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Sunday, May 14, 2006

Is Sarbanes-Oxley Really a Problem?

Originally Posted: March 19, 2006 -- 7:14PM
Fool Boards Link: http://boards.fool.com/Message.asp?mid=23855506

Is Sarbanes-Oxley another regulatory impairment to business or cheap macroeconomic insurance for our economy?


The March 18, 2006 edition of the Wall Street Journal had three unrelated, yet totally related stories and op ed pieces.

* The Perfect Payday - a story about suspect option grants to execs
* GM Board Seeks Probe of Mistakes in Bookkeeping - (self-explanatory)
* Two Cheers for Nancy Pelosi - op ed about re-thinking Sarbanes-Oxley

Here's the Readers' Digest version of the three pieces. "The Perfect Payday" described analysis conducted by the WSJ which found one case where the CEO of Affiliated Computer Services was granted six consecutive stock option grants where the grant dates coincided with low-points in the company's stock price. The WSJ analysis indicated the odds of this occurring at random were worse than 1 in 300 MILLION.

The "GM Board" story described the announcement from GM on Friday that they found new accounting errors, would restate 2005 earnings from a loss of -8.6 billion to -10.6 billion (that's a $2 billion oopsie…) and would have to restate earnings as far back as 2000. In each case where errors were found, they were always in favor of reporting more revenue or profits.

The "Two Cheers" op ed discusses how Nancy Pelosi and Elliot Spitzer (of all people, per the tone of the piece) have begun addressing the "burden" imposed by Sarbanes - Oxley compliance on businesses of all sizes. The piece cites a figure of about $35 billion in compliance costs since its rules kicked in.


Let's review, shall we?

The key elements of the Sarbanes-Oxley act of 2002 were:

* a requirement that CEOs and CFOs personally sign off
on annual financial reports
* more detailed disclosure of compensation arrangements
for senior executives
* longer jail terms and stiffer financial penalties for
execs found to willfully fudge results
* prohibition from audit firms providing other consulting
services and actuarial advice to the firm
* bans on personal loans from the company to the officers
of the company
* a requirement for firms to produce an annual report on
the strength of its internal audit processes (section 404)
* stricter limits on trading by corporate insiders and
stronger reporting requirements for suspected insider

The act was passed in the wake of scandals at Enron, Tyco and other similar meltdowns and passed with landslide majorities in the House and Senate. Critics of the legislation are now claiming the act has drastically increased accounting expenses for existing public firms and discouraged economic growth by discouraging private firms from raising capital by going public and subjecting themselves to the rigor SOX requires.

One problem with measuring the "value" of SOX is that the nature of its focus is likely to encourage over-reporting of compliance costs while discourage reporting of actual disasters averted. Every public company has earmarked dollars in the past three years for projects to implement new processes required by (or assumed to be required by) SOX. These special project dollars often become a catch-all for other projects that have been ignored for other reasons but "now that the SOX team has dollars, we can claim it is related to SOX and get our pet project funded."

On the flip side, how many public companies are going to come forward and announce cases where a new SOX-based process uncovered a major mistake in the company's accounting that averted a major correction in its public books? NONE. For the same reason banks never disclose when they've been hacked or suspect internal breaches of security affecting customer information -- doing so would spook customers or investors. Unless the new SOX-based audits turn up mistakes in books they've already closed and now HAVE to go back and correct, you'll never hear of a SOX success story.

Now think back to GM restating its 2005 earnings and finding $2 billion more in losses. IN ONE YEAR! That's not including the impact of their restatements back to 2000. Let's assume for a minute that the $35 billion cumulative cost to date for SOX is correct. First of all, much of that cost is likely one-time retrofit costs at large Fortune 500 firms as they gutted / replaced antiquated IT systems for newer, more flexible tools. Second, the "value" of SOX is not only the cash value of mistakes identified and corrected due to reporting that SOX put in place. The value also includes the larger damage averted by a $2 billion mistake being nipped in the bud (if $2B counts as a "nip") rather than mushrooming into a complete collapse.

GM is currently worth about $11.95 billion. Let's say GM didn't have any motivation to find those accounting errors that added up to $2 billion and, instead, the executives believed everything was relatively hunky-dory and continued operating the company as they have a bit longer. Things continue to get worse then suddenly the company gets hit with a larger surprise in two years that suddenly spooks investors and bondholders alike, bankrupting the company. Failure to catch that $2 billion mistake could mean the economy sees $11.95 billion vanish. Of course, the $11.95 billion doesn't "vanish", it's just sitting in the wrong hands from an economic standpoint, much in the same way the billions dropped on telecommunications and dot-coms in the 1990s didn't vanish, it just got squandered laying fiber no one needed or building business with no customers.

In short, wouldn't it be preferable to hold GM and other large firms to a tighter standard on financial reporting so financial and strategic mistakes get caught early in time for corrections? Or would you rather allow them to run "unhindered", continue to file rosy annual reports, reward their executives handsomely the whole time for bogus results, then have them suddenly realize there's NOTHING in the tank, file bankruptcy and take 50,000 jobs and pensions and healthcare benefits for another 100,000 with them in a heartbeat?

Is being "pro-SOX" an anti-business stance? Not to me. It's common sense and a "sound-business" stance. No one wants American business to succeed more than me. Pensions will be non-existent when I retire. Social Security in its current form will be non-existent when I retire. I'll likely be on my own for healthcare when I retire. In an environment absent those benefits, the only things I expect for my retirement planning are

1) the possibility of stable employment until I retire,
2) stable financial markets in which to invest my savings
3) stable financial markets in which to leave my nest egg
as I draw on it during retirement

All of these require sound businesses and a growing economy. Neither of these conditions can exist if investors have lost their retirement savings in accounting frauds or are too spooked by accounting frauds to put their money into new equities or bonds.

The "invisible hand" only works in "perfect markets" with large numbers of producers and large numbers of consumers of goods and services. That's not what modern capitalist economies are producing. Instead we are concentrating enormous market and economic power in the hands of two to three hundred global companies with executives so overpaid and under-qualified that one of their compensation perks is tax advice to help them prepare their personal income taxes. I'm sorry, if you can't figure out how to file your personal income taxes on a typical $3 to $6 million salary, we shouldn't be trusting you at the helm of a multi-national, multi-billion dollar public company affected by convoluted tax rules, accounting rules, fluctuating exchange rates, etc. without some outside, independent adult supervision.

Maybe the Fool needs to open a new discussion board on corporate governance and "forensic investing" for individual investors. Maybe the "Ill-Gotten Booty" board?