Regulatory overreaction

Two years ago, a Republican Congress and a Republican president enacted the most far-reaching new regulatory controls on Americans businesses since the 1930s.

They were reacting to Enron and other corporate scandals. But rather than carefully study the issue first, both rushed to do “something” by enacting the Sarbanes-Oxley Act (named for Sen. Paul Sarbanes, Maryland Democrat, and Rep. Michael Oxley, Ohio Republican) in record time.

Republicans are normally skeptical about government regulation of business — with good reason. Regulation is always ham-handed, forcing everyone — guilty and innocent alike — into the same cookie-cutter mold. All must pay the price for the sins of a few, even if existing laws and regulations, properly enforced, are more than sufficient for the purpose.

But fearing bad press, Republicans suspended their normal disbelief in the virtues of regulation and joined to pass a Democratic bill that has severely crippled business expansion.

No one denies there was a corporate governance problem that came to a head with the Enron scandal. But in the zeal to pass new legislation, no one in Congress stepped back to question the magnitude of the problem.

Some 12,000 companies are required to file public financial statements with the Securities and Exchange Commission. According to George Benston, accounting professor at Atlanta’s Emory University, no more than a few dozen per year ever were implicated in dishonest bookkeeping.

But rather than simply step up SEC enforcement, all companies were treated as guilty until proven innocent and forced to comply with onerous new regulatory requirements.

The most onerous provision of the Sarbanes-Oxley legislation is section 404, requiring extensive new internal controls for financial reporting. A recent study by industry group Financial Executives International found the average compliance cost for large companies was $4.6 million, involving 35,000 hours of internal manpower, $1.3 million on external consulting and software, and additional audit fees of $1.5 million.

These numbers probably are very low. FEI admits the compliance cost jumped sharply between its 2003 and 2004 surveys, as companies became more aware of what they had to do. On May 19, Maurice Greenberg, chairman of AIG, the world’s largest insurance company, told shareholders Sarbanes-Oxley was costing them $300 million yearly. General Electric recently said it was paying $30 million per year in compliance costs.

According to a new study by the law firm Foley & Lardner, the average cost for being a public company with sales of less than $1 billion increased $1.6 million last year due to Sarbanes-Oxley. There was also an unquantifiable loss of productivity because senior executives must spend so much time dealing with the law’s requirements. Scott McNealy, Sun Microsystems’ chief executive officer, calls Sarbanes-Oxley “buckets of sand in the gears of the market economy.”

The Foley study found 20 percent of companies surveyed were considering going private, eliminating public shareholders, to avoid Sarbanes-Oxley costs. Ed Nusbaum, CEO of accountants Grant Thornton, explains: “By going private, companies can greatly reduce their level of risk associated with shareholder litigation, while cutting costs and regaining a sense of control and confidentiality.”

The only problem is going private is not a cure-all. A study last year by Robert Half International, a staffing company, found numerous cases where even a private firm would be forced to comply with Sarbanes-Oxley. For example, companies doing business with governments may be forced to comply. Also, those with public debt or those required to report to government agencies may still find themselves in the Sarbanes-Oxley net even if they are private companies.

Europeans have been especially outspoken in criticizing Sarbanes-Oxley as many European companies are listed on American stock exchanges, and thus also forced to comply. As a result, new listings are down sharply.

It’s hard to specify the effect of Sarbanes-Oxley on the economy, but some economists suggest it may be behind the slow growth in investment and hiring. As The Washington Post’s columnist David Ignatius said March 9, Sarbanes-Oxley has “added to the wariness of CEOs” and “reduced the job-creating dynamism of the economy.”

Stephen Bainbridge, University of California Los Angeles professor of corporate law, thinks Sarbanes-Oxley completely unnecessary. He says all economic booms inevitably breed financial scandals. Those at Enron et al. would likely have occurred even if Sarbanes-Oxley had already been in effect.

Story Continues →