My Examiner column:
Apologists for the Sarbanes-Oxley Act claim that its corporate governance reforms benefit the American economy in a number of ways, including restored investor confidence in the integrity of the capital markets, enhanced corporate disclosures and reduced incentives for corporate management to manipulate stock prices. Unfortunately, these benefits are both intangible and resistant to measurement.
While we thus don’t know whether SOX in fact benefits the economy, we do know that it has imposed a much higher regulatory burden on U.S. public corporations than the law’s sponsors ever imagined. According to The Wall Street Journal, for example, 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.
The chief regulatory culprit is SOX section 404, which requires both management and the company’s outside auditors to annually assess the firm’s internal controls over financial disclosures. The Securities and Exchange Commission 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 greater than $5 billion in revenues spend an average of $4.7 million per year to comply with section 404.
The survey also projected expenditures of 35,000 staff hours — almost 100 times the SEC’s estimate. Finally, the survey estimated that firms will spend $1.3 million on external consultants and software and an extra $1.5 million (a jump of 35 percent) in audit fees.
To be sure, some of these costs were one-time expenses incurred to bring firms’ internal controls up to snuff. Yet, many other SOX compliance costs recur year after year. For example, the internal control process required by section 404 relies heavily on ongoing documentation. As a result, firms must constantly ensure that they are creating the requisite papertrail.
In addition, other ongoing expenses imposed by SOX include legal fees, premium increases in directors and officers insurance policies, and higher director fees to attract qualified independent directors to serve on boards of directors.
These costs are disproportionately borne by smaller public firms. A study by three University of Georgia economists, for example, found that post-SOX director compensation increases have been much higher at small firms. For small firms operating on thin margins, these and related SOX compliance costs can actually make the difference between profitability and losing money.
As a result, SOX has substantially distorted corporate financing decisions. On the one hand, SOX has discouraged privately held corporations from going public. As law professor Larry Ribstein observed on his blog, ideoblog.com, startup "companies are opting for financing from private-equity firms," rather than using an initial public offering to raise money from the capital markets.
In the long run, or perhaps the not-so-long run, this barrier to the public capital markets may have a very negative effect on the economy, according to Ribstein: "Since going public is an important venture capital exit strategy, partially closing the exit could impede startup financing and therefore make it harder to get ideas off the ground." Conversely, Ribstein notes, this is also a good deal of evidence that SOX is causing firms to go private.
Unfortunately, a recent study by former SEC Chief Economist Ken Lehn identified a new and very troubling consequence of SOX. Lehn’s study tested the proposition that SOX has a chilling effect on risk taking by managers.
Using a large sample of U.S. and U.K. companies, Lehn and his co-authors found that relative to U.K. firms, U.S. public corporations have significantly reduced their research and development and capital expenditures, while significantly increasingtheir cash holdings, since SOX. As a result, the equity of U.S. companies has become significantly less risky vis-à-vis U.K. companies since SOX.
Finally, they found that the likelihood that an IPO was conducted in the U.K. increased significantly after SOX and that this effect was especially high for firms in high research and development industries. Taken together, Lehn and his colleagues concluded, "the results support the view that SOX has had a chilling effect on risk taking by publicly traded U.S. corporations."
We usually think of a risk as a bad thing, but for investors it is the absence of risk that is a problem. Risk and return go hand in hand. The more risk you’re willing to take, the higher your return. This is why returns on shares are typically higher than returns on corporate bonds.
As the company’s residual claimants, shareholders stand last in line. They don’t get paid until all other claimants have been paid. Because shareholders get everything left over, however, their upside is unlimited. For the company to generate such returns for the shareholders, however, it has to take risks. If SOX is deterring managers from taking risks, it’s going to reduce returns to investors.
It’s a very odd result for a statute that claims to be all about investor protection.
