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SOX Five Years On

September 7, 2007


Just over five years ago, Congress passed the Sarbanes-Oxley Act in response to the corporate scandals at Enron, WorldCom, Tyco, etc. There have been many complaints about the law and publicly-owned companies have chaffed under its compliance requirements. Over the past couple of years I have written a number of posts on the subject [SOX: The Ante for Business in the 21st Century; Why Regulatory Compliance Remains Important; U.S. Business Regulations to be Examined; More on Compliance & Over Regulation; Small Companies to Get SOX Relief; Attacks on SOX Continue; Investors Like SARBOX; More on the Upside of Sarbanes-Oxley for Investors]. The Economist provides a non-U.S. perspective of the law five years on [“Smelly old SOX,” 28 July 2007], but the article begins by giving the common U.S. view of SOX.

“Today, SOX, as it is known, is widely reviled. In boardrooms across the world’s mightiest economy, it has become shorthand for foolish, heavy-handed state interference in the wealth-creating marvel that is corporate America. The cost of complying with its requirements, it is said, has been far higher than predicted. It is blamed for promoting risk aversion and mistrust in corporate boardrooms, driving a growing number of public companies into the clutches of private-equity firms, and undermining the global competitiveness of America’s capital markets. Much is wrong with SOX. It was passed in haste, and shoddily written. It took little account of current thinking about what a well-designed regulatory system should look like. Section 404 has caused the biggest problems. It makes top managers responsible for a firm’s internal risk controls, and requires companies to produce an annual report in which outside auditors ‘attest’ to their quality—a requirement that has turned out to be unreasonably expensive for small public companies.”

Sounds pretty bad doesn’t it? Well, the Economist believes it is not as bad as it sounds.

“Section 404 is being dealt with. Small companies have already won temporary exemption from full compliance. A newly issued set of guidelines for auditors ought to reduce the cost of complying with section 404 for other firms. And the other criticisms of the act are overdone. At a time when profits and share prices are touching record highs, it is hard to argue convincingly that America’s bosses have lost their capitalist zeal. Boardroom processes have certainly become more bureaucratic since SOX took effect, and board membership has shifted from entrepreneurs to watchdog types. That, however, is not necessarily a bad thing. Bosses may take fewer risks than they did in the past—but they may be taking the sensible risks, and avoiding the bad ones. Firms are indeed flooding away from public markets; but that is happening across the world, so cannot obviously be blamed on SOX. More likely, SOX is a convenient scapegoat for the bosses of public companies, who tend to get more money and less exposure to complaints about fat-cattery when their companies go private.”

The law was intended to help protect investors by forcing companies to be more transparent– a sort of forced integrity. Integrity was a characteristic too many corporate leaders seemed to have lost during the run-up to the Enron scandal. The real losers in many of these cases were employees who not only lost their jobs but lost their entire life’s savings because they were tied up in retirement accounts consisting mostly of company stock. The question is, “Has it worked?”

“Once they have stopped fulminating, many bosses privately admit that SOX has brought benefits. Managers are now far more confident about the quality of the numbers they get from their business units. And if buoyant share prices are any indication, the public seems to have plenty of confidence in the markets. Since the purpose of SOX was to get a better deal for shareholders, it may deserve some credit for that. Still, it is too soon for a final verdict on SOX. Only after the next economic downturn will it become clear whether the tighter rules have made American capitalism stronger or weaker. As Warren Buffett likes to say, ‘It’s only when the tide goes out that you learn who’s been swimming naked.'”

The article was written before the latest stock market “corrections,” but that correction had nothing to do with SOX. As most people are aware, the latest correction is primarily a response to bad business decisions by sub-prime lenders and investment groups willing to buy bundled mortgage security offerings with little due diligence on their part. Regulatory compliance will always be “painful” because it amounts to the non-productive expenditure of resources. On the other hand — as the Economist article implies — companies that have good compliance processes in place generally have higher valuations because investors have greater trust in them. Done right, therefore, a compliance process can actually be an investment rather than a liability. Companies that fully comply with SOX requirements won’t be found swimming naked.

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