Monday, April 18, 2005

The Growing Attack on Sarbanes-Oxley Act Section 404

One of the goals of the Sarbanes-Oxley Act was to require publicly-traded companies to improve their internal controls.  Section 404 of the act seeks to accomplish that goal by requiring the CEOs of companies and their auditors to attest annually to the effectiveness of the corporation's internal controls to ensure that financial statements are a prepared in accordance with GAAP.  A recent article by Linck, Netter, and Yang, Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards, assesses the costs of this provision, and concludes that it will imposes a "disproportionate burden" on smaller companies [Article available on SSRN here]. Increased costs will always draw a negative reaction, and one is brewing regarding this provision.  While few call for the repeal of the entire Sarbanes-Oxley Act, at least not publicly, and criticism is always prefaced by protestations that the Act is a fine example of effective corporate regulation, there is increasing criticism of Section 404.  Congressman Ron Paul (R-Texas) introduced on Thursday, April 14, the Due Process and Economic Competitiveness Restoration Act that would repeal Section 404.  The Congressman's statement accompanying the bill (here) is entitled "Repeal Sarbanes-Oxley!", and states:

Sarbanes-Oxley was rushed into law in the hysterical atmosphere surrounding the Enron and WorldCom bankruptcies, by a Congress more concerned with doing something than doing the right thing.  Today, American businesses, workers, and investors are suffering because Congress was so eager to appear “tough on corporate crime.” Sarbanes-Oxley imposes costly new regulations on the financial services industry. These regulations are damaging American capital markets by providing an incentive for small US firms and foreign firms to deregister from US stock exchanges. According to a study by the prestigious Wharton Business School, the number of American companies deregistering from public stock exchanges nearly tripled during the year after Sarbanes-Oxley became law, while the New York Stock Exchange had only 10 new foreign listings in all of 2004.The reluctance of small businesses and foreign firms to register on American stock exchanges is easily understood when one considers the costs Sarbanes-Oxley imposes on businesses. According to a survey by Kron/Ferry International, Sarbanes-Oxley cost Fortune 500 companies an average of  $5.1 million in compliance expenses in 2004, while a study by the law firm of Foley and Lardner found the Act increased costs associated with being a publicly held company by 130 percent.  Many of the major problems stem from section 404 of Sarbanes-Oxley, which requires Chief Executive Officers to certify the accuracy of financial statements.

One CEO who was openly critical of Sarbanes-Oxley was Maurice Greenberg, the former CEO of AIG who may ultimately run afoul of its provisions, and few CEOs appear willing to be lumped together with him at the moment.  While it is unlikely that Section 404 will be repealed in its entirety, look for some regulatory relief in the near future, especially if SEC Chairman William Donaldson leaves the Commission. (ph)

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