Exploring the impact of Sarbanes-Oxley

Today, Sarbanes-Oxley remains an extremely hot topic in business and legal circles. Proponents of the most sweeping legislation to affect corporations since the 1933 and 1934 securities acts contend that Sarbanes-Oxley has cleaned up corporate America, leading us into a new age of responsibility and accountability.

Critics, on the other hand, claim that despite the noble intentions of Congress, Sarbanes-Oxley has been nothing but intrusive, expensive, and heavy-handed. The truth probably lies somewhere in the middle.

Just a few years ago, accounting scandals at several major public companies completely eroded the confidence of the American public in the integrity of the financial reports of publicly-traded companies. The collapse of Enron Corp. and WorldCom Inc. merely highlighted what the public viewed as a steady stream of corporate malfeasance.

In response to this perceived crisis, Congress overwhelmingly enacted the Sarbanes-Oxley Act of 2002 (the act was approved by the House of Representatives by a vote of 423-3 and by the Senate by a vote of 99-0). Named after the bill’s sponsors, Sen. Paul Sarbanes of (Democrat-Maryland) and Rep. Michael G. Oxley of (Republican-Ohio), Sarbanes-Oxley established new, stricter standards for all public company boards, managements, and public accounting firms.

Major provisions

The major provisions of Sarbanes-Oxley are well-known. Sarbanes-Oxley requires that chief executive officers and chief financial officers of public companies sign off on a company’s financial reports. No longer can the CEO or CFO plead ignorance. The buck now clearly stops at the top.

Sarbanes-Oxley developed the Public Company Accounting Oversight Board, a private, nonprofit corporation, to ensure that financial statements are audited according to independent standards. The legislation also mandates that companies listed on stock exchanges have completely independent audit committees to oversee the relationship between the companies and their auditors. Sarbanes-Oxley further banned most personal loans to any executive officer or director, accelerated reporting of trades by insiders, and stiffened penalties for violations of securities laws.

Since its enactment, section 404 of Sarbanes-Oxley has been one of the most controversial parts of the law. Section 404 has two primary requirements: (1) it requires public companies to evaluate and disclose the effectiveness of their internal controls as they relate to financial reportings; and (2) it requires that the effectiveness of such internal controls be attested to by an independent outside auditor.

The concept underlying Section 404 - effective internal controls over financial reporting - is simple enough. Indeed, many companies had strong and effective internal controls in place before the enactment of Sarbanes-Oxley. What is unique about Sarbanes-Oxley is that, for the first time, companies are required to document their internal controls and verify that they are designed and operating effectively.

Oil and gas companies must pay particular attention to Sarbanes-Oxley’s internal control requirements. As PricewaterhouseCoopers recently noted, “Oil and gas and utility companies operate in an increasingly complex environment where internal control deficiencies can have an important impact on the accuracy of financial reporting. Reserves reporting, decommissioning, customer account collection difficulties, energy trading, taxation and carbon allowances are just a few of the areas posing specific challenges.”

Impact of Sarbanes-Oxley

So what has been the impact of the Sarbanes-Oxley law? Has it resolved systematic flaws in the way corporations have been reporting their earnings for decades? Or have the costs associated with Sarbanes-Oxley compliance outweighed any potential benefit of the legislation? The debate rages on in boardrooms and courtrooms.

“Four years after the passage of the Sarbanes-Oxley Act, investors and our capital markets continue to benefit from the legislation,” the bill’s co-sponsor Rep. Oxley said recently. He contends that by requiring corporate directors and executives to establish and test their internal controls to assure the accuracy of their financial statements, the law has successfully protected the investing public from fraud and deception. Supporting Rep. Oxley’s view is the fact that the number of new federal class-action lawsuits filed by disgruntled investors has dropped dramatically and is now at its lowest level since 1996, according to a recent Stanford University study.

Corporate governance experts also believe that Sarbanes-Oxley has made a significant impact on the changing nature of boardroom politics. Most experts think that corporate directors these days are taking their jobs much more seriously than in the past and spending considerable time focusing on the companies’ operations and financial statements.

This increase in director involvement is due to a number of factors, including new stock exchange listing standards that require a majority of directors to be independent of company management, a concern in light of the collapse of Enron and WorldCom that directors will be held personally liable for investor losses and last but not least, Sarbanes-Oxley’s requirements that put more responsibility on directors.

John Thain, chief executive officer of the New York Stock Exchange, spoke on behalf of many people in the business community, when he stated more than a year ago, “There is no question that, broadly speaking, Sarbanes-Oxley was necessary.”

