Easing Sarbanes-Oxley and the Race to the Regulatory Bottom

An amendment that would permanently exempt small public companies from complying with a key provision of the Sarbanes-Oxley Act advanced in Congress Wednesday. Such a waiver demonstrates the bankruptcy of our approach to reform.

Sarbox was passed in the wake of scandals at Enron, WorldCom and others to protect investors. Sections 404(a) and 404(b) are important provisions.

Section 404(a) requires executives to sign off on the integrity of internal controls. Can employees walk off with inventory? Are two people signing checks? Is accounting in order? Basic stuff to reduce the risk of misstatements and fraud.

Section 404(b) requires an outside audit of the above. And that costs money.

At the time, companies with market caps below $75 million successfully lobbied to delay compliance, arguing that the costs were too big relative to their size.

Apparently, a delay is no longer enough. Representative John Adler, a New Jersey Democrat, pushed through the House Financial Services Committee Wednesday an amendment that would permanently exempt companies below $75 million from 404(b). And it would direct the Securities and Exchange Commission to “study” how to ease rules for companies with market caps of under $250 million.

“This is an insult to investors given what we’ve experienced over the past year,” says Kurt Schacht of the CFA Centre for Financial Market Integrity. “Small companies have had plenty of time to plan for this.”

In a phone interview, Adler told me that 404(b) is problematic for several reasons. First, it has reduced the number of IPOs, comparing the 1990s with this decade. Conveniently, this forgets that the number of offerings last decade was dramatically inflated by the dot.com bubble.

Second, he says, small American companies are either moving their headquarters overseas or listing shares in London to dodge Sarbox compliance. Asked for examples, he cited Princeton Review (REVU) and Peet’s Coffee & Tea (PEET). Actually, Princeton Review is based in Massachusetts, Peet’s in California. And both are listed on Nasdaq.

Are small foreign companies listing less frequently in the United States because of Sarbox? Yes, according to a 2008 paper by Suraj Srinivasan of Harvard and Joseph Piotroski of Stanford.

So shed a tear or two for banks, which may lose underwriting fees, and for small foreign companies, which may get locked out, but American investors are protected as a result because our markets have more integrity.

This benefits larger foreign firms that do comply with Sarbox, Srinivasan notes, because compliance gives their managements more credibility.

The legitimate argument against compliance is that it costs money. Those are dollars that small firms can’t invest in their business. But cost estimates vary widely. Adler points to a 2006 SEC study that put the average cost for small firms at $900,000. Jeff Mahoney of the Council of Institutional Investors, however, cites other studies that suggest the cost is lower.

Because of concerns over cost, regulators have already issued guidance instructing auditors to go easy. So if small companies — which have a much higher rate of accounting misstatements than their larger brethren, by the way — don’t want to comply with Sarbox, that’s fine. But they should issue stock privately.

The race to the regulatory bottom continues. With no natural constituency fighting in favor of tough market rules, those subject to them steadily chip away.

The non-response to last year’s financial crisis — toothless reform for derivatives, “resolution authority” that codifies too-big-to-fail — suggests that it will take a total market collapse before we get real reform.

Glass-Steagall, for example, was a great piece of legislation that protected us from the worst excesses of banking. But it took a Depression to deliver it.

Comments

[Steve in Gr...:]

Mr. Winkler, you have missed the point completely.

Sarbanes-Oxley has been a complete fiasco. It has had zero impact in reducing corporate financial reporting fraud and this had been proven empirically.

Its only practical impacts have been to 1) run IPO activity and foreign registrants out of the U.S. stock exchanges, 2) reduce shareholder value by imposing a dead-weight loss in terms of non-value-added regulatory burden and 3) greatly increasing the profitability of the big 4 public accounting firms.

The only reasonable response is to repeal Sarbanes-Oxley.

(What did you expect of a piece of legislation with Paul Sarbanes name on it?)

Nov 04 09:44 PM

[THofler:]

Did I sleep through the last year and a half? Did I only dream that numerous large corporations blew up? That couldn't possibly have happened with the brilliant SarbOx legislation in force, could it?? Surely such an essential piece of legislation would have prevented any dire outcomes.

At a minimum, any corp. with a market cap less than $2B should be exempted from the stupidity that is SarbOx.

Nov 04 11:13 PM

[THofler:]

Large German companies are dropping their NYSE ADR listings. Companies like BASF. Why? There are several reasons, but a big one is the high cost of SarbOx.

The financial crisis has proven that SarbOx's value is nearly nil, but the cost is massively high when the unintended consequences are fully weighed.

Nov 04 11:29 PM

[H.J. Huneycutt:]

SarbOx is part of it, but US GAAP is a bigger part of that. Companies don't want to have to maintain two accounting teams --- one to do financial statements in IFRS and one to do statements in US GAAP.


On Nov 04 11:29 PM THofler wrote:

> Large German companies are dropping their NYSE ADR listings. Companies
> like BASF. Why? There are several reasons, but a big one is the
> high cost of SarbOx.
>
> The financial crisis has proven that SarbOx's value is nearly nil,
> but the cost is massively high when the unintended consequences are
> fully weighed.

Nov 05 12:46 AM

[H.J. Huneycutt:]

"Because of concerns over cost, regulators have already issued guidance instructing auditors to go easy. So if small companies — which have a much higher rate of accounting misstatements than their larger brethren, by the way — don’t want to comply with Sarbox, that’s fine. But they should issue stock privately."

How does this result benefit anyone?

The companies should be required to sign off on internal controls as SarbOx 404(a) requires. 404(b) is simply too expensive for small companies, however.

In an ideal world, would investors be able to audit the internal controls for every company? Yes. In the real world, do the costs of this outweight the benefits? I'd say no.

We could require more and more information from all publicly-traded companies, but each bit of information costs more and more to provide till the costs simply outweight the benefits. SarbOx 404(b) should really only be applied to large and mid sized companies because the high costs discourage companies from ever participating in the system to begin with. In essence, it's like taxing a good at such a high rate, that a black market forms. What good is it to force companies that would otherwise provide public information to the SEC to be private?

I say cap 404(b) to companies with market caps over $500M. Alternatively, allow small cap/micro cap companies that comply with 404(b) to be taxed at a more beneficial corporate rate.

Nov 05 12:54 AM