Fewer choices? Featured

11:07am EDT October 29, 2006
When the Sarbanes-Oxley Act (SOX) of 2002 was passed it was heralded as the major step toward restoring the American investor’s trust in U.S companies, their boards, management and public accounting firms.

Has it been the cure-all since the Enron, Tyco International and WorldCom scandals, or was it a knee-jerk reaction that went too far? As with any new legislation, there are numerous opinions.

According to James Falter, Ph.D. and chair of the Finance Program at Franklin University, “SOX is much bigger than an accounting issue. The positive intent of SOX was to build goodwill, but some of the unintended consequences are negative and need to be considered. Also, the compliance affects shareholders and the investing public. These and other areas need to be further researched and documented as we move forward.”

Smart Business asked Falter for further insight into some of the costs and consequences of SOX.

What are some of the costs associated with SOX?
First of all, there are the compliance costs. These include setting up systems and controls required by the act and the additional accounting and auditing costs that go with that. The largest burden is on smaller companies, those with under $100 million in annual revenues. While larger firms had many of the required control and audit systems in place, there are still extra costs that they had to absorb.

The overall additional costs for compliance vary; however one piece of research estimated costs in stock markets losses to exceed $1 trillion. In March of 2005, it was estimated that it would cost a company with less than $1 billion in annual sales approximately $4 million annually to comply with SOX. Additional costs to meet SOX could force smaller, struggling corporations to consider restructuring or, possibly, bankruptcy.

What are some of the other consequences of SOX?
One of these is less choice for investors. Part of that is created by smaller companies going private rather than going through the time and expense to become SOX compliant. This is especially true of companies that were considering that option already. When they look at all the aspects, it becomes an easier decision for them.

There was a 30 percent increase in the number of firms going private from 2002 to 2003 (the year after SOX). More recently, surveys found 21 percent of corporations considered going private over the past year.

Is there more to their decision than cost?
Yes. One of the variables is the proportion of ‘insider’ ownership. For a company with a larger concentration of shares being held by its executives, going private or ‘deregistering’ is an easier transaction.

Another variable is the personal liability of certification for management and board. Some folks may become excessively risk-adverse. They’ll take the firm private rather than subject themselves to significant personal risk. Again, the fewer public companies, the fewer choices for the investing public.

Shareholders may also become concerned that scared management is spending more time on avoiding risk and less time on maximizing the value of their firm.

Are there other concerns for the American investor?
There can be a further reduction in choice if internal firms avoid the American exchanges because of SOX.

Of the 25 largest successful IPOs in 2005, 23 listed abroad. One factor given by the Bank of China last year in their decision to not list on the NYSE was the additional requirements and costs associated with SOX. Some foreign investors are also concerned that the costs of SOX compliance will affect their investments in U.S. companies.

Are there any newly realized consequences of the SOX reporting requirements?
There certainly are possibilities. Companies used to have 45 days to make quarterly reports. They now have only 35 days. They used to have 75 days after the close of the fiscal year to complete annual reports. They now have 60 days.

The effort, time and money required completing these reports in a compressed time frame and the potential personal liability for management can cause companies to spend more time looking back instead of looking and moving forward.

Do you see any changes or relief on the horizon?
As with most forms of new regulation, SOX was intended to address a problem. Since its inception, however, we must realize that there are consequences. Recently, we have seen calls to re-examine SOX and its unintended consequences. Over the next several years, we will probably see relaxing of SOX 404 compliance.

JAMES FALTER, Ph.D., holds the designation of Certified Financial Planner (CFP), is the chair of the Finance Program, and is a professor in the Vantage MBA Program at Franklin University. Reach him at falterj@franklin.edu or (614) 947-6155.