Shareholder Protection…At What Cost?

Remember back to 2002 when Congress wanted to restore shareholder confidence by fighting fraud and making financial reporting more reliable? The Sarbanes-Oxley Act (SOX) was passed in a rush with the intended effect of mopping up the mess left by the Enron, Tyco, and other scandals. Our representatives in Washington could wash their hands of a few dishonest executives, and walk away, problem solved. Right? Wrong.

As Winston Churchill once said: “Where one stands depends on where one sits.” Well, I sit on several boards of directors and provide governance counseling to directors, and from where I sit, I can tell you that Congress used a broad brush to paint all executives as dishonest and fraudulent, and it’s the shareholders—the ones they were trying to protect—that are paying a tremendous price.

The Real Costs Revealed

The fact is that SOX implementation has been much more expensive than regulators promised it would be. Initial Securities and Exchange Commission estimates said it would cost about $91,000 for a company to comply with Section 404 of the law, considered the most burdensome. It says that it’s management’s responsibility to maintain an internal structure for financial reporting, and that it’s an auditor’s responsibility to attest to the soundness of management’s assessment of the overall financial control system.)

That estimate wasn’t even close. Compliance costs for 404 alone have mounted to more than $35 billion—20 times higher than the regulators originally estimated. Because auditors are taking a one-size-fits-all approach to small and large companies, Section 404 serves as a type of regressive tax on these businesses. In 2004, the average cost to comply with Section 404 at companies with revenues of $5 billion or more was 0.06 percent of total revenues, and for companies with revenues of $1 billion to $4.9 billion the cost was 0.16 percent, but for companies under $100 million in revenues the cost was an unbelievable 2.55 percent of total revenues. Some say those costs are going down each year as the learning curve evens out and one-time IT costs are paid off.

Horsepucky, I say. According to a report by the Financial Executives International, an association for financial executives based in Florham Park, New Jersey, ongoing 404 compliance for every public company will result in a 109 percent increase in their internal costs, a 42 percent jump in their external costs, and a 40 percent increase in the fees charged to them by external auditors. 

The bottom line is that the $35 billion SOX has cost is spent, gone, vanished, instead of adding to shareholder value. These costs would have otherwise been reported as earnings by the affected companies, and if you multiply the $35 billion times a conservative five times market multiple of their stock price, one could argue that the cost to shareholder value has been almost $2 trillion!

The reality of SOX is that the expense (i.e., wasted shareholder value) of implementing stricter reporting standards is far beyond the market value lost in Enron, Tyco, et al.

It was an overcorrection of a problem that has led to much bigger problems.

Costs of Transparency

The expected result of SOX was to make financial reporting more transparent to shareholders and investors. However, the cost of this transparency seems to be transparent to regulators. In addition to the disproportionate costs placed on small businesses, the burden of SOX compliance is putting American businesses at a disadvantage in the global marketplace.

Foreign listings on U.S. financial markets—an important barometer of foreign interest in the U.S. economy—have dwindled. Between 1996 and 2001, the New York Stock Exchange listed about 50 non-U.S. companies per year. By mid-2004, that number had dropped to one new listing. Can we afford to lose these investors in this highly competitive global economy?