The Call to Reform Section 404

In the wake of the 2002 corporate accounting scandals at Enron and WorldCom, Congress passed the Sarbanes-Oxley Act (SOX).  Garnering a combined vote of 522-3 in the House and Senate, SOX was billed as an attempt to strengthen corporate governance at America’s public companies.  In reality, the bill was a misguided mishmash of provisions passed in an uncritical hurry by a panicky Congress.

Nearly four years after implementation, many businesspeople and lawmakers are beginning to realize that some elements of the Sarbanes-Oxley “cure” are worse than the disease.  Instead of “safer” capital markets, we have wasted billions of dollars simply to see more companies leave U.S. public capital markets for London, or revert to private equity financing.  Indeed, by some accounts, fraud such as the recent Refco collapse is actually easier thanks to the mind-numbing accounting complexity created by Sarbanes-Oxley.        

Section 404

Labeled by President Bush as the “most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt” (a reference that should trouble any student of history), Sarbanes-Oxley contains a broad range of reform measures, including provisions to remedy conflict of interest problems and ensure legitimate accounting practices.  While some parts of Sarbanes-Oxley might make sense, most problems stem from Section 404 of the law.  Infamous in the business community, this 168 word section led is the reason many economists, businessmen, and lawmakers are calling for reform. 

Section 404 instructs every public firm to do an annual internal audit in addition to the already required external audit.  Further complicating matters is the way auditors have interpreted their mandate to remain “independent”—while they must inform companies of accounting problems, they cannot advise management on how to fix said problems.   

            As a result of the redundant accounting and costly oversight mandated by 404, Sarbanes-Oxley is costing U.S. businesses (and the investors the law is trying to protect) a fortune.  Before the law took effect, the SEC projected the total cost of compliance would be about $1.2 billion overall.  The most recent analysis, however, puts the figure at close to $35 billion—and that’s just direct costs.  Some economists estimate the aggregate cost of Section 404 compliance at a whopping $1.4 trillion, costs largely attributable to reductions in stock values. 

To make matters worse, small businesses are hit disproportionately hard with these costs, as many must make costly software upgrades in addition to hiring extra auditors, and have less overall revenue to absorb these new costs.    

London or Bust

In 2000, 90 percent of the dollars foreign companies raised through IPOs were in the New York Stock Exchange.  Five years later, that number was down to 10 percent, with most foreign companies opting instead to go public in London or Luxembourg.  In 2005, thirteen companies went public in New York, compared with 48 in London, and exchanges in London and Luxembourg captured $9.5 billion in new capital to New York’s $1.3 billion.

Why the lack of new activity in America’s capital markets?  The answer is in part: Sarbanes-Oxley is chasing it away.  Many companies are deciding not to list in the U.S. because doing so would make them subject to 404 compliance.  Listing in countries without such costly regulations keeps newly public firms competitive and agile.  

So strong is the urge to avoid Sarbanes-Oxley that the London Stock Exchange now boasts itself as a “SOX Free Zone.”  Section 404 is even chasing some U.S. companies out of the country, causing them to de-list in New York and move overseas.  In addition, some companies are avoiding going public altogether, instead opting to raise money through private equity.  Other U.S. public companies have gone private, citing Sarbanes-Oxley as one of the reasons for the switch. 

What’s more, the government has successfully prosecuted Enron’s leadership under pre-Sarbanes-Oxley law, raising further questions as to why Congress even needed to pass the law and its costly mandates.

Hope for Reform

              Aware of these losses, Congress is beginning to look at reform.  This year, Congressman Jeff Flake introduced legislation to make adoption of Section 404 rules subject to shareholder votes, rather than compulsory.  This approach would give shareholders the ultimate say over the accounting processes used in a firm.  If investors find the protections of Sarbanes-Oxley beneficial, they could adopt Section 404.  If not, the firm and its investors could opt out of this expensive regulatory regime.  Ultimately, it is good public policy to allow different approaches to improved accounting systems and disclosure.  Congress should move now to restore the competitive position of America’s public companies and capital markets by passing Rep. Flake’s legislation to put shareholders in control of Section 404.