WASHINGTON, DC – The U.S. Supreme Court is expected to hand down a decision affecting the Sarbanes-Oxley (SOX) act of 2002 soon. The Sarbanes-Oxley Act more than quadrupled corporate auditing costs for public corporations. Passed in response to the slack auditing that allowed companies such as Enron to appear healthy when they were not, SOX proved so costly that some public companies went private again, while it also reduced the number of companies going public.
That effect is still being felt in the venture financing industry, where a successful IPO is a coveted exit. We’ve heard from a number of smaller venture-backed firms that the cost of going public now means they aimed at a merger or acquisition exit from the start rather than for an IPO.
The case before the Supreme Court, says the Competitive Enterprise Institute (CEI) whose attorneys are service as co-counsel, mounts a constitutional challenge to the Public Company Accounting Oversight Board (PCAOB), the accounting regulatory body created by the law.
Negative impact on entrepreneurs
The CEI argues that the way in which the PCAOB board members are appointed violates the Appointments Clause of the U.S. Constitution. Namely, that PCAOB officers, who wield a great deal of regulatory power over businesses and industry-wide accounting practices, are “principal officers of the United States” who must be appointed by the President, with advice and consent of the Senate or by an agency head, as required by the Appointments Clause.
CEI says, “This requirement was intended by the Framers to instill a high level of accountability for officials who wield such vast powers. Although the PCAOB is a striking constitutional anomaly – a case of an independent agency (Securities and Exchange Commission) appointing an equally powerful independent agency – it’s a case that will also potentially change, for the better, how other government officials and regulatory bodies are answerable to the American people.”
CEI notes that SOX has had a negative impact on entrepreneurs and inventors.
Fewer IPOS
CEI says SOX permanently reduced the number of companies going public, increased the size of companies going public, and had a negative effect on job creation and economic growth. It also caused many foreign firms to stop listing on U.S. exchanges.
According to a 2009 Renaissance Capital report, IPO issuance in 2008 and 2009 is lower than any period since the 1970s, when business creation struggled against inflation, high interest rates and the Vietnam War.
Also, data compiled by Jay Ritter of the University of Florida show the number of U.S. IPOs were lower in every year after SOX was enacted in 2002 (2003 to present) than in every year of the decade from 1991 to 2000, including the early ’90s recession years. For instance, in the post-SOX boom year of 2006, there were 162 U.S. IPOs. Yet in 1991, a year when the U.S. was mired in recession but did not have SOX, there were 295 U.S. IPOs.
Bigger IPOs
The sheer size of companies going public has also increased, in large part because a company needs to be pretty big to afford the accounting costs that have shot up fourfold as a result of SOX, according to a summary of research in the Sarbanes-Oxley Compliance Journal.
According to Business Week, the median market cap (as measured by number of shares times share price) for a company doing an IPO was $52 million in the mid-‘90s. Today, it has shot up $227 million. Google had a $1 billion market cap when it went public of 2004. And Facebook still hasn’t gone public, despite having an estimated market cap of nearly $10 billion.
That means, says CEI, that budding Microsofts can no longer go public to raise money for growth. They must wait until they’re as big as a Google to go public. That forces firms to seek financing through debt, which is especially difficult in the current credit crunch.
CEI notes that evidence suggests that we were able to recover more quickly from the early ‘90s recession because an actual increase in companies — from Starbucks to Cisco — issuing IPOs. But SOX forecloses that possibility and makes for a longer recovery.
Accountants full employment act?
CEI also maintains that the PCAOB has stretched Sarbox’s requirement that auditors “attest” to a company’s internal controls over financial reporting in the law’s Section 404 to require a full-blown audit of trivial items that could remotely effect a financial statement. “This has turned the law into the “Accountants Full Employment Act” and the reason the Big 4 accounting firms lobby so hard against even minor rollbacks in Congress,” says CEI’s John Berlan, director of its Center for Entrepreneurs and Investors in a memo.
SOX was Hell for a company like Google
Even companies large enough to mount and IPO such as Google, faced difficulties with SOX.
According to John Battelle’s book The Search, considered a definitive history of Google Inc., Sarbox was “hell for a company like Google, which made its money literally pennies at a time, from millions upon millions of micro-transactions.”
Battelle reports that Sarbox compliance significantly delayed Google’s IPO. “According to engineers involved in the work, Google had to significantly restructure its advertising report system from the ground up.” If this was difficult for a company like Google, imagine what a burden it is to smaller companies.
SOX ineffective in fighting fraud
University of Minnesota accounting professor Ivy Zhang found that the law has cost the American economy $1.4 trillion in direct and indirect costs.
Almost as important is that Zhang and other researches have found that Sarbox has had no quantifiable benefits in fighting fraud. The PCAOB has done little or nothing about in telling accountants how to handle accounting for the off-balance sheet entities at issue in Enron that resurfaced with Lehman and other companies. Countrywide Financial, now charged by the SEC with accounting fraud, actually won an award for its Sarbox compliance from the Institute of Internal Auditors in 2007.
There is bipartisan support in Congress for regulatory relief from SOX.
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Peter Thiel, venture capitalist and first outside investor in Facebook, “The IPO window is almost closed and I think in part, this is a response to Sarbanes-Oxley to the ways in which being the CEO of a public company is simply no fun anymore. They’re subject to insane levels of scrutiny. You’re not able to pursue any sort of multi-year corporate strategy and instead you are held to a quarter-by-quarter earnings schedule which is ultimately quite detrimental to long-term planning.” bigthink.com/ideas/17716
Carl Schramm and Robert Litan, president and vice president of Kauffman Foundation, leading foundation on research in entrepreneurship: “Compliance with the Sarbanes-Oxley Act of 2002, in particular, has proven to be far more expensive for smaller companies than originally intended or forecasted. Since shareholders are the intended beneficiaries of Sarbox, why not let them vote on whether their company needs to comply with some or all of its provisions—the expensive requirement for auditing of internal controls, in particular.
We suspect that many shareholders would choose some form of opt-out, and in so doing, would enable more growing companies to continue growing as independent firms, rather than being bought out by larger companies that can intentionally or unintentionally rob the firms of the entrepreneurial magic that made them successful in the first place.” online.wsj.com/article/SB10001424052748704013004574517303668357682.html
Commentary on the Daily Caller: Sarbox reform would boost our economy, but even small reforms (such as small company exemptions) are being blocked by the powerful accounting lobby: dailycaller.com/2010/02/02/obama-can-aid-small-businesses-by-providing-regulatory-relief/
CEI study, “SOXing It To The Little Guy,” detailing Sarbox’s cost to Main Street entrepreneurs and investors.
Jack Welch, General Electric CEO responsible for turnaround in 80s and 90s. ”Small companies with all these financial controls that are in there now and the penalties that go on with small entrepreneurial companies, it’s tough.” Interview with Tavis Smiley.www.pbs.org/kcet/tavissmiley/archive/200504/20050426_welch.html
