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Sunset for SOX

I remember an exchange I had with Cypress Semiconductor CEO T.J. Rodgers this time in 2005 in his San Jose …

I remember an exchange I had with Cypress Semiconductor CEO T.J. Rodgers this time in 2005 in his San Jose headquarters on the subject of corporate malfeasance:

“There are about 17,500 companies in the US and after I get done naming the usual suspects, Tyco, Worldcom, Enron and the rest I would have trouble even naming 17. That’s one-tenth of one percent. I’ll have a bet with good old Sarbanes. I’ll put the deed of my house in the center of the table; he can put the deed for his house on the table. We’ll compare the percentage of companies that are crooked with the percentage of senators that are crooked or even in jail as we speak. Who ever is less crooked takes both deeds.

“He loses and I win.”

One July 1 the Sarbanes-Oxley Act (SOX) will celebrate its fifth birthday. Apart from the accounting profession few will be celebrating with cake and noisemakers. The law was enacted by Congress in 2002 in order to be seen as “doing something” to protect investors by improving the reliability of corporate disclosures in the wake of Enron and Worldcom scandals. Before we blow out the candles, perhaps it is about time our lawmakers step back and objectively judge the merits of the law and its unintended consequences. 

University of California at Los Angeles law professor Stephen Bainbridge who pens his own blog on a variety of legal issues, has recently published  “The Complete Guide to Sarbanes-Oxley” which is one of the best single volume appreciations of what SOX has wrought. Written in plain English, this work concisely sums up the disclosures and controls that are at the center of contention particularly for small to medium businesses on which the burden falls disproportionately. 

Bainbridge calls attention to several absurd results of Sarbanes-Oxley, one of which has been to make accountants unwilling to provide advice on the application of complex accounting standards for fear of compromising their “independence.” Equally bad have been accounting engagement teams who could not provide advice because of second-guessing by their head office bureaucracies. Either way, the essential professional duty to provide advice on complex and uncertain matters requiring judgment has been sacrificed.

He also offers several sobering thoughts based on his research: “There is an irreducible minimum in terms of man-hours and technology costs, so don’t expect to see annual 20% cost savings every year.  Many of these costs do not scale; i.e., they are fixed without regard to company size. Accordingly, when the non-accelerated filers begin having to become Section 404 compliant in the next year or so, they will face disproportionately high compliance costs. “The survey found no reduction in auditor costs. The savings were purely internal. Unless planned AS 5 significantly changes the way auditors approach their duties under 404, this share of compliance costs is likely to continue resisting shrinking.”

In other words if you are looking at ways to further pare SOX compliance costs you need to look elsewhere.

The central issue is simple. Is it worth it? Do the benefits to investors justify the costs? Speaking at the Manhattan Institute recently, Bainbridge recalls being buttonholed after a speech he gave in LA by four small cap CEO who wanted to share their compliance experiences.  “It’s worse than you think,” he recalls them telling him.

Regulatory costs to public companies averaged an astounding $4.36 million for the first year, according to the Committee on Capital Markets Regulation. In an analysis by Henry N. Butler and Larry E. Ribstein published in 2006, The Sarbanes-Oxley Debacle: What We’ve Learned; How to Fix It (AEI Press, 2006), the two authors argue that SOX has been a colossal failure since its enactment in 2002. The act’s unintended consequences, they say, have been onerous for firms that must comply with the new regulations and harmful to the ordinary investors it means to protect. Butler, a professor of economics at Chapman University, and Ribstein, a law professor at the University of Illinois College of Law, find that although direct costs are currently estimated at $6 billion per year, the indirect costs of SOX are, in fact, even greater. They claim that the best evidence indicates that SOX imposes additional net losses to financial markets totaling $1.4 trillion. Indirect costs include creating opportunities for excessive litigation; diverting executives’ attention from maximizing shareholder value; increasing risk aversion by managers; distorting executives’ and directors’ incentives and investment decisions; reducing access to capital markets by entrepreneurs who now have to deal with the increasing startup and ongoing costs of compliance.

But the direct costs are really a minor part of the problem. One CEO of a multi billion retail operation told me that the biggest burden is the opportunity cost. Having to put one’s best brightest people spending time working with accountants and lawyers trying to figure out how to comply with Section 404 and having little definition of when you’re complying or not, means they are not spending time with customers or building or marketing better products.

Capital markets around the world have taken note. The London Stock Exchange has had over 31 dif­ferent presentations for American entrepreneurs who are considering going public, or for investors, where they brag at every opportunity that they are SOX-free. London‘s biggest selling point is that you don’t have to live with this if you list with them. Hong Kong, Shanghai, Luxem­bourg, and in other exchanges are singing from the same hymn book. In 2001, the U.S. raised 48 percent of the public capital in America. In 2006, it’s down to 40 percent. Some projections this figure will decline to 35 percent or 30 percent.

Global capital markets are in flux and not all competitive woes of U.S. financial markets are due to SOX, but why carry the rod if it serves no purpose going forward? Florida Congressman Tom Finney and South Carolina Senator Jim DeMint have proposed a bill that would exempt public companies under $700 million in market capitalization and whose revenues do not exceed $125 million from SOX Section 404. Entitled the “Competitive and Open Markets that Protect and Enhance the Treatment of Entrepreneurs Act,” the measure reflects a recommendation of the SEC’s Advisory Committee on Smaller Public Companies.

Finney is one of the few in Congress who have experienced the dead-hand of regulatory burden. “Years ago, I worked for Chase Manhattan, and at that point we had rep­resentatives from every bank regulatory agency, and frankly, from some of the foreign regulatory agencies who worked in the bank full-time. They didn’t exactly look over our shoulders at every available opportunity, but they sure tried.”

Butler and Ribstein go even further and advocate repealing SOX. They realize that political reality dictates that Congress will not abandon SOX, but most likely will respond to the mounting criticism by fixing the act’s most egregious faults. (The Free Enterprise Fund has brought a landmark lawsuit charging that the Public Company Accounting Oversight Board (PCAOB)-the regulatory body created by SOX is unconstitutional due to its lack of Presidential oversight.)

The two professors propose a number of sensible changes which would go along way to alleviating the burden without injury to investors:

�. Defuse the litigation time bomb by prohibiting private lawsuits;

�. Allow firms to opt into or opt out of some of SOX’s provisions;

�. Exempt foreign firms either from SOX generally or from specific provisions;

�. Exempt all but the largest corporations;

�. Remove criminal penalties to avoid the potential for prosecutorial abuse of criminal sanctions;

�. Revise and soften section 404-the internal control provision-which penalizes and even criminalizes the failure of executives to disclose even remote risks that might later turn into problems.

They also recommend that Congress take a page from the Patriot Act which was passed less than a year before SOX. Unlike SOX the Patriot Act includes sunset provisions for some of its most controversial

Provisions. Investors, say Butler and Ribstein, “would benefit from a sober reevaluation of SOX.” 

Cypress Semiconductor’s irrepressible CEO dismissed SOX as “trivial and expensive” and reckoned that once most of the compliance was automated, much as payroll deductions are, it could become “trivial and cheap.” Resigned to the fact that it wasn’t going away, he urged others to just automate and move on. Maybe it’s time to fight it after all.

About J.P. Donlon

J.P. Donlon
J.P. Donlon is Editor Emeritus of Chief Executive magazine.