Four More Ways to Fix Sarbox
from
January/February 2007
by Rob Norton
Board members and corporate executives have devoted vast amounts of time, effort, and money to revamping governance and financial-reporting structures to comply with the Sarbanes-Oxley Act of 2002. As we move into the new law’s fifth year, two big questions are being asked with growing passion. First, was it worth it? And second, what can we do to make it work better?
The good news, from the standpoint of many, is that securities and accounting regulators are finally addressing Section 404, which covers internal controls. New guidance from the regulators, designed to ease some of the section’s most onerous provisions, is expected to be in place before 2007 audits begin in the spring. Securities and Exchange Commission chairman Christopher Cox and Mark Olson, chairman of the Public Company Accounting Oversight Board (PCAOB), which regulates the auditors, met in mid-November to discuss the changes and were expected to unveil a draft proposal in December, which would then be subject to public comment.
Section 404 has been the business community’s biggest beef with Sarbanes-Oxley from the get-go. The consensus is that the regulatory agencies have interpreted the section’s provisions too rigidly, needlessly complicating internal-controls procedures and expanding the scope of audits. Widespread complaints and increasingly heavy lobbying have cited the enormous expense of compliance. For large companies, that’s averaged $4.4 million a year, according to a 2005 survey by Financial Executives International, a trade association of CFOs and other financial executives. Midsize and small outfits have carried an even heavier burden. A 2005 survey by the American Electronics Association, a leading high-tech trade group, found that Section 404 compliance costs companies with revenues under $100 million about 2.5% of revenues, compared with fractions of a percent for larger companies. All this has led J. Michael Cook, former chairman and chief executive of Deloitte & Touche and chairman of the audit committees at Comcast, Eli Lilly, and International Flavors & Fragrances, to call Section 404 “the poster child for costs without benefits.”
The stock markets have taken issue with Sarbanes-Oxley too. Wall Streeters say the law has helped make U.S. capital markets less competitive with foreign markets and deters foreign companies from going public here, as
Corporate Board Member
reported in our September/October issue (“What China’s IPOs Don’t Like About the U.S.”). Weakness in domestic initial public offerings has underscored those worries. One reaction was the formation in late 2006 of the private-sector Committee on Capital Markets Regulation, headed by leading academics and including prominent representatives from industry, law, investment banking, and accounting—and heralded by Treasury secretary Henry Paulson Jr. Besides making suggestions for SEC rulemaking to reform Sarbanes-Oxley, the committee called in late November for reforms in the way the Justice Department prosecutes corporate wrongdoing, and for limitations on class-action lawsuits.
These anticipated changes will affect how the SEC and other regulators implement the laws already written, but they don’t seem to presage new legislation or major changes, even of Section 404. It’s worth remembering that Section 404 was not something that sprang full-blown from the minds of the U.S. Congress, nor was it a hasty reaction to the excesses of Enron, WorldCom, and their felonious brethren. Accounting and auditing professionals had been concerned about the robustness of corporate internal controls for many years. In 1992 they recommended a “best practice” approach in a report by the Committee of Sponsoring Organizations of the Treadway Commission. Some large companies voluntarily adopted the commission’s suggested framework years before the passage of Sarbanes-Oxley.
So what about the small but vociferous band of Sarbanes-Oxley critics that’s been pushing for outright repeal of the law—or at least wholesale legislative revision—in op-ed columns, position papers, and especially blogs? They claim that the direct and indirect costs of the law have been vastly larger than anyone anticipated, with few if any offsetting benefits. Their argument is weakened because it’s frequently based on a single 2005 Ph.D. thesis by a University of Rochester graduate student that suggested that the passage of Sarbanes-Oxley caused a $1.4
trillion
drop in the stock-price value of U.S. corporations during the summer of 2002. Those citing this research fail to note that the final, published version included significant caveats: The author, Ivy Xiying Zhang, said it was impossible to disentangle the impact of Sarbanes-Oxley from other effects on stock prices at the time and that the likely costs were significantly less than that widely quoted figure.
There is little support in the majority of boardrooms and executive suites for a massive revision of Sarbanes-Oxley, much less for repeal. Interviews with directors, executives, and other experts confirm the conclusion that most have learned to live with the law. “Many of its provisions have worked very well,” says J. Michael Cook. He cites “the restrictions on loans to corporate officers, the certification process, the accelerated filing of financial information, and the whistleblower provisions” as examples of parts of the law that have been implemented smoothly and have even turned out to be cost-effective for many corporations.
