The Sarbox Ball and Chain
July 1 2003 by Pamela Mendels
As a former business school dean who taught courses in corporate ethics, Gary Costley hardly fits the profile of the wayward CEO. But like chief executives at public companies throughout the United States, he is doing penance for the sins of others.
Thanks to the financial scandals at Enron, WorldCom and elsewhere, Costley, chairman and CEO of International Multifoods, a $940 million food marketer in Minneapolis, is coping with understanding and carrying out a slew of new federal regulations aimed at preventing corporate wrongdoing. The rules have brought some benefits, he says. But they have also led to longer board meetings, a doubling of directors’ and officers’ insurance rates and more employee time devoted to the business of compliance rather than the business of business. In the end, the Enron debacle will have cost International Multifoods millions of dollars.
Costley is hardly alone. As the new rules of corporate governance mark their first anniversary this month, CEOs and directors across the country are just beginning to get their arms around the impact of the Sarbanes-Oxley Act, or Sarbox as it’s become known. The 66-page overhaul of corporate regulation established new rules on everything from the composition of audit committees to penalties facing corporate chiefs-turned-scoundrels-up to $5 million in fines and 20 years in prison. CEOs and their teams are now scrambling to comprehend a whole new set of rules and get new policies and procedures in place. They can’t afford to make mistakes. “CEOs have taken it on the chin as far as public relations,” says David B.H. Martin, partner in charge of the securities practice for the Washington, D.C.-based law firm of Covington & Burling. “They are on a shorter leash.”
Many large companies have had a head start in getting ready for Sarbox and new regulations proposed by the stock exchanges-and they also have the resources to put the necessary procedures in place. Henry McKinnell, chairman and CEO of $32 billion Pfizer, for example, says his company had met the bulk of Sarbox mandates before the law was even passed. He argues that the scandals had so tainted business, that they demanded a “very public” response. Sarbox and the stock exchange proposals, he says, “went a long way to restoring investor confidence.”
But for smaller companies, particularly those under $1 billion in sales, the costs of complying are more significant proportionately. The new rules also imply a change in tone at companies that prided themselves on informality and collegiality. In more and more board rooms, CEOs and directors are treating each other with a heightened awareness of their separate roles. “There’s a subtle more €˜you’ and €˜I’ than €˜we,’” says Sidney W. Emery Jr., chairman and CEO of MTS Systems, a $350 million supplier of testing and simulation equipment in Eden Prairie, Minn.
The law re-enforces this formality in a number of ways, including prodding greater independence of directors. Under the new regime, for example, a listed company’s audit committee, which must contain at least one financial expert or disclose why it lacks one, assumes the responsibility of appointing and overseeing independent auditors. The New York Stock Exchange aims to go further, proposing that the boards of listed companies be composed of a majority of independent directors and that nominating and compensation committees exclude insiders altogether.
As they seek an appropriate balance between skepticism and collegiality, boards are also spending more time with CEOs. “The meetings are longer and there are more of them,” says Stephen Marcus, CEO and chairman of The Marcus Corp., a $350 million Milwaukee-based lodging and entertainment company. Board service typically lasts twice as long as it did pre-Sarbox, according to Julie Daum, the US board practice leader for Spencer Stuart. And there’s more work. A number of nominating committees, for example, have decided to vet candidates before the CEO does, a reversal of the pre-Sarbox practice, says Korn/Ferry Managing Director Charles King.
Sarbox has prompted some boards to do serious house cleaning. At Marcus, directors and executives held a special meeting to discuss the new rules and ended up examining the duties of all committees. One result was that committee charters, previously about a paragraph long, were re-drafted and transformed into detailed, three- or four-page descriptions of responsibilities.
In some cases, the introspection is provoking significant change at the top. Earlier this year, Applica, a $370 million Miami Lakes, Fla., manufacturer of small appliances, altered membership of its board to ensure it would seat a majority of independent directors. It also went beyond the new rules and took a step that many good governance advocates endorse: separating the CEO and chairman positions.
David Friedson, Applica’s chairman, decided this was the best way to ensure that the chairman and CEO maintain different, if complementary, takes on the company. The change is already evident in subtle ways , he says. In early spring, just as reports of the SARS crisis in the Far East began trickling in, employees were about to embark on business travel to Hong Kong and China. Pressed to meet this year’s numbers, a CEO/chairman might have decided to proceed with the trips. The board, however, took a longer view and canceled them.
Strengthening of boards has presented little problem for CEOs who think emboldened directors lend valuable insight to a company. Costley believes the new climate may have encouraged his already-involved board to redouble its efforts, and recalls one director asking a question he had never before heard: Do local auditors consult with their national offices when accounting matters could have varying interpretations, and, if so, what is the outcome? “It’s an excellent question, because it gives an audit committee some idea of the interplay between a local division of an accounting firm and its national office,” says Costley, who intends to pose the question himself at his own company and at meetings of the two outside boards on which he sits.