Few business leaders will publicly disagree that some legislative reforms were inevitable in the wake of high-profile corporate accounting scandals. However, it is the cost of implementing Sarbanes-Oxley’s requirements that has led some to widespread questioning of how effective or necessary the specific provisions of the law truly are.

Do the costs outweigh the benefits?

There are, without question, significant costs associated with Sarbanes-Oxley compliance. These include internal control costs, accounting fees, and an increase in directors and officers liability insurance premiums. These are costs that most companies pass on to customers as higher prices. These are also costs that for small companies can wipe away any operating profit.

“Sarbanes-Oxley compliance is a real pain,” said one executive of an oil and gas company. “You have to devote considerable resources to make sure you comply with the law. In addition to employees who focus solely on compliance issues, you have to hire a bunch of accountants and lawyers. It is incredibly expensive to do so.”

Expensive indeed. According to a survey conducted by Financial Executives International, a networking and advocacy organization, publicly traded companies spent an average of $4.36 million annually to comply with Sarbanes-Oxley. Other surveys put the costs of compliance much higher.

Respondents to a 2005 Ernst & Young LLP cross-industry survey indicated that Sarbanes-Oxley compliance costs were more than 50% higher than originally estimated. Not surprisingly, an entire cottage industry of companies offering Sarbanes-Oxley compliance services has blossomed to take advantage of the unique marketing opportunity.

In addition to the enormous compliance costs, a common complaint from business leaders is that Sarbanes-Oxley has diverted and distorted management time and priorities. Top executives and board members are spending more time trying to avoid Sarbanes-Oxley liability than focusing on how to create shareholder value.

Critics of Sarbanes-Oxley also claim that the law has had a substantial impact on the nation’s financial markets. Because of the costs and rigors of Sarbanes-Oxley compliance, some companies that might have gone public have not. And many companies that once looked to the US markets to raise capital have, instead, rushed to markets abroad. Nine of the 10 largest initial public offerings last year, and 24 of the 25 largest public offerings in 2004, were conducted in overseas markets. This contrasts with the 1990s, when nearly all initial public offerings were done in the US financial markets.

What lies ahead?

Small businesses, in particular, have complained bitterly about the costs of complying with Sarbanes-Oxley. Even the law’s proponents acknowledge that there need to be some reforms made with respect to small businesses. The concern is that the law’s audit requirements are so expensive that they will likely wipe away small companies’ operating profit and force companies to go private to avoid the expense.

In May, the Securities Exchange Commission said it would not exempt small companies from the Section 404 regulation, but would instead issue better guidance on how to comply with it. Small companies were supposed to start reporting on whether their financial controls promote accurate reports and prevent fraud in mid-2007. The SEC agreed to postpone the deadline for small businesses to comply with Sarbanes-Oxley until the end of 2007.

Hank Paulson, the former head of Goldman Sachs worldwide who left that position earlier this year to become the new Secretary of the Treasury, has suggested that Sarbanes-Oxley has caused too much damage to United States competitiveness internationally and should be revised. Congress, however, has shown little interest in revisiting the law.

Although there might be some cosmetic changes made to Sarbanes-Oxley in the near future, most corporate governance experts believe Sarbanes-Oxley is here to stay.

“Companies are going to have to stop complaining and realize that Sarbanes-Oxley is simply another cost of doing business. There is nothing we can do about it,” said one oil and gas executive.

Although the jury may be still out on the ultimate success of Sarbanes-Oxley, there is no question the legislation will play a pivotal role in the foreseeable future in trying to restore investor confidence in the financial results publicly-traded companies report.

The author

Andrew Edison is a partner in the trial section of Bracewell & Giuliani LLP, based in Houston. He can be reached at 713-221-1371 or [email protected].

For Sarbanes-Oxley help, go to www.business.gov

The US Small Business Administration has created a single web site - www.business.gov - that businesses can turn to for federal compliance information, including questions related to the Sarbanes-Oxley Act. The new site is scheduled to be launched in October.

The Small Business Administration manages the site, which is intended to help small- to medium-sized businesses, in a partnership with 21 federal agencies. The goal is to help companies save time and money spent searching for compliance information.

Business.gov contains keyword compliance searches, industry- and topic-specific searches, access to more than 120,000 compliance-related documents from 94 government web sites, and compliance contracts for each government agency.

The goal is to provide quick and focused compliance search results, a comprehensive catalog of federal government forms, a directory of knowledgeable government contacts, and links to key industry resources and “how to” information related to your business.

Originally launched in 2004, the site contained information on starting, managing, growing, and getting out of a business. The new focus on compliance information was driven by the requests of small business owners.

Future enhancements to www.business.gov will include state and municipal government compliance information. In addition, users will be able to customize the site to their specific needs.