Revisiting Sarbanes-Oxley Featured

8:00pm EDT September 25, 2007

The Enron and WorldCom debacles opened everyone’s eyes to the fact that greed and mismanagement can lead to negative consequences in large companies. The result was the Sarbanes-Oxley Act (SOX) of 2002.

However, SOX has mostly had a negative effect on corporations, according to James Strain, shareholder/director, chair of the Business Law Practice Group of Sommer Barnard PC.

Smart Business spoke with Strain about how much SOX has cost publicly held corporations and whether reexamining it would be worthwhile.

Has the act accomplished the legislative justifications for its passage?

The stated legislative justifications for the passage of SOX were to address systemic and structural weaknesses affecting the capital markets, ultimately for the purpose of protecting investors by improving the reliability and accuracy of corporate disclosures made pursuant to the securities laws. It’s fair to say that SOX has increased corporate awareness of public disclosure responsibility, and has largely decoupled the rendering of auditing and other services offered by accounting firms. Whether it has had any hand in restoring investor confidence, however, is far more problematic.

Was SOX necessary to accomplish the asserted justifications?

As passed, SOX contained some good features and many bad features. It’s often thought of as a statute fraught with unintended consequences. The Securities and Exchange Commission (SEC) had enough authority before SOX to have caught and punished those who engaged in securities fraud. The rules imposed on lawyers (‘up the ladder’ reporting of securities fraud, withdrawal from an engagement, etc.) had been required by the SEC since 1980.

The incentives changed with the passage of SOX. There was a perception that lower-level employees of publicly held corporations could ‘blow the whistle’ on securities fraud with impunity and that CEOs could go to jail for signing off on bad financial statements. Independence of board members on audit and other committees and independence of auditing firms became a mandate, because of both SOX and the self-regulatory organizations, such as the New York Stock Exchange and NASDAQ, imposing their wills. What changed for lawyers was sweeping state law breaches of fiduciary duty in with securities fraud.

As important as SOX was in these changes, the rise of percentage of investments made by institutional investors and the fact that they’ve ceded many duties to organizations such as Institutional Shareholder Services has had an equally important, if not greater, effect on corporate governance and responsibility. This trend is unrelated to the passage of SOX.

What has compliance with SOX cost publicly held corporations?

In 2004, Foley & Lardner found that, for publicly held companies with revenues under $1 billion, the average continuing annual costs of being public more than doubled from $1.3 to $2.9 million. Of the 115 companies responding to the survey, 21 percent were considering going private, 6 percent were considering selling and 7 percent were considering merging, all because of the cost of SOX compliance.

In a Ph.D. dissertation by Ivy Xiying Zhang (Economic Consequences of the Sarbanes-Oxley Act of 2002), the author concludes ‘the loss in market value around the most significant SOX rulemaking events amounts to $1.4 trillion, which likely reflects direct compliance costs, indirect costs and expected costs of future anti-business legislation.’

Have the costs of compliance hurt the country in unintended ways?

It seems clear to me that the country has been hurt by SOX. The loss of market value of securities aside, many believe that capital market innovation, long a strength of the American economy, is being driven to foreign countries since the costs of compliance are sufficiently less and their markets are sufficiently global.

Also, the mandated independence has created more of a combative relationship between executives of publicly held companies and their directors. Directors are more worried about personal liability and asserting their independence than they are about making sure the corporation is headed in the right direction. CEOs are spending more time kowtowing to their boards’ desires than strategically planning for the long-term. This trend will undoubtedly hurt the competitiveness of U.S. companies and their ability to prosper.

Has SOX been worth its cost to the country or should it be revisited?

It may be too soon to say there’s an irreversible move away from U. S. capital markets towards global markets elsewhere, but that trend should be a concern. It seems to me that a more thoughtful approach to SOX and an examination of the consequences to date would be good for the country and for the economy.

JAMES STRAIN is shareholder/director, chair of the Business Law Practice Group of Sommer Barnard PC. Reach him at (317) 713-3460.