The CEO now also must attend to a number of new mandates-and it’s been a part-time job just to figure them out. Ned Regan, former comptroller of New York State and now president of Baruch College in New York City, says he might not have met the Securities and Exchange Commission’s original definition, now broadened, of an audit committee’s “financial expert.” And more than one executive is grumbling about a burgeoning business in compliance consulting.
Perhaps no aspect of the law has caused CEOs more consternation than Section 404, requiring annual reports to contain management’s assessment of a company’s internal financial controls. The SEC issued final rules for compliance only in late May, so the provision will take effect for fiscal years ending on or after June, 2004 for larger companies-or April, 2005 for companies with a market cap less than $75 million-not September, 2003 as originally planned. But in the face of uncertainty earlier this year as they awaited the final rules, many CEOs pushed ahead to introduce new procedures.
At International Multifoods, the CFO, general counsel, division heads, internal auditors and a number of others-the equivalent of five full-time employees-were enlisted to develop a plan to produce the documentation necessary under Section 404, and they expected to be at the job for six to eight months. “It’s a task not unlike starting a new computer system,” Costley says.
An expensive proposition
Sarbox is consuming resources in other ways, too. In April, Champps Entertainment, a Littleton, Colo.-based restaurant company, was rolling out an 800 phone number for whistleblowers to call, in accordance with the rules for Section 301, requiring that board audit committees provide a way for employees to make confidential and anonymous complaints if they suspect financial impropriety. “Our audit committee was very aggressive in making sure we were in compliance,” says CEO and Chairman William Baumhauer, who adds that the group hired a law firm, at about $75,000, for a thorough review of all board procedures.
Add to that the Sarbox provision requiring that CEOs and CFOs of public companies certify that their annual reports offer a fair picture of the company’s finances. While CEOs may have always assumed they were liable for the accuracy of the numbers they put out to the public, the new mandate ups the ante. Essentially, it gives federal authorities who want to prosecute executive fraudsters “a real legal hook they didn’t have before,” says Stephen Wallenstein, a law professor and executive director of the Global Capital Markets Center at Duke University’s Fuqua School of Business. Indeed, the first action against a CEO under the new provision came only months after the law was signed, when Richard Scrushy, the ousted CEO of HealthSouth, faced charges related to his certification of its financial statements.
There is some anecdotal evidence that many executives are taking heed of the certification provisions and scrutinizing financials more carefully before signing off on them. The number of late filings of 10-Ks, for example, jumped considerably to 1,634 in the first three months of 2003, from 1,268 in the same pre-Sarbox period last year, according to Martin X. Zacarias, who runs 10Kwizard.com, a Web site that gives access to SEC filings. And a number of companies are adopting the practice of “cascading” certifications, in which division heads and others must sign their financials before passing them up to the next level in the corporate hierarchy, says Rick Fumo, senior vice president at Parson Consulting, a Chicago firm that specializes in corporate finance functions.
For the moment, at least, this new attention to detail means more time on the job for the number-crunchers. In a March survey by Parson of 100 senior financial executives, respondents reported their work weeks were being stretched by an average of three hours to meet the demands of Sarbox.
The new law weighs so heavily on financial executives that Fumo predicts more “healthy tension” between CEOs intent on forging ahead and CFOs determined to make sure the numbers from past quarters are squeaky clean.
Executives at some smaller enterprises are feeling tension of a different sort: They say Sarbox is simply too expensive. Thirty-two senior executives at small- and mid-cap companies, polled by the Foley & Lardner law firm, calculated that the reforms-and the climate that created them-would bring, on average, a 90 percent jump in the cost of compliance with governance regulations, from about $1.3 million annually to about $2.5 million. D&O insurance, for example, was expected almost to double, to $639,000 a year. Bert Brodsky, CEO of Sandata Technologies, an information systems company in Port Washington, N.Y., calculated that Sarbox would boost compliance expenses to about $500,000 a year, or about 3 percent of annual revenues. “It’s outrageous,” he says, and he has responded dramatically-by deciding to take his company private.
Few CEOs plan to go as far as Brodsky, and it would be difficult to find a chief who did not agree with the rules’ goal of stamping out corporate corruption. Still, many say the regulations are heavy-handed. Walter Young, chairman and CEO of Champion Enterprises, an Auburn Hills, Mich.-based builder of manufactured homes, fears they could turn entrepreneurial executives into corporate compliance officers. “We are going to be spending most of our time in CYA [Cover Your Ass],” he says.
The considerable challenge now, for CEOs of companies of all sizes, is to successfully repair the damage to corporate reputation, while not letting that distract them from the business of growing their companies for the future.