In today's W$J, Alan Murray uses Georgia-Pacific's going private transaction as a whipping boy in defense of Sarbanes-Oxley. The increased compliance costs imposed on public corporations was one of the reasons G-P offered for its decision to go private. Murray argues:
A recent study by Foley & Lardner LLP found that all the costs associated with being a big public company averaged $14.3 million last year. That was up 45% from the year before, due largely to the requirements of Sarbanes-Oxley. But for a company like Georgia-Pacific, it's still not that big a number.
The implication is that SOX is not driving companies to go private. The problem is that the one piece of empirical evidence Murray cites paints a very incomplete picture.
It is true that for large public corporations, SOX-related costs are a relatively small additional burden. (Of course, for want of a nail ....) But while SOX compliance costs admittedly are difficult to determine, mainly due to a lack of disclosure, the best available evidence suggests that those costs tend to be relatively fixed. According to one study by ARC Morgan, for example, companies with annual sales less than $250 million incurred $1.56 million in external resource costs simply to comply with one SOX provision (the internal controls required by section 404). Note that that figure includes internal costs, opportunity costs, and intangibles. In contrast, firms with annual sales of $1-2 billion incurred an average of $2.4 million in such costs.
As a result, SOX compliance weighs disproportionately on small public corporations. For many of these firms, operating on thin margins, the additional cost is a significant percentage of their annual revenues. Indeed, it seems fair to say that for such firms SOX compliance costs are "that big a number." Not surprisingly, these are precisely the companies most likely to go private rather than incur these costs.
As for the claim that the high cost of SOX compliance is encouraging such firms to go private, Emory law professor Bill Carney found evidence of just such an effect. Indeed, as Illinois law professor Larry Ribstein explains, there is considerable such evidence:
There is evidence that SOX did have an effect in causing firms to eliminate or reduce public ownership. Studies have shown that 200 firms went dark in 2003, the year after SOX was enacted, that going private transactions increased after the passage of SOX, and that 44 of 114 firms that went private in 2004 cited SOX compliance costs as a reason. Evidence of smaller firms? negative share price reactions to SOX, and of more positive share price reactions to going private after enactment of SOX than before, supports the inferences that SOX caused at least some going private transactions, and that the costs of remaining public are higher after SOX. There is also evidence that firms with higher audit fees were more likely to go dark, thereby linking this decision with the costs of complying with SOX.
Turning to the normative implications of the problem, Ribstein explains:
This SOX-caused avoidance of securities disclosure has potentially high social costs. First, firms may benefit from public ownership, including by enabling diversification of risk. While the costs of public ownership, including potentially higher agency costs, may outweigh the benefits for some firms, it would be inefficient to impose a regulatory ?tax? that causes firms, which would be publicly held without the tax, to be closely held. Yet this could be the effect of SOX if the costs of compliance outweigh the benefits in terms of reducing fraud and agency costs.
Second, SOX may be encouraging publicly held firms to go dark and thereby lose disclosure transparency for the benefit of insiders and the detriment of outside shareholders who remain in the firm. ...
Third, there is arguably a positive social externality from public or community ownership. ... This is indicated by evidence that a significant percentage of firms going private in 2004 were community financial institutions, thereby causing a loss of community ownership.
Finally, there is the flip side of the equation. Just as SOX compliance costs may be driving some publicly held firms to go private, it may be discouraging some privately owned firms from going public. Ribstein reports:
... companies are opting for financing from private-equity firms, which are helping companies face this ?new world of regulatory scrutiny."
The CEO of one company that went this route said ?I think staying private versus tackling Sarbanes-Oxley head-on is something a lot of companies think about." The article also notes that Sarbanes-Oxley has ?made it harder for small companies to attract outsiders to sit on their boards.? Seems the good directors don?t want to take this risk in the SOX environment.
This is a boon for private equity funds. But since going public is an important venture capital exit strategy, partially closing the exit could impede start-up financing, and therefore make it harder to get ideas off the ground.
Because these small cap firms are such an important engine of economic growth and technological innovation, the ripple effects of SOX will be felt throughout the economy. By raising the cost of access to the capital markets, SOX likely will slow down the economy in the long-run.
