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Sarbanes-Oxley: Unintended Consequences
The United States has a new accounting law to deter corporate scandals, but the consequence of this law could make American markets less attractive to global investors. Thunderbird accounting professor Thomas I. Selling, Ph.D., CPA and member of the advisory board of the Association of Audit Committee Members explains the potential consequences.
Enron, Tyco, Kmart. While everyone is familiar with the accounting scandals of these companies, a new accounting law has now gone into effect to bring honesty and transparency back to the US capital markets. The law is known as Sarbanes-Oxley and it is the biggest change in US financial reporting in the last 70 years. Sarbanes-Oxley is a restructuring of accounting responsibilities, corporate governance requirements and penalties for top executives, board members and auditors.
Sarbanes-Oxley is actually the Public Company Accounting Reform and Investor Protection Act of 2002, sponsored by Paul Sarbanes, a Democratic Senator from the state of Maryland. At that time, Sarbanes was the chairman of the Committee on Banking, Housing and Urban Affairs in the Senate. The cornerstone of the Sarbanes bill was mandatory auditor rotation, which was vigorously opposed by the American Institute of Certified Public Accountants (AICPA), the lobbying group of the accounting profession. The theory behind mandatory auditor rotation was that successor auditors would have a strong economic incentive to be thorough in their initial work so as to avoid exposure to blame for negative restatements occurring on their watch. The really interesting part is the effect this has on the predecessor auditor, who anticipates the zeal of the successor and tries to avoid blame being placed on itself by making sure that the decks are clear before the handover. It’s not hard to imagine why the AICPA would oppose such a change, and they argued in public that the costs of auditor change would far exceed the benefits, which moreover have never been demonstrated.
Into the breach stepped Michael Oxley, a Republican Representative from the state of Ohio and well-known supporter of the accounting profession. Oxley was also the Financial Services Committee Chair in the House. Most of the burdensome responsibilities on corporations in the Act —CEO/CFO certification, management’s report on and auditor’s attestation to internal controls, new board and audit committee requirements to name a few —were added by Oxley in exchange for eliminating the requirement of mandatory auditor rotation. Sarbanes-Oxley was unanimously passed in the Senate, approved in the House, and signed into law by President George W. Bush on July 30, 2002.
With the new law, the following major changes have gone into effect:
• Prohibition of loans to directors and executive officers
• Forfeiture of bonuses and trading profits after a financial restatement
• CEO and CFO certification of financial reports exposing them to additional civil liability and potential criminal liability
• New audit committee requirements to consist solely of independent directors, establish “whistleblower” protection and procedures, and to have at least one “financial expert” on the committee
• Accelerated filing of reports to the SEC and new disclosure requirements
• Limitations on the use of “pro forma” numbers (e.g., EBITDA) in company communications and reports
Consequences?
While Sarbanes-Oxley is still new, it will take some time to fully analyze its costs and benefits. However, it already has had a significant impact on corporate behavior and capital market regulation in other countries. For example, the Israeli Government Companies Authority has adopted part of Sarbanes-Oxley and will apply it to companies under its jurisdiction. As reported in the February 25, 2004 edition of Israel’s Business Arena, the Government Companies Authority notified accounting firms and auditors about a key guideline: Chairmen, CEOs and CFOs of government companies must sign declarations attesting to the veracity of financial reports.
Though Sarbanes-Oxley could be seen as a model by other regulators, it is already having unintended consequences for the American economy. In the pre-Sarbanes-Oxley era, the SEC made numerous concessions to foreign companies who wanted to list in the US or to acquire American companies. In many respects, their financial reporting, disclosure and corporate governance requirements were limited to those applicable in their home countries. These concessions helped to make the US markets attractive to foreign companies and foreign investors. This also made the American stock exchanges competitive with other world exchanges, which helped to create more capital and investment in the US.
However, Sarbanes-Oxley makes no exceptions for foreign companies who have, or would like access to US capital markets—although SEC regulations have made some minor technical adjustments. Not only do foreign companies have to comply, but also compliance and the penalties and personal costs are very high if they do not. A trade publication, The Accountant, reported in a February 26, 2004, article that European companies listed on American Stock Exchanges will have a 35% rise in audit costs to comply with Sarbanes-Oxley, per a survey conducted by HandySoft and MarketingUK. Directors' and officers' insurance was also expected to soar and parallel the sums spent annually on audit fees.
To combat this, European companies are forming a campaign to lobby the SEC to make it easier for European companies to stop complying with US securities laws, as reported by the International Herald Tribune in a February 12, 2004 article. In a letter to SEC chairman William Donaldson, 11 organizations claimed they represented 100,000 European companies including more than 100 whose securities are traded in the United States, and asked for changes that would make it easier to de-list with the SEC. The letter was signed by European business leaders—including Alain Joly, the president of the European Association for Listed Companies, and the chairman of the supervisory board of French company Air Liquide.
The early effects of Sarbanes-Oxley can already be seen in data on recent initial public offering (IPO) activity. While a recovery of IPO activity in the US is now occurring, it is mostly among American companies. New listings of foreign companies are now a relatively rare occurrence—especially from the perspective of the previous five years when the number of foreign issuers increased twofold to approximately 1,600. A February 23, 2004 article from the Financial Times reported, “New listings by foreign companies in US markets have dropped sharply since the passage in 2002 of the Sarbanes-Oxley act. And among foreign companies already listed on US markets, many would like to escape the burdens imposed by the act's requirements, which have roughly doubled the cost of a US listing.”
Not only does Sarbanes-Oxley make US stock exchanges less attractive, but it makes acquisitions of US public companies by foreign firms more expensive. If the foreign acquiror is not listed in the US it will be difficult, if not impossible, to issue its own shares to the selling shareholders of the US firm. This is because US laws require registration of the foreign company shares with the SEC before the transaction can take place. Registration entails, among other things, full compliance with Sarbanes-Oxley.
While Sarbanes-Oxley is relatively new, its costs have been quite dramatic in terms of diminished foreign IPO activity in the US, cost for all companies to comply, additional constraints on foreign acquisitions of US companies, and the evidence that other countries are adopting parts of the law for their own capital markets. Only time will tell whether this law actually restores the faith of investors in the honesty and transparency of companies who offer their securities to the general public.
Thomas Selling, Ph.D. is an associate professor of accounting at Thunderbird. He is currently an advisor on the Advisory Board of the Association of Audit Committee Members and a former Securities and Exchange Commission (SEC) member. He can be reached at sellingt@t-bird.edu. Thunderbird Alumna Kristina Grammatico ’01 provided research assistance.
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