It is unlikely that we will see major legislative change anytime soon. For one thing, Congress is generally loath to revisit complex laws in the absence of intense and widespread pressure for change. That hasn’t materialized thus far—and kindness to the business lobby is unlikely to be high on the agenda of the new Democratic majorities. In addition, the electorate seems to have embraced the assumption that companies are continuing to do bad things. “Unfortunately, every time that attitude seems to be going away, something else, like options backdating, comes along,” says Robert E. Mittelstaedt Jr., dean of the W.P. Carey School of Business at Arizona State University and a board member of Innovative Solutions & Support and Laboratory Corp. of America. “Corporate America just keeps shooting itself in the foot.”
As long as no new round of scandals erupts, there may still be an opportunity to make further incremental changes. Corporate Board Member supports toning down the gusto with which Section 404 enforcement has been pursued. Moreover, we’ve identified four additional fixes that would help make Sarbanes-Oxley less burdensome and more cost-effective. None necessarily requires legislative change; they could largely be effected either by rule-making adjustments at the SEC and the PCAOB or by companies themselves.
Fix No. 1 Modify compensation disclosure for small companies
Smaller businesses foresee problems similar to those posed by Section 404 with one of the SEC’s latest Sarbanes-Oxley elaborations—the requirements, set to go into effect in 2007, for detailed disclosure of executive and director compensation, related-party transactions, and director independence. Among other things, companies will have to include in their proxies a description of compensation policies akin to the “management’s discussion and analysis of financial condition” now required in the 10-K report.
“These won’t be as big a deal as Section 404, but it’s still going to be a significant piece of work,” says Morgan Burns, a partner with the corporate group of the Minneapolis law firm Faegre & Benson. He notes that large companies will file exhaustive disclosures of compensation-committee policies, procedures, and performance measures, and he thinks small companies will feel obligated to include similar details. “It may make sense when you’re talking about a multinational with highly complex compensation packages in the tens of millions,” he says, “but not for a small public company with one factory, where the executives are making a few hundred thousand, all in cash, and they all live in the same town.”
Fix No. 2 Reconsider director independence for small companies
Another Sarbanes-Oxley modification that would make life easier for smaller public outfits is a relaxation of the rules on director independence. Recruiting independent directors has been a challenge for all companies, because the detailed independence rules have significantly narrowed the pool of potential board members. In the resulting scramble for qualified individuals, larger companies hold the advantage. Smaller ones report that the difficulty is keenest in recruiting directors for the audit committee, since the required qualifications for that committee’s members are the highest and the independence tests are the most stringent. “For smaller companies, practically everyone in your network—all the people you’ve had dealings with—are people who can’t meet the definitions,” says Burns.
Fix No. 3 Refine the certifications rules
While the problems associated with Section 404 compliance have gotten the most attention, another troublesome part of Sarbanes-Oxley is Section 302, which requires that executives certify their companies’ financial statements and other SEC reports. “Section 302 pertains to controls and procedures related to all information in SEC filings beyond what Section 404 covers,” says Richard Steinberg, principal of Steinberg Governance Advisors Inc. in Westport, Connecticut, and former governance leader at PricewaterhouseCoopers. “Companies continue to struggle to determine what exactly they need to do, and further guidance from the SEC certainly could clarify that.” For example, Section 302 certifications will cover the controls and procedures surrounding the required new disclosures of executive compensation. Some experts question whether that’s appropriate, since the processes for determining senior executive pay are in the hands of the board’s compensation committee and thus are not subject to oversight by management.
Fix No. 4 Narrow procedures for whistleblowers
A final way to limit Sarbanes-Oxley headaches is to make sure that the whistleblower provisions don’t morph into larger and more general programs than the law calls for. The Sarbanes-Oxley requirements are designed to uncover problems related to financial disclosure, but at some companies employees are using them to air general job grievances and troubles more appropriately handled by the human-resources department. This is one fix that companies can make on their own, with ethics officers and corporate attorneys ensuring that the whistleblower program is working appropriately and according to law.
So far each year of Sarbanes-Oxley has been something of an adventure, forcing executives and board members to navigate unfamiliar waters, often with only rudimentary charts. As more experience is gained and compliance becomes more routine, the burden of the law should continue to lessen. The Section 404 reforms will help, and if some or all of the fixes outlined above are adopted, the weight could lighten further.
Lawyers have an adage that “an old tax is a good tax,” because people have grown accustomed to it, understand how it operates, and have factored it into their decision-making. In that sense, one of the chief problems with Sarbanes-Oxley has been that so many of its provisions were, in effect, new laws. Four years after its enactment, Sarbanes-Oxley appears less menacing than it did in 2002. Perhaps by the end of the decade it won’t be controversial.
