After months of vociferous complaints and plenty of hand wringing about Sarbanes-Oxley, the SEC is giving several clear indications that it’s finally feeling business’ pain.
Although concerns are varied, the crux of the issue is generally cost. Tom Lehner, director of public policy at the Business Roundtable, an organization of more than 150 CEOs from large US public companies, says several blue chips are paying over $10 mn to comply with Sox. General Electric has publicly stated that management’s assessment of internal controls – the crux of Section 404 – cost it $30 mn. And Tracey Pierce, head of international business development at the London Stock Exchange (LSE), notes that some large British firms also listed in New York have paid ‘tens of millions of pounds’ in additional compliance costs.
The real question is how far the SEC can and will go in relaxing regulations arising from Sox, which Congress enacted to quell investor dissatisfaction with public scandals like Enron and WorldCom. ‘There are some competing pressures the SEC will have to balance,’ says Harvey Pitt, former SEC commissioner and now CEO of Kalorama Partners, a global strategic consulting firm. ‘Because of the extensive requirements of 404 in particular, the cost can fall disproportionately on small and mid-cap companies. In addition, there are foreign registrants that have problems complying.’
On the other hand, Pitt describes Section 404 as ‘the centerpiece of Sox’ and maintains that it’s absolutely critical. ‘If companies had been doing what they should have been doing, there would have been no need for Section 404,’ he points out.
A climate for change?
Criticism of Sox is seemingly reaching a crescendo, with even normally cautious types like corporate lawyers loudly decrying Section 404 and other new regulations. Stephen Poss, a partner with Goodwin Procter and head of the Boston firm’s securities litigation and SEC enforcement practice group, says, ‘If you wanted to write a book about Sox, you’d entitle it: When bad things happen to good companies.’ It doesn’t matter if you’re a bad company or a good company – you still have to spend a fortune on this.’
This is why the SEC’s acknowledgement that regulations arising from Sox deserve a second look is attracting so much attention. On December 16, 2004 the commission announced the creation of the advisory committee on smaller public companies, which will address a number of issues – with internal controls topping the list. In January SEC chairman William Donaldson told the London School of Economics he understood the hardships foreign issuers face in complying with US listing requirements and suggested relief might be on the way. In February the commission announced intentions to hold a roundtable discussion on Section 404 this month.
These moves are provoking a range of emotions, from glee to skepticism. Poss, for instance, is reserving judgment. ‘I’m always happy when the SEC at least makes the effort to entertain suggestions concerning the effects of its regulations,’ he comments. ‘But the proof will be whether it actually does anything about it.’
Others remain convinced the SEC will roll back some of Sox’s more oppressive and costly aspects. Bryn Vaaler, a partner in the corporate group of Dorsey & Whitney in Minneapolis, notes ‘there’s already been a bit of slippage’ on Section 404 deadlines. Specifically, in March the commission extended the 404 filing deadline for non-accelerated filers and foreign issuers to July 2006. ‘I don’t think it made the SEC look bad,’ Vaaler says. ‘It made it look reasonable and responsive to conditions out there.’
Finally, Pitt argues there’s no shame in relaxing regulations under the right circumstances. ‘There are places where rules can be tweaked, but if people are looking for a dramatic overhaul, I think they’re going to be disappointed,’ he says. ‘I don’t think expectations that the rules will be rolled way, way back are realistic.’
The little guy
One fertile area for change, adds Vaaler, is how the SEC’s new regulations affect smaller businesses. In November Vaaler attended a meeting of Minneapolis businessmen and lawyers at which Donaldson spoke. ‘You should have heard the smaller public company people in the room gnashing their teeth about a lot of this,’ he says. ‘But, to his credit, Donaldson expressed acknowledgement of the cost issues.’
Robert Kohl, one of the co-chairs of the national securities practice at Katten Muchin Zavis Rosenman, is convinced the SEC will find a way to ease the burden, especially on smaller issuers, because this is where compliance costs have hit hardest. ‘A $100 mn company doesn’t just pay one tenth of what a $1 bn company pays for 404 compliance,’ complains Kohl. ‘It might pay half, so the proportionate costs are much heavier.’ He notes that these costs have famously driven some smaller public companies to take themselves private.
