VOICES FROM THE INDUSTRY: After 5 years, it’s time to think about changing SOX

Almost five years ago, the Sarbanes-Oxley Act, or SOX, was passed in haste, largely in response to the large-scale securities frauds and market dislocations surrounding Worldcom, Enron and other large accounting scandals involving public firms.

It imposed new federalized standards
for internal controls, corporate governance, accounting independence and review, whistle-blowing and legal review. It represented the most important change to the federal securities laws since the passage of the Securities Act of 1933 and the Securities and Exchange Act of 1934.

SOX in review

Now is a good time to look back to determine whether it has accomplished the legislative justifications for its passage – to restore confidence in our capital markets and to improve corporate governance
to enhance value to shareholders.

Some studies have demonstrated that the economic realities associated with SOX have cost our markets in the trillions of dollars. A Ph.D. dissertation by Ivy Xiying Zhang (“Economic Consequences of the Sarbanes-Oxley Act of 2002”) concludes that the “loss in market value around the most significant SOX rule-making events amounts to $1.4 trillion, which likely reflects direct compliance costs, indirect costs and expected costs of future antibusiness legislation.”

Other anecdotal evidence suggests SOX
is driving innovation in the capital markets to foreign countries. Many companies are now deciding that rather than attempt to become public companies in the United States, it makes more sense to go public in the United Kingdom or Canada.

High compliance costs

A survey by the law firm of Foley & Lardner found that the average continuing annual costs of being a public company had doubled from $1.3 million to $2.9 million for companies with revenues under $1 billion. Moreover, of the 115 public companies responding to that 2004 survey, 21 percent indicated they were considering going private, 6 percent were considering selling the company, and 7 percent were considering merging with another company as a result of SOX requirements.

In my personal experience, I have helped public companies both go private and go dark, principally because of the costs of compliance with SOX. I have advised others to consider private equity transactions or management-led leveraged buy-outs simply to avoid the added costs of SOX compliance.

One of the very difficult areas for the SEC has been the implementation of Section 404, which requires enhanced accounting controls that translate into additional personnel and expense. While for large public companies, that may not be much of a stretch, for the typical small public company, it represents a large portion of their typical revenue.

The SEC recently said it plans to give relief to small companies in complying with Section 404. It is widely anticipated that it will significantly lower, but not eliminate, the costs of compliance for smaller companies. Whether they can afford to remain public remains to be seen.

Has Sarbanes-Oxley been worth it? Clearly, the returns are not in yet. Anecdotal evidence alone is not yet enough to point to an irreversible trend of foreign market attractiveness over US. markets.

The SEC’s new interpretative guidance regarding Section 404 still has to kick in. It is easy to say that it has been a worthy achievement to decouple accounting services from advisory services. Before SOX, both services were being performed by the same accounting firms.

Similarly, holding CEOs and CFOs responsible for the numbers on which the stock of their corporations is traded has probably enhanced their awareness of the financial impact of their decisions.

Passed too fast

Nonetheless, it is equally clear that it was passed far too quickly and has resulted in unintended consequences that are having long-term deleterious effects on our capital markets. However, each of the act’s authors vow that it is not likely to be changed in any significant way soon.

Therefore, we must continue to deal with its fallout. All we can hope is that it does not do too much damage before Congress recognizes that our overall economy has been adversely affected by its passage and that a more thoughtful approach to securities fraud might be better.