Today's corporate environment is clouded by widespread suspicion and mistrust. The high-profile failures of Enron, WorldCom and Global Crossing, followed by the revelations of improper financial reporting in complicity with outside auditors led Congress to enact the Sarbanes-Oxley Act (SOX) in 2002.
In hopes of restoring investor's faith in corporate America, SOX established significant changes in both management's reporting responsibilities and the scope and nature of the auditor's responsibilities.
The cost of SOX compliance comes with a high price tag. Companies face both direct (quantifiable) and indirect (non-quantifiable) costs such as increased D&O insurance premiums, higher directors fees as a result of greater time commitments and responsibilities, larger expenses related to internal control software and higher costs relating to consulting fees.
Both types of costs have proven to be significantly higher than originally estimated by the Securities and Exchange Commission (SEC).
Since SOX was passed, much has been written about the costs and benefits of corporate compliance -- specifically Section 404 which mandates an audit of internal accounting controls.
Corporate America and the government agree that restoring investor confidence is in the best interest of the economy, publicly traded corporations, and investors; however, they disagree on the actual cost of SOX compliance.
Investors know that final solution is to create a moral and ethical environment in which corporate wrongdoing cannot occur. Will SOX create this environment? Doubtful, however it can play a major role. Below is a discussion about the impact the high costs of compliance and potential long-term benefits to companies, investors and the U.S. financial markets.
Cost of complianceThe direct and indirect cost of compliance can grouped into three sections: Costs related to increases in personal liability obligations; costs associated with internal control improvements; and costs to the U.S. financial markets.
Through new substantive requirements, increased penalties, and an increased emphasis on enforcement, SOX regulations have increased the risk that corporate officers and directors will be subject to personal civil and criminal liability. This risk results in increased legal fees; executive, board and officer compensation; insurance premiums and outsourcing costs to help monitor internal audits.
Personal Liability ObligationsAuditors now face additional costs that are passed on to corporate clients. For example, large accounting firms must undergo annual quality reviews, while smaller firms must undergo a review every three years. SOX"s requirement that audit partners must rotate every five years, and that outside auditors attest to and report on the management"s assessment of the internal controls of each issuer also increases auditor costs.
Due to heightened political and legal risks associated with service as a CEO, CFO or board member, companies have been forced to increase compensation to lure executives into running a company under intense scrutiny.
Finding suitable individuals has become an expensive undertaking and the fees for an executive search must be shared by companies, investors and customers.
Companies additionally face increased legal fees because boards must hire outside lawyers and consultants for advice on their expanded role and help minimize risk.
With increased responsibility and accountability for directors and officers, D&O coverage has become more difficult to obtain and thus more expensive.
For many companies, outsourcing the compliance procedure is a better alternative than managing the procedure with internal resources. Retaining a third-party helps ensure independence, achieve broader coverage, and compensate for a lack of internal expertise and staff availability.
As a result of the increase in personal liability, companies may become more cautious and risk-adverse in the post-SOX environment and this is where indirect costs come into play. Many corporate officers and directors might be too fearful of personal liability to take business actions with risks.
These individuals may decide that it is far better for a company to restrain its growth and produce steady profits than to take the risks associated with reaching for dominance in its market or entering entirely new areas of activity. This approach inevitably stifles innovation, and the economic growth of both the company and the economy.
Costs associated with Internal Control Improvement In order to create strong internal controls, many companies must update and refurbish their existing information technology systems to allow standardization and integration throughout all applications company-wide.
Time and money are limited resources for companies. Devoting time and money to SOX compliance can limit other activities for which those resources could have been used from research at a biotech plant, to analyst hiring at an asset management firm, to maintenance of an employee benefit program. Additionally, as companies scrutinize their internal controls and become more conscious of the process used to make decisions, they may become more risk-adverse and slower to seize opportunities.
