

"This SOX-caused avoidance of securities disclosure has potentially high social costs. First, firms may benefit from public ownership, including by enabling diversification of risk. While the costs of public ownership, including potentially higher agency costs, may outweigh the benefits for some firms, it would be inefficient to impose a regulatory "tax" that causes firms, which would be publicly held without the tax, to be closely held. Yet this could be the effect of SOX if the costs of compliance outweigh the benefits in terms of reducing fraud and agency costs.

"Second, SOX may be encouraging publicly held firms to go dark and thereby lose disclosure transparency for the benefit of insiders and the detriment of outside shareholders who remain in the firm. ...

"Third, there is arguably a positive social externality from public or community ownership.

"... This is indicated by evidence that a significant percentage of firms going private in 2004 were community financial institutions, thereby causing a loss of community ownership."

Finally, there is the flip side of the equation. Just as SOX compliance costs may be driving some publicly held firms to go private, it may be discouraging some privately owned firms from going public. Ribstein reports:

"... companies are opting for financing from private-equity firms, which are helping companies face this 'new world of regulatory scrutiny.'

"The CEO of one company that went this route said 'I think staying private versus tackling Sarbanes-Oxley head-on is something a lot of companies think about.' The article also notes that Sarbanes-Oxley has 'made it harder for small companies to attract outsiders to sit on their boards.' Seems the good directors don't want to take this risk in the SOX environment.

"This is a boon for private equity funds. But 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."

Because these small cap firms are such an important engine of economic growth and technological innovation, the ripple effects of SOX will be felt throughout the economy. By raising the cost of access to the capital markets, SOX likely will slow down the economy in the long-run.


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