Legislate in Haste, Repent at Leisure

We live in an era of instant responses—faxes, cell phones, e-mails—and when, during the Enron scandal, Congress was desperate to be seen as doing something—anything—about corporate governance, we got instant legislation: the Public Company Accounting Reform and Investor Protection Act, popularly known as the Sarbanes-Oxley Act (SOX). Unfortunately, Congress was in too much of a hurry to engage in serious cost-benefit analysis. Instead, it threw a bunch of ideas into a single basket and rushed it into law so that angry investors would blame somebody—anybody—other than Congress for the bursting of the stock market bubble and the corporate governance scandals.

Now the business community, the Securities and Exchange Commission (SEC), and even Congress are waking up to a basic fact: SOX costs us a lot more than anybody anticipated. Talk of regulatory relief is in the air, although there are signs that the relief on offer from Washington will prove less extensive than the business community hopes.

In any case, having legislated in haste, Congress is now repenting at leisure. Whether or not its repentance leads to significant relief, the costly debacle should stand as a cautionary tale the next time Congress wants an instant response to some new scandal.

The Unanticipated Costs of SOX Compliance

As an investor, I don't want my portfolio companies spending a dollar on “good corporate governance” unless doing so adds at least a buck to the bottom line. I don't have any voice in how much to spend on corporate governance, however. Instead, those decisions are made by boards of directors and top management. Unfortunately they have strong incentives to overinvest in compliance.

Why? The answer lies in the incentive structures of the relevant players. Who pays the bill if a director is found liable for breaching his federal or state duties? The director. If the director has adequately processed decisions and consulted with advisers, will the director be held liable? Unlikely. Who pays the bill for hiring corporate governance consultants, lawyers, investment bankers, auditors, and so on to advise the board? The corporation and, ultimately, the shareholders.

Suppose you were faced with potentially catastrophic losses, for which somebody offered to sell you an insurance policy. Better still, you don't have to pay the premiums, someone else will do so. Buying the policy therefore doesn't cost you anything. Why wouldn't you buy it? Unfortunately, that's precisely the choice SOX gave directors and se-nior managers.

According to the Wall Street Journal, publicly traded U.S. corporations routinely report that their audit costs have gone up as much as 30 percent, or even more, as a result of the tougher audit and accounting standards imposed by SOX. Indeed, just paying the fees now required to fund the Public Company Accounting Oversight Board can run as much as $2 million a year for the largest firms.

Professional surveys of U.S. corporations confirm the Journal's report. Corporate law firm Foley & Lardner, for example, found that senior managers of public middle-market companies expect costs to increase by almost 100 percent as a result of SOX, new SEC regulations, and changes to exchange listing requirements.

The most costly statutory provision appears to be Section 404, which requires inclusion of internal control disclosures in each public corporation's annual report. This disclosure statement must include (1) a written confirmation by which firm management acknowledges its responsibility for establishing and maintaining a system of internal controls and procedures for financial reporting; (2) an assessment, as of the end of the most recent fiscal year, of the effectiveness of the firm's internal controls; and (3) a written attestation by the firm's outside auditor confirming the adequacy and accuracy of those controls and procedures.

The SEC initially estimated that Section 404 compliance would require only 383 staff hours per company per year. According to a Financial Executives International survey of 321 companies, however, firms with more than $5 billion in revenues will spend an average of $4.7 million per year to comply with Section 404. The survey also projects expenditures of 35,000 staff hours—almost 100 times the SEC's estimate. In addition, the survey estimates that firms will spend $1.3 million on external consultants and software and an extra $1.5 million in audit fees, a jump of 35 percent.

In fairness, it must be acknowledged that some of these costs were onetime expenses to bring internal controls up to snuff. Yet many will recur year after year. The internal control process post–Section 404 relies heavily on ongoing documentation. As a result, firms must constantly ensure that they are creating the requisite paper trail.

Other ongoing expenses include legal fees, director and officer liability insurance premium increases, and high director fees to attract qualified, independent directors to serve on their boards.

The most troubling aspect of the dramatic increase in compliance costs, however, is that those costs are disproportionately borne by smaller public firms. For many of these firms, the additional cost is a significant percentage of their annual revenues. For those firms operating on thin margins, SOX compliance costs can make the difference between profitability and losing money.

These costs have substantially distorted corporate financing decisions. On the one hand, SOX has discouraged privately held corporations from going public. On the other hand, many publicly held corporations are going private. SOX thus reduces investor choice, makes many investments less liquid, and in the long run likely discourages entrepreneurship by denying start-ups access to financing in the capital markets. By raising the cost of access to the capital markets, SOX will likely retard economic growth.

Yet another major cost associated with SOX is the federalization of corporate governance. The country as a whole benefits from corporate governance being regulated by the states rather than the federal government. The markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core on the fact that corporations are generally organized under, and governed by, the law of the state of their incorporation. This is in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. By expanding the federal role in regulating corporations, SOX has reduced the ability of the states to engage in just such valuable experimentation.

The Purported Benefits

To be sure, SOX has its defenders. New York Times business columnist Joseph Nocera, for example, claims that SOX's various benefits—restored investor confidence, greater corporate transparency, and so on—outweigh the costs it imposes on business. On the benefit side, however, Nocera offers little more than self-serving praise by the law's own authors; on the cost side he disregards much relevant evidence.

The purported benefits Nocera identifies are as follows:

• “Formerly a self-regulated profession, accountants now have to deal with a regulator—the Public Company Accounting Oversight Board—which audits their audits, and isn't shy about telling them what they've done wrong. Auditors are no longer allowed to do consulting work for the same companies they audit. Accounting firms no longer report to management; they report directly to the audit committee of the board, which, thanks to Sarbanes-Oxley, can be made up of only independent directors.”

Nobody has yet shown that any of these changes would have prevented debacles such as Enron or will do so in the future. Indeed, Enron itself had an independent audit committee headed by Robert Jaedicke, a professor of accounting at Stanford University, who could hardly have been more qualified for the job.

• “It sought to increase badly needed money for the SEC, whose enforcement staff is bigger than it was before SOX.”

A law of the breadth of SOX was hardly necessary to increase the SEC's budget.

• “It forces chief executives and chief financial officers to vouch, in writing, for their companies' financial statements.”

This change largely duplicated existing law. Nobody has shown that it has accomplished anything that could not have been accomplished by rigorous enforcement of existing law.

• “It outlaws most corporate loans to top executives.”

In doing so, it federalized state law governing related-party transactions, restricted corporate flexibility with respect to compensation packages, raised questions about the validity of advancement of litigation expenses under state indemnification statutes, and made it harder for companies in high-housing-cost areas to attract talent by denying them the ability to subsidize mortgages.

• “It has forced directors to become more independent of management—allowing them to better serve shareholders, which is supposed to be their primary role.”

These developments are not supported by the evidence on director performance and, moreover, adopt an undesirable one-size-fits-all approach. The point is not that independent directors have no legitimate role in corporate governance. State law appropriately looks to independent directors to approve conflict-of-interest transactions, for example. The point is only that one size does not fit all. Firms have unique needs and should be free—as state law now allows—to develop unique accountability mechanisms carefully tailored for the firms' special needs.

Time for Relief

Instant solutions rarely prove satisfying, as anyone who's ever suffered through a cup of instant coffee knows. Instant legislation is no better. By rushing SOX into law, Congress and President Bush sacrificed the American economy at the altar of short-term political gain. It's time for them to go back and grant the SEC clear authority to provide carefully crafted regulatory relief, especially for the small firms that have disproportionately suffered from the unanticipated costs of complying with SOX.