Marc Morgenstern

Wednesday, 26 May 2004 12:19

Best intentions

The corporate world was dramatically altered by The Sarbanes-Oxley Act, Congress' hasty response to corporate scandals. Intended to restore investor confidence, the legislation increased public company financial statement transparency, management liability and board involvement. Its unintended statutory consequences, however, created an unacceptable cost-benefit.

Direct costs for even small public companies range from $500,000 to $2 million annually, sharply contrasting with the SEC's $5,000 estimate. The costs directly decrease profits, since there is no offsetting revenue. Reduced net income yields a lower stock price and market capitalization.

Less easily measured is the cost of management time diverted to statutory compliance. Unlike at larger public companies, mid-cap CFOs make significant operational decisions in addition to their financial and disclosure roles. Time spent installing systems and meeting with professionals hurts profitability.

The act also increases personal liability for directors. Director response has led to lengthier board meetings designed more to evidence fulfillment of their fiduciary obligations than to achieve corporate goals.

Financial statements are disproportionately emphasized rather than sales, growth and profitability. This cautious environment minimizes risks rather than maximizing rewards.

True investor confidence is created and sustained by profit and growth, not legislation. Profit and growth are generated by marketing, technology, global sourcing, and economic and political sophistication. Broad operational experience permits a skill-balanced board to effectively shape corporate strategy and decisions.

That is clearly not the teaching of Sarbanes-Oxley, nor is it how companies have redesigned boards in response. Companies are appointing accountants and CFOs with increasing frequency. Potential directors with great business talent but without financial statement orientation are reluctant to serve as directors.

And many public companies are questioning the fundamental benefits of being public.

Many profitable private companies are remaining private or achieving corporate liquidity through business combinations with competitors. Smaller public companies are deregistering their stock or selling to competitors. The consequence is a less vibrant public marketplace and diminished competition.

Sarbanes-Oxley is classic example of legislative overreaction reflecting political hysteria rather than reasoned analysis. Long term, the statute harms the marketplace and the investors it sought to help.

The governance issues raised statutorily need to be readdressed and modified. If not, public companies will be increasingly managed by directors with narrow skill sets incapable of achieving the congressional goal. The number of smaller public companies will further diminish. These results are unintended, undesirable and should be unacceptable. Marc Morgenstern is the managing partner of Kahn Kleinman. He is a nationally known expert on securities and corporate legal matters. Morgenstern is a veteran dealmaker and has handled hundreds of transactions. His observations have been quoted extensively in the national media, including The Wall Street Journal, Business Week and USA Today. Reach him at (216) 696-3311.