Rethinking Sarbanes-Oxley

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The genius of the American economy has always resided in the entrepreneurial spirit animating its participants and a flexible legal, cultural and institutional environment allowing it to flourish. There has always been a certain tension between the unfettered capitalist ethic and the need for rules and regulations to make the system run smoothly and prevent distortions.

At its inception in 2002, following the highly publicized corporate scandals early in the new century, the Sarbanes-Oxley Act (SOX) was viewed as a necessary periodic rebalancing of the system. But several years of experience with its implementation gives rise to serious doubts about its effectiveness and utility, especially since there are increasingly clear signs it has been very costly to those companies that must abide by it.

In terms of the direct cost to subject companies, many studies have shown huge increases in outside auditing costs, consulting fees and internal costs to achieve compliance. The most recent Manufacturers Alliance/MAPI member survey shows that, while the direct and indirect costs of Section 404 attestation declined in the second year of practice, overall audit fees continued their inexorable climb upward.

Moreover, the reduction in these essentially new costs was from levels averaging 5.8 percent of net income before taxes in the first year among MAPI member companies. Before SOX was enacted, the SEC estimated compliance costs at around $91,000 per company. But the most recent Alliance survey shows average costs the past year for 40 MAPI companies was $1.613 million for external audit fees for Section 404 compliance, plus about $1.894 million for internal work for compliance.

And this increased level of effort and cost, related primarily to Section 404, has not reduced overall financial audit costs, which continued to climb in the first two years of experience with SOX compliance. It is unsurprising only 5 percent of the Board audit committees of member companies in our survey found compliance costs "fair and reasonable," while 41 percent said costs are too high.

Is this just the grousing of frustrated executives? There is -- for better or worse -- emerging solid empirical evidence that high compliance costs are affecting entrepreneurial and risk-taking behavior and driving economic activity outside the United States. In 2005, the London Stock Exchange saw 129 new listings, while the New York Stock Exchange gained only 6 net new listings and the NASDAQ only 14.

Not one of the 10 largest new global listings was registered in the United States, and 22 of the top 25 were registered outside the U.S. Only five years before, $9 in every $10 raised by foreign companies was realized through U.S. exchanges.

Of those choosing new issues in London, 38 percent considered the United States, but 90 percent of those cited the onerous demands of SOX as tipping the balance in favor of London. Global companies are also increasingly gravitating to International Financial Reporting Standards and away from the U.S. standard, GAAP.

There are many reasons for this shift away from U.S. markets, but at a minimum it seems clear the benefits of SOX are not enough to outweigh this and other reasons for choosing U.S. exchanges and U.S. accounting standards.

Many have commented elsewhere on the relative slowness of new manufacturing investment and start-ups in the last few years, despite rapid growth of the global economy, rebounding profits and highly liquid balance sheets of manufacturing companies. While there are numerous reasons for a restrained exuberance, SOX requirements are almost certainly among them.

In the first year of SOX, Alliance companies devoted an average of 38,252 hours to Section 404 implementation. This is real executive time and effort that could be devoted to growing businesses. And evidence of material weaknesses -- as bitter experience has shown -- can readily be linked to financial underperformance by creative trial lawyers eager to generate yet another cycle of litigation.

Finally, senior executives are subject to criminal penalties for some SOX violations. Is it any wonder risk-taking may be somewhat restrained?

So, in addition to adding costs to the bottom line, undermining the flexibility available to executives, and diverting the attention of executives from offensive to defensive matters, SOX is quickly eroding one of the U.S. economy's systemic strengths: its large, highly responsive and nimble financial markets.

If companies feel compelled to go outside the United States for financing or for listing their shares, they will be forced to rely on smaller, less responsive networks for timely allocation of capital to the best possible uses.

There is no shortage of ideas for reforming SOX, with ideas ranging from exempting smaller companies to making Section 404 voluntary, to requiring accounting firms to apply SOX themselves. Other ideas, which could be adopted by administrative actions, relate to moderating the very strict standards of reviewing all procedures with a remote possibility of resulting in material weaknesses, and requiring the Public Company Accounting Oversight Board to scrutinize auditors for overzealous application of Section 404 rules.

The Securities and Exchange Commission is reviewing SOX and Congress is increasingly concerned with its impact. Surely the evidence favors significant restructuring.

Thomas J. Duesterberg is president and chief executive officer of the Manufacturers Alliance/MAPI.