John Holcomb Speaks: Five Years of SOX and Future Directions

Impact of Sarbanes-Oxley Act

John M. Holcomb

Department of Business Ethics and Legal Studies

Daniels College of Business

University of Denver

This discussion will examine the elements of support and opposition that have formed around Sarbox, its impact on corporate practices, compliance costs, the impact on the capital marketplace, the impact on law enforcement, and its impact on shareholders. The discussion will then conclude by briefly addressing important gaps in the law.

Support and Opposition:

• SEC Chairman Christopher Cox has defended Sarbox as restoring confidence in financial markets
• All previous SEC Chairs have endorsed and defended the law
• Leading Fortune 500 CEOs such as Jeffrey Immelt of General Electric and Charles Schwab have defended the law
• Institutional investors and shareholder advisory services have enthusiastically defended the law
• Accounting firms have praised the law, partially because of all the additional work it has produced for them, and with a new specialty of section 404 investigations it has produced; Sarbox has been called a “full employment act” for accountants
• Critics have included chief financial officers, who have seen evidence of excesses in the law and its financial impact
• Critics also include those who oppose government regulation generally, including conservative and libertarian think tanks and scholars
• Some scholars criticize Sarbox for federalizing corporate law, a field that has traditionally been a matter of state law and regulation
• The Business Roundtable and the U.S. Chamber of Commerce have been the chief corporate critics of Sarbox, but even the Roundtable has acknowledged its positive impact on the integrity of the financial markets
• Conservative litigation groups, such as the Free Enterprise Fund, have criticized the Public Company Accounting Oversight Board (PCAOB) authorized by Sarbox, and brought a suit charging unconstitutional appointment provisions that violated the separation of powers.

Impact on corporate practices:

• Audit committees are busier, more diligent, and meet much more often
• Ethics codes are more prevalent, and ethics training is more rigorous
• Whistleblowers enjoy more protection, and corporate ombuds officers are more common
• Directors and audit committee members are more independent and meet more frequently in separate sessions from the rest of the board and the CEO
• Lead directors are more frequently elected, and there has been a slight movement away from the combined CEO/Chair positions, though the U.S. still trails the UK by a wide margin in separating the two positions
• While restatements of financial results tripled between 2003 and 2006, the restatements have since trended downward
• Reports of material weaknesses in internal controls, in response to section 404, increased through 2005 and have also trended downward since that time
• Many directors, and especially audit committee members, resigned and have avoided serving on public company boards, due to the increased burdens and risks of serving

Compliance Costs:

• The major fear of excessive compliance costs still remains but has abated somewhat
• By the end of 2007, companies will have spent $26 billion in compliance costs
• The front-end costs were heaviest, and the marginal compliance costs have declined over time
• Small firms were most concerned about compliance costs and lobbied for an exemption from 404 requirements, but Chairman Cox did not support the exemption, and it failed

Impact on Capital Markets:

• There was some initial concern that public companies would go private in order to avoid compliance with Sarbox.
• That has happened, but for a multiplicity of reasons.
• Going private not a permanent escape from Sarbox, as many private firms. eventually want to return to the public equity markets, and banks that finance private firms are toughening their requirements to include Sarbox-like standards.
• Following the passage of Sarbox, many IPOs avoided U.S. exchanges and listed in foreign exchanges, especially London’s Alternative Investment Market (AIM). That trend too has abated, as firms have become more comfortable with Sarbox. Very few small companies are now listing in the AIM, and more prefer to list on NASDAQ.
• Both U.S. and foreign firms still find great advantages in listing on U.S. stock exchanges, in terms of their own credibility, visibility, liquidity, and enhanced shareholder value.
• Treasury Secretary Henry Paulson has expressed continuing fears about the impact of regulation on the capital markets and instigated the formation of a Committee on Capital Markets Regulation, with leading corporate CEOs as members. The Committee has called for limits on the liability of accounting firms, targeting of individual executives rather than firms for prosecution, and the scaling back of shareholder lawsuits.

Impact on Enforcement:

• Sarbox led to increased funding and staffing for the SEC
• There were turf battles between the SEC and activist state attorneys general, especially Eliot Spitzer, when he was attorney general of N.Y., and Spitzer’s activism probably goaded the SEC into a more activist stance
• SEC investigations went on a three-year decline in 2003, prompting Senator Charles Grassley (R- IA) to call for a review of the SEC by the Government Accounting Office. He felt the decline in enforcement actions was due more to SEC lethargy than to improved corporate behavior
• Grassley has also called for stronger scrutiny and regulation of the governance of nonprofit organizations and of hedge funds.

Impact on Shareholders:

· The stock market has performed well since the passage of Sarbox, indicating some renewed confidence, though there are still many individual investors who have not returned to the market since the corporate scandals and the related stock market bubble.

· Securities class-action lawsuits have fallen over the past two years from over 200 in 2004. In 2007, only about 50 such suits have been filed. That may indicate fewer potential corporate frauds, but it also indicates a more robust stock market and less activity by class-action firms that have themselves been subject to scrutiny and litigation.

Necessary but Insufficient Law:

• While some have criticized Sarbox for overreaching, others have seen it as falling short and not being tough enough on corporate misbehavior.
• Sarbox may suffer, as do all laws, from targeting yesterday’s problem and failing to address other festering problems. It was obviously designed to curb accounting fraud, so should not be unduly criticized for failing to address other problems.
• Sarbox does ignore the protracted problems associated with executive compensation, the subject of some recent SEC disclosure actions, legislative initiatives, and continuing shareholder concerns.
• Sarbox also assumes the director-centric model of corporate governance in the U.S. and does little to empower shareholders. SEC proposals to facilitate shareholder nomination of directors are now in a holding pattern, though court decisions are now separately addressing the issue.

Comments

[Thomas I. Selling PhD, CPA]

Much of the enthusiasm for SOX by accounting firms and CEOs may stem from their aversion to mandatory audit firm rotation. I invite you to see my weblog post on this topic:
http://accountingonion.typepad.com/theaccountingonion/2007/08/enron-tyco-kmar.html