Sarbanes-Oxley May Need Some Tweaking

I think the time has come to see if the landmark Sarbanes-Oxley act can be tweaked, while maintaining its primary goal of better financial disclosure. I keep reading that the U.S. is losing foreign companies to European and Asian exhanges:

London has certainly benefited from others' actions. For example, the Sarbanes-Oxley legislation in the U.S. has created a governance framework that discourages foreign companies from raising capital in the U.S.

On the other hand, as an investor I prefer to invest in equity markets that are transparent, I suspect that foreign and domestic long-term or institutional investors feel the same way. Remember that Sarbanes-Oxley passed at the hight of the Enron/Worldcom/Adelphia/Qwest/etc. meltdowns, so a re-examination may now be warranted. The NYTimes had a recent article on the backlash and the reaction of institutional investors:

"There is no question that, broadly speaking, Sarbanes-Oxley was necessary," said John A. Thain, chief executive of the New York Stock Exchange, in remarks echoed by others at the roundtable.

Nick S. Cyprus, controller and chief accounting officer for the Interpublic Group of Companies, was even more specific, praising a provision of the law that has become a particular target for many critics. "I'm a big advocate of 404," he said, referring to Section 404 of the law, "and I would not make any changes at this time."

Section 404 requires companies and their auditors to assess the companies' internal controls, which are the practices or systems for keeping records and preventing abuse or fraud. Something as simple as requiring two people to sign a company check, for example, is one type of internal control.

Of the 2,500 companies that filed internal controls reports with the Securities and Exchange Commission by the end of March, about 8 percent, or 200, found material weaknesses, the agency's chairman, William H. Donaldson, said at the roundtable. That exceeds the 5.6 percent rate that Compliance Week magazine found in a review of the first 1,457 companies to report.

Executives at the roundtable consistently said that complying with Section 404 has been more expensive than they had anticipated, and they questioned whether the benefit - which no one has been able to quantify - is worth the cost.

There are, perhaps unsurprisingly, several studies of the cost of compliance from various business groups. Financial Executives International, a networking and advocacy organization, said last month that a survey of 217 publicly traded companies showed they had spent $4.36 million, on average, to comply with Section 404.

A different survey, of 90 clients of the Big Four accounting firms - Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PricewaterhouseCoopers - found that the companies spent an average of $7.8 million on compliance. That was about 0.10 percent of their revenue, and less than the $9.8 million paid, on average, to C.E.O.'s at 179 companies whose annual filings were surveyed earlier this month in Sunday Business.

The accounting firms noted that as companies become more familiar with Section 404, the amount they spend to comply with it may drop this year, by as much as 46 percent, according to the survey.

Despite forecasts like this, complaints seem to have registered with regulators. William J. McDonough, the chairman of the S.E.C.'s Public Company Accounting Oversight Board, said at Wednesday's event that the agency would consider ways to provide more guidance on 404 requirements in the next few months.

The quiet campaign against provisions of the Sarbanes-Oxley Act may have had something to do with the proposal by Representative Ron Paul, a Republican from Texas, on Thursday to eliminate Section 404 entirely. In a statement, the congressman said the provision "has raised the costs of doing business, thus causing foreign companies to withdraw from American markets and retarding economic growth."

But representatives of institutional investors emphasized that they are the real parties paying the bill for compliance, and that they are happy to do so. Changes to the rules - and certainly to the underlying legislation - are premature, Cynthia L. Richson, corporate governance officer for the Ohio Public Employees Retirement System, said in a telephone interview after the roundtable. "At this point," she said, "the benefits are just starting to be realized and, of course, the first year is going to be somewhat difficult from a cost perspective."

Scott C. Newquist, chief executive of Board Governance Services, a consulting firm to corporate directors, said he felt little sympathy for executives seeking to lighten the burden of the new reporting requirements. After all, he said, the law was passed in the wake of several big corporate frauds. "It relates back to the argument that there are only a few bad apples and it's not a systemic problem," he said. "I would argue that a lot of these problems are systemic."

BEYOND the costs of assessing their internal controls, executives focused on a few specific concerns. Auditors, they said, were too conservative - requiring disclosure of everything, testing controls that could not have a material effect on financial reports - because they worry about second guessing by regulators and plaintiffs' lawyers.

Meeting the demands of Section 404, they added, also took time away from more productive activities. Executives from smaller public companies said they should not have to meet the same requirements as larger companies, which they said have more resources to handle regulatory compliance. Several executives complained that relations with outside auditors had deteriorated.

Raymond J. Beier, a partner at PricewaterhouseCoopers, said that while some of these concerns had merit, 2004 was the first year that the new rules had been in place. "Refinements in the process will better serve the system," he said in a telephone interview after the roundtable.

Ms. Richson of the Ohio pension fund said the environment might only become more charged, and added that she expected companies to try to weaken Section 404 and other Sarbanes-Oxley provisions once the atmosphere turned more friendly to business.

"If you listened carefully, you can reach the conclusion that there's more to come, if the business interests are successful at trying to erode some of the investor protections that were put in place three years ago," she said. "That would not be a good thing."