William J. Carney, the Costs of Being Public After Sarbanes-oxley: the Irony of "going Private"

• Citation: Vol. 55 No. 1
• Publication year: 2006

THE COSTS OF BEING PUBLIC AFTER SARBANES-OXLEY: THE IRONY OF "GOING PRIVATE"

William J. Carney^*

The enactment of the Sarbanes-Oxley Act (SOX) in 2002 may represent the final act in regulation of corporate disclosure.¹By that I mean that the costs of regulation clearly exceed its benefits for many corporations. When Congress originally enacted the Securities Acts in the 1930s, one justification given was that these laws would restore investor confidence and allow businesses to raise capital once again.²The relevant question today is whether regulation has gone so far as to force honest businesses, at least those of modest size, to consider abandoning public markets for less regulated private markets. Similar questions arise with respect to foreign issuers that have the option of foreign markets of increasingly competitive quality.

In an economically rational world we would not want to prevent all fraud, because that would be too expensive. Instead, the goal should be to keep spending on fraud prevention until the returns on a dollar invested in prevention are no more than a dollar. There is an "[o]ptimal [a]mount of

[f]raud."³We have never before had such an opportunity to look at compliance costs for all of securities regulation, because so much of it is embedded in existing accounting and legal systems within firms that we can no longer estimate it easily.⁴The introduction of new and substantial regulation in this area now offers a unique and natural experiment in costs and benefits of such regulation.

These new procedures will not prevent all or even most financial fraud.⁵

Section 404 of SOX, the principal factor in increased costs, deals strictly with financial statement issues, and leaves the rest of corporate disclosure untouched.⁶Prior to SOX, financial fraud was already illegal and subject to both civil liability and criminal penalties. Section 404 mandates greater attention to accounting controls in the wake of Enron and WorldCom- apparently without recognizing that such controls have always been with us and still failed to prevent these meltdowns.⁷All internal control systems can be defeated by a conspiracy among employees to commit fraud, so section

404 becomes a due diligence standard rather than antifraud protection.⁸The other reform initiatives from the SEC thus far mostly involve acceleration of periodic filings that were already required.⁹Estimating the benefits of new regulations is much more difficult, and can only be approached indirectly.¹⁰I do so here by looking at the possibility of exit from U.S. public markets (presumably attractive to most companies) because of increased (and cumulative) regulatory costs that exceed the benefits that these firms perceive.

There is certainly anecdotal evidence that the increased cost of regulation is forcing some smaller issuers out of public markets.¹¹The process of "going dark" through termination of reporting under the securities laws is said to impose a liquidity penalty of about ten percent upon announcement.¹²Once a company has reduced its shareholders below three hundred it can terminate its registration under the Securities Exchange Act.¹³Termination of registration does not mean the end of trading activity. Brokers and dealers can continue to trade a stock in the "Pink Sheets," which are a poor substitute for the more complete and instantaneous information of other trading systems.¹⁴Trading in this market can occur if the issuer furnishes (makes "publicly available") information comparable to that required by '34 Act reporting, except there are no requirements that financial statements be audited and there is no SEC filing or review.¹⁵Companies traded in this manner are not subject to the requirements of SOX.¹⁶In many cases even this limited amount of trading will not exist, as ownership is concentrated in a relative handful of stockholders. So the alternatives to SOX are trading with a lower level of disclosure or no access to public trading markets for shareholders. Ultimately we must ask why an increasing number of companies are finding these alternatives attractive. This Article makes no attempt to estimate the benefits of SOX, except to note that securities fraud was already illegal and subject to severe penalties prior to the law's enactment.¹⁷The main impact of SOX, then, may be to require controls that would not otherwise be selected absent a statutory mandate.

