Blaming SOX (Again)

Fitting that on Christmas morning we find ourselves back at the beginning.  This Blog began as a prosoxblog, dedicated to ensuring accurate and complete discussion of Sarbanes Oxley.  We return to the subject because of an editorial in the WSJ on the topic from earlier in the week.

After the adoption of Sarbanes-Oxley back in 2002, the knives came out as pundits blamed the Act for everything from a decline in the number of IPOs to the number of companies "going dark," to the increase in listings on the London Stock Exchange.  Most of these charges were wrong or at least misleading.  These were addressed in Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.   The criticism died down both because the empirical underpinning for the claims proved incorrect and because the constant stream of corporate wrongdoing (Enron followed by the backdating scandal followed by the subprime loan scandal) made arguments for weakening governance regulation must less credible.

Notwithstanding this evolution, some still occasionally try to blame SOX for all that is wrong with corporate America.  An example occurred in the WSJ on Monday.  The editorial, Washington Is Killing Silicon Valley, was full of unsubstantiated, largely discredited, claims about the impact of SOX (and, incidentally, the system of corporate disclosure).  The one piece of empirical evidence in the piece concerns the decline in the number of public offerings.  As the piece notes:

• The new laws and regulations have neither prevented frauds nor instituted fairness. But they have managed to kill the creation of new public companies in the U.S., cripple the venture capital business, and damage entrepreneurship. According to the National Venture Capital Association, in all of 2008 there have been just six companies that have gone public. Compare that with 269 IPOs in 1999, 272 in 1996, and 365 in 1986.

The cause?  Why SOX of course. As the article notes:

• For all of this, we can first thank Sarbanes-Oxley. Cooked up in the wake of accounting scandals earlier this decade, it has essentially killed the creation of new public companies in America, hamstrung the NYSE and Nasdaq (while making the London Stock Exchange rich), and cost U.S. industry more than $200 billion by some estimates.

It takes a significant amount of termity to blame SOX for a weak IPO market when the stock market has fallen 40%, investors are fleeing in droves, and the blame mostly rests with excessive risk taking by corporate management. 

But let us examine the allegations a bit more closely.  First, it doesn't explain how SOX "killed" public companies or limited the stock exchanges. It's important to identify the grievances in SOX because usually they are not in SOX at all.  Thus, there are plenty of people who complain about the requirement that the board of a public company include a majority of independent directors and have three standing committees (nominating, audit and compensation), all made up of independent directors.  Yet these requirements are not in SOX at all but were imposed by the stock exchanges themselves.

SOX mostly regulated accounting firms and strengthened audit committees.  Other than requiring audit committees with independent directors as a listing standard, SOX had little or no impact on the stock exchanges.  The Act did require officer certification of financial statements and did require accounting firms to examine each company's internal controls but the requirement has largely not applied to smaller public companies.  Moreover, while there was considerable concern (and expense) initially, the SEC (and the PCAOB) has backed off the requirements to some degree.  Moreover, there is general agreement that much of the accounting attestation process has become more efficient and less expensive.

But the real weakness is in the data itself.  For one thing, the data in the editorial shows that the number of IPOs was already in decline by the time the late 1990s rolled around.  In other words, there was something going on that was causing a decrease and it wasn't SOX.  For another, the data apparently comes from a study done by the NVCA along with Reuters.  Sure enough, the study reports that through the first three quarters of '08, there have been only six IP0s of "venture-backed companies."

The same study, however, shows that in 2002 there were 22 IPOs, a number that increased to 29 in 2003, 93 in 2004, 57 in 2005, 57 in 2006 and 86 in 2007.  In other words, until 2008, the lowest ebb of IPOs preceded the adoption of SOX and, with the adoption of SOX, the numbers increased.  The data, therefore, does not show that a decline occurred after the adoption of SOX.  Quite the reverse.  The number of IPOs increased after the adoption of SOX. 

In the end, SOX improved governance.  If there is a serious problem with SOX, it is that it did not go far enough.  That is what the latest set of scandals demonstrates.

Comments

[John Blackshire]

If SOX was implemented properly it would not have been seen as a big cost. Most of the accounting firms are still concentrating on the details, i.e. looking at the payroll process, testing every IT general control.... They refuse to address risk assessment and the entity level controls that make senior management and the board accountable.

The entity level controls, like the committees of the board of directors, are the most important controls. They actually protect the organization against the biggest risks.

The most recent example of a failure of internal controls was Madoff. I would guess that none of the people that fell victim to Madoff had the risk management controls in place that would help to assure the investor would be protected. Did any of the major investors look at Madoff's audited financial statements and did the auditors report cover internal controls? No...they did not. Did any of these investors have an independent analyst review the results of each money manager to determine if the results were believable???

The boards of the non-profits should look at their actions and maybe they should be held responsible for the losses. We all should be responsible for our actions. jb

[J. Robert Brown]

I agree with the comments. Of course, the non-profits are not public entities so will always be treated differently. Nonetheless, some of the SOX provisions probably ought to be extended to them. For me, the main failing of SOX is that it does not address risk controls at all. As a result, you can have audits that as you say refuse to examine risk controls.