Securities Regulation: Accounting for the Cost of SOX
Regulation in the U.S. financial markets is objectively a rigid and mechanical process; statutes and codes define and prescribe regulatory procedures, businesses comply with these directives, and lawyers and compliance officers enforce them. However, the evolutionary process of regulation in this sector has followed anything but a scientific formula. Driven by psychology and sociology as much as it as by mathematics and economics, the financial sector appears to possess the impulses and motivations of a complex individual rather than the makings of a clear cut chemical equation.
The accounting profession, which is characterized by its members’ independence, serves an integral role in the financial regulatory machine, and unfortunately, is also not immune to such human impulses. As seen in the events surrounding Enron, when the gatekeepers, particularly accountants, are producing counterfeit keys, and allowing fraud to penetrate the inner workings of a company, the results are catastrophic.
Following this disaster, lawmakers were catapulted back into their seats, charged with the task of devising a new system to combat and deter fraudulent escapades by companies, as well as taking a closer look at the professions that by definition support these actors, law and accounting. The result amended the Securities Exchange Act of 1934 Act to include the Sarbanes-Oxley Act of 2002 (SOX). In hindsight, scholars, such as Professor Jennings of Wyoming Law School, wrestle with the psychology behind the Enron disaster. Termed a “Yeehaw Culture,” the atmosphere at Enron was characterized by pressure to maintain those numbers and that performance, fear and silence, a weak board, and other factors that paralyzed the ability for moral integrity to prevail over a culture of . The U.S. Senate Permanent Subcommittee on Investigations’ findings showed Fiduciary Failure, high Risk Accounting, Extensive Undisclosed Off-the-Books Activity, Excessive Compensation, Lack of Independence.
Legislative history demonstrates that Sarbanes-Oxley was passed very quickly and without significant debate. Criticism about this piece of legislation centers not around the legitimacy of fraud, but rather the legitimacy of any sweeping regulation that is not forced to survive significant debate. The report from the Committee on Capital Markets Regulation (the “Paulson Report,” 2006) does not call for appeal, but questions its implementation and the effect the regulatory system in the U.S. has had on the competitiveness of the U.S. markets. It also makes specific recommendations about safeguarding certain accounting firms in order to allocate risk and cost, thus protecting the investors in a more efficient and effective way.
There are many regulations to this piece of legislation, and according to The FEI 2007 study and research by the Institute of Internal Auditors (IIA) that found that “SOX has improved investor confidence in financial reporting, a primary objective of the legislation,” as well as, “indicated improvements in board, audit committee, and senior management engagement in financial reporting and improvements in financial controls,” the benefits are many.
Some specific mandates of this Act:
Title I creates the Public Company Accounting Oversight Board (PCAOB), five member board, five year terms, two term limits.
Section 302, addressing internal controls, requires the CEO and CFO to be held accountable for their financial statements.
Section 201 prohibits auditors from having interests in the firms for which they are performing services.
Section 404, addressing assessment of internal controls, requires management and the external auditor to report on the adequacy of the company’s internal control over financial reporting (ICFR); management must submit an “internal control report” as part of each annual Exchange Act report.
Analyzing the effects of this piece of legislation requires a brief discussion of the fundamentals of securities regulations. These laws determine the parameters for gaining access to the necessary capital and long-term used to sustain and grow businesses. Congresses had two purposes for originally passing the Federal Securities Laws; first, to protect investors, and second, to help honest business to get access to capital following the Wall Street Crash of 1929 . The result was the Securities Act of 1933 and the Securities Exchange Act of 1934. These statutes are premised on disclosure, and not merit, where “full and fair disclosure of all material facts” is the main objective. If disclosure is made, issuers are permitted to sell securities to the public, regardless of the prospects for success in any particular investment. Financial cost is inherent in the implementation of all regulation, and the result inevitably precludes business from those who are not able to comply. So, again, the question is what’s the benefit relative to the costs?
Other consequences include, more companies going private; U.S. share has declined significantly in the global market, and U.S. IPOs have dropped from 30% to 10%. The reality is that the markets need a more efficient way to achieve goals. This objective is difficult to measure since benefits are much more intangible and speculative, while the overwhelming costs are seen on the company’s balance sheets as well as participation in the U.S. markets as a whole. The numbers are telling. Upon implementation companies’ costs went up on average 130%, an average of $5.1 million/year, insurance premiums tripling to cover officers, accounting and lawyers fees account for much of the additional cost.
With respect to the accounting profession, the Paulson Report also notes that, “Audit firms play a key role in ensuring the integrity of financial statements and the effectiveness of internal controls of public companies. The demise of another U.S. audit firm would impose huge costs on U.S. shareholders.” To guard against such potentially crippling consequence, the Report suggests safe harbors for certain defined auditing practice, as well as a cap on liability. Advocating for such defensive measures for an industry that played a critical role in perpetuating practices that caused such a precarious state in the markets begs the question: is regulating the cost of the implementation of this legislation more important than punishing malfeasance? Of course it is necessary to mention that this question presents a false dilemma as alternatives are possible, but were arguably not given adequate consideration. Also, is avoiding criminal prosecution of corporations for the good of the industry ethically sound? To those subscribing to utilitarian thinking, this path checks out; but what about the other philosophies that charge all actors with the responsibility of acting with the good in mind at all times, and not just when it benefits the most people. Finding a path that would satisfy philosophical thinkers as well as the business world is difficult, if not impossible. Or have lawmakers and those in business world simply been operating according to a false assumption that these success in business and morality always separate and adverse? The answer to this question directly relates to how one measures and justifies costs of legislation and business operation.
Regulators being faced with the daunting task of creating reactionary measures following a financial disaster is the unfortunate trend this country has come to know well. A more proactive approach to regulation and greater attention to the intangible costs of regulation may help to undo some of the damage to US markets as well as improve the operation of SOX. Recognition of the complicated relationship between the regulations and those who enforce and carry them out, as well as a heightened awareness of the consequences of regulation prior to future financial regulatory meltdowns may also result in avoiding the criticism and incurring the overwhelming costs that the most recent examples of this type of legislation have demonstrated.
