After the Enron scandal erupted, when Congress was desperate to be seen as doing something -- anything -- about corporate governance, nobody bothered with very much in the way of serious cost-benefit analysis. That particular chicken is now coming home to roost -- and bringing the financial equivalent of bird flu with it. We are now beginning to see just how costly the post-Enron Sarbanes-Oxley Act (SOX) will prove.
According to the Wall Street Journal, publicly traded US corporations routinely report that their audit costs have gone up as much as 30%, or even more, due to the tougher audit and accounting standards imposed by SOX. Indeed, just paying the fees they are now required to fund the PCAOB -- the accounting oversight board created by SOX -- can run as much as $2 million a year for the largest firms.
Professional surveys of US corporations confirm the Journal's reportage. Foley & Lardner, for example, found that: "Senior management of public middle market companies expect costs directly associated with being public to increase by almost 100% as a result of corporate governance compliance and increased disclosure as a result of the Sarbanes-Oxley Act of 2002 (SOX), new SEC regulations and changes to exchange listing requirements."
As a particularized example, consider the havoc being wreaked by SOX § 404. Intended to buttress internal corporate controls, § 404 requires public corporations to include in their annual reports an acknowledgement of management's obligation to ensure adequate internal controls and procedures for financial disclosure. More substantively, the annual report also must contain an assessment by management of the adequacy and effectiveness of those internal controls and financial reporting procedures. Finally, § 404 mandates a report by the corporation's outside auditor attesting to the adequacy and effectiveness of the corporation's internal controls and financial reporting procedures.
The SEC initially estimated § 404 compliance would require only 383 staff hours. According to a Financial Executives International survey of 321 companies, however, firms with greater than $5 billion in revenues will spend an average of $4.7 million per year to comply with § 404. The survey projects expenditures of 35,000 staff hours -- almost 100 times the SEC's estimate. The survey also estimates that firms will spend $1.3 million on external consultants and software and an additional $1.5 million (a jump of 35 percent) in audit fees.
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. The board of directors and top management make that decision (as they should, of course). Unfortunately for the bottom line, however, directors and management have a strong incentive to over-invest in corporate governance consultants and so on.
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 advisors, 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. Would not you buy it? Isn't that exactly the choice SOX gave directors and senior managers?
No doubt, there are some benefits to SOX -- renewed investor confidence and so on. No doubt, moreover, § 404 had laudatory goals. Faulty internal controls, after all, contributed to a number of recent corporate scandals. Given how badly Congress and the SEC underestimated compliance costs, however, serious questions are raised as to whether SOX would pass muster if a serious cost-benefit analysis were to be performed.
We live in an era that expects instantaneous responses. We have instant communication by phone, fax, and email, instant punditry in the blogosphere, and instant books on every scandal du jour. SOX was insta-legislation rushed into law so that angry investors would blame somebody -- anybody -- other than Congress for the Enron scandal. The costly aftermath should stand as a cautionary tale the next time Congress wants an instant response to some new scandal. Somehow, however, I'm not going to be holding my breath.