Some companies must pass their administrative costs of SOX compliance onto customers by increasing prices, thus making the company less competitive in the marketplace, especially to foreign competition not subject to SOX. Critics argue that although SOX has raised the level of disclosure, the readjustment of costs affects a company"s global competitiveness. Furthermore, the restraints from internal controls reduce the flexibility to respond to customer concerns.
Costs to U.S. Financial MarketsThe burdens of the SOX are forcing many smaller public companies to consider "going private". A study by accounting firm Grant Thornton LLP found that "going-private" transactions in the 16 months following enactment of the SOX increased 30% over the 16-month period immediately preceding enactment Some companies see Section 404, which has resulted in higher than expected costs for many public companies, as the final straw which may result in another wave of companies electing to abandon their public status.
In its revised proxy statement filed December 30, 2004, the equipment leasing company Bestway, Inc. stated it was going private because of the cost and burden associated with SOX. Rather than going private, some companies are deregistering from exchanges or "going dark"; a process which decreases the burden of disclosing financial information.
Technically, the shares can still be bought and sold, however they are listed on the "pink sheets", the National Quotation Bureau's list of daily quotes for companies not listed on any stock exchange. An article by Jan Norman in the Orange Country Register cites Anacomp as an example.
According to Norman, Anacomp estimates that deregistering will save approximately $3.2 million over the next two years, primarily in costs for complying with SOX Although concerning, relatively few public companies have the ability to "go-dark". To qualify, there can be no more than 300 holders of record, or fewer than 500 record holders and less than $10 million in assets.
These requirements are limiting, as it is far fewer than what a typical company would hold. Holders of record, which are different from shareholders, include brokerage firms that hold shares on behalf of hundreds of shareholders.
Conversely, fewer companies are willing to enter the market. SOX requirements make "going public" costly and the maintenance required to "stay public" prohibitively expensive, forcing companies to look elsewhere to raise capital.
Foreign companies are also hesitant about the requirements that SOX regulations would impose and are reluctant to commit to the U.S. capital markets. U.S. institutional investors are becoming more willing to invest in foreign markets. For some, the benefits of being on a U.S. exchange may not outweigh the costs of U.S. legal and regulatory compliance (in addition to the typical international challenges of cultural and regulatory differences).
For example, Porsche AG elected not to list shares on the NYSE, reportedly due to its objection to the certification of financial statements requirement of the SOX Act.
In addition, SOX makes acquisitions of U.S. public companies by foreign entities more expensive. U.S. laws require registration of the foreign company shares with the SEC before the transaction can take place. Registration entails, among other things, full compliance with SOX. Therefore, if the foreign acquirer is not listed in the U.S. it will be difficult to issue its own shares to the selling shareholders of the U.S. firm.
Shot & long run impact of costsThe costs of SOX compliance negatively affect companies, markets, investors, and economic growth in the short run. So what can we expect in the long run?
If rising costs persuade large numbers of companies to exit the public markets to sidestep SEC regulation, two distinct problems are created. First, the overall economy could suffer because corporations limit investment projects due to the higher-cost sources of capital to fund potentially new operations.
Second, financially stressed companies that "go dark" are the very companies shareholders need to monitor and where transparency is most important. Ironically if Enron had gone dark, shareholders would not be funding them by purchasing their stock.
Although the U.S. markets and economy are currently suffering, evidence suggests this may only be a temporary glitch. For example, there has been a recent resurgence in the IPO market and foreign countries have started adopting and applying various parts of SOX to companies under their jurisdiction.
If costs of compliance fall or stabilize over time, and international markets adopt a similar version of SOX, U.S. markets could potentially create even more wealth and productivity for the U.S. economy and surpass levels of the late 1990s.
The primary goal of SOX was to help investor confidence in the public marketplace. Investors had lost faith that their investments in American companies were safe. This lack of faith resulted in the decline of stock values. Investors also believe that most of the scandals could have been prevented if the accounting misconducts could have been better monitored and thus deterred by regulatory agencies.
