The SEC Takes a First Step Toward Reform
Friday, December 15, 2006
The Sarbanes-Oxley Act, particularly the notoriously inefficient implementation of its Section 404, has become a synonym for wasteful expense, bureaucracy and paperwork. On Wednesday, the SEC moved toward a remedy.
Since the costs it imposes greatly exceed the benefits, Sarbanes-Oxley implementation is by definition bad for investors. This is despite its intention to “protect investors.” It is also bad for the international competitiveness of American business and capital markets.
Sarbanes-Oxley was a bipartisan overreaction to the scandals of its day, almost five years ago. Responding to much intense criticism of the results, the SEC took a first step in reform on December 13. By a bipartisan 5-0 vote, it proposed guidance to try to redress the imbalance of costs over benefits. Better late than never.
Auditors can reduce their risk of being blamed for problems—and expand their profits—by forcing their clients to pay for more and more elaborate audits.
The SEC proposed new official guidance to companies about how to comply with the law. The proposed guidance is intended to reduce compliance costs and provide more flexibility, especially for smaller companies. The idea is to focus the review activity required by Sarbanes-Oxley on the search for, and identification of, material risks—the kind of problems that could change an investor’s view of a company. At the same time, ideally, the rules would not require expensive paperwork in situations where it’s unlikely to have any benefit. The PCAOB is scheduled to announce a related revision next week.
In the panic that followed the Enron and Worldcom scandals and the destruction of “Big Five” accounting firm Arthur Andersen, auditors became extremely risk averse. Thanks to Sarbanes-Oxley’s section 404 requirements, the auditors can reduce their risk of being blamed for problems—and expand their profits—by forcing their clients to pay for more and more elaborate audits. Another aim of the proposed new SEC guidance is to re-balance control over 404 audits between auditors and managers.
Yesterday’s vote is symbolically important as a public, official recognition of the need for reform. Everyone should hope that the new guidance will achieve its goals. But we need to observe how it will work in practice as it moves through the regulatory bureaucracies and the accounting firms, who have in practice become assistant regulators.
The historical context is that Sarbanes-Oxley and its implementation followed the time-honored tradition of imposing costs on everybody—including the innocent 99 percent—to try to avoid repetition of the scandals caused by a guilty few. The lessons of financial history are clear: these overreactions never prevent the next scandals when the fever of the next financial boom or bubble sets in, and Sarbanes-Oxley won’t either. But the costs imposed are ongoing and real—not only the cash costs, but also the opportunity costs.
Surveying the many ebbs and flows of financial history, the economist Charles Kindleberger observed, “The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom.” This fact of human nature is unlikely to be changed even by an infinite number of accounting procedures, or a vast library of three-ring binders filled with risk control memoranda. Fraud will remain illegal, but will cyclically emerge.
Reforms enacted in the wake of a boom turned to bust typically focus exclusively on trying to prevent downside outcomes, and this pattern has repeated itself in the 21st century. But the real contribution of enterprise and capitalism is to create the upside. Carl Schramm in his new book, The Entrepreneurial Imperative, suggests this deficiency of Sarbanes-Oxley: “its thesis seems to be that successful business firms are founded exclusively on processes and controls.” This “erroneously presumes that bureaucracy is the font of superior performance,” thus “fostering risk aversion and undermining a key cog of entrepreneurial capitalism: risk.”
The SEC has taken a positive step, but Congress needs to stay involved. Just as the act was a bipartisan overreaction, perhaps its reform can be a bipartisan project. Bloomberg reported that Democratic soon-to-be Speaker of the House Nancy Pelosi has stated that there need to be changes in Sarbanes-Oxley, especially for smaller companies. Democratic Senator Chuck Schumer co-authored a Wall Street Journal op-ed arguing for re-examination of the act. Republicans Tom Feeney in the House and Jim DeMint in the Senate have already introduced reform bills. Both namesake Democrat Paul Sarbanes and Republican Mike Oxley are retiring from the Congress.
As these discussions and comments on the SEC’s proposal proceed, remember that accounting firms have a strong financial incentive to defend the expense and paperwork that are at issue. We need to fix mistakes made nearly five years ago. The journalistic rhetoric that this effort to cut deadweight bureaucracy amounts to “weakening standards” or “rolling back accountability” should be dismissed.
We need to realize that America no longer has an international competitive advantage in natural resources, labor, capital or knowledge. However, we do have a continuing advantage in social infrastructure: the rule of law, property rights, political stability, financial markets and keeping a lid on stifling bureaucracy. This advantage is being weakened by the bureaucracy, cost, and accountants-rampant generated by Sarbanes-Oxley.
The SEC has taken a first step. The Congress should not relax, but keep working on more fundamental reforms.
Alex J. Pollock is a Resident Fellow at the American Enterprise Institute.