After the Securities and Exchange Commission’s latest public meeting, the media widely reported that the commission was preparing significant regulatory relief for the smaller public corporations on whi Sarbanes-Oxley imposes significant costs.
Columnist Phil Mattera complained that the SEC will "soften one of the key regulations enacted by Congress to prevent corporate fraud." A U.K. financial reporter said "small U.S. companies received an early Christmas present from the SEC," while The Associated Press likewise called it one of several "early Christmas gifts for corporate America." On close examination, however, the media attention is much ado about little, because the SEC changes turn out to be mostly cosmetic.
No serious observer doubts that the Sarbanes-Oxley Act has cost far more than even its most fervent critics anticipated when the bill was pending back in 2002. 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, due to the tougher audit and accounting standards imposed by SOX. Indeed, just paying the fees now required to fund the PCAOB can run as much as $2 million a year for the largest firms.
Professional surveys of U.S. corporations confirm the Journal’s report. Foley & Lardner, for example, found that middle market companies saw "costs directly associated with being public to increase by almost 100 percent as a result of corporate governance compliance and increased disclosure as a result of SOX, new SEC regulations and changes to exchange listing requirements."
The Paulson Committee recently concluded that "complying with Section 404 of the Sarbanes-Oxley Act cost companies, on average, $4.36 million in the first year — a stiff price for most public companies and a significant burden for small ones, particularly first time market entrants."
Worse yet, many of these costs have proven to be both recurring and resistant to scaling. As a consequence of the latter, costs have fallen disproportionately heavily on smaller firms. The Paulson Committee’s report confirms that these costs are making it hard for such firms to compete and, as a result, U.S. competitiveness as a whole is suffering.
At present, the smallest public corporations are exempt from complying with Section 404, although they must comply with the rest of Sarbanes-Oxley’s numerous requirements. Many observers have recommended that the SEC permanently exempt smaller firms from Section 404 and consider making other SOX provisions less onerous for such firms.
At its recent meeting, however, the SEC confirmed that no such exemption will be forthcoming. Instead, the deadline by which smaller firms must be fully compliant with Section 404 was extended by about a year. In addition, the SEC promised to release "guidance" on which managers can rely in complying with Section 404 that will reduce costs.
Guidance does not create safeharbors by which compliant firms are insulated from liability. To the contrary, guidance is inevitably vague and ambiguous, leaving plenty of room for interpretation and disagreement. Conversely, determination of whether a particular firm has complied with its SOX obligations is highly fact-specific and contextual, such that mere guidance is unlikely to be determinative of whether the firmproperly complied.
Mere guidance will not change the incentives of corporate officers and directors. The Sarbanes-Oxley Act created significant new civil and even criminal liabilities for officers and directors whose firms have inadequate internal controls or improper financial disclosures.
The best way for directors and officers to avoid these liability risks is to pump a lot of corporate resources into ensuring compliance with Section 404 and the rest of SOX. Because it is a corporation’s directors and officers who control the purse strings, they get to decide just how much resources the corporation spends on SOX compliance. Because the money spent on compliance programs comes out of the corporation’s bottom-line, however, the money comes out of the stockholders’ pockets.
To put the directors and officer’s incentives in everyday terms, suppose you’re playing Monopoly and can buy a get out of jail card using somebody else’s money. Wouldn’t you do it every time?
Nothing the SEC has done or plans to do will change the existing incentive structure for officers and directors. The firm’s top management will still have plenty of incentives to spend shareholder money on protecting themselves from SOX liability.
American business is hemorrhaging and the SEC’s solution is to slap a Band-Aid on the problem. What’s needed here is surgery. As the SEC’s own advisory committee recommended last year, we need to establish a scaled system of regulation in which smaller firms bear a regulatory burden proportionate to their size.
Because the costs of complying with Section 404 have proven so resistant to scaling, moreover, the smallest public corporations (so-called microcaps) ought to be permanently exempted from the internal control audit requirement.