The critics correctly assert that complying with SOX is not sufficient to restore faith in America"s financial markets. Indeed, additional steps are necessary because, by itself, SOX simply cannot address one of the driving causes of the accounting failures “ the short-term thinking of corporate managers who want to increase the current stock price without appropriate regard for the long-term cost and ethical issues.
However, by embracing the spirit of SOX, managers can improve their internal controls, board performance, and increase disclosure and reduce costs. Yes, costs can likely be reduced over time.
A company with good communication, a more involved board of directors, more robust audits by external auditors, enhanced internal audit resources and performance, higher quality financial statements, fewer restatements of financials and improved operational efficiency will clearly be more attractive to investors.
Companies that adhere to the minimum necessary for compliance will realize little in the way of benefits of SOX. Not only are they wasting an important opportunity; but investors, lenders, insurance companies may question whether such companies are sincere in establishing a culture of ethics, transparency, and a commitment to reliable financial reporting.
As more companies exceed mandatory compliance, competitors will need to conform otherwise they will find themselves at a competitive disadvantage.
For example, individuals with a poor credit record may not be able to lease an apartment; likewise, companies that fail to comply with SOX are not desirable to investors and banks. By over complying, a company can create an environment in which competitors must follow suit.
While the initial costs of SOX are high, the potential long-term benefits of improved operating will translate into substantial cost savings down the road. The hope is that the majority of SOX costs will be one-time, start-up expenditures and learning curve costs that typically occur with any new compliance regime. Costs such as software installation and development of disclosure controls should hopefully decline after the first year of implementation.
If the ultimate goal of SOX is to restore investor confidence in the markets, then the question should not be if companies can afford compliance, but rather can investors and financial advisors afford to be without it? Additional information on balance sheets and executive accountability helps companies stay on course however there is the highly unquantifiable matter of confidence.
Without it, investors will view the American equity marketplace as too volatile and expect greater returns for that higher degree of risk. Refco and Bayou are two recent reminders that underscore this point.
In the long run, companies that invest in appropriate internal controls are not only more likely to have more reliable financial statements, but also will benefit from better management information structures. Other improvements include the reconciliation and segregation of duties, and enhancement of IT.
Companies that have more confidence in their control structure and are evaluating accounting risks should enable investors to have more confidence in the reliability of unaudited data furnished to the securities' market. Thus, better information and internal controls lead to too greater operational efficiency and better long-term performance.
Risk management, reduced fraud risk, enhanced governance, and strengthened controls resulting from implementation of SOX will strengthen investor confidence. This in turn reflects positively on the U.S. economy, and the intangible benefits should hopefully outweigh the calculable costs to public corporations of compliance with SOX.
Initial spending on compliance will divert funds that could have been used to boost earnings and dividends. In the short-term, valuations may shift downward. However, if SOX helps to restore investor faith in the honesty and transparency of public companies, these downward valuations may become positive valuations in the long run.
ConclusionClearly, SOX has both positive and negative effects. However, the implementation problems of the past three years do not provide sufficient reason to weaken or eliminate SOX requirements or to adopt significant exemptions based on company size.
This would be premature and could seriously damage important reforms that are helping to restore confidence in the U.S. capital markets. Three years is not enough time to fully measure SOX"s ongoing costs and benefits. This is not to suggest that investors will tolerate unnecessary costs or gouging by audit firms related to internal control certification.
Rather that we must exercise patience. In time, corporate America and the U.S. government will be able to produce a more accurate cost/benefit analysis. Then and only then will we know if this "reactionary" Congressional Act has a predominating positive effect of increased investor confidence in the market or a prohibitory cost that results in lowered productivity of public companies and dilution of the dominant U.S. financial services market.
Paul Lowengrub, Ph.D., is a manager in the Network Industries Strategies group of the FTI Economic Consulting practice and is based in Washington D.C. Dr. Lowengrub is an expert in corporate finance, applied econometrics, international finance, and applied microeconomics.
He holds a Ph.D. in Economics and Finance. He is also an adjunct faculty member in the School of Professional Studies and Business Education at Johns Hopkins University.