I. THE COSTS OF SOX

A. The Major Shifts in Compliance Activities

The earliest change imposed by SOX on executives involved the section

302 requirement that Chief Executive Officers (CEO) and Chief Financial Officers (CFO) certify the accuracy of financial statements.¹⁸This has created a daisy chain effect in which these officers require lower-level employees to certify accuracy of those portions of the financials for which they are responsible, and is creating a practice of a series of meetings down the line to discuss control issues.¹⁹The law also forbids corporate loans to officers and directors,²⁰requires issuers to disclose a code of ethics for senior financial officers or explain why one has not been adopted,²¹and prohibits adverse employment actions against whistleblowers.²²But this is just the start, as section 404 requirements kick in, which require assessment of internal controls.²³Corporate controllers and inside counsel are involved in creating checklists of disclosure issues for operating divisions, which have individual disclosure committees at many companies, although the SEC only recommended them and did not require them.²⁴Control issues are being discussed down the ranks in many corporations, as documentation of controls of even routine small transactions becomes more important.

Requirements of evaluation of internal controls may require retention of outside firms to assist in this process.²⁵Assisting in developing internal control evaluation systems has been a booming industry for consultants. One firm, for example, recommends having the CEO head the team for developing these controls, and using a task force including representatives from finance, accounting, information technology, legal, and internal audit departments.²⁶It further recommends that persons in operations, such as sales and collections, be involved in assuring that controls assure accurate revenue reporting.²⁷

Another dramatic change involves audit committees. While SOX requires listing organizations to require audit committees,²⁸regulations for OTC Bulletin Board companies do not.²⁹SOX requires that all reporting companies either have a "financial expert" on the audit committee or provide an explanation for the absence of such an expert.³⁰That is effectively a mandate for all companies; explaining the absence of such an expert is like answering the question if you've stopped beating your wife-addressing the question is a fatal admission. In any event, the increased responsibilities for audit committees will inevitably add to meeting and preparation time, and ultimately to directors' fees. SOX invited audit committees to retain separate outside counsel, although it is too early to know to what extent this will occur.³¹

Acceleration of disclosure obligations has proceeded at a steady pace. Regulation FD, requiring simultaneous release of information to the entire world, was only the start.³²Accelerated filings on Form 4 for insider trades was another piece.³³Form 8-K has been expanded in coverage, and filing deadlines have been shortened.³⁴For accelerated filers able to use Form S - 3 the time for filing Form 10-Q is being reduced from f o r t y- f i v e days to t h i r t y- f i v e days after the close of a quarter.³⁵The time for filing Form 10-K is being reduced from ninety to sixty days.³⁶Whistle-blowing regulations create another accelerated disclosure obligation.³⁷If the board receives a report from its audit committee that a material illegal act has occurred, it must inform the SEC of this information within one day.³⁸All these pressures for accelerated disclosure create greater risk of inaccuracy, with its attendant liabilities.

At the same time that requirements are more onerous, the penalties for violations have increased to as much as twenty years of imprisonment and fines as large as $ 5 m illio n for willful violations, an increase from ten years and $l million.³⁹This is coupled with an increase in the number of prosecutions of corporate executives and, in some cases, even lower level employees.⁴⁰A recent survey showed that thirty-six percent of companies now have a chief compliance officer to deal with reporting issues, creating yet another layer of bureaucracy and cost for smaller companies.⁴¹Companies also report that general counsel are spending significant amounts of their time on SOX compliance.⁴²

B. The Empirical Evidence of Compliance Costs

1. The Emerging Evidence of Costs

One of the major costs of SOX compliance will not show up directly in income statements because it is the opportunity cost of compliance with the executive certification requirements of section 302,⁴³and the corresponding requirements of company certification of its internal controls in section 404.⁴⁴

There are reports of increased staff meetings to discuss potential disclosure items at several levels within companies, along with increased attention from general counsel.⁴⁵Control requirements are leading to demands for more separation of functions, increasing administrative head counts for smaller companies where one employee formerly performed multiple functions.⁴⁶

Litigation costs will rise with rising disclosure costs, as reflected in insurance premiums. One recent study shows that the cost of D&O insurance has risen by 25% to 40% for companies with healthy balance sheets, and as much as 300% to 400% for companies with financial troubles.⁴⁷

Auditors face additional costs that will be passed on to client firms. As one example, large accounting firms must undergo annual quality reviews, while smaller firms...