One possible solution would be to establish a modified internal control framework and standard for companies that fall beneath a certain market cap. One such framework is being developed by the Committee of Sponsoring Organizations of the Treadway Commission (Coso), notes Kohl. A simplified process would make sense, he says, because it would decrease costs.
Should such a solution be implemented, Kohl urges speed. Even though deadlines have been eased for smaller filers – those with less than $75 mn in public float – this group of companies is now beginning to spend money on Section 404. ‘If there’s going to be reform it has to be very soon to relieve the burden,’ Kohl says.
The view from abroad
Foreign issuers are also clamoring for regulatory relief from the SEC. ‘From the very beginning, the applicability of Sox to foreign issuers was a troublesome issue,’ notes Vaaler. ‘If nothing else, you run into differences in Gaap from country to country. And it’s difficult to impose US notions of internal controls globally.’
Pierce notes that European companies with dual listings in New York have expressed three main concerns: increased costs, the amount of management time spent on complying with Sox, and the risk of both criminal and civil liability in cases of fraud. But she also notes that many of the possible changes Donaldson discussed at the London School of Economics, such as a delay in reporting deadlines, which was announced in early March, would have marginal benefits at best. Of more interest, she says, is the idea the SEC might make de-listing easier. ‘Until the commission is specific on what it proposes to do, however, it’s difficult to say whether any of those concessions would benefit issuers significantly,’ she adds.
In recent years, the LSE has attracted many new international issuers. In 2004, for instance, it added 49 international IPOs, including Air China, compared with eleven at the NYSE and 18 at Nasdaq, observes Pierce. She argues that a desire to avoid the greater burdens of Sox is one reason for London’s success. ‘Issuers that chose a London listing would say capital, liquidity and profile attracted them to London,’ she explains. ‘But if asked what deterred them from New York, they’d say Sox.’
When it comes to non-US issuers, Pitt again urges companies to keep their expectations realistic. He believes non-US issuers are good candidates for regulatory reform, but he points out that the US is hardly unique in strengthening its corporate governance requirements. ‘The irony is that, all over Europe, regulators are announcing they’re going to move much closer to the Sox/SEC type standards than people were expecting,’ he says.
Ideas for reform
Given that not even the most pie-in-the-sky optimists believe the regulations spawned by Sox will simply disappear, experts are discussing what may happen. One crucial debate surrounds whether the financial and time burdens of the first year were an anomaly. Those who think so generally want the rules to be tweaked. On the other hand, those who believe Section 404 will always be expensive and laborious are demanding far more sweeping changes.
Poss, a member of the latter camp, suggests companies with a clean 404 assessment two years running should undergo the process only every three years thereafter. ‘Companies that go through the same review every year will be going through the motions, simply spending a lot of money on consultants and accountants and 404 witch doctors,’ he explains. ‘If you have had two clean years under 404, why should you spend a fortune of the shareholders’ money every year to reaudit, retest and redocument all of your internal controls and their efficacy unless something material has changed?’
Poss also believes the pass/fail nature of 404 presents a problem. ‘If you’re a company with no internal controls and weaknesses from top to bottom, your report looks just the same as that of a company with impeccable internal controls that just happens to have a material weakness in one particular area,’ he points out. ‘Under Section 404, the corporate jaywalkers are put in the same holding pen as the hardened criminals.’ He’d therefore like to see more context and analysis in 404 reports.
Not everyone believes fundamental change to Sox rules is warranted, however. The CEOs of the Business Roundtable are not looking for a major rollback of Sox, according to Lehner, but for ways to make the rules more efficient. Here, the timetables are a prime target. Poss suggests one way to lighten executives’ workloads is for the SEC to allow companies to submit their 404 reports after their 10Ks rather than requiring the two reports to be completed simultaneously.
Whatever comes out of the April 404 roundtable and other initiatives, most experts agree the SEC’s willingness to listen and consider remedies is praiseworthy. ‘The SEC has heard people’s concerns and is doing its best to be responsive,’ concludes Pitt. ‘In fact, the commission is doing exactly what it should be doing.’
